**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-K**

 

**FOR ANNUAL AND TRANSITIONAL REPORTS**

**PURSUANT TO SECTIONS 13 AND 15(d) OF THE**

**SECURITIES EXCHANGE ACT OF 1934**

 

**ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE**

**SECURITIES EXCHANGE ACT OF 1934**

 

**(Mark One)**

 
| **ý** | **FOR THE  FISCAL YEAR ENDED DECEMBER 31, 2001** |
|------------|--------------------------------------------------|

 

**OR**

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

 

**For the transitionperiod from                  to             .**

 

**Commission File No: 000-24567**

 

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**NATROL, INC.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                              |   | **95-3560780**                       |
|-----------------------------------------------------------|--------|--------------------------------------|
| (State of Incorporation)                                  |   | (I.R.S. Employer Identification No.) |
|                                                      |   |                                 |
| **21411 Prairie  Street**                                 |
| **Chatsworth,  California 91311**                         |
| (Address of principal executive offices)                  |
|                                                      |   |                                 |
| **(818)  739-6000**                                       |
| (Registrant’s telephone number, including area code) |

 

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

 

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

 

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Indicate by a check mark whether the registrant (1) has filed allreports required to be filed by section 13 or 15 (d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. Yes ý  No o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Registration S-K is not contained herein, and will not be contained,to the best of the registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K orany amendment to this form 10-K. o

 

The aggregate market value of the shares of the registrant’s Common Stockheld by non-affiliates of the registrant on March 15,2002 was approximately$23.1 million based upon the closing price per share of the registrant’s CommonStock as reported on the NASDAQ National Market on such date. Calculations ofholdings by non-affiliates is based upon the assumption, for these purposesonly, that executive officers, directors, and persons holding 10% or more ofthe outstanding Common Stock are affiliates. This determination of affiliatestatus is not necessarily a conclusive determination for other purposes.

 

As of March 15, 2002, the registrant had 12,842,714 shares of CommonStock outstanding.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions of theregistrant’s definitive proxy statement for its 2002 Annual Meeting ofStockholders are incorporated by reference into Part III of thisForm 10-K.

 

 

**NATROL, INC.**

# **2001 ANNUAL REPORT on Form 10-K**

 

**TABLE OF CONTENTS**

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

 

**CAUTIONARYSTATEMENT REGARDING FORWARD-LOOKING STATEMENTS**

 

This report contains “forward looking statements.” The Company isincluding this statement for the express purpose of availing itself ofprotections of the safe harbor provided by the Private Securities LitigationReform Act of 1995 with respect to all such forward looking statements.Examples of forward looking statements include, but are not limited to, the useof forward-looking terminology such as “believes,” “expects,” “may,” “will,”“should”, “intend”, “estimate”, “assume”, “plan” or “anticipates” or thenegative thereof, other variations thereon, or comparable terminology, or bydiscussions of strategy that predict or indicate future events or trends orthat are not historical facts. The Company cannot assure the future results oroutcome of the matters described in these statements; rather, these statementsmerely reflect its current expectations of the approximate outcome of thematter discussed. The Company does not undertake to update any such statementsat any time in the future.

 

The Company’s ability to predict results or the effect of certainevents on the Company’s operating results is inherently uncertain.Forward-looking statements should not be unduly relied on since they involveknown and unknown risks, uncertainties and other factors, some of which arebeyond the Company’s control. These risks, uncertainties and other factors may causeactual results, performance or achievements to differ materially

 

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fromthe anticipated future results, performance or achievements expressed orimplied by such forward-looking statements. Therefore, the Company wishes tocaution each reader of this report to carefully consider the following factorsand certain other factors discussed herein, including the factors discussedunder the caption “Business Risk Factors & Factors Affecting ForwardLooking Statements,” and factors discussed in other past reports, including butnot limited to the prior year annual reports on Form 10-K filed with theSecurities and Exchange Commission. The factors discussed herein may not beexhaustive. Therefore, the factors contained herein should be read togetherwith other reports and documents that are filed by the Company with the SECfrom time to time, which may supplement, modify, supersede or update thefactors listed in this document.

 

Factors that could cause or contribute to the Company’s actual resultsdiffering materially from those discussed herein or for the Company’s stockprice to be affected adversely include, but are not limited to:(i) industry trends, including a general downturn or slowing of the growthof the dietary supplement industry which has occurred during the past two yearsand may continue, (ii) increased competition from current competitors andnew market entrants including but not limited to increased competition fromprivate label house brands supported by retailers seeking to increase themarket share of their proprietary house brands, (iii) adverse publicityregarding the dietary supplement industry or the Company’s products,(iv) the Company’s dependence upon its ability to develop new products,(v) a continued high rate (or increase in the rate) of returns of theCompany’s products, (vi) the Company’s ability to gain or expand ormaintain distribution within new or existing customers and new or existingchannels of trade, (vii) an increase in the cost of obtaining andmaintaining shelf space with major national retailers who demand various formsof incentives from their suppliers such as slotting fees, coop advertising, orrebates, (viii) adverse changes in government regulation, (ix) exposureto product liability claims including product liability claims from productswhich include ephedrine or other products for which the Company has either notbeen able to secure product liability coverage or been able to secure suchcoverage at reasonable prices. (as of March 15, 2002, the availability ofproduct liability insurance for ephedrine based products was non-existent),(x) dependence on significant customers, (xi) the Company’s abilityto keep and attract key management employees, (xii) the Company’sinability to manage growth and execute its business plan, or the Company’sability to modify its business plan in response to market conditions,including, but not limited to, its ability to enter new businesses andcapitalize upon new business opportunities (xiii) the Company’s ability toconsummate future acquisitions and its ability to integrate acquiredbusinesses, including without limitation Prolab Nutrition, Inc.(“Prolab”), acquired in October, 1999 for which the Company took a $20 millionimpairment charge in the year ending December 31, 2001 due to the write down ofgoodwill associated with the acquisition, (xiv) the absence of conclusiveclinical studies for many of the Company’s products, (xv) the Company’sinability to obtain raw materials that are in short supply including itsability to obtain garlic powders under its supply agreement with ConAgra forits Essentially Pure Ingredient (EPI) raw material sales division,(xvi) sales and earnings volatility, (xvii) volatility of the stockmarket (xviii) the Company’s ability to manufacture its productsefficiently, (xix) the Company’s ability to manage inventory or sell itsinventory before such inventory becomes outdated, (xx) the Company’sreliance on independent brokers to sell its products, (xxi) the inabilityof the Company to protect its intellectual property, (xxii) control of theCompany

 

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byprincipal shareholders, (xxiii) the possible sale of large amounts ofstock by controlling shareholders, (xxiv) a general downturn in thenational economy as a whole, and (xxv) continued market acceptance ofNatrol supplements, Laci Le Beau teas, Prolab’s sports nutrition products, andEssentially Pure Ingredients’ raw material products.

 

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**PART I**

 

**ITEM 1. BUSINESS**

 

The Company’s executive offices are located at 21411 Prairie Street,Chatsworth, California 91311 and its telephone number is 818-739-6000. Unlessthe context otherwise requires the terms the “Company” and “Natrol” refer toNatrol, Inc. and, as applicable, its direct and indirect subsidiaries.

 

**GENERAL**

 

Natrol manufactures and markets branded, high-quality dietarysupplements, herbal teas, nutraceutical ingredients and sports nutrition products.The Company’s core Natrol brand focuses on supplements that are in high demandas well as specialty niche and proprietary formulations that have potentiallystrong margins. The Company positions Natrol as a premium brand of vitamins,minerals and other supplements rather than as a value brand. The Companymanufactures and sells approximately 185 products packaged into approximately670 SKUs.

 

Dietary supplements are sold primarily under the Company’s Natrolbrand. These supplements include vitamins, minerals, hormonal supplements,herbal products and specialty combination formulas that contribute to anindividual’s mental or physical well-being. The Company sells its productsthrough multiple distribution channels throughout the United States. These channelsinclude domestic health food stores and mass market drug, retail and grocerystore chains. The Company also sells its products through independent catalogs,internet shopping sites, and, to a limited degree, within select foreigncountries through international distributors. The Company’s strategy emphasizesbuilding strong recognition of the Natrol brand across multiple distributionchannels through an advertising strategy that includes print advertising,television advertising,  radioadvertising and coop advertising spending with customers designed to buildconsumer awareness and increase the purchase of its products by consumers.

 

Herbal teas are sold under the Company’s Laci Le Beau brand name. LaciLe Beau teas are flavored herbal teas. The primary tea category is Laci Le Beau*Dieter’s*tea. The Company uses essentially the same sales people and brokers to sellteas as it does supplements. And, as with its supplement business, theCompany’s strategy emphasizes building strong recognition of the Laci Le Beaubrand across multiple distribution channels.

 

In October 1999, the Company acquired Prolab Nutrition, Inc.The Prolab sports nutrition line of products is targeted to body builders andhealth minded individuals seeking a high degree of physical fitness. Prolab’sproducts include supplements designed to help these individuals gain and loseweight as well as improve muscle mass and muscle definition. Prolab productsare sold through gyms, health food stores, and internationally, throughselected distributors. Prolab products are sold primarily by a dedicated Prolabsales force. However, Prolab shares many Natrol resources and the Prolab andNatrol sales forces coordinate the dissemination of information on Prolabproducts and promotional activity.

 

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The Company also sells nutraceutical grade ingredients, primarilygarlic, vegetable powders, kava kava, melatonin, soy isoflavones and cetylmyristoleate complex to other manufacturers. In 2000, the Company renamed itsingredient supply division from Pure-Gar to Essentially Pure Ingredients (EPI).The Company’s strategy is to establish exclusive relationships with primarymanufacturers of raw materials and to sell these ingredients to other users ofnutraceutical grade materials. EPI maintains an independent national salesforce.

 

The Company’s consumer products fall into the general definition ofvitamin, minerals, and supplements. Each year the Company strives to broadenits product offering so as to increase revenue and gross profits whilelessening the Company’s dependence upon any one product.

 

Only one line of products, the MSM-line of joint care products with10.2% of gross sales, accounted for more than 10% of the Company’s gross salesin 2001. In 2000, MSM products accounted for 13.4% of the Company’s grosssales.

 

The Laci Le Beau tea business accounted for approximately 7.2% of theCompany’s gross sales in 2001 and the Essentially Pure Ingredients businesswhich accounted for 7.2% of the Company’s business. Prolab Nutrition Inc.,which sells a variety of sports nutrition products accounted for 22.4% of theCompany’s gross sales during the year 2001.

 

**SALES**

 

*BRANDEDPRODUCTS*

 

The Company distributes its Natrol supplements and Laci Le Beau teasprimarily to domestic health food stores and mass market drug, retail and foodstores. Although the Company sells the same Natrol or Laci Le Beau products toboth the health food and mass market channels of distribution, it has builtdifferent sales organizations to meet the differing requirements of eachchannel of trade.

 

The Company sells its branded Natrol and Laci Le Beau products tohealth food stores through leading national distributors, including *UnitedNatural Foods* and *Tree of Life*, as well as directly to *GNC*(General Nutrition Company). Natrol and Laci Le Beau products are sold byhealth food store chains such as *Wild Oats Markets, Whole Foods Market, Hi-Health,Vitamin Cottage, Fred Meyer Nutrition Centers* and *VitaminShoppes*, as well as most independent health food stores.

 

Within the health food channel of trade, the Company maintains a salesstaff of approximately 12 representatives across the country who are managed bya national manager and two regional managers who report to the Company’s VicePresident of Sales. These sales representatives call on individual store ownersand distributors promoting the Natrol, Laci Le Beau and Prolab lines.

 

The mass market distribution channel is managed by the Company’s VicePresident of Sales**,**a Vice President of National Accounts andregional managers who work with a

 

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networkof independent brokers. The Company’s employees service certain of its largermass market accounts directly while independent brokers service others inconjunction with the Company’s management. The Company sells its products tomass market merchandisers either directly or through distributors of vitamins,minerals and other supplement products such as *Bergen Brunswick, McKesson*and *Cardinal*.Some of the Company’s major mass market retail customers are *Walgreens,CVS, American Drug Stores, Rite Aid, Long’s Drug, Drug Emporium, Eckerd,Snyders, Brooks Drug, Wal-Mart, Kmart, Target, ShopKo*, *BJ’sWholesale Club and Sam’s Clubs*. The Company also sells its productsin grocery stores and supermarkets, including *Dominick’s, Ralphs, Von’s, Schnucks,Cub Foods, Food For Less* and *Wegmans*.

 

Sales of vitaminsand supplements within the mass market channel of trade for the industry as awhole have been showing negative trends during the last two years.  In addition, many mass market retailershave, during this period of time, either expanded or placed additional emphasison in-house private label brands.  Thiscombination of factors has placed increased pressure on branded vitamin andsupplement companies such as Natrol.  Many mass market retailers have, within recent months, begun to reduceshelf space allocated to vitamins and supplements as a whole or they have announcedthat such reductions were intended.  Inthis negative environment, the Company’s central strategy is to ensure thatshould any of its shelf space be reduced, that its most profitable items remainon retailers shelves.  This strategy pertains to the Company’s coreproducts.  In addition, the Company iscontinually seeking to develop or acquire rights to new products able tocapture a substantial consumer following.

 

Market data for the health food channel of trade is not as availableand the quality of information that is produced is not as reliable as that forthe mass market channel of trade.  Evenso, anecdotal evidence indicates that market trends for the health food channelof trade have also been negative.  TheCompany, however, believes that its product line is under represented withinthe health food channel of trade and its strategy within that channel of tradeis to ensure that  retail outletscarry  a higher percentage of what theCompany considers to be its core line of products.

 

The Company provides retailers in both the health food store and themass market distribution channels with a wide array of comprehensive servicestailored to meet their individual needs. In the health food store channel, theCompany’s dedicated sales force maintains direct and regular contact with key storepersonnel, informing them of new product developments and industry trends,aiding them in the design of store sets and creating merchandising programsthat promote brand and category awareness. The Company’s regional salesmanagers and independent brokers in the mass market distribution channel workwith corporate buyers focusing on special promotional activities and brand andcategory awareness in order to improve the consumer take away of Natrolproducts and increase the  movement ofitems through each outlet. The objective of these activities is to build strongrelationships with the Company’s marketing partners, to increase the number ofstores carrying its products and improve the profitability of the items soldwithin each of the Company’s trading partners.

 

Prolab products are sold primarily through gyms,health food stores and

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internationallythrough designated distributors.  Thereis little overlay between the Prolab distributors and those distributors servedby the  Natrol brand in its health foodchannel of trade. The typical Prolab distributor specializes in distributingsports nutrition products. Approximately 43.1% of Prolab’s business is to distributor’s whosebusiness is to sell product to European, Canadian and other non-domesticaccounts**.**

 

Prolab’s domestic sales are primarily to distributors who in turnservice retail accounts. Prolab’s distributor network focuses on health foodstores and gyms that cater to body builders and other individuals seeking ahigh level of fitness.

 

Prolab’s sales force is independent of Natrol’s sales’ force. However,the two sales forces coordinate efforts where appropriate**.**

 

The Company had no customer whose sales amounted to more than 10% ofthe Company’s gross sales during the last two years.

 

*PRIVATE LABELAND INGREDIENT SUPPLY SALES*

 

The Company manufactures a number of products pursuant to contractswith customers who distribute the products under their own private labels.Sales to private label customers accounted for 3.3% of the Company’s grosssales for 2001.

 

In its bulk ingredient business, the Company primarily sellsnutraceutical grade dehydrated vegetable products, mostly garlic, to othermanufacturers, distributors and marketers of dietary supplements. Non-vegetablebased products include Melatonin and Cetyl Myristoleate. The Company obtainsits bulk vegetable ingredients from ConAgra Foods, Inc. (ConAgra) pursuantto a multi-year supply agreement that gives the Company the exclusive right tosell ConAgra’s nutraceutical grade vegetable powders in the dietary supplementindustry.

 

Bulk ingredient sales are the responsibility of the Company’sEssentially Pure Ingredients division and accounted for 7.2% of the Company’sgross sales in 2001. Sales personnel from this division call on more than 120customers nationwide.

 

The Company’s strategy is to establish exclusive relationships withprimary manufacturers of raw materials and to sell these ingredients to otherusers of nutraceutical grade materials. The Company’s strategy is to broadenits product offerings as favorable distribution opportunities arise.

 

**MARKETING**

 

*BRANDEDPRODUCTS*

 

Management believes the Company’s strategy of selling the Natrol, LaciLe Beau and Prolab brands through all channels of distribution including thehealth, mass market, convenience store, gym and internet channels distinguishesthe Company from its

 

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competition.Most competitors sell products into each channel using different brand nameswithin each channel. Often, in the case of the Company’s competitors, the brandsold in the health channel is positioned as the quality brand while the massmarket line is positioned as the value brand.

 

The Company’s core strategy is to continue to build the Natrol, Laci LeBeau and Prolab brand names within multiple channels of distribution in orderto develop increased brand awareness and strong brand recognition amongconsumers seeking products with a reputation for quality. The Company believesit can leverage its reputation for high quality products developed within thehealth food distribution channel in the mass market and other channels bypositioning its products as a high quality brand rather than a value brand.

 

The Company utilizes print, radio and television advertising as well ascooperative and other incentive programs to build consumer awareness andgenerate sales revenue. The Company spent approximately $4.3 million or5.5%****ofnet sales in 2001 in traditional media outlets and an additional$12.4 million or 16.0% of net sales on various forms of sales incentivessuch as coop advertising and incentive rebates. The Company spent approximately$6.0 million or 6.9% of net sales in 2000 in traditional media outlets andan additional $15.4 million or 17.6% of net sales in 2000 with retailersfor coop advertising and other incentive rebates. The high level ofexpenditures with retailers on coop advertising and other incentives has beendue in a large part to negative industry trends during the last two years whichhave led to lower than anticipated sales revenues and necessitated additionalincentive spending to drive sales and limit a higher than anticipated rate ofreturn caused in part by retailers seeking to lower warehouse inventory levels.

 

Although the Company is attempting to better manage its level of salesincentive spending for such items as slotting fees, coop advertising andrebates, the Company cannot guarantee that it will be able to manageexpenditures below the percentage levels experienced during the last two years.

 

The Company generally usestargeted, health-oriented magazines, such as *Better Nutrition*and *Great Life,*to support the health food distribution channel and uses mainstreampublications such as *Prevention, Health, USA Today, TV Guide,* *Parade, Cosmopilitan, Reader’s Digest* and *Women’s Day*to support the mass market distribution channel. Prolab uses primarily printadvertising in specialty fitness and weight-lifting publications, such as *Flex,Ironman,*and *Muscle &Fitness*.

 

During 2001, the Company’stelevision commercials were featured on such soap operas as the *Bold &Beautiful* and *Guiding Light*, the *NBC* and *ABC* evening news, such game shows as the *Price isRight, Wheel of Fortune* and *Jeopardy*, and on cable networks like *Lifetime*and *A&E*.  The bulk of the Company’s televisionspending in 2001 was used to support the introduction of Flexanew, a new jointcare product introduced by the Company during the last quarter of 2001.

 

Radio advertising in 2001 was limitedto selected opportunities throughout the year.

 

The Company constantly reviews its media mix for its effectiveness increating

 

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consumerdemand. As such, the Company’s use of certain media in past operating periodsis not necessarily an indicator of media choices to be made in future operatingperiods.

 

*PRIVATE LABELAND INGREDIENT SUPPLY SALES*

 

The Company does not actively market its private label business andrelies on word-of-mouth as well as the delivery of information from its salesstaff, primarily its Essentially Pure Ingredients sales people.

