**UNITES STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

**(Mark One)**

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

**ForThe Fiscal Year Ended December 31, 2006**

**OR**

**o**                                   TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe transition period from                           to                           **

**CommissionFile No: 000-24567**

**NATROL, INC.**

(Exact name of registrantas specified in its charter)

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

 

**21411 Prairie StreetChatsworth, California 91311**

(Address of principalexecutive offices)

**(818) 739-6000**

(Registrant’s telephonenumber, including area code)

Securities registeredpursuant to section 12(b) of the Act: 

| Title of Class |   | Name of Exchange  on |
|----------------|--------|----------------------|
| Common Stock,  |   | which registered     |
| par value      |   | Nasdaq               |
| $.01 per share |   | Global Market        |

 

Securitiesregistered pursuant to Section 12(g) of the Act: **None**

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

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

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

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

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
| Large accelerated filer o | Accelerated  filer o | Non-accelerated  filer x |
|--------------------------------|---------------------------|-------------------------------|

 

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

The aggregate market valueof the shares of the registrant’s common stock held by non-affiliates of theregistrant on June 30, 2006 was approximately $14.2 million, based uponthe closing price per share of the registrant’s common stock as reported on theNasdaq National Market on such date. The calculation of holdings bynon-affiliates is based upon the assumption, that executive officers,directors, and persons holding 10% or more of the outstanding common stock areaffiliates.

As of March 25, 2007the registrant had 14,152,227 shares of Common Stock outstanding.

**DOCUMENTS INCORPORATED BYREFERENCE**

Portionsof the registrant’s definitive proxy statement to be filed within 120 days of December 31,2007 for the registrant’s 2007 Annual Meeting of Stockholders to be held on June 7,2007 are incorporated by reference in Part III of this Annual Report on Form 10-K.

 

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**NATROL, INC.2006 ANNUAL REPORT on Form 10-K**

**TABLE OF CONTENTS**
|                   | ** ** | ** **                                                                                       | ** ** | **Page** |
|-------------------|------------|--------------------------------------------------------------------------------------------------|------------|----------|
| PART I       |       | 2                                                                                                |       |
| Item 1.           |       | Business                                                                                         |       | 2        |   |
| Item 1A.          |       | Risk Factors                                                                                     |       | 13       |   |
| Item 1B.          |       | Unresolved  Staff Comments                                                                       |       | 20       |   |
| Item 2.           |       | Properties                                                                                       |       | 20       |   |
| Item 3.           |       | Legal  Proceedings                                                                               |       | 21       |   |
| Item 4.           |       | Submission  of Matters to a Vote of Security Holders                                             |       | 21       |   |
| PART II      |       | 22                                                                                               |       |
| Item 5.           |       | Market  for Registrant’s Common Equity and Related Stockholder Matters                      |       | 22       |   |
| Item 6.           |       | Selected  Financial Data                                                                         |       | 24       |   |
| Item 7.           |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations      |       | 26       |   |
| Item 7A.          |       | Quantitative  and Qualitative Disclosures About Market Risk                                      |       | 37       |   |
| Item 8.           |       | Financial  Statements and Supplementary Data                                                     |       | 38       |   |
| Item 9.           |       | Changes  and Disagreements with Accountants on Accounting and Financial Disclosure               |       | 58       |   |
| Item 9A.          |       | Controls  and Procedures                                                                         |       | 58       |   |
| Item 9B.          |       | Other  Information                                                                               |       | 58       |   |
| PART III     |       | 58                                                                                               |       |
| Item 10.          |       | Directors,  Executive Officers and Corporate Governance                                          |       | 58       |   |
| Item 11.          |       | Executive  Compensation                                                                          |       | 58       |   |
| Item 12.          |       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters |       | 59       |   |
| Item 13.          |       | Certain  Relationships and Related Transactions, and Director Independence                       |       | 59       |   |
| Item 14.          |       | Principal  Accountant Fees and Services                                                          |       | 59       |   |
| PART IV      |       | 60                                                                                               |       |
| Item 15.          |       | Exhibits  and Financial Statement Schedules                                                      |       | 60       |   |
| Signatures        |       | 62                                                                                               |       |
| Index to Exhibits |       |                                                                                             |       |

 

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**CAUTIONARY NOTEREGARDING FORWARD-LOOKING STATEMENTS**

*This Annual Report on Form 10-K, including “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” inItem 7, contains forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934. These statements relate to our future plans, objectives,expectations, intentions, financial performance and capital expenditures andthe assumptions that underlie these statements. Forward looking statements mayinclude words such as “believes,” “expects,” “may,” “will,” “should,” “intend,”“estimate,” “assume,” “plan,” or “anticipates” and other similar words. Althoughwe believe that the expectations reflected in our forward looking statementsare reliable, actual results may differ materially from those projected orassumed in any of our forward looking statements.  Our future financial condition, results ofoperations and strategy, as well as any forward looking statements are subjectto change and to inherent risks and uncertainties, such as those disclosed inthis Form 10-K, including but not limited to:*

·       *Our ability to develop and implement our current business strategies;*

·       *Our ability to appropriately respond to changing consumer preferences;*

·       *Our ability to effectively compete;*

·       *Our dependence upon certain large customers;*

·       *Our ability to obtain raw materials for our Ester-C**Ò  line ofproducts at favorable prices, or at all, after the term of our currentsupply contract which ends in March 2008;*

·       *Adverse publicity or consumer perception ofour products or any similar products distributed by others;*

·       *Our ability to address the risks associated with our acquisitionstrategy;*

·       *Our ability to retain and attract key management and otherpersonnel;*

·       *Exposure to product liability and other legal claims;*

·       *Limits to the**scope of ourinsurance coverage and third party indemnification rights;*

·       *Greater than expected product returns;*

·       *Our ability to adequately anticipate sales trends and the writedown of our inventory;*

·       *The effect of natural disasters involving our manufacturing and otherfacilities;*

·       *Our abilityto protect our intellectual property;*

·       *Intellectual propertylitigation and infringement claims against us; and*

·       *Legal actions brought by federal, state and local governmentauthorities and private parties.*

*For a detaileddiscussion of these risks and uncertainties, see “Risk Factors” in Item 1A ofthis Form 10-K.*

*We do not haveany intention or obligation to update any forward-lookingstatements whether as a result of new information, future events orotherwise.*

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**PART I**

**ITEM 1.**                Business

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

**GENERAL**

We manufacture and market branded, high-qualitydietary supplements, herbal teas, and sports nutrition products under threeprimary brands: Natrol®, Laci Le Beau®, and Prolab®. Through our EssentiallyPure Ingredients® (EPI) division we  sellnutraceutical grade ingredients to other manufacturers of nutrition productsand provide contract manufacturing services to companies within thenutraceutical industry.

We recentlyacquired the rights to manufacture, market and or sell the following brands:

·       NuHair® and Shen Min® (men’s and women’s hair regrowth products in the naturalproducts category);

·       Promensil®(red clover isoflavones-based products for the relief of menopausal symptomsand maintenance of bone and heart health); and,

·       Trinovin®(red clover isoflavones-based products for the maintenance of prostate andurinary health).

The Nu Hair and Shen Min brands were acquired fromBiotech, Inc., a Connecticut company. The Promensil and Trinovin brandsare owned by Novogen Limited (NASDAQ: NVGN), an Australian-based biotechnologycompany. These brands are sold worldwide, and we acquired the patent andtrademark rights to these products, in perpetuity, within the United States. Ourproducts fall into the general definition of vitamins, minerals, herbs anddietary supplements and are regulated by the U.S. Food and Drug Administration(USFDA).

The majority of the dietary supplements we sell aresold under the Natrol brand. Our Natrol brand focuses on supplements that arein high demand as well as specialty niche and proprietary formulations thathave potentially strong margins. These supplements include vitamins, minerals,hormonal supplements, herbal products and specialty combination formulas thatcontribute to an individual’s physical and mental well-being.

We sell our products through multiple distributionchannels throughout the United States. These channels include domestic healthfood stores and mass-market drug, club, retail and grocery store chains. Wealso sell our products through independent catalogs, Internet shopping sites,and within approximately 40 foreign countries through internationaldistributors as well a subsidiary in the United Kingdom.

Our Natrol brand strategy emphasizes building strongrecognition of the Natrol brand across multiple distribution channels through amarketing strategy that includes cooperative promotional programs as well asprint, television, radio and public relations campaigns that are designed tobuild consumer awareness and increase the purchase of our products byconsumers.

Herbal teas are sold under the Laci Le Beau brand.Laci Le Beau teas are flavored herbal teas. The primary tea category is ourSuper Dieter’s Tea®. We use the same sales people and brokers to sell herbalteas as supplements. As with our supplement business, our Laci Le Beau strategyemphasizes building strong recognition of the Laci Le Beau brand acrossmultiple distribution channels.

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The Prolab sports nutrition line of products istargeted to body builders and health minded individuals seeking a high degreeof physical fitness. Prolab’s products include supplements designed to helpthese individuals gain and lose weight as well as improve muscle mass andmuscle definition. Prolab products are sold primarily through sports nutritionretail stores, fitness centers, websites, health-food stores and,internationally, through designated distributors.

During the third quarter of 2006, we established asubsidiary, Natrol U.K., in Guildford, England, to sell our products in theUnited Kingdom and the European Union (EU). This division sells both Natrol andProlab products but is focused on building our sports nutrition business. Duringthe fourth quarter of 2006, Natrol U.K. sold approximately $425,000 of goods,mostly Prolab products.

The newly acquired Nu Hair brand of hair products issold exclusively through the mass-market channel of distribution in the UnitedStates while the Shen Min brand of hair products is sold exclusively within thehealth food channel of trade.

The Promensil and Trinovin brands are sold acrossmultiple channels of distribution.

The Nu Hair, Shen Min, Promensil, and Trinovin brandsare sold by the same sales staff that manages the Natrol and Laci LeBeau linesof products.

We also sell nutraceutical grade ingredients such asgarlic to other manufacturers through our EPI division. In addition, the EPIdivision markets Natrol’s manufacturing capabilities to other nutraceuticalbusinesses that need contract manufacturing support. EPI shares all of Natrol’sresources including Natrol’s headquarters facility, its manufacturing andresearch and development personnel and expertise, its financial resources, aswell as accounting and management resources.

Only one product category,Ester-C®, has represented more than 10% of revenue in each of the last threeyears. In addition, the Carb Intercept® category represented more than 10% ofrevenue in 2004. In 2006, the manufacturer and patent holder of Ester-C® wasacquired by NBTY (NASDAQ:NTY), a competitor of ours. NBTY has indicated that itdoes not intend to continue selling Ester-C® to third party manufacturersbeyond the term of existing supply contracts. Natrol’s supply agreement extendsthrough March, 2008. We are now working on a strategy to replace the Ester-C®business which may be lost once raw material can no longer be acquired.

**BUSINESS STRATEGY**

*Efficient Supplierof Quality Products*

Our primary business strategy is to position ourselvesas a quality supplier of nutraceutical products that can be trusted byconsumers and retailers alike. The Natrol, Laci Le Beau, Promensil, andTrinovin brands are sold across multiple channels of distribution includinghealth food stores, mass-market retail outlets including club stores, catalogsand Internet sales organizations. Nu Hair is only sold in the mass-marketchannel of distribution. Shen Min is only sold in the health food channel ofdistribution. The Prolab brand is 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, we place a strong emphasis onquality control because we believe that quality standards play a criticalfactor in consumer purchasing decisions and in differentiating the Natrolbrand. Our products are manufactured in accordance with all applicable federalregulations as well as current Good Manufacturing Practices (GMPs) standardsset by the Natural Products Association (NPA). We carefully review our productsto ensure regulatory compliance, safety and efficacy.

Much as we recognize theimportance of quality, we also recognize that our industry is very competitiveand, as such, we place a high degree of emphasis on being an efficientmanufacturer. We are constantly assessing our manufacturing processes in orderto streamline them and manufacture our 

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productsas cost effectively as possible in order to improve gross profit margins. Thegross profit margin improvement experienced in 2006 is a result of our focus onefficiency as well as improved purchase pricing of many raw materials.

*BusinessDevelopment*

A core part of our business strategy is to acquire,or, develop internally, products, brands and businesses that are complementaryto our existing product line. In 2006, we acquired the Nu Hair, Shen Min,Promensil and Trinovin lines as part of this strategy of developing ourportfolio of products.

In acquiring or developingproducts we seek to capitalize upon our existing infrastructure, which includesour sales distribution and marketing expertise as well as our generaladministrative skills.

*ExpandInternationally*

Our products areunder-represented internationally. In 2006, we established a subsidiary in theUnited Kingdom, Natrol UK, which, in September 2006, began importing andselling Natrol and Prolab products into the United Kingdom. Our strategy is toexpand our product registrations internationally and to establish newrelationships as well as expand existing relationships that allow our productsto be sold multi-nationally.

*Customer Relations*

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

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

We believe that within thehealth food store channel of distribution, our products are under-representedand our strategy within that channel of trade is to ensure that retail outletscarry a higher percentage of what we consider to be our core line of products.

*MaintainInfrastructure for Growth*

We have a history ofinvesting in our infrastructure to ensure that we can meet the needs of ourcustomers. We regularly evaluate our operations and as a business strategy makeinvestments in building and maintaining our infrastructure as necessary.

*ExperiencedManagement Team*

Our management team has extensive experience inmanaging and acquiring businesses in this country and internationally.

During the first quarter of 2006, the Board ofDirectors appointed Wayne Bos as President and CEO and Craig Cameron as ChiefOperating Officer.

Mr. Bos is an entrepreneur, investor andgrowth-company executive. Among his most notable successes, Mr. Bos workedclosely with the management team of Uniqema, a division of Imperial ChemicalIndustries in London, to complete an acquisition of one of the business units.Following completion of the acquisition in 2000, Symex Holdings Limited wasestablished as a 100 percent owned Australian company and successfully listedon the Australian Stock Exchange. Today, Symex is Australia’s largest producerof Oleo products.

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Mr. Bos also served as CEO and Director ofSausage Software, an Australian public company. Under his leadership, Sausagegrew from a single product company with 35 people and revenues of $5 million,to an eBusiness solutions house with more than 1500 people and revenues of morethan $150 million. Sausage Software, with wholly owned subsidiaries in the UK,USA and Asia grew to a market capitalization of more than $2 billion during thelate 1990s and early 2000s.

Mr. Cameron’s professional background includes 23years of international executive management experience in sales, marketing,strategy, operations, and R&D. During his 16-year career with NCRCorporation, he served as Senior Managing Director in Japan, Managing Directorof New Zealand, Director of Marketing in Canada, and Head of Corporate Strategyin the United States. More recently, Mr. Cameron served as head ofstrategy and marketing for Telstra Corporation (Australia’s largesttelecommunications company). He subsequently became Chief Executive Officer ofAdvantra, a $300MM joint venture company of IBM, Lend Lease and Telstra.

The Company will continue to employ talented and experiencedprofessionals with a broad range of experience to help it grow.

Our Board of Directors isalso experienced and each member of the board has been selected because of themember’s business background and that person’s ability to contribute to thelong-term success of the Company.

**SALES**

*BRANDED PRODUCTS*

We distribute Natrol supplements, Laci Le Beau herbalteas, Nu Hair and Shen Min hair products, Promensil, and Trinovin primarily todomestic, independent, health food stores and mass-market club, drug, retailand food stores.

Products are sold to health food stores primarilythrough leading national distributors, including *United Natural Foods, Nature’s Best* and *Tree of Life*who resell our productsdirectly to independent health food stores. These products are also solddirectly to certain health food store chains such as *GNC*, *Fred Meyer NutritionCenters* and *The Vitamin Shoppes*.

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

The mass-market distribution channel is also managedby the Vice President of Sales. We employ three sales managers who manage anindependent broker network of more than 40 groups throughout the country. Ouremployees directly service our larger mass-market accounts while independentbrokers service others in conjunction with the sales people and management. Wesell our products to mass-market merchandisers either directly or throughdistributors of vitamins, minerals and other supplement products such as: *Amerisource Bergen*, *McKesson*, and *Cardinal*.

Our major drug, club and mass-market retail andgrocery customers include:
| ·*Albertsons*               |   | ·  *Dominick’s* |   | ·  *Rite Aid*  |
|----------------------------------|--------|--------------------------------|--------|--------------------------|
| ·*BJ’s Wholesale Club* |   | ·  *Hannaford*       |   | ·  *Vons*      |
| ·*Brooks/Eckerd*            |   | ·  *HEB*             |   | ·  *Walgreens* |
| ·*Costco*                   |   | ·  *Kroger*          |   | ·  *Wal-Mart*  |
| ·*CVS*                      |   | ·  *Longs Drug*      |   | * *                 |

 

Sales of vitamins and other supplements within themass-market channel of trade are extremely competitive with all vendorscompeting vigorously to defend their positions within each mass-market 

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account. Many mass-marketretailers emphasize their own in-house private label brand, which createsadditional competition. Many retailers have more than one private label brand.Vendors to the mass-market class of trade continually analyze their own shelfspace as well as that of their competitors in an effort to maximize profits forthemselves and the mass-market retailer. The result is a cycle in whichcompanies such as ours prune slower moving items from store shelves, replacingthem with faster selling products. Our central strategy is to ensure that ourmost profitable and rapidly selling items remain on retailers’ shelves while wetry to obtain more shelf space for additional, potentially profitable, items.

Throughout the last decade there has been substantialconsolidation within the mass-market channel of trade. When one chain is boughtby another, the vendors to the acquired retailer will gain or lose businessdepending upon the intent of the acquiring company. How a consolidation willaffect a vendor is difficult to quantify immediately after the announcedconsolidating event because representatives of the acquirer and the acquiredbusiness are most often difficult to reach and IT systems in each companytypically do not work well with each other. The result is that smaller vendorshave to wait for months before being able to obtain an accurate description ofthe acquirer’s plans.

Within the health food store channel of distribution,we believe that our product line is could be better represented and ourstrategy within this channel of trade is to ensure that retail outlets carry ahigher percentage of what we consider to be our core line of products.

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

Prolab products are sold primarily through sportsnutrition retail stores, fitness centers, web sites, health food stores andinternationally through designated distributors. Approximately 28.6% of Prolab’ssales are international.

The Prolab business fell nearly $3.3 million in 2006.Approximately two-thirds of this decline was due to a decline in internationalshipments. This decline is one of the factors that led to our opening asubsidiary in the United Kingdom, Natrol UK. This subsidiary began sellingProlab products to customers in the UK in late September 2006 and sales ofProlab products through this division amounted to approximately $418,000 in2006. We are working on a strategy to improve Prolab sales through thedevelopment of new products and stronger marketing programs.

Two of our customers eachrepresented more than 10% of net sales for the year ended December 31,2006. The lead customer represented 11.4% of net sales and the second customerrepresented 10.9% of net sales. For the year ended December 31, 2005 onlyone customer, representing 12.8% of net sales, accounted for more than 10% ofnet sales and no customer represented more than 10% of net sales in 2004.

