**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

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**FORM10-K/A**

**(Amendment No. 3)**

 

**FORANNUAL AND TRANSITIONAL REPORTS**

**PURSUANTTO SECTIONS 13 AND 15(d) OF THE**

**SECURITIESEXCHANGE ACT OF 1934**

 

**(Mark One)**
| **ý** | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|------------|------------|-----------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                    |
| ** ** | ** ** | **For The Fiscal Year Ended December 31, 2004**                                               |
| ** ** | ** ** | ** **                                                                                    |
| **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**

 

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**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 Street**

**Chatsworth, California 91311**

(Address of principal executive offices)

 

**(818) 739-6000**

(Registrant’s telephone number, includingarea code)

 

Securities registered pursuantto Section 12(b) of the Act: **None**

Securities registered pursuantto section 12(g) of the Act: **Common Stock, par value$.01 per share**

 

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

 

Indicate by check mark if disclosure ofdelinquent filers pursuant to Item 405 of Registration S-K is not containedherein, and will not be contained, to the best of the registrant’s knowledge,in definitive proxy or information statements incorporated by reference in PartIII of this Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Exchange Act Rule 126-2). Yes  o  No ý

 

The aggregate market value of the shares ofthe registrant’s Common Stock held by non-affiliates of the registrant on June30, 2004 was approximately $19.9 million based upon the closing price per shareof the registrant’s Common Stock as reported on the NASDAQ National Market onsuch date. Calculations of holdings by non-affiliates is based upon theassumption, for these purposes only, that executive officers, directors, andpersons holding 10% or more of the outstanding Common Stock are affiliates.This determination of affiliate status is not necessarily a conclusivedetermination for other purposes.

 

As of February 4, 2005, the registrant had13,387,998 shares of Common Stock outstanding.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions of the registrant’s definitive proxystatement for its 2004 Annual Meeting of Stockholders are incorporated byreference into Part III of this Form 10-K.

 

 

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**NATROL, INC.**

 

**2004 ANNUAL REPORT on Form 10-K**

 

**TABLE OF CONTENTS**

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

 

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**CAUTIONARY STATEMENT REGARDING FORWARD-LOOKINGSTATEMENTS**

 

This report contains “forward looking statements.” Natrol, Inc., aDelaware corporation organized in 1980, the “Company” or “Natrol”, is includingthis statement for the express purpose of availing itself of protections of thesafe harbor provided by the Private Securities Litigation Reform Act of 1995with respect to all such forward looking statements. Examples of forwardlooking statements include, but are not limited to, the use of forward-lookingterminology such as “believes,” “expects,” “may,” “will,” “should,” “intend,” “estimate,”“assume,” “plan,” or “anticipates” or the negative thereof, other variationsthereon, or comparable terminology, or by discussions of strategy that predictor indicate future events or trends or that are not historical facts. TheCompany cannot assure the future results or outcome of the matters described inthese statements; rather, these statements merely reflect its currentexpectations of the approximate outcome of the matter discussed. The Companydoes not undertake any obligation and does not currently intend to update anysuch statements at any time in the future.

 

The Company’s ability to predict results or the effect of certainevents on the Company’s operating results is inherently uncertain. Forward-lookingstatements should not be unduly relied on since they involve known and unknownrisks, uncertainties and other factors, some of which are beyond the Company’scontrol. These risks, uncertainties and other factors may cause actual results,performance or achievements to differ materially from the anticipated futureresults, performance or achievements expressed or implied by such forward-lookingstatements. Therefore, the Company wishes to caution each reader of this reportto carefully consider the following factors and certain other factors discussedherein, including the factors discussed under the caption “RiskFactors and Factors Affecting Forward Looking Statements,” and factorsdiscussed in other past reports. The factors discussed herein may not be exhaustive.Therefore, the factors contained herein should be read together with otherreports and documents that are filed by the Company with the SEC from time totime, which may supplement, modify, supersede or update the factors listed inthis document.

 

Factors that could cause or contribute to the Company’s actual resultsdiffering materially from those discussed herein or for the Company’s stockprice to be affected adversely include, but are not limited to: (i) industrytrends, including a general downturn or slowing of the growth of the dietarysupplement industry; (ii) increased competition from current competitorsand new market entrants including but not limited to increased competition fromprivate label house brands supported by retailers seeking to increase themarket share of their proprietary house brands. Private label brands controlthe largest share of the vitamin, mineral and supplement (VMS) sector; (iii) adversepublicity regarding the dietary supplement industry or the Company’s products; (iv) exposureto product liability claims, in particular because the Company has chosen toself-insure against product liability claims due to the high price of productliability insurance, the inability to secure occurrence based coverage, as wellas the limited amount of coverage provided by insurers willing to provideinsurance at high prices; (v) exposure to and the expense of defending andresolving potential product liability claims that are left uncovered byinsurance as well as the expense of defending and resolving other litigationwhich may or may not be covered by insurance; (vi) the Company’sdependence upon its ability to develop new products; (vii)  returns of theCompany’s products which may be returned by customers at any time due to lackof sell through to consumers or because competitors have convinced the Company’scustomers that Natrol’s products should be replaced with competitor products; (viii) theCompany’s ability to manage inventory or sell its inventory before suchinventory becomes outdated, (ix) the Company’s ability to gain or expandor maintain distribution within new or existing customers and new or existingchannels of trade; (x) an increase in the cost of obtaining andmaintaining shelf space with major national retailers who demand various formsof incentives from their suppliers such as slotting fees, coop advertising, orrebates; (xi) adverse changes in government regulation or changes in localor national laws; (xii) dependence on significant customers; (xiii) theCompany’s ability to keep and attract key management employees; (xiv) theCompany’s inability to manage growth and execute its business plan, or theCompany’s ability to modify its business plan in response to market conditions,including,

 

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but not limited to, its abilityto enter into new businesses and capitalize upon new business opportunities orto divest itself of businesses that are not profitable or do not deliversufficient profit to meet that Company’s goals; (xv) the Company’s abilityto consummate future acquisitions and its ability to integrate acquiredbusinesses; (xvi) the absence of conclusive clinical studies for many ofthe Company’s products; (xvii) the Company’s inability to obtain rawmaterials that are in short supply (xviii) sales and earnings volatility,(xix) volatility of the stock market; (xx) the Company’s ability tomanufacture its products efficiently; (xxi) the Company’s reliance onindependent brokers to sell its products; (xxii) the inability of theCompany to protect its intellectual property; (xxiii) control of theCompany by principal shareholders, (xxiv) the possible sale of largeamounts of stock by controlling stockholders; (xxv) a general downturn inthe national economy as a whole; (xxvi) continued market acceptance ofNatrol supplements, Laci Le Beau teas, Prolab’s sports nutrition products, andEPI’s raw material products, (xxvii) increases in the cost of borrowings;(xxviii) and, the unavailability of additional debt or equity capital;(xix) legal actions brought forth by federal, state and local governmentaland private parties; and (xxx) the introduction of new federal, state,local or foreign legislation or regulation or adverse determinations byregulators anywhere in the world (including the banning of products).

 

There are a number of other factors affecting the Company’s business,including the following risk factors of which investors should be aware:

 

Natrol and its other brands, Laci Le Beau and Prolab, have each sold ephedra-basedproducts in past years. The volume of such sales has not been large relative tothe overall sales of the Company and as of March 31, 2003 the Companystopped selling or manufacturing ephedra-based products. The sale of ephedra-basedproducts in the United Stated was banned by the U.S. Food and DrugAdministration (FDA) in February 2004. Even so, the Company cannotguarantee that all of the ephedra-based products produced and sold to retailersare no longer on retailer shelves and unavailable for sale.

 

During 2002, product liability insurance for ephedra-based products wasgenerally unavailable. Occurrence-based product liability insurance becameunavailable during the fourth quarter of 2002. “Claims-made insurance,” thatwas available for these products, was offered to the Company only withsubstantially lower limits than the Company had carried in prior years and atrates that were many times higher than those paid in prior years. As of July,2003, the Company chose to self-insure against product liability claims due tothe high price of product liability insurance, the inability to secureoccurrence based coverage, as well as the limited amount of coverage providedby insurers willing to provide insurance at high prices. The Company cannot predictthe state of the insurance market in future years, or for that matter, whetheror not insurance will be available to the Company at any price.

 

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**PART I**

 

**ITEM1.  BUSINESS**

 

The Company’s executive offices are located at 21411 Prairie Street,Chatsworth, California 91311 and its telephone number is 818-739-6000.Company information may be accessed via the Company’s web site at http://www.natrol.com. Unless the context otherwise requires the terms the “Company”and “Natrol” refer to Natrol, Inc. and, as applicable, its subsidiaries.

 

**GENERAL**

 

Natrol manufactures and markets branded, high-quality dietarysupplements, herbal teas, nutraceutical ingredients and sports nutritionproducts under three labels: the Natrol brand, the Laci Le Beau brand of herbalteas, and the Prolab sports nutrition brand. The Company also markets highquality nutraceutical ingredients to other manufacturers of supplements orfortified foods through its Essentially Pure Ingredient (EPI) raw materialsupply division which also markets contract manufacturing services to companieswithin the nutraceutical industry.

 

The Company’s core Natrol brand focuses on supplements that are in highdemand as well as specialty niche and proprietary formulations that havepotentially strong margins. The Company positions Natrol as a premium brand ofsupplements rather than as a value brand.

 

Dietary supplements are sold primarily under the Company’s Natrolbrand. These supplements include vitamins, minerals, hormonal supplements,herbal products and specialty combination formulas that contribute to anindividual’s physical well being. The Company sells its products throughmultiple distribution channels throughout the United States. These channelsinclude domestic health food stores and mass-market drug, clubs, retail andgrocery store chains. The Company also sells its products through independentcatalogs, Internet shopping sites, and within approximately 40 foreigncountries through international distributors who purchase Natrol’s productsF.O.B. the United States. The Company’s strategy emphasizes building strongrecognition of the Natrol brand across multiple distribution channels throughan advertising strategy that includes print advertising, televisionadvertising, radio advertising and coop advertising with customers designed tobuild consumer awareness and increase the purchase of its products byconsumers.

 

Herbal teas are sold under the Company’s Laci Le Beau brand. Laci LeBeau teas are flavored herbal teas. The primary tea category is Laci Le Beau *Dieter’s* tea. The Company uses the samesales people and brokers to sell teas as it does supplements. And, as with itssupplement business, the Company’s strategy emphasizes building strongrecognition of the Laci Le Beau brand across multiple distribution channels.

 

The Prolab sports nutrition line of products is targeted to bodybuilders and health minded individuals seeking a high degree of physicalfitness. Prolab’s products include supplements designed to help theseindividuals gain and lose weight as well as improve muscle mass and muscledefinition. Prolab products are sold through fitness centers, health foodstores, and internationally, through selected distributors. Prior to October 2003,Prolab was operated as a separate operating segment with its own management andadministration. This operating segment was managed in Bloomfield, Connecticut.During 2003, the Company integrated Prolab into the core Natrol business withProlab becoming a sub-brand within Natrol similar to Laci Le Beau. Thisconsolidation was completed at the end of the third quarter of 2003 and as ofthe fourth quarter of 2003, the Company no longer reported Prolab as a separateoperating entity. As of the completion of the consolidation, all management andadministration for Prolab was consolidated into the Company’s headquarters inChatsworth, California and the only functions remaining in Bloomfield,Connecticut are warehousing and distribution.

 

The Company also sells nutraceutical grade ingredients such as garlicand arabinogalactan to other manufacturers through its EPI division. The EPIdivision also markets Natrol’s manufacturing

 

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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 general definition of vitamin,minerals, herbs and dietary supplements (VHMS). Each year, every segment of theCompany strives to broaden its product offerings so as to increase revenue andgross profits while lessening dependence upon any one product. The Companydivides its business other than the EPI business into approximately 50 productcategories. The products in these categories are packaged into approximately500 stock keeping units (SKUs).

 

Two product categories, Ester-C and Carb Intercept represented morethan 10% of gross sales in 2004 and one product category, Ester-C, representedmore than 10% of gross sales in 2003. No product category represented more than10% of gross sales in 2002.

 

The Company actively participates in and financially supports a numberof scientific and educational industry organizations that promote consumer wellbeing. These include the Citizens for Health, the National Nutritional FoodsAssociation (NNFA), American Herbal Products Association, American HerbalPharmacopoeia, and the American Botanical Council. The Company is also afounding member of the Dietary Supplement Education Alliance (DSEA) of which Mr. Balbert,the Company’s president, serves as the CEO. The DSEA is a not-for-profitorganization consisting of more than 60 companies whose role is to improvepublic health by communicating the benefits of dietary supplements.

 

**BUSINESS STRATEGY**

 

*Quality Supplier*

 

The Company’s primary business strategy is to position itself as aquality supplier of nutraceutical products that can be trusted by consumers andretailers alike.

 

The Natrol and Laci Le Beau brands are sold across multiple channels ofdistribution including health foods, stores, mass-market retail outletsincluding club stores, catalogs and Internet sales organizations.

 

The Prolab brand is also sold across multiple channels of distributionbut sales through the mass-market channel of distribution are limited becausethis is not a channel where sports nutrition products are primarily sold.

 

As a quality supplier, the Company places a strong emphasis on qualitycontrol because it believes that quality standards play a critical factor inconsumer purchasing decisions and in differentiating the Natrol brand. TheCompany’s products are manufactured in accordance with current GoodManufacturing Practices (GMPs) standards set by the National Nutritional FoodsAssociation (NNFA).

 

The Company also carefully reviews its products to ensure regulatorycompliance, safety and efficacy.

 

*Product Innovation*

 

A core part of the business strategy is to be a product leader. As suchthe Company’s Research and Development (R&D) department is constantlyworking to identify and develop new product and technologies related to thesupplement business. Products can be internally developed or acquired fromthird parties. There is no guarantee that the Company can, in any given timeperiod, develop or acquire commercially successful products. New products, evenwith large resources, are difficult to develop. The Company’s resources areless than those of its larger competitors. The Company’s

 

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inability to develop newproducts or technologies could have a material adverse effect on the Company’sbusiness.

 

*Customer Relations*

 

As a quality supplier of nutraceutical products, the Company’s strategyincludes developing and maintaining strong working relationships with itscustomers.

 

The Company works with its mass-market retailers to ensure that itsmost profitable and rapidly selling items remain on retailers’ shelves while itseeks to obtain more shelf space for additional, potentially profitable, items.

 

Within the health food store channel of distribution, the Companybelieves that its product line is under-represented and its strategy withinthat channel of trade is to ensure that retail outlets carry a higherpercentage of what the Company considers to be its core line of products.

 

*Maintain Infrastructure for Growth*

 

Natrol has a state-of-the art SAP enterprise resource planning softwaresystem to manage production, sales and accounting. In 2004, the Companyexpanded its quality control facility in order to facilitate that it will beable to meet future regulatory requirements. The Company regularly evaluatesits operations and makes investments in building infrastructure, as necessary.

 

*Experienced Management Team*

 

The Company’s management team has extensive experience in thenutritional supplement industry and has developed long-standing relationshipswith its suppliers and its customers. The Company believes that the quality ofits management team at all levels is important and seeks to employ managerswith experience in each respective position.

 

**SALES**

 

*BRANDED PRODUCTS*

 

The Company distributes its Natrol supplements and Laci Le Beau teasprimarily to domestic, independent, health food stores and mass-market club,drug, retail and food stores. Although the Company sells the same Natrol orLaci Le Beau products to both the health food and mass-market channels ofdistribution, it has built different sales organizations to meet the differingrequirements of each channel of trade.

 

The Company sells its branded Natrol and Laci Le Beau products tohealth food stores primarily through leading national distributors, including *United Natural Foods, Nature’s Best* and *Tree of Life*. Natrol and Laci Le Beauproducts are also sold by health food store chains such as *Wild Oats Markets*, *Whole Foods Market*, *GNC*, *FredMeyer Nutrition Centers* and *The VitaminShoppes*, as well as by most independent health food stores.

 

Within the health food channel of trade, the Company maintains a salesstaff of regional representatives across the country managed by a nationalmanager who reports to the Company’s Vice President of Retail Sales. Thesesales representatives call on individual storeowners and distributors promotingthe Natrol and Laci Le Beau lines.

 

The mass-market distribution channel is also managed by the Company’sVice President of Retail Sales. The Company employs three sales managers whomanage an independent broker network of more than 40 groups throughout thecountry. The Company’s employees service certain of its larger mass-marketaccounts directly while independent brokers service others in conjunction withthe Company’s management. The Company sells its products to mass-marketmerchandisers either directly

 

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or through distributors ofvitamins, minerals and other supplement products such as: *Amerisource Bergen*, *McKesson*, and *Cardinal*.

 

Some of the Company’s major drug, club and mass-market retail andgrocery customers include:

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

 

Sales of vitamins and supplements within the mass-market channel oftrade are extremely competitive with all vendors competing vigorously to defendtheir positions within each mass-market account. Many mass-market retailersemphasize their own in-house private label brand which creates additionalcompetition. Vendors to the mass-market class of trade continually analyzetheir own shelf space as well as that of their competitors in an effort tomaximize profits for themselves and the mass-market retailer. The result is anatural cycle in which companies such as Natrol prune slower moving items fromstore shelves, replacing them with faster selling products. The Company’scentral strategy is to ensure that its most profitable and rapidly sellingitems remain on retailers’ shelves while it seeks to obtain more shelf spacefor additional, potentially profitable, items.

 

Within the health food store channel of distribution, the Companybelieves that its product line is under-represented and its strategy withinthat channel of trade is to ensure that retail outlets carry a higherpercentage of what the Company considers to be its core line of products.

 

The Company provides retailers in both the health food store and themass-market distribution channels with a wide array of comprehensive servicestailored to meet their individual needs. In the health food store channel, theCompany’s dedicated sales force maintains direct and regular contact with keystore personnel informing them of new product developments and industry trends,aiding them in the design of store sets and creating merchandising programsthat promote brand and category awareness. The Company’s regional managers andindependent brokers in the mass-market distribution channel work with corporatebuyers focusing on special promotional activities and brand and categoryawareness in order to improve the consumer purchases of Natrol products andincrease the movement of items through each outlet. The objective of theseactivities is to build strong relationships with the Company’s marketingpartners, to increase the number of stores carrying its products and improvethe profitability of the items sold within each of the Company’s tradingpartners.

 

Prolab products are sold primarily through sports nutrition retailstores, fitness centers, websites, health food stores and internationallythrough designated distributors. Approximately 37.0% of Prolab’s sales are todistributors who sell products to European, Canadian and other non-domesticaccounts.

 

Prolab’s domestic sales are primarily to wholesalers who in turnservice retail accounts. Prolab’s wholesaler network focuses on health foodstores, health clubs and fitness facilities that cater to body builders andother individuals seeking a high level of fitness.

 

No customer of the Company represented more than 10% of net sales forthe years ended December 31, 2004 and 2003. One customer represented 12.3%of net sales in the year ended December 31, 2002.

 

*CONTRACT MANUFACTURING AND INGREDIENT SUPPLYSALES: EPI*

 

The Company’s contract manufacturing services are primarily marketedthrough the EPI sales force. The Company manufactures a number of productspursuant to contracts with customers who distribute the products under theirown private labels. As a contract manufacturer, the Company will

 

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often assist its customers inthe formulation of their products. Contract manufacturing accounted forapproximately 5.1% of the Company’s gross sales in 2004.

 

In its bulk ingredient business, EPI sells nutraceutical grade garlic,kava kava, melatonin and arabinogalactan to other manufacturers of nutritionalproducts. Bulk ingredient sales accounted for 2.3% of the Company’s gross salesin 2004. This part of the Company’s business weakened substantially during2004. Sales of garlic and vegetable powders fell approximately 40% in 2004.Reasons for the decline include market conditions and competition from domesticand international suppliers. This decline was partially offset by sales ofarabinogalactan. However, in 2004, the Company ended its exclusive supplyagreement with Larex, Inc., “Larex,” for the supply of arabinogalactan.Larex continues to supply the Company with arabinogalactan but on anon-exclusive basis. In January 2005, the Company also exercised its rightto not renew the endorsement contract for arabinogalactan with Earvin “Magic”Johnson for the promoting of the Company’s My Defense formulation and otherformulations containing arabinogalactan. Due to these factors, sales ofarabinogalactan are expected to be less in 2005 than in 2004.

 

Through the end of 2004, EPI obtained its nutraceutical grade garlicfrom ConAgra Foods, Inc. (ConAgra) pursuant to a multi-year supplyagreement that gave the Company the exclusive right to sell ConAgra’snutraceutical grade garlic in the dietary supplement industry. The agreement,which extended until December 31, 2007 and stipulated certain pricing andvolume terms was terminated by the mutual consent of ConAgra and the Company inFebruary 2005. Nutraceutical grade garlic is also available frominternational suppliers at competitive prices.

 

Due to the decline in the sales of garlic and vegetable powders as wellas the ending of the exclusive supply agreement with Larex and ConAgra, theCompany has begun to re-examine its business strategy as it relates to theingredient supply business. Total gross shipments of vegetable powders andarabinogalactan in 2004 amounted to approximately $2.1 million. A newstrategy for the EPI ingredient supply business may call for a substantialalteration in EPI’s structure as well as changes or limitations to the productsand services provided by this division of the Company.

 

The Company’s current strategy with respect to its contractmanufacturing business is to selectively bid on profitable contractmanufacturing business that can help the Company improve the utilization of itsmanufacturing plant.

 

**MARKETING**

 

*BRANDED PRODUCTS*

 

Management believes the Company’s strategy of selling the Natrol andLaci Le Beau and Prolab brands through all appropriate channels of distributionincluding the health, mass-market, convenience store, fitness and health clubsand Internet channels distinguishes the Company from its competition. Mostcompetitors sell products into each channel using different brand names withineach channel.