 

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

 

**RESEARCH &PRODUCT DEVELOPMENT**

 

The Company’s product development department consists of an internalstaff of professionals with extensive nutraceutical and scientific backgrounds.This group of product development professionals reports to the Vice Presidentof Marketing and works with marketing brand managers to evaluate productcategories and SKUs for trends in sales and profitability, de-emphasizing ordropping products when profitability or SKU velocity lags. New products areintroduced to replace slower moving products, capitalize on market trends anddiversify the Company’s product offerings.

 

The Company has established a focused process to anticipate consumerdemand, monitor product developments within the dietary supplement industry andfacilitate the generation of new ideas for product introductions. The Company’sproduct development staff constantly reviews periodicals, scientific researchand relevant clinical studies within medical journals and searches on-linedatabases. The staff meets with vendors and evaluates new ingredients. Theproduct development team also consults scientists and employs researchconsultants on a regular basis regarding new product concepts.

 

Before a product is introduced, the product development team reviewsthe safety and efficacy of ingredients, standards for production, and withassistance from FDA and patent counsel reviews labeling information, labelclaims and potential patent, trademark, legal or regulatory issues. TheCompany’s marketing team also attempts to assess potential marketing demandthrough focus groups and other research techniques.

 

The Company actively participates in and financially supports a numberof scientific and educational industry organizations that promote consumer wellbeing. These include the Citizens for Health (CFH), the National NutritionalFoods Association (NNFA), American Herbal Products Association (AHPA), AmericanHerbal Pharmacopoeia (AHP), and the American Botanical Council (ABC). TheCompany is also a founding member of the Dietary Supplement Education Alliance(DSEA) of which Mr. Balbert serves as the CEO. The DSEA is a not-for-profit organization that supports research anddevelopment for the vitamin, mineral, and supplement category.

 

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**MANUFACTURINGAND PRODUCT QUALITY**

 

*DIETARYSUPPLEMENTS*

 

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

 

The Company placesa strong emphasis on quality control because it believes that quality standardsplay a critical factor in consumer purchasing decisions and in differentiatingthe Natrol brand. The Company’s products are manufactured in accordance withcurrent GMPs (Good Manufacturing Practices) of the FDA for foods and theapplicable regulations of other agencies. During 2001 the Company was awardedan “A” compliance rating in the National Nutritional Foods Association’s GoodManufacturing Practices (GMP) Third Party Certification Program. Based inNewport Beach, CA, the National Nutritional Foods Association (NNFA) is thelargest dietary supplement trade association, representing 3,000 retailers and1,000 manufacturers, suppliers and distributors of health foods, dietarysupplements, natural ingredient cosmetics and other natural products. Natrol isonly the twenty-first company in the NNFA membership to be awarded theprestigious “A” compliance rating.  TheNNFA GMP Certification Program is designed to verify compliance with astandardized set of good manufacturing practices (GMPs) developed  by the NNFA.

 

**The Company’s manufacturing facility includes an on-sitelaboratory, which is staffed by the Director of Quality Assurance, qualifiedscientists, chemists, technicians and support personnel to provide GMP/GLPcompliance services.   In support of itscommitment to analytical product analysis, the Natrol laboratory uses state ofthe art computerized instrumentation for providing reliable, accurate productanalysis testing for a single raw material to complex multi-vitamins.  The major laboratory instrumentationsinclude the mass spectrophotometer and several high performance liquidchromatographs.  The laboratory is alsoencompassed by atomic absorption, infrared spectrophotometer (FTIR),ultraviolet-visible spectrophotometer, Karl Fisher moisture analyzer, densitytester, thin layer chromatography application and stability environmentalchamber for product shelf life determination.**

 

The Company requires all raw materials or finished product produced bythird party vendors to be placed in quarantine upon receipt and tested by theCompany’s quality control laboratory. The Company conducts sample testing,weight testing, purity testing, dissolution testing and, where required,microbiological testing. When raw materials are released from quarantine, eachlot is assigned a unique lot number which is tracked throughout themanufacturing process. Materials are blended, tested and then encapsulated orformed into pills which may or may not be coated. The Company routinelyperforms qualitative and quantitative quality control procedures on itsfinished products.

 

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The Company obtains its raw materials for the manufacture of itsproducts from third-party suppliers. Many of the raw materials used in theCompany’s products are harvested internationally. With the exception of bulkgarlic, the Company does not have contracts with any suppliers committing suchsuppliers to provide the materials required for the production of its products.In the last few years, natural vitamin E, beta carotene, Melatonin, Kava,Sam-E, and St. John’s Wort have had significant price fluctuations as a resultof short supply and or increases in demand. The Company has experiencedoccasional shortages of raw materials for a limited number of its products, butto date has only encountered short-term production interruptions as a result ofsuch shortages. No supplier accounted for more than 10% of the Company’s rawmaterial purchases during 2001 and only one supplier, ConAgra accounted for asmore than 10% of the Company’s raw material purchases in 2000. ConAgra suppliesthe Company’s EPI division nutraceutical grade vegetable powders, primarilygarlic, under an exclusive supply agreement (see INGREDIENT SUPPLY below).Because the Company does not control the actual production of these rawmaterials, it is also subject to delays caused by interruption in production ofmaterials based on conditions not within its control. Such conditions includejob actions or strikes by employees of suppliers, weather, crop conditions,transportation interruptions and natural disasters or other catastrophic events**.**For example, during 1999, the Company encountered problems in its garlic supplydue to poor crop yields of garlic and from work stoppages caused by a strike atits major supplier. Both of these occurrences, from time to time, affected theCompany’s ability of the Company’s Essentially Pure Ingredients division todeliver garlic powders in a timely manner. With respect to products that aresold by the Company under the supplier’s trademark, such as the Company’sEster-C® line of products, the Company is limited to that single supplier as asource of raw materials for that product. As a result, any shortage of rawmaterials from that supplier would adversely affect the Company’s ability tomanufacture that product. The inability of the Company to obtain adequatesupplies of raw materials for its products at favorable prices, or at all,could have a material adverse effect on the Company’s business, financialcondition and results of operations.

 

In addition to the agreement with Con-Agra, the Company has minimumpurchase and pricing agreements with a limited number of vendors.  These volume pricing agreements are intendedto help the Company obtain raw materials at preferential prices.

 

The Company has current manufacturing capability to produce four milliontablets and capsules per eight hour shift and 420,000 bottles per week pereight hour shift. The Company believes it can triple current sales volumeswithout the necessity of expanding its current manufacturing facility. Such atripling of production would require additional space for the warehousing ofraw material as well as the addition of some manufacturing and packagingequipment.

 

The Company operates flexible manufacturing lines which enable it toshift output efficiently among various pieces of equipment depending upon suchfactors as batch size, tablets or capsule count and labeling requirements. TheCompany strives to fulfill and ship all orders within 48 hours.

 

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The Company also owns a 132,000 sq. ft. warehouse facility located lessthan one-quarter mile from its manufacturing facility. Approximately 52,000 sq.ft. of this warehouse facility is subleased. The remaining 80,000 sq. ft. isnow being used by the Company to ship finished goods to the Company’scustomers. Finished goods are transferred from the Company’s packaging lines tothe shipping facility for storage prior to shipment to customers.

 

*TEAS*

 

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

 

*PROLAB*

 

The Company produces, at its headquarters/manufacturing facility,Prolab supplements that are sold in tablet or capsule form. However, theCompany relies on third party vendors to process and package a majority ofProlab’s products which consists of powders, nutrition bars and drinks. Prolabowns a 30,000 square foot headquarters facility in Connecticut, in which itpackages a limited amount of powdered product that is manufactured by thirdparty vendors.

 

*INGREDIENTSUPPLY*

 

The Company’s Essentially Pure Ingredients division provides rawmaterial ingredients to the Company and approximately 120 other customers. TheCompany acquires nutraceutical grade garlic and other vegetable powderspursuant to a multi-year supply agreement with ConAgra Foods, Inc. (the“ConAgra Agreement”), which requires ConAgra to sell and the Company topurchase specified amounts of certain vegetable, fruit, herbal and botanicalproduct. The ConAgra Agreement gives the Company the exclusive right to sellcertain ConAgra products in the dietary supplement industry. The ConAgraAgreement may be terminated by either party upon a material breach of theobligations of the other party, or certain other specified conditions, if thebreach is not cured within 60 days, or within 15 days in the case ofnon-payment by the Company. The ConAgra Agreement was originally signed withBasic Vegetable Products in 1998 when the Company purchased BVP’s Pure GarDivision. In November 2000, Basic Vegetable Products was acquired by ConAgraFoods, Inc. As the successor to Basic Vegetable Products, ConAgra wasobligated to assume the terms and conditions of the original Supply Agreement.Natrol and ConAgra negotiated certain modifications to the original agreementincluding an extension of the Supply Agreement. These modifications wereconsidered beneficial by both parties.

 

The EPI division may source other raw ingredients and contract for theprocessing of these ingredients when management feels market conditions aresuch that the purchasing and processing of these materials would be beneficialto the Company and its customers.

 

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**TRADEMARKS ANDPATENTS**

 

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

 

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

 

Currently, the Company has received one United States patent for itsKavatrol product and has received two United States patents on its amino acidproducts, SAF and SAF for Kids. To the extent the Company does not have patentson its products, another company may replicate one or more of the Company’sproducts.

 

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

 

**COMPETITION**

 

The dietary supplement industry is highly competitive. Numerouscompanies, many of which have greater size and financial, personnel,distribution and other resources than the Company, compete with the Company inthe development, manufacture and marketing of dietary supplements.   The Company’s principal competition in thehealth food store distribution channel comes from a limited number of largenationally known manufacturers and many smaller manufacturers of dietarysupplements. In the mass market distribution channel, the Company’s principalcompetition comes from broadline manufacturers, major private labelmanufacturers and other companies. In addition, several large pharmaceuticalcompanies, including Bayer and American Home Products, compete with thenutritional supplement companies. Increased competition from such companiescould have a material adverse effect on the Company because such companies havegreater financial and other resources available to them and possessmanufacturing, distribution and marketing capabilities far greater than thoseof the Company. The Company also faces competition in both the health foodstore and mass market distribution channels from private label dietarysupplements and multivitamins offered by health and natural food store chains,drugstore chains, mass merchandisers and supermarket chains.

 

The Company competes on the basis of product quality, pricing, customerservice, product development and marketing support.

 

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**REGULATORYMATTERS**

 

The manufacture, packaging, labeling, advertising, promotion,distribution and sale of the Company’s products are subject to regulation bynumerous governmental agencies which regulate the Company’s products. TheCompany’s products are also subject to regulation by, among other regulatoryentities, the Consumer Product Safety Commission (the “CPSC”), the U.S.Department of Agriculture (the “USDA”) and the Environmental Protection Agency(the “EPA”) and the U.S. Food and Drug Administration (the “FDA”). Advertisingand other forms of promotion and methods of marketing of the Company’s productsare subject to regulation by the U.S. Federal Trade Commission (the “FTC”),which regulates these activities under the Federal Trade Commission Act (the“FTCA”). The manufacture, labeling and advertising of the Company’s productsare also regulated by various state and local agencies as well as those of eachforeign country to which the Company distributes its products.

 

The Dietary Supplement Health and Education Act of 1994 (“DSHEA”)revised the provisions of the FDCA concerning the regulation of dietarysupplements. In the judgment of the Company, the DSHEA is favorable to thedietary supplement industry. The legislation for the first time defined“dietary supplement.” The term “dietary supplement” is defined as a productintended to supplement the diet that contains one or more of certain dietaryingredients, such as a vitamin, a mineral, an herb or botanical, an amino acid,a dietary substance for use by man to supplement the diet by increasing thetotal dietary intake, or a concentrate, metabolite, constituent, extract, orcombination of the preceding ingredients. The substantial majority of theproducts marketed by the Company are regulated as dietary supplements under theFDCA.

 

Under the current provisions of the FDCA there are four categories ofclaims that pertain to the regulation of dietary supplements. Health claims areclaims that describe the relationship between a nutrient or dietary ingredientand a disease or health related condition and can be made on the labeling ofdietary supplements if supported by significant scientific agreement andauthorized by the FDA in advance via notice and comment rulemaking. Nutrientcontent claims describe the nutritional value of the product and may be made ifdefined by the FDA through notice and comment rulemaking and if one serving ofthe product meets the definition. Health claims may also be made if ascientific body of the U.S. government with official responsibility for thepublic health has made an authoritative statement regarding the claim, theclaim accurately reflects that statement and the manufacturer, among otherthings, provides the FDA with notice of and the basis for the claim at least120 days before the introduction of the supplement with a label containingthe health claim into interstate commerce. For health claims that the FDA hasapproved, no prior notification is required. Statements of nutritional supportor product performance, which are permitted on labeling of dietary supplementswithout FDA pre-approval, are defined to include statements that:(i) claim a benefit related to a classical nutrient deficiency disease anddiscloses the prevalence of such disease in the United States;(ii) describe the role of a nutrient or dietary ingredient intended toaffect the structure or

 

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functionin humans; (iii) characterize the documented mechanism by which a dietaryingredient acts to maintain such structure or function; or (iv) describegeneral well-being from consumption of a nutrient or dietary ingredient. Inorder to make a nutritional support claim the marketer must possesssubstantiation 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 the relevantstatement and notification to the FDA of the claim is required. Drug claims arerepresentations that a product is intended to diagnose, mitigate, treat, cureor prevent a disease. Drug claims are prohibited from use in the labeling ofdietary supplements.

 

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

 

The FDA has also announced that it is considering promulgating new GMPsspecific to dietary supplements. Such GMPs, if promulgated, may besignificantly more rigorous than currently applicable GMP requirements andcontain quality assurance requirements similar to GMP requirements for drugproducts. Therefore, the Company may be required to expend additional capitaland resources on manufacturing in the future in order to comply with the law.

 

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

 

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

 

The Company’s advertising of its dietary supplement products is subjectto regulation by the FTC under the FTCA. Section 5 of the FTCA prohibitsunfair methods of competition and unfair or deceptive acts or practices in oraffecting commerce. Section 12

 

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ofthe FTCA provides that the dissemination or the causing to be disseminated ofany false advertisement pertaining to drugs or foods, which would includedietary supplements, is an unfair or deceptive act or practice. Under the FTC’sSubstantiation Doctrine, an advertiser is required to have a “reasonable basis”for all objective product claims before the claims are made. Failure toadequately substantiate claims may be considered either deceptive or unfairpractices. Pursuant to this FTC requirement the Company is required to haveadequate substantiation for all material advertising claims made for itsproducts.

 

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

 

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

 

Advertising and labeling for dietary supplements and conventional foodsare also regulated by state and local authorities. There can be no assurancethat state and local authorities will not commence regulatory action whichcould restrict the permissible scope of the Company’s product claims.

 

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

 

In addition, the Company has in the past, from time to time, been thesubject of investigation by the FTC, however, the Company is not currently aparty to any consent order or other decree of the FTC. The Company may be thesubject of investigation in the future. The FTC may impose limitations on theCompany’s advertising of its products. Any such limitations could materiallyadversely affect the Company’s ability to successfully market its products.

 

The Company manufactures certain products pursuant to contracts withcustomers who distribute the products under their own or other trademarks. Suchprivate label

 

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customersare subject to government regulations in connection with their purchase,marketing, distribution and sale of such products. The Company is subject togovernment regulations in connection with its manufacture, packaging andlabeling of such products. However, the Company’s private label customers areindependent companies, and their labeling, marketing and distribution of suchproducts is beyond the Company’s control. The failure of these customers tocomply with applicable laws or regulations could have a material adverse effecton the Company’s business, financial condition and results of operations.

 

The Company may be subject to additional laws or regulations by the FDAor other federal, state or foreign regulatory authorities, the repeal of lawsor regulations which the Company considers favorable, such as the DietarySupplement Health and Education Act of 1994, or more stringent interpretationsof current laws or regulations, from time to time in the future. The Company isunable to predict the nature of such future laws, regulations, interpretationsor applications, nor can it predict what effect additional governmentalregulations or administrative orders, when and if promulgated, would have onits 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 the Company’sbusiness, financial condition and results of operations.

 

EMPLOYEES

 

As ofMarch 1, 2002, the Company had approximately 255 employees. Of suchemployees, approximately 67 were engaged in marketing and sales, 150 weredevoted to production and distribution and 38 were responsible for managementand administration. None of the Company’s employees is covered by a collectivebargaining agreement. The Company considers its relations with its employees tobe good.

 

**RISK FACTORSAND FACTORS AFFECTING FORWARD LOOKING STATEMENTS**

 

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

 

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

 

*Industrytrends.*  The total United States retailmarket for nutritional supplements, the vitamin, mineral and supplement market(“VMS”) is highly fragmented. Industry sources report that the VMS sector grewsubstantially during most of the 1990s, in many years at a

 

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doubledigit pace. However, there is evidence, that during the last two years, therate of growth in the industry became negative.

 

Information Resources, Inc. (“IRI”) tracks sales data within thefood, drug, and mass market channels of distribution. For the 52 weeks endingJanuary 6, 2002, vitamin and supplement sales in these channels of distributionfell 4.2% when compared to the same period a year earlier.****These trends have adversely affected Natrol’s business and results ofoperation in 2000 and 2001.****There can be no assurance that theindustry trends will change positively or other competitors will not gainmarket share when compared to Natrol.

 

In addition to the trends in our specific industry, the United Stateseconomy experienced a significant downturn in after the events of September 11,2001.   Sales in the Company’s fourthquarter of 2001 were particularly weak in part due to the downturn in theeconomy.  A continued sluggish economywould contribute significantly to downward trends in our industry throughout2002 or beyond.

 

There can be no assurance that the more robust industry growth ratesexperienced between 1995 and 1999 can be regained. In addition, there can be noassurance that the industry growth rate will not continue to decline in futureoperating periods or that the growth rate of the U.S. economy may not benegative. Such a failure to achieve and sustain growth in the industry or inthe U.S. economy as a whole may have a material adverse effect on the Company’sability to return its results to its historic rates of growth and its resultsof operations.

 

*Competition.*  The dietary supplement industry is highlycompetitive. Numerous companies, many of which have greater size and financial,personnel, distribution and other resources than the Company, compete with theCompany in the development, manufacture and marketing of dietary supplements.The Company’s principal competition in the health food store distributionchannel comes from a limited number of large nationally known manufacturers andmany smaller manufacturers of dietary supplements. In the mass marketdistribution channel, the Company’s principal competition comes from broadlinemanufacturers, major private label manufacturers and other companies. Inaddition, large pharmaceutical companies have begun to compete with the Companyand others in the dietary supplement industry. Packaged food and beveragecompanies compete with the Company on a limited basis in the dietary supplementmarket. Increased competition from such companies could have a material adverseeffect on the Company because such companies have greater financial and otherresources available to them and possess manufacturing, distribution andmarketing capabilities far greater than those of the Company. The Company alsofaces competition in both the health food store and mass market distributionchannels from private label dietary supplements and multivitamins offered byhealth and natural food store chains, drugstore chains, mass merchandisers andsupermarket chains. Private label brands at mass market chains representsubstantial sources of income for these merchants and in a softening market forvitamins and supplements as a whole, these mass market merchants often supporttheir own labels at the expense of third party brands such as Natrol, Laci LeBeau or Prolab.