*CONTRACTMANUFACTURING AND INGREDIENT SUPPLY SALES: EPI*

Our contract manufacturing services are marketedthrough EPI. We manufacture a number of products for customers who distributethe products under their own private labels. As a contract 

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manufacturer, we willoften assist our customers in the formulation of their products. Contractmanufacturing accounted for approximately 3.1% of our net sales in 2006.

In our bulk ingredient business, EPI sellsnutraceutical grade garlic and miscellaneous ingredients to other manufacturersof nutritional products. Bulk ingredient sales accounted for 1.5% of our netsales in 2005.

During the last two years, we have de-emphasized ourcontract manufacturing. We reviewed the profitability of allcontract-manufacturing customers and limit our contract manufacturing to workwe believe will deliver minimum profit levels.

The result is that net shipments of the EPI divisionfell from $6.5 million in 2004 to $4.7 million in 2005 and to $3.0 million in2006. Although revenue has declined, the net contribution of the EPI divisionhas improved due to higher margins on the remaining business and lower expensesto maintain the business that we now have.

Our strategy with respectto contract manufacturing business is to selectively bid on profitable contractmanufacturing business that can help us more fully utilize of our manufacturingplant.

**MARKETING**

*BRANDED PRODUCTS*

Our core strategy has been to build our brands withinthe channels of distribution that are appropriate for each brand and to developincreased brand awareness and strong brand recognition among consumers seekingproducts with a reputation for quality.

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

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

*INGREDIENT SUPPLYSALES AND CONTRACT MANUFACTURING SALES*

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

**RESEARCH &DEVELOPMENT**

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

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

**MANUFACTURING ANDPRODUCT QUALITY**

*DIETARY SUPPLEMENTS*

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

We manufacture most of our tablets and capsules in our94,000 square foot manufacturing facility and headquarters located inChatsworth, California. At this facility, we manufacture tablets and capsules,which account for the vast majority of our supplement sales. Our liquidproducts, powders, softgels and herbal teas are outsourced to third partymanufacturers.

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

Our procedures requirethat all raw materials be tested from the receiving stage and stored in adesignated quarantine area until they are approved for use by our qualitycontrol department. Bulk materials are tested for physical characteristics,active ingredient content, and for contamination such as heavy metals andmicrobes.

*Raw Material Supply:*

We obtain our rawmaterials from third-party suppliers. Many of the raw materials used in ourproducts are harvested internationally. We do not have substantial multi-yearcontracts with suppliers committing such suppliers to provide the materialsrequired for the production of our products. During the last decade, coenzymeQ10 (CoQ10), whey protein concentrate, natural vitamin E, beta-carotene,melatonin, kava, and a select number of other raw materials have hadsignificant price fluctuations as a result of short supply and/or increases indemand. As a result, we have experienced occasional shortages of raw materialsfor a limited number of our products or, alternately, supply for these rawmaterials has only been available at sharply higher prices. In our industry, itis very difficult to increase our pricing when the cost of raw materialsfluctuate. One of our suppliers accounted for more than 10% of our purchases in2006 and two of our suppliers each accounted for more than 10% of our purchasesin 2005. The loss of any of these suppliers could have a material adverseeffect on our ability to produce and sell goods. We do not have materiallong-term supply agreements with these suppliers.

*SpecialtySuppliers:*

We sell a limited number of products under a supplier’strademark. In 2006, the most significant of these was our Ester-C line ofproducts, which accounted for a little more than 10% of our invoiced sales. During2006, the patent and trademark holder of the Ester-C was sold to NBTY, acompetitor of Natrol’s. NBTY has indicated that it intends to stop sellingEster-C to third party manufacturers and distributors of Ester-C. Natrol has asupply contract requiring NBTY to supply Ester-C until March 2008. Thecontract does not specify the price at which Ester-C must be supplied. We arenow working on a strategy to replace lost Ester-C business.

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Ester-C exemplifies therisk assumed when we market products under a supplier’s trademark. We arelimited to that single supplier as a source of raw materials for that product.As a result, any shortage of raw materials from that supplier adversely affectsour ability to manufacture that product. Price increases from these supplierscould severely impact the profitability of these items. Our inability to obtainadequate supplies of raw materials for our products at favorable prices couldhave a material adverse effect on our business, financial condition and resultsof operations.

*ShippingFacilities:*

We ship all of ourproducts from our 132,000 square foot warehouse facility located less thanone-quarter mile from our headquarters/manufacturing facility. Approximately52,000 square feet of this warehouse facility has been subleased. Rental incomewas approximately $105,000,  $300,000,$389,000 for the years ended December 31, 2006, 2005 and 2004,respectively. Income in 2006 was low due to the bankruptcy of a tenant. Theremaining 80,000 square feet is being used to ship finished goods to ourcustomers.

*HERBAL TEAS*

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

*PROLAB*

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

**TRADEMARKS ANDPATENTS**

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

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

We have received one United States patent for ourKavatrol product and we have received two United States patents related to twoamino acid products, SAF and SAF for Kids. Sales of these patented items arenot material. When appropriate, we will seek to protect our research anddevelopment efforts by filing patent applications for proprietary products. Tothe extent that we do not have patents on our products, another company mayreplicate one or more of them.

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

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**COMPETITION**

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

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

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

**REGULATORY MATTERS**

The manufacture, packaging, labeling, advertising,promotion, distribution and sale of our products are subject to regulation bynumerous governmental agencies. Our products are subject to regulation by,among other regulatory entities, the Consumer Product Safety Commission (CPSC),the U.S. Department of Agriculture (USDA), the Environmental Protection Agency(EPA) and the U.S. Food and Drug Administration (FDA). Advertising and otherforms of promotion and methods of marketing are subject to regulation primarilyby the U.S. Federal Trade Commission (FTC), which regulates these activitiesunder the Federal Trade Commission Act (FTCA). The manufacture, labeling andadvertising of our products are also regulated by various state and localagencies as well as those of each foreign country to which we distribute ourproducts.

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

Under the current provisions of the FFDC Act, thereare four categories of claims that pertain to the regulation of dietarysupplements. Health claims are claims that describe the relationship between anutrient or dietary ingredient and a disease or health related condition andcan be made on the labeling of dietary supplements if supported by significantscientific agreement and authorized by the FDA in advance via notice andcomment rulemaking. Nutrient content claims describe the nutritional value ofthe product and may be made if defined by the FDA through notice and commentrulemaking and if one serving of the product meets the definition. Statementsof nutritional support or product performance, which are permitted on labelingof dietary supplements without FDA pre-approval, are defined to includestatements that: (i) claim a benefit related to a classical nutrientdeficiency disease and disclose the prevalence of such disease in the UnitedStates; (ii) describe the role of a nutrient or dietary ingredientintended to affect the structure or function in humans; (iii) characterizethe documented mechanism by which a dietary ingredient acts to maintain suchstructure or function; or (iv) describe general well-being fromconsumption of a nutrient or dietary ingredient. In order to make a nutritionalsupport claim, the marketer 

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must possess adequatesubstantiation to demonstrate that the claim is not false or misleading and ifthe claim is for a dietary ingredient that does not provide traditionalnutritional value, prominent disclosure of the lack of FDA review of therelevant statement and notification to the FDA of the claim is required. Drugclaims are representations that a product is intended to diagnose, mitigate,treat, cure or prevent a disease. Drug claims are prohibited from use in thelabeling of dietary supplements.

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

Our dietary supplements must comply with the DietarySupplement and Nonprescription Drug Consumer Protection Act, which will becomeeffective on December 22, 2007. This Act amends the FFDC Act to mandatethe reporting of serious adverse events received by us to the FDA. Weanticipate full compliance by the effective date without an undue expenditure ofresources.

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

Our failure to comply with applicable FDA regulatoryrequirements could result in, among other things, injunctions, productwithdrawals, recalls, product seizures, fines and criminal prosecutions. Weintend to comply with the new GMPs once they are adopted. The new GMPs,predicted to be finalized shortly, would be more detailed and stringent thanthe GMPs that currently apply to dietary supplements and may, among otherthings, require dietary supplements to be prepared, packaged, produced and heldin compliance with regulations similar to the GMP regulations for drugs. Therecan be no assurance that, if the FDA adopts GMP regulations for dietarysupplements, we will be able to comply with the new regulations withoutincurring a substantial expense.

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

Our advertising of dietary supplement products issubject to regulation by the FTC under the FTCA. Section 5 of the FTCAprohibits unfair methods of competition and unfair or deceptive acts orpractices in or affecting commerce. Section 12 of the FTCA provides thatthe dissemination or the causing to be disseminated of any false advertisementpertaining to drugs or foods, which would include dietary supplements, is anunfair or deceptive act or practice. Under the FTC’s Substantiation Doctrine,an 

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advertiser is required tohave a “reasonable basis” for all objective product claims before the claimsare made. Failure to adequately substantiate claims may be considered eitherdeceptive or unfair practices. Pursuant to this FTC requirement, we arerequired to have adequate substantiation for all material advertising claimsmade for our products.

On November 18, 1998, the FTC issued “DietarySupplements: An Advertising Guide for Industry.” This guide provides marketersof dietary supplements with guidelines on applying FTC law to dietarysupplement advertising. It includes examples of the principles that should beused when interpreting and substantiating dietary supplement advertising.Although the guide provides additional explanation, it does not substantivelychange the FTC’s existing policy that all supplement marketers have anobligation to ensure that claims are presented truthfully and to verify theadequacy of the support behind such claims. Our internal staff, in conjunctionwith outside counsel, reviews our advertising claims for compliance with FTCrequirements.

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

Advertising and labeling for dietary supplements andconventional foods are also regulated by state, county and other localgovernmental authorities. Some states also permit these laws to be enforced byprivate attorney generals. These private attorney generals may seek relief forconsumers, seek class action certifications, seek class-wide damages, seekclass-wide refunds and product recalls of products sold by us. In the ordinarycourse of business, we are named as a defendant in these types of stategovernmental agency and private attorney general Actions along with othervitamin and supplement companies. Until the courts rule that laws havebeen violated, that the actions can proceed by state governmental agencies orprivate attorney general class actions and that cognizable injuries haveoccurred, we do not believe such actions will have any material impact on ouroperations. There can be no assurance that state and local authorities will notcommence regulatory action, which could restrict the permissible scope of ourproduct advertising claims, or products that can be sold in the future.

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

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

We may be subject toadditional laws or regulations by the FDA or other federal, state, county,local or foreign regulatory authorities, the repeal of laws or regulationswhich the Company considers favorable, such as DSHEA, or more stringentinterpretations of current laws or regulations, from time to time in thefuture. We are unable to predict the nature of such future laws, regulations,interpretations or applications, 

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nor canwe predict what effect additional governmental regulations, legal proceedingsor administrative orders, when and if promulgated or initiated, would have onour business in the future. They could, however, require the reformulation ofcertain products to meet new standards, the recall or discontinuance of certainproducts not able to be reformulated, imposition of additional record keepingrequirements, expanded documentation of the properties of certain products,expanded or different labeling and scientific substantiation. Any or all ofsuch requirements could have a material adverse affect on our business,financial condition and results of operations.

**EMPLOYEES**

As of December 31,2006, we had 251 employees. Of such employees, approximately 41 were engaged inmarketing and sales, 166 were devoted to production and distribution and 44were responsible for management and administration. Our employees are notcovered by a collective bargaining agreement. We consider our relations withour employees to be good.

**AVAILABLEINFORMATION**

The Securities andExchange Commission (SEC) maintains an Internet site (http://www.sec.gov), which contains reports, proxy andinformation statements, and other information regarding us. Our Annual Reporton Form 10-K filed with the SEC includes all exhibits required to befiled with the SEC. We make available, free of charge, on our website, ourAnnual Report on Form 10-K, Quarterly Reports on Form 10-Q,Current Reports on Form 8-K and all amendments to these reportsfiled or furnished pursuant to Section 13(a) or 15(d) of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”). Such reportsare available as soon as is reasonably practicable after we electronically filesuch materials with the SEC. Additionally, copies of this Annual Report on Form 10-K,not including any of the exhibits listed under Item 15 of this Annual Report onForm 10-K, are available without charge upon request.

**ITEM 1A:**       RISKFACTORS

**Forward LookingStatements and Certain Risks**

*The statementscontained in this report that are not purely historical are “forward-lookingstatements” within the meaning of Section 21E of the Securities ExchangeAct. These statements regard our expectations, hopes, beliefs, commitments,intentions, and strategies regarding the future. They may be identified by theuse of words or phrases, such as “believe,” “expect,” “anticipate,” “should,”“plan,” “estimate,” and “potential,” among others. Forward-looking statementsinclude, but are not limited to, statements contained in “Business” and“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” regarding our financial performance, revenue and expense levels inthe future, and the sufficiency of our existing assets to fund futureoperations and capital spending needs. Actual results could differ materiallyfrom the anticipated results or other expectations expressed in theseforward-looking statements or for the reasons discussed below. The fact thatsome of the risk factors may be the same or similar to past reports we havefiled with the SEC means only that the risks are present in multiple periods.We believe that many of the risks detailed here are part of doing business inthe industry in which we operate and compete and will likely be present in allperiods reported. The fact that certain risks are endemic to the industry doesnot lessen their significance. The forward-looking statements contained in thisreport are made as of the date of this report, and we assume no obligation toupdate them or to update the reasons why actual results could differ from thoseprojected in these forward-looking statements.*

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

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

**If we fail to successfully implement our currentbusiness strategies, our ability to increase our revenues and operating profitscould be adversely affected and our overall business could be harmed.**

Our key currentbusiness strategies consists of:

·       achievingcost savings through improvements to our operations;

·       makingacquisitions that support our strategic direction; and

·       expandingour international operations.

We are constantly trying to achieve cost savingsthrough continued improvement in the operational efficiency of ourmanufacturing facilities. At times, achieving additional efficiency requires anup front investment for equipment or personnel. These investments are madebased upon projections of future savings. Our expected costs savings andefficiency improvements may not occur at all or at levels that we anticipate. Asdiscussed below, there are significant risks associated with our acquisitionsstrategy. Operations in foreign markets may be affected by currencyfluctuations, different consumer preferences, government regulation and localmarket conditions. In addition, there can be no assurance that we will be ableto identify new international markets that meet our expansion criteria, or ifwe identify such markets, that we will successfully implement or achieve ourexpansion goals. For example, we may not achieve the operating margins that weexpect. If we are unable to successfully implement our business strategies, ourgrowth and results of operations could be adversely affected.

Our failure to appropriately respond to competitivechallenges, changing consumer preferences and demand for new products couldsignificantly harm our customer relationships and product sales.

The nutritional supplement industry is characterizedby intense competition for product offerings and rapid and frequent changes inconsumer demand. Our failure to accurately predict product trends couldnegatively impact our products and inventory levels and cause our revenues todecline. For example, sales of our Carb Intercept product grew consistently in2003 and in 2004 reached $11.0 million in gross shipments. In 2005, grossshipments of Carb Intercept fell to $1.8 million. We believe these fluctuationsresulted from changing consumer preferences and publicity surrounding the low-carbohydrateAtkins-type diet.

Our success withany particular product offering (whether new or existing) depends upon a numberof factors, including our ability to:

·       accuratelyanticipate customer needs;

·       differentiateour product offerings from those of our competitors;

·       competitivelyprice our products

·       developand/or acquire new products; and

·       deliverproducts in a timely manner in sufficient volumes.

Products often have to be promoted heavily in storesor in the media to obtain visibility and consumer acceptance. Acquiringdistribution for products is difficult and often expensive due to slotting andother promotional charges mandated by retailers. Products can take substantialperiods of time to develop consumer awareness, consumer acceptance and salesvolume. Accordingly, some products fail to gain or maintain sufficient salesvolume and as a result have to be discontinued.

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Our industry is highly competitive, and our failure tocompete effectively could adversely affect our market share, financialcondition and future growth.

The dietarysupplement industry is highly competitive with respect to:

·       price;

·       shelfspace;

·       brandand product recognition;

·       new product introductions;and

·       raw materials.

Several of our competitors are larger, more establishedand possess greater financial, personnel, distribution and other resources. Weface competition (1) in the health food channel from a limited number oflarge nationally known manufacturers, private label brands and many smallermanufacturers of dietary supplements; and (2) in the mass-marketdistribution channel from broadline manufacturers, major private labelmanufacturers and others.

Private label brands at mass-market chains representsubstantial sources of income for these merchants and the mass-market merchantsoften support their own labels at the expense of other brands. The privatelabel business has been a significant growth element within our industry. Thegrowth of private label sales negatively impacts the sales of branded productssuch as ours. As such, the growth of our brands within food, drug, and generalmass-market merchants is highly competitive and uncertain. If we cannot competeeffectively, we may be unable to maintain sufficient market share to beprofitable.

We rely on a limited number of customers for asubstantial portion of our sales, and the loss of or material reduction inpurchase volume by any of these customers would adversely affect our sales andoperating results.

Two major customers eachrepresented more than 10% of net sales in 2006. These customers accounted forapproximately 22.3% of net sales. One major customer during 2005 representedmore than 10.0% of net sales. Our top ten customers accounted for approximately47.1% of net sales in 2006. The loss of any of our major customers, asignificant reduction in purchases by any major customer, or, any seriousfinancial difficulty of a major customer, could have a material adverse effecton our sales and results of operations.

**We may be unable to continue to obtain raw materialsfor our Ester-C line of products at favorable prices or at all, which couldadversely affect our business and operating results.**

We license the intellectual property rights and obtainall of the raw material for our Ester-C product line from a third partylicensor. Our Ester-C product line accounted for approximately 10.3% ofinvoiced sales in fiscal 2006 and 10.8% of invoiced sales in fiscal 2005.

In October 2006, thelicensor of Ester-C sold its dietary supplement and raw material business to oneof our competitors. Although we have a supply and licensing arrangement forEster-C through March 2008, we cannot be certain that we will be able toobtain raw material for Ester-C at favorable prices prior and we do not believewe will be able to continue selling Ester-C after our contract expires. Ourinability to obtain Ester-C raw material at favorable prices or our inabilityto continue to sell Ester-C after March 2008 could have a material adverseeffect on our business and operating results.

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**Adverse publicity or consumer perception of ourproducts and any similar products distributed by others could harm ourreputation and adversely affect our sales and revenues.**

We are highly dependentupon positive consumer perceptions of the safety and quality of our products aswell as similar products distributed by other dietary supplement companies. Consumerperception of dietary supplements and our products in particular can besubstantially influenced by scientific research or findings, national mediaattention and other publicity about product use. Adverse publicity from suchsources regarding the safety, quality or efficacy of dietary supplements andour products could harm our reputation and results of operations. The merepublication of reports asserting that such products may be harmful orquestioning their efficacy could have a material adverse effect on ourbusiness, financial condition and results of operations, regardless of whethersuch reports are scientifically supported or whether the claimed harmfuleffects would be present at the dosages recommended for such products.