 

The Company’s core strategy has been to build the Natrol, Laci Le Beauand Prolab brand names within multiple channels of distribution in order todevelop increased brand awareness and strong brand recognition among consumersseeking products with a reputation for quality. The Company believes it canleverage its reputation for high quality products developed within the healthfood distribution channel in the mass-market and other channels by positioningits products as a high quality brand rather than a value brand.

 

The Company has utilized print, radio and television advertising aswell as cooperative and other incentive programs to build consumer awarenessand generate sales revenue.

 

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The Company periodically reviews its media mix for its effectiveness increating consumer demand. As such, the Company’s use of certain media in pastoperating periods is not necessarily an indicator of media choices to be madein future operating periods.

 

*INGREDIENT SUPPLY SALES AND CONTRACTMANUFACTURING SALES*

 

The Company’s EPI bulk ingredients division relies primarily onvisibility developed through trade shows, advertising in trade publications andbrochures to supplement the sales efforts of its sales people.

 

The contract manufacturing business relies on trade shows, tradepublications, and word-of-mouth as well as the delivery of information from itssales staff, primarily its Essentially Pure Ingredients sales people.

 

**RESEARCH & DEVELOPMENT**

 

The Company maintains a research and development department whose roleis to monitor developments within the dietary supplement industry and toidentify or develop new, marketable products for the Company. The Company’sresearch and development staff constantly reviews periodicals, scientificresearch and relevant clinical studies within medical journals and on-linedatabases. The staff meets with vendors and evaluates new ingredients. Theresearch and development team also consults scientists and employs researchconsultants on a regular basis regarding new product concepts. The Company’sresearch and development department is constantly seeking to acquire new products,product rights, and technologies that can be profitably marketed to itscustomers.

 

Before a product is introduced, research and development assists withthe review of the safety and efficacy of ingredients, standards for productionand further assists in the review of labeling information, label claims andpotential patent, trademark, legal or regulatory issues. The R&D departmenthelps in the overall process of ensuring that all the Company’s products meetlabel claims and that all formulations are safe and efficacious if produced tothe standards that have been developed.

 

**MANUFACTURING AND PRODUCT QUALITY**

 

*DIETARY SUPPLEMENTS*

 

The Company manufactures its branded Natrol and private labelsupplements as well as Prolab tablets and capsules at its 90,000 square footmanufacturing facility/headquarters located in Chatsworth, California. At thisfacility, the Company manufactures both tablets and two-piece capsules, whichaccount for the vast majority of the Company’s supplement sales. The Companyuses third party vendors to produce its liquid products, powders, softgels andtea.

 

The Company has current manufacturing capability to produce fourmillion tablets and capsules per eight hour shift and 420,000 bottles per week.

 

The Company operates flexible manufacturing lines which enable theCompany to shift output efficiently among various pieces of equipment dependingupon such factors as batch size, tablets or capsule count and labelingrequirements. The Company strives to fulfill and ship all orders within48 hours.

 

The Company places a strong emphasis on quality control because itbelieves that quality standards play a critical factor in consumer purchasingdecisions and in differentiating the Natrol brand. The Company’s products aremanufactured in accordance with current Good Manufacturing Practices (GMPs)standards set by the National Nutritional Foods Association (NNFA).

 

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The Company requires all raw materials or finished products to beplaced in quarantine upon receipt before release by the Company’s qualitycontrol laboratory. The Company conducts sample testing, weight testing, puritytesting, dissolution testing and, where required, microbiological testing. Whenmaterials are released from quarantine, each lot is assigned a unique lotnumber which is tracked throughout the manufacturing process. Materials areblended, tested and then encapsulated or formed into pills which may or may notbe coated. The Company routinely performs qualitative and quantitative qualitycontrol procedures on its finished products.

 

*Raw Material Supply:*

 

The Company obtains its raw materials for the manufacture of itsproducts from third-party suppliers. Many of the raw materials used in theCompany’s products are harvested internationally. The Company does not havecontracts with any suppliers committing such suppliers to provide the materialsrequired for the production of its products. During the last decade, coenzymeQ10, natural vitamin E, beta carotene, melatonin, kava, and a select number ofother raw materials have had significant price fluctuations as a result ofshort supply and or increases in demand. The Company has experienced occasionalshortages of raw materials for a limited number of its products, but to datehas only encountered short-term production interruptions as a result of suchshortages. Three of the Company’s suppliers each accounted for more than 10% ofthe Company’s inventory purchases in 2004. The loss of any of these supplierscould have a material adverse effect on the Company’s ability to produce andsell goods. The Company does not have a long-term supply agreement with any ofthese three suppliers.

 

*Specialty Suppliers:*

 

The Company also sells a limited number of products under the supplier’strademark. In 2004, the most significant of these is the Company’s Ester-C®line of products which accounts for approximately 11% of the Company’s grosssales. When the Company markets products under the supplier’s trademark, theCompany is limited to that single supplier as a source of raw materials forthat product. As a result, any shortage of raw materials from that supplierwould adversely affect the Company’s ability to manufacture that product. Priceincreases from these suppliers could severely impact the profitability of theseitems. The inability of the Company to obtain adequate supplies of rawmaterials for its products at favorable prices, or at all, could have amaterial adverse effect on the Company’s business, financial condition andresults of operations.

 

The Company’s source of arabinogalactan is a single suppler, Larex, Inc.It is possible that Larex may not be able to adequately meet demand. TheCompany does not believe that other sources of the nutraceutical grade ofarabinogalactan are readily available from other suppliers.

 

*Shipping facilities*:

 

The Company also owns a 132,000 sq. ft. warehouse facility located lessthan one-quarter mile from its manufacturing facility. Approximately 52,000 sq.ft. of this warehouse facility is subleased. Rental income was approximately$389,000, $473,000 and $460,000, for the years ended December 31, 2004,2003 and 2002 respectively. The remaining 80,000 sq. ft. is now being used bythe Company to ship finished goods to the Company’s customers. Finished goodsare transferred from the Company’s packaging lines to the distribution facilityfor storage prior to shipment to customers.

 

Prolab products are shipped from the company-owned, 25,000 sq. ft.facility located in Bloomfield, Connecticut.

 

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*TEAS*

 

The Company primarily relies upon third parties for the milling andprocessing of its herbal teas. The Company directly provides a majority of theherbs and other raw materials used in the production of its teas to these thirdparties. Tea bags produced by these parties are packaged into boxes at theCompany’s manufacturing facility in Chatsworth, California.

 

*PROLAB*

 

The Company produces, at its headquarters/manufacturing facility,Prolab supplements that are sold in tablet or capsule form. However, theCompany relies on third party vendors to process and package a majority ofProlab’s products which consists of powders, nutrition bars and drinks.

 

**TRADEMARKS AND PATENTS**

 

The Company regards its trademarks, patent applications and otherproprietary rights as valuable assets. The Company believes that protecting itskey trademarks is crucial to its business strategy of building strong brandname recognition and that such trademarks have significant value in the marketingof its products. The Company may in some cases seek to protect its research anddevelopment efforts by filing patent applications for proprietary products.

 

The Company’s policy is to pursue registrations for all of thetrademarks associated with its key products. The Company relies on common lawtrademark rights to protect its unregistered trademarks as well as its tradedress rights. Common law trademark rights generally are limited to thegeographic area in which the trademark is actually used, while a United Statesfederal registration of a trademark enables the registrant to stop theunauthorized use of the trademark by any third party anywhere in the UnitedStates. Furthermore, the protection available, if any, in foreign jurisdictionsmay not be as extensive as the protection available to the Company in theUnited States.

 

Currently, the Company has received one United States patent for itsKavatrol product and has received two United States patents related to twoamino acid products, SAF and SAF for Kids. To the extent the Company does nothave patents on its products, another company may replicate one or more of theCompany’s products.

 

Although the Company seeks to ensure that it does not infringe on theintellectual property rights of others, there can be no assurance that thirdparties will not assert intellectual property infringement claims against theCompany.

 

**COMPETITION**

 

The dietary supplement industry is highly competitive. Competition isbased primarily on price, quality and assortment of products, customer service,marketing support, and the availability of new products. The Company competesby primarily positioning itself as a supplier of quality products, oftentimeswith unique compositions, as opposed to positioning itself as a value brandwhich competes primarily through low pricing.

 

The Company’s direct competition consists primarily of publicly andprivately owned companies, which tend to be fragmented in terms of bothgeographical market coverage and product categories. Numerous companies, manyof which are greater in size and financial, personnel, distribution and otherresources than the Company, compete with the Company in the development,manufacture and marketing of dietary supplements. Numerous competitors sellbroader product lines than the Company.

 

The Company’s principal competition in the health food storedistribution channel comes from a limited number of large nationally knownmanufacturers and many smaller manufacturers of dietary supplements. In themass-market distribution channel, the Company’s principal competition comesfrom

 

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broadline manufacturers, majorprivate label manufacturers and other companies. In addition, several largepharmaceutical companies compete with the nutritional supplement companies.Competition from such companies is difficult because such companies havegreater financial and other resources available to them and possessmanufacturing, distribution and marketing capabilities far greater than thoseof the Company. The Company also faces competition in both the health foodstore and mass-market distribution channels from private label dietarysupplements and multivitamins 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 the Company’s products are subject to regulation bynumerous governmental agencies which regulate the Company’s products. TheCompany’s products are subject to regulation by, among other regulatoryentities, the Consumer Product Safety Commission (CPSC), the U.S. Department ofAgriculture (USDA), the Environmental Protection Agency (EPA) and the U.S. Foodand Drug Administration (FDA). Advertising and other forms of promotion andmethods of marketing of the Company’s products are subject to regulation by theU.S. Federal Trade Commission (FTC), which regulates these activities under theFederal Trade Commission Act (FTCA). The manufacture, labeling and advertisingof the Company’s products are also regulated by various state and localagencies as well as those of each foreign country to which the Companydistributes its products.

 

The Dietary Supplement Health and Education Act of 1994 (DSHEA) revisedthe provisions of the Federal Food, Drug, and Cosmetic Act (FFDC Act)concerning the regulation of dietary supplements. The substantial majority ofthe products marketed by the Company are regulated as dietary supplements underthe FFDC Act.

 

Under the current provisions of the FFDC Act there are four categoriesof claims that pertain to the regulation of dietary supplements. Health claimsare claims that describe the relationship between a nutrient or dietary ingredientand a disease or health related condition and can be made on the labeling ofdietary supplements if supported by significant scientific agreement andauthorized by the FDA in advance via notice and comment rulemaking. Nutrientcontent claims describe the nutritional value of the product and may be made ifdefined by the FDA through notice and comment rulemaking and if one serving ofthe product meets the definition. Statements of nutritional support or productperformance, which are permitted on labeling of dietary supplements without FDApre-approval, are defined to include statements that: (i) claim a benefitrelated to a classical nutrient deficiency disease and discloses the prevalenceof such disease in the United States; (ii) describe the role of a nutrientor dietary ingredient intended 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 from consumptionof a nutrient or dietary ingredient. In order to make a nutritional supportclaim the marketer must possess substantiation to demonstrate that the claim isnot false or misleading and if the claim is for a dietary ingredient that doesnot provide traditional nutritional value, prominent disclosure of the lack ofFDA review of the relevant statement and notification to the FDA of the claimis required. Drug claims are representations that a product is intended todiagnose, mitigate, treat, cure or prevent a disease. Drug claims areprohibited from use in the labeling of dietary supplements.

 

Claims made for the Company’s dietary supplement products may includestatements of nutritional support and health and nutrient content claims whenauthorized by the FDA or otherwise allowed by law. The FDA’s interpretation ofwhat constitutes an acceptable statement of nutritional support may change inthe future thereby requiring that the Company revise its labeling. In addition,a dietary supplement that contains a new dietary ingredient (i.e., one not onthe market before October 15, 1994) must have a history of use or otherevidence of safety establishing that it is reasonably expected to be safe. Themanufacturer must notify the FDA at least 75 days before marketingproducts

 

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containing new dietaryingredients and provide the FDA the information upon which the manufacturerbased its conclusion that the product has a reasonable expectation of safety.

 

The FDA in the first quarter of 2004 banned ephedra products. TheCompany discontinued the sale of ephedra-based products in the first quarter of2003.

 

The FDA has also announced its intention to promulgate new GMPsspecific to dietary supplements, to fully enforce DSHEA and monitor compliancewith the Bioterrorism Act of 2002.

 

The failure of the Company to comply with applicable FDA regulatoryrequirements could result in, among other things, injunctions, productwithdrawals, recalls, product seizures, fines and criminal prosecutions. TheCompany intends to comply with the new GMPs once they are adopted.

 

As a result of the Company’s efforts to comply with applicable statutesand regulations, the Company has from time to time reformulated, eliminated orrelabeled certain of its products and revised certain of its advertisingclaims. The Company cannot predict the nature of any future laws, regulations,interpretations or applications, nor can it determine what effect additionalgovernmental regulations or administrative orders, when and if promulgated,would have on its business in the future. They could, however, require thereformulation of certain products to meet new standards, the recall ordiscontinuance of certain products not capable of reformulation, additionalrecord keeping, expanded documentation of the properties of certain products,expanded or different labeling, and/or scientific substantiation. Any or all ofsuch requirements could have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

The Company’s advertising and sale of its dietary supplement productsis subject to regulation by the FTC under the FTCA. Section 5 of the FTCAprohibits unfair methods of competition and unfair or deceptive acts or practicesin or affecting commerce. Section 12 of the FTCA provides that thedissemination 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 the Company is required to have adequate substantiation for allmaterial advertising claims made for its products.

 

On November 18, 1998, the FTC issued “Dietary Supplements: AnAdvertising Guide for Industry.” This guide provides marketers of dietarysupplements with guidelines on applying FTC law to dietary supplementadvertising. It includes examples of the principles that should be used wheninterpreting and substantiating dietary supplement advertising. Although the guideprovides additional explanation, it does not substantively change the FTC’sexisting policy that all supplement marketers have an obligation to ensure thatclaims are presented truthfully and to verify the adequacy of the supportbehind such claims. The Company’s internal staff, in conjunction with outsidecounsel, reviews its advertising claims for compliance with FTC requirements.

 

The FTC has a variety of processes and remedies available to it forenforcement, both administratively and judicially, including compulsoryprocess, cease and desist orders and injunctions. FTC enforcement can result inorders requiring, among other things, limits on advertising, correctiveadvertising, consumer redress, divestiture of assets, rescission of contractsand such other relief as may be deemed necessary. A violation of such orderscould have a material adverse effect on the Company’s business, financialcondition and results of operations.

 

Advertising and labeling for dietary supplements and conventional foodsare also regulated by state, county and other local governmental authorities.Some states also permit these laws to be enforced by Private Attorneys General.These Private Attorneys Generals may seek relief for consumers, seek classaction certifications, seek class-wide damages, seek class-wide refunds andproduct recalls of products sold by the Company. In the ordinary course ofbusiness, the Company is

 

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named as a defendant in thesetypes of state governmental agency and Private Attorneys General Actions alongwith other vitamin and supplement companies. Until the courts rule thatlaws have been violated, that the actions can proceed by state governmentalagencies or Private Attorneys General and or Class Actions and thatcognizable injuries have occurred, the Company does not believe such actionswill have any material impact on its operations. There can be no assurance thatstate and local authorities will not commence regulatory action which couldrestrict the permissible scope of the Company’s product advertising claims orproducts that can be sold in the future.

 

Governmental regulations in foreign countries where the Company plansto commence or expand sales may prevent or delay entry into the market orprevent or delay the introduction, or require the reformulation, of certain ofthe Company’s products. Compliance with such foreign governmental regulationsis generally the responsibility of the Company’s distributors for thosecountries. These distributors are independent contractors over whom the Companyhas limited control.

 

The Company manufactures certain products pursuant to contracts withcustomers who distribute the products under their own or other trademarks. Suchprivate label customers are subject to government regulations in connectionwith their purchase, marketing, distribution and sale of such products. TheCompany is subject to government regulations in connection with itsmanufacture, packaging and labeling of such products. However, the Company’sprivate label customers are independent companies, and their labeling,marketing and distribution of such products is beyond the Company’s control.The failure of these customers to comply with applicable laws or regulationscould have a material adverse effect on the Company’s business, financialcondition and results of operations. The Company many be named in legalproceedings directed at the independent companies’ sales and liability creatingactivities.

 

The Company may be subject to additional laws or regulations by the FDAor other federal, state, county, local or foreign regulatory authorities, therepeal of laws or regulations which the Company considers favorable, such asthe Dietary Supplement Health and Education Act of 1994, or more stringentinterpretations of current laws or regulations, from time to time in thefuture. The Company is unable to predict the nature of such future laws,regulations, interpretations or applications, nor can it predict what effectadditional governmental regulations, legal proceedings or administrativeorders, when and if promulgated or initiated would have on its business in thefuture. They could, however, require the reformulation of certain products tomeet new standards, the recall or discontinuance of certain products not ableto be reformulated, imposition of additional record keeping requirements,expanded documentation of the properties of certain products, expanded ordifferent labeling and scientific substantiation. Any or all of such requirementscould have a material adverse affect on the Company’s business, financialcondition and results of operations.

 

**EMPLOYEES**

 

As of December 31, 2004, the Company had approximately 284employees. Of such employees, approximately 43 were engaged in marketing andsales, 198 were devoted to production and distribution and 43 were responsiblefor management and administration. None of the Company’s employees is coveredby a collective bargaining agreement. The Company considers its relations withits employees to be good.

 

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**RISK FACTORS AND FACTORS AFFECTING FORWARDLOOKING STATEMENTS**

 

The Company’s ability to predict results or the effect of certainevents on the Company’s operating results is inherently uncertain. Therefore,the Company wishes to caution each reader of this report to carefully considerthe following factors and certain other factors discussed herein and in otherpast filings with the Securities and Exchange Commission.

 

Factors that could cause or contribute to the Company’s actual resultsdiffering materially from those discussed herein and in any forward lookingstatement or for the price of the Company’s Common Stock to be affectedadversely include but are not limited to:

 

*Industry trends.*  The total United States retail market fornutritional supplements is highly fragmented. Highly documented industry datais not readily available and, when available, it is generally historical innature, reporting on periods 12 months or more in arrears. One industrysource, the Nutrition Business Journal, a trade publication, reported in mid2004 that supplement sales have grown from $18.1 billion in 2001 to$19.8 billion in 2003, which reflects a compounded growth rate ofapproximately 3%.

 

Information Resources, Inc. (“IRI”) tracks sales data within thefood, drug, and mass-market channels of distribution. This tracking does notinclude Wal-mart sales which are a significant portion of this sector. For the52 weeks ended December 5, 2004, VMS sales as tracked by IRI showed adecline of 1% in year over year comparisons

 

Private label business has been a significant growth element within theVMS industry. The growth of private label sales impacts the sales of brandedproducts such as those distributed by Natrol. Private label sales are, to anever-greater degree, being emphasized by large mass-market retailers. As such,the growth of brands such as Natrol, Laci Le Beau, and Prolab within food,drug, and general mass-market merchants remains both highly competitive anduncertain.

 

In addition to the trends in the nutraceutical industry, the UnitedStates economy has experienced significant fluctuations over the last fewyears, in part due to uncertainty over foreign events, terrorists’ activities,the war with Iraq, unemployment and job creation in the United States andswings in overall consumer confidence. A sluggish economy inevitably impactsNatrol as well as the entire vitamin, mineral and supplement sector.

 

*Competition.*  The dietary supplement industry is highlycompetitive. Numerous companies, many of which have greater size and financial,personnel, distribution and other resources than the Company, compete with theCompany in the development, manufacture and marketing of dietary supplements.The Company’s principal competition in the health food store distributionchannel comes from a limited number of large nationally known manufacturers andmany smaller manufacturers of dietary supplements. In the mass-marketdistribution channel, the Company’s principal competition comes from broadlinemanufacturers, major private label manufacturers and other companies. Inaddition, large pharmaceutical companies compete with the Company and others inthe dietary supplement industry. Packaged food and beverage companies competewith the Company on a limited basis in the dietary supplement market. Increasedcompetition from such companies could have a material adverse effect on theCompany because such companies have greater financial and other resourcesavailable to them and possess manufacturing, distribution and marketingcapabilities far greater than those of the Company. The Company also facescompetition in both the health food store and mass-market distribution channelsfrom private label dietary supplements and multivitamins offered by health andnatural food store chains, drugstore chains, mass merchandisers and supermarketchains. Private label brands at mass-market chains represent substantialsources of income for these merchants and the mass-market merchants oftensupport their own labels at the expense of other brands.

 

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*Effect of Unfavorable Publicity.*  The Company believes the dietary supplementmarket is significantly affected by national media attention regarding theconsumption of dietary supplements. Future scientific research or publicity maynot be favorable to the dietary supplement industry or to any particularproduct or ingredient and may not be consistent with earlier favorable researchor publicity. Because of the Company’s dependence on consumers’ perceptions,adverse publicity associated with illness or other adverse effects resultingfrom the consumption of the Company’s products or ingredients or any similarproducts distributed by other companies and future reports of research that areperceived as less favorable or that question earlier research could have amaterial adverse effect on the Company’s business, financial condition andresults of operations. The Company is highly dependent upon consumers’perceptions of the safety and quality of its products as well as dietarysupplements distributed by other companies. Thus, the mere publication ofreports asserting that such products may be harmful or questioning theirefficacy could have a material adverse effect on the Company’s business,financial condition and results of operations, regardless of whether suchreports are scientifically supported or whether the claimed harmful effectswould be present at the dosages recommended for such products.

 

There is no guarantee that unfavorable publicity will not have asimilar negative effect on other products in the future. This may be the caseregardless of whether or not the negative publicity is warranted to any degree.