 

 

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*Effect ofUnfavorable Publicity.*  TheCompany believes the dietary supplement market is significantly affected bynational media attention regarding the consumption of dietary supplements.Future scientific research or publicity may not be favorable to the dietarysupplement industry or to any particular product, and may not be consistentwith earlier favorable research or publicity. Because of the Company’sdependence on consumers’ perceptions, adverse publicity associated with illnessor other adverse effects resulting from the consumption of the Company’s productsor any similar products distributed by other companies and future reports ofresearch that are perceived as less favorable or that question earlier researchcould have a material adverse effect on the Company’s business, financialcondition and results of operations. The Company is highly dependent uponconsumers’ perceptions of the safety and quality of its products as well asdietary supplements distributed by other companies. Thus, the mere publicationof reports asserting that such products may be harmful or questioning theirefficacy could have a material adverse effect on the Company’s business,financial condition and results of operations, regardless of whether suchreports are scientifically supported or whether the claimed harmful effectswould be present at the dosages recommended for such products. For example,during 2001, reports were published questioning the efficacy of garlic, vitaminC, St. John’s Wort, ephedrine and other products manufactured and distributedby the Company. As a result of extremely negative publicity surroundingephedrine, product liability insurance coverage for the Company’s ephedrinebased products effectively disappeared. The Company has not been able to find product liability coverage forephedrine.  The lack of coverage mayaffect the willingness of retailers to sell ephedrine based products as well asthe willingness of consumers to purchase ephedrine based products.

 

*Dependence onNew Products.*  The Companybelieves growth of its net sales is substantially dependent upon its ability tointroduce new products. The Company seeks to introduce additional products eachyear. The success of new products is dependent upon a number of factors,including the Company’s ability to develop products that will appeal to consumersand respond to market trends in a timely manner. There can be no assurance thatthe Company’s efforts to develop new products will be successful or thatconsumers will accept the Company’s new products. During 2001, the Companyintroduced a number of new products and spent the majority of its televisionbudget to support the introduction of new products. Actual sales from newproducts amounted to 5.6% of gross sales in 2001.  New products can often take substantial periods of time todevelop consumer awareness, consumer acceptance and sales volume. Some newproducts fail and as a result have to be discontinued.  In addition,  products currently experiencing strong popularity and rapidgrowth may not maintain their sales volumes over time.

 

*ProductReturns.*  Product returnsare a recurring part of the Company’s business. Products may be returned forvarious reasons including expiration dates or lack of sufficient salesvelocity. The Company accrues a reserve for returns based on historical data.During 2001, returns amounted to approximately 12.8% of gross shipments.  While the Company is working to lessen theimpact of returns through better management of its SKU count at retailestablishments and more effective use of sales and marketing programs, there isno guarantee that future returns will not exceed the high levels experienced in2001 or will be in line with past return percentages experience prior to theyear 2000 when returns began to increase. Moreover, it is possible that currentreserves may be inadequate and that the Company could, at some future time,have to accept returns substantially larger in scope

 

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thanthose received in the past and that these returns could have a material adverseeffect on the Company’s business, financial condition and results ofoperations. The risk of returns is amplified by the current industry trend (see*IndustryTrends*) which shows negative growth. If this trend continues,retailers may decide to reduce inventory levels from their suppliers, includingNatrol, by returning goods from their warehouse distribution centers.

 

*DistributionGains.*  One of the Company’s primegoals has been to gain additional distribution in all channels of trade thatsell vitamins and supplements to consumers. The Company continues to seekadditional avenues to sell its products.   However, given current industry trends, particularly negative industrytrends within the mass market channel of trade as well as that channel’semphasis on private label to satisfy the broad scope of consumer demand, theCompany is now focused on ensuring the profitability of each item it sellswithin this class of trade.  Ensuringprofitability may require more focus on core products at the expense of lesswidely accepted secondary items.  Inorder to offset possible SKU reductions that may either voluntarily orinvoluntarily occur and to maintain or increase the Company’s growth rate, theCompany will have to increase the sale of core products within its channels ofdistribution as well as to increase distribution of its products into newretail outlets and ancillary channels of distribution. The Company’s failure tomake addition distribution gains or to maintain current distribution and expandsales of core product could have an adverse material effect on the Company’sbusiness, financial condition and results of operations.

 

*Cost of RetailRelationships.*  Many largeretailers demand various forms of incentive payments in order to conductbusiness with them. These payments include slotting fees, coop advertisingpayments, rebate incentives, price off promotions and other forms of support.The Company must continually evaluate specific demands to ascertain theprofitability of potential business from the retailer making the demand.Because of such demands, the Company may, depending upon the demands beingmade, ascertain that it cannot profitably do business with certain retailers.This may cause the Company to stop doing business with existing customers ornot allow the Company to enter into a business relationship with a potentialnew customer, each of which in turn could dampen future revenue growth.

 

 *Government Regulation.*  The manufacture, packaging, labeling,advertising, promotion, distribution and sale of the Company’s products aresubject to regulation by numerous governmental agencies which regulate theCompany’s products. The Company’s products are also subject to regulation by,among other regulatory entities, the Consumer Product Safety Commission (the “CPSC”),the U.S. Department of Agriculture (the “USDA”) and the EnvironmentalProtection Agency (the “EPA”) and the U.S. Food and Drug Administration (the“FDA”). Advertising and other forms of promotion and methods of marketing ofthe Company’s products are subject to regulation by the U.S. Federal TradeCommission (the “FTC”), which regulates these activities under the FederalTrade Commission Act (the “FTCA”). The manufacture, labeling and advertising ofthe Company’s products are also regulated by various state and local agenciesas well as those of each foreign country to which the Company distributes itsproducts.

 

The Company’s products are generally regulated as dietary supplementsunder the

 

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FDCA,and are, therefore, not subject to pre-market approval by the FDA. However,these products are subject to extensive regulation by the FDA relating toadulteration and misbranding. For instance, the Company is responsible forensuring that all dietary ingredients in a supplement are safe, and must notifythe FDA in advance of putting a product containing a new dietary ingredient(i.e., an ingredient not marketed for use as a supplement beforeOctober 15, 1994) on the market and furnish adequate information toprovide reasonable assurance of the ingredient’s safety. Furthermore, if theCompany makes statements about the supplement’s effects on the structure orfunction of the body, the Company must, among other things, have substantiationthat the statements are truthful and not misleading. In addition, the Company’sproduct labels must bear proper ingredient and nutritional labeling and theCompany’s supplements must be manufactured in accordance with current GoodManufacturing Practice regulations (“GMPs”) for foods. The FDA has issued anadvanced notice of proposed rulemaking to consider whether to develop specificGMP regulations for dietary supplements and dietary supplement ingredients.Such regulations, if promulgated, may be significantly more rigorous thancurrent requirements and contain quality assurance requirements similar to GMPsfor drug products. A product can be removed from the market if it is shown topose a significant or unreasonable risk of illness or injury. Moreover, if theFDA determines that the “intended use” of any of the Company’s products is forthe diagnosis, cure, mitigation, treatment or prevention of disease, theproduct would meet the definition of a drug and would require pre-marketapproval of safety and effectiveness prior to its manufacture and distribution.Failure of the Company to comply with applicable FDA regulatory requirementsmay result in, among other things, injunctions, product withdrawals, recalls,product seizures, fines and criminal prosecutions.

 

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

 

In recent years the FTC has initiated numerous investigations ofdietary supplement and weight loss products and companies. On November 18,1998, the FTC issued “Dietary Supplements: An Advertising Guide for Industry.”This guide provides marketers of dietary supplements with guidelines onapplying FTC law to dietary supplement advertising. It includes examples of theprinciples that should be used when interpreting and substantiating dietarysupplement advertising. Although the guide provides additional explanation, itdoes not substantively change the FTC’s existing policy that all supplementmarketers have an

 

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obligationto ensure that claims are presented truthfully and to verify the adequacy ofthe support behind such claims. The Company’s internal staff, in conjunctionwith outside counsel, reviews its advertising claims.

 

The Company is not currently a party to any investigation, consentorder or other decree of the FTC. The Company may be subject to investigationby the FTC in the future. If the FTC has reason to believe the law is beingviolated (e.g., the Company does not possess adequate substantiation forproduct claims), it can initiate enforcement action. The FTC has a variety ofprocesses and remedies available to it for enforcement, both administrativelyand judicially, including compulsory process authority, cease and desist ordersand injunctions. FTC enforcement could result in orders requiring, among otherthings, limits on advertising, consumer redress, divestiture of assets,rescission of contracts and such other relief as may be deemed necessary.Violation of such orders could result in substantial financial or otherpenalties. Any such action by the FTC could materially adversely affect theCompany’s ability to successfully market its products.

 

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

 

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

 

The Company may be subject to additional laws or regulations by the FDAor other federal, state or foreign regulatory authorities, the repeal of lawsor regulations which the Company considers favorable, such as the DietarySupplement Health and Education Act of 1994 (“DSHEA”), or more stringentinterpretations of current laws or regulations, from time to time in thefuture. The Company is unable to predict the nature of such future laws,regulations, interpretations or applications, nor can it predict what effectadditional governmental regulations or administrative orders, when and ifpromulgated, would have on its business in the future. They could, however,require the reformulation of certain products to meet new standards, the recallor discontinuance of certain products that cannot be reformulated, impositionof additional record keeping requirements, expanded documentation of theproperties of certain products, or expanded or different labeling or scientificsubstantiation. Any or all of these requirements could have a material adverseeffect on the Company’s business, financial condition and results ofoperations.

 

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*ProductLiability.*  The Company,like other retailers, distributors and manufacturers of products designed forhuman consumption, faces an inherent risk of exposure to product liabilityclaims in the event that the use of its products results in injury. The Companymay be subjected to various product liability claims, including, among others,that its products include inadequate instructions for use or inadequatewarnings concerning possible side effects and interactions with othersubstances. In addition, although the Company maintains strict quality controlsand procedures, including the quarantine and testing of raw materials andqualitative and quantitative testing of selected finished products, there canbe no assurance that the Company’s products will not contain contaminatedsubstances. In addition, in certain cases the Company relies on third partymanufacturers for its products. With respect to product liability claims, the Companyhas $2.0 million in aggregate liability insurance. If such claims shouldexceed $2.0 million, the Company has excess umbrella liability insuranceof up to $25.0 million. However, there can be no assurance that suchinsurance will continue to be available at a reasonable cost, or, if available,will be adequate to cover liabilities. When the Company renewed its productliability coverage during the year 2001, it was not able to renew or find newcoverage for its ephedrine-based products. The Company generally seeks toobtain contractual indemnification from parties supplying raw materials for itsproducts or manufacturing or marketing its products, and to be added as anadditional insured under such parties’ insurance policies. Any suchindemnification or insurance, however, is limited by its terms and any suchindemnification, as a practical matter, is limited to the creditworthiness ofthe indemnifying party. In the event that the Company does not have adequateinsurance or contractual indemnification, product liabilities relating to itsproducts could have a material adverse effect on the Company’s business,financial condition and results of operations.

 

*Dependence onSignificant Customers.*  Nocustomer during 2001 accounted for more than 10% of the Company’s business.However, the Company’s top 10 customers account for approximately 42% of theCompany’s business. There is no assurance that the Company’s major customerswill continue as major customers of the Company. The loss of a significantnumber of other major customers, or a significant reduction in purchase volumeby or financial difficulty of such customers, for any reason, could have amaterial adverse effect on the Company’s business, financial condition andresults of operations.

 

*Dependence onKey Personnel.*  The Companybelieves that its continued success depends to a significant extent on themanagement and other skills of Elliott Balbert, the Company’s Chairman, ChiefExecutive Officer and President, and its senior management team, as well as itsability to attract and retain other skilled personnel. The Company’s employeesare not covered by a non-competition agreement, and the ability of the Companyto enforce such an agreement in California, the state in which the Company’soperations are principally located, is limited and uncertain. The loss orunavailability of the services of Mr. Balbert or the other members of theCompany’s senior management team or the inability to attract other skilledpersonnel could have a material adverse effect on the Company’s business,financial condition and results of operations.

 

*Ability toManage Business Fluctuations.*  In reaction to current industry trends and the Company’sfinancial performance, the Company has reduced its workforce through attrition

 

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andlayoffs. Should such trends continue to be negative, the Company may have tofurther reduce its work force as well as various forms of overhead.  Moreover, in order to grow revenue andprofits, the Company may have to substantially alter its business strategywhich may include entering into new businesses or new avenues of distributionin which the Company lacks experience. And the Company may not be able to reduce expenses as rapidly as isnecessary to return to profitability in the immediate future. If corporate orindustry trends reverse themselves and the Company’s revenues begin to growmore rapidly, the Company’s management, operations, sales and administrativepersonnel and other resources may be strained in the short term. Given therecent negative industry trends, attracting, training, motivating, managing andretaining qualified employees may be difficult. The Company’s ability to managefurther growth depends in part upon the Company’s ability to expand itsoperating, management, information and financial systems, and productioncapacity, which may significantly increase its future operating expenses. Noassurance can be given that the Company’s business will grow in the future orthat the Company will be able to effectively manage such growth. Nor canassurance be given that if the Company’s core business erodes in line withrecent industry trends, the Company can stabilize its revenue and manage theCompany back to profitability in the short term. The Company’s inability tomanage its growth or negative growth successfully could have a material adverseeffect on the Company’s business, financial condition and results ofoperations.

 

*RisksAssociated with Acquisitions.*  The Company completed one acquisition in 1999, two acquisitionsin 1998, and, although no acquisitions were completed during 2000 or 2001, theCompany expects to pursue additional acquisitions and new businessopportunities in the future as a part of its business strategy. The Companyfaces significant competition for acquisition opportunities from numerouscompanies, many of which have greater financial resources than the Company.Accordingly, there can be no assurance that attractive acquisitionopportunities will be available to the Company. The Company’s line of credit(see *Liquidityand Capital Resources*) does not allow for acquisitions without theprior consent of its lender and there can be no assurance that the Company willbe able to obtain financing for or otherwise consummate any futureacquisitions. Moreover, acquisitions involve numerous risks, including the riskthat the acquired business will not perform in accordance with expectations,difficulties in the integration of the operations and products of the acquiredbusinesses with those of the Company, the diversion of the management’sattention from other aspects of the Company’s business, the risks associatedwith entering geographic and product markets in which the Company has limitedor no direct prior experience and the potential loss of key employees of theacquired business. The acquisition of another business can also subject theCompany to liabilities and claims arising out of such business.

 

The Company has faced allof these challenges with its acquisitions, in particular its acquisition ofProlab in October 1999. In 2001, the Company recorded a charge of $20million as a result of the impairment of Prolab.  While the Company continues to believe that the Prolab businessis an important part of the Company’s product mix, there can be no guaranteethat Prolab sales will increase or increase at rates that are satisfactory

 

Accounting rules and goodbusiness practice demand that the Company continually

 

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evaluatewhether events and circumstances have occurred indicating that any portion ofthe remaining balance of the amount allocable to the Company’s intangibleassets may not be recoverable. When factors indicate that the amount allocableto the Company’s intangible assets should be evaluated for possible impairment,the Company may be required to reduce the carrying value of such assets. Anyfuture determination requiring the write-off of a significant portion ofunamortized intangible assets could have a material adverse effect on theCompany’s business, financial condition and operating results.

 

Regardless of the potential problems surrounding an potentialacquisition, the Company regularly evaluates potential acquisitions of otherbusinesses, products and product lines and may hold discussions regarding suchpotential acquisitions. Future acquisitions would likely require additionalfinancing, which would likely result in an increase in the Company’sindebtedness or the issuance of additional capital stock, which may be dilutiveto the Company’s stockholders. As a general rule, the Company will publiclyannounce such acquisitions only after a definitive agreement has been signed.

 

*Absence ofConclusive Clinical Studies.*  Although many of the ingredients in the Company’s products arevitamins, minerals, herbs and other substances for which there is a longhistory of human consumption, some of the Company’s products containingredients for which no such history exists. In addition, although the Companybelieves all of its products are safe when taken as directed by the Company,there is little long-term experience with human consumption of a number ofthese product ingredients in concentrated form. Accordingly, there can be noassurance that the Company’s products, even when used as directed, will havethe effects intended or will not have harmful side effects. Any such unintendedeffects may result in adverse publicity or product liability claims which couldhave a material adverse effect on the Company’s business, financial conditionand results of operations.

 

*RisksAssociated with Supply of Raw Materials.*  The Company obtains all of its raw materials for the manufactureof its products from third-party suppliers. Many of the raw materials used inthe Company’s products are harvested internationally. With the exception ofbulk garlic, the Company does not have contracts with any suppliers committingsuch suppliers to provide the materials required for the production of itsproducts. In the last few years, natural vitamin E, beta carotene and Melatoninhave had significant price fluctuations as a result of short supply and/ orincreases in demand. The Company has experienced occasional shortages of rawmaterials for a limited number of its products. There can be no assurance thatsuppliers, including suppliers of bulk garlic and Ester-C(R), willprovide the raw materials needed by the Company in the quantities requested orat a price the Company is willing pay. Because the Company does not control theactual production of these raw materials, it is also subject to delays causedby interruption in production of materials based on conditions not within itscontrol. Such conditions include job actions or strikes by employees ofsuppliers, weather, crop conditions, transportation interruptions and naturaldisasters or other catastrophic events. During 1999, Basic Vegetable Products,the Company’s supplier of bulk garlic at that time, experienced work stoppagesdue to a strike as well as supply problems due to a poor harvest of garlicbulbs. With respect to products that are sold by the Company under thesupplier’s trademark, such as Ester-C(R), the Company is limited tothat single supplier as a source of raw material for that product. As a

 

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result,any shortage of raw materials from that supplier would adversely affect theCompany’s ability to manufacture that product. The inability of the Company toobtain adequate supplies of raw materials for its products at favorable prices,or at all, could have a material adverse effect on the Company’s business,financial condition and results of operations.

 

*Sales andEarnings Volatility.*  The Company’ssales and earnings continue to be subject to volatility based upon, among otherthings: (i) trends and general conditions in the dietary supplementindustry and the ability of the Company to recognize such trends andeffectively introduce and market new products in response to such trends;(ii) the introduction of new products by the Company or its competitors;(iii) the loss of one or more significant customers; (iv) increasedmedia attention on the use and efficacy of dietary supplements;(v) consumers’ perceptions of the products and operations of the Companyor its competitors;(vi) the availability of raw materials from suppliers(vii) the Company’s ability to accurately predict inventory needs so thatit does not overstock items which eventually must be written off due to lowdemand, or, that it fails to stock enough of an item so that sales are not lostdue to lack of supply. Sales and earnings volatility as a result of theforegoing factors may affect the Company’s operating results from period toperiod which may adversely affect the market price of the Common Stock.

 

*Possible Volatilityof Stock Price.*  There can be noassurance that an active market in the Company’s stock will be sustained. Thetrading price of the Common Stock has historically been subject to widefluctuations and daily trading volume is currently relatively low.

 

The price of the Common Stock may fluctuate in the future in responseto quarter-to-quarter variations in the Company’s operating results, materialannouncements by the Company or its competitors, governmental regulatoryaction, conditions in the dietary supplement industry, or other events orfactors, many of which are beyond the Company’s control. In addition, the stockmarket has historically experienced significant price and volume fluctuationswhich have particularly affected the market prices of many dietary supplementcompanies and which have, in certain cases, not had a strong correlation to theoperating performance of such companies. In particular, the stock market hasexperienced a significant downward trend in recent months primarily due to a generaldownturn in the overall economy. In addition, the Company’s operating resultsin future quarters may be below the expectations of securities analysts andinvestors. In such event, the price of the Common Stock would likely decline,perhaps substantially.