**There are many risks associated with our acquisitionstrategy and our inability to address these risks could harm our business andoperating results.**

A key part of ourgrowth strategy is and has been to acquire brands or companies that broaden ourproduct offerings or complement our lines of business. In 2006, we acquired ourNu Hair and Shen Min brands and licensed the rights to Promensil and Trinovin. Whilewe expect to continue to make selective acquisitions in 2007, our ability tomake any acquisition is restricted under the terms of our credit facility withWachovia Capital Finance (Western), as agent. In addition, acquisitions involvecertain known and unknown risks that could cause our actual growth or operatingresults to differ from our expectations or the expectations of securitiesanalysts. For example:

·       acquisitionsmay not perform as expected and we may fail to realize anticipated revenue andprofits;

·       acquisitionsmay expose us to unanticipated liabilities, including product liability orother claims, all of which could harm our reputation and business.

·       wemay fail to successfully integrate or manage acquisitions due to differences inbusiness backgrounds or corporate cultures;

·       wemay be unable to retain key employees of an acquired company or brand whichcould negatively impact the acquisition’s future performance;

·       wemay be unable to identify suitable acquisition candidates or make acquisitionson acceptable terms; and

·       we compete with others toacquire companies, which may result in decreased availability of, oroverpayment for, suitable acquisition candidates.

In addition, ouracquisition strategy may divert management’s attention away from our existingbusiness, result in the loss of key customers or key employees and cause ourresults of operations to suffer.

**If we are unable to retain key personnel, our abilityto manage our business effectively and continue our growth could be negativelyimpacted.**

Key management employeesinclude Wayne M. Bos, Craig Cameron, Dennis R. Jolicoeur and certain otherindividuals. These key management employees are primarily responsible for ourday-to-day operations, and we believe our success depends in large part on ourability to retain them and to continue to attract additional qualifiedindividuals to our management team. Currently, we do not have an employmentagreement with any of our key management employees, other than Mr. Bos. Theloss or limitation of the services of any of our key management employees orthe inability to attract additional qualified personnel could have a materialadverse effect on our business and results of operations.

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**We may be exposed to material product liabilityclaims, which could increase our costs and adversely affect our reputation andbusiness.**   

As a marketer, manufacturer and distributor ofproducts designed for human consumption, we are subject to product liabilityclaims if the use of our products or products we manufacture for others isalleged to have resulted in injury. Our products consist of vitamins, minerals,herbs and other ingredients that are classified as dietary supplements and inmost cases are not subject to pre-market regulatory approval in the UnitedStates or internationally. Previously unknown adverse reactions resulting fromhuman consumption of these ingredients could occur.

We have been in the past,and in the future may be, subject to various product liability claims,including among others that our products had inadequate instructions for use,or inadequate warnings concerning possible side effects and interactions withother substances. In 2003, we chose to self-insure against product liabilityclaims due to the high price of product liability insurance, the inability tosecure occurrence based coverage, as well as the limited amount of coverageprovided by insurers willing to provide insurance at high prices. We deposited$5.0 million for a five-year policy term with an insurance carrier who providescertificates of insurance to our vendors. The $5.0 million earns interest andis classified as a non-current asset entitled “Restricted Cash” on theaccompanying consolidated balance sheet. The $5.0 million is fully refundableshould we decide to end the self-insurance program at the end of the policyterm. The limits of such self-insurance program may not be sufficient to coverlegal claims or costs associated with defending against such claims. The costof defense can be substantially higher than the cost of settlement even whenclaims are without merit. The high cost to defend or settle product liabilityclaims could have a material adverse effect on our business and operatingresults.

**Our insurance coverage or third party indemnificationrights may not be sufficient to cover our legal claims or other losses that wemay incur in the future.**

We maintain insurance, including property, general andproduct liability, workers’ compensation and directors’ and officers’liability, to protect ourselves against potential loss exposures. In thefuture, insurance coverage may not be available at adequate levels or onadequate terms to cover potential losses, including on terms that meet ourcustomer’s requirements. If insurance coverage is inadequate or unavailable, wemay face claims that exceed coverage limits or that are not covered, whichcould increase our costs and adversely affect our operating results.

In addition, we generallyrequest contractual indemnification rights from third parties that supply rawmaterials for or manufacture our products, and request to be added as an additionalinsured under such parties’ insurance policies. Any such indemnification orinsurance is limited by its terms and any such indemnification, as a practicalmatter, is limited to the creditworthiness of the indemnifying party. In theevent that we do not have adequate insurance or contractual indemnification,product liabilities relating to our products or contract manufacturingactivities could have a material adverse effect on our business, financialcondition and results of operations.

**We may experience greater than expected productreturns, which might adversely affect our sales and results of operations.**

Product returns are a customary part of our business. Whilecustomers generally do not have an absolute right of return, products may bereturned for various reasons, including expiration dates or lack of sufficientsales volume. In addition, we may experience significantly more returns as aresult of a loss of a customer account or the purchase of one customer byanother. For example, when there is a consolidation among our customers, we maylose the account or experience substantially greater returns. In 2004, theEckerd drug store chain was sold to the CVS and the Brooks drugstore chains. Asa result, in 2005 CVS and Brooks returned $0.9 million more of our productsthan in 2004 when our account was with Eckerd.

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We accrue allowances forreturns based on historical data and future expectations. We review our retailbase on a customer-by-customer basis and accrue for returns as soon asestimates can be reasonably calculated. While we continually work to lessen theimpact of returns through the management of our SKU count at retailestablishments and the more effective use of sales and marketing programs, weoften experience fluctuations and, in the future, returns may equal or exceedthe levels experienced in years prior. For example, while our expense forreturns and charges for damages and outdated products amounted to approximately5.5% of gross shipments in 2006, in 2005 these charges amounted to 6.2% ofgross shipments. If product returns greatly exceeded our estimates, ourrevenues and results of operations would be adversely affected.

**If we fail to adequately anticipate sales trends forour products, we may be required to write down the value of our inventory,which could aversely affect our results of operations.**

Our products are testedfor stability and each product has an associated expiration date after whichthe product cannot be sold. Expiration dates can be as short as months or, insome cases, as long as several years. As sales trends change, we mayover-produce finished goods inventory or have excess raw materials that wecannot use before their expiration dates. We regularly dispose of overstockedfinished goods and expired raw material inventory. When sales trends change toorapidly or when manufacturing planning does not estimate future demandaccurately, we are required to write off or write down inventory, whichadversely affects our results of operations during the period in which the write-downsof inventory occur. For example, in 2005 we wrote off $1.9 million of inventory—ornearly 2.5 times the amount we wrote off in 2006 and 2004—in a large partbecause of the significant decline of Carb Intercept sales in 2005.

**A significant natural disaster, such as an earthquake,involving our manufacturing facility could harm or disrupt our operations.**

We are dependent upon thecontinued operation of our manufacturing facility at its current levels. Ourmanufacturing facility is located in Southern California, a geographic areathat has historically been prone to earthquakes and other natural disasters,which in some cases have been catastrophic. In 1994, the building where ourmanufacturing facility is located was severely damaged in a major earthquake. Thebuilding has since been retrofitted to meet newer building codes. Regardless,we do not carry earthquake insurance on our facilities. Any significant damageor destruction of our manufacturing facility as a result of a natural or otherdisaster would disrupt our operations and have a material adverse effect onbusiness and results of operations.

**A shortage in the supply of key raw materials couldincrease our costs or adversely affect our sales and revenues.**

We obtain all of our rawmaterials from third-party suppliers with whom we do not have significantlong-term supply contracts. We have experienced occasional shortages of ordelays in the supply of raw materials for a limited number of products. Shortagesoften result in materially higher raw material prices or adversely affect ourability to manufacture a product. Price increases from a supplier woulddirectly affect our profitability if we are not able to pass price increases onto customers. Our inability to obtain adequate supplies of raw materials in atimely manner or a material increase in the price of our raw materials couldhave a material adverse effect on our business, financial condition and resultsof operations.

**Our inability to protect our intellectual propertyrights could adversely affect our business.**

We have investedsignificant resources to protect our brands and intellectual property rights. However,we may be unable or unwilling to strictly enforce our intellectual propertyrights, including our trademarks and to a lesser extent our patents, frominfringement. Our failure to enforce our intellectual 

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propertyrights could diminish the value of our brands and product offerings and harmour business and future growth prospects.

**Intellectual property litigation and infringementclaims against us could cause us to incur significant expenses or prevent usfrom manufacturing, selling or using some aspect of our products.**

We have been and in thefuture may be subject to intellectual property litigation and infringementclaims, which could cause us to incur significant expenses to defend suchclaims, divert management’s attention or prevent us from manufacturing, sellingor using some aspect of our products. If we chose or are forced to settle suchclaims, we may be required to pay for a license to certain rights, payingroyalties on both a retrospective and prospective basis, and/or cease ourmanufacturing and sale of certain products that are alleged to be infringing. Futureinfringement claims against us by third parties may adversely impact ourbusiness, financial condition and results of operations.

**Our quarterly operating results are subject tosignificant fluctuations and, if our operating results decline or are worsethan expected, our stock price could fall.**

Our sales and earningshave been and continue to be volatile as a result of, among other things:

·       ourability to recognize product trends;

·       theloss of one or more significant customers;

·       theintroduction of successful new products by our competitors;

·       adversemedia reports on the use or efficacy of dietary supplements; and

·       generalconditions and trends in the dietary supplement industry.

Lower sales or earnings asa result of the foregoing factors may adversely affect our operating results inany period and cause the market price of our common stock to decline.

**The terms of our senior credit facility prohibit usfrom our engaging in many transactions and may limit or restrict our ability togrow our business.**

The terms of oursenior credit facility impose operating and financial restrictions on us andour subsidiaries which could have a negative impact on our business, financialcondition and results of operations by limiting or prohibiting us from takingcertain actions or engaging in certain transactions without bank consent,including:

·       incurringor guaranteeing additional indebtedness;

·       engagingin mergers, acquisitions or consolidations;

·       declaringor paying dividends;

·       repurchasingcapital stock;

·       issuingor selling capital stock;

·       transferringor selling assets;

·       repurchasingstock and certain indebtedness; and

·       engaging in transactionswith affiliates.

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**Our failure to meet investor expectations, materialannouncements by us or our competitors or other material events could cause ourstock price to fall.**

The trading priceof our common stock has historically been subject to wide fluctuations anddaily trading volume is relatively low. The price of our common stock maydecline, perhaps substantially, in response to:

·       changesin stock market analyst recommendations regarding us or our competitors;

·       quarter-to-quartervariations in our operating results;

·       materialannouncements by us or our competitors;

·       adversepublicity or consumer perception of our products or similar productsdistributed by others; or

·       adverse actions against usor our competitors by governmental authorities or private litigants.

**Because we are subject to numerous laws andregulations, and involved in litigation from time to time, we could incursubstantial judgments, fines, legal fees and other costs.**

Our industry is highlyregulated. The manufacture, labeling and advertising for our products areregulated by various federal, state and local agencies as well as those of eachforeign country to which we distribute. These governmental authorities maycommence regulatory or legal proceedings, which could restrict the permissiblescope of our product claims or the ability to manufacture and sell our productsin the future. The FDA regulates our products to ensure that the products arenot adulterated or misbranded. Failure to comply with FDA requirements mayresult in, among other things, injunctions, product withdrawals, recalls,product seizures, fines and criminal prosecutions. Our advertising is subjectto regulation by the FTC under the FTCA. In recent years the FTC has initiatednumerous investigations of dietary supplement and weight loss products andcompanies. Additionally, some states also permit advertising and labeling lawsto be enforced by private attorney generals, who may seek relief for consumers,seek class action certifications, seek class wide damages and product recallsof products sold by us. Any of these types of adverse actions against us bygovernmental authorities or private litigants could have a material adverseeffect on our business, financial condition and results of operations.

**ITEM 1B.**       Unresolved Staff Comments

We do not have anyunresolved comments from the SEC staff.

**ITEM 2.**                Properties

At December 31, 2006, we owned our 94,000 squarefoot manufacturing, distribution and office facility in Chatsworth, California.We have occupied this facility since March 1997. The facility was designedand constructed to our specifications and includes areas for receiving,quarantine of new materials, manufacture, quality control and laboratoryactivities, research and development, packaging, warehousing and administrativeoffices.

We also owned our 132,000 square foot warehousefacility. This facility is located within one-quarter mile of our headquartersfacility. We have generally leased 52,000 square feet of this space to a thirdparty. This space was mostly unoccupied in 2006 due to the bankruptcy of thetenant. A new tenant occupied the 52,000 square feet of rental space in February 2007,signing a five-year lease.

At December 31, 2006,the two buildings were encumbered by two mortgage notes amounting to $6.7million.

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**ITEM 3.**                Legal Proceedings

From time to time, we aresubject to litigation incidental to our business, including product liabilityclaims, state agency actions, private attorney general actions and classactions. We are a party to a number of lawsuits that arise in the ordinarycourse of business and may become a party to additional lawsuits. We are notcurrently a party to any material legal proceedings. Although none of thelawsuits in which we are involved in as of the date of this filing arereasonably estimated to be material, the possibility exists that futurelawsuits could arise, or, that developments could occur in existing legalactions that could have a material adverse effect on us. Such claims, ifsuccessful, could exceed the $5.0 million retention under ourself-insurance program.

**ITEM 4.**                Submission Of Matters To A Vote Of SecurityHolders

During the fourth quarter of 2006, no matters weresubmitted to a vote of our security holders.

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**PART II**

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

*PRICE RANGE OFCOMMON STOCK*

Our Common Stock is traded on the NASDAQ Global Marketunder the symbol “NTOL.” On March 25 2007, the last reported closing salesprice of our Common Stock as reported on the NASDAQ National Market was $2.71.As of March 25, 2007 there were 23 holders of record of our Common Stock.

Thehigh and low sales closing prices for the Common Stock as reported by theNASDAQ National Market for the years ended December 31, 2006 and 2005 areset below:

| ** **                             | ** ** | **Fiscal year ended  December 31, 2006** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                             | ** ** | **   High   **                 | ** ** | **   Low   ** | ** ** |
| Quarter ended  March 31, 2006     |       |                                                         | $          | 2.47 |   |   |   | $ | 1.64 |   |   |
| Quarter ended  June 30, 2006      |       |                                                         | 2.36       |   |   |   | 1.80 |   |   |
| Quarter ended  September 30, 2006 |       |                                                         | 1.95       |   |   |   | 1.42 |   |   |
| Quarter ended December 31, 2006   |       |                                                         | 2.64       |   |   |   | 1.45 |   |   |

 

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

 

*SHAREHOLDER RETURNPERFORMANCE GRAPH*

Set forth below is a linegraph comparing the yearly percentage change in the cumulative totalshareholder return on the Company’s Common Stock, based on the market price ofthe Company’s Common Stock, with the total return of companies included withinthe Standard & Poor’s Small Cap 600 Market Index, the Standard &Poor’s 500 Index, the Russell 2000 Small Cap Index, and a peer group ofcompanies for the five years ended December 2006. For its peer group, theCompany chose those companies listed as part of the Cannacord Adams Better Foodand Nutrition Index. Included in the index are Green Mountain Roasters (GMCR),Hain Celestial Group, Inc. (HAIN), Martek Biosciences Corporation (MATK),NBTY, Inc. (NTY), Wild Oats Markets, Inc. (OATS), The J.M. SmuckerCompany. (SJM), SunOpta Inc. (STKL), United Natural Foods, Inc.(UNFI) and Whole Foods Markets (WFMI). MCP Ingredients, Inc. (MGPI),Herbalife, LTD. (HLF), Monterey Gourmet Foods, Inc. (PSTA), Integrated BioPharma Inc. (INB), WeiderNutrition International Inc. (WNI), Fresh Del Monte Produce Inc. (FDP), Reliv International Inc. (RELV),Medifast Inc, (MED), John B San Felipe & Son (JBSS), Nature’s SunshineProducts, Inc. (NATRE), Chiquita Brands International Inc. (CQB), NaturalAlternatives International Inc. (NAII), Forbes Medic-Tech Inc. (FMTI), KYOCERAInternational Inc, (YOCM), Nu Skin Enterprises, Inc. (NUS), Vermont PureHoldings Ltd. (VPS), USANA Health Sciences Inc. (USNA), Maui Land &Pineapple Co. (MLP), Nutraceutical International Corp. (NUTR), Mannatech, Inc.(MTEX), Cyanotech Corp. (CYAN), Gaiam Inc. (GAIA), Omega Protein Corp. (OME),Circle Group Holdings Inc. (CXN), Lifeway foods Inc. (LWAY), Glacier WaterServices, Inc., (GWSV), Calavo Growers, Inc., (CVGW) and GalaxyNutritional Foods Inc. (GXY). The calculation of total cumulative returnassumes a $100 investment in the Company’s Common Stock, the Standard &Poor’s Small Cap 600 Market Index, the Standard & Poor’s 500 Index,the Russell 2000 Small Cap Index and the Cannacord Adams Better Food andNutrition Index on January 1, 2001 and the reinvestment of all dividends.

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**Comparisonof 5 Year Cumulative Total ReturnAssumes Initial Investment of $100December 2006**

*DIVIDEND POLICY*

We currently intend toretain earnings to finance our operations and future growth and do notanticipate paying dividends on our Common Stock in the foreseeable future.Under our senior credit facility, we are prohibited from paying or declaringcash dividends.