 

*Reduced Product Liability Insurance Coverageand Exposure to Product Liability Claims.*  The Company, like other retailers,distributors and manufacturers of products designed for human consumption,faces an inherent risk of exposure to product liability claims in the eventthat the use of its products results in injury. The Company may be subjected tovarious product liability claims, including, among others, that its productsinclude inadequate instructions for use or inadequate warnings concerningpossible side effects and interactions with other substances. In addition,although the Company maintains 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 Company’s products will not contain contaminated substances. Inaddition, in certain cases, the Company relies on third party manufacturers forits products. With respect to product liability claims, the Companyself-insures. The company formerly maintained occurrence based insurancecoverage. However, such coverage became unavailable during the Company’srenewal period in 2002. The cost of limited claims made coverage with highdeductibles rose to such an extent, that the Company chose to self-insure as ofJuly 2003. The company deposited $5.0 million for a five-year policyterm with an insurance carrier who provides certificates of insurance to theCompany’s vendors. The $5.0 million earns interest and is classified as anon-current asset entitled “Restricted Cash” on the accompanying December 31,2003 consolidated balance sheet. The $5 million is fully refundable to theCompany should it decide to end the self-insurance program at the end of thepolicy term.

 

There can be no assurance that insurance will, in future years, beavailable at a reasonable cost or available with limits that meet therequirements of the Company’s current customer base, or, if available, will beadequate to cover liabilities or that any insurance carrier will be willing tocontinue assisting the Company with its self insurance program in future years.

 

In order to limit its exposure to lawsuits, the Company generally seeksto obtain contractual indemnification from parties supplying raw materials forits products or manufacturing or marketing its products, and to be added as anadditional insured under such parties’ insurance policies. Any suchindemnification or insurance, however, is limited by its terms and any suchindemnification, as a practical matter, is limited to the creditworthiness ofthe indemnifying party. In the event that the Company does not have adequateinsurance or contractual indemnification, product liabilities relating to itsproducts or contract manufacturing activities could have a material adverseeffect on the Company’s business, financial condition and results ofoperations.

 

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There are many other reasons the Company can be sued other than forproduct liability. The cost of the Company defending itself from legal claims,no matter 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 the Company’s business, financial condition andresults of operations.

 

*Dependence on New Products.*  The Company believes growth of its net salesis substantially dependent upon its ability to introduce new products. TheCompany seeks to introduce additional products each year. The success of newproducts is dependent upon a number of factors, including the Company’s abilityto develop products that will appeal to consumers and respond to market trendsin a timely manner. There can be no assurance that the Company’s efforts todevelop new products will be successful or that consumers will accept theCompany’s new products. New products can often take substantial periods of timeto develop consumer awareness, consumer acceptance and sales volume. Some newproducts fail and as a result have to be discontinued. In addition, productscurrently experiencing strong popularity and rapid growth may not maintaintheir sales volumes over time.

 

*Product Returns.*  Product returns are a part of the Company’sbusiness. While customers generally do not have an absolute right of return,products may be returned for various reasons including expiration dates or lackof sufficient sales velocity. The Company accrues allowances for returns basedon historical data and future expectations. During 2004, returns and chargesfor damages and outdated products amounted to approximately 3.5%, less than the4.7% figure for 2003 and the 8.7% figure for 2002. The Company continuallyworks to lessen the impact of returns through better management of its SKUcount at retail establishments and more effective use of sales and marketingprograms. Even so, there is no guarantee that future returns will not equal orexceed the levels experienced in prior years when returns amounted to as muchas 14.5% of gross shipments. Furthermore, the loss of a major account couldresult in a substantial amount of returns.

 

*Inventory Risk.*  The Company’s products are tested forstability and each product has associated with it an expiration date afterwhich the product cannot be sold. Expiration dates can be as short as monthsor, in some cases as long as three years or four years. In order to provide thefreshest product possible, the Company makes every attempt to produce a producton a just-in-time basis. However, as sales trends change it is possible for theCompany to over-produce finished goods inventory or have excess raw materialswhich are not used before their expiration dates. The Company regularlydisposes of overstocked finished goods and expired raw material inventory.Should sales trends change too rapidly or should manufacturing planning bepoor, the Company could be subject to larger than normal expenses for writingoff inventory which would effect the financial condition of the Company andresults of operations during the period in which larger than expected writedowns of inventory were to occur.

 

The Company closely monitors its inventory. In addition, the Companyregularly reviews its inventory, the velocity of sales, and raw material andcomponent usage relative to inventory, in an effort to ensure that on handinventory is good and usable and that potentially unusable inventory isadequately reserved.

 

*Distribution Gains.*  One of the Company’s primary goals has been togain additional distribution in the various channels of trade that sellvitamins and supplements to consumers. The Company continues to seek additionalavenues to sell its products as well as to gain additional distribution forprofitable and rapidly selling products in its existing accounts. The Company’sfailure to make additional distribution gains or to maintain currentdistribution and expand sales of core products could have an adverse materialeffect on the Company’s business, financial condition and results ofoperations.

 

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*Cost of 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. The Company must continuallyevaluate specific programs to ascertain the profitability of potential businessfrom each retailer. Because of such brand based programs, the Company mayascertain that it cannot profitably do business with a retailer. This may causethe Company to stop doing business with existing customers or not allow theCompany to enter into a business relationship with a potential new customer,each of which in turn could dampen future revenue growth. In 2004,approximately 10.9% of the revenue from gross shipments was allocated to suchsupport programs.

 

*Government Regulation.*  The manufacture, packaging, labeling,advertising, promotion, distribution and sale of the Company’s products aresubject to regulation by numerous governmental agencies which regulate theCompany’s products. The Company’s products are also subject to regulation by,among other regulatory entities, the CPSC, the USDA, the EPA and the UnitedStates FDA. Advertising and other forms of promotion and methods of marketingof the Company’s products are subject to regulation by the FTC which regulatesthese activities under the FTCA. The manufacture, labeling and advertising ofthe Company’s products are also regulated by various state and local agenciesas well as those of each foreign country to which the Company distributes itsproducts.

 

The Company’s products are generally regulated as dietary supplementsunder the FDCA, and are, therefore, not subject to pre-market approval by theFDA. However, these products are subject to extensive regulation by the FDArelating to adulteration and misbranding. For instance, the Company isresponsible for ensuring that all dietary ingredients in a supplement are 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 theCompany makes statements about the supplement’s effects on the structure orfunction of the body, the Company must, among other things, have substantiationthat the statements are truthful and not misleading. In addition, the Company’sproduct labels must bear proper ingredient and nutritional labeling and theCompany’s supplements must be manufactured in accordance with current GMPs forfoods. The FDA has issued an advanced notice of its intention to promulgate newGMPs which, when finally adopted may be more expensive to follow than priorGMPs. A product can be removed from the market if it is shown to pose asignificant or unreasonable risk of illness or injury. Moreover, if the FDAdetermines that the “intended use” of any of the Company’s products is for thediagnosis, cure, mitigation, treatment or prevention of disease, the productwould meet the definition of a drug and could not be sold as a dietarysupplement without a modification of its “intended use” claims. Failure of theCompany to comply with applicable FDA regulatory requirements may result in,among other things, injunctions, product withdrawals, recalls, productseizures, fines and criminal prosecutions.

 

The Company’s advertising of its dietary supplement products is subjectto regulation by the FTC under the FTCA. Section 5 of the FTCA prohibitsunfair methods of competition and unfair or deceptive acts or practices in oraffecting commerce. Section 12 of the FTCA provides that the disseminationor the causing to be disseminated of any false advertisement pertaining to,among other things, drugs or foods, which includes 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 product claimsat the time the claims are first used in advertising or other promotions.Failure to adequately substantiate claims may be considered either as adeceptive or unfair practice. Pursuant to this FTC requirement, the Company isrequired to have adequate substantiation for all advertising claims made aboutits products. The type of substantiation will be dependent upon the productclaims made. For example, a health claim normally would require competent andreliable scientific evidence, while a taste claim would require only surveyevidence.

 

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In recent years the FTC has initiated numerous investigations ofdietary supplement and weight loss products and companies. On November 18,1998, the FTC issued “Dietary Supplements: An Advertising Guide for Industry.”This guide provides marketers of dietary supplements with guidelines onapplying FTC law to dietary supplement advertising. It includes examples of theprinciples that should be used when interpreting and substantiating dietarysupplement advertising. Although the guide provides additional explanation, itdoes not substantively change the FTC’s existing policy that all supplementmarketers have an obligation to ensure that claims are presented truthfully andto verify the adequacy of the support behind such claims. The Company’sinternal staff, in conjunction with outside counsel, reviews its advertisingclaims.

 

The Company is not currently a party to any investigation, consentorder or other decree of the FTC. The Company may be subject to investigationby the FTC in the future. If the FTC has reason to believe the law is beingviolated (e.g., the Company does not possess adequate substantiation forproduct claims), it can initiate enforcement action. The FTC has a variety ofprocesses and remedies available to it for enforcement, both administrativelyand judicially, including compulsory process authority, cease and desist ordersand injunctions. 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 theCompany’s ability to successfully market its products.

 

The Company manufactures certain products pursuant to contracts withcustomers who distribute the products under their own or other trademarks. Suchprivate label customers are subject to government regulations in connectionwith their purchase, marketing, distribution and sale of such products, and theCompany is subject to government regulations in connection with itsmanufacture, packaging and labeling of such products. However, the Company’sprivate label customers are independent companies, and their labeling,marketing and distribution of such products is beyond the Company’s control.The failure of these customers to comply with applicable laws or regulationscould have a material adverse effect on the Company’s business, financialcondition and results of operations.

 

Governmental regulations in foreign countries where the Company plansto commence or expand sales may prevent or delay entry into the market orprevent or delay the introduction, or require the reformulation, of certain ofthe Company’s products. Compliance with such foreign governmental regulationsis generally the responsibility of the Company’s distributors in thosecountries. These distributors are independent contractors over whom the Companyhas limited control.

 

The Company may be subject to additional laws or regulations by the FDAor other federal, state or foreign regulatory authorities, the repeal of lawsor regulations which the Company considers favorable, such as the DSHEA of1994, or more stringent interpretations of current laws or regulations, fromtime to time in the future. The Company is unable to predict the nature of suchfuture laws, regulations, interpretations or applications, nor can it predictwhat effect additional governmental regulations or administrative orders, whenand if promulgated, would have on its business in the future. They could,however, require the reformulation of certain products to meet new standards,the recall or discontinuance of certain products that cannot be reformulated,imposition of additional record keeping requirements, expanded documentation ofthe properties of certain products, or expanded or different labeling orscientific substantiation. Any or all of these requirements could have amaterial adverse effect on the Company’s business, financial condition andresults of operations.

 

*Dependence on Significant Customers.*  No major customer during 2004 represented 10%of gross sales. The Company’s top 10 customers accounted for approximately48.4% of the Company’s business. There is no assurance that the Company’s majorcustomers will continue to be major customers of the Company. The loss of asignificant number of major customers, or a significant reduction in purchase

 

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volume by or financialdifficulty of such customer, for any reason, could have a material adverseeffect on the Company’s business, financial condition and results ofoperations.

 

*Dependence on Key Personnel.*  The Company believes that its continuedsuccess depends to a significant extent on the management and other skills ofElliott Balbert, the Company’s Chairman, Chief Executive Officer and President,and its senior management team, as well as its ability to attract and retainother skilled personnel. All of the members of the Company’s management teamare employees-at-will and no executive is subject to an employment contract.The Company’s employees are not covered by a non-competition agreement. Theloss or unavailability of the services of Mr. Balbert or the other membersof the Company’s senior management team or the inability to attract otherskilled personnel could have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

*Ability to Execute its Business Plans.*  In reaction to past industry trends and theCompany’s financial performance, the Company has worked to manage expenses suchas payroll and advertising in order to ensure the profitability of the Company.Such restrictions on expenditures may have a long-term effect on revenuegrowth. Should industry and general economic trends for the nation as a wholebe difficult, the Company may have to reduce payroll as well as other forms ofoverhead and fixed expenses. Such cutbacks could affect, in a negative manner,the Company’s ability to increase revenues and profits.

 

Additionally, should national economic trends deteriorate, the Companymay not be able to reduce expenses as rapidly as is necessary to maintainprofitability. If corporate or industry trends strengthen in a strong, positiveway resulting in sudden growth of the Company’s revenues, the Company’smanagement, 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 the Company’s business will grow in the future orthat the Company will be able to effectively manage such growth. Nor canassurance be given that if the Company’s core business erodes, the Company canstabilize its revenue and manage the Company profitably in the short term. TheCompany’s inability to manage its growth or negative growth successfully couldhave a material adverse effect on the Company’s business, financial conditionand results of operations.

 

Furthermore, the Company may have to substantially alter its businessstrategy to grow the business. During 2002 and 2003, the Company investedapproximately $3 million, including operating losses, in an effort to growrevenue and profits by entering new marketplaces, namely multi-level marketingthrough an investment in Annasa as well as direct marketing through aninvestment in personnel to manage a direct marketing business. Neither effortwas successful and as such both efforts were abandoned in 2003. In the future,the Company may deem it necessary to divest itself of other business units orto cease doing business in certain areas which would affect both gross revenuesand net income. While such decisions would be made with the expectation thatthe decisions redeploying assets would benefit the corporation over thelong-term, in the short-term, such decisions could have a negative impact onrevenue and net income. The Company diligently looks for opportunities tobroaden distribution into additional markets. There is no guarantee that theCompany’s efforts will succeed.

 

*Risks Associated with Acquisitions.*  The Company completed one acquisition in1999, two acquisitions in 1998, and, although no acquisitions were completedsince, the Company may pursue additional acquisitions and new businessopportunities in the future as a part of its business strategy. The Companyfaces significant competition for acquisition opportunities from numerouscompanies, many of which have greater financial resources than the Company.Accordingly, there can be no assurance that attractive acquisitionopportunities will be available to the Company. Should an acquisitionopportunity arise, the Company would have to seek outside funding to supportsuch an

 

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acquisition. There is no guarantee that the Company would be able toobtain financing for or otherwise consummate any future acquisitions even ifmanagement believes such an acquisition would be beneficial to the Company.Moreover, future acquisitions would likely require additional financing whichwould likely result in an increase in the Company’s indebtedness or theissuance of additional stock which may be dilutive to the Company’sshareholders. Acquisitions involve numerous risks, including the risk that theacquired business will not perform in accordance with expectations,difficulties in the integration of the operations and products of the acquiredbusinesses with those of the Company, the diversion of the management’sattention from other aspects of the Company’s business, the risks associatedwith entering geographic and product markets in which the Company has limitedor no direct prior experience and the potential loss of key employees of theacquired business. The acquisition of another business can also subject theCompany to liabilities and claims arising out of such business. As a generalrule, the Company will publicly announce acquisitions only after a definitiveagreement has been signed.

 

Regardless of the potential problems surrounding a potentialacquisition, the Company regularly evaluates potential acquisitions of otherbusinesses, products and product lines and may hold discussions regarding suchpotential acquisitions.

 

*Absence of Conclusive Clinical Studies.*  Although many of the ingredients in theCompany’s products are vitamins, minerals, herbs and other substances for whichthere is a long history of human consumption, some of the Company’s productscontain ingredients with more recent history of use and effects. Accordingly,the Company’s products are evaluated to identify any harmful side effects. Anysuch unintended and unconnected effects may result in adverse publicity orproduct liability claims which could have a material adverse effect on theCompany’s business, financial condition and results of operations.

 

*Risks Associated with Supply of RawMaterials.*  TheCompany obtains all of its raw materials for the manufacture of its productsfrom third-party suppliers. Many of the raw materials used in the Company’sproducts are harvested internationally. With the exception of bulk garlic, theCompany does not have contracts with any suppliers committing such suppliers toprovide the materials required for the production of its products. During thelast decade, coenzyme Q10, natural vitamin E, beta carotene and melatonin havehad significant price fluctuations as a result of short supply and/ orincreases in demand. The Company has experienced occasional shortages of rawmaterials for a limited number of its products. There can be no assurance thatsuppliers, including suppliers of bulk garlic, will provide the raw materialsneeded by the Company in the quantities requested or at a price the Company iswilling pay.

 

The Company also sells a limited number of products under the supplier’strademark. The most significant of these is the Company’s Ester-C® line ofproducts which accounts for approximately 11% of the Company’s gross sales in2004. When the Company markets products under the supplier’s trademark, theCompany is limited to that single supplier as a source of raw materials forthat product. As a result, any shortage of raw materials from that supplierwould adversely affect the Company’s ability to manufacture that product.

 

Because the Company does not control the actual production of these rawmaterials, it is also subject to delays caused by interruption in production ofmaterials based on conditions not within its control. Such conditions includejob actions or strikes by employees of suppliers, weather, crop conditions, transportationinterruptions and natural disasters or other catastrophic events. As a result,any shortage of raw materials from that supplier would adversely affect theCompany’s ability to manufacture that product. Price increases from suchsuppliers would directly affect the Company’s profitability should the Companybe unable to pass such price increases on to its direct customers. Theinability of the Company to obtain adequate supplies of raw materials for itsproducts at favorable prices, or at all, could have a material adverse effecton the Company’s business, financial condition

 

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and results of operations. The Company purchases goods from a varietyof vendors. Three vendors each accounted for more than 10% of the Company’spurchases of raw materials in 2004. The loss of a large vendor could have amaterial impact on the Company’s ability to source raw material and manufacturefinished product associated with the raw materials supplied by this vendor. Theresult could be a material and adverse effect on the Company’s profitability.

 

*Sales and Earnings Volatility.*  The Company’s sales and earnings continue tobe subject to volatility based upon, among other things: (i) trends andgeneral conditions in the dietary supplement industry and the ability of theCompany to recognize such trends and effectively introduce and market newproducts in response to such trends; (ii) the introduction of new productsby the Company or its competitors; (iii) the loss of one or moresignificant customers; (iv) increased media attention on the use andefficacy of dietary supplements; (v) consumers’ perceptions of theproducts and operations of the Company or its competitors; (vi) theavailability of raw materials from suppliers; and, (vii) the Company’sability to accurately predict inventory needs so that it does not overstockitems which eventually must be written off due to low demand, or, that it failsto stock enough of an item so that sales are not lost due to lack of supply.Sales and earnings volatility as a result of the foregoing factors may affectthe Company’s operating results from period to period which may adverselyaffect the market price of the Common Stock.

 

*Possible Volatility of Stock Price.*  There can be no assurance that an activemarket in the Company’s stock will be sustained. The trading price of theCommon Stock has historically been subject to wide fluctuations and dailytrading volume is currently relatively low.

 

The price of the Common Stock may fluctuate in the future in responseto quarter-to-quarter variations in the Company’s operating results, materialannouncements by the Company or its competitors, governmental regulatoryaction, conditions in the dietary supplement industry, or other events orfactors, many of which are beyond the Company’s control. In addition, the stockmarket has historically experienced significant price and volume fluctuationswhich have particularly affected the market prices of many dietary supplementcompanies and which have, in certain cases, not had a strong correlation to theoperating performance of such companies. In addition, the Company’s operatingresults in future quarters may be below the expectations of securities analystsand investors. In such event, the price of the Common Stock would likelydecline, perhaps substantially.

 

*Risks Associated with Manufacturing.*  The Company’s results of operations aredependent upon the continued operation of its manufacturing facility inChatsworth, California at its current levels. The operation of dietarysupplement manufacturing plants involves many risks, including the breakdown,failure or substandard performance of equipment, natural and other disasters,and the need to comply with the requirements of directives of governmentagencies, including the FDA. In particular, the Company’s manufacturingfacility is located in Southern California, a geographic area that hashistorically been prone to earthquakes, which in some cases have beencatastrophic. Prior to the Company’s build-out of the building in which itsmanufacturing facility is located, the building was severely damaged in a majorearthquake 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, the Company’s manufacturing facility could be damaged ordestroyed in the event of an earthquake. Any such damage or destruction wouldhave a material adverse effect on the Company’s business, financial conditionand results of operations. The Company does not carry earthquake insurance onits facilities. In addition, the Company’s softgel and liquid products, theLaci Le Beau tea products as well as all of Prolab’s non-tablet and capsuleproducts which make up a majority of Prolab’s business are manufactured bythird party contractors. The Company’s profit margins on these products and itsability to deliver these products on a timely basis are dependent upon theability of the outside manufacturers to continue to supply products that meetthe Company’s quality standards in a timely and cost-efficient manner. Theoccurrence of any of

 

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the foregoing or other material operational problems could have amaterial adverse effect on the Company’s business, financial condition andresults of operations during the period of such operational difficulties.

 

*Reliance on Independent Brokers.*  The Company places significant reliance on anetwork of independent brokers to act as its first-line sales force tomass-market retailers. Although the Company employs management personnel,including regional sales managers, to closely monitor the brokers, such brokersare not employed or otherwise controlled by the Company and are generally freeto conduct their business at their own discretion. Although these brokers enterinto contracts with the Company, such contracts typically can be terminatedupon 30 days notice by the Company or the independent broker.

 

*Intellectual Property Protection.*  The Company’s policy is to pursueregistrations for all of the trademarks associated with its key products. TheCompany relies on common law trademark rights to protect its unregisteredtrademarks as well as its 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. The Company intends to register its trademarksin certain foreign jurisdictions where the Company’s products are sold.However, the protection available, if any, in such jurisdictions may not be asextensive as the protection available to the Company in the United States.

 

Currently, the Company has few patents on its products and no materialbusiness is derived from those items that are patented. To the extent theCompany does not have patents on its products, another company may replicateone or more of the Company’s products.

 

Although the Company seeks to ensure that it does not infringe theintellectual property rights of others, there can be no assurance that thirdparties will not assert intellectual property infringement claims against theCompany.

 

*Risk Associated with Large ControllingShareholders.* Natrol’s public float is relatively small, consisting of less than 30%of the Company’s issued shares. More than 77% of the Company’s stock is ownedby its top five shareholders. The decision by any one of these shareholders tosell their interest in the Company could materially and adversely affect theCompany’s share price.