 

*RisksAssociated with Manufacturing.*  The Company’s results of operations are dependent upon thecontinued operation of its manufacturing facility in Chatsworth, California, atits current levels. The operation of dietary supplement manufacturing plantsinvolves many risks, including the breakdown, failure or substandardperformance of equipment, natural and other disasters, and the need to complywith the requirements of directives of government agencies, including the FDA.In particular, the Company’s manufacturing facility is located in southernCalifornia, a geographic area that has historically been prone to earthquakes,which in some cases have been catastrophic. Prior to the Company’s build-out ofthe building in which its manufacturing facility is located, the building wasseverely damaged in a major earthquake on January 17, 1994, the epicenterof which was within five

 

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milesof the building. Although the building was rebuilt with an enhanced ability towithstand earthquakes and conforms to current local and state coderequirements, the Company’s manufacturing facility could be damaged ordestroyed in the event of an earthquake. Any such damage or destruction wouldhave a material adverse effect on the Company’s business, financial conditionand results of operations. The Company does not carry earthquake insurance onits facilities. In addition, the Company’s softgel and liquid products, theLaci Le Beau tea products as well as all of Prolab’s non-tablet and capsuleproducts are manufactured by third party contractors. The Company’s profitmargins on these products and its ability to deliver these products on a timelybasis are dependent on the ability of the outside manufacturers to continue tosupply products that meet the Company’s quality standards in a timely andcost-efficient manner. The occurrence of any of the foregoing or other materialoperational problems could have a material adverse effect on the Company’sbusiness, financial condition and results of operations during the period ofsuch operational difficulties.

 

*InventoryRisk.*  The Company’s products aretested for stability and each product has associated with it an expiration dateafter which the product cannot be sold. Expiration dates can be as short as one year or, in some cases as longas three years.  In order to provide thefreshest product possible, the Company makes every attempt to produce producton a just-in-time basis.  However, assales trends change it is possible for the Company to over-produce finishedgoods inventory or to fail to use up raw material inventory before theexpiration dates of those raw materials. The Company regularly disposes of overstocked finished goods and expiredraw material inventory. Should sales trends change too rapidly or shouldmanufacturing planning be poor, the Company could be subject to large thannormal expenses for writing off inventory which would effect the  financial condition of the Company andresults of operations during the period in which larger than expected writedowns of inventory were to occur.

 

*Reliance onIndependent Brokers.*  The Companyplaces significant reliance on a network of independent brokers to act as itsprimary sales force to mass market retailers. Although the Company employsmanagement personnel, including regional sales managers, to closely monitor thebrokers, such brokers are not employed or otherwise controlled by the Companyand are generally free to conduct their business at their own discretion. Althoughthese brokers enter into contracts with the Company, such contracts typicallycan be terminated upon 30 days notice by the Company or the independentbroker. The simultaneous loss of the services of a number of these independentbrokers could have a material adverse effect on the Company’s business,financial condition and results of operations

 

*IntellectualProperty Protection.*  The Company’spolicy is to pursue registrations for all of the trademarks associated with itskey products. The Company relies on common law trademark rights to protect itsunregistered trademarks as well as its trade dress rights. Common law trademarkrights generally are limited to the geographic area in which the trademark isactually used, while a United States federal registration of a trademarkenables the registrant to stop the unauthorized use of the trademark by anythird party anywhere in the United States. The Company intends to register itstrademarks in certain foreign jurisdictions where the Company’s products aresold. However, the protection available, if

 

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any,in such jurisdictions may not be as extensive as the protection available tothe Company in the United States.

 

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

 

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

 

**ITEM 2. PROPERTIES**

 

In December 1998, the Company purchased, for $5.25 million,the 90,000 square foot manufacturing, distribution and office facility inChatsworth, California it had been leasing. The Company has occupied thisfacility since March 1997. The facility was designed and constructed to theCompany’s specifications and includes areas for receiving, quarantine of newmaterials, manufacture, quality control and laboratory activities, research anddevelopment, packaging, warehousing and administrative offices.

 

In December 1999, the Company purchased a 132,000 square footwarehouse facility for $7.2 million. This facility is located withinone-quarter mile of the Company’s headquarters facility. The Company leases52,000 sq. ft. of this space to a third party. The Company also owns a 25,000 sq. ft. light manufacturing and warehousefacility which houses its Prolab operations in Connecticut.

 

**ITEM 3.  LEGALMATTERS**

 

From time to time the Company is subject to litigation incidental toits business, including possible product liability claims. Such claims, ifsuccessful, could exceed applicable insurance coverage.

 

The Company is not currently a party to anymaterial legal proceedings.

 

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

 

During the fourth quarter of the calendar year 2001, no matters weresubmitted to a vote of the security holders of the Company.

 

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**PART II**

 

**ITEM 5.  MARKETFOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

 

### *PRICE RANGE OF COMMON STOCK*

 

The Common Stock of the Company has traded on the NASDAQ NationalMarket under the symbol “NTOL” since the Company’s initial public offering(“IPO”) in July 1998, in which 3,200,000 shares of Common Stock wereissued and sold by the Company. The Company sold an additional 295,500 sharesin connection with the underwriter’s exercise of their over-allotment option inthe IPO**.**Prior to the IPO, there was no market for the Common Stock**.**On March 15, 2002,  the lastreported sales price of the Company’s Common Stock as reported on the NASDAQNational Market was $1.80**.**As of March 15, 2002****therewere 27 holders of record of the Company’s Common Stock.

 

The high and lowsales closing prices for the Common Stock as reported by the NASDAQ NationalMarket for the years ended December 31, 2001 and 2000 are set below:

 
|                              |   | **Fiscal  year ended  December 31, 2001** |   |
|-----------------------------------|--------|-------------------------------------------|--------|
|                              |   | **High**                                  |   | **Low** | ** ** |
| Quarter ended March 31, 2001      |   | $                                         | 2.06   |   | $ | 1.31 |   |
| Quarter ended June 30, 2001       |   | 2.35                                      |   | 1.25 |   |
| Quarter ended September 30,  2001 |   | 4.20                                      |   | 2.14 |   |
| Quarter ended December 31,  2001  |   | 3.40                                      |   | 2.35 |   |
|                                   |        |                                           |        |  |  |  |  |

 
|                             |   | **Fiscal year ended  December 31, 2000** |   |
|----------------------------------|--------|------------------------------------------|--------|
|                             |   | **High**                                 |   | **Low** | ** ** |
| Quarter ended March 31, 2000     |   | $                                        | 8.94   |   | $ | 5.03 |   |
| Quarter ended June 30, 2000      |   | 5.63                                     |   | 3.25 |   |
| Quarter ended September 30, 2000 |   | 3.38                                     |   | 1.94 |   |
| Quarter ended December 31, 2000  |   | 2.50                                     |   | 1.06 |   |
|                                  |        |                                          |        |  |  |  |  |

 

*DIVIDENDPOLICY*

 

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

 

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**ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA**

 

The following selected financial data is derived from the consolidatedfinancial statements of Natrol, Inc. and subsidiaries, which have beenaudited by Ernst & Young LLP, independent auditors. The data set forthbelow should be read in conjunction with “Management’s Discussion and Analysisof Financial Condition and Results of Operations” and the ConsolidatedFinancial Statements of the Company and Notes thereto included herein.

 
|                                             |   | **Year Ended December 31,**              |   |
|--------------------------------------------------|--------|------------------------------------------|--------|
|                                             |   | **1997**                                 |   | **1998** |   | **1999** |   | **2000** |   | **2001** |   |
|                                             |   | **(in thousands except per share data)** |   |
| **Consolidated Statements of Operations Data:**  |   |                                     |   |   |   |   |   |   |   |   |   |
| Net sales                                        |   | $                                        | 42,875 |   | $ | 68,207 |   | $ | 81,590 |   | $ | 87,089 |   | $ | 76,161 |   |
| Cost of goods sold                               |   | 19,800                                   |   | 32,012 |   | 39,850 |   | 49,934 |   | 42,063 |   |
| Gross profit                                     |   | 23,075                                   |   | 36,195 |   | 41,740 |   | 37,155 |   | 34,098 |   |
| Selling and marketing expenses                   |   | 11,398                                   |   | 17,757 |   | 18,916 |   | 32,293 |   | 22,625 |   |
| General and administrative expenses              |   | 4,450                                    |   | 6,513 |   | 8,542 |   | 11,216 |   | 10.490 |   |
| Reduction in goodwill                            |   | —                                   |   | — |   | — |   | — |   | 20,000 |   |
| Total operating expenses                         |   | 15,848                                   |   | 24,270 |   | 27,458 |   | 43,509 |   | 53,115 |   |
| Operating income(loss)                           |   | 7,227                                    |   | 11,925 |   | 14,282 |   | (6,354 | ) | (19,017 | ) |
| Interest income (expense), net                   |   | (220                                     | )      | 197 |   | 538 |   | (1,231 | ) | (736 | ) |
| Income (loss) before income tax provision        |   | 7,007                                    |   | 12,122 |   | 14,820 |   | (7,585 | ) | (19,753 | ) |
| Income tax provision (benefit)                   |   | 2,816                                    |   | 4,606 |   | 5,632 |   | (2,369 | ) | 587 |   |
| Net income (loss)                                |   | $                                        | 4,191  |   | $ | 7,516 |   | $ | 9,188 |   | $ | (5,216 | ) | $ | (20,340 | ) |
| Basic earnings (loss) per share                  |   | $                                        | 0.59   |   | $ | 0.76 |   | $ | 0.69 |   | $ | (0.39 | ) | $ | (1.59 | ) |
| Diluted earnings (loss) per share                |   | $                                        | 0.41   |   | $ | 0.63 |   | $ | 0.67 |   | $ | (0.39 | ) | $ | (1.59 | ) |
| Weighted average shares outstanding–basic   |   | 7,100                                    |   | 9,854 |   | 13,325 |   | 13,237 |   | 12,783 |   |
| Weighted average shares outstanding–diluted |   | 10,273                                   |   | 11,891 |   | 13,638 |   | 13,237 |   | 12,783 |   |

 
|                                      |   | **December 31,**                         |   |
|-------------------------------------------|--------|------------------------------------------|--------|
|                                      |   | **1997**                                 |   | **1998** |   | **1999** |   | **2000** |   | **2001** |   |
|                                      |   | **(in thousands except per share data)** |   |
| **Consolidated Balance Sheet Data:**      |   |                                     |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                 |   | $                                        | 1,800  |   | $ | 559 |   | $ | 485 |   | $ | 4,004 |   | $ | 5,485 |   |
| Marketable securities                     |   | —                                   |   | 19,010 |   | — |   | — |   | — |   |
| Working capital                           |   | 8,424                                    |   | 35,673 |   | 19,626 |   | 15,399 |   | 18,190 |   |
| Total assets                              |   | 19,716                                   |   | 68,708 |   | 92,596 |   | 87,921 |   | 59,357 |   |
| Long-term debt, less current maturities   |   | 2,606                                    |   | — |   | 8,700 |   | 8,369 |   | 8,083 |   |
| Convertible participating preferred stock |   | 12,000                                   |   | — |   | — |   | — |   | — |   |
| Total stockholders’ equity (deficit) |   | (1,564                                   | )      | 59,641 |   | 69,986 |   | 62,892 |   | 42,640 |   |
|                                           |        |                                          |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

 

*The followingdiscussion of the results of operations and financial condition of the Companyshould be read in conjunction with the “Selected Consolidated Financial Data”and the audited Consolidated Financial Statements of the Company and the notesthereto included elsewhere in this document.*

 

**OVERVIEW**

 

Natrol’s core business is the manufacturing and marketing of branded,high-quality dietary supplements.

 

The Company sells its core products under the Natrol brand name throughmultiple distribution channels throughout the United States, including domestichealth food stores and mass market drug, retail and grocery store chains.

 

In addition to the core brand, Natrol sells herbal teas under the LaciLe Beau brand name within the same channels of trade as the Natrol core brand.The Company also markets sports nutrition products under the Prolab brand name.Prolab products are sold primarily in the health food store channel of trade aswell as health clubs and gyms and internationally in select countries throughinternational distributors. The Company acquired the Laci Le Beau brand of teasin October 1998 and the Prolab sports nutrition line of products inOctober 1999.

 

Another aspect of the Company’s business is the marketing ofnutraceutical grade raw materials, primarily garlic and other vegetable powdersto other manufacturers of nutritional supplement products.

 

The Company also manufactures certain products pursuant to contractswith customers who distribute the products under their own private labels. TheCompany’s strategy with respect to private label sales is to take advantage ofits excess manufacturing capacity by offering to manufacture products for othervendors. The Company does not foresee adding capacity in order to meet privatelabel demand.

 

Natrol products are broadly distributed and are visible to some degreein most mass market chain drug retail outlets such as *Walgreens, Rite Aid, Walmart, Eckerd,CVS,* and *Target,* most health food stores including *GNC, WholeFoods Markets,* and *Wild Oats* and, to a more limited degree,grocery stores such as *Albertson*’s and *Ralphs.*

 

During 2001, the market for nutritional supplements was verycompetitive and industry data for the mass market channel of trade whichaccounts for approximately 63.8% of the Company’s branded Natrol/Laci Le Beaubusiness and 42.9% of the Company’s total business was negative. InformationResources, Inc. (“IRI”) tracks sales data within the food, drug, and massmarket channels of distribution. For the 52 weeks ending January 6, 2002,vitamin and supplement sales in these channels of distribution fell 4.2% whencompared to

 

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thesame period a year earlier.  Dependabledata for the Company’s health food channel of trade is not readily availablebut anecdotal evidence suggest that industry-wide sales in this channel oftrade decreased as well.

 

In this negativeenvironment, the Company was not able to grow its business during 2001.  In this environment, major retail outletswere not as willing as in past years to promote vitamins, minerals andsupplements (VMS) as they had in the past. Many retailers reduced the amount of shelf space devoted to the VMSsector and retailers in general demanded higher levels of promotional support fromvendors of VMS product.

 

In past years,Natrol’s growth was supported by increased penetration of its core mass marketand health food channels of trade as well as by new product introduction.  During 2001, the Company was not able toincrease its overall presence within its channels of trade.  Faced with increased competition from othervendors and private label “house” brands which have been strongly supported bythe Company’s largest mass market customers, the Company, in a number ofinstances, reduced the number of items on the shelves of its customers,deleting slow unprofitable items.

 

During 2001, the Company introduced approximately a dozen new productsor product line extensions which accounted for approximately 5.6% of theCompany’s gross sales. The Company’s leading product introduction was Flexanew,a new joint care product.

 

The Company has also grown through acquisitions, completing two in 1998and one in 1999. Each acquisition introduced the Company to a new line ofbusiness. The Essentially Pure Ingredient (EPI) supply business, acquired inearly 1998, accounted for 7.2% of the Company’s gross sales in 2001. The LaciLe Beau tea business, also acquired in 1998, accounted for approximately 7.2%of the Company’s gross sales in 2001. Prolab, which was acquired at thebeginning of the fourth quarter of 1999, accounted for 22.4% of the Company’sgross sales during the year 2001.

 

Industry trends during the year 2001 were negative for the secondsuccessive year and, although the Company did increase its business withcertain customers, the Company did not gain a volume of new distribution withany particular customer and volume with some customers declined, leading to areduction of net sales. The Company also failed to introduce any single new productthat contributed materially to the growth of its revenues. No acquisitions weremade in the year 2001.

 

Product returns are a recurring part of the Company’s business.Products may be returned for various reasons including expiration dates or lackof sufficient sales velocity. The Company accrues a reserve for returns basedon historical data. During 2001, returns amounted to approximately 12.8% ofgross shipments.  While the Company isworking to lessen the impact of returns through better management of its SKUcount at retail establishments and more effective use of sales and marketingprograms, there is no guarantee that future returns will not exceed the highlevels experienced in 2001 or will be in line with past return percentagesexperience prior to the year 2000 when returns began to increase. Moreover, itis possible that current reserves may be inadequate and that the

 

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Companycould, at some future time, have to accept returns substantially larger inscope than those received in the past and that these returns could have amaterial adverse effect on the Company’s business, financial condition andresults of operations. The risk of returns is amplified by the current industrytrend (*see ITEM 1-  RISK FACTORS AND FACTORS AFFECTING FORWARD LOOKING STATEMENTS**-IndustryTrends*) which shows negative growth. If this trend continues,retailers may decide to further reduce inventory levels from their suppliers,including Natrol, by returning goods from their warehouse distribution centers.

 

*ACQUISITIONS  OF PROLAB IN 1999 AND GOODWILL WRITE DOWN*

 

In October, 1999, the Company purchased all of the stock of ProlabNutrition, Inc. (Prolab) for $28,500,000 in cash and 124,270 shares ofCommon Stock. Prolab is a formulator, packager and marketer of sports nutritionproducts for body builders and health minded individuals through gyms, healthfood stores and other outlets both domestically and internationally. Includedin the purchase price were assets, consisting of cash of $2,259,722, tradeaccounts receivables of $3,667,046, inventories of $2,063,180, fixed assets of$1,125,280 and other assets of $623,054, and liabilities assumed consisting ofaccounts payable of $3,667,832, accrued expenses of $2,033,960 and debt of$763,836. The acquisition was accounted for using the purchase method, andaccordingly, the acquired assets and liabilities assumed are recorded at theirestimated fair values with revenues and expenses from the date of acquisitionincluded in the consolidated statement of operations.  The excess of cost over the fair value of net assets acquired, orgoodwill, of approximately $27 million was being amortized over twenty yearsthrough the end of 2001. After reviewing 2001 and prior year financial results,the Company wrote off $20 million of the goodwill associated with the Prolabacquisition as an impairment charge to operating earnings. The Company did soafter carefully weighing current market conditions, historical cash flows andestimating future cash flows of the Prolab business.

 

CRITICALACCOUNTING POLICIES

 

Theconsolidated financial statements of the Company are prepared in accordancewith accounting principles generally accepted in the United States, whichrequires the Company to make certain estimates and assumptions affecting thereported amounts in the consolidated financial statements and accompanyingnotes. The Company bases its estimates on historical experience and on variousother assumptions believed to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results may differ from these estimates under different assumptions orconditions.

 

Managementbelieves the following critical accounting policies, among others, affect itsmore significant judgments and estimates used in the preparation of itsconsolidated financial statements.

 

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*RevenueRecognition.*The Company sells its products to retail outlets througha direct sales force and a national broker network. The Company recognizesrevenue from sales only after product is shipped.  Net sales represent products shipped less returns, estimates forfuture returns, spoilage allowances, allowances for product deemed to beunsaleable by customers, and free goods shipped to customers for promotional orother purposes. Estimates and allowances are based upon known claims and anestimate of additional returns.

 

Effective January 1, 2002 the Company adopted the Financial AccountingStandards Board’s (FASB) Emerging Issues Task Force (EITF) Issue No. 01-9“Accounting for Consideration Given by a Vendor to a Customer or Reseller ofthe Vendor’s Products, which codified and reconciled the consensus reached onEITF Issue No. 00-14, “Accounting for Certain Sales Incentives,” EITF Issue No.00-22 “Accounting for ‘Points’ and Certain Other Time-Based or Volume BasedSales Incentive Offers, and Offers of Free Products or Services to be Deliveredin the Future,” and EITF Issue No. 00-25 “Vendor Income StatementCharacterization of Consideration Paid to a Reseller of the Vendor’sProducts.”  The guidance in these Issuesis to be applied for financial statements for any period beginning afterDecember 15, 2001. Under this pronouncement, slotting fees, rebates, pricereduction scanbacks and miscellaneous other expense items which in effectreduce the cost of product to the Company’s customers must be deducted fromgross sales revenue when calculating net sales revenue. In 2001, the Companyincurred approximately $4.2 million of these expenses and recorded them asselling expenses. Had the Company accounted for these expendituresretroactively according to the new guidance in these pronouncements, net salesand selling expenses would have each been reduced by $4.2 million in 2001.

 

*Inventories*. Inventories arecarried at the lower of cost (first-in, first-out method) or market. TheCompany tracks the expiration dates of its inventory and regularly writes offraw material and finished goods inventory that is reaching its expirationdate.  The Company also regularly testsits inventory in relation to sales trends and its policy is to write offproduct that it deems cannot be sold in a timely manner.