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**ITEM 6.**                SELECTEDCONSOLIDATED FINANCIAL DATA

Thefollowing selected financial data is derived from our audited consolidatedfinancial statements. The data set forth below should be read in conjunctionwith “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations” and our consolidated financial statements and related notesincluded elsewhere in this report.

| ** **                                                                                     | ** ** | **Year Ended December 31,**                        | ** ** |
|------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2006**                                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                     | ** ** | **(in thousands except per share data)** | ** ** |
| **Consolidated Statements of  Operations Data:**                                               | ** ** | ** **                                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                                                                      |       | $                                                                 | 65,564     |   | $ | 67,530 |   | $ | 79,269 |   | $ | 72,658 |   | $ | 70,260 |   |
| Cost of goods  sold                                                                            |       | 37,131                                                            |       | 44,107 |   | 46,820 |   | 44,246 |   | 41,715 |   |
| Gross profit                                                                                   |       | 28,433                                                            |       | 23,423 |   | 32,449 |   | 28,412 |   | 28,545 |   |
| Selling and  marketing expenses                                                                |       | 16,655                                                            |       | 18,000 |   | 19,560 |   | 17,701 |   | 16,915 |   |
| General and  administrative expenses                                                           |       | 11,065                                                            |       | 9,525 |   | 9,348 |   | 10,063 |   | 8,744 |   |
| Total operating  expenses                                                                      |       | 27,720                                                            |       | 27,525 |   | 28,908 |   | 27,764 |   | 25,659 |   |
| Operating income  (loss)                                                                       |       | 713                                                               |       | (4,102 | ) | 3,541 |   | 648 |   | 2,886 |   |
| Interest income  (expense), net                                                                |       | (461                                                              | )          | (449 | ) | (529 | ) | (595 | ) | (644 | ) |
| Gain on sale of  property                                                                      |       | 230                                                               |       | — |   | — |   | — |   | — |   |
| Income (loss)  from continuing operations before income taxes                             |       | 482                                                               |       | (4,551 | ) | 3,012 |   | 53 |   | 2,242 |   |
| Income tax  provision (benefit)                                                                |       | 47                                                                |       | (1,918 | ) | 1,144 |   | 34 |   | 861 |   |
| Income (loss)  from continuing operations before cumulative change in accounting principles    |       | 435                                                               |       | (2,633 | ) | 1,868 |   | 19 |   | 1,381 |   |
| 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                                   |       | 435                                                               |       | (2,633 | ) | 1,868 |   | (1,468 | ) | 693 |   |
| Cumulative effect  of change in accounting principle(2)                                        |       | —                                                            |       | — |   | — |   | — |   | (6,819 | ) |
| Net income (loss)                                                                              |       | $                                                                 | 435        |   | $ | (2,633 | ) | $ | 1,868 |   | $ | (1,468 | ) | $ | (6,126 | ) |
| Income (loss) per  share:                                                                      |       |                                                              |       |   |   |   |   |   |   |   |   |
| Basic income (loss) from continuing operations                                                 |       | $                                                                 | 0.03       |   | $ | (0.20 | ) | $ | 0.14 |   | $ | 0.00 |   | $ | 0.11 |   |
| Diluted income (loss) from continuing operations                                               |       | 0.03                                                              |       | (0.20 | ) | 0.13 |   | 0.00 |   | 0.11 |   |
| 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                                                                |       | 0.03                                                              |       | (0.20 | ) | 0.14 |   | (0.11 | ) | (0.48 | ) |
| Diluted earnings (loss) per share                                                              |       | 0.03                                                              |       | (0.20 | ) | 0.13 |   | (0.11 | ) | (0.48 | ) |
| Weighted average shares outstanding—basic                                                 |       | 13,620                                                            |       | 13,474 |   | 13,277 |   | 12,946 |   | 12,852 |   |
| Weighted average  shares outstanding—diluted                                              |       | 13,747                                                            |       | 13,474 |   | 14,113 |   | 13,452 |   | 12,992 |   |

 

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| ** **                               | ** ** | **December 31,**   | ** ** |
|------------------------------------------|------------|-------------------------|------------|
| ** **                               | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                               | ** ** | **(in thousands)** | ** ** |
| **Consolidated Balance Sheet  Data:**    | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents               |       | $                       | 1,003      |   | $ | 3,097 |   | $ | 6,022 |   | $ | 2,599 |   | $ | 10,077 |   |
| Working capital                          |       | 12,115                  |       | 15,910 |   | 18,260 |   | 13,328 |   | 18,722 |   |
| Total assets                             |       | 54,600                  |       | 51,462 |   | 52,924 |   | 51,439 |   | 53,357 |   |
| Long-term debt,  less current maturities |       | 6,301                   |       | 7,165 |   | 7,685 |   | 7,451 |   | 7,778 |   |
| Total stockholders’  equity         |       | 37,390                  |       | 35,404 |   | 37,760 |   | 35,558 |   | 36,651 |   |
|                                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          During the fourth quarterof 2003, we discontinued our Annasa and Tamsol operations.

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

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

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

**OVERVIEW**

The year 2006 was ayear of substantial change and transition. Significant events included:

·       Theemployment of a new CEO and COO during the first quarter of the year.

·       Theestablishment of a new line of credit, with a three-year term, allowing us toborrow up to $10 million depending on the level of accounts receivable andinventory.

·       Theestablishment of a subsidiary in the United Kingdom, Natrol U.K., to sell ourproducts in the United Kingdom and the European Union.

·       Theacquisition of two brands of hair products, Nu Hair and Shen Min.

·       Theacquisition of the exclusive patent and trademark rights in the United Statesrelated to the Promensil and Trinovin brands of products.

All of these events support the strategy which hasbeen implemented by the new management team.

The key elements ofthis strategy are to:

·       Controlour cost and improve margins;

·       Developor acquire new products and product lines that can help us capitalize upon ourinfrastructure;

·       Expandthe distribution of our products to new markets, including internationally;

·       Improvethe marketing of our products; and

·       Control the cost of doingbusiness in our various channels of trade.

***Significant events***

*New SeniorManagement Team*

During the first quarter of 2006, our Board ofDirectors appointed Wayne Bos as President and CEO and Craig Cameron as ChiefOperating Officer. Concurrently, Mr. Elliott Balbert, former President andCEO assumed new responsibilities as Executive Chairman of the Company.

In connection with hisappointment, Mr. Bos was awarded fully vested options to purchase6,029,500 shares of our common stock with a strike price of $2.282 per share.The strike price was equal to the price of the last reported trade immediatelyprior to the time our Board determined to grant this option and thereforereflects the fair market value of our common stock at the time of the grant.For a period of three years, Mr. Bos’ ability to sell the majority of theshares he receives upon exercise of these options is restricted, with therestrictions lapsing based upon the stock price reaching defined hurdles. Thegrant received the approval of shareholders at the Company’s annual shareholders’meeting in June 2006.

*Senior SecuredCredit Facility*

In August 2006, we entered into a loan andsecurity agreement with Wachovia Capital Finance (Western), a subsidiary ofWachovia Bank, N.A. The loan agreement provides for a three-year secured 

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revolving credit facilityof up to $10 million. Borrowings under the facility may be used forongoing working capital purposes and certain future acquisitions.

The interest rate on borrowings under the creditfacility is equal to: (1) agent’s publicly announced prime rate for primerate loans or (2) 2.25% plus the applicable Eurodollar rate for anyEurodollar rate loans. Interest is payable monthly in arrears, not later thanthe first day of each calendar month.

The facility is secured bya first priority lien on all our assets and properties, subject to certainexceptions. The obligations under the credit facility are guaranteed by certainof our current and by each of our future subsidiaries. The credit facilitycontains certain covenants and also provides for customary events of default,including non-payment defaults, covenant defaults and cross-defaults to ourother material indebtedness.

*UK Subsidiary*

During the third quarter of 2006, we established asubsidiary in the United Kingdom to sell our products in the United Kingdom andthe European Union (EU). This division is currently focused on building oursports nutrition business in Europe, but our intention is to also sell Natrolproducts through this division into the EU.

We began selling productin late September 2006, and net revenue from the subsidiary amounted toapproximately $425,000 in 2006.

*Acquisition/LicensingTransactions*

*Nu Hair and ShenMin Brands.*

In October 2006, we purchased the Nu Hair andShen Min brands from Biotech, including without limitation the brand’sintellectual property rights. Nu Hair products, distributed within the massmarket channel, include hair regrowth tablets for men and women, as well astopical products, such as Thinning Hair Serum and Thickening Shampoo. Shen Min products,marketed primarily within the health food channel, consist of a similar line ofproducts.

The purchase priceconsisted of $5.4 million in cash. We also agreed to make earn outpayments to Biotech, depending upon the total amount invoiced to customers ofthe Nu Hair and Shen Min brands during each of the three-year periods afterclosing. As part of the acquisition, we also entered into a two-year consultingagreement with Gregory J. Kelly, Biotech’s founder. Under the consultingagreement, we agreed to pay Mr. Kelly $100,000 per year and granted him anon-qualified stock option to purchase 50,000 shares of Natrol common stock atan exercise price of $4.00 per share, vesting quarterly over two years.

*Promensil andTrinovin Brands*.

*In October 2006, we licensed the U.S. rights tothe Promensil*Ò and TrinovinÒbrands from Novogen Limited, and acquired substantially all of the U.S.inventory for the brands. The PromensilÒand TrinovinÒ brands are dietary supplements based on redclover isoflavones that are designed to meet the specific health needs of agingadults.

*Summary of Results*

As a result of the emphases on margin improvement,cost controls, new product acquisitions, and expanding our distribution, wewere able to return to profitability.

Net sales were less in 2006 than in 2005, $65.6million vs. $67.5 million, primarily due to a fall off in sales from EPI andProlab.

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EPI sales fell $1.6 million. The decline was directlydue to the company’s strategy of foregoing unprofitable business. Despite thelower sales volume, EPI produced more gross profit in 2006 than in 2005.

The Prolab business fell nearly $3.3 million in 2006.Approximately two-thirds of this decline was due to a decline in internationalshipments. This decline is one of the factors that lead us to open a subsidiaryin the United Kingdom, Natrol UK. This subsidiary began selling Prolab productsto customers in the UK in late September 2006 and sales of Prolab productsthrough this division amounted to approximately $418,000 in 2006. We are workingon a strategy to improve Prolab sales.

The declines from EPI and Prolab were partially offsetby improved sales of the Natrol brand and $1.5 million of additional sales fromthe acquired brands and trademarks.

Gross Profit margins improved from 34.7% in 2005 to43.4% in 2006. The reasons for the margin improvement include better pricing ofraw materials, in particular CoQ10, improved production efficiency, changes inour product mix, less scrapped inventory and less return expense.

As a result of thesechanges and achievements, we recorded four successive profitable quarters andoperating income in 2006 of $0.7 million vs. an operating loss of $4.1 millionin 2005. Net income amounted to $0.4 million in 2006 vs. a net loss of $2.6million in 2005.

**CRITICAL ACCOUNTINGPOLICIES**

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

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

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

Our recognition of revenue from sales to distributorsand retailers is impacted by agreements giving them rights to return damagedand outdated products as well as the fact that as a practical business matter,our sales force, along with our customers, is constantly working to ensure theprofitability of our products within retailers by rotating slow moving itemsout of stores and replacing those products with what we and the retailer expectwill be more profitable, faster selling items. Our obligation to accept returnsof slow moving items may or may not be contractually bound.

Ouraccounting and sales staffs regularly monitor historical patterns of returnsfrom individual customers as well as current and ongoing sales to customersand, when information is available, consumer purchases of our products from ourcustomers. We have determined that historical trends with respect to productsales of individual items are not a good barometer of future returns of thoseitems. Excellent 

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historical sales with few returns does not guaranteestrong future sales and a low level of future returns. This is due to a numberof factors including: changes in consumer demand for individual items; increasingor decreasing competition from industry participants; different levels ofperiodic support from retail partners; the amount of advertising with which wemay be able to support products; and, favorable or unfavorable publicity.Products that sell well at one account may not sell well at another account dueto factors that are unique to the particular customer such as: poor vs.excellent product placement on the customer’s shelves, the fact that customersdo not carry the same products, the carrying by a customer of more or fewercompetitive products, and pricing at the retail level which is controlled bythe customer. In order to reduce the amount of subjectivity when analyzingsales trends and reserving for future returns, we perform a detailed analysesof trends at each of our major customers, i.e., those customers who havehistorically accounted for the bulk of returns. This analysis takes intoaccount sales patterns of individual products at each customer on acustomer-by-customer basis as well as inventory levels at the customer,scheduled promotional events, and the probability that items will bediscontinued. We believe that this analysis creates appropriate estimates ofnecessary future reserves. Our use of the term returns throughout this documentincludes estimates of our liability for damaged and outdated product within ourchannels of trade. Over the last three years, returns and estimates of returnliability were as follows (in thousands):

| **Description**                    | ** ** | ** ** | ** ** | **Balance at  Beginning  of Year** | ** ** | **Charged to  Cost and  Expense** | ** ** | **Deductions** | ** ** | **Balance at  End of Year** | ** ** |
|------------------------------------|------------|------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| Allowance for Sales  Returns:      |       |       |       |                                         |       |                                        |       |           |       |                                       |       |   |   |   |   |   |   |
| Year ended December 31, 2004  |       |       | $          | 1,235                                        |       |                                        |       | $              | 3,172      |                                       |       |   | $ | 3,340 | (1) |   |   | $ | 1,067 |   |   |
| Year ended December 31, 2005  |       |       | 1,067      |                                         |       |                                        | 4,874      |           |       |                                       | 3,664      | (1) |   |   | 2,277 |   |   |
| Year ended  December 31, 2006 |       |       | 2,277      |                                         |       |                                        | 4,207      |           |       |                                       | 3,837      | (1) |   |   | 2,647 |   |   |
|                                    |            |            |            |                                              |            |                                             |            |                |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Represents actualreturns

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

The total expense charged against sales for returns,damages and outdates in 2006, 2005, and 2004 was $4.2 million,$4.9 million and $3.2 million, respectively.

*Impairmentof Goodwill.**  *Wehave adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142requires that goodwill not be amortized. In accordance with the adoption, weidentified all reporting units in conjunction with the provisions of SFAS No. 142and allocated all goodwill accordingly.

Goodwill is evaluated for impairment annually, or morefrequently if changes in circumstances indicate that the carrying amount ofgoodwill may not be recoverable. We consider a number of variables including,but not limited to, the market capitalization of the Company, estimates offuture earnings and discounted cash flows, third party assessments of the valueof the Company and transactions involving the purchase and sale of businessessimilar to ours.

*IncomeTaxes.**  *Deferredincome tax assets have been established for future tax benefits related to netoperating losses, deductible goodwill for which we have recorded an impairmentcharge, and, for certain other temporary items, the aggregate benefit of whichis approximately $5.9 million. Realization of this benefit is dependent ongenerating sufficient taxable income in future periods. Although it is notassured, management believes it is more likely than not that the carrying valueof this benefit will be realized. The 

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amount of the benefit thatis considered realizable, however, could change if estimates of future taxableincome are adjusted in future periods.

*Inventory.**  *We monitor inventory and analyze iton a monthly basis. Cycle counts are taken daily to verify inventory levels. Inaddition, we analyze the movement of items within inventory in an effort todetermine the likelihood that inventory will be sold or used before expirationdates are reached. We provide an allowance against that portion of inventorythat we believe is unlikely to be sold or used before expiration dates arereached. At December 31, 2006, inventory allowances were approximately$1.0 million.

**RESULTS OFOPERATIONS**

***Year Ended December 31, 2006 Compared to YearEnded December 31, 2005***

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

Net sales in 2006 decreased 2.9% or $1.9 million to$65.6 million from $67.5 million in 2005. Net sales are calculated bysubtracting from gross revenue certain expenses such as incentive rebates,shipping damages, and returns. Our expense for returns was $0.7 million less in2006 than in 2005, amounting to $4.2 million versus $4.9 million in 2005.

Thenet revenue of Natrol (including Laci Le Beau), EPI, and Prolab changed asfollows from 2005 to 2006. Natrol and Prolab sales include sales that were madein the United Kingdom by our UK subsidiary. New product sales include the salesof our branded products that are not sold under the Natrol, Laci LeBeau orProlab brand names, all of which began after October 20, 2006.

| ** **                      | ** ** | **Years Ended  December 31,** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|
| ** **                      | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| ** **                      | ** ** | **(in thousands)**                 | ** ** |
| Net revenue                     |       |                                    |       |   |   |
| Natrol (including Laci Le Beau) |       | $                                       | 49,329     |   | $ | 47,720 |   |
| EPI                             |       | 3,040                                   |       | 4,676 |   |
| Prolab                          |       | 11,785                                  |       | 15,134 |   |
| New products                    |       | 1,410                                   |       | — |   |
| Total net revenue               |       | $                                       | 65,564     |   | $ | 67,530 |   |

 

Sales of the core Natrol brand increased 3.4%. Nomajor new products were launched in 2006. The increase reflects increased salesof Natrol’s core items. The decline in EPI’s net revenue was caused by astrategic decision to focus on more profitable business and not to sellmarginally profitable items. Gross margins from the EPI division improved in2006 relative to 2005.

The decline in Prolab business was caused primarily bya decline in international sales. This trend is one of the reasons we launcheda subsidiary in the United Kingdom whose focus is to regain these lost sales. Inaddition, we recognize that the Prolab line requires additional productinnovation and we are working to expand the Prolab line to attract moredomestic and international consumers.

During 2006 and 2005, only the Ester-C productcategory accounted for more than 10% of our net revenue. In 2004, both Ester-Cand Carb Intercept each accounted for more than 10% revenue.

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*GrossProfit.**  *Grossprofit increased 21.4% or $5.0 million to approximately $28.4 as comparedto $23.4 million in 2005. Gross profit margin increased to 43.4% from34.7%. Gross profit margin fluctuates depending upon product mix, the cost ofraw materials, labor and overhead as well as the difference between grossrevenue and net sales revenue.

The improvement ingross profit and gross profit margin occurred for three reasons:

·       Morefavorable raw material pricing

·       Increasedproduction efficiency

·       Highermargins from newly acquired products

In 2005, the price of CoQ10 rose sharply, costing usapproximately $1.2 million more than it had in 2004. The price of whey alsoincreased in 2005, costing us approximately $1.3 million more than it had in2004. The price of CoQ10 fell back to the pricing experienced in 2004 and inmore recent months has declined even further. The price of whey has not droppedsignificantly.

In 2006, we benefited from the lower CoQ10 pricing. But,we also worked assiduously with each supplier to obtain better pricing for allof our raw materials.

Also in 2006, our new Chief Operating Officer, inconjunction with the operations staff, set specific goals to improve labor andmaterial efficiency. The goals were to reduce labor per unit as well as toensure that the least amount of raw material would be wasted within eachproduction run. These efforts delivered meaningful results, which are reflectedin the improved gross margins.

Lastly, each acquisition brought us products withhigher gross profit margins than the average gross profit margin for theCompany as a whole. This helped our margins for the fourth quarter and for theyear.

*Sellingand Marketing Expenses.**  *Selling and marketing expenses consist primarily ofadvertising and promotional expenses, costs of distribution, and relatedpayroll expenses and commissions. Selling and marketing expenses decreased by7.5% or $1.3 million to $16.7 million from $18.0 million in2005. The decrease was due primarily to less spending on traditional media suchas radio and print advertising. In 2005, we heavily promoted the launch of ourbrainSpeedÒ products using radio and print advertising.

*Generaland Administrative Expenses.**  *General and administrative expenses consist primarilyof personnel costs related to general management functions, research anddevelopment, finance, accounting and information systems, as well asprofessional fees. General and administrative expenses increased 16.2% or $1.5million to $11.1 million from slightly more than $9.5 million in 2005.

Approximately $0.6 million of the increase was due tothe expensing of stock options due to our adopting of SFAS 123R. Executivepayroll was approximately $1.0 million more in 2006 than in 2005. This was dueto the employment of Mssrs. Bos and Cameron as well as the fact that forseveral months during 2006, Mr. Gary DeMello, the Company’s former COOworked in conjunction with his successor, Mr. Cameron. Other general andadministrative expenses were comparable to prior years.

