**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

**(Mark one)**
| **x**                                             | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------|------------|------------------------------------------------------------------------------------------------|
| ** **                                        |
| **FOR THE  QUARTERLY PERIOD ENDED JUNE 30, 2007** |
| ** **                                        |
| **OR**                                            |
| ** **                                        |
| **o**                                             | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**FOR THE TRANSITION PERIOD FROM             TO             **

**COMMISSION FILE NO: 0-24567**

**NATROL, INC.**

(Exact name of registrant as specified in its charter)

| **Delaware**                                                     |   | **95-3560780**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (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)

**Not Applicable**

(Former name, former address and former fiscal year,if changed since last report)

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

Indicate by check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12-B2 of the Exchange Act. (checkone)

| Large accelerated filer o |   | Accelerated  filer o |   | or  Non-accelerated filer x |
|---------------------------|--------|----------------------|--------|-----------------------------|

 

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the ExchangeAct).  Yes o  No x

As ofAugust 5, 2007, 14,157,044 shares of the registrant’s common stock wereoutstanding.

 

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**TABLEOF CONTENTS**
| PART I        |   | FINANCIAL INFORMATION                                                                       |   |
|---------------|--------|---------------------------------------------------------------------------------------------|--------|
|          |   |                                                                                        |   |
| Item 1.       |   | Financial Statements                                                                        |   |
|          |   |                                                                                        |   |
|          |   | Consolidated Balance Sheets                                                                 |   |
|          |   |                                                                                        |   |
|          |   | Consolidated Statements of Income                                                           |   |
|          |   |                                                                                        |   |
|          |   | Consolidated Statements of Cash Flows                                                       |   |
|          |   |                                                                                        |   |
|          |   | Notes to  Consolidated Unaudited Financial Statements                                       |   |
|          |   |                                                                                        |   |
| Item 2.       |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|          |   |                                                                                        |   |
| Item 3.       |   | Quantitative  and Qualitative Disclosures About Market Risk                                 |   |
|          |   |                                                                                        |   |
| Item 4.       |   | Controls and Procedures                                                                     |   |
|          |   |                                                                                        |   |
| PART II.      |   | OTHER INFORMATION                                                                           |   |
|          |   |                                                                                        |   |
| Item  1A.     |   | Risk  Factors                                                                               |   |
|          |   |                                                                                        |   |
| Item 5.       |   | Other Information                                                                           |   |
|          |   |                                                                                        |   |
| Item  6.      |   | Exhibits                                                                                    |   |
|          |   |                                                                                        |   |
| Signature     |   |                                                                                        |   |
|          |   |                                                                                        |   |
| Exhibit Index |   |

 

2

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**PART1—FINANCIAL INFORMATION**