 

*Long-LivedAssets.*****The Company reviewsfor the impairment of long-lived assets and certain identifiable intangibleswhenever events or changes in circumstances indicate that the carrying amountof any asset may not be recoverable. An impairment loss would be recognizedwhen the estimated undiscounted future cash flows expected to result from theuse of the asset and its eventual disposition is less than the carrying amount.If an impairment is indicated, the amount of the loss to be recorded is basedon an estimate of the difference between the carrying amount and the fair valueof the asset. Fair value is based upon discounted estimated cash flows expectedto result from the use of the asset and its eventual disposition and othervaluation methods.

 

In June 2001, the FASB issued Statement of Financial AccountingStandards (SFAS) No. 142, “Goodwill and Other Intangible Assets.” SFAS 142prohibits the amortization of goodwill and intangibles with indefinite usefullives and requires these assets to be reviewed for impairment at leastannually. Intangible assets with finite lives will continue to be amortizedover their estimated useful lives. The Company will apply SFAS 142 in the firstquarter of fiscal 2002 and application of the nonamortization provisions of

 

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thisstandard is expected to result in an increase in net income of $821,000 in2002. SFAS 142 requires testing of goodwill impairment under a two-stepprocess. The first step is screen for potential impairment, while the secondstep measures the amount of impairment, if any.

 

During 2001, the Company reviewed the goodwill associated with its LaciLe Beau, EPI, and Prolab acquisitions. The Company measured the valuation of the unamortized goodwillassociated with these acquisitions relative to the market capitalization of theCompany as a whole, relative to the undiscounted cash flows produced by theseentities as well as potential future discounted cash flows with these cashflows being discounted by a required rate of return that took into account therisk-free rate of return as measured by the 20-year long bond rate of return aswell as other measures of risk such as the Company’s small capitalization, riskassociated with market size, volatility, historical cash flows and earnings,depth of management and other measures.

 

After the review, the Company determined that the unamortized goodwillassociated with its Laci Le Beau acquisition was not impaired.  It further determined that in accordancewith SFAS 142 nowrite down of this goodwill would be necessary in 2002 unless conditionssurrounding this division’s performance change substantially.  In 2001, the Company amortized $340,000relative to goodwill associated with its acquisition of Laci Le Beau.

 

The Company nextdetermined that the unamortized goodwill associated with its acquisition of EPIwas also not impaired.  However, theCompany also determined that due to the nature of its supply agreement withConAgra which expires in approximately six years and the fact that ConAgra isEPI’s major source of supply for the majority of its business, the goodwillrecorded related to the intangible value of the favorable terms of the contractacquired. As such, this intangible will be separated from goodwill once SFAS142 is adopted and continue to be amortized at the rate of $600,000 per year,consistent with the amount of goodwill amortized for EPI in 2001.

 

With respect tothe Prolab acquisition, the Company determined that it was appropriate to writedown associated goodwill by $20 million. The Company considered all of thefactors mentioned above but focused on the Company’s declining sales volume,issues surrounding Prolab’s ephedrine-based products, the Sports Nutritionmarket as a whole, and undiscounted cash flows.  Based on all of these considerations, the Company deemed that inaccordance with current accounting rules a $20 million write down of goodwillwas appropriate.  In addition, theCompany reviewed Prolab and future expectations in accordance with SFAS142.  The Company does not believe thata further write down of goodwill is will be necessary during 2002.  However, in accordance with SFAS 142, theCompany will review the valuation of all of its goodwill during 2002 and itcannot guarantee that a further reduction of Prolab’s goodwill or a reductionof Laci Le Beau’s or EPI’s goodwill in addition to what has been described willnot be necessary.

 

36

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**RESULTS OF OPERATIONS**

 

***YearEnded December 31, 2001 Compared to Year Ended December 31, 2000***

 

*Net revenue.*  Net revenue in 2001 decreased 12.5%, or$10.9 million, to $76.2 million from $87.1 million in 2000. Net sales inthe year 2001 and 2002 were adversely affected by a very high level of productreturns. The level of returns was approximately 12.8% of gross sales in 2001and 10% of gross sales in 2000, levels that are approximately three timeshigher than that experienced by the Company in prior years. The Company believesthis rate of returns was caused by negative industry trends which causedretailers to decrease warehouse stocking levels and in some cases to reduce theamount of shelf space devoted to vitamins as well as to the failure of certainproducts introduced during 1998 and 1999 to gain popularity with consumers. TheCompany cannot predict when or if these high rate of returns will decrease.

 

Only one line of products, the MSM-line of joint care products with10.2% of gross sales, accounted for more than 10% of the Company’s gross salesin 2001 and no customer accounted for more than 10% of sales although theCompany’s top ten customers accounted for approximately 42% of grossrevenue.  During 2001, the Company introducedapproximately 12 new products which account for approximately 5.6% of grosssales.

 

*Gross profit.*  Gross profit decreased 8.2%, or$3.1 million, to $34.1 million, in 2001 as compared to$37.2 million in 2000. Gross margin increased to 44.8% in 2001 from 42.7%in 2000. The increase was mainly due to product mix, an emphasis on the salesof products that carry better margins, and an effort to control discounting ofproduct.

 

*Selling andmarketing expenses.*  Selling andmarketing expenses decreased 29.9%, or $9.7 million, to $22.6 million in 2001from $32.3 million in 2000. As a percentage of net sales, selling andmarketing expenses decreased to 29.7% in 2001 from 37.1% in 2000, which was thehighest in the Company’s history. After experiencing the highest selling andmarketing expenses in its history in 2000, the Company focused on reducingthese expenditures in 2001.  Advertisingexpenditures in both traditional media as well as coop advertising contractswere reduced sharply.  Even so, theCompany was forced to spend heavily on various promotions in order to supportsales in a declining market.  While theCompany continues to attempt to control the level of its selling and marketingexpenditures, the Company cannot predict the absolute effect of reducing salesand marketing expenditures on future sales.

 

*General andadministrative expenses.*  Generaland administrative expenses decreased 6.5% or $726,000 , to$10.5 million in 2001 from $11.2 million in 2000. As a percentage ofnet sales, general and administrative expenses increased to 13.8% in 2001 from12.9% in 1999. The reason for the percentage increase in general andadministrative expenses is the 12.5% decline in net sales which outweighed the6.5% decline in general and administrative expenses. The Company continues totry and manage general and administrative expenses which are relatively fixedin nature through greater efficiency in its management processes.

 

*Reduction in goodwill. *During 2001, the Company wrote off $20 million of the goodwillassociated with the acquisition of Prolab as an impairment charge to operatingearnings after carefully weighing current market conditions, historical cashflows and estimating future cash flows. No such reductions were recorded orrequired during 2000.

 

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*Interestincome (expense), net.*  Netinterest expense for 2001 was $737,000 versus net interest expense of $1.2million in 2000. Interest income in 2001 amounted to $149,000 versus $146,000in 2000. Interest expense fell in 2001 because, for most of the year, theCompany had no borrowings on its line of credit. A substantial portion of theinterest expense paid during 2000 stemmed from the Company’s borrowings underits line of credit which averaged $7.5 million for the year ended December 31,2000.

 

*Income taxprovision (benefit).*  The Company isestimating a net income taxes of $587,000 in 2001.  Expenses taken for the amortization and write-off of Prolabgoodwill were not tax deductible in 2001. In 2000, the Company received a benefit of $2.4 million. TheCompany obtained the net benefit because of the operating losses it incurred.

 

***YearEnded December 31, 2000 Compared to Year Ended December 31, 1999***

 

*Net revenue.*  Net revenue in 2000 increased 6.7%, or$5.5 million, to $87.1 million from $81.6 million in 1999.However $21.2 million of the Company’s sales were generated by Prolabwhich was acquired in October 1999. Sales generated by Prolab amounted to$4.8 million during the last quarter of 1999, the only period in which theCompany owned Prolab during 1999. Excluding Prolab, net sales of the Companywere $65.9 million in 2000 as compared to $76.8 million in 1999.

 

Net sales in the year 2000 were adversely affected by a very high levelof product returns. The level of returns was approximately 10% of gross sales,a level that is approximately three times higher than that experienced by theCompany in prior years. The Company believes this rate of returns was caused byindustry trends which caused retailers to decrease warehouse stocking levels aswell as the failure of certain products introduced during 1998 and 1999 to gainpopularity with consumers. The Company cannot predict when or if this high rateof returns will decrease.

 

Only one line of product, MSM joint care products, which accounted forapproximately 13.4% of revenue, accounted for more than 10% of the Company’srevenue. No other product line accounted for more than 10% of the Company’srevenues in 2000.

 

*Gross profit.*  Gross profit decreased 11.0%, or$4.6 million, to $37.2 million, in 2000 as compared to$41.7 million in 1999. The gross margin decreased sharply to 42.7% in 2000from 51.2% in 1999. The decrease was due primarily to the heavy returns as wellas the percentage of the Company’s business generated by Prolab. The grossprofit percentage from Prolab products is approximately one-third less than forthe rest of the Company’s business. Returns are deducted from gross sales whencalculating net revenue. In a majority of instances, the product returned isclose to expiration and as such has no value. The original cost of goods ofthis returned product must then be included in the overall cost of goodscalculation which in turn increases cost of goods and decreases the grossmargin. Before accounting for returns and the change in the Company’s productmix due to the Prolab acquisition, the Company’s gross margin percentage wasapproximately the same as that of prior years.

 

38

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*Selling andmarketing expenses.*  Selling andmarketing expenses increased 70.7%, or $13.4 million, to$32.3 million in 2000 from $18.9 million in 1999. As a percentage ofnet revenue, selling and marketing expenses increased to 37.1% in 2000 from23.2% in 1999, the highest in the Company’s history. The increase was due to anincreased volume of incentive payments such as slotting and coop advertisingwith major retailers. These expenses were amplified by the general downturn inthe industry as the Company created incentives for retailers to stimulate salesat the consumer level though price off and other promotions. The Companyprovided these incentives in an effort to maintain market share and toforestall warehouse returns from these same retailers that it believes wouldhave been more costly.

 

*General andadministrative expenses.*  Generaland administrative expenses increased 31.3%, or $2.7 million, to$11.2 million in 2000 from $8.5 million in 1999. As a percentage ofnet sales, general and administrative expenses increased to 12.9% in 2000 from10.5% in 1999. Of the absolute dollar increase, $1.2 million was due toincreased administration costs recorded at Prolab during 2000 and$1.0 million was due to increased goodwill amortization recorded from theProlab acquisition. Prolab was acquired in October 1999 and, as such, theCompany recorded one quarter of Prolab’s expenses in 1999 as compared with afull year of expenditures in 2000. Of the remaining $500,000 increase ingeneral and administrative expenses in the year 2000, $336,500 was due toadditional depreciation. Approximately half of the additional depreciation wasdue to the acquisition of the Company’s shipping facility inDecember 1999.

 

*Interestincome (expense), net.*  Netinterest expense for 2000 was $1.2 million for 2000 versus net interestincome of $537,000 in 1999. Interest earned in 2000 amounted to $146,000 versus$804,000 in 1999. A portion of the interest earned was taxable as income to theCompany and a portion was non-taxable. Interest expense in 2000 was due tomortgage debt and an average balance of approximately $7.5 million underthe Company’s line of credit. Substantially all of the interest expense paidduring 1999 stemmed from the Company’s mortgage debt because the Company hadminimal borrowings under its line of credit.

 

*Income tax provision(benefit).*  The Company isestimating a net income tax benefit of $2.4 million in 2000 as comparedwith a net income tax provision of $5.6 million in 1999. The Companyobtained the net benefit because of the operating losses it incurred.

 

**LIQUIDITY ANDCAPITAL RESOURCES**

 

At December 31, 2001, the Company had working capital of$18.2 million, as compared to $15.4 million in working capital atDecember 31, 2000. The increase was primarily due to a decrease in the inthe Company’s line of credit borrowings, an increase in cash and prepaidexpenses offset by a decreases in accounts receivable, inventory and income taxreceivables as well as an increase in accounts payable.

 

Net cash provided in operating activities was $10.3 million for theyear ended December 31, 2001 versus net cash used of $151,000 and net cashprovided of $6.8 million in 2000 and 1999, respectively. The increase innet cash provided by operating activities in

 

39

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2001was primarily due to differences in the nature of the net losses experienced ineach year.  In 2001, the Company’s netloss was $20.3 million.  However, duringthe year, the Company wrote down $20 million of goodwill associated with itsacquisition of Prolab.  The write downof goodwill is a non-cash expense.  In2000, the Company’s loss was $5.2 million. In 2001, the Company also reduced inventory, accounts receivable andincome taxes receivable by $7.5 million. Normal depreciation of property, plant and equipment and amortization ofgoodwill comparable to that taken in prior years  provided an additional $3.7 million of operating cash flow.  Offsetting these items in 2001, were a netincrease in prepaid expenses and a decrease of payables and accruedexpenditures of $757,000.

 

At December 31, 2001, the Company’s average trade receivable agingwas approximately 33 days versus 2000 when the average receivable agingwas 40 days.

 

In 2000, cash fromoperating activities was negatively affected by a decrease in trade payables andother accruals of $3.8 million, from $11.6 million at year end 1999to $7.8 million at December 31, 2000. The Company’s large loss alsocreated a net income tax receivable of $4.1 million at December 31,2000 as compared with a net income tax payable of $181,000 at December 31,1999. This receivable reduced cash from operating activities by$4.3 million.

 

The decrease in net cash provided by operating activities in 2000compared to 1999 was primarily due the Company’s net loss, an increase inincome tax receivables, and a decrease in accounts payable offset by a decreasein accounts receivable, a decrease in inventories and an increase indepreciation and amortization. In reaction to industry trends in 2000, theCompany began to actively reduce its inventory levels from $15.1 millionat December 31, 1999 to $12.2 million at December 31, 2000. TheCompany also actively reduced trade receivables which fell to $9.6 millionat December 31, 2000 from $15.8 million at December 31, 1999. AtDecember 31, 2000, the Company’s average trade receivable aging wasapproximately 40 days versus 1999 when the average receivable aging was55 days. Amortization of goodwill grew to $2.3 million atDecember 31, 2000 from $1.3 million at December 31, 1999 due tothe amortization of goodwill incurred through the Prolab acquisition.Depreciation grew from $1.1 million in 1999 to $1.4 million in 2000due to the acquisition of the Company’s shipping facility in December 1999 andthe acquisition of other assets needed in the operation of the Company’sbusiness. Cash from operating activities was negatively affected by a decreasein trade payables and other accruals of $3.8 million, from$11.6 million at year end 1999 to $7.8 million at December 31,2000. The Company’s large loss also created a net income tax receivable of$4.1 million at December 31, 2000 as compared with a net income taxpayable of $181,000 at December 31, 1999. This receivable reduced cashfrom operating activities by $4.3 million.

 

Net cash used in investing activities was $379,000 for the year ended2001 and $588,000 and $16.9 million for the years ended 2000 and 1999,respectively.

 

All of the cash used for investing activities in 2001 and 2000 was forthe acquisition of property, plant and equipment.

 

Of the net cash used in investing activities in 1999, the Company used$26.6 million 

40

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toconsummate the acquisition of Prolab, $7.2 million was used to purchase awarehouse/shipping facility and $2.1 million was invested in plant andequipment and $19.0 million in marketable securities was liquidated.

 

Net cash used by financing activities was $8.5 million for theyear ended December 31, 2001 as opposed to net cash provided by financingactivities of  $4.3 million and$10.0 million in 1999 and 1998, respectively.

 

Of the net cash used infinancing activities in 2001, $8.3 million was used to pay down the Company’sline of credit and $265,000 was used to reduce the Company’s long-term mortgageborrowings. The Company raised $80,000 through the sale of stock to employeesvia the Company’s employee stock purchase plan and the exercise of stockoptions granted under the Company’s stock option plan.

 

Net cash provided by financing activities in the year endedDecember 31, 2000 consisted primarily of $6.5 million of netborrowing from the Company’s line of credit. The remainder of the cash providedwas generated from the sale of Common Stock to employees through the Company’semployee stock purchase program and the exercise of stockholder options. Cashprovided by financing activities was offset by $2.3 million of cash usedto repurchase Company stock on the open markets and $236,000 used to repaylong-term debt.

 

Net cash provided by financing activities in the year ended December 31,1999 consisted of $8.9 million of mortgage debt assumed in connection withthe purchase of the Company’s headquarters’ facility and the Company’swarehouse and shipping facility, each of which was financed during 1999 as wellas $1.8 million of net borrowing from the Company’s line of credit. Theremainder of cash provided was generated from the sale of Common Stock toemployees through the Company’s employee stock purchase program, the exerciseof stockholder options and the repayment of a portion of a shareholder loan.

 

As of the end of 2001, the Company had $8.4 million of outstandingdebt. All of this debt is due to a mortgage on the Company’smanufacturing/headquarters facility and a mortgage on the Company’s shippingfacility.

 

The Company’s cash balance at the close of 2001 was approximately$5.5 million.

 

At December 31, 2001, the Company was out of compliance with certainfinancial ratios contained in its line of credit agreement. The Company iscurrently working with its bank, Wells Fargo, N.A., to renegotiate its line ofcredit agreement and the covenants therein. There is no guarantee that theCompany will be able to negotiate terms that it finds satisfactory with WellsFargo.  However, given the strength ofthe Company’s balance sheet, the Company’s historical cash flows, and the largenumber of unencumbered assets in its possession, the Company believes that itcan obtain sufficient financing to maintain its operations from alternativefinancial institutions should that be necessary. If the Company is unable to doso, its sources of liquidity will be reduced.

 

Furthermore, theCompany believes that its year end cash balance together with cash 

 

41

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generated fromoperations, cash it expects to receive because of its income tax receivablewill be sufficient to fund its anticipated working capital needs and permittedcapital expenditures for at least the next 12 months.

 

In providing the Companywith additional funds, Wells Fargo or other potential lenders may seek toinstitute covenants restricting the Company from certain activities and if theCompany deems it necessary to borrow funds with these restrictions inplace,  it may find that its ability to competeeffectively in its market sector is hindered.

 

In order to meet its long-term liquidity needs or consummate futureacquisitions, the Company may be required to incur additional indebtedness orissue additional equity and debt securities, subject to market and otherconditions. There can be no assurance that such additional financing will beavailable on terms acceptable to the Company or at all. The failure to raisethe funds necessary to finance its future cash requirements or consummatefuture acquisitions could adversely affect the Company’s ability to pursue itsstrategy and could negatively affect its operations in future periods.

 

**IMPACT OFINFLATION**

 

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

 

**ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**

 

The following discussion about the Company’s market risk disclosuresinvolves forward-looking statements. Actual results could differ materiallyfrom those projected in the forward-looking statements. The Company is exposedto market risk related to changes in interest rates. The risks related toforeign currency exchange rates are immaterial and the Company does not usederivative financial instruments.

 

If the Company enters into a renegotiated line-of-credit or borrowsother funds, it may be subject to interest rate market risk associated with avariable rate line of credit or fixed rate long-term debt. Even so, the Companydoes not believe the risk associated with such borrowing is significant.Additionally, the Company does not believe that the risk is significant for itslong-term debt due to the low fixed rates and insignificance of the long-termdebt to the Company’s consolidated balance sheet.

 

**ITEM 8:  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 

The Report of Independent Auditors and the Consolidated FinancialStatements and notes thereto are presented under Item 14 of this Report.

 

**PART III**

 

Information required under Part III (Items 10, 11, 12, and13) is incorporated herein by reference to the Company’s definitive proxystatement to be filed with the Securities and Exchange Commission within120 days after the year covered by this Form 10-K with respect to itsAnnual Meeting of Stockholders to be held on June 13, 2002.