*InterestIncome (Expense), net.**  *Interestexpense was approximately $690,000 in 2006 versus $638,000 in 2005. Interestincome was approximately $229,000 in 2006 versus $189,000 in 2005. Interest expenseincreased in 2006 due to our using the line of credit we established withWachovia to help us pay for our acquisitions. Interest income increased in 2006as a result of rising interest rates and the average level of cash on handduring the year.

*Income Tax Provision(Benefit).**  *Werecorded income tax expense of approximately $50,000 in 2006 as opposed to anincome tax benefit of $1.9 million in 2005. Our effective tax rate was10.4% in 2006 and 42.1% in 2005. The prime reason for the variance wereresearch and development credits, which lowered our taxes by $183,000 in 2006.

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

*NetSales.  *Net sales in 2005 decreased 14.8%, or$11.7 million, to $67.5 million from $79.2 million in 2004. Netsales is calculated by subtracting from gross revenue certain expenses such asincentive rebates, shipping damages, and returns. Gross revenue decreased lessthan net sales because total deductions from gross revenue were $1.2 millionmore in 2005 than in 2004. Our return expense in 2005 was $1.7 more than in2004. This expense was offset in part by reducing other discounts. Off invoicepromotional discounts in particular were $0.4 million less in 2005 than in2004.

The largest relative change in returns came from theCVS, Brooks, and Eckerd drug store chains after the purchase of Eckerd Drug bythe CVS and Brooks drug store chains. The returns from this group were$0.9 million higher in 2005 than in 2004.

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

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

 

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

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

Prolab sales fell nearly $3.0 million in 2005. A keyfactor was our Canadian distributor whose sales in 2005 declined $1.5 millionwhen compared to 2004. During the year, we worked to resolve issues with thisdistributor as they relate to contractual minimum purchases, pricing, andstrategies for building the Prolab brand. The issues were not resolved to whatwe believe are our best interests and as a result, we limited our business withthis distributor. We are contractually prevented from using a different distributorin Canada (outside of Quebec) until September 2007. We believe thatdespite the immediate problems this presents in terms of gross sales and netincome, our long term prospects in Canada are better if we sell directly inCanada or find another distributor who is willing to build the Prolab brand ina manner we believe is appropriate.

We believe that an additional reason for the declinein Prolab sales was the high cost of product to consumers. The price ofwhey-based products increased 26% during 2005 forcing us to implement two priceincreases. The price increases did not make up for the lost margin to us. Evenso, consumers purchased less from us in response to the price increases theyreceived.

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*GrossProfit.**  *Grossprofit decreased 27.8% or $9.0 million to $23.4 as compared to$32.4 million in 2004. Gross margin decreased to 34.7% from 40.9%. Had thegross profit margin remained 40.9% in 2005, our gross profit would have fallen$4.8 million due to the lower volume of sales.

An important factor in the $9.0 million drop ingross profit is the high cost of two important raw materials in 2005, CoQ10 andwhey. CoQ10 accounts for a little more than 6% of our sales volume and wheyproducts account for a little more than 11% of our sales volume. The averageprice of CoQ10 in 2005 was approximately 68% higher than it was in 2004, whichresulted in our spending approximately $1.2 million more than we wouldhave if the pricing of CoQ10 had remained at 2004 levels. We were unable topass much of this cost to consumers via price increases. Similarly, wheyproduct pricing increased 26% which cost us approximately $1.3 millionrelative to 2004 and as with CoQ10, very little of the extra cost could bepassed on to consumersAnother significant issue was the sharp decline in CarbIntercept sales, which had the additional impact of making previously good rawmaterial and finished goods inventory obsolete because the product would expirebefore it could be used or sold. This problem caused us to write down inventoryby approximately $690,000, reducing our gross profit.

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

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

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

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

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

**LIQUIDITY ANDCAPITAL RESOURCES**

At December 31, 2006,we had working capital of $12.1 million, as compared to $15.9 millionin working capital at December 31, 2005.

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**OperatingActivities**

In 2006, operating activities provided $0.3 million ofcash as opposed to 2005 when operating activities used $2.2 million ofcash. Operating activities provided $1.7 million of cash in 2004.

In 2006, net income of $0.4 million and a $2.1million net change in non cash charges, which had the effect of providing cash,were partially offset by a $2.2 million net change in operating assets andliabilities which used cash.

Non-cash charges had the effect of providing cash dueto $1.4 million of depreciation and approximately $0.6 million of optionexpenses, as well as a small amount of foreign currency translation and sharesissued for services, which were partially offset by small changes in theallowance for bad debts and deferred income taxes.

Changes in operating assets and liabilities used cashdue to a $1.6 million decrease in accounts payable, a $1.0 millionincrease in prepaid expenses and a $0.3 million decrease in accrued expenses,offset by a decrease in accounts receivable of $0.3 million, an increase in accruedpayroll of $0.4 million and a small decrease in our income tax receivable.

At December 31, 2006,the number of days sales outstanding in trade receivables was approximately 36days versus 37 days and 32 days in 2005 and 2004, respectively.

**Investing Activities**

Net cash used in investingactivities was approximately $6.0 million in 2006 versus $0.5 million used in2005 and net cash provided by investing activities of approximately $0.9million in 2004. We invested approximately $0.3 in plant and equipment in 2006.We sold property in Connecticut that formally housed Prolab and this providedapproximately $0.8 million. We invested approximately $5.3 million to purchasethe NuHair and Shen Min trademarks and $0.4 million to acquire the trademarkrights to Promensil and Trinoven in the United States. This $5.7 millioninvestment is recorded as Trademarks on our balance sheet. These acquisitionsused cash. We also invested $0.4 million to acquire certain rights associatedwith the patents that relate to the Promensil and Trinoven products in theUnited States. These rights are being amortized over the life remaining life ofthe patents which is approximately six years. This investment, as well as $0.3million that was invested to secure our debt facility, used cash.

**FinancingActivities**

Financing activitiesprovided $3.6 million in 2006, used $0.2 million in 2005 and provided $0.7million in 2004. In 2006, we entered into our line of credit with Wachovia and,as of the end of the year, we had borrowed $3.7 million under the line. Thecash was used to finance our acquisitions and to pay off part of our long-termdebt. We repaid approximately $1.0 million of our long-term debt during theyear which used cash. The sale of stock to employees who participated in ourEmployee Stock Purchase program, or to employees or board members who exercisedstock options provided approximately $0.9 million of cash.

**Long Term Debt**

As of December 31, 2006, we had$10.4 million in outstanding debt versus $8.2 million at the end of2005. The debt at the end of 2006 included $3.7 million of debt related to ourline of credit and $6.7 million of mortgage debt secured by our buildings.

In August 2006, we entered into a loan andsecurity agreement with Wachovia Capital Finance (Western), as agent, thelenders party thereto, Prolab Nutrition, our wholly owned subsidiary, andcertain of our other subsidiaries, as guarantors. The loan agreement providesfor a three-year secured revolving credit facility of up to $10 million. Borrowingsunder the facility will be used for ongoing outstanding 

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working capital purposesand certain future acquisitions. At March 6, 2007, we had $3.3 million ofborrowings under the facility.

Under the credit facility, we may borrow up to thelesser of $10 million and the borrowing base (calculated based upon eligibleinventory and eligible accounts). The interest rate on borrowings under thecredit facility is equal to: (1) agent’s publicly announced prime rate forprime rate loans or (2) 2.25% plus the applicable Eurodollar rate for anyEurodollar rate loans. Interest is payable monthly in arrears not later thanthe first day of each calendar month.

The credit facility requires that all principal berepaid in full on the third anniversary of the closing date. Additionally, borrowingsunder the credit facility must be repaid when the borrowings exceed theborrowing base.

The facility is secured by a first priority lien onall our assets and properties (which includes the assets and properties ofProlab Nutrition, the guarantors and our future subsidiaries), subject tocertain exceptions. The obligations under the credit facility are guaranteed byNatrol Products, Inc., Natrol Acquisition Corp. and Natrol Direct, Inc.and by each of our future subsidiaries.

The credit facility contains covenants restricting ourability to, among other things: (1) incur or guarantee additional debt; (2) engagein any mergers or acquisitions (subject to certain exceptions); (3) engagein any asset sales or dispose of any assets (other than in the ordinarycourse); (4) engage in transactions with affiliates; (5) incur liens;(6) make any loans or investments; and (7) declare or pay dividendsor redeem or repurchase capital stock.

The credit facility also provides for customary eventsof default, including non-payment defaults, covenant defaults andcross-defaults to our other material indebtedness.

Our cash balance at the close of 2006 wasapproximately $1.0 as opposed to approximately $3.1 million at the end of2005.

We believe that our line of credit, combined with ouroperating cash flows should be sufficient to fund our anticipated workingcapital needs and planned capital expenditures for the next 12 months. Ifwe do not meet our operating plan we may need additional borrowings to fundworking capital needs.

However, our businessstrategy includes making acquisitions. In order to meet our liquidity needs, wemay be required to incur additional indebtedness or to issue additional equityand debt securities, subject to market and other conditions. There can be noassurance that such additional financing will be available on terms acceptableto us or at all. The failure to raise the funds necessary to finance our futurecash requirements or to consummate future acquisitions could adversely affectour ability to pursue our business strategy and could negatively affect ouroperations in future periods.

**RECENTLY ISSUEDACCOUNTING STANDARDS**

In February 2006, the FASB issued FASB Statement No. 155,Accounting for Certain Hybrid Financial Instruments. This Statement amends FASBStatements No. 133, Accounting for Derivative Instruments and HedgingActivities, and No. 140, Accounting for Transfers and Servicing ofFinancial Assets and Extinguish­ments of Liabilities. As we do not issue orexpect to issue hybrid financial instruments, we do not believe that theadoption of FASB No. 155 will have a material impact on our consolidatedfinancial statements.

The Financial Accounting Standards Board issuedInterpretation No. 48, *Accounting forUncertainty in Income Taxes* (“FIN 48”) in June 2006. Theinterpretation clarifies the accounting for uncertainty in income taxesrecognized in financial statements in accordance with SFAS 109. FIN 48 iseffective for fiscal years beginning after December 15, 2006. We havenot determined the effect, if any, the adoption of FIN 48 will have on ourconsolidated financial statements.

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On June 28, 2006 the Board of the FASB ratifiedthe conclusion reached by the EITF and contained therein in Issue No. 06-03.The Task Force reached a conclusion that the presentation of taxes on either agross or net basis is an accounting policy decision that should be disclosedpursuant to Opinion 22. Currently, the Company presents its sales tax liabilityon a net basis. Sales are not grossed up with the attendant taxes deducted as aseparate line item. The EITF becomes effective for interim and annual reportingperiods beginning after December 15, 2006. At such time, the Company willdisclose this matter in its accounting policies.

In September 2006, the SEC issued StaffAccounting Bulletin No. 108, *Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements* (“SAB 108”). SAB 108 providesguidance on how prior year misstatements should be taken into considerationwhen quantifying misstatements in current year financial statements forpurposes of determining whether the current year’s financial statements arematerially misstated. SAB 108 is effective for fiscal years ending on or after November 15,2006. The adoption of SAB 108 did not have a material impact on ourconsolidated financial statements.

In September 2006, the FASB issued Statement SFASNo. 157 (“FAS 157”), “ *Fair ValueMeasurements*,” which defines fair value, establishesguidelines for measuring fair value and expands disclosures regarding fairvalue measurements. FAS 157 does not require any new fair value measurementsbut rather eliminates inconsistencies in guidance found in various prioraccounting pronouncements. SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007. Earlier adoption is permitted, providedthe company has not yet issued financial statements, including for interimperiods, for that fiscal year. The Company is currently evaluating the impactof FAS 157, but does not expect the adoption of FAS 157 to have a materialimpact on its consolidated financial position, results of operations or cashflows.

We periodically review newaccounting standards that are issued from time to time. Although some of theseaccounting standards may be applicable to us, we have not identified any othernew standards that we believe merit further discussion, and we expect that nonewould have a significant impact on our consolidated financial statements.

**CONTRACTUALOBLIGATIONS AND COMMITMENTS**

Thefollowing table discloses our obligations and commitments to make futurepayments under contractual obligations at December 31, 2006.

| ** **                 | ** ** | **Payment Due by Period** | ** ** |
|----------------------------|------------|------------------------------------------|------------|
| ** **                 | ** ** | **Total**                                | ** ** | **Less  than  1 Year** | ** ** | **2-3  Years** | ** ** | **4-5  Years** | ** ** | **Thereafter** | ** ** |
| ** **                 | ** ** | **(in thousands)**                  | ** ** |
| Note payable               |       | $                                        | 6,715      |   | $ | 414 |   | $ | 934 |   | $ | 1,098 |   |   | $ | 4,269 |   |   |
| Interest on notes  payable |       | 3,765                                    |       | 536 |   | 966 |   | 802 |   |   | 1,461 |   |   |
| Leases                     |       | 188                                      |       | 89 |   | 89 |   | 10 |   |   | 0 |   |   |
| Total                      |       | $                                        | 10,668     |   | $ | 1,039 |   | $ | 1,989 |   | $ | 1,910 |   |   | $ | 5,730 |   |   |

 

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On February 1,2007, we began to lease part of our shipping facility and future minimum leasepayments due to us according to the lease are (in thousands):

| 2007  |   | $   | 310    |   |
|-------|--------|-----|--------|--------|
| 2008  |   | 412 |   |
| 2009  |   | 430 |   |
| 2010  |   | 443 |   |
| 2011  |   | 456 |   |
| Total |   | $   | 2,051  |   |

 

**IMPACT OF INFLATION**

Generally, inflation hasnot had a material impact on our historical operations or profitability. Inrecent years, inflation has been modest. The competitive environment somewhatlimits our ability to recover higher costs resulting from inflation by raisingprices. We seek to mitigate the adverse effects of inflation primarily throughimproved productivity and cost containment programs. We do not believe thatinflation has had a material impact on our results of operations for theperiods presented.

**ITEM 7A.**        QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK.

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

We aresubject to interest rate market risk associated with our bank debt. Even so, wedo not believe the risk associated with such borrowing is significant. At December 31,2006, our debt consisted of our line of credit, with an outstanding balance of$3.7 million and long-term mortgage debt on our properties which was comprisedof two fixed rate notes with a total principal balance of approximately $6.7million collateralized by our headquarters building and our shipping facility.The table below presents principal cash flows and related interest rates byfiscal year of maturity.

| ** **       | ** ** | **Expected Year of Maturity** | ** ** |
|------------------|------------|----------------------------------------------|------------|
| ** **       | ** ** | **2007**                                     | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** | **Total** | ** ** | **Fair Value  December 31,  2006(1)** | ** ** |
| ** **       | ** ** | **(in thousands)**                      | ** ** |
| Notes payable(2) |       | $                                            | 414        |   | $ | 448 |   | $ | 486 |   | $ | 527 |   | $ | 571 |   |   | $ | 4,269 |   |   | $ | 6,715 |   |   | $ | 7,015 |   |   |
|                  |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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

(2)          The weighted averageinterest rate for all years presented is 8.0%.

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**ITEM8.**                FinancialStatements And Supplementary Data
| Index to Consolidated  Financial Statements:                                                                               |   |   |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
| Report  of Independent Registered Public Accounting Firm—Stonefield  Josephson, Inc.                             |   | 39     |   |
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                                         |   | 40     |   |
| Consolidated  Statements of Operations for the years ended December 31, 2006, 2005  and 2004                          |   | 41     |   |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2006, 2005 and 2004 |   | 42     |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2006, 2005  and 2004                          |   | 43     |   |
| Notes to Consolidated  Financial Statements                                                                                |   | 44     |   |

 

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

Board of Directors and StockholdersNatrol, Inc. and its Subsidiaries

We have audited the accompanying consolidated balancesheets of Natrol, Inc. and its subsidiaries as of December 31, 2006and 2005, and the related consolidated statements of income, stockholders’equity, and cash flows for each of the three years in the period ended December 31,2006. Our audits also included the financial statement schedule listed in theIndex at Item 15(a)(2). These consolidated financial statements and scheduleare the responsibility of the Company’s management. Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudits.

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require thatwe plan and perform the audits to obtain reasonable assurance about whether theconsolidated financial statements are free of material misstatement. We werenot engaged to perform an audit of the Company’s internal control overfinancial reporting. Our audit included consideration of internal control overfinancial reporting as a basis for designing audit procedures that areappropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Natrol, Inc. and its subsidiaries as of December 31, 2006and 2005, and the results of their operations and their cash flows for each ofthe three years in the period ended December 31, 2006 in conformity withaccounting principles generally accepted in the United States of America. Also,in our opinion, the related financial statement schedule, when considered inrelation to the financial statements taken as a whole, presents fairly in allmaterial respects the information set forth therein.