 

*Risk Associated with National Trends.*  Natrol sells its products nationally inseveral channels of distribution. As such, the Company is not immune fromtrends in the national economy. Negative employment or other economic trendsdirectly affects the average consumer’s purchasing ability which in turn canaffect Natrol sales. Uncertainty due to the world events such as the war in theMiddle East can affect the general willingness of consumers to spend on anyitem, including Natrol products, that the consumer may not feel is essential.National economic trends affect Natrol’s customers. Should any one of Natrol’snational customers fail due to national trends, their failure could have adirect impact on the success of the Natrol business.

 

*Continued Acceptance of Natrol Products.*  The Company works assiduously to continuallyburnish the brand image of its products. Even so, negative events, negativepublicity about supplements in particular or in general, and other factorscould lead to a future lack of acceptance of the Company’s products. Suchevents or publicity may not be related to the Company itself. Even so suchevents or other factors could reduce demand for Natrol products.

 

*Availability of Capital.*  Should the Company need to borrow beyond itscurrent debt facilities, the cost of capital may be high. Traditional debtfinancing may be unavailable and the Company may have to seek alternativesources of financing, including the issuance of new shares of stock orpreferential stock that could dilute current shareholders.

 

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*Risk of Litigation from Private AttorneysGeneral and others.* Advertising and labeling for dietary supplements and conventional foodsare, in addition to the federal government, regulated by state, county andlocal authorities. Some states also permit these laws to be enforced by PrivateAttorneys General. These Private Attorneys General may seek relief forconsumers, seek class action certifications, seek class wide damages andproduct recalls of products sold by the Company. In the ordinary course ofbusiness, the Company is named as a defendant in these types of State Attorneysand Private Attorneys General Actions along with other vitamin and supplementcompanies. Until the courts rule that laws have been violated, that theactions can proceed as Private Attorneys General Class Actions and thatthe cognizable injury has occurred, the Company does not believe such actionswill have any material impact on its 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 Company’sproduct claims or the ability to sell its products in the future.

 

**ITEM 2.****  PROPERTIES**

 

The Company owns its 90,000 square foot manufacturing, distribution andoffice facility in Chatsworth, California. The Company has occupied thisfacility since March 1997. The facility was designed and constructed tothe Company’s specifications and includes areas for receiving, quarantine ofnew materials, manufacture, quality control and laboratory activities, researchand development, packaging, warehousing and administrative offices.

 

The Company owns its 132,000 square foot warehouse facility. Thisfacility is located within one-quarter mile of the Company’s headquartersfacility. The Company leases 52,000 sq. ft. of this space to a third party.

 

The Company also owns a 25,000 sq. ft. light manufacturing andwarehouse facility which houses its Prolab shipping operations in Bloomfield,Connecticut.

 

**ITEM 3.****  LEGAL MATTERS**

 

From time to time, the Company is subject to litigation incidental toits business, including product liability claims, state agency actions, PrivateAttorneys General Actions and class actions. Such claims, if successful, couldexceed the $5 million retention under the Company’s self-insuranceprogram. The Company is not currently a party to any material legalproceedings.

 

**ITEM 4.****  SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS**

 

During the fourth quarter of 2004, no matters were submitted to a voteof the security holders of the Company.

 

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**PART II**

 

**ITEM 5.****  MARKET FORREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURITIES**

 

*PRICE RANGE OF COMMON STOCK*

 

The Common Stock of the Company is traded on the NASDAQ National Marketunder the symbol “NTOL.” On February 4, 2005, the last reported salesprice of the Company’s Common Stock as reported on the NASDAQ National Marketwas $3.00. As of February 4, 2005 there were 25 holders of record of theCompany’s Common Stock.

 

The high and low sales closing prices for the Common Stock as reportedby the NASDAQ National Market for the years ended December 31, 2004 and2003 are set below:

 
| ** **                            | ** ** | **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 |   |
|                                       |            |                                               |            |  |  |  |  |

 
| ** **                            | ** ** | **Fiscal year ended  December 31, 2003** | ** ** |
|---------------------------------------|------------|-----------------------------------------------|------------|
| ** **                            | ** ** | **High**                                      | ** ** | **Low** | ** ** |
| Quarter ended March 31, 2003     |       | $                                             | 1.49       |   | $ | 1.05 |   |
| Quarter ended June 30, 2003      |       | 2.37                                          |       | 1.40 |   |
| Quarter ended September 30, 2003 |       | 3.49                                          |       | 2.18 |   |
| Quarter ended December 31, 2003  |       | 3.18                                          |       | 2.40 |   |
|                                       |            |                                               |            |  |  |  |  |

 

*DIVIDEND POLICY*

 

The Company currently intends to retain earnings to finance itsoperations and future growth and does not anticipate paying dividends on itsCommon Stock in the foreseeable future. Under Delaware law, the Company ispermitted to pay dividends only out of its surplus, or, if there is no surplus,out of its net profits.

 

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**ITEM 6.****  SELECTEDCONSOLIDATED FINANCIAL DATA**

 

The following selected financial data is derived from the auditedconsolidated financial statements of Natrol and its subsidiaries. The data setforth below should be read in conjunction with “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” and the ConsolidatedFinancial Statements of the Company and Notes thereto included herein.

 
| ** **                                                                                  | ** ** | **Year Ended December 31,**         | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                                  | ** ** | **(In thousands except per share data)** | ** ** |
| **Consolidated Statements of Operations Data:**                                             |       |                                     |       |   |   |   |   |   |   |   |   |
| Net sales                                                                                   |       | $                                        | 79,269     |   | $ | 72,658 |   | $ | 70,260 |   | $ | 71,821 |   | $ | 77,561 |   |
| Cost of goods sold                                                                          |       | 46,820                                   |       | 44,246 |   | 41,715 |   | 42,989 |   | 50,334 |   |
| Gross profit                                                                                |       | 32,449                                   |       | 28,412 |   | 28,545 |   | 28,832 |   | 27,227 |   |
| Selling and marketing expenses                                                              |       | 19,560                                   |       | 17,701 |   | 16,915 |   | 18,103 |   | 23,263 |   |
| General and administrative expenses                                                         |       | 9,348                                    |       | 10,063 |   | 8,744 |   | 9,746 |   | 10,318 |   |
| Impairment of goodwill                                                                      |       | —                                   |       | — |   | — |   | 20,000 |   | — |   |
| Total operating expenses                                                                    |       | 28,908                                   |       | 27,764 |   | 25,659 |   | 47,849 |   | 33,581 |   |
| Operating income (loss)                                                                     |       | 3,541                                    |       | 648 |   | 2,886 |   | (19,017 | ) | (6,354 | ) |
| Interest income (expense), net                                                              |       | (529                                     | )          | (595 | ) | (644 | ) | (736 | ) | (1,231 | ) |
| Income (loss) from continuing operations  before income taxes                               |       | 3,012                                    |       | 53 |   | 2,242 |   | (19,753 | ) | (7,585 | ) |
| Income tax provision (benefit)                                                              |       | 1,144                                    |       | 34 |   | 861 |   | 587 |   | (2,369 | ) |
| Income (loss) from continuing operations  before cumulative change in accounting principles |       | 1,868                                    |       | 19 |   | 1,381 |   | (20,340 | ) | (5,216 | ) |
| 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                                |       | 1,868                                    |       | (1,468 | ) | 693 |   | (20,340 | ) | (5,216 | ) |
| Cumulative effect of change in accounting  principle(2)                                     |       | —                                   |       | — |   | (6,819 | ) | — |   | — |   |
| Net income (loss)                                                                           |       | $                                        | 1,868      |   | $ | (1,468 | ) | $ | (6,126 | ) | $ | (20,340 | ) | $ | (5,216 | ) |
|                                                                                        |       |                                     |       |   |   |   |   |   |   |   |   |
| Income (loss) per share:                                                                    |       |                                     |       |   |   |   |   |   |   |   |   |
| Basic income (loss) from continuing  operations                                             |       | $                                        | 0.14       |   | $ | 0.00 |   | $ | 0.11 |   | $ | (1.59 | ) | $ | (0.39 | ) |
| Diluted income (loss) from continuing  operations                                           |       | $                                        | 0.13       |   | $ | 0.00 |   | $ | 0.11 |   | $ | (1.59 | ) | $ | (0.39 | ) |
| 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                                                             |       | $                                        | 0.14       |   | $ | (0.11 | ) | $ | (0.48 | ) | $ | (1.59 | ) | $ | (0.39 | ) |
| Diluted earnings (loss) per share                                                           |       | $                                        | 0.13       |   | $ | (0.11 | ) | $ | (0.48 | ) | $ | (1.59 | ) | $ | (0.39 | ) |
| Weighted average shares outstanding—basic                                              |       | 13,277                                   |       | 12,946 |   | 12,852 |   | 12,783 |   | 13,237 |   |
| Weighted average shares outstanding—diluted                                            |       | 14,113                                   |       | 13,452 |   | 12,992 |   | 12,783 |   | 13,237 |   |

 

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| ** **                              | ** ** | **December 31,**                    | ** ** |
|-----------------------------------------|------------|------------------------------------------|------------|
| ** **                              | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                              | ** ** | **(In thousands except per share data)** | ** ** |
| **Consolidated Balance Sheet Data:**    |       |                                     |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents               |       | $                                        | 6,022      |   | $ | 2,599 |   | $ | 10,077 |   | $ | 5,485 |   | $ | 4,004 |   |
| Working capital                         |       | 18,260                                   |       | 13,328 |   | 18,722 |   | 18,190 |   | 15,399 |   |
| Total assets                            |       | 52,924                                   |       | 51,439 |   | 53,357 |   | 59,357 |   | 87,921 |   |
| Long-term debt, less current maturities |       | 7,685                                    |       | 7,451 |   | 7,778 |   | 8,083 |   | 8,369 |   |
| Total stockholders’ equity         |       | 37,760                                   |       | 35,558 |   | 36,651 |   | 42,640 |   | 62,892 |   |
|                                         |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)                                  During the fourthquarter of 2003, the Company discontinued its Annasa and Tamsol operations, seeNote 9 to the consolidated financial statements.

 

(2)                                  In 2002, the Companyadopted SFAS No. 142, “Goodwill and Other Intangible Assets.” Inconnection with the adoption of SFAS No. 142, the Company recorded animpairment loss on the goodwill of its Natrol reporting unit. The impairmentloss was recorded as a cumulative effect of a change in accounting principle(net of an income tax benefit of $4,139) in the consolidated statement ofoperations for the year ended December 31, 2002.

 

**ITEM 7.****  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*The following discussion of the results ofoperations and financial condition of the Company should be read in conjunctionwith the “Selected Consolidated Financial Data” and the audited ConsolidatedFinancial Statements of the Company and the notes thereto included elsewhere inthis document.*

 

**OVERVIEW**

 

Since divesting itself of its unprofitable multi-level marketing anddirect marketing units in 2003 (see discontinued operations), the Company’sbusiness plan has been to focus on its core brands. The Natrol and Laci Le Beaubrands are sold in health food stores, in mass-market drug, food and retailchains as well as club stores. Prolab products are sold through distributorswho in turn service retail accounts. Prolab’s distributor network focuses onhealth food stores, health clubs and fitness facilities that cater to bodybuilders and other individuals seeking a high level of fitness. With theintegration of Prolab as a brand within Natrol, Natrol’s health food orientedsales professionals have become responsible for presenting appropriate Prolabproducts to health food retailers, who in turn, order from distributors whocarry Prolab product. In addition, in 2004 more than 40% of Prolab sales are todistributors who sell Prolab products outside the United States. The Company iscontinually seeking to expand the distribution of its best selling items toadditional retail outlets and to create promotional opportunities for itsproducts within its existing customer base.

 

The Company also provides contract manufacturing services to othersupplement companies and sells a limited number of raw material ingredients toother nutraceutical companies.

 

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

 

The nutritional supplement business is dependent upon new productintroductions for both growth and to replace volume lost by products reachingthe end of their product life cycles. As such, the Company is continuallyresearching potential new products for placement into the marketplace.Developing a single new product can be a multi-year effort depending upon thecomplexity of the product and the amount of testing that must be completed tovalidate the product concept.

 

Product introductions do not come without risk. Product launches canrequire substantial marketing support. Oftentimes retailers demand slottingfees or other up front expenditures. If a

 

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product launch is not as successful as anticipated, additionalpromotional expenditures may be needed to sustain sales and reduce possiblereturns. Most vendors retain certain rights as they relate to product returns.A broad product launch, one in which a new product is introduced into thousandsof retail outlets, can cause a strain on corporate resources since inventoriesmust be produced and delivered. The resulting sales increase also leads to anincrease in accounts receivable with customers.

 

Nutritional supplements must maintain potency levels during theirselling life. As a result, products must be stamped with an expiration date andretailers will not accept product with limited shelf life into theirwarehouses. Shelf life issues require a high degree of supply chain managementof raw materials and finished goods to ensure that shelf life is maximized andthat the out-of-date inventory is minimized.

 

The competition for shelf space at retailers is intense. Natrol hasongoing discussions with its retail customers with regards to the allocation ofshelf space and the level of promotional support for products. Retailers lookto their vendors for promotional support for the products on their shelves inorder to maximize sales. Vendors such as Natrol look to retailers foradvantageous placement of their products and promotion of their products withinstores and within a retailer’s promotional media such as newspaperadvertisements placed by retailers. The cost of promotions and support to theretailer on the part of vendors such as Natrol can be very high and managementmust continually review its promotional efforts with retailers to ensure thatsales are profitable.

 

Future challenges include maintaining the current positive trends forthe Company across all product lines as well as developing new innovativeproducts and delivery systems that will capture the support of consumers andsustain the growth experienced in 2004. As noted earlier the supplementbusiness is characterized by trends in which some products fall out of favorpresenting companies in the nutritional supplement business with the challengeof introducing new products which can replace business lost from products thatare waning.

 

The Company continues to believe that additional opportunities forgrowth exist as it seeks to improve its position with retailers and consumers.Management seeks to capitalize on these opportunities in what remains a verycompetitive marketplace.

 

**CRITICAL ACCOUNTING POLICIES**

 

The consolidated financial statements of the Company are prepared inaccordance with accounting principles generally accepted in the United Statesof America, which requires the Company to make certain estimates andassumptions affecting the reported amounts in the consolidated financialstatements and accompanying notes. The Company bases its estimates onhistorical experience and on various other assumptions believed to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions.

 

Management believes the following critical accounting policies, amongothers, affect its more significant judgments and estimates used in thepreparation of its consolidated financial statements.

 

*Revenue Recognition.*  The Company sells its products to retailoutlets through a direct sales force and a national distributor network. TheCompany recognizes revenue from sales only after product is shipped and titleis transferred. Net sales represent product shipped less actual and estimatedfuture returns, spoilage allowances, allowances for product deemed to beunsaleable by customers, and slotting fees, rebates and other expenditureswhich, using Generally Accepted Accounting Principles (GAAP) should beaccounted for as reductions of revenue.  Estimatesand allowances are based upon known claims and an estimate of additionalreturns, however, the amount of future returns can be reasonably estimated.

 

The Company’s recognition of revenue from sales to distributors andretailers is impacted by agreements giving them rights to return damaged andoutdated products as well as the fact that as a

 

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practical business matter, the Company and its customers are constantlyworking to ensure the profitability of its products within retailers byrotating slow moving items out of stores and replacing those products with whatthe Company and the retailer expect will be more profitable, faster sellingitems. The Company’s obligation to accept returns of slow moving items may ormay not be contractually bound.

 

The Company regularly monitors its historical patterns of returns fromcustomers as well as current and ongoing sales to customers and, wheninformation is available, consumer purchases of the Company’s products from theCompany’s customers.  The Company hasdetermined that historical trends with respect to product sales of individualitems are not a good barometer of future returns of those items.  Excellent historical sales with few returnsdoes not guarantee strong future sales and a low level of future returns.  This is due to a number of factors including:changes in consumer demand for individual items; increasing or decreasingcompetition from industry participants; different levels of periodic supportfrom retail partners; the amount of advertising the Company may be able tosupport; and, favorable or unfavorable publicity.  Products that sell well at one account maynot sell well at another account due to factors that are unique to the particularcustomer such as: poor vs. excellent product placement on the customer’sshelves, the fact that customers do not carry the same products, the carryingby a customer of more or fewer competitive products, and pricing at the retaillevel which is controlled by the customer. In order to reduce the amount of subjectivity when analyzing salestrends and reserving for future returns, the Company performs a detailedanalyses of trends at each of its major customers, i.e., those customers whohave historically accounted for the bulk of returns.  This analyses takes into account salespatterns of individual products at each customer on a customer-by-customerbasis as well as inventory levels at the customer, scheduled promotionalevents, and the probability that items will be discontinued.  The Company believes that this analysis createsappropriate estimates of necessary future reserves.  The Company’s use of the term returnsincludes estimates of its liability for damaged and outdated product within itschannels of trade.  Over the last threeyears, returns and estimates of return liability were as follows:

 
| **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, 2002 |       | $                                 | 1,020      |                              | $          | 6,700          |       | $                           | 6,127      | (1) | $ | 1,593 |   |
| 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 |   |

 

In recent years, as a result of a combination of the factors describedabove, gross sales have been materially offset by the estimated amount ofreturns and other charges to arrive at net sales. It is also possible thatreturns could increase rapidly and significantly in the future.  Accordingly, although the Company attempts toeliminate as much subjectivity as it believes possible, the Company recognizesthat estimating product returns requires a degree of management judgment.  For this reason, the accounting estimaterelated to product returns is a “critical accounting estimate.”

 

The total amount charged against sales for returns and damages andoutdates in 2004, 2003, and 2002 respectively, was $3.2 million$4.0 million, and $6.7 million.

 

*Impairment of Goodwill.*  On January 1, 2002, the Company adoptedSFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142requires that goodwill not be amortized. In accordance with such adoption, theCompany identified all reporting units in conjunction with the provisions ofSFAS No. 142 and allocated all goodwill accordingly. Beginning in 2002,goodwill is evaluated for impairment annually, or whenever events or changes incircumstances indicate that the carrying amount of goodwill may not berecoverable. In 2002, the Company tested goodwill for impairment using thetwo-step process prescribed in SFAS No.142. The first step is a screen forpotential impairment, while the second step measures the amount of theimpairment, if any. The Company performed the impairment test and determinedthat the there was potential impairment of the Natrol segment. The Companyperformed the second step as of January 1, 2002 for the Natrol segment anddetermined that its 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, in theaccompanying consolidated statement of operations for the year ended December 31,2002.

 

The remaining goodwill balance at December 31, 2002 and 2003 wasapproximately $4.0 million. In the fourth quarter of 2003, the Companycompleted its annual goodwill impairment testing and determined that goodwillwas not impaired. Additionally, during March 2004, the Company settled itslitigation with the former owners of Prolab Nutrition, Inc. The Companyreceived $2 million in cash, which was reflected in the financialstatements for the quarter ending March 31, 2004 as a reduction ofgoodwill. In accordance with the provisions of SFAS No. 142, the Companyperformed its annual impairment test of goodwill during the fourth quarter of2004 and concluded that it was not impaired.

 

*Income Taxes.*  Deferred income tax assets have beenestablished for future tax benefits related to deductible goodwill for whichthe Company has recorded an impairment charge and for certain other temporaryitems, the aggregate benefit of which is approximately $4.7 million.Realization of this benefit is dependent on generating sufficient taxableincome in future periods. Although it is not assured, management believes it ismore likely than not that the carrying value of this benefit will be realized.The amount of the benefit that is considered realizable, however, could changeif estimates of future taxable income are adjusted in future periods.

 

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*Inventory.*  The Company monitors its inventory andanalyzes it on a regular basis. Cycle counts are taken to verify inventorylevels. In addition, the Company analyzes the movement of items within itsinventory in an effort to determine the likelihood that inventory will be soldor used before expiration dates are reached. The Company provides an allowanceagainst that portion of its inventory that it believes is unlikely to be soldor used before expiration dates are reached. At December 31, 2004,inventory allowances were approximately $1.4 million.

 

**RESULTS OF OPERATIONS**

 

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

 

*Net Sales.*  The Company recognizes revenue from salesonly after product is shipped and title is transferred. Net sales representproduct shipped less actual and estimated future returns, spoilage allowances,allowances for product deemed to be unsaleable by customers, free goods shippedto customers for promotional or other purposes, rebates, slotting fees andother promotional expenditures. Estimates and allowances are based upon knownclaims and an estimate of additional returns when the amount of future returnsfrom customers can be reasonably estimated.

 

Net sales in 2004 increased 9.1%, or $6.6 million, to$79.3 million from $72.7 million in 2003. Net sales is calculated bysubtracting from gross revenue certain expenses such as incentive rebates,shipping damages, and returns. Net sales in 2004 were positively affected by alower level of returns than in 2003. The level of 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. Other deductionsfrom gross revenue fell from 9.0% in 2003 to 7.9% in 2004.  These other deductions are due to: paymentdiscounts given to customers for timely payment, audit claims from customersfor such items as shipping shortages, and promotional support such as rebateincentives and pricing reductions which, according to GAAP rules must berecorded as reductions of revenue. The level of promotional support recorded asa reduction of revenue declined from 6.2% of gross shipments in 2003 to 5.9% ofgross shipments in 2004.  The remainderof the 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 result of many factorsincluding customer relations and the popularity of the Company’s products withconsumers. During 2004, the Company improved the level of sales with clubstores and mass market merchants and certain categories of products,weight-loss products in particular, proved to be popular with consumers. Salesgains in these areas were partially offset by the loss of sales with othercustomers and declining sales of certain other product categories.

 
| ** **                      | ** ** | **Years Ended  December 31,** | ** ** |
|---------------------------------|------------|------------------------------------|------------|
| ** **                      | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| Net Revenue                     | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Natrol (including Laci-Le Beau) |       | $                                  | 54,668     |   | $ | 46,502 |   |
| EPI                             |       | 6,515                              |       | 7,373 |   |
| Prolab                          |       | 18,086                             |       | 18,783 |   |
| Total net Revenue               |       | $                                  | 79,269     |   | $ | 72,658 |   |

 

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

 

The largest sales declines were due to slower sales within the Company’sEPI raw materials division. Bulk ingredient sales accounted for 2.3% of theCompany’s gross sales in 2004. Approximately 61% of these sales or$1.4 million were generated through the sales of garlic and othervegetable powders. The balance of sales were from the sale of arabinogalactan.Sales of garlic and vegetable powders fell approximately 40% in 2004. Reasonsfor the decline include market conditions and competition from domestic andinternational suppliers. This decline was partially offset by sales ofarabinogalactan.