 

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**PART IV**

 

**ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES ANDREPORTS ON FROM 8-K**

 

 
| (a)    |   | (1)                                                                           | Index to Consolidated Financial Statements:                                                                                                                                                                                                                                                                                                   |
|--------|--------|-------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                          | Report of Independent  Auditors                                                                                                                                                                                                                                                                                                               |
|   |   |                                                                          | Consolidated Balance Sheets  as of December 31, 2001 and 2000                                                                                                                                                                                                                                                                                 |
|   |   |                                                                          | Consolidated  Statements of Operations for the years ended December 31, 2001, 2000 and 1999                                                                                                                                                                                                                                                   |
|   |   |                                                                          | Consolidated  Statements of Stockholders’ Equity for the years ended December 31, 2001,  2000 and 1999                                                                                                                                                                                                                                   |
|   |   |                                                                          | Consolidated  Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999                                                                                                                                                                                                                                                   |
|   |   |                                                                          | Notes to  Consolidated Financial Statements                                                                                                                                                                                                                                                                                                   |
| (a)    |   | (2)                                                                           | Index to Consolidated Financial Statement Schedules:                                                                                                                                                                                                                                                                                          |
|   |   |                                                                          | Schedule  II—    Valuation and Qualifying Accounts  -1                                                                                                                                                                                                                                                                    |
|   |   |                                                                          | All other schedules for which provision is made in the applicable  accounting regulations of the Securities and Exchange Commission are not  required under the related instructions or are not material, and therefore  have been omitted.                                                                                                   |
| (a)    |   | (3)                                                                           | Index to Exhibits:                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                          |                                                                                                                                                                                                                                                                                                                                          |
|   |   |                                                                          |                                                                                                                                                                                                                                                                                                                                          |
| (2)    |   | Plan of Acquisition, Reorganization, Arrangement, Liquidation or  Succession: |
|   |   | 2.1                                                                           | Stock Purchase Agreement by and among Natrol, Inc., Thomas E.  Roark, John Yves Morin, Dwight Otis, Andrew M Esposito, Jr. and Prolab  Nutrition, Inc. dated as of October 8, 1999 (incorporated herein by  reference to Item 7 (c) of the Company’s Current Reports on  Form 8-K filed October 19, 1999.) |
| (3)    |   | Articles of Incorporation and By-Laws:                                        |
|   |   | 3.1                                                                           | The Third Amended and Restated Certificate of Incorporation of the  Company incorporated herein by reference to Exhibit 3.1 to the Company’s  Annual Report on Form 10-K, as amended, filed on March 31, 1999.                                                                                                            |
|   |   | 3.2                                                                           | The Amended and Restated By-Laws of the Company (incorporated herein  by reference to Exhibit 3.6 to the Company’s Registration Statement on  Form S-1, as amended, File No. 333-52109).                                                                                                                                  |
| (4)    |   | Instruments Defining the Rights of Security Holders, Including  Indentures:   |
|   |   | 4.1                                                                           | Specimen Stock Certificate for shares of Common Stock, $.01 par  value, of the Company (incorporated herein by reference to Exhibit 4.1  to the Company’s Registration Statement on Form S-1, as amended, File  No. 333-52109).                                                                                           |

 

 

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| (10)   |   | Material Contracts                                                                                                                         |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|
|   |   | 10.1                                                                                                                                       | Natrol, Inc. Amended and Restated 1996 Stock Option Plan  (incorporated herein by reference to Appendix A filed on May 2,  2000 File No 000-24567 Proxy Statement); |
|   |   | 10.2                                                                                                                                       | Natrol, Inc. Employee Stock Purchase Plan (incorporated herein  by reference to Exhibit 10.3 to the Company’s Registration Statement on  Form S-1, as amended, File No. 333-52109); |
|   |   | 10.3                                                                                                                                       | Form of Indemnification Agreement between Natrol, Inc. and each  of its directors (incorporated herein by reference to Exhibit 10.4 to  the Company’s Registration Statement on Form S-1, as amended, File  No. 333-52109); |
|   |   | 10.4                                                                                                                                       | Form of Incentive Stock Option Agreement  of the Natrol, Inc. Stock Option and Grant Plan (incorporated  herein by reference to Exhibit 10.9 to the Company’s Registration  Statement on Form S-1, as amended, File No. 333-52109); |
|   |   | 10.5                                                                                                                                       | Amended and Restated Credit Agreement with Wells Fargo Bank,  N. A (incorporated herein by reference to Exhibit 10.9 to the  Company’s Registration Statement on Form S-1, as amended, File  No. 333-52109); |
|   |   | 10.6                                                                                                                                       | Credit Agreement with Wells Fargo Bank, N.A., dated as of March 1,  2001; (incorporated herein by reference to Exhibit 10.6 to the Company’s Form  10-K, File No. 000-24567); |
|   |   | 10.7                                                                                                                                       | Revolving Line of Credit Agreement with Wells Fargo Bank, N.A., dated  as of March 1, 2001, (incorporated herein by reference to Exhibit 10.7  to the Company’s Form 10-K, File No. 000-24567); |
|   |   | 10.8                                                                                                                                       | Agreement, dated as of February 8, 1998, by and between the  Company and Basic Vegetable Products, L.P. (incorporated herein by reference  to Exhibit 10.10 to the Company’s Registration Statement on Form S-1,  as amended, File No. 333-52109); |
|   |   | 10.9                                                                                                                                       | Assignment and Amendment to Supply and Royalty Supply Agreement,  dated as of November 7, 2000 by and between the Company and ConAgra  Foods, Inc., (incorporated by reference to Exhibit 10.9 to the Company’s  Form 10-K, File No. 000-24567); |
| (21)   |   | Subsidiaries of Natrol, Inc., (incorporated herein by reference  to Exhibit 10.7 to the Company’s Form 10-K, File No. 000-24567) |
| (23)   |   | Consent of Experts and Counsel: Consent of Ernst & Young LLP  is filed herewith as Exhibit 23.1.                             |
|   |   |                                                                                                                                       |   |
|   |   | (b)                                                                                                                                        | Reports on Form 8-K: |
|   |   |                                                                                                                                       |   |
|   |   |                                                                                                                                       | No current reports on Form 8-K were filed by the Company during  the three month period ending December 31, 2001. |

 

 

 

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**SIGNATURE**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized, this29th day of March, 2002.

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

 

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Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theRegistrant and in the capacities indicated and on the dates indicated.

 

| **Signatures  Signed** |   | **Title**                                                                                                                      |   | **Date**            |
|------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|
| Elliott Balbert        |   | Chairman of the Board, Chief Executive Officer, President and  Director (Principal Executive Officer)                          |   | March 29, 2002 |
| Dennis R. Jolicoeur    |   | Chief Financial Officer, Executive Vice President and Director  (Principal Financial Officer and Principal Accounting Officer) |   | March 29, 2002 |
| Norman Kahn            |   | Director                                                                                                                       |   | March 29, 2002 |
| Dennis Griffin         |   | Director                                                                                                                       |   | March 29, 2002 |
| Dennis DeConcini       |   | Director                                                                                                                       |   | March 29, 2002 |

 

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Report ofIndependent Auditors

 

The Board of Directors

Natrol, Inc.

 

We have audited theaccompanying consolidated balance sheets of Natrol, Inc. and subsidiaries as ofDecember 31, 2001 and 2000, and the related consolidated statements ofoperations, stockholders’ equity and cash flows for each of the years in thethree year period ended December 31, 2001. Our audit also included thefinancial statement schedule listed at the index in item 14(a). These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

 

Weconducted our audits in accordance with auditing standards generally acceptedin the United States. Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Natrol, Inc. andsubsidiaries at December 31, 2001 and 2000, and the consolidated resultsof its operations and its cash flows for each of the years in the three yearperiod ended December 31, 2001, in conformity with accounting principlesgenerally accepted in the United States. Also, in our opinion, the relatedfinancial statement schedule, when considered in relation to the basicfinancial statements taken as a whole, presents fairly, in all materialrespects, the information set forth therein.

 

                                                                                                /s/Ernst & Young LLP

 

March 1, 2002

Woodland Hills,California

 

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Natrol, Inc.

 

ConsolidatedBalance Sheets

 

 
|                                                                                                                       |   | **December 31** |       |
|----------------------------------------------------------------------------------------------------------------------------|--------|----------------------|------------|
|                                                                                                                       |   | **2001**             | ** ** | **2000** | ** ** |
| **Assets**                                                                                                                 |   |                 |       |   |   |
| Current assets:                                                                                                            |   |                 |       |   |   |
| Cash and cash  equivalents                                                                                                 |   | $                    | 5,485,412  |   | $ | 4,004,445 |   |
| Accounts receivable,  net of allowances of $362,634  and  $479,100 at December 31, 2001 and 2000, respectively   |   | 6,786,643            |       | 9,574,078 |   |
| Inventories                                                                                                                |   | 9,742,964            |       | 12,246,635 |   |
| Income taxes receivable                                                                                                    |   | 1,408,217            |       | 4,091,428 |   |
| Deferred taxes                                                                                                             |   | 1,324,079            |       | 1,075,588 |   |
| Prepaid expenses and  other current assets                                                                                 |   | 1,825,615            |       | 838,704 |   |
| Total current assets                                                                                                       |   | 26,572,930           |       | 31,830,878 |   |
|                                                                                                                       |   |                 |       |   |   |
| Property and equipment:                                                                                                    |   |                 |       |   |   |
| Building and  improvements                                                                                                 |   | 15,625,150           |       | 15,571,595 |   |
| Machinery and equipment                                                                                                    |   | 5,708,151            |       | 5,538,839 |   |
| Furniture and office  equipment                                                                                            |   | 2,018,604            |       | 1,862,938 |   |
|                                                                                                                       |   | 23,351,905           |       | 22,973,372 |   |
| Accumulated  depreciation and amortization                                                                                 |   | (5,606,040           | )          | (4,215,475 | ) |
|                                                                                                                       |   | 17,745,865           |       | 18,757,897 |   |
|                                                                                                                       |   |                 |       |   |   |
| Goodwill, net of  accumulated amortization of $26,423,003 and $4,143,075 at December 31,  2001 and 2000, respectively |   | 14,983,584           |       | 37,263,512 |   |
|                                                                                                                       |   |                 |       |   |   |
| Other assets                                                                                                               |   | 54,360               |       | 68,378 |   |
|                                                                                                                       |   |                 |       |   |   |
| Total assets                                                                                                               |   | $                    | 59,356,739 |   | $ | 87,920,665 |   |

 

48

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|                                                                                                                  |   | **December 31** |       |
|-----------------------------------------------------------------------------------------------------------------------|--------|----------------------|------------|
|                                                                                                                  |   | **2001**             |       | **2000** | ** ** |
| **Liabilities and stockholders’ equity**                                                                         |   |                 |       |   |   |
| Current liabilities:                                                                                                  |   |                 |       |   |   |
| Line  of credit                                                                                                       |   | $                    | —     |   | $ | 8,300,000 |   |
| Accounts  payable                                                                                                     |   | 3,371,777            |       | 4,186,227 |   |
| Accrued  expenses                                                                                                     |   | 4,240,233            |       | 2,967,155 |   |
| Accrued  payroll and related liabilities                                                                              |   | 493,443              |       | 722,878 |   |
| Current  portion of long-term debt                                                                                    |   | 277,451              |       | 256,061 |   |
| Total current  liabilities                                                                                            |   | 8,382,904            |       | 16,432,321 |   |
|                                                                                                                  |   |                 |       |   |   |
| Deferred  income taxes, noncurrent                                                                                    |   | 250,673              |       | 226,646 |   |
| Long-term  debt, less current portion                                                                                 |   | 8,083,316            |       | 8,369,389 |   |
|                                                                                                                  |   |                 |       |   |   |
| 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 — 13,712,354 and 13,658,820 at December 31, 2001 and 2000,  respectively     |   | 137,124              |       | 136,588 |   |
| Additional  paid-in capital                                                                                           |   | 61,868,719           |       | 61,781,624 |   |
| Retained  earnings (deficit)                                                                                          |   | (16,485,120          | )          | 3,854,974 |   |
|                                                                                                                  |   | 45,520,723           |       | 65,773,186 |   |
| Shares  held in treasury, at cost — 921,900 and 625,900 shares at December 31,  2001 and 2000, respectively |   | (2,880,877           | )          | (2,326,814 | ) |
| Receivable  from stockholder                                                                                          |   | —               |       | (554,063 | ) |
| Total  stockholders’ equity                                                                                      |   | 42,639,846           |       | 62,892,309 |   |
| Total liabilities and  stockholders’ equity                                                                      |   | $                    | 59,356,739 |   | $ | 87,920,665 |   |

 

*See accompanying notes.*

 

49

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Natrol, Inc.

 

ConsolidatedStatements of Operations

 

 
|                                                |   | **Year ended December 31** |        |
|-----------------------------------------------------|--------|---------------------------------|-------------|
|                                                |   | **2001**                        |        | **2000** |   | **1999** | ** ** |
|                                                |   |                            |        |   |   |   |   |
| Net sales                                           |   | $                               | 76,160,658  |   | $ | 87,089,154 |   | $ | 81,589,935 |   |
| Cost of goods sold                                  |   | 42,063,446                      |        | 49,934,486 |   | 39,849,632 |   |
| Gross profit                                        |   | 34,097,212                      |        | 37,154,668 |   | 41,740,303 |   |
|                                                |   |                            |        |   |   |   |   |
| Selling and marketing expenses                      |   | 22,624,778                      |        | 32,293,373 |   | 18,915,663 |   |
| General and administrative expenses                 |   | 10,489,303                      |        | 11,215,339 |   | 8,542,308 |   |
| Reduction in goodwill                               |   | 20,000,000                      |        | — |   | — |   |
| Total operating expenses                            |   | 53,114,081                      |        | 43,508,712 |   | 27,457,971 |   |
| Operating income (loss)                             |   | (19,016,869                     | )           | (6,354,044 | ) | 14,282,332 |   |
|                                                |   |                            |        |   |   |   |   |
| Interest income                                     |   | 148,837                         |        | 146,303 |   | 803,855 |   |
| Interest expenses                                   |   | (885,348                        | )           | (1,377,767 | ) | (266,668 | ) |
| Income (loss) before income tax provision (benefit) |   | (19,753,380                     | )           | (7,585,508 | ) | 14,819,519 |   |
|                                                |   |                            |        |   |   |   |   |
| Income tax provision (benefit)                      |   | 586,714                         |        | (2,369,290 | ) | 5,631,416 |   |
| Net income (loss)                                   |   | $                               | (20,340,094 | ) | $ | (5,216,218 | ) | $ | 9,188,103 |   |
|                                                |   |                            | ** **  |   | ** ** |   | ** ** |
| Basic earnings (loss) per share                     |   | $                               | (1.59       | ) | $ | (0.39 | ) | $ | 0.69 |   |
| Diluted earnings (loss) per share                   |   | $                               | (1.59       | ) | $ | (0.39 | ) | $ | 0.67 |   |
|                                                |   |                            |        |   |   |   |   |
| Weighted average shares outstanding - basic         |   | 12,783,118                      |        | 13,236,734 |   | 13,324,510 |   |
| Weighted average shares outstanding - diluted       |   | 12,783,118                      |        | 13,236,734 |   | 13,637,653 |   |

 

*See accompanying notes.*

 

50

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Natrol, Inc.

 

ConsolidatedStatements of Stockholders’ Equity

 

 
|                                                        |   | **Common  Stock** |   | **Additional  Paid-In** |    | **Retained  Earnings** |   | **Shares  Held** |   | **Receivable  From** |        |            |   |
|-------------------------------------------------------------|--------|-------------------|--------|-------------------------|---------|------------------------|--------|------------------|--------|----------------------|-------------|-----------------|--------|
|                                                        |   | **Shares**        |   | **Amount**              |    | **Capital**            |   | **(Deficit)**    |   | **In  Treasury**     |        | **Stockholder** |   | **Total** |   |
|                                                        |   |              |   |                    |    |                   |   |             |   |                 |        |            |   |   |   |
| Balance at  January 1, 1999                                 |   | 13,301,990        |   | $                       | 133,020 |                   | $      | 60,187,301       |   | $                    | (116,911    | )               | $      | — |   | $ | (562,500 | ) | $ | 59,640,910 |   |
| Exercise of stock options                                   |   | 29,000            |   | 290                     |    | 54,085                 |   | —           |   | —               |        | —          |   | 54,375 |   |
| Shares issued in connection with Prolab acquisition         |   | 124,270           |   | 1,243                   |    | 977,383                |   | —           |   | —               |        | —          |   | 978,626 |   |
| Issuance of common stock under employee stock purchase plan |   | 18,775            |   | 187                     |    | 115,611                |   | —           |   | —               |        | —          |   | 115,798 |   |
| Payments on shareholder loan                                |   | —            |   | —                  |    | —                 |   | —           |   | —               |        | 8,437           |   | 8,437 |   |
| Net income                                                  |   | —            |   | —                  |    | —                 |   | 9,188,103        |   | —               |        | —          |   | 9,188,103 |   |
| Balance at  December 31, 1999                               |   | 13,474,035        |   | 134,740                 |    | 61,334,380             |   | 9,071,192        |   | —               |        | (554,063        | )      | 69,986,249 |   |
| Shares issued in exchange for services                      |   | 25,919            |   | 259                     |    | 128,021                |   | —           |   | —               |        | —          |   | 128,280 |   |
| Exercise of stock options                                   |   | 133,500           |   | 1,335                   |    | 263,040                |   | —           |   | —               |        | —          |   | 264,375 |   |
| Issuance of common stock under employee stock purchase plan |   | 25,366            |   | 254                     |    | 56,183                 |   | —           |   | —               |        | —          |   | 56,437 |   |
| Purchase of treasury shares                                 |   | —            |   | —                  |    | —                 |   | —           |   | (2,326,814           | )           | —          |   | (2,326,814 | ) |
| Net loss                                                    |   | —            |   | —                  |    | —                 |   | (5,216,218       | )      | —               |        | —          |   | (5,216,218 | ) |
| Balance at  December 31, 2000                               |   | 13,658,820        |   | 136,588                 |    | 61,781,624             |   | 3,854,974        |   | (2,326,814           | )           | (554,063        | )      | 62,892,309 |   |
| Repurchase of restricted stock                              |   | —            |   | —                  |    | —                 |   | —           |   | (554,063             | )           | 554,063         |   | — |   |
| Exercise of stock options                                   |   | 32,000            |   | 320                     |    | 57,730                 |   | —           |   | —               |        | —          |   | 58,050 |   |
| Shares issued in exchange for services                      |   | 4,491             |   | 45                      |    | 7,830                  |   | —           |   | —               |        | —          |   | 7,875 |   |
| Issuance of common stock under employee stock purchase plan |   | 17,043            |   | 171                     |    | 21,535                 |   | —           |   | —               |        | —          |   | 21,706 |   |
| Net loss                                                    |   | —            |   | —                  |    | —                 |   | (20,340,094      | )      | —               |        | —          |   | (20,340,094 | ) |
| Balance at  December 31, 2001                               |   | 13,712,354        |   | $                       | 137,124 |                   | $      | 61,868,719       |   | $                    | (16,485,120 | )               | $      | (2,880,877 | ) | $ | — |   | $ | 42,639,846 |   |

 

*See accompanying notes.*

 

51

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Natrol, Inc.