Asdiscussed in Note 1 to the consolidated financial statements, in 2006 theCompany adopted Statement of Financial Accounting Standards No. 123(Revised 2004), *Share-Based Payment*.
| /s/ STONEFIELD JOSEPHSON, INC. |   |
|-------------------------------------|--------|
| CERTIFIED PUBLIC  ACCOUNTANTS       |
| Los Angeles,  California            |
| March 29,  2007                |

 

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

| ** **                                                                                                      | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Assets**                                                                                                      |       |                  |       |   |   |
| Current assets:                                                                                                 |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                      |       | $                     | 1,003      |   | $ | 3,097 |   |
| Accounts  receivable, net of allowances of $181 and $247 at December 31,   2006 and 2005, respectively     |       | 6,485                 |       | 6,723 |   |
| Inventory                                                                                                       |       | 11,788                |       | 11,797 |   |
| Income taxes  receivable                                                                                        |       | 375                   |       | 439 |   |
| Deferred income  taxes                                                                                          |       | 1,630                 |       | 2,021 |   |
| Prepaid expenses  and other current assets                                                                      |       | 1,743                 |       | 726 |   |
| Total current assets                                                                                            |       | 23,024                |       | 24,803 |   |
| Property and equipment:                                                                                         |       |                  |       |   |   |
| Building and  improvements                                                                                      |       | 14,953                |       | 14,930 |   |
| Machinery and  equipment                                                                                        |       | 5,757                 |       | 5,754 |   |
| Furniture and  office equipment                                                                                 |       | 3,013                 |       | 2,900 |   |
|                                                                                                            |       | 23,723                |       | 23,584 |   |
| Accumulated depreciation  and amortization                                                                      |       | (9,912                | )          | (8,684 | ) |
| Property and equipment,  net                                                                                    |       | 13,811                |       | 14,900 |   |
| Property held for sale,  net                                                                                    |       | —                |       | 761 |   |
| Restricted cash                                                                                                 |       | 5,000                 |       | 5,000 |   |
| Deferred income taxes                                                                                           |       | 4,265                 |       | 3,905 |   |
| Goodwill, net of  accumulated amortization and impairment charge of $37,381                                     |       | 2,026                 |       | 2,026 |   |
| Trademarks                                                                                                      |       | 5,730                 |       | — |   |
| Other assets                                                                                                    |       | 744                   |       | 67 |   |
| Total assets                                                                                                    |       | $                     | 54,600     |   | $ | 51,462 |   |
| **Liabilities and stockholders’ equity**                                                                   |       |                  |       |   |   |
| Current liabilities:                                                                                            |       |                  |       |   |   |
| Line of credit                                                                                                  |       | $                     | 3,694      |   | $ | — |   |
| Accounts payable                                                                                                |       | 3,058                 |       | 4,647 |   |
| Accrued expenses                                                                                                |       | 2,558                 |       | 2,888 |   |
| Accrued payroll  and related liabilities                                                                        |       | 1,185                 |       | 826 |   |
| Current portion of  long-term debt                                                                              |       | 414                   |       | 532 |   |
| Total current liabilities                                                                                       |       | 10,909                |       | 8,893 |   |
| Long-term debt, less  current portion                                                                           |       | 6,301                 |       | 7,165 |   |
| 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—14,116,148 and 13,535,837 at December 31, 2006 and  2005, respectively |       | 141                   |       | 135 |   |
| Additional paid-in  capital                                                                                     |       | 61,638                |       | 60,113 |   |
| Accumulated  deficit                                                                                            |       | (24,409               | )          | (24,844 | ) |
| Accumulated other  comprehensive income                                                                         |       | 20                    |       | — |   |
| Total stockholders’  equity                                                                                |       | 37,390                |       | 35,404 |   |
| Total liabilities and stockholders’ equity                                                                 |       | $                     | 54,600     |   | $ | 51,462 |   |

 

*See notes to consolidated financial statements.*

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

| ** **                            | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                             |       | $                                           | 65,564     |   | $ | 67,530 |   | $ | 79,269 |   |
| Cost of goods  sold                   |       | 37,131                                      |       | 44,107 |   | 46,820 |   |
| Gross profit                          |       | 28,433                                      |       | 23,423 |   | 32,449 |   |
| Selling and  marketing expenses       |       | 16,655                                      |       | 18,000 |   | 19,560 |   |
| General and  administrative expenses  |       | 11,065                                      |       | 9,525 |   | 9,348 |   |
| Total operating  expenses             |       | 27,720                                      |       | 27,525 |   | 28,908 |   |
| Operating income  (loss)              |       | 713                                         |       | (4,102 | ) | 3,541 |   |
| Gain on sale of  property             |       | 230                                         |       | — |   | — |   |
| Interest income                       |       | 229                                         |       | 189 |   | 101 |   |
| Interest expense                      |       | (690                                        | )          | (638 | ) | (630 | ) |
| Income (loss)  before income taxes    |       | 482                                         |       | (4,551 | ) | 3,012 |   |
| Income tax  provision (benefit)       |       | 47                                          |       | (1,918 | ) | 1,144 |   |
| Net income (loss)                     |       | $                                           | 435        |   | $ | (2,633 | ) | $ | 1,868 |   |
| Basic income (loss) per  share:       |       |                                        |       |   |   |   |   |
| Income (loss) per share               |       | $                                           | 0.03       |   | $ | (0.20 | ) | $ | 0.14 |   |
| Diluted income (loss)  per share:     |       |                                        |       |   |   |   |   |
| Income (loss) per share               |       | $                                           | 0.03       |   | $ | (0.20 | ) | $ | 0.13 |   |
| Weighted-average shares  outstanding: |       |                                        |       |   |   |   |   |
| Basic                                 |       | 13,619,783                                  |       | 13,473,647 |   | 13,276,618 |   |
| Diluted                               |       | 13,746,670                                  |       | 13,473,647 |   | 14,112,965 |   |

 

*See notes to consolidated financial statements.*

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

| ** **                                                             | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Retained  Earnings  (accumulated** | ** ** | **Comprehensive** | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|--------------------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                             | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**                          | ** ** | **deficit)**      | ** ** | **Income** | ** ** | **Totals** | ** ** |
| Balance,  January 1, 2004                                         |       | 13,132,409            |       |                    | $          | 131                                  |       |              |       | $          | 59,506     |   |   |   | $ | (24,079 | ) |   |   | $ | — |   |   | $ | 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                                        |       | 13,360,028            |       |                    | 133        |                                 |       |              | 59,838     |       |       |   | (22,211 | ) |   |   | — |   |   | 37,760 |   |
| Exercise of stock options                                              |       | 147,276               |       |                    | 2          |                                 |       |              | 201        |       |       |   | — |   |   |   | — |   |   | 203 |   |
| Issuance of common stock under employee stock  purchase plan |       | 28,533                |       |                    | —     |                                 |       |              | 74         |       |       |   | — |   |   |   | — |   |   | 74 |   |
| Net loss                                                               |       | —                |       |                    | —     |                                 |       |              | —     |       |       |   | (2,633 | ) |   |   | — |   |   | (2,633 | ) |
| Balance, December 31, 2005                                        |       | 13,535,837            |       |                    | 135        |                                 |       |              | 60,113     |       |       |   | (24,844 | ) |   |   | — |   |   | 35,404 |   |
| Exercise of stock options                                              |       | 542,563               |       |                    | 6          |                                 |       |              | 858        |       |       |   | — |   |   |   | — |   |   | 864 |   |
| Shares issued in exchange for services                                 |       | 15,000                |       |                    | —     |                                 |       |              | 32         |       |       |   | — |   |   |   | — |   |   | 32 |   |
| Issuance of common stock under employee stock  purchase plan |       | 22,748                |       |                    | —     |                                 |       |              | 35         |       |       |   | — |   |   |   | — |   |   | 35 |   |
| Expensing of options per adoption of SFAS 123(R)                  |       | —                |       |                    | —     |                                 |       |              | 600        |       |       |   | — |   |   |   | — |   |   | 600 |   |
| Change in comprehensive  income                                        |       | —                |       |                    | —     |                                 |       |              | —     |       |       |   | — |   |   |   | 20 |   |   | 20 |   |
| Net income                                                             |       | —                |       |                    | —     |                                 |       |              | —     |       |       |   | 435 |   |   |   | — |   |   | 435 |   |
| Balance,  December 31, 2006                                       |       | 14,116,148            |       |                    | $          | 141                                  |       |              |       | $          | 61,638     |   |   |   | $ | (24,409 | ) |   |   | $ | 20 |   |   | $ | 37,390 |   |

 

*See notes to consolidated financial statements.*

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

| ** **                                                                                       | ** ** | **Years ended December 31** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Operating activities**                                                                         | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                                |       | $                                          | 435        |   | $ | (2,633 | ) | $ | 1,868 |   |
| Adjustments to  reconcile income (loss) to net cash provided by (used in) operating  activities: |       |                                       |       |   |   |   |   |
| Change in net assets of discontinued operations                                                  |       | —                                     |       | — |   | 35 |   |
| Depreciation and amortization                                                                    |       | 1430                                       |       | 1,341 |   | 1,277 |   |
| Foreign currency translation                                                                     |       | 20                                         |       | — |   | — |   |
| Provision for bad debts                                                                          |       | (66                                        | )          | (174 | ) | (223 | ) |
| Deferred income taxes                                                                            |       | 51                                         |       | (1,483 | ) | 570 |   |
| Shares issued for services                                                                       |       | 32                                         |       | — |   | 2 |   |
| Option expenses                                                                                  |       | 600                                        |       | — |   | — |   |
| Changes in  operating assets and liabilities:                                                    |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                              |       | 304                                        |       | 881 |   | 490 |   |
| Inventory                                                                                        |       | 9                                          |       | (2,075 | ) | (670 | ) |
| Income taxes receivable/payable                                                                  |       | 65                                         |       | 517 |   | (607 | ) |
| Prepaid expenses and other current assets                                                        |       | (1,017                                     | )          | 69 |   | 121 |   |
| Accounts payable                                                                                 |       | (1,589                                     | )          | 1,743 |   | (2,697 | ) |
| Accrued expenses                                                                                 |       | (330                                       | )          | 405 |   | 751 |   |
| Accrued payroll and related liabilities                                                          |       | 359                                        |       | (763 | ) | 817 |   |
| Net cash provided  by (used in) operating activities                                             |       | 283                                        |       | (2,172 | ) | 1,734 |   |
| **Investing activities**                                                                         | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchases of  property and equipment                                                             |       | (301                                       | )          | (691 | ) | (920 | ) |
| Sale of property                                                                                 |       | 761                                        |       | — |   | — |   |
| Reduction of  goodwill arising from Prolab settlement                                            |       | —                                     |       | — |   | 2,000 |   |
| Acquisition of  trademarks                                                                       |       | (5,730                                     | )          | — |   | — |   |
| Other assets                                                                                     |       | (718                                       | )          | 151 |   | (135 | ) |
| Net cash provided  by (used in) investing activities                                             |       | (5,988                                     | )          | (540 | ) | 945 |   |
| **Financing activities**                                                                         | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from  line of credit                                                                    |       | 3,694                                      |       | — |   | — |   |
| Proceeds from  issuance of long-term debt                                                        |       | —                                     |       | — |   | 750 |   |
| Repayments on  long-term debt                                                                    |       | (982                                       | )          | (490 | ) | (338 | ) |
| Proceeds from  issuance of common stock                                                          |       | 899                                        |       | 277 |   | 332 |   |
| Net cash provided  by (used in) provided by financing activities                                 |       | 3,611                                      |       | (213 | ) | 744 |   |
| Net increase  (decrease) in cash and cash equivalents                                            |       | (2,094                                     | )          | (2,925 | ) | 3,423 |   |
| Cash and cash  equivalents, beginning of year                                                    |       | 3,097                                      |       | 6,022 |   | 2,599 |   |
| Cash and cash  equivalents, end of year                                                          |       | $                                          | 1,003      |   | $ | 3,097 |   | $ | 6,022 |   |
| **Supplemental disclosures of  cash flow information**                                           | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during the  year for:                                                                  |       |                                       |       |   |   |   |   |
| Interest                                                                                         |       | $                                          | 692        |   | $ | 637 |   | $ | 630 |   |
| Income taxes                                                                                     |       | 106                                        |       | 173 |   | 1,174 |   |

 

*See notes to consolidated financial statements.*

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

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

***Description of Business***

Natrol, Inc. and subsidiaries (collectively, the “Company”)manufactures and markets branded, high-quality dietary supplement productsunder the branded labels, Natrol, Laci Le Beau, Nu Hair, Shen Min, Promensil,Trinovin and Prolab. Our core brands market vitamins, minerals, hormonal andherbal supplements, herbal teas, specialty combination formulations and sportsnutrition products. We sell our products through multiple channels ofdistribution that reach consumers through mass-market retailers, health foodstores, fitness centers, the Internet, catalogues and other points ofdistribution in the United States and selected foreign countries.

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

***Principles of Consolidation***

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

***Estimates and Assumptions***

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

***Significant Risks and Uncertainties***

Product returns are a recurring part of our business.Estimating product returns requires significant management judgment. Productsmay be returned for various reasons including expiration dates or lack ofsufficient sales. During 2006, our expense for returns and reimbursements fordamages and outdated products amounted to 5.5% of gross shipments, a decreasefrom the 6.2% of gross shipments experienced in 2005 but above the 3.5%experienced in 2004. In past years, the rate of returns has been considerablyhigher. There is no guarantee that future returns will not increase to, orexceed, the levels experienced in the past. Furthermore, the possibility existsthat should we lose a major account, we may agree to accept a substantialamount of returns.

We monitor our inventoryand analyze it on a regular basis. Cycle counts are taken daily to verifyinventory levels. In addition, we analyze the movement of items within ourinventory in an effort to determine the likelihood that inventory will be soldor used before expiration dates are reached. We provide an allowance againstthat portion of inventory that we believe is unlikely to be sold or used beforeexpiration dates are reached. At December 31, 2006, inventory allowanceswere approximately $1.0 million.

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***Cash***

The Company’s cash washeld in four banks at December 31, 2006 and, as a result of this, theCompany does not believe it is subject to any unusual financial risk beyond thenormal risk associated with commercial banking relationships.

***Restricted Cash***

Restricted cash representscash that has been deposited with an insurance company as part of ourself-insurance program. The cash earns interest at a current rate of 1.65% perannum, and will be returned should we terminate the policy. The policy, whichis cancelable by us, is effective through 2008.

***Inventory***

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

***Property and Equipment***

Property and equipment arestated at cost. Depreciation is computed using the straight-line method overthe estimated useful lives of the assets ranging from three-to-ten years forfurniture, machinery and equipment. Buildings are depreciated overforty years, and improvements are depreciated over periods ranging fromfive-to-forty years, using the straight-line method. Amortization of leaseholdimprovements is computed using the straight-line method over the shorter of theestimated useful lives of the assets or the lease terms. Depreciation expensein the years ended December 31, 2006, 2005 and 2004 amounted to $1,389,$1,338, and $1,277, respectively.

***Long-Lived Assets***

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

***Goodwill***

In June 2001, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 141, *BusinessCombinations*, and SFAS No. 142, *Goodwill and Other Intangible Assets*. SFAS No. 141requires business combinations entered into after June 30, 2001 to beaccounted for using the purchase method of accounting. SFAS No. 142requires that goodwill not be amortized, but be tested for impairment at leastannually. We adopted SFAS No. 142 on January 1, 2002. We performedour annual impairment test as of December 31 for each of the yearspresented and concluded that goodwill was not impaired. As part of ourimpairment test, we considered a number of variables including, but not limitedto, the market capitalization of the Company, estimates of future earnings anddiscounted cash flows, third party assessments of the value of the Company andtransactions involving the purchase and sale of businesses similar to ours.

***Income Taxes***

Deferred income taxes areprovided for temporary differences between the financial statement and incometax bases of assets and liabilities, based on enacted tax rates. Managementprovides a valuation 

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allowancewhen it believes it is more likely than not that some portion or all of thedeferred income tax assets will not be realized.

***Revenue Recognition***

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

***Advertising Costs***

Advertising andpromotional costs are expensed as incurred. Advertising and promotional costswere (in thousands) $5,531, $7,073, and $6,122 for the years ended December 31,2006, 2005 and 2004, respectively. These amounts are exclusive of brochure andpublic relations expenses, as well as promotional and other costs that are nettedagainst sales revenue.

***Research and Development Costs***

Our research anddevelopment costs are expensed as incurred and were (in thousands) $891, $964and $752 for the years ended December 31, 2006, 2005 and 2004,respectively.

***Shipping and Handling Costs***

We record all amountscharged to customers for shipping and handling as revenue. All shipping andfulfillment costs are classified as selling and marketing expenses and were (inthousands) $3,353, $3,340 and $3,432 for the years ended December 31,2006, 2005 and 2004, respectively.

***Stock-Based Compensation***

Through the end of 2005, the Company measuredcompensation for stock-based incentive programs utilizing the intrinsic valuemethod prescribed by Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees,*andrelated interpretations. Under this method, the Company did not recordcompensation expense when stock options were granted to eligible participantsas long as the exercise price was not less than the fair market value of thestock when the option was granted. In accordance with Statement of FinancialAccounting Standards (SFAS) No. 123, *Accountingfor Stock-Based Compensation*, (SFAS 123) and SFAS No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure*, the Company disclosed the pro forma net income pershare as if the fair value-based method had been applied in measuringcompensation expense for stock-based incentive awards. No stock-basedcompensation cost was recognized in the Consolidated Statement of Operationsfor the years prior to 2006, as all unvested options granted had an exerciseprice equal to or greater than the fair market value of the underlying commonstock on the date of grant.

In December 2004, the Financial AccountingStandards Board (FASB) issued SFAS 123R, *ShareBased Payment: An Amendment of FASB Statements No. 123 and 95*(SFAS 123R). This statement requires that the cost resulting from allshare-based payment transactions be recognized in the Company’s consolidatedfinancial statements. In addition, in March 2005 the SEC released SECStaff Accounting Bulletin No. 107, *Share-BasedPayment* (SAB 107). SAB 107 provides the SEC’s staff’s positionregarding 

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the application of SFAS123R and certain SEC rules and regulations, and also provides the staff’sviews regarding the valuation of share-based payment arrangements for publiccompanies. Generally, the approach in SFAS 123R is similar to the approachdescribed in SFAS 123. However, SFAS 123R requires all share-based payments toemployees, including grants of employee stock options, to be recognized in thestatement of operations based on their fair values. Pro forma disclosure offair value recognition, as prescribed under SFAS 123, is no longer analternative.

In 2006, the Company adopted the fair valuerecognition provisions of SFAS 123R utilizing themodified-prospective-transition method, as prescribed by SFAS 123R. Under thetransition method, compensation cost recognized for the year ended December 31,2006 includes: (a) compensation cost for all share-based payments grantedprior to, but not yet vested as of January 1, 2006, based on the grantdate fair value estimated in accordance with SFAS 123, and (b) compensationexpense for all share-based payments granted subsequent to January 1,2006, based on the grant-date fair value estimated in accordance with theprovisions of SFAS 123R. Under the modified-prospective-transition method,results for the prior periods have not been restated.

During the year ended December 31, 2006, the Companygranted options to purchase 7,454,499 shares of common stock. Of the 7,454,499shares, 6,029,500 options were granted to Wayne M. Bos upon his appointment asthe Company’s CEO and President. This option award was approved by thestockholders of the Company at its 2006 annual meeting of stockholders. Theremaining 1,424,999 options were granted to other employees and directors. Theoptions granted to Mr. Bos have certain service and performance conditionswhich were discussed in the Company’s proxy statement for the 2006 annualmeeting of stockholders. These options were fully vested upon grant, and werecognized a related expense of $0.3 million during the first quarter of2006. During the year ended December 31, 2006 we recorded a total expenseof approximately $0.6 million as a result of the adoption of SFAS 123R. 