 

During 2004, two product categories each accounted for more than 10% ofgross shipments. During 2003, only one category accounted for more than 10% ofgross shipments. No customer accounted for 10% or more of gross sales in 2004or 2003. The Company’s top 10 customers accounted for approximately 48% and 47%of the Company’s gross sales in 2004 and 2003, respectively.

 

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*Gross Profit.*  Gross profit increased 14.2% or$4.0 million to $32.4 million in 2004 as compared to$28.4 million in 2003. Gross margin increased to 40.9% in 2004 from 39.1%in 2003. Gross margin fluctuates depending upon product mix, the cost of rawmaterials, labor and overhead as well as the difference between gross revenueand 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.

 

*Selling and Marketing Expenses.*  Selling and marketing expenses consist primarilyof advertising 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 million in 2003. Of the $1.9 million net increase in sellingand marketing expenses, approximately $280,000 was due to the increased cost ofshipping product, approximately $780,000 was due to increased promotionalexpenditures, approximately $250,000 was due to increased public relations expenditures,and approximately $460,000 was due to payroll and broker commissions increasesoutside of the shipping department.

 

*General and Administrative Expenses.*  General and administrative expenses consistprimarily of personnel costs related to general management functions, researchand development, finance, accounting and information systems, as well asprofessional fees. General and administrative expenses decreased 7.1% or$.7 million in 2004 from $10.1 million in 2003 to $9.3 millionin 2004.

 

The largest savings in general and administrative expenses came fromthe closing of Prolab’s headquarters facility in October 2003 and theconsolidation of all administrative functions for Prolab into Natrol’sheadquarters facility. This consolidation reduced net payroll by approximately$850,000 when compared to 2003. The Company also saved approximately $750,000when compared to 2003 through the implementation of its self-insurance programfor product liability insurance in July 2003. These savings were partiallyoffset by the establishment of a research and development department within theadministrative area in October 2003. The Company spent approximately$575,000 more on this department in 2004 than in 2003. Also offsetting savingsgenerated by the Prolab closure and the self-insurance program was the Company’sbonus incentive program. This program was established in 2004 and resulted inthe granting of approximately $600,000 in incentive payments to qualifiedemployees.

 

*Interest Income (Expense), net.*  Interest expense was approximately $630,000in 2004 versus interest expense of approximately $649,000 in 2003. Interestincome in 2004 was approximately $101,000 versus approximately $54,000 in 2003.Interest expense decreased in 2004 as the Company had less debt outstandingduring the year. Interest income increased due to the average level of cash onhand earning interest.

 

*Income Tax Provision (Benefit).*  Income taxes were $1.1 million in 2004as compared to approximately $34,000 in 2003. The difference in income taxexpense was primarily due to the differences in taxable income earned in 2004versus 2003. The Company’s tax rate was 38.0% in 2004 versus 64.2% in 2003. Thedifference was due primarily to the fact that the some of the Company’sexpenses cannot be expensed for tax purposes. When earnings are at a low level,these permanent adjustments to taxable income have a proportionately greatereffect on the company’s tax rate than when total earnings are at a higherlevel.

 

***Year Ended December 31,2003 Compared to Year Ended December 31, 2002***

 

*Net Sales.*  Net sales in 2003 increased 3.4%, or$2.4 million, to $72.7 million from $70.3 million in 2002. Netsales in 2003 were positively affected by a lower level of returns than in2002. The level of returns was approximately 4.7% of gross shipments in 2003and as compared to 8.7% of gross shipments in 2002. During 2002, the Companyworked to “rationalize” its product offerings in the mass-market channel oftrade where returns are most likely to occur. During 2001 it became apparent

 

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to the Company that sales of secondary and tertiary items in thischannel of trade were not sufficient to prevent significant product returns.This rationalization process directly resulted in lower net revenue since theCompany stopped selling many secondary and tertiary items within mass-marketaccounts. The Company limited the sale of these items to specialty stores wherethe volume of sales was sufficient to prevent a large volume of returns. As aresult of this rationalization process, the level of returns was reducedsubstantially in both 2002 and 2003. The reduction in returns helped increasenet revenue since returns reduce gross sales revenue when calculating netsales.

 

The Company did not have any products that represented 10% or more ofits gross sales in either 2003 or 2002. One customer accounted for 10% or moreof the Company’s gross sales in 2002. The Company’s top 10 customers accountedfor approximately 47% and 44% of the Company’s gross sales in 2003 and 2002,respectively.

 

*Gross Profit.*  Gross profit decreased $133,000, to$28.4 million, in 2003 as compared to $28.5 million in 2002. Grossmargin decreased to 39.1% in 2003 from 40.6% in 2002. Product mix, increase in costof materials, labor rates and an increase in quality assurance expendituresresulted in the decrease in gross margin.

 

*Selling and Marketing Expenses.*  Selling and marketing expenses increased by0.3% to 24.4% in 2003 from 24.1% of net sales in 2002. The dollar amount spentfor sales and marketing expenses increased 4.6% or $786,000 in 2003, from$16.9 million in 2002 to $17.7 million in 2003. Of the $786,000 netincrease in selling and marketing expenses, approximately $670,000 was due to theincreased cost of shipping product and approximately $420,000 of payrollincreases. These increases were partially offset by decreases in media spendingand other forms of promotional support and well as decreases in other expenses.

 

*General and Administrative Expenses.*  General and administrative expenses increased15.1% or $1.3 million in 2003 from $8.7 million in 2002 to$10.1 million in 2003. Of this increase $179,000 was due to theestablishment of a research and development department in the fourth quarter of2003. General insurance expenses increased $711,000 relative to 2002. In orderto reduce these expenditures, the Company began to self-insure its productliability exposure in July of 2003. Depreciation expense was $131,000higher in 2003 than in 2002, primarily because of the implementation of theCompany’s SAP software system in November 2002. The Company also accrued$164,000 more for bad debt expenses in 2003 than it did in 2002. The Companyincreased its allowances for bad debts due to the larger amount of receivablescarried at year end 2003 than at year end 2002. The remainder of the increasein general and administrative expenses was due to increases in payrollpartially offset by miscellaneous decreases in other expenditures.

 

*Interest Income (Expense), net.*  Interest expense was $649,000 in 2003 versusinterest expense of $731,000 in 2002. Interest income in 2003 was $54,000versus $87,000 in 2002. Interest expense decreased in 2003 as the Company hadless debt outstanding. Interest income decreased due to the level of interestrates as well as the average level of cash on hand earning interest.

 

*Income Tax Provision (Benefit).*  Income taxes were $34,000 in 2003 as comparedto $861,000 in 2002. The difference in income tax expense was primarily due tothe differences in taxable income earned in 2003 versus 2002. The Company’s taxrate in 2003 was 64.2% in 2003 versus 38.4% in 2002. The difference was dueprimarily to the fact that the some of the Company’s expenses cannot beexpensed for tax purposes. When earnings are at a low level, these permanentadjustments to taxable income have a proportionately greater effect on thecompany’s tax rate than when total earnings are at a higher level.

 

In December 2003, the Company discontinued its Annasa and Tamsolunits. Annasa, a subsidiary of Natrol, a multi-level marketer of proprietarynutritional products began operations in 2002. Tamsol was also formed in 2002,to generate direct-to-consumer sales via radio, television, direct mail and

 

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other non-retail venues. Annasa had revenue of $44,000 in 2002 and$667,000 in 2003. Operating losses for Annasa in 2002 were approximately$1.1 million and, were approximately $1.8 million in 2003. Theselosses were higher than anticipated and the Company discontinued the operationsof Annasa at year-end 2003. During 2002, Tamsol had $27,000 of net revenue anda loss before income taxes of $41,000. During 2003, Tamsol failed to meetrevenue or profit goals and its operations were discontinued during the fourthquarter of 2003. For the year ended December 31, 2003, Tamsol had netrevenue of $30,000 and a loss before income taxes of $542,000. The Company hasreclassified its financial statements to segregate the revenues, direct costsand expenses (excluding allocated costs), assets and liabilities and cash flowsof the discontinued operations. The net operating results, net assets and netcash flows of these businesses have been reported as “Discontinued Operations”in the accompanying consolidated financial statements.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

At December 31, 2004, the Company had working capital of$18.3 million, as compared to $13.3 million in working capital at December 31,2003. The prime reasons for the increase in working capital during 2004 were$2 million received as part of a legal settlement with the former ownersof Prolab, the generation of $l.9 million of net income and the receipt of$750,000 in bank financing. The legal settlement was recorded as a receipt ofcash and a reduction of goodwill.

 

Net cash provided by operating activities was $1.7 million for theyear ended December 31, 2004 versus net cash used of $2.2 million in2003 and net cash provided of $6.2 million in 2002. In 2004, net incomeprovided $1.9 million and $1.8 million was provided by non-cashcharges. Change in operating assets and liabilities used $1.9 million. Theprimary uses from operating assets and liabilities were increases approximately$670,000 in inventory and a decrease of $2.7 million in accounts payableoffset by a decrease in accounts receivable of approximately $381,000, anincrease in accrued expenses of approximately $751,000 and increase on payrolland related liabilities of approximately $817,000, a decrease in prepaid expensesof approximately $120,000 and an increase in income taxes receivable ofapproximately $607,000. The non-cash charges consisted primarily of$1.3 million of depreciation and amortization and an approximately $35,000change in net assets of discontinued operations offset by a decrease ofapproximately $223,000 in the provision for bad debt.

 

At December 31, 2004, the Company’s days sales outstanding in itstrade receivable was approximately 32 days versus 38 days in 2003 and35 days in 2002.

 

Net cash provided by investing activities was approximately $945,000 in2004 versus net cash used of $5.4 million in 2003 and $1.5 million in2002. The Company invested approximately $920,000 in plant and equipment in2004, primarily for the expansion of a quality control laboratory. Other assetsgrew by approximately $135,000 during the year. These uses of cash were offsetby the receipt of $2 million due to the settlement of litigation with theformer owners of Prolab.

 

Nearly all of the cash used for investing activities in 2004, 2003 and2002, with the exception of the insurance deposit made in 2003, was for theacquisition of property, plant and equipment. Substantially all of theinvestment in 2002 related to the installation of a new integrated SAP softwaresystem and related computer equipment to manage the Company’s business.

 

Net cash provided by financing activities was approximately $744,000and approximately $56,000 for the years ended December 31, 2004 and 2003,respectively, versus net cash used of approximately $161,000 in 2002. In 2004,the Company borrowed $750,000 from its bank. The note with the bank calls forthe Company to repay the bank over a five-year period with equal principalpayments of $12,500 per month. During 2004, the Company repaid approximately$338,000 on its long-term debt. The Company also raised approximately $332,000through the exercise of employee stock options and the sale of stock toemployees through the Company’s Employee Stock Purchase Program. During 2003,the Company reduced its debt by approximately $303,000. This use of cash wasoffset by approximately 

 

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$359,000 raised through theexercise of employee stock option or the sale of stock to employees through theCompany’s Employee Stock Purchase Program.

 

As of December 31, 2004, the Company had $8.2 million inoutstanding debt versus $7.8 at the end of 2003. The outstanding debt isrelated to a mortgage on the Company’s manufacturing/headquarters facility anda mortgage on the Company’s shipping facility as well as the term notedescribed under cash provided by financing activities.

 

The Company’s cash balance at the close of 2004 was approximately$6 million (excluding $5 million in restricted cash) as opposed toapproximately $2.6 million (excluding $5 million in restricted cash)at the end of 2003 and $10.1 million at the end of 2002.

 

During 2004, the Company also entered into a line of credit with itsbank. The line of credit allows the Company to borrow up to $3 million.The line of credit includes certain covenants that could limit its borrowingsunder the line of credit to less than $3 million and if the Company failsto meet certain financial covenants, borrowing under the line of credit may notbe possible and any outstanding borrowing may have to be repaid upon demand.The most restrictive covenants for the $3 million Revolving Note are (a) TangibleNet Worth plus Subordinated Debt of not less than $29.4 million at alltimes; (b) a ratio of Total Senior Liabilities to Tangible Net Worth plusSubordinated Debt of not more than 1.25 to 1 at all times; and (c) a ratioof Cash Flow from Operations to Debt Service of not less than 1.25 to 1 foreach fiscal quarter on a rolling 12 month basis. Should the Company failto meet the required financial covenants, there is no guarantee that, shouldthe Company need additional capital, that financial institutions will bewilling to provide capital to the Company. Also, in providing the Company withadditional funds, potential lenders may seek to institute covenants restrictingthe Company from certain activities and if the Company deems it necessary toborrow funds with these restrictions in place, it may find that its ability tocompete effectively in its market sector is hindered.

 

In order to meet its long-term liquidity needs, the Company may berequired to incur additional indebtedness or issue additional equity and debtsecurities, subject to market and other conditions. There can be no assurancethat such additional financing will be available on terms acceptable to theCompany or at all. The failure to raise the funds necessary to finance itsfuture cash requirements or consummate future acquisitions could adverselyaffect the Company’s ability to pursue new acquisitions and could negativelyaffect its operations in future periods.

 

The Company believes that its cash balance together with cash generatedfrom operations and the potential use of its line of credit should besufficient to fund its anticipated working capital needs and planned capitalexpenditures for the next 12 months. However, if the Company does not meetits operating plan it may also need additional borrowings to fund workingcapital needs.

 

The Company currently has no outstanding debt on its books other thanmortgage debt on its properties and a five-year term note secured by theCompany’s non-real estate assets. The balance of this term-note on December 31,2004 was $737,500

 

**RECENTLY ISSUED ACCOUNTING STANDARDS**

 

In December 2002, the FASB issued SFAS No. 148, “Accountingfor Stock-Based Compensation—Transition and Disclosure.” This statement amendsSFAS No. 123, to provide alternative methods of voluntary transition tochange to the fair value based method of accounting for stock-based employeecompensation. Additionally, this statement amends disclosure requirements ofaccounting for stock-based employee compensation and the effect of the methodused on reporting results. As of December 31, 2002, the Company hasadopted the disclosure requirements of SFAS No. 148, but has elected tocontinue to account for stock-based compensation to its employees and directorsusing the intrinsic value method proscribed by APB No. 25 and relatedinterpretations.

 

In January 2003, the FASB issued FASB Interpretation No. (“FIN”)46, “Consolidation of Variable Interest Entities” (“FIN 46”). In December 2003,FIN 46 was replaced by FASB interpretation

 

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No. 46(R) “Consolidation of Variable Interest Entities.” FIN 46(R)clarifies the application of Accounting Research Bulletin No. 51, “ConsolidatedFinancial Statements,” to certain entities in which equity investors do nothave the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties. FIN 46(R)requires an enterprise to consolidate a variable interest entity if thatenterprise will absorb a majority of the entity’s expected losses, is entitledto receive a majority of the entity’s expected residual returns, or both. FIN46(R) is effective for entities being evaluated under FIN 46(R) forconsolidation no later than the end of the first reporting period that endsafter March 15, 2004. The Company does not currently have any variableinterest entities that will be impacted by adoption of FIN 46(R).

 

On April 30, 2003, the Financial Accounting Standards Board issuedSFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and HedgingActivities.” SFAS No. 149 amends and clarifies accounting for derivativeinstruments, including certain derivative instruments embedded in othercontracts, and for hedging activities under SFAS No. 133. The new guidanceamends SFAS No. 133 for decisions made as part of the DerivativesImplementation Group (“DIG”) process that effectively required amendments toSFAS No. 133, and decisions made in connection with other FASB projectsdealing with financial instruments and in connection with implementation issuesraised in relation to the application of the definition of a derivative andcharacteristics of a derivative that contains financing components. Inaddition, it clarifies when a derivative contains a financing component thatwarrants special reporting in the statement of cash flows. SFAS No. 149 iseffective for contracts entered into or modified after June 30, 2003 andfor hedging relationships designated after June 30, 2003. Adoption of thisstandard did not have an impact on the Company’s consolidated financialstatements.

 

In May 2003, the FASB issued SFAS No. 150 *Accounting for Financial Instruments with theCharacteristics of Both Liabilities and Equities*. SFAS No. 150establishes standards regarding the manner in which an issuer classifies andmeasures certain types of financial instruments having characteristics of bothliabilities and equity. Pursuant to SFAS No. 150, such freestandingfinancial instruments (i.e., those entered into separately from an entity’sother financial instruments or equity transactions or that are legallydetachable and separately exercisable) must be classified as liabilities or, insome cases, assets. In addition, SFAS No. 150 requires that financialinstruments containing obligations to repurchase the issuing entity’s equityshares and, under certain circumstances, obligations that are settled bydelivery of the issuer’s shares be classified as liabilities. Certain aspectsof SFAS No. 150 have been deferred; however, the Statement is effectivefor financial instruments entered into or modified after May 31, 2003 andfor other instruments at the beginning of the first interim period beginningafter June 15, 2003. The Company does not currently have any financialinstruments that have been impacted by SFAS No. 150. The adoption of SFAS No. 150did not have a material impact on the Company’s financial position or resultsof operations.

 

In December 2003, the SEC issued Staff Accounting Bulletin (“SAB”)No. 104, “Revenue Recognition.” SAB 104, which was effective upon issuance,updates portions of the interpretive guidance included in Topic 13 of thecodification of Staff Accounting Bulletins and revises or rescinds portions ofthe interpretative guidance included in SAB 101 in order to make thisinterpretive guidance consistent with current authoritative accounting andauditing guidance and SEC rules and regulations. The principal revisionsrelate to the incorporation of certain sections of the staff’s Frequently AskedQuestion (“FAQ”) document on revenue recognition into Topic 13. SAB 101, “RevenueRecognition in Financial Statements,” which was issued in December 1999,provides guidance to SEC registrants on the recognition, presentation anddisclosure of revenues in the financial statements. Since the Company hasalready adopted all such standards upon issuance, the application of thisrevised guidance did not impact its consolidated financial position, results ofoperations, or disclosure requirements.

 

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In November 2004, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Accounting Standards (“SFAS”) No. 151, “InventoryCosts” an amendment of Accounting Research Bulletin (“ARB”) No. 43, toclarify the accounting for abnormal amounts of idle facility expense, freight,handling costs, and wasted material (spoilage). This Statement requires thatthose items be recognized as current-period charges regardless of whether theymeet the criterion of “so abnormal”. In addition, this Statement requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities. Companies are required toadopt the provisions of this Statement for fiscal years beginning after June 15,2005. The Company does not believe there will be a material effect on itsconsolidated financial position or results of operations from the adoption ofthis standard.

 

In December 2004, the FASB issued SFAS No.153, “Exchanges ofNonmonetary Assets, an amendment of APB Opinion No. 29, Accounting forNonmonetary Transactions.” The amendments made by Statement 153 are based onthe principle that exchanges of nonmonetary assets should be measured based onthe fair value of the assets exchanged. Further, the amendments eliminate thenarrow exception for nonmonetary exchanges of similar productive assets andreplace it with a broader exception for exchanges of nonmonetary assets that donot have commercial substance. Previously, Opinion 29 required that theaccounting for an exchange of a productive asset for a similar productive assetor an equivalent interest in the same or similar productive asset should bebased on the recorded amount of the asset relinquished. Opinion 29 provided anexception to its basic measurement principle (fair value) for exchanges ofsimilar productive assets. The Board believes that exception required that somenonmonetary exchanges, although commercially substantive, be recorded on acarryover basis. By focusing the exception on exchanges that lack commercialsubstance, the Board believes this Statement produces financial reporting thatmore faithfully represents the economics of the transactions. The Statement iseffective for nonmonetary asset exchanges occurring in fiscal periods beginningafter June 15, 2005. Earlier application is permitted for nonmonetaryasset exchanges occurring in fiscal periods beginning after the date ofissuance. The provisions of this Statement shall be applied prospectively. TheCompany has evaluated the impact of the adoption of SFAS 152, and does notbelieve the impact will be significant to the Company’s overall results ofoperations or financial position.

 

In December 2004, the FASB issued SFAS No.123 (revised 2004), “Share-BasedPayment”. Statement 123(R) will provide investors and other users of financialstatements with more complete and neutral financial information by requiringthat the compensation cost relating to share-based payment transactions berecognized in financial statements. That cost will be measured based on thefair value of the equity or liability instruments issued. Statement 123(R)covers a wide range of share-based compensation arrangements including shareoptions, restricted share plans, performance-based awards, share appreciationrights, and employee share purchase plans. Statement 123(R) replaces FASBStatement No. 123, Accounting for Stock-Based Compensation, and supersedesAPB Opinion No. 25, Accounting for Stock Issued to Employees. Statement123, as originally issued in 1995, established as preferable a fair-value-basedmethod of accounting for share-based payment transactions with employees.However, that Statement permitted entities the option of continuing to applythe guidance in Opinion 25, as long as the footnotes to financial statementsdisclosed what net income would have been had the preferable fair-value-basedmethod been used. Public entities (other than those filing as small businessissuers) will be required to apply Statement 123(R) as of the first interim orannual reporting period that begins after June 15, 2005. The Company hasevaluated the impact of the adoption of SFAS 123(R), and the effect ofwhich is discussed in Footnote 1.