 

ConsolidatedStatements of Cash Flows

 

 
|                                                                                                 |   | **Year ended December 31** |        |
|------------------------------------------------------------------------------------------------------|--------|----------------------------|-------------|
|                                                                                                 |   | **2001**                   |        | **2000** |   | **1999** | ** ** |
| **Operating activities**                                                                             |   |                       | ** **  |   | ** ** |   | ** ** |
| Net income (loss)                                                                                    |   | $                          | (20,340,094 | ) | $ | (5,216,218 | ) | $ | 9,188,103 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |   |                       |        |   |   |   |   |
| Depreciation and  amortization                                                                       |   | 1,393,955                  |        | 1,361,256 |   | 1,115,797 |   |
| Amortization of  goodwill                                                                            |   | 2,279,928                  |        | 2,279,928 |   | 1,274,979 |   |
| Provision for bad debts  and returns                                                                 |   | 437,600                    |        | 400,000 |   | 170,630 |   |
| Deferred taxes                                                                                       |   | (224,464                   | )           | 117,659 |   | 215,462 |   |
| Shares issued for  services                                                                          |   | 7,875                      |        | 128,280 |   | — |   |
| Reduction of goodwill                                                                                |   | 20,000,000                 |        | — |   | — |   |
| Changes in operating  assets and liabilities:                                                        |   |                       |        |   |   |   |   |
| Accounts receivable                                                                                  |   | 2,349,835                  |        | 5,802,535 |   | (2,293,195 | ) |
| Inventories                                                                                          |   | 2,503,671                  |        | 2,814,158 |   | 439,842 |   |
| Income taxes  receivable/payable                                                                     |   | 2,683,211                  |        | (4,273,218 | ) | (1,712,624 | ) |
| Prepaid expenses and  other current assets                                                           |   | (986,911                   | )           | 189,509 |   | (522,980 | ) |
| Other assets                                                                                         |   | 10,628                     |        | 25,775 |   | (14,616 | ) |
| Accounts payable                                                                                     |   | (814,450                   | )           | (3,640,402 | ) | (1,784,427 | ) |
| Accrued expenses                                                                                     |   | 1,273,078                  |        | 824,111 |   | (166,385 | ) |
| Accrued payroll and  related liabilities                                                             |   | (229,435                   | )           | (964,863 | ) | 883,118 |   |
| Net cash provided by  (used in) operating activities                                                 |   | 10,344,427                 |        | (151,490 | ) | 6,793,704 |   |
|                                                                                                 |   |                       |        |   |   |   |   |
| **Investing  activities**                                                                            |   |                       |        |   |   |   |   |
| Assets purchased, net  of liabilities assumed in connection with acquisitions                        |   | —                     |        | — |   | (26,578,024 | ) |
| Purchases of marketable  securities                                                                  |   | —                     |        | — |   | (69,203,000 | ) |
| Sales of marketable  securities                                                                      |   | —                     |        | — |   | 88,213,826 |   |
| Purchases of property  and equipment                                                                 |   | (378,533                   | )           | (587,647 | ) | (9,325,753 | ) |
| Net cash used in  investing activities                                                               |   | (378,533                   | )           | (587,647 | ) | (16,892,951 | ) |
|                                                                                                 |   |                       |        |   |   |   |   |
| **Financing  activities**                                                                            |   |                       |        |   |   |   |   |
| Net borrowings  (repayments) on line of credit                                                       |   | (8,300,000                 | )           | 6,500,000 |   | 1,800,000 |   |
| Proceeds from long-term  debt                                                                        |   | —                     |        | — |   | 8,900,000 |   |
| Repayments on long-term  debt                                                                        |   | (264,683                   | )           | (235,560 | ) | (802,826 | ) |
| Capitalized loan fees                                                                                |   | —                     |        | — |   | (50,817 | ) |
| Purchases of treasury  shares                                                                        |   | —                     |        | (2,326,814 | ) | — |   |
| Repayments on shareholder  loan                                                                      |   | —                     |        | — |   | 8,437 |   |
| Proceeds from issuance  of common stock,  net of issuance  costs                                |   | 79,756                     |        | 320,812 |   | 170,173 |   |
| Net cash (used in)  provided by financing activities                                                 |   | (8,484,927                 | )           | 4,258,438 |   | 10,024,967 |   |
| Net increase (decrease)  in cash and cash equivalents                                                |   | 1,480,967                  |        | 3,519,301 |   | (74,280 | ) |
| Cash and cash  equivalents, beginning of year                                                        |   | 4,004,445                  |        | 485,144 |   | 559,424 |   |
| Cash and cash  equivalents, end of year                                                              |   | $                          | 5,485,412   |   | $ | 4,004,445 |   | $ | 485,144 |   |

 

52

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Natrol, Inc.

 

ConsolidatedStatements of Cash Flows (continued)

 

 
|                                                   |   | **Year ended December 31** |       |
|--------------------------------------------------------|--------|---------------------------------|------------|
|                                                   |   | **2001**                        |       | **2000** |   | **1999** | ** ** |
|                                                   |   |                            | ** ** |   | ** ** |   | ** ** |
| **Supplemental  disclosures of cash flow information** |   |                            |       |   |   |   |   |
| Cash paid during the  year for:                        |   |                            |       |   |   |   |   |
| Interest                                               |   | $                               | 885,348    |   | $ | 1,377,767 |   | $ | 266,668 |   |
| Income taxes                                           |   | $                               | 927,180    |   | $ | 786,850 |   | $ | 6,624,087 |   |

 

**Supplementalnon-cash transactions**

 

In February 2001,the Company repurchased 296,000 shares of common stock from an officer of theCompany in exchange for an outstanding note receivable due from the officer.

 

In October 1999,the Company issued 124,270 shares of common stock valued at $978,626 inconnection with its acquisition of Prolab, Nutrition, Inc.

 

*See accompanying notes.*

 

53

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Natrol, Inc.

 

Notes toConsolidated Financial Statements

 

December 31, 2001

 

 

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

 

**Description of Business**

 

Natrol,Inc. (collectively with its subsidiaries, referred to as the Company)manufactures and markets branded, high-quality dietary supplement products,including vitamins, minerals, hormonal supplements, herbal products, specialtycombination formulations and sports nutrition supplements. The Companyprimarily sells its products under the Natrol and Prolab brand names throughmultiple distribution channels throughout the United States, including domestichealth food stores and mass market drug, retail and grocery store chains.

 

**Principles in Consolidation**

 

Theconsolidated financial statements include the accounts and operations ofNatrol, Inc. and its wholly owned subsidiaries. All significant intercompanyaccounts have been eliminated in consolidation.

 

**Estimates and Assumptions**

 

Thepreparation of consolidated financial statements in conformity with accountingprinciples generally accepted in the United States 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 the Company’s consolidated financial position or results ofoperations.

 

**Cash and Cash Equivalents**

 

The Company considers allhighly liquid debt instruments with original maturity dates of three months orless when purchased to be cash equivalents.

** **

**Marketable Securities**

 

TheCompany determines the appropriate classification of debt and equity securitiesat the time of purchase and re-evaluates such designations at each balancesheet date. Realized gains and losses on investment transactions are recognizedwhen realized based on settlement dates and recorded as interest income.Interest and dividend income on securities are recognized when earned.

 

54

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** **

**Inventories**

 

Inventoriesare carried at the lower of cost (first-in, first-out method) or market.

 

**Property and Equipment**

 

Propertyand equipment are stated on the basis of cost. Depreciation is computed usingthe straight-line method over the estimated useful lives of the assets rangingfrom five to 10 years for furniture, machinery and equipment. Buildings andimprovements are depreciated using straight-line methods over five to 40 years.Amortization of leasehold improvements is computed using the straight-linemethod over the shorter of the estimated lives of the assets or the leaseterms.

 

**Trademarks and Patents**

 

Costsof obtaining trademarks and patents are capitalized and amortized using thestraight-line basis over the estimated useful life of eleven years. Trademarksand patents are included in other assets at $50,500 at December 31, 2001and 2000, net of accumulated amortization of $37,922 and $33,584 atDecember 31, 2001 and 2000, respectively. The costs of servicing theCompany’s patents and trademarks are expensed as incurred.

 

**Goodwill**

 

Goodwillrepresents the excess of the purchase price over the estimated fair value ofthe net assets acquired in connection with acquisitions. Amortization isprovided for on a straight-line basis over periods ranging from 15 to 20 years.Amortization expense related to goodwill was approximately $2,279,928,$2,279,928 and $1,274,979 for the years ended December 31, 2001, 2000 and1999, respectively, and is included in general and administrative expenses.Reduction in goodwill in the year ended December 31, 2001, relates to animpairment charge taken as discussed further in Note 10.

 

**Long-Lived Assets**

 

TheCompany reviews for the impairment of long-lived assets and certainidentifiable intangibles whenever events or changes in circumstances indicatethat the carrying amount of any asset may not be recoverable. An impairmentloss would be recognized 

 

 

55

----

 

whenthe estimated undiscounted future cash flows expected to result from the use ofthe asset and its eventual disposition is less than the carrying amount. If animpairment is indicated, the amount of the loss to be recorded is based on anestimate of the difference between the carrying amount and the fair value ofthe asset. Fair value is based upon discounted estimated cash flows expected toresult from the use of the asset and its eventual disposition and othervaluation methods.

 

**Income Taxes**

 

TheCompany accounts for income taxes under the liability method. Under thismethod, deferred tax assets and liabilities are determined based on differencesbetween enacted rates and laws that will be in effect when the differences areexpected to reverse. Deferred taxes arising from temporary differences that arenot related to an asset or liability are classified as current or noncurrentdepending on the periods in which the temporary differences are expected toreverse.

 

**Revenue Recognition**

 

TheCompany sells its products to retail outlets through a direct sales force and anational broker network. Sales are recorded when products are shipped tocustomers by the Company. Net sales represent products shipped, less estimatedreturns and allowances for which provisions are made at the time of sale.Generally the returns and allowances are limited to damaged goods and expiringproduct and the estimates recorded are based upon known claims and an estimateof additional returns.

 

**Advertising Costs**

** **

Advertisingand promotional costs are expensed at first showing. In addition, the Companyadvertises on a cooperative basis by accruing an obligation to reimburseretailers for qualified advertising of Company products. The Company providesfor cooperative advertising obligations in the same period as the relatedrevenue is recognized. Advertising and promotional costs amounted to$10,710,797, $17,614,623, and $10,936,242, respectively, for the years endedDecember 31, 2001, 2000 and 1999.

 

56

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**Research and Development Costs**

 

TheCompany incurs research and development costs relating to the development ofits dietary supplement products. Research and development costs are expensed asincurred and amounted to $550,726, $649,613 and $417,552 for the years endedDecember 31, 2001, 2000 and 1999, respectively. Research and developmentcosts are included in general and administrative expenses on the consolidatedstatements of operations.

 

**Shipping and Handling Costs**

 

TheCompany records all charges for outbound shipping and handling as revenue. Alloutbound shipping and fulfillment costs are classified as selling and marketingexpenses and totaled $2,959,392, $3,087,173 and $2,366,578 for the years endedDecember 31, 2001, 2000 and 1999, respectively.

 

**Major Products**

 

TheCompany’s sales of one product line comprised 10.2% and 13.4% of gross salesduring the years ended December 31, 2001 and 2000, respectively. TheCompany’s sales of a different product line comprised 11.5% of gross salesduring the year ended December 31, 1999.

 

**Stock-Based Compensation**

 

Statementof Financial Accounting Standard (SFAS) No. 123, “Accounting for Stock-BasedCompensation,” encourages, but does not require, companies to recordcompensation cost for stock-based employee compensation plans at fair value.The Company has chosen to continue to account for stock-based compensationusing the intrinsic value method prescribed in Accounting Principles BoardOpinion (APB) No. 25, “Accounting for Stock Issued to Employees,” as clarifiedby Financial Interpretation No. 44, “Accounting for Certain TransactionsInvolving Stock Compensation — an Interpretation of APB Opinion No. 25.”

 

 

57

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**Earnings (Loss) Per Share**

 

The Company calculates earnings (loss) per share in accordance withSFAS No. 128, “Earnings per Share.” Basic earnings (loss) per share have beencomputed by dividing net income (loss) by the weighted average number of commonshares outstanding. Diluted earnings per share have been computed by dividingnet income (loss) by securities or other contracts to issue Common Stock as ifthese securities were exercised or converted to Common Stock.

 

The following table sets forth the calculation for basic and dilutedearnings (loss) per share for the periods indicated:

 
|                                                  |   | **Year ended December 31** |        |
|-------------------------------------------------------|--------|---------------------------------|-------------|
|                                                  |   | **2001**                        |        | **2000** |   | **1999** | ** ** |
| Earnings (loss):                                      |   |                            |        |   |   |   |   |
| Net income (loss)                                     |   | $                               | (20,340,094 | ) | $ | (5,216,218 | ) | $ | 9,188,103 |   |
|                                                  |   |                            |        |   |   |   |   |
| Shares:                                               |   |                            |        |   |   |   |   |
| Weighted average shares  for basic earnings per share |   | 12,783,118                      |        | 13,236,734 |   | 13,324,510 |   |
| Stock options                                         |   | —                          |        | — |   | 313,143 |   |
|                                                  |   | 12,783,118                      |        | 13,236,734 |   | 13,637,653 |   |
|                                                       |        |                                 |             |  |  |  |  |  |  |  |

 

Sharesissuable under stock options of 2,695,500, 1,987,000 and 615,000 atDecember 31, 2001, 2000 and 1999, respectively, have been excluded fromthe computation of diluted earnings per share because the effect would beantidilutive.

 

**Comprehensive Income (Loss)**

 

TheCompany’s comprehensive income (loss) items are not material atDecember 31, 2001, 2000 and 1999 and therefore no disclosures have beenmade.

 

 

58

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**Concentration of Credit Risk**

 

Concentrationsof credit risk with respect to trade receivables are limited due to thedistribution of sales over a large customer base. The Company performs periodiccredit evaluations of its customers’ financial conditions and generally doesnot require collateral. Credit losses have been within management’sexpectations.

 

**Segment Reporting**

 

TheCompany is engaged principally in one line of business, the manufacturing andmarketing of high-quality dietary supplement products, including vitamins,minerals, herbs and specialty formulations, weight control products andhormones, which represents more than 90% of consolidated sales.

 

**Recently Issued Accounting Standards**

 

In June 2001, the FASBissued SFAS No. 141, “Business Combinations” (SFAS 141), and No. 142, “Goodwilland Other Intangible Assets” (SFAS 142). SFAS 141 requires the purchase methodof accounting be used for all business combinations initiated after June 30,2001. SFAS 141 also includes guidelines on the initial recognition andmeasurement of goodwill and other intangible assets arising from businesscombinations completed after June 30, 2001. SFAS 142 prohibits the amortizationof goodwill and intangible assets with indefinite useful lives. SFAS 142requires these assets be reviewed for impairment at least annually. Intangibleassets with finite lives will continue to be amortized over their estimateduseful lives.

 

The Company applied SFAS142 in the beginning of 2002. Application of the nonamortization provisions ofSFAS 142 is expected to result in an increase of net income of $821,000 in 2002on an annual basis. The Company tested goodwill for impairment using thetwo-step process prescribed in SFAS 142. The first step is a screen forpotential impairment, while the second step measures the amount of theimpairment, if any. The Company performed the first of the required impairmenttests of goodwill and indefinite lived intangible assets as of January 1, 2002in January 2002. The Company has determined these impairment tests will have noeffect on the earnings and financial position of the Company.

** **

 

59

----

 

**Recently Issued Accounting Standards(continued)**

 

Emerging Issues Task Force(EITF) Issues No. 00-14, “Accounting for Certain Sales Incentives,” No. 00-22,“Accounting for ‘Points’ and Certain Other Time-Based or Volume-Based SalesIncentives Offers, and Offers for Free Products or Services to be Delivered inthe Future,” and No. 00-25, “Vendor Income Statement Characterization ofConsideration Paid to a Reseller of the Vendor’s Products,” address variousaspects of accounting for consideration given by a vendor to a customer or areseller of the vendor’s products. The purpose of EITF Issue No. 01-9,“Accounting for Consideration Given by a Vendor to a Customer or a Reseller ofthe Vendor’s Products,” is to codify and reconcile the consensuses on all orspecific aspects of those Issues, and identify other related interpretiveissues that have not yet been addressed. The guidance for these Issues shouldbe applied to transactions entered into after November 15, 2001 and forfinancial statements for any period beginning after December 15, 2001.Revenues would have been reduced by expenses of $4,163,813, $9,337,137 and$1,504,615, which are currently categorized in selling and marketing expenses,in the years ended December 31, 2001, 2000 and 1999, respectively, had theguidance in these Issues been applied.

 

In August 2001, the FASBissued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets” (SFAS 144), which addresses financial accounting and reporting for theimpairment or disposal of long-lived assets and supersedes SFAS No. 121,“Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assetsto Be Disposed Of,” and the accounting and reporting provisions of APB OpinionNo. 30, “Reporting the Results of Operations-Reporting the Effects of Disposalof a Segment of a Business, and Extraordinary, Unusual and InfrequentlyOccurring Events and Transactions,” for the disposal of a segment of abusiness. SFAS 144 is effective for financial statements issued for fiscalyears beginning after December 15, 2001, with early application encouraged.The Company expects to adopt SFAS 144 in the first quarter of 2002, and doesnot expect the adoption of the statement will have a significant impact on theCompany’s financial position or result of operations.

 

**Reclassifications**

 

Certainreclassifications have been made to the 2000 and 1999 consolidated financialstatements to conform to the presentation in 2001.

 

60

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**2. Acquisitions**

 

InOctober 1999, the Company purchased all of the outstanding shares of stock ofProlab Nutrition, Inc. (Prolab) for $28,500,000 in cash, excluding acquisitioncosts, and 124,270 shares of the Company’s Common Stock. Prolab is adistributor, manufacturer and marketer of food supplement products which aresold primarily to distributors, wholesalers and retailers located throughoutthe United States and also on a worldwide basis. Included in the purchase pricewere assets, consisting primarily of cash of $2,259,722, trade accountsreceivable of $3,667,046, inventories of $2,063,180, fixed assets of $1,125,280and other assets of $623,054, and liabilities assumed consisting primarily ofaccounts payable of $3,667,832, accrued expenses of $2,033,960 and debt of$763,836. The acquisition was accounted for using the purchase method, andaccordingly, the acquired assets and liabilities assumed were recorded at theirestimated fair values with revenues and expenses from the date of acquisitionincluded in the consolidated statements of operations. The excess of cost overthe fair value of net assets acquired of $27,041,662 is being amortized over 20years.

 

The following pro forma information presents a summary of consolidatedresults of operations of the Company as if the acquisition of Prolab hadoccurred at the beginning of the year ended December 31, 1999, with proforma adjustments for the amortization of goodwill, interest expense andcertain income tax adjustments. The pro forma financial information is notnecessarily indicative of the results of operations as they would have been hadthe acquisitions been effected on the assumed dates or of future results of thecombined entities.

 
|                        |   | **Year  ended December  31** |        |
|-----------------------------|--------|-----------------------------------|-------------|
|                        |   | **1999**                          |        |
|                        |   | *(Unaudited)*                     | * *    |
| Revenues                    |   | $                                 | 105,556,000 |   |
| Income from operations      |   | 16,615,000                        |        |
| Net income                  |   | 10,414,000                        |        |
| Basic earnings per  share   |   | $                                 | 0.78        |   |
| Diluted earnings per  share |   | $                                 | 0.76        |   |

** **

 

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**3.Inventories**

 

Inventoriesconsist of the following:

 
|                                 |   | **December 31** |      |
|--------------------------------------|--------|-----------------|-----------|
|                                 |   | **2001**        |      | **2000** | ** ** |
| Raw material and  packaging supplies |   | $               | 4,279,891 |   | $ | 5,334,997 |   |
| Finished goods                       |   | 5,463,073       |      | 6,911,638 |   |
|                                 |   | $               | 9,742,964 |   | $ | 12,246,635 |   |

 

**4. Financing**

 

OnSeptember 24, 1999, the Company entered into a credit agreement with abank that provided for a revolving line of credit for borrowings up to$10,000,000, as amended, based on a formula, through 2002. Advances under thecredit agreement bore interest at the bank’s adjusted LIBOR rate plus 1.25% orthe bank’s prime rate at the option of the Company.