Theeffect of the change in applying the original provisions of SFAS 123 resultedin lowering operating income, income before taxes, net income and basic anddiluted earnings per share as follows:

| ** **                                | ** ** | **Year Ended**             | ** ** |
|-------------------------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **December 31, 2006** | ** ** |
| ** **                                | ** ** | **As per SFAS  123R** | ** ** | **Change to 2006  results** | ** ** |
| Operating income                          |       |                            | $          | 713 |   |   |   | $ | (600 | ) |   |
| Income before  provision for income taxes |       |                            | 482        |   |   |   | (600 | ) |   |
| Net income                                |       |                            | 435        |   |   |   | (538 | ) |   |
| Net income per  share:                    |       |                            |       |   |   |   |   |   |   |
| Basic                                     |       |                            | .03        |   |   |   | (.04 | ) |   |
| Diluted                                   |       |                            | .03        |   |   |   | (.04 | ) |   |

 

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Thefollowing table illustrates the effect on the operating results and income(loss) per share if SFAS 123(R) had been in effect for the years ended December 31,2005 and 2004.

| ** **                                                                                                                                                                       | ** ** | **The years ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                                                                                       | ** ** | **December, 31**         | ** ** |
| ** **                                                                                                                                                                       | ** ** | **2005**                      | ** ** | **2004** | ** ** |
| Income (loss)  from operations                                                                                                                                                   |       | $                             | (2,633     | ) | $ | 1,868 |   |
| Total stock-based  employee compensation expense determined under the fair value-based method  for all awards, net of related tax benefits (“Stock Compensation”) |       | (38                           | )          | (53 | ) |
| Net profit  (loss)—pro forma                                                                                                                                                |       | $                             | (2,671     | ) | $ | 1,815 |   |
| Net loss per  share:                                                                                                                                                             |       |                          |       |   |   |
| Basic—as reported                                                                                                                                                           |       | $                             | (0.20      | ) | $ | 0.13 |   |
| Basic—pro forma                                                                                                                                                             |       | (0.20                         | )          | 0.13 |   |
| Diluted—as reported                                                                                                                                                         |       | (0.20                         | )          | 0.13 |   |
| Diluted—pro forma                                                                                                                                                           |       | (0.20                         | )          | 0.13 |   |

 

The Company used a Monte Carlo method to simulatestock price paths over the term of the 6,029,500 options awarded to Mr. Bos.All other options were valued using a Black-Sholes model. The Monte Carlomethod, which is one acceptable valuation method per SFAS 123R, was used due tomany factors which make utilizing a Black-Sholes model inappropriate for ablock of options of this magnitude. These factors include but are not limitedto the size of the grant in relation to the total shares outstanding, thetrading volume of the Company’s stock and the holder’s ability to resell theshares, and the control factor, which the size of the grant implies. TheCompany used the services of a well-credentialed group of valuation experts toperform the valuation of Mr. Bos’ options. This group developed multiplescenarios including continuing operation and sale scenarios, to assess thepotential to create shareholder value over the term of the options. Theresulting Monte Carlo analysis gave rise to a range of fair values for whichthe mean amount was utilized in valuing the options for Mr. Bos.

All other stock options were valued using aBlack-Sholes model. Under SFAS 123R, the Company will continue to utilize theBlack-Sholes model to estimate the fair market value related to stock optionsafter January 1, 2006, unless such method is clearly inappropriate for asignificant block of stock options, such as were granted to Mr. Bos. TheCompany’s assessment of the estimated compensation charges for these otherstock options is affected by its stock price as well as assumptions regarding anumber of complex and subjective variables and the related tax impact. Thesevariables include, but are not limited to the Company’s stock price volatilityand expected employee stock option behavior.

Thefollowing summarizes the Company’s stock option activity for the 12 monthsended December 31, 2006.

| ** **                              | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-----------------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| Number of option  shares:               |       |       |       |                                   |       |                                                |       |                            |       |   |   |   |   |   |   |
| Outstanding at  January 1, 2006    |       | 2,310,820  |       |                                   | $          | 3.13                                                |       |                            |       |   |   |   |   |   |   |   |
| Granted                                 |       | 7,454,999  |       |                                   | 2.28       |                                                |       |                            |       |   |   |   |   |   |   |
| Exercised                               |       | 542,563    |       |                                   | 1.59       |                                                |       |                            |       |   |   |   |   |   |   |
| Canceled or  expired                    |       | 605,000    |       |                                   | 5.56       |                                                |       |                            |       |   |   |   |   |   |   |
| Outstanding at  December 31, 2006  |       | 8,618,256  |       |                                   | $          | 2.32                                                |       |                            |       | 4.71 |   |   |   | $ | 0.0 |   |   |
| Exercisable at September 30,  2006 |       | 7,386,682  |       |                                   | $          | 2.27                                                |       |                            |       | 4.31 |   |   |   | $ | 0.0 |   |   |

 

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Thefollowing summarizes the fair value of the Company’s stock options for the 12months ended December 2006.

| ** **                           | ** ** | **Shares** | ** ** | **Weighted  Average Fair  Value** | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------------------|------------|
| Nonvested at  January 1, 2006   |       | 99,501     |       |                                   | $          | 1.48 |   |   |
| Granted                              |       | 7,454,999  |       |                                   | 0.21       |   |   |
| Vested                               |       | 6,322,926  |       |                                   | 0.09       |   |   |
| Nonvested at  December 31, 2006 |       | 1,231,574  |       |                                   | $          | 0.91 |   |   |

 

The total fair value of the nonvested options as of December 31,2006 was $1,115,779.

TheBlack-Sholes option-pricing model is used by the Company to determine theweighted average fair value of stock options except for the Wayne Bos stockoptions. The fair value of stock options at date of grant and the assumptionsutilized to determine such values are indicated in the following table:

| ** **                       | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|
| ** **                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected dividend  yield         |       | 0.0                                         | %          | 0.0 | % | 0.0 | % |
| Expected stock  price volatility |       | 59.9                                        |       | 63.0 |   | 64.6 |   |
| Risk free  interest rate         |       | 5.0                                         | %          | 3.9 | % | 3.6 | % |
| Expected life of options         |       | 4 years                                     |       | 5 years |   | 5 years |   |

 

These assumptions resulted in weighted-average fairvalues of $0.21, $1.54 and $1.66 for each stock option granted in 2006, 2005and 2004, respectively.

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

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

Stock options to purchase8,618,256, 2,310,820, and 2,442,000 shares of common stock at December 31,2006, 2005 and 2004, respectively, were outstanding and of these shares, 7,749,999,2,310,820, and 520,000 were respectively considered anti-dilutive.

***Fair Value of Financial Instruments***

The carrying value ofcertain financial instruments, including cash, accounts receivable, accountspayable and accrued expenses approximates fair market value based on theirshort-term nature. The fair value of the our long-term notes payable isestimated using discounted cash flow analyses, based on our current incrementalborrowing rates for similar types of borrowing arrangements. The estimated fairvalue of long-term notes payable exceeded the carrying value by approximately$0.3 million at December 31, 2006.

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***Concentration of Credit Risk***

Financial instruments, which potentially subject us toconcentration of credit risk, consist principally of cash and accountsreceivable. We believe our exposure as it relates to cash is limited due to thefact that the cash we have is placed with several banks, each of which has astrong financial position. Significant portions of our sales are made directlyto mass merchandisers and national retailers. Due to the increased volume ofsales to these channels, we have experienced an increased concentration ofcredit risk, and as a result, may at anytime have individually significantreceivable balances with such mass merchandisers and national retailers. Whilewe monitor and manage this risk, financial difficulties on the part of one ormore major customers may have a material adverse effect. We perform ongoingcredit evaluations of customers and maintain an allowance for potential creditlosses.

Two of our customers represented more than 10% of netsales for the year ended December 31, 2006. The lead customer represented11.4% of net sales and the second customer represented 10.9% of net sales. Forthe year ended December 31, 2005 only one customer, representing 12.8% ofnet sales, accounted for more than 10% of net sales and no customer representedmore than 10% of net sales in 2004.

One account representedmore than 10% of our accounts receivable at December 31, 2006. Twoaccounts represented more than 10% of our net accounts receivable as of December 31,2005.

***Recently Issued Accounting Standards***

In February 2006, the FASB issued FASB Statement No. 155,Accounting for Certain Hybrid Financial Instruments. This Statement amends FASBStatements No. 133, Accounting for Derivative Instruments and HedgingActivities, and No. 140, Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities. As we do not issue orexpect to issue hybrid financial instruments, we do not believe that theadoption of FASB No. 155 will have a material impact on our consolidatedfinancial statements.

The Financial Accounting Standards Board issuedInterpretation No. 48, *Accounting forUncertainty in Income Taxes* (“FIN 48”) in June 2006. Theinterpretation clarifies the accounting for uncertainty in income taxesrecognized in financial statements in accordance with SFAS 109. FIN 48 iseffective for fiscal years beginning after December 15, 2006. We havenot determined the effect, if any, the adoption of FIN 48 will have on ourconsolidated financial statements.

On June 28, 2006 the Board of the FASB ratifiedthe conclusion reached by the EITF and contained therein in Issue No. 06-03.The Task Force reached a conclusion that the presentation of taxes on either agross or net basis is an accounting policy decision that should be disclosedpursuant to Opinion 22. Currently, the Company presents its sales tax liabilityon a net basis. Sales are not grossed up with the attendant taxes deducted as aseparate line item. The EITF becomes effective for interim and annual reportingperiods beginning after December 15, 2006. At such time, the Company willdisclose this matter in its accounting policies.

In September 2006, the SEC issued StaffAccounting Bulletin No. 108, *Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements* (“SAB 108”). SAB 108 providesguidance on how prior year misstatements should be taken into considerationwhen quantifying misstatements in current year financial statements forpurposes of determining whether the current year’s financial statements arematerially misstated. SAB 108 is effective for fiscal years ending on or after November 15,2006. The adoption of SAB 108 did not have a material impact on ourconsolidated financial statements.

In September 2006,the FASB issued Statement SFAS No. 157 (“FAS 157”), “ *Fair Value Measurements*,” which definesfair value, establishes guidelines for measuring fair value andexpands 

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disclosuresregarding fair value measurements. FAS 157 does not require any new fair valuemeasurements but rather eliminates inconsistencies in guidance found in variousprior accounting pronouncements. SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007. Earlier adoption is permitted, providedthe company has not yet issued financial statements, including for interimperiods, for that fiscal year. The Company is currently evaluating the impactof FAS 157, but does not expect the adoption of FAS 157 to have a materialimpact on its consolidated financial position, results of operations or cash flows.

**2.** Inventory

Inventoryconsists of the following:

| ** **                           | ** ** | **December 31,**   | ** ** |
|--------------------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **(in thousands)** | ** ** |
| Raw material and  packaging supplies |       | $                       | 6,778      |   | $ | 7,547 |   |
| Finished goods                       |       | 5,010                   |       | 4,250 |   |
|                                 |       | $                       | 11,788     |   | $ | 11,797 |   |

 

One of our suppliersaccounted for more than 10% of our inventory purchases in 2006. The loss ofthis supplier could have a material adverse effect on our ability to produceand sell goods. We do not have a long-term supply agreement with this supplier.

**3.** Trademarks

In October 2006, we acquired the NuHair and ShenMin brands of hair products from Biotech, International Corporation. Themajority of the assets acquired were the NuHair and Shen Min trademarks forwhich we paid approximately $5.4 million. In accordance with FASB Statement No. 142*Goodwill and Other Intangible Asset,* wehave made the judgment that the trademarks/brand names acquired initially havean indefinite life and as such should not be amortized. Instead the intangibleasset acquired should be tested for impairment annually and the Company will beperforming an impairment during the fourth quarter of each year or at any othertime at which it deems the trademarks may be impaired.

In October 2006, we alsolicensed certain trademark and patent rights related to the Promensil andTrinoven Brands from Novogen Limited (Nasdaq:NVGN). Of the amount paid,$425,000 was classified as trademarks which, as with the Nu Hair and Shen Mintrademarks, is not being amortized but will be tested for impairment annually. Another$425,000 of the consideration paid was classified as patents and is beingamortized over the remaining six-year life of the patent rights that wereacquired.

**4.   Financing**

During 1999, we entered into two mortgage notespayable in the aggregate amount of approximately $8,900,000, collateralized byour facilities. These notes are payable in monthly installments ofapproximately $74,000 in the aggregate, including interest ranging from 7.75%to 8.32%, maturing in 2014 and 2019. As of December 31, 2006 the principalbalance of these notes amounted to approximately $6.7 million.

In August 2006, we entered into a loan andsecurity agreement with Wachovia Capital Finance (Western), a subsidiary ofWachovia Bank, N.A. The loan agreement provides for a three-year securedrevolving credit facility of up to $10 million. Borrowings under thefacility may be used for ongoing working capital purposes and certain futureacquisitions.

The interest rate on borrowings under the creditfacility is equal to: (1) agent’s publicly announced prime rate for primerate loans or (2) 2.25% plus the applicable Eurodollar rate for anyEurodollar rate 

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loans. Interest is payablemonthly in arrears, not later than the first day of each calendar month. Ourinterest rate on December 31, 2006 was 8.25%.

The facility is secured by a first priority lien onall our assets and properties, subject to certain exceptions. The obligationsunder the credit facility are guaranteed by certain of our current and by eachof our future subsidiaries. The credit facility contains certain covenants andalso provides for customary events of default, including non-payment defaults,covenant defaults and cross-defaults to our other material indebtedness.

At December 31, 2006, we had borrowings ofapproximately $3.7 million under this line of credit.

Futurematurities of long-term mortgage debt at December 31, 2006 are as follows(in thousands):

| 2007       |   | $     | 414    |   |
|------------|--------|-------|--------|--------|
| 2008       |   | 448   |   |
| 2009       |   | 486   |   |
| 2010       |   | 527   |   |
| 2011       |   | 571   |   |
| Thereafter |   | 4,269 |   |
| Total      |   | $     | 6,715  |   |

 

**5.** IncomeTaxes

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

| ** **                    | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------|------------|---------------------------------------------|------------|
| ** **                    | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current:                      |       |                                        |       |   |   |   |   |   |   |
| Federal                       |       |                                        | $          | — |   |   | $ | (402 | ) | $ | 540 |   |
| State                         |       |                                        | —     |   |   | (32 | ) | 34 |   |
| Total current                 |       |                                        | —     |   |   | (434 | ) | 574 |   |
| Deferred                      |       |                                        | 47         |   |   | (1,484 | ) | 570 |   |
| Total income taxes  (benefit) |       |                                        | $          | 47 |   |   | $ | (1,918 | ) | $ | 1,144 |   |

 

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

| ** **                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory rate  applied to income (loss) from operations |       | $        | 164        |     | $          | (1,547   | )          | $ | 1,008 |   |
| State tax  provision                                     |       | 40       |       | (172     | )          | 115      |       |
| Other                                                    |       | (157     | )          | (199     | )          | 21       |       |
| Income tax provision  from continuing operations         |       | $        | 47         |     | $          | (1,918   | )          | $ | 1,144 |   |

 

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

| ** **                        | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Deferred income tax  assets:      |       |                                        |       |   |   |   |   |
| Accounts receivable allowances    |       | $                                           | 72         |   | $ | 98 |   | $ | 167 |   |
| Inventory                         |       | 291                                         |       | 883 |   | 573 |   |
| Accrued liabilities               |       | 1,187                                       |       | 1,235 |   | 838 |   |
| Goodwill impairment               |       | 2,435                                       |       | 2,808 |   | 3,191 |   |
| Net operating loss carryforward   |       | 1,811                                       |       | 1,317 |   | — |   |
| Foreign deferred tax asset        |       | 37                                          |       | — |   | — |   |
| Other                             |       | 470                                         |       | — |   | 107 |   |
|                              |       | 6,303                                       |       | 6,341 |   | 4,876 |   |
| Deferred tax  income liabilities: |       |                                        |       |   |   |   |   |
| Federal effect of state taxes     |       | (292                                        | )          | (282 | ) | (223 | ) |
| Depreciation                      |       | (116                                        | )          | (133 | ) | (211 | ) |
| Net deferred tax assets           |       | $                                           | 5,895      |   | $ | 5,926 |   | $ | 4,442 |   |

 

As of December 31,2006 and 2005 the Company had net operating loss carryforwards of approximately$4,791 for federal and $4,628 for state and $3,333 for federal and $3,171 forstate respectively, which begin to expire in the years 2025 and 2016. Furthermorethe Company has approximately $193,000 of federal research and developmentcredit carryovers.

**6.** Stockholders’Equity

***Stock Repurchase Program***

In 2000, the Board ofDirectors authorized a stock repurchase program for our common stock. Under thestock repurchase program, we can effect common stock repurchases from time totime up to an aggregate of $10,000,000. The stock repurchase program does nothave an expiration date. No such repurchases were made in 2006 or 2005.

***Stock Options***

During 2006, our 1996 Stock Option and Grant Planexpired. At the annual shareholders meeting in June 2006, the shareholdersapproved our 2006 Stock Option and Grant plan, (the “Plan”). Under the plan,the Board of Directors is authorized to grant incentive stock options ornon-qualified stock options. Incentive stock options may be granted only toemployees and directors. Non-qualified stock options may be granted to officersand employees as well as to non-employees. As of December 31, 2006, thenumber of shares available to be issued under the Plan is 3,292,547 shares. Theplan contains an evergreen provision, which increases the number of sharesavailable on June 30th and December 31st ofeach year. The number of shares added to the amount of options available equals15% of the number of shares issued during the prior six months. The maximumnumber of shares that may be available at any time is 3,970,500. All optionsgranted under the Plan have been made at prices not less than the fair marketvalue of the stock at the date of grant. Generally, the options granted underthe Plan vest over three-to-five years. Options granted under the Plan have aterm of not more than 10 years.

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

| ** **                             | ** ** | **Number of  Options  (000’s)** | ** ** | **Weighted-Average  Exercise Price  Per Share** | ** ** | **Exercise Price  Per Share** | ** ** |
|----------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------|------------|
| Outstanding at  December 31, 2003 |       |                                      | 2,949      |                                                      |       |                                    | $          | 2.89 |   |   | $ | 1.10—$13.00 |   |
| Granted                                |       |                                      | 90         |                                                      |       |                                    | 2.84       |   |   | 2.67—3.04 |   |
| Forfeited                              |       |                                      | (405       | )                                                         |       |                                    | 3.35       |   |   | 1.10—6.03 |   |
| Exercised                              |       |                                      | (192       | )                                                         |       |                                    | 1.30       |   |   | 1.15—1.50 |   |
| Outstanding at December 31, 2004  |       |                                      | 2,442      |                                                      |       |                                    | 3.07       |   |   | 1.10—13.00 |   |
| Granted                                |       |                                      | 65         |                                                      |       |                                    | 2.72       |   |   | 1.74—3.09 |   |
| Forfeited                              |       |                                      | (49        | )                                                         |       |                                    | 5.16       |   |   | 1.32—10.40 |   |
| Exercised                              |       |                                      | (147       | )                                                         |       |                                    | 1.38       |   |   | 1.10—1.94 |   |
| Outstanding at December 31, 2005  |       |                                      | 2,311      |                                                      |       |                                    | 3.13       |   |   | 1.10—13.00 |   |
| Granted                                |       |                                      | 7,455      |                                                      |       |                                    | 2.28       |   |   | 1.61—4.00 |   |
| Forfeited                              |       |                                      | (605       | )                                                         |       |                                    | 5.56       |   |   | 1.45—10.40 |   |
| Exercised                              |       |                                      | (543       | )                                                         |       |                                    | 1.59       |   |   | 1.15—1.94 |   |
| Outstanding at  December 31, 2006 |       |                                      | 8,618      |                                                      |       |                                    | 2.32       |   |   | 1.25—13.00 |   |
|                                        |            |                                           |            |                                                           |            |                                         |            |  |  |  |  |  |  |

 

At December 31,2006, 3,292,547 shares were available for future grant. The weighted-averageremaining contractual life for the outstanding options in years was 4.71, 4.84,and 5.57 at December 31, 2006, 2005 and 2004, respectively.
|                                             | ** ** | **Options Outstanding**               | ** ** | ** **                                 | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **Weighted Average Outstanding** | ** ** | **Weighted Average Exercisable** | ** ** |
| **Range of Exercise Prices** | ** ** | ** **                                 | ** ** | **Number  Outstanding  (000’s)**      | ** ** | **Remaining  Contractual Life  (Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Shares  Exercisable  (000’s)** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $1.25—$2.00                            |       |                                       | 1,268      |                                       |       |   | 4.93 |   |   |   | $ | 1.76 |   |   |   | 893 |   |   |   | $ | 1.69 |   |   |
| $2.01—$3.00                            |       |                                       | 7,125      |                                       |       |   | 4.70 |   |   |   | 2.57 |   |   |   | 6,335 |   |   |   | 2.29 |   |   |
| $3.01—$13.00                           |       |                                       | 225        |                                       |       |   | 3.86 |   |   |   | 6.37 |   |   |   | 159 |   |   |   | 7.45 |   |   |
| Total                                       |       |                                       | 8,618      |                                       |       |   | 4.71 |   |   |   | 2.32 |   |   |   | 7,387 |   |   |   | 2.27 |   |   |
|                                             |            |                                            |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**7.** Commitmentsand Contingencies

We lease some equipment under noncancelable operatingleases that expire in various years through 2006. Rent expense under operatingleases totaled approximately $134,000, $160,000, and $162,000, for the yearsended December 31, 2006, 2005 and 2004, respectively.