 

In December 2004 the Financial Accounting Standards Board issuedtwo FASB Staff Positions—FSP FAS 109-1, *Application of FASB Statement 109 “Accounting for Income Taxes” to theTax Deduction on Qualified Production Activities Provided by the American JobsCreation Act of 2004,* and FSP FAS 109-2 *Accounting and Disclosure Guidance for the ForeignEarnings Repatriation Provision within the*

 

35

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*American Jobs Creation Act of 2004.* Neither ofthese affected the Company as it does not participate in the relatedactivities.

 

**CONTRACTUAL OBLIGATIONS AND COMMITMENTS**

 

The following table discloses the Company’s obligations and commitmentsto make future payments under contractual obligations at December 31,2004.

 
| ** **                | ** ** | **Payment Due by Period (In Thousands)** | ** ** |
|---------------------------|------------|------------------------------------------|------------|
| ** **                | ** ** | **Total**                                | ** ** | **Less  than  1 Year** | ** ** | **2-3  Years** | ** ** | **4-5  Years** | ** ** | **Thereafter** | ** ** |
| Note Payable              |       | $                                        | 8,188      |   | $ | 503 |   | $ | 1,097 |   | $ | 1,222 |   | $ | 5,366 |   |
| Interest on Notes Payable |       | $                                        | 5,022      |   | 636 |   | 1,153 |   | 979 |   | 2,254 |   |
| Leases                    |       | 339                                      |       | 134 |   | 182 |   | 19 |   | 4 |   |
| Total                     |       | $                                        | 8,527      |   | $ | 637 |   | $ | 1,279 |   | $ | 1,241 |   | $ | 5,370 |   |

 

The Company leases part of its Jordan facility and future minimum leasepayments due to the Company are (in thousands):

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

 

**IMPACT OF INFLATION**

 

Generally, inflation has not had a material impact on the Company’shistorical operations or profitability.

 

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

 

The Company’s exposure to market risks is limited to interest raterisks. The risks related to foreign currency exchange rates are immaterial andthe Company does not use derivative financial instruments.

 

The Company is subject to interest rate market risk associated with itsbank debt. Even so, the Company does not believe the risk associated with suchborrowing is significant. Additionally, the Company does not believe that therisk is significant for its long-term debt due to the low fixed rates andrelative insignificance of the fixed long-term debt to the Company’sconsolidated balance sheet. The Company’s long-term debt is comprised of twofixed rate notes with a total principal balance of approximately $7,451,000collateralized by the Company’s headquarters building and its shipping facilityand one variable rate note with a principal balance of approximately $737,000collateralized by the Company’s general assets. The table below presentsprincipal cash flows and related interest rates by fiscal year of maturity.

 
| ** **       | ** ** | **Expected Year of Maturity (In Thousands)** | ** ** |
|------------------|------------|----------------------------------------------|------------|
| ** **       | ** ** | **2005**                                     | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **Thereafter** | ** ** | **Total** | ** ** | **Fair Value  December 31,  2004(1)** | ** ** |
| Notes payable(2) |       | $                                            | 503        |   | $ | 532 |   | $ | 564 |   | $ | 598 |   | $ | 624 |   | $ | 5,367 |   | $ | 8,188 |   | $ | 9,285 |   |
|                  |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)           The Company’sestimate of the fair value of its notes payable was based on an analysis ofcurrent market interest rates.

 

(2)           The weighted averageinterest rate for all years presented is 8.0% for the fixed rate notes and 6%for the variable rate note.

 

36

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**ITEM 8.****  FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 
| Index to Consolidated Financial Statements:                                                                     |   |
|-----------------------------------------------------------------------------------------------------------------|--------|
| Report of Independent Registered Public Accounting Firm-Stonefield  Josephson, Inc.                        |   |
| Report of Independent Registered Public Accounting Firm-Deloitte &  Touche, LLP                        |   |
| Consolidated Balance Sheets as of December 31, 2004 and 2003                                               |   |
| Consolidated Statements of Operations for the years ended December 31,  2004, 2003, and 2002               |   |
| Consolidated Statements of Stockholders’ Equity for the years ended  December 31, 2004, 2003 and 2002 |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and  2002               |   |
| Notes  to Consolidated Financial Statements                                                                     |   |

 

37

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**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

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

 

We have audited the accompanying consolidated balance sheet of Natrol, Inc.and its subsidiaries (the “Company”) as of December 31, 2004, and therelated consolidated statement of operations, stockholders’ equity, and cashflows for the year then ended. Our audit also included the financial statement schedule listedat the index in Item 15(a) as of and for the year ended December 31,2004. These consolidated financial statements and schedules are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these consolidated financial statements and schedule based onour audit.

 

We conducted our audit in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit includedexamining, on a test basis, evidence supporting the amounts and disclosure inthe estimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audit provides a reasonable basisfor our opinion.

 

The consolidated financial statements referred to above present fairly,in all material respects, the financial position of Natrol, Inc. and itssubsidiaries as of December 31, 2004, and the results of their operationsand their cash flows for the year then ended, in conformity with accountingprinciples generally accepted in the United States of America. Also, in ouropinion, the financial statement schedule when considered in relation tothe basic consolidated financial statements, taken as a whole, presents fairly,in all material respects, the information set forth therein.

 
| */s/ STONEFIELD JOSEPHSON, INC.* |   |
|----------------------------------|--------|
| CERTIFIED PUBLIC ACCOUNTANTS     |
| Santa Monica, California         |
| February 7, 2005            |

 

38

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**Report of Independent Auditors**

 

**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

To the Board of Directors and Stockholders of Natrol, Inc.

Chatsworth, California

 

We have audited the accompanying consolidated balance sheets of Natrol, Inc.and its subsidiaries (the “Company”) as of December 31, 2003, and therelated consolidated statements of operations, stockholders’ equity, and cashflows for the years ended December 31, 2003 and 2002. Our audits alsoincluded the financial statement schedule listed in the index at Item 15(a) asof December 31, 2003 and for the years ended December 31, 2003 and2002. These financial statements and schedule are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements and schedule based on our audits.

 

We conducted our audits in accordance with standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly,in all material respects, the financial position of Natrol, Inc. and itssubsidiaries as of December 31, 2003, and the results of their operationsand their cash flows for the years ended December 31, 2003 and 2002. Also,in our opinion, the related financial statement schedule, when considered inrelation to the basic financial statements taken as a whole, presents fairly,in all material respects, the information set forth therein as of December 31,2003 and for the years ended December 31, 2003 and 2002.

 

As discussed in Note 1 to the consolidated financial statements,effective January 1, 2002, the Company changed its method of accountingfor goodwill and other intangible assets to conform to Statement of FinancialAccounting Standards No. 142, “Goodwill and Other Intangible Assets.”

 
| /s/ Deloitte & Touche, LLP |   |
|--------------------------------|--------|
| Los Angeles, California        |
| April 14, 2004            |

 

39

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**Natrol, Inc. and Subsidiaries**

** **

**Consolidated Balance Sheets**

** **

**(In thousands, except share and per share data)**

 
| ** **                                                                                                       | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                       | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Assets**                                                                                                       |       |                  |       |   |   |
| Current assets:                                                                                                  |       |                  |       |   |   |
| Cash                                                                                                             |       | $                     | 6,022      |   | $ | 2,599 |   |
| Accounts receivable, net of allowances of  $421 and $635 at December 31, 2004 and 2003, respectively        |       | 7,431                 |       | 7,698 |   |
| Inventory                                                                                                        |       | 9,723                 |       | 9,053 |   |
| Income taxes receivable                                                                                          |       | 956                   |       | 349 |   |
| Deferred income taxes                                                                                            |       | 814                   |       | 1,110 |   |
| Prepaid expenses and other current assets                                                                        |       | 793                   |       | 914 |   |
| Net assets of discontinued operations                                                                            |       | —                |       | 35 |   |
| Total current assets                                                                                             |       | 25,739                |       | 21,758 |   |
| Property and equipment:                                                                                          |       |                  |       |   |   |
| Building and improvements                                                                                        |       | 15,891                |       | 15,612 |   |
| Machinery and equipment                                                                                          |       | 5,332                 |       | 5,215 |   |
| Furniture and office equipment                                                                                   |       | 3,112                 |       | 3,158 |   |
|                                                                                                             |       | 24,335                |       | 23,985 |   |
| Accumulated depreciation and amortization                                                                        |       | (8,022                | )          | (7,315 | ) |
| Property and equipment, net                                                                                      |       | 16,313                |       | 16,670 |   |
| Restricted cash                                                                                                  |       | 5,000                 |       | 5,000 |   |
| Deferred income taxes                                                                                            |       | 3,628                 |       | 3,902 |   |
| Goodwill, net of accumulated amortization  and impairment charge of $37,381                                      |       | 2,026                 |       | 4,026 |   |
| Other assets                                                                                                     |       | 218                   |       | 83 |   |
| Total assets                                                                                                     |       | $                     | 52,924     |   | $ | 51,439 |   |
|                                                                                                             |       |                  |       |   |   |
| **Liabilities and stockholders’ equity**                                                                    |       |                  |       |   |   |
| Current liabilities:                                                                                             |       |                  |       |   |   |
| Accounts payable                                                                                                 |       | $                     | 2,904      |   | $ | 5,601 |   |
| Accrued expenses                                                                                                 |       | 2,483                 |       | 1,732 |   |
| Accrued payroll and related liabilities                                                                          |       | 1,589                 |       | 772 |   |
| Current portion of long-term debt                                                                                |       | 503                   |       | 325 |   |
| Total current liabilities                                                                                        |       | 7,479                 |       | 8,430 |   |
| Long-term debt, less current portion                                                                             |       | 7,685                 |       | 7,451 |   |
| 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 — 14,281,928  and 14,054,309 at December 31, 2004 and 2003, respectively |       | 143                   |       | 141 |   |
| Additional paid-in capital                                                                                       |       | 62,709                |       | 62,377 |   |
| Accumulated deficit                                                                                              |       | (22,211               | )          | (24,079 | ) |
|                                                                                                             |       | 40,641                |       | 38,439 |   |
| Shares held in treasury, at cost—921,900  shares at December 31, 2004 and 2003                         |       | (2,881                | )          | (2,881 | ) |
| Total stockholders’ equity                                                                                  |       | 37,760                |       | 35,558 |   |
| Total liabilities and stockholders’ equity                                                                  |       | $                     | 52,924     |   | $ | 51,439 |   |

 

*See notes to consolidated financialstatements.*

 

40

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**Natrol, Inc. and Subsidiaries**

** **

**Consolidated Statements of Operations**

** **

**(In thousands, except share and per sharedata)**

 
| ** **                                                                                | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net sales                                                                                 |       | $                                 | 79,269     |   | $ | 72,658 |   | $ | 70,260 |   |
| Cost of goods sold                                                                        |       | 46,820                            |       | 44,246 |   | 41,715 |   |
| Gross profit                                                                              |       | 32,449                            |       | 28,412 |   | 28,545 |   |
| Selling and marketing expenses                                                            |       | 19,560                            |       | 17,701 |   | 16,915 |   |
| General and administrative expenses                                                       |       | 9,348                             |       | 10,063 |   | 8,744 |   |
| Total operating expenses                                                                  |       | 28,908                            |       | 27,764 |   | 25,659 |   |
| Operating income from continuing operations                                               |       | 3,541                             |       | 648 |   | 2,886 |   |
| Interest income                                                                           |       | 101                               |       | 54 |   | 87 |   |
| Interest expense                                                                          |       | (630                              | )          | (649 | ) | (731 | ) |
| Income from continuing operations before  income taxes                                    |       | 3,012                             |       | 53 |   | 2,242 |   |
| Income tax provision                                                                      |       | 1,144                             |       | 34 |   | 861 |   |
| Income from continuing operations before  cumulative change in accounting principles      |       | 1,868                             |       | 19 |   | 1,381 |   |
| Discontinued operations:                                                                  |       |                              |       |   |   |   |   |
| (Loss) from operations of discontinued  Annasa component                                  |       | —                            |       | (1,766 | ) | (1,068 | ) |
| (Loss) from operations of discontinued  Tamsol component                                  |       | —                            |       | (542 | ) | (41 | ) |
| Income tax benefit                                                                        |       | —                            |       | 821 |   | 421 |   |
| Loss on discontinued operations                                                           |       | —                            |       | (1,487 | ) | (688 | ) |
| Income (loss) before cumulative effect of  accounting change                              |       | 1,868                             |       | (1,468 | ) | 693 |   |
| Cumulative effect of change in accounting  principle, net of income tax benefit of $4,139 |       | —                            |       | — |   | (6,819 | ) |
| Net income (loss)                                                                         |       | $                                 | 1,868      |   | $ | (1,468 | ) | $ | (6,126 | ) |
| Basic income (loss) per share:                                                            |       |                              |       |   |   |   |   |
| Income per share from continuing operations                                               |       | $                                 | 0.14       |   | $ | 0.00 |   | $ | 0.11 |   |
| Loss per share from discontinued operations                                               |       | —                            |       | (0.11 | ) | (0.06 | ) |
| Loss per share attributable to cumulative  effect of change in accounting principle       |       | —                            |       | — |   | (0.53 | ) |
| Income (loss) per share                                                                   |       | $                                 | 0.14       |   | $ | (0.11 | ) | $ | (0.48 | ) |
|                                                                                      |       |                              |       |   |   |   |   |
| Diluted income (loss) per share:                                                          |       |                              |       |   |   |   |   |
| Income per share from continuing operations                                               |       | $                                 | 0.13       |   | $ | 0.00 |   | $ | 0.11 |   |
| Loss per share from discontinued operations                                               |       | —                            |       | (0.11 | ) | (0.06 | ) |
| Loss per share attributable to cumulative  effect of change in accounting principle       |       | —                            |       | — |   | (0.53 | ) |
| Income (loss) per share                                                                   |       | $                                 | 0.13       |   | $ | (0.11 | ) | $ | (0.48 | ) |
|                                                                                      |       |                              |       |   |   |   |   |
| Weighted-average shares outstanding:                                                      |       |                              |       |   |   |   |   |
| Basic                                                                                     |       | 13,276,618                        |       | 12,945,938 |   | 12,852,008 |   |
| Diluted                                                                                   |       | 14,112,965                        |       | 13,451,764 |   | 12,991,906 |   |

 

*See notes to consolidated financialstatements.*

 

41

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**Natrol, Inc. and Subsidiaries**

**Consolidated Statements of Stockholders’Equity**

**(In thousands, except share data)**

 
| ** **                                                   | ** ** | ** ** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Retained  Earnings  (Accumulated  Deficit)** | ** ** | **Shares Held  in Treasury** | ** ** | **Totals** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|----------------------------------|------------|------------------------------------------------|------------|------------------------------|------------|------------|------------|
| ** **                                                   |
| **Common Stock**                                             |
| **Shares**                                                   | ** ** | **Amount** |
| Balance, January 1, 2002                                |       | 13,712,354 |       | $                                | 137        |                                           | $          | 61,869                       |       | $          | (16,485    | ) | $ | (2,881 | ) | $ | 42,640 |   |
| Exercise of stock options                                    |       | 49,166     |       | 1                                |       | 92                                             |       |                         |       |       |       | 93 |   |
| Shares issued in exchange for services                       |       | 12,480     |       |                             |       | 17                                             |       |                         |       |       |       | 17 |   |
| Issuance of common stock under employee  stock purchase plan |       | 14,720     |       |                             |       | 27                                             |       |                         |       |       |       | 27 |   |
| Net loss                                                     |       |       |       |                             |       |                                           |       | (6,126                       | )          |       |       | (6,126 | ) |
|                                                         |       |       |       |                             |       |                                           |       |                         |       |       |       |   |   |
| Balance, December 31, 2002                              |       | 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 |   |

 

*See notes to consolidated financialstatements.*

 

42

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**Natrol, Inc. and Subsidiaries**

 

**Consolidated Statements of Cash Flows**

 

**(In thousands)**

 
| ** **                                                                                                          | ** ** | **Years ended December 31** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                          | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Operating activities**                                                                                            |       |                             |       |   |   |   |   |
| Net income (loss)                                                                                                   |       | $                                | 1,868      |   | $ | (1,468 | ) | $ | (6,126 | ) |
| Cumulative effect of change in accounting  principle, net of income taxes benefit of $4,139                         |       | —                           |       | — |   | 6,819 |   |
| Loss from discontinued operations                                                                                   |       | —                           |       | 1,487 |   | 688 |   |
| Income from continuing operations before  cumulative effect of change in accounting principle                       |       | 1,868                            |       | 19 |   | 1,381 |   |
| Adjustments to reconcile income from  continuing operations to net cash provided by (used in) operating activities: |       |                             |       |   |   |   |   |
| Loss from discontinued operations                                                                                   |       | —                           |       | (1,487 | ) | (688 | ) |
| Change in net assets of discontinued  operations                                                                    |       | 35                               |       | 33 |   | (68 | ) |
| Depreciation and amortization                                                                                       |       | 1,277                            |       | 1,498 |   | 1,428 |   |
| Gain on disposal of property and equipment                                                                          |       | —                           |       | (3 | ) | (10 | ) |
| Provision for bad debts                                                                                             |       | (223                             | )          | 397 |   | 233 |   |
| Deferred income taxes                                                                                               |       | 570                              |       | (494 | ) | 694 |   |
| Shares issued for services                                                                                          |       | 2                                |       | 16 |   | 17 |   |
| Changes in operating assets and  liabilities:                                                                       |       |                             |       |   |   |   |   |
| Accounts receivable                                                                                                 |       | 490                              |       | (1,315 | ) | (226 | ) |
| Inventory                                                                                                           |       | (670                             | )          | (445 | ) | 1,135 |   |
| Income taxes receivable/payable                                                                                     |       | (607                             | )          | (554 | ) | 1,613 |   |
| Prepaid expenses and other current assets                                                                           |       | 121                              |       | 538 |   | 374 |   |
| Accounts payable                                                                                                    |       | (2,697                           | )          | 1,206 |   | 1,022 |   |
| Accrued expenses                                                                                                    |       | 751                              |       | (1,615 | ) | (893 | ) |
| Accrued payroll and related liabilities                                                                             |       | 817                              |       | 92 |   | 187 |   |
| Net cash provided by (used in) operating  activities                                                                |       | 1,734                            |       | (2,114 | ) | 6,199 |   |
| **Investing activities**                                                                                            |       |                             |       |   |   |   |   |
| Purchases of property and equipment                                                                                 |       | (920                             | )          | (384 | ) | (1,474 | ) |
| Proceeds for sale of property and equipment                                                                         |       | —                           |       | 8 |   | 13 |   |
| Restricted cash                                                                                                     |       | —                           |       | (5,000 | ) | — |   |
| Reduction of goodwill arising from Prolab  settlement                                                               |       | 2,000                            |       | — |   | — |   |
| Other assets                                                                                                        |       | (135                             | )          | (44 | ) | 15 |   |
| Net cash provided by (used in) investing  activities                                                                |       | 945                              |       | (5,420 | ) | (1,446 | ) |
| **Financing activities**                                                                                            |       |                             |       |   |   |   |   |
| Proceeds from issuance of long-term debt                                                                            |       | 750                              |       | — |   | — |   |
| Repayments on long-term debt                                                                                        |       | (338                             | )          | (303 | ) | (281 | ) |
| Proceeds from issuance of common stock                                                                              |       | 332                              |       | 359 |   | 120 |   |
| Net cash provided by (used in) provided by  financing activities                                                    |       | 744                              |       | 56 |   | (161 | ) |
| Net increase (decrease) in cash and cash  equivalents                                                               |       | 3,423                            |       | (7,478 | ) | 4,592 |   |
| Cash and cash equivalents, beginning of  year                                                                       |       | 2,599                            |       | 10,077 |   | 5,485 |   |
| Cash and cash equivalents, end of year                                                                              |       | $                                | 6,022      |   | $ | 2,599 |   | $ | 10,077 |   |
| **Supplemental disclosures of cash flow  information**                                                              |       |                             |       |   |   |   |   |
| Cash paid during the year for:                                                                                      |       |                             |       |   |   |   |   |
| Interest                                                                                                            |       | $                                | 630        |   | $ | 650 |   | $ | 675 |   |
| Income taxes                                                                                                        |       | $                                | 1,174      |   | $ | 337 |   | $ | 55 |   |

 

*See notes to consolidated financialstatements.*

 

43

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**Natrol, Inc.**

 

**Notes to Consolidated Financial Statements**

 

**1. Business and Summary of Significant Accounting Policies**

 

**Description of Business**

 

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. The Company’s coreNatrol brand markets vitamins, minerals, hormonal supplements, herbal products,and specialty combination formulations. The Laci Le Beau brand sells specialtyteas and the Prolab brand markets sports nutrition products to athletes andother health minded individuals. The Company sells its products throughmultiple channels of distribution that reach consumers through mass marketretailers, health food stores, fitness centers, the Internet, catalogues andother points of distribution.

 

The Company also sells raw materials and markets limited contractmanufacturing through its Essentially Pure Ingredients division which operateswithin the Company’s core operating unit.

 

**Principles of Consolidation**

 

The consolidated financial statements include the accounts andoperations of Natrol, Inc. and its wholly owned subsidiaries. Allsignificant intercompany accounts have been eliminated in consolidation.

 

**Estimates and Assumptions**

 

The preparation of consolidated financial statements in conformity withaccounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions affecting the reportedamounts in the consolidated financial statements and accompanying notes. Actualresults could differ from those estimates, although management does not believeany differences would materially affect the Company’s consolidated financialposition or results of operations.