 

Thecredit agreement required the Company to comply with certain financialcovenants and is collateralized by the Company’s assets. The Company was not incompliance with all of the financial covenants at December 31, 2000. InMarch 2001, the Company entered into a new credit agreement with its bankwhereby the covenant violations of the prior credit agreement are waived. Thenew credit agreement provides for a revolving line of credit for borrowings upto $5,000,000, as amended in August 2001, based on a formula, through July2002. Advances under the credit agreement bear interest at the bank’s adjustedLIBOR rate plus 3.00% or the bank’s prime rate plus 0.50% at the option of theCompany. Further, the credit agreement requires the Company comply with certainfinancial covenants and is collateralized by the Company’s assets. The Companywas not in compliance certain financial covenants at December 31, 2001 andis seeking a waiver from its lender for the violations.

 

During1999, the Company entered into two mortgage notes payable in the aggregate amountof $8,900,000 collateralized by the Company’s facilities. These notes arepayable in monthly installments of $73,779 in the aggregate including interestranging from 7.75% to 8.32% maturing in 2014 and 2019. Interest expense relatedto these notes for the years ended December 31, 2001, 2000, and 1999 was$694,264, $687,228, and $169,876, respectively.

 

 

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Futurematurities of long-term debt at December 31, 2001 are as follows:

 
| 2002       |   |   |   | $         | 277,451   |   |
|------------|--------|--------|--------|-----------|-----------|--------|
| 2003       |   |   |   | 300,630   |      |
| 2004       |   |   |   | 324,538   |      |
| 2005       |   |   |   | 352,866   |      |
| Thereafter |   |   |   | 7,105,282 |      |
|       |   |   |   | $         | 8,360,767 |   |

 

**5. Income Taxes**

 

Theincome tax provision (benefit) consists of the following:

 
|                                 |   | **Year ended December 31** |    |
|--------------------------------------|--------|---------------------------------|---------|
|                                 |   | **2001**                        |    | **2000** |   | **1999** | ** ** |
| Current:                             |   |                            |    |   |   |   |   |
| Federal                              |   | $                               | 727,250 |   | $ | (2,496,949 | ) | $ | 4,566,332 |   |
| State                                |   | 83,928                          |    | 10,000 |   | 849,622 |   |
|                                 |   | 811,178                         |    | (2,486,949 | ) | 5,415,954 |   |
| Deferred:                            |   |                            |    |   |   |   |   |
| Federal                              |   | (217,975                        | )       | 317,518 |   | 172,922 |   |
| State                                |   | (6,489                          | )       | (199,859 | ) | 42,540 |   |
|                                 |   | (224,464                        | )       | 117,659 |   | 215,462 |   |
| Total income tax  provision benefit) |   | $                               | 586,714 |   | $ | (2,369,290 | ) | $ | 5,631,416 |   |

 

Thedifference between actual income tax expense (benefit) and the U.S. Federalstatutory income tax rate is as follows:

 
|                   |   | **Year ended December 31** |   |
|------------------------|--------|---------------------------------|--------|
|                   |   | **2001**                        |   | **2000** |   | **1999** | ** ** |
|                   |   |                            |   |   |   |   |   |
| Statutory rate         |   | (34.0                           | )%     | (34.0 | )% | 34.0 | % |
| Nondeductible goodwill |   | 37.0                            |   | 6.0 |   | — |   |
| State tax provision    |   | —                          |   | (1.0 | ) | — |   |
| Other                  |   | —                          |   | (2.0 | ) | 4.0 |   |
|                   |   | 3.0                             | %      | (31.0 | )% | 38.0 | % |

 

 

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Thesignificant components of the Company’s deferred tax assets and liabilities areas follows:

 
|                          |   | **December 31** |      |
|-------------------------------|--------|----------------------|-----------|
|                          |   | **2001**             |      | **2000** |   | **1999** | ** ** |
| Deferred tax assets:          |   |                 |      |   |   |   |   |
| Accounts receivable  reserves |   | $                    | 144,257   |   | $ | 190,663 |   | $ | 200,038 |   |
| Inventory reserves            |   | 127,476              |      | 189,846 |   | 78,640 |   |
| Various accrued  liabilities  |   | 889,810              |      | 502,331 |   | 543,208 |   |
| State taxes                   |   | —               |      | — |   | 254,190 |   |
| Net operating losses          |   | 162,536              |      | 192,748 |   | — |   |
|                          |   | 1,324,079            |      | 1,075,588 |   | 1,076,076 |   |
| Deferred tax liability:       |   |                 |      |   |   |   |   |
| Depreciation                  |   | (250,673             | )         | (226,646 | ) | (109,475 | ) |
|                          |   | $                    | 1,073,406 |   | $ | 848,942 |   | $ | 966,601 |   |

 

Deferredtaxes arising from temporary differences that are not related to an asset orliability are classified as current or noncurrent depending on the periods inwhich the temporary differences are expected to reverse. The Company has statenet operating loss carryforwards of approximately $2,797,527 expiring beginningin fiscal 2005.

 

**6. Stockholders’ Equity**

 

**Receivable from Stockholder**

 

Thereceivable from stockholder represents an interest bearing note from astockholder in the amount of $554,063 at December 31, 2000 and 1999,issued by the stockholder to finance in part the purchase of 300,000 shares ofthe Company’s Common Stock at its fair value of $1.88 per share. The note bearsinterest at 6.60% per year with interest payments due annually. The note is duewithin ten days of the receipt by the stockholder of proceeds from the sale ofthe Company’s Common Stock or November 14, 2006, whichever occurs first.Included in interest income is $36,568 and $36,568 for the years endedDecember 31, 2000 and 1999, respectively, for interest from thisstockholder. On February 1, 2001, the Company repurchased the 296,000 shares ofCommon Stock from the stockholder for $1.88 per share, the market price of thestock on the repurchase date, of which all but 30,000 shares were fully vested,by exchanging the outstanding note, including accrued but unpaid interest, forthe shares.

** **

 

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**Stock Repurchase Program**

 

In April 2000, the Boardof Directors of the Company authorized a stock repurchase program for theCompany’s Common Stock. Under the stock repurchase program, the Company caneffect stock repurchases from time to time up to an aggregate of $10,000,000 ofits Common Stock. The stock repurchase program does not have an expirationdate. In the years ended December 31, 2001 and 2000, the Companyrepurchased 296,000 and 625,900, respectively, shares of its Common Stock at acost of $554,063 and $2,326,814, respectively, under this program.

 

**Stock Options**

 

TheCompany has adopted the 1996 Stock Option and Grant Plan, as amended (thePlan), which authorizes the Board of Directors of the Company to grantincentive stock options or non-qualified stock options. Incentive stock optionsmay be granted only to employees of the Company. Non-qualified stock optionsmay be granted to officers and employees of the Company as well as tonon-employees. The maximum number of shares to be issued under the Plan is3,356,778 shares, as amended. All options granted under the Plan have been madeat prices not less than the estimated fair market value of the stock at thedate of grant. Generally the options granted under the Plan vest over three tofive years. Options granted under the plan have a term of not more than 10years.

 

 

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Asummary of the Company’s stock option activity, and related information is asfollows:

 
|                              |   | **Number of Options** |   | **Weighted Average Exercise Price Per Share** |   | **Exercise Price Per   Share** |   |
|-----------------------------------|--------|-----------------------|--------|-----------------------------------------------|--------|-------------------------------------|--------|
|                              |   |                  |   |                                          |   |                                |   |
| Outstanding at January  1, 1999   |   | 845,000               |   | 6.67                                          |   | $1.88 – $13.00                 |   |
| Granted                           |   | 845,000               |   | 7.88                                          |   | $6.03 – $10.63                 |   |
| Forfeited                         |   | (45,000               | )      | 10.39                                         |   | $6.03 – $11.25                 |   |
| Exercised                         |   | (29,000               | )      | 1.88                                          |   | $1.88                               |   |
| Outstanding at December  31, 1999 |   | 1,616,000             |   | 7.28                                          |   | $1.88 – $13.00                 |   |
| Granted                           |   | 1,182,000             |   | 2.87                                          |   | $1.50 – $7.00                  |   |
| Forfeited                         |   | (677,500              | )      | 7.74                                          |   | $2.10 – $10.40                 |   |
| Exercised                         |   | (133,500              | )      | 1.98                                          |   | $1.88 – $2.10                  |   |
| Outstanding at December  31, 2000 |   | 1,987,000             |   | 4.59                                          |   | $1.88 – $13.00                 |   |
| Granted                           |   | 1,000,000             |   | 1.63                                          |   | $1.32 – $3.60                  |   |
| Forfeited                         |   | (32,000               | )      | 1.81                                          |   | $1.50 – $10.63                 |   |
| Exercised                         |   | (259,500              | )      | 3.01                                          |   | $1.32 – $1.94                  |   |
| Outstanding at December  31, 2001 |   | 2,695,500             |   | 3.58                                          |   | $1.32 – $13.00                 |   |
|                              |   |                  |   |                                          |   |                                |   |
| Exercisable at:                   |   |                  |   |                                          |   |                                |   |
| December 31, 1999                 |   | 475,895               |   | $5.43                                         |   | $1.88 – $13.00                 |   |
| December 31, 2000                 |   | 675,326               |   | $5.07                                         |   | $1.88 – $13.00                 |   |
| December 31, 2001                 |   | 1,547,482             |   | $4.00                                         |   | $1.32 – $13.00                 |   |

 

AtDecember 31, 2001, 736,278 shares were available for future grant. Theweighted average remaining contractual life for the outstanding options inyears was 8.37, 8.82 and 8.83 at December 31, 2001, 2000 and 1999,respectively.

 

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If the Company had elected to recognize compensationexpense based on the fair value of the options granted at grant date for itsstock-based compensation plans consistent with the methodprescribed by SFAS No. 123, the Company’s net income (loss) would have beenreduced to the pro forma amounts indicated below:

 
|                        |   | **Year ended December 31** |        |
|-----------------------------|--------|---------------------------------|-------------|
|                        |   | **2001**                        |        | **2000** |   | **1999** | ** ** |
| Net income (loss):          |   |                            |        |   |   |   |   |
| As reported                 |   | $                               | (20,340,094 | ) | $ | (5,216,218 | ) | $ | 9,188,103 |   |
| Pro forma                   |   | (21,183,444                     | )           | (5,768,339 | ) | 8,790,433 |   |
|                        |   |                            |        |   |   |   |   |
| Earnings (loss) per  share: |   |                            |        |   |   |   |   |
| As reported – basic    |   | $                               | (1.59       | ) | $ | (0.39 | ) | $ | 0.69 |   |
| Pro forma – basic      |   | (1.66                           | )           | (0.44 | ) | 0.66 |   |
| As reported – diluted  |   | (1.59                           | )           | (0.39 | ) | 0.67 |   |
| Pro forma – diluted    |   | (1.66                           | )           | (0.44 | ) | 0.64 |   |

 

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

 
|                             |   | **Year ended December 31** |   |
|----------------------------------|--------|---------------------------------|--------|
|                             |   | **2001**                        |   | **2000** |   | **1999** | ** ** |
| Expected dividend yield          |   | 0.0                             | %      | 0.0 | % | 0.0 | % |
| Expected stock price  volatility |   | 75.6                            |   | 75.6 |   | 55.9 |   |
| Risk free interest rate          |   | 5.5                             | %      | 5.5 | % | 5.5 | % |
| Expected life of  options        |   | 5 years                         |   | 5 years |   | 5 years |   |

 

Theseassumptions resulted in weighted average fair values of $1.05, $2.04 and $3.61for each stock option granted in 2001, 2000 and 1999, respectively.

 

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**7. Commitments and Contingencies**

 

The Company leasescertain equipment and facilities under noncancelable operating leases thatexpire in various years through 2006. Rent expense under operating leasestotaled $108,031, $118,060 and $255,356 for the years ended December 31,2001, 2000 and 1999, respectively.

 

Future minimum lease payments under noncancelableoperating leases with initial terms of one year or more consisted of thefollowing at December 31, 2001:

 
| 2002                          |   | $       | 127,116 |   |
|-------------------------------|--------|---------|---------|--------|
| 2003                          |   | 109,241 |    |
| 2004                          |   | 93,895  |    |
| 2005                          |   | 7,448   |    |
| Total minimum lease  payments |   | $       | 337,700 |   |

 

From time to time theCompany is subject to litigation incidental to its business, including possibleproduct liability claims. Such claims, if successful, could exceed applicableinsurance coverage. The Company is not currently a party to any material legalproceedings.

 

**8. Employee Benefits Plans**

 

TheCompany has a profit sharing 401(k) plan that covers substantially all of itsemployees. Eligible employees may contribute up to 10% of their compensation.Contributions are discretionary; however, the Company generally matches 10% ofthe employees’ contributions up to the maximum of 1% of eligible compensation.Amounts recognized as expense were $19,659, $9,555 and $10,045 for the years endedDecember 31, 2001, 2000 and 1999, respectively.

 

InMay 1998, the Board of Directors approved the Natrol, Inc. Employee StockPurchase Plan (the ESPP) which allows substantially all employees to purchaseshares of Common Stock of the Company, through payroll deductions, at 85% ofthe fair market value of the shares at the beginning or end of the offeringperiod, whichever is lower. The ESPP provides for employees to authorizepayroll deductions of up to 10% of their compensation for each pay period. Inconjunction with the ESPP, the Company registered with the Securities andExchange Commission 225,000 shares of the Company’s 

 

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CommonStock reserved for purchase under the ESPP. As of December 31, 2001 and2000, 163,816 and 172,579 shares are available for issuance under this plan.For the year ended December 31, 2001, 17,043 shares were issued at pricesranging from $1.28 to $2.00 per share under the plan. For the year endedDecember 31, 2000, 25,366 shares were issued at prices ranging from $1.28to $2.76 per share under the plan. For the year ended December 31, 1999,18,775 shares were issued at prices ranging from $5.95 to $6.38 per share underthe plan.

 

**9. Fair Value of Financial Instruments**

 

Thefollowing methods and assumptions were used by the Company in estimating itsfair value disclosures for financial instruments.

 

*Cash and Cash Equivalents:*the carrying amountapproximates fair value.

 

*Accounts Receivable and Accounts Payable:*the carryingamount approximates fair value.

 

*Debt:*The carrying amount of the Company’sborrowings on its revolving line of credit approximates fair value. The fairvalue of the Company’s long-term notes payable are estimated using discountedcash flow analyses, based on the Company’s current incremental borrowing ratesfor similar types of borrowing arrangements. The carrying amount of long-termnotes payable approximates their fair value at December 31, 2001.

 

**10. Impairment of Goodwill**

 

TheCompany, as part of its review of financial results for 2001, performed anassessment of the carrying value of the Company’s long-lived assets to be heldand used, including significant amounts of goodwill recorded in connection withits various acquisitions. The assessment was performed pursuant to SFAS 121because of the significant negative industry and economic trends affecting boththe Company’s current operations and expected future sales as well as thegeneral decline in market valuations. The conclusion of that assessment wasthat the decline in market conditions within the Company’s industry wassignificant and other than temporary. As a result, the Company recorded acharge of $20,000,000 to reduce goodwill during the fourth quarter of 2001,based on the amount by which the carrying amount of these assets exceeded theirestimated fair value. 

 

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**10. Impairment of Goodwill (continued)**

 

Thetotal writedown is primarily related to the goodwill recorded in connection withthe Company’s acquisition of Prolab. The charge is included in the captionreduction of goodwill on the statements of operations. Fair value wasdetermined based on discounted future cash flows for the operating entity. Thecash flow periods used were six years using an annual growth rate of 2% to 20%.The discount rate used was 26.55% for each of the following six years. Theassumptions supporting the estimated future cash flows reflect management’sbest estimates. The discount rate was based upon the risk free rate as adjustedfor the risks associated with the operations.

 

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

 
|                               |   | **Three Months Ended**                   |     |
|------------------------------------|--------|------------------------------------------|----------|
|                               |   | **March 31**                             |     | **June 30** |   | **September 30** |   | **December 31** |   |
|                               |   | *(In  Thousands, Except Per Share Data)* | * * |
| 2001:                              |   |                                     |     |   |   |   |   |   |   |
| Net sales                          |   | $                                        | 19,769   |   | $ | 20,277 |   | $ | 21,199 |   | $ | 14,916 |   |
| Gross profit                       |   | 8,703                                    |     | 9,234 |   | 10,262 |   | 5,898 |   |
| Net income (loss)                  |   | 657                                      |     | 920 |   | 1,048 |   | (22,965 | ) |
| Basic earnings (loss)  per share   |   | $                                        | 0.05     |   | $ | 0.07 |   | $ | 0.08 |   | $ | (1.79 | ) |
| Diluted earnings (loss)  per share |   | $                                        | 0.05     |   | $ | 0.07 |   | $ | 0.08 |   | $ | (1.79 | ) |
|                               |   |                                     |     |   |   |   |   |   |   |
| 2000:                              |   |                                     |     |   |   |   |   |   |   |
| Net sales                          |   | $                                        | 22,694   |   | $ | 24,083 |   | $ | 22,283 |   | $ | 18,029 |   |
| Gross profit                       |   | 10,775                                   |     | 9,275 |   | 10,174 |   | 6,931 |   |
| Net income (loss)                  |   | 736                                      |     | (2,408 | ) | (521 | ) | (3,023 | ) |
| Basic earnings (loss)  per share   |   | $                                        | 0.06     |   | $ | (0.18 | ) | $ | (0.04 | ) | $ | (0.23 | ) |
| Diluted earnings (loss)  per share |   | $                                        | 0.05     |   | $ | (0.18 | ) | $ | (0.04 | ) | $ | (0.23 | ) |

 

 

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Natrol, Inc

 

Schedule II – Valuationand Qualifying Accounts

 

Years endedDecember 31, 2001, 2000 and 1999

 
| **Description**                    |   | **Balance at  Beginning of  Period** |      | **Charged to  Cost and  Expense** |   | **Additions  charged to  Acquisitions** |   | **Deductions** |   | **Balance at  End of  Period** |   |
|------------------------------------|--------|--------------------------------------|-----------|-----------------------------------|--------|-----------------------------------------|--------|----------------|--------|--------------------------------|--------|
| Allowance for Doubtful  Accounts:  |   |                                 |      |                              |   |                                    |   |           |   |                           |   |
| Year ended December 31,  1999 |   | $                                    | 332,000   |                              | $      | 92,700                                  |   | $              | 97,647 |                           | $      | 19,847 |   | $ | 502,500 |   |
| Year ended  December 31, 2000 |   | $                                    | 502,500   |                              | $      | 400,000                                 |   | $              | — |                           | $      | 423,400 |   | $ | 479,100 |   |
| Year ended  December 31, 2001 |   | $                                    | 479,100   |                              | $      | 437,600                                 |   | $              | — |                           | $      | 554,066 |   | $ | 362,634 |   |
|                               |   |                                 |      |                              |   |                                    |   |           |   |                           |   |
| Allowance for Sales  Returns:      |   |                                 |      |                              |   |                                    |   |           |   |                           |   |
| Year ended  December 31, 1999 |   | $                                    | 667,075   |                              | $      | 1,108,859                               |   | $              | — |                           | $      | 531,852 | (1) | $ | 1,244,082 |   |
| Year ended  December 31, 2000 |   | $                                    | 1,244,082 |                              | $      | 3,790,276                               |   | $              | — |                           | $      | 3,574,324 | (1) | $ | 1,460,034 |   |
| Year ended December 31,  2001      |   | $                                    | 1,460,034 |                              | $      | 2,008,498                               |   | $              | — |                           | $      | 2,448,215 | (1) | $ | 1,020,317 |   |

 

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(1) Represents actual returns of goods

 

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