Futureminimum lease payments under noncancelable operating leases with initial termsof one year or more consisted of the following at December 31, 2006 (inthousands):

| 2007                          |   | $      | 89     |   |
|-------------------------------|--------|--------|--------|--------|
| 2008                          |   | 50     |   |
| 2009                          |   | 39     |   |
| 2010                          |   | 10     |   |
| 2011                          |   | — |   |
| Total minimum lease  payments |   | $      | 188    |   |

 

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

| 2007  |   | $   | 373    |   |
|-------|--------|-----|--------|--------|
| 2008  |   | 406 |   |
| 2009  |   | 406 |   |
| 2010  |   | 406 |   |
| 2011  |   | 406 |   |
| Total |   | $   | 1,997  |   |

 

*Acquisitioncommitments*

Consideration for the acquisition of the NuHair andShen Min brands includes potential incentive payments based upon the net amountof invoiced sales of the NuHair and Shen Min products during each of the threeyears after the anniversary date of the acquisition of the brands whichoccurred in October 2006. With respect to Year 1, the Seller will be paid$1.00 (one dollar) for every dollar of net invoiced sales above $7.6 million. Thepotential payment for sales that occur in year one may not exceed $2.0 million.During Year 2, the Seller will earn 15% of amount by which net invoiced salesexceed $11.4 million. During Year 3, the Seller will earn 15% of the amount bywhich net invoiced sales exceed $13.68 million.

Consideration for theacquisition of the U.S. rights to the Promensil and Trinoven brands include aroyalty on net sales revenue that exceeds $2.0 million. During the first yearafter the anniversary of the acquisition, the Seller will earn a royalty equalto 5.0% of net sales above $2.0 million but below $3.0 million and a royaltyequal to 7.5% of net sales above $3.0 million. After the first anniversaryperiod, the Seller will earn a royalty equal to 2% of net sales above $2.0 millionbut below $3.0 million and a royalty equal to 3.0% of net sales above $3.0million.

**8.** EmployeeBenefits Plans

We have a profit sharing 401(k) plan that coverssubstantially all of our employees. Eligible employees may contribute up to themaximum allowed under law. Contributions are discretionary. However, wegenerally match 10.0% of the employees’ contributions up to the maximum of 1.0%of eligible compensation. Amounts recognized as expense were approximately$30,343, $22,000, and $33,000, for the years ended December 31, 2006, 2005and 2004, respectively.

In 1998, the Board of Directors approved the Natrol, Inc.Employee Stock Purchase Plan (ESPP), which allowed substantially all employeesto purchase shares of our common stock, through payroll deductions, at 85.0% ofthe fair market value of the shares at the beginning or end of each of twoannual offering periods, whichever is lower. This plan was cancelled by theBoard of Directors as of the end of the last offering period of 2006. Weexpense two thirds of the 15.0% discount given to employees under the plan. Forthe year ended December 31, 2006, 22,748 shares were issued at pricesranging from $1.52 to $1.55. For the year ended December 31, 2005, 28,533shares were issued at prices ranging from $1.36 to $2.39. For the year ended December 31,2004, 34,419 shares were issued at $2.33 per share.

In 2006, 2005 and 2004, weadopted a bonus program for certain employees. The bonuses granted aredependent upon a formula based on corporate profits before taxes and interest.We awarded approximately $134,000 in bonus compensation under the 2006 bonusplan. No bonus payments were issued to employees under the plan in 2005. Theamount of bonus expensed in 2004 relative to this plan was approximately$600,000.

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**9.** Impairmentof Goodwill

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

During March 2004, we settled litigation with theformer owners of Prolab Nutrition, Inc. We received $2.0 million incash, which was reflected in the financial statements as a reduction ofgoodwill. We 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.

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

**10.** Selected QuarterlyFinancial Data (unaudited)

| ** **                           | ** ** | **2006 Quarters Ended**                                     | ** ** |
|--------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                           | ** ** | **March 31,**                                                    | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                           | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net sales                            |       |                                                                  | $          | 16,923 |   |   | $ | 16,587 |   |   | $ | 15,660 |   |   |   | $ | 16,393 |   |   |
| Gross profit                         |       |                                                                  | 6,894      |   |   | 7,193 |   |   | 6,688 |   |   |   | 7,657 |   |   |
| Net income                           |       |                                                                  | 73         |   |   | 100 |   |   | 40 |   |   |   | 222 |   |   |
| Basic and diluted income  per share: |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic income per share               |       |                                                                  | $          | 0.01 |   |   | $ | 0.01 |   |   | $ | 0.00 |   |   |   | $ | 0.02 |   |   |
| Diluted income  per share            |       |                                                                  | 0.01       |   |   | 0.01 |   |   | 0.00 |   |   |   | 0.02 |   |   |

 

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

 

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Natrol, Inc.and Subsidiaries Schedule II—Valuation and Qualifying Accounts Years EndedDecember 31, 2006, 2005 and 2004

| **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, 2004  |       |       | $          | 635                                          |       |                                        |       | $              | (223       | )                                          |       |   | $ | (9 | ) |   |   | $ | 421 |   |   |
| Year ended December 31, 2005  |       |       | 421        |                                         |       |                                        | 147        |           |       |                                       | 321        |   |   |   | 247 |   |   |
| Year ended December 31, 2006  |       |       | 247        |                                         |       |                                        | (19        | )              |       |                                       | 47         |   |   |   | 181 |   |   |
| Allowance for Sales  Returns:      |       |       |       |                                         |       |                                        |       |           |       |                                       |       |   |   |   |   |   |   |
| Year ended December 31, 2004  |       |       | $          | 1,235                                        |       |                                        |       | $              | 3,172      |                                       |       |   | $ | 3,340 | (1) |   |   | $ | 1,067 |   |   |
| Year ended December 31, 2005  |       |       | 1,067      |                                         |       |                                        | 4,874      |           |       |                                       | 3,664      | (1) |   |   | 2,277 |   |   |
| Year ended  December 31, 2006 |       |       | 2,277      |                                         |       |                                        | 4,207      |           |       |                                       | 3,837      | (1) |   |   | 2,647 |   |   |

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(1)          Representsactual returns of goods

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**ITEM 9.**                CHANGES AND DISAGREEMENTSWITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None

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

*Evaluationof Disclosure Controls and Procedures.**  *We maintain disclosure controls andprocedures that are designed to ensure that information required to bedisclosed in our Exchange Act reports is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s rules and forms and that such information is accumulated andcommunicated to our management, including our principal executive and principalfinancial officers, as appropriate, to allow for timely decisions regardingrequired disclosure.

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

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

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

**Item9B.****               *Other Information***

None.

**PART III**

Information required underPart III (Items 10, 11, 12, 13, and 14 other than the information requiredby Item 201(d) of Regulation S-K for Item 12) is incorporatedherein by reference to the Company’s definitive proxy statement to be filedwith the SEC within 120 days after the year covered by this Form 10-Kwith respect to its Annual Meeting of Stockholders to be held in June 2007.

**ITEM 10.**         DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.

See the information setforth in the sections entitled “Proposal No.1—Election of Directors,” “CorporateGovernance,” “Meetings and committees of the Board,” “Information ConcerningOur Executive Officers,” “Audit Committee Report” and “Section 16(a) BeneficialOwnership Reporting Compliance” in our proxy statement for the 2007 annualmeeting of stockholders to be filed with the SEC within 120 days after the endof the fiscal year December 31, 2006 which is incorporated herein byreference.

**ITEM 11.**         EXECUTIVECOMPENSATION.

See the information setforth in the sections entitled “Meetings and Committees of the Board—compensationCommittee Interlocks and Insider participation,” “Compensation committee Report”and “Executive Compensation” in our 2007 proxy statement, which is incorporatedherein by reference.

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**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS.

See the section entitled “Security Ownership ofCertain Beneficial Owners and Management” in our 2007 proxy statement, which isincorporated herein by reference.

The following tableprovides information as of December 31, 2006 regarding shares of ourcommon stock that may be used under our existing equity compensation plans,including the 1996 and 2006 Stock Option and Grant Plans.

**EquityCompensation Plan Information Table—Overview**

| ** **                                                  | ** ** | **Equity Compensation Plan Information** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **Plan category**                                      | ** ** | ** **                                              | ** ** | **Number of  Securities to be  Issued Upon  Exercise of  Outstanding  Options, Warrants  and Rights   (a)** | ** ** | **Weighted-Average  Exercise Price of  Outstanding Options,  Warrants and Rights** | ** ** | **Number of Securities  Remaining Available  for Future Issuance  Under Equity  Compensation Plans  (Excluding Securities  Reflected in Column  (a)** | ** ** |
| Equity  compensation plans approved by security holders     |       |                                                    | 8,618,256  |   |   |   | $ | 2.32 |   |   |   | 3,292,547 |   |   |
| Equity  compensation plans not approved by security holders |       |                                                    | —     |   |   |   | — |   |   |   | — |   |   |
| Total                                                       |       |                                                    | 8,618,256  |   |   |   | $ | 2.32 |   |   |   | 3,292,547 |   |   |
|                                                             |            |                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**ITEM 13.**         CERTAINRELATIONSHIPS, RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE.

See the information setforth in the sections entitled “Related-Party Transactions,” “Proposal No. 1Election of Directors,” “Compensation Committee Interlocks and InsiderParticipation” and “Corporate Governance” in our 2007 proxy statement, which isincorporated herein by reference.

**ITEM 14.**         PRINCIPALACCOUNTING FEES AND SERVICES.

See the information setforth in the section entitled “2006 and 2005 Audit Fees” in our 2007 proxystatement, which is incorporated herein by reference.

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**PART IV**

**ITEM15.**         EXHIBITS AND FINANCIALSTATEMENT SCHEDULES
|        | ** ** | ** **                                                                                                                                                                                                  | ** ** | **Page** |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| (a)(1) |       | Consolidated Financial Statements:                                                                                                                                                                          |       |     |   |
|   |       | The financial statements included in this Annual  Report on Form 10-K are provided under Item 8.                                                                                                       |       |     |   |
| (a)(2) |       | Consolidated Financial Statement Schedules:                                                                                                                                                                 |       |     |   |
|   |       | Schedule II—Valuation and Qualifying Accounts                                                                                                                                                     |       | 59       |   |
|   |       | All other schedules for which provision is made in  the applicable accounting regulations of the SEC are not required under the  related instructions or are not material, and therefore have been omitted. |       |     |   |

 

(a)(3) Exhibits:
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                                                                           |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Third  Amended and Restated Certificate of Incorporation of Natrol, Inc. (the  “Company”) (incorporated herein by reference to Exhibit 3.1 of the  Annual Report on Form 10-K of the Company, as amended, filed with  the SEC on March 31, 1999)            |
| 3.2             |       | Amended and Restated By-Laws of the Company  (incorporated herein by reference to Exhibit 3.6 of Amendment No. 2  to the Registration Statement on Form S-1 of the Company, filed  with the SEC on July 2, 1998)                                                      |
| 4.1             |       | Specimen Stock Certificate for Common Stock, $.01  par value, of the Company (incorporated herein by reference to  Exhibit 4.1 of the Registration Statement on Form S-1 of the  Company, filed with the SEC on May 7, 1998)                                               |
| 10.1            |       | Natrol, Inc. Amended and Restated 1996 Stock  Option and Grant Plan (incorporated herein by reference to Appendix A of the  Definitive Proxy Statement on Schedule 14A of the Company, filed with the SEC  on May 2, 2000)*                                                     |
| 10.3            |       | Form of Indemnification Agreement between  Natrol, Inc. and each of its directors (incorporated herein by reference  to Exhibit 10.4 of Amendment No. 1 to the Registration Statement on  Form S-1 of the Company, filed with the SEC on June 12, 1998)     |
| 10.4            |       | Form of Stock Option Agreement of the  Natrol, Inc. 1996 Stock Option and Grant Plan (incorporated herein by  reference to Exhibit 10.9 of Amendment No. 1 to the Registration  Statement on Form S-1 of the Company, filed with the SEC on  June 12, 1998) |
| 10.5            |       | Indemnification Agreement dated February 14,  2006 between Natrol, Inc. and Wayne Bos (incorporated herein by  reference to the Current Report on Form 8-K of the Company, filed  with the SEC on April 3, 2006)*                                                     |
| 10.6            |       | Employment Agreement  dated March 30, 2006 between Natrol, Inc. and Wayne Bos  (incorporated herein by reference to the Current Report on Form 8-K  of the Company, filed with the SEC on April 3, 2006)*                                                             |
| 10.7            |       | Non-Qualified Stock  Option Agreement dated March 31, 2006 between BDL Investment Trust FBO  Wayne Bos and Natrol, Inc. (incorporated herein by reference to the  Current Report on Form 8-K of the Company, filed with the SEC on  April 3, 2006)*                   |

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| 10.8  |   | 2006 Bonus Incentive Compensation Plan (incorporated  herein by reference to the Current Report on Form 8-K of the  Company, filed with the SEC on May 1, 2006)*                                                                                                                                                                                                                                                                                                                                           |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.9  |   | Natrol, Inc. 2006  Stock Option and Incentive Plan (incorporated herein by reference to the  Current Report on Form 8-K of the Company, filed with the SEC on  July 7, 2006)*                                                                                                                                                                                                                                                                                                                         |
| 10.10 |   | Form of  Non-Qualified Stock Option Agreement under the Natrol, Inc. 2006 Stock  Option and Incentive Plan (incorporated herein by reference to the Current  Report on Form 8-K of the Company, filed with the SEC on  July 7, 2006)*                                                                                                                                                                                                                                                            |
| 10.11 |   | Loan and Security  Agreement dated August 25, 2006 by and among Wachovia Capital Finance  Corporation (Western), as agent (“Agent”), lenders signatory thereto  (“Lenders”), Natrol, Inc. and Prolab Nutrition, Inc., as borrowers,  and Natrol Products, Inc., Natrol Acquisition Corp. and Natrol Direct, Inc.,  as Guarantors (incorporated herein by reference to the Current Report on  Form 8-K of the Company, filed with the SEC on August 31,  2006) |
| 10.12 |   | Guaranty dated  August 25, 2006 by Natrol Products, Inc., Natrol Acquisition Corp.  and Natrol Direct, Inc., in favor of Agent and Lenders (incorporated  herein by reference to the Current Report on Form 8-K of the  Company, filed with the SEC on August 31, 2006)                                                                                                                                                                                                                     |
| 10.13 |   | Asset Purchase Agreement  dated as of October 13, 2006 among Natrol, Inc., Biotech  International Corporation and Gregory J. Kelly (incorporated herein by  reference to the Current Report on Form 8-K of the Company, filed  with the SEC on October 9, 2006)                                                                                                                                                                                                                                  |
| 10.14 |   | Summary of Compensation  Program for Non-Employee Directors (incorporated herein by reference to the  Current Report on Form 8-K of the Company, filed with the SEC on  October 19, 2006)*                                                                                                                                                                                                                                                                                                                 |
| 10.15 |   | Summary of Option Grants  to Non-Employee Directors (incorporated herein by reference to the Current  Report on Form 8-K of the Company, filed with the SEC on  October 19, 2006)*                                                                                                                                                                                                                                                                                                                         |
| 10.16 |   | Change of Control Bonus  Plan for Five Senior Executives dated November 8, 2005 (incorporated herein  by reference to the Quarterly Report on Form 10-Q of the Company, filed with  the SEC on November 14, 2005)*                                                                                                                                                                                                                                                                                                   |
| 21.1  |   | Subsidiaries of  Natrol, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 23.1  |   | Consent of Experts and  Counsel: Consent of Stonefield Josephson, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 31.1  |   | Certification of Chief  Executive Officer pursuant to section 302 of the Sarbanes Oxley Act of  2002                                                                                                                                                                                                                                                                                                                                                                                                            |
| 31.2  |   | Certification of Chief  Financial Officer pursuant to section 302 of the Sarbanes Oxley Act of  2002                                                                                                                                                                                                                                                                                                                                                                                                            |
| 32.1  |   | Certification of Chief  Executive Officer pursuant to section 901 of the Sarbanes Oxley Act of  2002                                                                                                                                                                                                                                                                                                                                                                                                            |
| 32.2  |   | Certification of Chief  Financial Officer pursuant to section 901 of the Sarbanes Oxley Act of  2002                                                                                                                                                                                                                                                                                                                                                                                                            |

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*                    Managementcontract or compensatory plan or arrangement required to be filed as an exhibitto this report pursuant to Item 14(c).

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**SIGNATURE**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this Form 10-K to besigned on its behalf by the undersigned, thereunto duly authorized, this 31st day of March, 2007.

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

 

Date: March 29, 2007

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

| Signatures Signed        | ** ** | ** **                                                                                                        | ** ** | **Title**           | ** ** | **Date** |
|--------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|----------|
| Elliott Balbert          |       | Chairman of the Board and Executive Chairman                                                                      |       | March 31, 2007 |
| Wayne Bos                |       | President, Chief Executive Officer and Director  (Principal Executive Officer)                                    |       | March 31, 2007 |
| Dennis Jolicoeur         |       | Chief Financial Officer, Executive Vice President  (Principal Financial Officer and Principal Accounting Officer) |       | March 31, 2007 |
| Dennis De Concini        |       | Director                                                                                                          |       | March 31, 2007 |
| Thomas Doorley, III |       | Director                                                                                                          |       | March 31, 2007 |
| Joel Katz                |       | Director                                                                                                          |       | March 31, 2007 |
| James Peters             |       | Director                                                                                                          |       | March 31, 2007 |
| Ralph  Simon             |       | Director                                                                                                          |       | March 31, 2007 |

 

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