 

**Significant Risks and Uncertainties**

 

Product returns are a recurring part of the Company’s business.Estimating product returns requires significant management judgment. Productsmay be returned for various reasons including expiration dates or lack ofsufficient sales. During 2004, returns and reimbursements for damages andoutdated products were 3.5% of gross shipments a decrease from 2003 and 2002when returns and reimbursements for damages and outdated products wererespectively 4.7% and 8.7% of gross sales. There is no guarantee that futurereturns will not increase to, or exceed, the levels experienced in 2002.Furthermore, the possibility exists that should the Company lose a major account,the Company may agree to accept a substantial amount of returns.

 

The Company monitors its inventory and analyzes it on a regular basis.Cycle counts are taken daily to verify inventory levels. In addition, theCompany analyzes the movement of items within its inventory in an effort todetermine the likelihood that inventory will be sold or used before expirationdates are reached. The Company provides an allowance against that portion ofits inventory that it believes is unlikely to be sold or used before expirationdates are reached. At December 31, 2004, inventory allowances wereapproximately $1.4 million.

 

**Restricted Cash**

 

Restricted cash represents cash that has been deposited with aninsurance company as part of the Company’s self-insurance program. The cashearns interest at a current rate of 1.65% per annum, and

 

44

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will be returned to the Company should the Company terminate thepolicy. The policy, which is cancelable by the Company, is effective through2008.

 

**Inventory**

 

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

 

**Property and Equipment**

 

Property and equipment are stated at cost. Depreciation is computedusing the straight-line method over the estimated useful lives of the assetsranging from three-to-ten years for furniture, machinery and equipment.Buildings are depreciated over 40 years, and improvements are depreciatedover periods ranging from five-to-forty years, using the straight-line method.Amortization of leasehold improvements is computed using the straight-linemethod over the shorter of the estimated useful lives of the assets or thelease terms.

 

**Long-Lived Assets**

 

The Company evaluates long-lived assets and certain identifiableintangibles for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Recoverability ofassets is measured by a comparison of the carrying amount of an asset to futureundiscounted net cash flows expected to be generated by the asset. If suchassets are considered to be impaired, the impairment to be recognized ismeasured by the amount by which the carrying amount of the asset exceeds itsfair value.

 

**Goodwill**

 

In June 2001, the Financial Accounting Standards Board (“FASB”)approved two new statements: Statement of Financial Accounting Standards (“SFAS”)No. 141, *Business Combinations*,and SFAS No. 142, *Goodwill and OtherIntangible Assets*. SFAS No. 141 requires business combinationsentered into after June 30, 2001 to be accounted for using the purchasemethod of accounting. SFAS No. 142 requires that goodwill not beamortized, but be tested for impairment at least annually. The Company adoptedSFAS No. 142 on January 1, 2002. In accordance with such adoption,the Company identified all reporting units in conjunction with the provisionsof SFAS No. 142 and allocated all goodwill accordingly. Beginning in 2002,goodwill is evaluated for impairment annually as of December 31. TheCompany tested goodwill for impairment using the two-step process prescribed inSFAS No. 142. The first step is a screen for potential impairment, whilethe second step measures the amount of the impairment, if any. In 2002, theCompany performed the first step of the impairment test and that there waspotential impairment of the Natrol segment. The Company performed the secondstep as of December 31, 2002 for the Natrol segment and determined thatits goodwill balance of $10,958,000 was impaired. The impairment loss wasrecorded as a cumulative effect of accounting change in the accompanyingconsolidated statement of operations for the year ended December 31, 2002.

 

The Company performed its annual impairment test as of December 31,2004 and December 31, 2003 and concluded that goodwill was not impaired ineither year.

 

45

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As part of a legal settlement with the former owners of Prolab, in2004, the Company received $2.0 million which was recorded as reduction ofgoodwill. The balance of goodwill as of December 31, 2004, therefore, wasreduced to approximately $2 million.

 

The changes in the carrying value of goodwill for the years ended December 31,2002, 2003 and 2004 were as follows (in thousands):

 
| Balance, December 31, 2001                      |   | $       | 14,984 |   |
|------------------------------------------------------|--------|---------|--------|--------|
| Cumulative effect of change in accounting  principle |   | (10,958 | )      |
| Balance, December 31, 2002 and 2003             |   | $       | 4,026  |   |
| Reduction of goodwill from legal settlement  in 2004 |   | (2,000  | )      |
| Balance, December 31, 2004                      |   | $       | 2,026  |   |

 

**Income Taxes**

 

Deferred income taxes are provided for temporary differences betweenthe financial statement and income tax bases of assets and liabilities, basedon enacted tax rates. Management provides a valuation allowance when itbelieves, it is more likely than not that some portion or all of the deferredincome tax assets will not be realized.

 

**Revenue Recognition**

 

The Company sells its products to retail outlets through a direct salesforce and a national broker network. The Company recognizes revenue from saleswhen product is shipped and title is transferred. Net sales represent productshipped less actual and estimated returns, spoilage allowances, allowances forproduct deemed to be unsaleable by customers, and slotting fees, rebates andother expenditures which, using Generally Accepted Accounting Principles (GAAP)should be accounted for as reductions of revenue. Estimates and allowances arebased upon known claims and an estimate of additional returns when the amountof future returns can be reasonably estimated.

 

**Advertising Costs**

 

Advertising and promotional costs are expensed as incurred. Advertisingand promotional costs were (in thousands) $6,122, $5,427, and $6,778 for theyears ended December 31, 2004, 2003 and 2002, respectively. These amountsare exclusive of promotional and other costs that are netted against salesrevenue.

 

**Research and Development Costs**

 

The Company incurs costs in support of its dietary research anddevelopment. These costs are expensed as incurred and were (in thousands) $752,$608, and $504, for the years ended December 31, 2004, 2003 and 2002,respectively.

 

**Shipping and Handling Costs**

 

The Company records all amounts charged to customers for shipping andhandling as revenue. All shipping and fulfillment costs are classified as sellingand marketing expenses and were (in thousands) $3,455, $3,172, and $2,504, forthe years ended December 31, 2004, 2003 and 2002, respectively.

 

46

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**Stock-Based Compensation**

 

As allowed under SFAS 123, the Company accounts for its employeestock option plan under the intrinsic value method prescribed by AccountingPrinciples Board Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations.

 

The Company has a stock-based compensation plan, which is describedmore fully in Note 5. The Company’s operating results do not include acompensation charge related to this plan, as all options granted had anexercise price equal to the market value of the underlying common stock on thedate of grant. The following table illustrates the effect on the operatingresults and per share amounts, if the fair value recognition provisions of SFASNo. 123, *Accounting for Stock-BasedCompensation*, had been applied to stock-based employee compensation.

 
| ** **                                                                                                                                                                  | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                                                                                  | ** ** | **(In thousands)**                | ** ** |
| Income from continuing operations before  cumulative effect of accounting change                                                                                            |       | $                                 | 1,868      |   | $ | 19 |   | $ | 1,381 |   |
| Total stock-based employee compensation  expense determined under the fair value-based method for all awards, net of  related tax benefits (“Stock Compensation”) |       | (53                               | )          | (222 | ) | (294 | ) |
| Income (loss) from continuing  operations-pro forma                                                                                                                         |       | $                                 | 1,815      |   | (203 | ) | 1,087 |   |
| Loss from discontinued operations                                                                                                                                           |       | —                            |       | (1,487 | ) | (688 | ) |
| Cumulative effect of change in accounting  principle-net of tax                                                                                                             |       | —                            |       | — |   | (6,819 | ) |
| Net profit (loss)—pro forma                                                                                                                                            |       | $                                 | 1,815      |   | $ | (1,690 | ) | $ | (6,420 | ) |
| Income (loss) per share from continuing  operations:                                                                                                                        |       |                              |       |   |   |   |   |
| Basic-as reported                                                                                                                                                           |       | $                                 | 0.14       |   | $ | 0.00 |   | $ | 0.11 |   |
| Basic-pro forma                                                                                                                                                             |       | $                                 | 0.14       |   | $ | (0.02 | ) | $ | 0.09 |   |
| Diluted-as reported                                                                                                                                                         |       | $                                 | 0.14       |   | $ | 0.00 |   | $ | 0.11 |   |
| Diluted-pro forma                                                                                                                                                           |       | $                                 | 0.14       |   | $ | (0.02 | ) | $ | 0.09 |   |
| Net loss per share:                                                                                                                                                         |       |                              |       |   |   |   |   |
| Basic-as reported                                                                                                                                                           |       | $                                 | 0.13       |   | $ | (0.11 | ) | $ | (0.48 | ) |
| Basic-pro forma                                                                                                                                                             |       | $                                 | 0.13       |   | $ | (0.13 | ) | $ | (0.50 | ) |
| Diluted-as reported                                                                                                                                                         |       | $                                 | 0.13       |   | $ | (0.11 | ) | $ | (0.48 | ) |
| Diluted-pro forma                                                                                                                                                           |       | $                                 | 0.13       |   | $ | (0.13 | ) | $ | (0.50 | ) |

 

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

 
| ** **                      | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------|------------|-----------------------------------|------------|
| ** **                      | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| Expected dividend yield         |       | 0.0                               | %          | 0.0 | % | 0.0 | % |
| Expected stock price volatility |       | 64.6                              |       | 68.7 |   | 73.3 |   |
| Risk free interest rate         |       | 3.6                               | %          | 3.0 | % | 4.2 | % |
| Expected life of options        |       | 5 years                           |       | 5 years |   | 5 years |   |

 

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These assumptions resulted in weighted-average fair values of $1.66,$0.87, and $0.87 for each stock option granted in 2004, 2003 and 2002,respectively.

 

**Income (Loss) Per Share**

 

The Company calculates income (loss) per share in accordance with SFAS No. 128,*Earnings per Share*. Basic income(loss) per share has been computed by dividing net income (loss) by theweighted-average number of common shares outstanding during the period. Dilutedincome (loss) per share has been computed by dividing net income (loss) by theweighted average number of common shares and dilutive common stock equivalents(stock options).

 

Stock options to purchase 2,442,000, 2,950,000, and 2,916,000 shares ofcommon stock at December 31, 2004, 2003 and 2002, respectively, wereoutstanding and of these shares, 520,000, 2,950,000 and 2,916,000, wererespectively considered anti-dilutive.

 

**Fair Value of Financial Instruments**

 

The carrying value of certain financial instruments, including cash andcash equivalents, accounts receivable, accounts payable and accrued expensesapproximates fair market value based on their short-term nature. The fair valueof the Company’s long-term notes payable is estimated using discounted cashflow analyses, based on the Company’s current incremental borrowing rates forsimilar types of borrowing arrangements. The estimated fair value of long-termnotes payable exceeded the carrying value by approximately $1.1 million atDecember 31, 2004.

 

**Concentration of Credit Risk**

 

Financial instruments which potentially subject the Company toconcentration of credit risk consist principally of cash and cash equivalents,and accounts receivable. Cash and cash equivalents are placed with high credit-qualityinstitutions and the amount of credit exposure to any one institution islimited. Significant portions of the Company’s sales are made directly to massmerchandisers and national retailers. Due to the increased volume of sales tothese channels, the Company has experienced an increased concentration ofcredit risk, and as a result, may at anytime have individually significantreceivable balances with such mass merchandisers and national retailers. Whilethe Company monitors and manages this risk, financial difficulties on the partof one or more major customers may have a material adverse effect on theCompany. The Company performs ongoing credit evaluations of customers andmaintains an allowance for potential credit losses.

 

No one customer represented 10% or more of the Company’s net sales in2004 and 2003 and no account represented more than 10% of the Company’s netaccounts receivable as of December 31, 2004. Accounts receivable from onecustomer represented approximately 16.0% of net accounts receivable at December 31,2003. One customer represented 12.3% of net sales in the year ended December 31,2002. This customer accounted for 13.4% of accounts receivable at December 31,2002. No other customers represented more than 10% of net sales in 2002.

 

**Recently Issued Accounting Standards**

 

In December 2002, the FASB issued SFAS No. 148, “Accountingfor Stock-Based Compensation—Transition and Disclosure.” This statement amendsSFAS No. 123, to provide alternative methods of

 

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voluntary transition to change to the fair value based method ofaccounting for stock-based employee compensation. Additionally, this statementamends disclosure requirements of accounting for stock-based employeecompensation and the effect of the method used on reporting results. As of December 31,2002, the Company has adopted the disclosure requirements of SFAS No. 148,but has elected to continue to account for stock-based compensation to itsemployees and directors using the intrinsic value method proscribed by APB No. 25and related interpretations.

 

In January 2003, the FASB issued FASB Interpretation No. (“FIN”)46, “Consolidation of Variable Interest Entities” (“FIN 46”). In December 2003,FIN 46 was replaced by FASB interpretation No. 46(R) “Consolidation ofVariable Interest Entities.” FIN 46(R) clarifies the application of AccountingResearch Bulletin No. 51, “Consolidated Financial Statements,” to certainentities in which equity investors do not have the characteristics of acontrolling financial interest or do not have sufficient equity at risk for theentity to finance its activities without additional subordinated financialsupport from other parties. FIN 46(R) requires an enterprise to consolidate avariable interest entity if that enterprise will absorb a majority of theentity’s expected losses, is entitled to receive a majority of the entity’sexpected residual returns, or both. FIN 46(R) is effective for entities beingevaluated under FIN 46(R) for consolidation no later than the end of the firstreporting period that ends after March 15, 2004. The Company does notcurrently have any variable interest entities that will be impacted by adoptionof FIN 46(R).

 

On April 30, 2003, the Financial Accounting Standards Board issuedSFAS No. 149, “Amendment of Statement 133 on Derivative Instruments andHedging Activities.” SFAS No. 149 amends and clarifies accounting forderivative instruments, including certain derivative instruments embedded inother contracts, and for hedging activities under SFAS No. 133. The newguidance amends SFAS No. 133 for decisions made as part of the DerivativesImplementation Group (“DIG”) process that effectively required amendments toSFAS No. 133, and decisions made in connection with other FASB projectsdealing with financial instruments and in connection with implementation issuesraised in relation to the application of the definition of a derivative andcharacteristics of a derivative that contains financing components. Inaddition, it clarifies when a derivative contains a financing component thatwarrants special reporting in the statement of cash flows. SFAS No. 149 iseffective for contracts entered into or modified after June 30, 2003 andfor hedging relationships designated after June 30, 2003. Adoption of thisstandard did not have an impact on the Company’s consolidated financialstatements.

 

In May 2003, the FASB issued SFAS No. 150 *Accounting for Financial Instruments with theCharacteristics of Both Liabilities and Equities*. SFAS No. 150establishes standards regarding the manner in which an issuer classifies andmeasures certain types of financial instruments having characteristics of bothliabilities and equity. Pursuant to SFAS No. 150, such freestandingfinancial instruments (i.e., those entered into separately from an entity’sother financial instruments or equity transactions or that are legallydetachable and separately exercisable) must be classified as liabilities or, insome cases, assets. In addition, SFAS No. 150 requires that financialinstruments containing obligations to repurchase the issuing entity’s equityshares and, under certain circumstances, obligations that are settled bydelivery of the issuer’s shares be classified as liabilities. Certain aspectsof SFAS No. 150 have been deferred; however, the Statement is effectivefor financial instruments entered into or modified after May 31, 2003 andfor other instruments at the beginning of the first interim period beginningafter June 15, 2003. The Company does not currently have any financialinstruments that

 

49

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have been impacted by SFAS No. 150. The adoption of SFAS No. 150did not have a material impact on the Company’s financial position or resultsof operations.

 

In December 2003, the SEC issued Staff Accounting Bulletin (“SAB”)No. 104, “Revenue Recognition.” SAB 104, which was effective uponissuance, updates portions of the interpretive guidance included in Topic 13 ofthe codification of Staff Accounting Bulletins and revises or rescinds portionsof the interpretative guidance included in SAB 101 in order to make thisinterpretive guidance consistent with current authoritative accounting andauditing guidance and SEC rules and regulations. The principal revisionsrelate to the incorporation of certain sections of the staff’s Frequently AskedQuestion (“FAQ”) document on revenue recognition into Topic 13. SAB 101, “RevenueRecognition in Financial Statements,” which was issued in December 1999,provides guidance to SEC registrants on the recognition, presentation anddisclosure of revenues in the financial statements. Since the Company hasalready adopted all such standards upon issuance, the application of thisrevised guidance did not impact its consolidated financial position, results ofoperations, or disclosure requirements.

 

In November 2004, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Accounting Standards (“SFAS”) No. 151, “InventoryCosts” an amendment of Accounting Research Bulletin (“ARB”) No. 43, toclarify the accounting for abnormal amounts of idle facility expense, freight,handling costs, and wasted material (spoilage). This Statement requires thatthose items be recognized as current-period charges regardless of whether theymeet the criterion of “so abnormal”. In addition, this Statement requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities. Companies are required toadopt the provisions of this Statement for fiscal years beginning after June 15,2005. The Company does not believe there will be a material effect on itsconsolidated financial position or results of operations from the adoption ofthis standard.

 

In December 2004, the FASB issued SFAS No.153, “Exchanges ofNonmonetary Assets, an amendment of APB Opinion No. 29, Accounting forNonmonetary Transactions.” The amendments made by Statement 153 are based onthe principle that exchanges of nonmonetary assets should be measured based onthe fair value of the assets exchanged. Further, the amendments eliminate thenarrow exception for nonmonetary exchanges of similar productive assets andreplace it with a broader exception for exchanges of nonmonetary assets that donot have commercial substance. Previously, Opinion 29 required that theaccounting for an exchange of a productive asset for a similar productive assetor an equivalent interest in the same or similar productive asset should bebased on the recorded amount of the asset relinquished. Opinion 29 provided anexception to its basic measurement principle (fair value) for exchanges ofsimilar productive assets. The Board believes that exception required that somenonmonetary exchanges, although commercially substantive, be recorded on acarryover basis. By focusing the exception on exchanges that lack commercialsubstance, the Board believes this Statement produces financial reporting thatmore faithfully represents the economics of the transactions. The Statement iseffective for nonmonetary asset exchanges occurring in fiscal periods beginningafter June 15, 2005. Earlier application is permitted for nonmonetaryasset exchanges occurring in fiscal periods beginning after the date ofissuance. The provisions of this Statement shall be applied prospectively. The Companyhas evaluated the impact of the adoption of SFAS 152, and does not believethe impact will be significant to the Company’s overall results of operationsor financial position.

 

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In December 2004, the FASB issued SFAS No.123 (revised 2004), “Share-BasedPayment.” Statement 123(R) will provide investors and other users of financialstatements with more complete and neutral financial information by requiringthat the compensation cost relating to share-based payment transactions berecognized in financial statements. That cost will be measured based on thefair value of the equity or liability instruments issued. Statement 123(R)covers a wide range of share-based compensation arrangements including shareoptions, restricted share plans, performance-based awards, share appreciationrights, and employee share purchase plans. Statement 123(R) replaces FASBStatement No. 123, Accounting for Stock-Based Compensation, and supersedesAPB Opinion No. 25, Accounting for Stock Issued to Employees. Statement123, as originally issued in 1995, established as preferable a fair-value-basedmethod of accounting for share-based payment transactions with employees.However, that Statement permitted entities the option of continuing to applythe guidance in Opinion 25, as long as the footnotes to financial statementsdisclosed what net income would have been had the preferable fair-value-basedmethod been used. Public entities (other than those filing as small businessissuers) will be required to apply Statement 123(R) as of the first interim orannual reporting period that begins after June 15, 2005. The Company hasevaluated the impact of the adoption of SFAS 123(R), and does not believethe impact will be significant to the Company’s overall results of operationsor financial position.

 

In December 2004 the Financial Accounting Standards Board issuedtwo FASB Staff Positions—FSP FAS 109-1, *Application of FASB Statement 109 “Accounting for Income Taxes” to theTax Deduction on Qualified Production Activities Provided by the American JobsCreation Act of 2004,* and FSP FAS 109-2 *Accounting and Disclosure Guidance for the ForeignEarnings Repatriation Provision within the American Jobs Creation Act of 2004.*Neither of these affected the Company as it does not participate in the relatedactivities.

 

**2. Inventory**

 

Inventory consists of the following:

 
| ** **                          | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ** **                          | ** ** | **(In thousands)**    | ** ** |
| Raw material and packaging supplies |       | $                     | 5,357      |   | $ | 3,736 |   |
| Finished goods                      |       | 4,366                 |       | 5,317 |   |
|                                |       | $                     | 9,723      |   | $ | 9,053 |   |

 

Three of the Company’s suppliers each accounted for more than 10% ofthe Company’s inventory purchases in 2004. The loss of any of these supplierscould have a material adverse effect on the Company’s ability to produce andsell goods. The Company does not have a long-term supply agreement with any ofthese three suppliers.

 

**3. Financing**

 

During 1999, the Company entered into two mortgage notes payable in theaggregate amount of approximately $8,900,000, collateralized by the Company’sfacilities. These notes are payable in monthly

 

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installments of approximately $74,000 in the aggregate, includinginterest ranging from 7.75% to 8.32%, maturing in 2014 and 2019.

 

In November 2004, the Company entered into a Revolving Note, aPromissory Note, an Equipment Line Facility, a Commercial Guaranty, aCommercial Security Agreement, a Corporate Resolution to GrantCollateral/Guarantee, and a Commercial Security Agreement with City NationalBank, a national banking association (“CNB”).

 

In November 4, 2004, the Company executed a Revolving Note infavor of CNB for the principal sum of $3,000,000. The Company also executed aPromissory Note in favor of CNB for the original principal sum of $750,000, andan Agreement for Equipment Line Facility in favor of CNB for the originalprincipal sum of $500,000. Under the Agreement, CNB agreed to make equipmentacquisition loans to the Company up to the amount of $500,000, until December 1,2005.

 

The most restrictive covenants for the $3 million Revolving Noteare (a) Tangible Net Worth plus Subordinated Debt of not less than$29.4 million at all times; (b) a ratio of Total Senior Liabilitiesto Tangible Net Worth plus Subordinated Debt of not more than 1.25 to 1 at alltimes; and (c) a ratio of Cash Flow from Operations to Debt Service of notless than 1.25 to 1 for each fiscal quarter on a rolling 12 month basis.

 

The $750,000 note payable is collateralized by the company’s assetsother than real estate. This note is payable in monthly installments ofapproximately $12,500 plus interest at a variable rate based upon prime plus apremium of .75%. The initial rate upon entering into the note was 5.5%.

 

Future maturities of long-term debt at December 31, 2004 are asfollows (in thousands):

 
| 2005       |   | $     | 503    |   |
|------------|--------|-------|--------|--------|
| 2006       |   | 532   |   |
| 2007       |   | 564   |   |
| 2008       |   | 598   |   |
| 2009       |   | 624   |   |
| Thereafter |   | 5,367 |   |
| Total      |   | $     | 8,188  |   |

 

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**4. Income Taxes**

 

The income tax (benefit) provision consists of the following (inthousands):

 
| ** **                                                                          | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                          | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| Current:                                                                            |       |                              |       |   |   |   |   |
| Federal                                                                             |       | $                                 | 540        |   | $ | 526 |   | $ | 82 |   |
| State                                                                               |       | 34                                |       | 2 |   | 85 |   |
| Total current                                                                       |       | 574                               |       | 528 |   | 167 |   |
| Deferred                                                                            |       | 570                               |       | (494 | ) | 694 |   |
| Total income taxes for continuing  operations                                       |       | $                                 | 1,144      |   | $ | 34 |   | $ | 861 |   |
| Income tax benefit from discontinuing  operations                                   |       | —                            |       | $ | (821 | ) | $ | (421 | ) |
| Deferred income tax benefit on cumulative  effect of change in accounting principle |       | —                            |       | — |   | $ | (4,139 | ) |

 

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The difference between actual income tax provision (benefit) and theamount computed using the U.S. federal statutory income tax rate is as follows(in thousands):

 
| ** **                                                          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                          | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| Statutory rate applied to income (loss)  from continuing operations |       | $                                 | 1,008      |   | $ | 19 |   | $ | 762 |   |
| State tax provision                                                 |       | 115                               |       | 2 |   | 85 |   |
| Other                                                               |       | 21                                |       | 13 |   | 14 |   |
| Income tax provision from continuing  operations                    |       | $                                 | 1,144      |   | $ | 34 |   | $ | 861 |   |

 

The significant components of the Company’s deferred income tax assetsand liabilities are as follows (In Thousands):

 
| ** **                        | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|
| ** **                        | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| Deferred income tax assets:       |       |                              |       |   |   |   |   |
| Accounts receivable allowances    |       | $                                 | 167        |   | $ | 253 |   | $ | 163 |   |
| Inventory                         |       | 573                               |       | 565 |   | 77 |   |
| Accrued liabilities               |       | 838                               |       | 780 |   | 504 |   |
| Goodwill impairment               |       | 3,191                             |       | 3,572 |   | 4,139 |   |
| State operating loss carryforward |       | —                            |       | 107 |   | 84 |   |
| Other                             |       | 107                               |       | 72 |   | 101 |   |
|                              |       | 4,876                             |       | 5,349 |   | 5,068 |   |
| Deferred tax income liabilities:  |       |                              |       |   |   |   |   |
| Federal effect of state taxes     |       | (223                              | )          | (271 | ) | (255 | ) |
| Depreciation                      |       | (211                              | )          | (66 | ) | (295 | ) |
|                              |       | $                                 | 4,442      |   | $ | 5,012 |   | $ | 4,518 |   |

 

**5. Stockholders’ Equity**

 

**Stock Repurchase Program**

 

In 2000, the Board of Directors of the Company authorized a stockrepurchase program for the Company’s common stock. Under the stock repurchaseprogram, the Company can effect common stock repurchases from time to time upto an aggregate of $10,000,000. The stock repurchase program does not have anexpiration date. No such repurchases were made in 2004 or 2003.

 

**Stock Options**

 

Under the Company’s 1996 Stock Option and Grant Plan, as amended (the “Plan”),the Board of Directors of the Company is authorized to grant incentive stockoptions or non-qualified stock options. Incentive stock options may be grantedonly to employees of the Company. Non-qualified stock options may be granted toofficers and employees of the Company as well as to non-employees. The maximumnumber of shares to be issued under the Plan is 3,442,214 shares, as amended.All options granted under the Plan have been made at prices not less than theestimated fair market value of the stock at 

 

54

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the date of grant. Generally,the options granted under the Plan vest over three-to-five years. Options grantedunder the Plan have a term of not more than 10 years.

 

A summary of the Company’s stock option activity and relatedinformation is as follows (in thousands, except per share data):

 
| ** **                            | ** ** | **Number of  Options  (000’s)** | ** ** | **Weighted-Average  Exercise Price  Per Share** | ** ** | **Exercise Price  Per Share** | ** **        |
|---------------------------------------|------------|--------------------------------------|------------|-------------------------------------------------|------------|-------------------------------|-------------------|
| Outstanding at December 31, 2001 |       | 2,696                                |       | $                                               | 3.58       |                          | $1.32—$13.00 |   |
| Granted                               |       | 700                                  |       | 1.37                                            |       | 1.10—1.75                |              |
| Forfeited                             |       | (431                                 | )          | 3.41                                            |       | 1.13—13.00               |              |
| Exercised                             |       | (49                                  | )          | 1.88                                            |       | 1.50—1.94                |              |
|                                  |       |                                 |       |                                            |       |                          |              |
| 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               |              |
|                                       |            |                                      |            |                                                 |            |                               |                   |  |

 

At December 31, 2004, 1,000,082 shares were available for futuregrant. The weighted-average remaining contractual life for the outstandingoptions in years was 5.57, 6.91 and 7.71, and at December 31, 2004, 2003and 2002, 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** | ** ** |
| $1.10—$2.35             |       | 1,867                                 |       | 6.1                                      |       | $                                     | 1.68       |   | 1,734 |   | $ | 1.70 |   |
| $2.76—$6.03             |       | 290                                   |       | 6.0                                      |       | 4.35                                  |       | 243 |   | 4.66 |   |
| $7.00—$13.00            |       | 285                                   |       | 3.6                                      |       | 10.88                                 |       | 285 |   | 10.88 |   |
| Total                        |       | 2442                                  |       | 5.57                                     |       | $                                     | 3.07       |   | 2,262 |   | $ | 3.17 |   |

 

**6. Commitments and Contingencies**

 

The Company leases certain equipment and facilities under noncancelableoperating leases that expire in various years through 2006. Rent expense underoperating leases totaled approximately $162,000, $155,000, and $117,000, forthe years ended December 31, 2004, 2003 and 2002, respectively.

 

55

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Future minimum lease payments under noncancelable operating leases withinitial terms of one year or more consisted of the following at December 31,2004 (in thousands):

 
| 2005                         |   | $   | 134    |   |
|------------------------------|--------|-----|--------|--------|
| 2006                         |   | 109 |   |
| 2007                         |   | 73  |   |
| 2008                         |   | 11  |   |
| 2009                         |   | 8   |   |
| 2010                         |   | 4   |   |
| Total minimum lease payments |   | $   | 339    |   |

 

The Company leases part of its Jordan facility and future minimum leasepayments due to the Company are (in thousands):

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

 

The Company is a party to certain legal actions arising in the normalcourse of business. In the opinion of management, the ultimate outcome of suchlitigation will not have a material adverse effect on the financial position orresults of operations of the Company.

 

**7. Employee Benefits Plans**

 

The Company has a profit sharing 401(k) plan that covers substantiallyall of its employees. Eligible employees may contribute up to the maximumallowed under law. Contributions are discretionary; however, the Companygenerally matches 10% of the employees’ contributions up to the maximum of 1%of eligible compensation. Amounts recognized as expense were approximately$33,000, $26,000, and $14,000, for the years ended December 31, 2004, 2003and 2002, respectively.

 

In 1998, the Board of Directors approved the Natrol, Inc. EmployeeStock Purchase Plan (“ESPP”), which allows substantially all employees topurchase shares of common stock of the Company, through payroll deductions, at85% of the fair market value of the shares at the beginning or end of theoffering period, whichever is lower. The Company expenses two thirds of the 15%discount given to employees under the plan. The ESPP provides for employees toauthorize payroll deductions of up to 10% of their compensation for each payperiod. In conjunction with the ESPP, the Company registered with the Securitiesand Exchange Commission 225,000 shares of the Company’s common stock reservedfor purchase under the ESPP. As of December 31, 2004 and 2003, 93,453 and96,402 shares are available for issuance under this plan. For the year ended December 31,2004, 34,419 shares were issued at prices ranging from $2.20 to $2.56. For theyear ended December 31, 2003, 38,267 shares were issued at $0.98 per shareunder the plan. For the year ended December 31, 2002, 14,720 shares wereissued at prices ranging from $1.68 to $1.85 per share under the plan.

 

56

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In 2004, the Company adopted a bonus program for certain employees. Thebonuses granted are dependent upon a formula based on corporate profits beforetaxes, interest. The amount of bonus expensed in 2004 relative to this plan wasapproximately $600,000.

 

**8. Impairment of Goodwill**

 

On January 1, 2002, the Company adopted SFAS No. 142, “Goodwilland Other Intangible Assets.” SFAS No. 142 requires that goodwill not beamortized. In accordance with such adoption, the Company identified allreporting units in conjunction with the provisions of SFAS No. 142 andallocated all goodwill accordingly. Beginning in 2002, goodwill is evaluatedfor impairment annually, or whenever events or changes in circumstancesindicate that the carrying amount of goodwill may not be recoverable. In 2002,the Company tested goodwill for impairment using the two-step processprescribed in SFAS No. 142. The first step is a screen for potential impairment,while the second step measures the amount of the impairment, if any. TheCompany performed the impairment test and determined that there was potentialimpairment of the Natrol segment. The Company performed the second step as of January 1,2002 for the Natrol segment and determined that its goodwill balance of$10,958,000 was impaired. The impairment loss was recorded as a cumulativeeffect of a change in accounting principle, net of income tax benefit ofapproximately $4.1 million, in the accompanying consolidated statement ofoperations for the year ended December 31, 2002.

 

The remaining goodwill balance at December 31, 2002 and 2003 wasapproximately $4.0 million. In the fourth quarter of 2003, the Companycompleted its annual goodwill impairment testing and determined that goodwillwas not impaired. Additionally, during March 2004, the Company settled itslitigation with the former owners of Prolab Nutrition, Inc. The Companyreceived $2 million in cash, which was reflected in the financial statementsfor the quarter ending March 31, 2004 as a reduction of goodwill. TheCompany determined that this was the proper accounting for the settlementbecause the sellers did not deliver a key asset in the condition warranted,which was a clear and direct link to the purchase price, and accordinglyresulted in a purchase price adjustment reducing goodwill, as opposed to acharge to income.  In accordance with theprovisions of SFAS No. 142, the Company performed its annual impairmenttest of goodwill during the fourth quarter of 2004 and concluded that it wasnot impaired.

 

The Company, as part of its review of financial results for 2004,performed an assessment of the carrying value of the Company’s goodwillrecorded in connection with its various acquisitions and determined that noimpairment existed. The carrying value of the Company’s goodwill at December 31,2004 was approximately $2 million.

 

**9. Discontinued Operations**

 

In December 2003, the Company discontinued its Annasa and Tamsolunits. Annasa, a subsidiary of Natrol, a multi-level marketer of proprietarynutritional products began operations in 2002. Tamsol was also formed in 2002,to generate direct-to-consumer sales via radio, television, direct mail andother non-retail venues. The Company has reclassified its financial statementsto segregate the revenues, direct costs and expenses (excluding allocatedcosts), assets and liabilities and cash flows of the discontinued operations.The net operating results, net assets and net cash flows of these businesseshave been reported as “Discontinued Operations” in the accompanyingconsolidated financial statements.

 

The Company sold Annasa’s trademarks and certain other assets to aninvestor group led by former Annasa distributors. The Company received $35,000for the intellectual property assets. The investor group has agreed to also paythe Company a royalty of between one and two percent of net revenue for20 years.

 

57

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Summarized financial information for the discontinued operations is asfollows (in thousands):

 
| ** **                             | ** ** | **Fiscal Year ended:**      | ** ** |
|----------------------------------------|------------|-----------------------------|------------|
| ** **                             | ** ** | **December 31,  2003** | ** ** | **December 31,  2002** | ** ** |
| Annasa:                                |       |                        |       |   |   |
| Revenue                                |       | $                           | 667        |   | $ | 44 |   |
| Gross Margin                           |       | 452                         |       | 32 |   |
| Selling and Marketing expenses         |       | 1,224                       |       | 501 |   |
| General and administrative             |       | 994                         |       | 599 |   |
| Loss from operations                   |       | (1,766                      | )          | (1,068 | ) |
| Income tax benefit                     |       | 616                         |       | 404 |   |
| Net loss                               |       | $                           | (1,150     | ) | $ | (664 | ) |
| Tamsol:                                |       |                        |       |   |   |
| Revenue                                |       | $                           | 30         |   | $ | 27 |   |
| Gross Margin                           |       | 30                          |       | 27 |   |
| Selling and Marketing expenses         |       | 152                         |       | 2 |   |
| General and administrative             |       | 420                         |       | 66 |   |
| Loss from operations                   |       | (542                        | )          | (41 | ) |
| Income tax benefit                     |       | 205                         |       | 17 |   |
| Net loss                               |       | $                           | (337       | ) | $ | (24 | ) |
| Net assets of discontinued operations: |       |                        |       |   |   |
| Current assets                         |       | $                           | 115        |   | $ | 71 |   |
| Total assets                           |       | 150                         |       | 92 |   |
| Current liabilities                    |       | 115                         |       | 24 |   |
| Net assets of discontinued operations  |       | 35                          |       | 68 |   |

 

**10. Operating Segments**

 

Prior to the fourth quarter of 2003, the Company reported its revenueand income through three operating segments; Natrol, Annasa and Prolab. Asdiscussed in Note 9, Annasa was discontinued in the fourth quarter of2003. Additionally, the Company consolidated its Prolab operating unit into thecore Natrol operating unit as of October 1, 2003 and as of that dateProlab began operating as a brand within the core operating unit similar to theCompany’s other brands. As of October 1, 2003, the Company no longerconsidered Prolab a separate operating segment. As a result, segment operatingresults are no longer being reported.

 

58

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**11. Selected Quarterly Financial Data (unaudited)**

 
| ** **                          | ** ** | **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 |   |

 
| ** **                                      | ** ** | **2003 Quarters Ended**                      | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                      | ** ** | **March 31,**                           | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                      | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Net sales                                       |       | $                                            | 18,995     |   | $ | 18,866 |   | $ | 17,398 |   | $ | 17,399 |   |
| Gross profit                                    |       | 8,129                                        |       | 6,604 |   | 6,810 |   | 6,869 |   |
| Income (loss) from continuing operations        |       | 228                                          |       | (246 | ) | 25 |   | 12 |   |
| Loss from discontinued operations               |       | (352                                         | )          | (304 | ) | (417 | ) | (414 | ) |
| Net loss                                        |       | (124                                         | )          | (550 | ) | (392 | ) | (402 | ) |
| Basic and diluted net Income (loss) per  share: |       |                                         |       |   |   |   |   |   |   |
| Income from continuing operations               |       | $                                            | 0.02       |   | $ | (0.02 | ) | $ | (0.00 | ) | $ | (0.00 | ) |
| Loss from discontinued operations               |       | (0.03                                        | )          | (0.02 | ) | (0.03 | ) | (0.03 | ) |
| Net loss                                        |       | $                                            | (0.01      | ) | $ | (0.04 | ) | $ | (0.03 | ) | $ | (0.03 | ) |

 

59

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Natrol, Inc. and Subsidiaries Schedule II—Valuation andQualifying Accounts Years Ended December 31, 2004, 2003 and 2002

 
| **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, 2002 |       | $                                  | 363        |                              | $          | 233            |       | $                           | 187        |   | $ | 409 |   |
| Year ended December 31, 2003 |       | $                                  | 409        |                              | $          | 397            |       | $                           | 171        |   | $ | 635 |   |
| Year ended December 31, 2004 |       | $                                  | 635        |                              | $          | (223           | )          | $                           | (9         | ) | $ | 421 |   |
| Allowance for Sales Returns:      |       |                               |       |                              |       |           |       |                        |       |
| Year ended December 31, 2002 |       | $                                  | 1,020      |                              | $          | 6,700          |       | $                           | 6,127      | (1) | $ | 1,593 |   |
| 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 |   |

 

----

(1)           Represents actualreturns of goods

 

60

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**ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE**

 

On December 22, 2004, the Audit Committee of the Board ofDirectors of Natrol informed Deloitte & Touche, LLP (Deloitte), theCompany’s independent public accountants for the fiscal year ended December 31,2003, of its decision to no longer engage Deloitte & Touche, LLP asthe Company’s independent public accountants. On December 22, 2004, theAudit Committee of the Board of Directors of Natrol engaged StonefieldJosephson, Inc. to serve as the Company’s independent public accountantsfor the fiscal year ended December 31, 2004. On December 28, 2004,Natrol filed a Form 8-K announcing this change in independent publicaccountants.

 

Deloitte’s independent auditors’ reports on the Company’s consolidatedfinancial statements for each of the fiscal years in the two-year period ended December 31,2003 did not contain an adverse opinion, or disclaimer of opinion, nor werethey qualified or modified as to uncertainty, audit scope or accountingprinciples. During the two fiscal years ended December 31, 2003 and thesubsequent interim period through December 22, 2004, there were nodisagreements with Deloitte on any matter of accounting principle or practice,financial statement disclosure, or auditing scope or procedure which, if notresolved to Deloitte’s satisfaction, would have caused them to make referenceto the subject matter of the disagreement in connection with their reports onthe Company’s consolidated financial statements for such periods; and therewere no reportable events as defined in Item 304(a)(1)(v) ofRegulation S-K during the two fiscal years ended December 31, 2003and the subsequent interim period through December 22, 2004.

 

During the fiscal years ended December 31, 2002 and 2003 andthrough December 22, 2004, the Company did not consult StonefieldJosephson, Inc. with respect to the application of accounting principlesto a specified transaction, either completed or proposed, or the type of auditopinion that might be rendered on the Company’s consolidated financialstatements, or any other matters or reportable events as set forth in Items304(a)(2)(i) and (ii) of Regulation S-K.

 

**Item 9A**

 

**DisclosureControls and Procedures**

As required by Rule 13a-15under the Securities Exchange Act of 1934, as of December 31, 2004 we carriedout an evaluation under the supervision and with the participation of ourmanagement, including our Chief Executive Officer and Chief Financial Officer,of the effectiveness of our disclosure controls and procedures.  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures were effective as of the end of the period covered bythis report.

 

**Changes inInternal Controls over Financial Reporting**

There was no change in ourinternal control over financial reporting that occurred during the periodcovered by this Annual Report on Form 10-K that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

**Item9B.  *Other Information***

None.

 

**PART III**

 

Information required under Part III (Items 10, 11, 12, 13, and 14other than the information required by Item 201(d) of Regulation S-Kfor Item 12) is incorporated herein by reference to the Company’s definitiveproxy statement to be filed with the Securities and Exchange Commission within120 days after the year covered by this Form 10-K with respectto its Annual Meeting of Stockholders to be held in June 2004.

 

**ITEM 12. SECURITES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS**

 

The following table provides information as of December 31, 2004regarding shares of common stock of the Company that may be used under ourexisting equity compensation plans, including the Company’s 1996 Stock Optionand Grant Plan (the “1996 Plan”) and the Company’s 1998 Employee Stock PurchasePlan (the “ESPP”).

 

61

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**Equity Compensation Plan InformationTable—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(1)  |       | 2,441,932                                                                                                     |       | $ | 3.07 |   | 1,000,282 | (1) |
| Equity compensation Plans not approved by  security holders |       |                                                                                                          |       |   |   |   |   |
| Total                                                       |       | 2,441,932                                                                                                     |       | $ | 3.07 |   | 1,000,282 | (1) |

 

----

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

 

62

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**PART IV**

 

**ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K**

 
| (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                                                                                                                                                                                                                |   |   |
|                                                                        |   |                                                                                                                                                                                                                                                              |   |   |
|                                                                        |   | All other schedules for which provision is made in the applicable  accounting regulations of the Securities and Exchange Commission 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). |
|   |   |                                                                                                                                                                                                                                                                                    |
| 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                                                                                                                                                                                |

----

*Filed herewith

**Previously filed

 
|   |                                     |                                                                                                                                                                     |
|--------|------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (b)    | Reports on Form 8-K: 8-K  filed on: |
|   |                                     |                                                                                                                                                                     |
|   |                                     | On November 26, 2004, the Company furnished a Current Report on Form 8-K,  dated November 4, 2004, regarding entry into a material definitive  agreement. |
|   |                                     |                                                                                                                                                                     |
|   |                                     | On December 28, 2004, the Company furnished a Current Report on Form 8-K,  dated December 22, 2004, regarding changes in its certifying accountant.       |

 

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**SIGNATURE**

 

Pursuant to the requirements ofSection 13 or 15(d) of the Securities Exchange Act of 1934, the registranthas duly caused this Form 10-K/A to be signed on its behalf by the undersigned,thereunto duly authorized, this 21st day of July, 2005.

 
|   | NATROL, INC. |                                    |   |
|--------|--------------|-----------------------------------------|--------|
|   | By:          | */s/ Elliott Balbert*                   |   |
|   |         | Elliott Balbert                         |   |
|   |         | *President and Chief Executive Officer* |   |

 

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