##### **Item 1. Financial Statements**

**Natrol, Inc. andSubsidiaries**

**ConsolidatedCondensed Balance Sheets**

**(In thousands, except share andper share data)**
| ** **                                                                                                                                                                                               | ** ** | **June 30** | ** ** | **December 31** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|----------------------|------------|
| ** **                                                                                                                                                                                               | ** ** | **2007**         | ** ** | **2006**             | ** ** |
| ** **                                                                                                                                                                                               | ** ** | **(unaudited)**  | ** ** | ** **           | ** ** |
| **Assets**                                                                                                                                                                                               | ** ** | ** **       | ** ** | ** **           | ** ** |
| Current assets:                                                                                                                                                                                          |       |             |       |                 |       |
| Cash and cash  equivalents                                                                                                                                                                               |       | $                | 8,640      |                 | $          | 1,003 |   |
| Accounts  receivable, net of allowances of $241 and $181 at June 30, 2007 and December  31, 2006, respectively                                                                                           |       | 11,274           |       | 6,485                |       |
| Inventory                                                                                                                                                                                                |       | 20,057           |       | 11,788               |       |
| Income taxes  receivable                                                                                                                                                                                 |       | —           |       | 375                  |       |
| Deferred income  taxes                                                                                                                                                                                   |       | 1,635            |       | 1,630                |       |
| Prepaid expenses  and other current assets                                                                                                                                                               |       | 1,164            |       | 1,743                |       |
| Total current assets                                                                                                                                                                                     |       | 42,770           |       | 23,024               |       |
| Property and equipment:                                                                                                                                                                                  |       |             |       |                 |       |
| Building and  improvements                                                                                                                                                                               |       | —           |       | 14,953               |       |
| Machinery and  equipment                                                                                                                                                                                 |       | 6,122            |       | 5,757                |       |
| Furniture and  office equipment                                                                                                                                                                          |       | 3,038            |       | 3,013                |       |
|                                                                                                                                                                                                     |       | 9,160            |       | 23,723               |       |
| Accumulated  depreciation and amortization                                                                                                                                                               |       | (7,343           | )          | (9,912               | )          |
| Property and equipment,  net                                                                                                                                                                             |       | 1,817            |       | 13,811               |       |
|                                                                                                                                                                                                     |       |             |       |                 |       |
| Restricted cash                                                                                                                                                                                          |       | 5,250            |       | 5,000                |       |
| Deferred income taxes                                                                                                                                                                                    |       | 4,265            |       | 4,265                |       |
| Goodwill, net of  accumulated amortization and impairment charge                                                                                                                                         |       | 2,026            |       | 2,026                |       |
| Trademarks                                                                                                                                                                                               |       | 5,730            |       | 5,730                |       |
| Other assets                                                                                                                                                                                             |       | 1,047            |       | 744                  |       |
| Total assets                                                                                                                                                                                             |       | $                | 62,905     |                 | $          | 54,600 |   |
| ** **                                                                                                                                                                                               | ** ** | ** **       | ** ** | ** **           | ** ** |
| **Liabilities and stockholders’  equity**                                                                                                                                                           | ** ** | ** **       | ** ** | ** **           | ** ** |
| Current liabilities:                                                                                                                                                                                     |       |             |       |                 |       |
| Line of credit                                                                                                                                                                                           |       | $                | —     |                 | $          | 3,694 |   |
| Accounts payable                                                                                                                                                                                         |       | 8,039            |       | 3,058                |       |
| Accrued expenses                                                                                                                                                                                         |       | 3,081            |       | 2,558                |       |
| Accrued payroll  and related liabilities                                                                                                                                                                 |       | 1,364            |       | 1,185                |       |
| Income taxes  payable                                                                                                                                                                                    |       | 2,850            |       | —               |       |
| Current portion  of long-term debt                                                                                                                                                                       |       | 12               |       | 414                  |       |
| Total current  liabilities                                                                                                                                                                               |       | 15,346           |       | 10,909               |       |
|                                                                                                                                                                                                     |       |             |       |                 |       |
| Long-term debt, less  current portion                                                                                                                                                                    |       | 31               |       | 6,301                |       |
| Deferred benefit from  sale leaseback                                                                                                                                                                    |       | 5,280            |       | —               |       |
|                                                                                                                                                                                                     |       |             |       |                 |       |
| Commitments and  contingencies                                                                                                                                                                           |       | —           |       | —               |       |
|                                                                                                                                                                                                     |       |             |       |                 |       |
| Stockholders’ equity:                                                                                                                                                                               |       |             |       |                 |       |
| Preferred stock,  par value of $0.01 per share: Authorized shares—2,000,000; Issued and outstanding  shares—none                                                                               |       | —           |       | —               |       |
| Common stock,  par value of $0.01 per share: Authorized shares—50,000,000, Issued and  outstanding shares—14,155,544 and 14,116,148 at June 30, 2007 and  December 31, 2006, respectively |       | 142              |       | 141                  |       |
| Additional  paid-in capital                                                                                                                                                                              |       | 61,965           |       | 61,638               |       |
| Accumulated  deficit                                                                                                                                                                                     |       | (19,896          | )          | (24,409              | )          |
| Accumulated  other comprehensive income                                                                                                                                                                  |       | 37               |       | 20                   |       |
| Total stockholders’  equity                                                                                                                                                                         |       | 42,248           |       | 37,390               |       |
| Total liabilities and stockholders’ equity                                                                                                                                                          |       | $                | 62,905     |                 | $          | 54,600 |   |

See accompanying notes

3

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**Natrol, Inc. and Subsidiaries**

**Consolidated CondensedStatements of Income**

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

**(unaudited)**
| ** **                                                  | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                  | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                  | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                        |       |                             |       |                           |       |   |   |   |   |
| Net sales                                                   |       | $                                | 19,547     |                           | $          | 16,587 |   | $ | 38,254 |   | $ | 33,511 |   |
| Cost of goods  sold                                         |       | 10,263                           |       | 9,394                          |       | 20,184 |   | 19,423 |   |
| Gross profit                                                |       | 9,284                            |       | 7,193                          |       | 18,070 |   | 14,088 |   |
|                                                        |       |                             |       |                           |       |   |   |   |   |
| Selling and  marketing expenses                             |       | 5,549                            |       | 4,092                          |       | 10,575 |   | 8,183 |   |
| General and  administrative expenses                        |       | 2,998                            |       | 2,831                          |       | 6,015 |   | 5,649 |   |
| Total operating  expenses                                   |       | 8,547                            |       | 6,923                          |       | 16,590 |   | 13,832 |   |
| Operating income                                            |       | 737                              |       | 270                            |       | 1,480 |   | 256 |   |
|                                                        |       |                             |       |                           |       |   |   |   |   |
| Interest income                                             |       | 151                              |       | 60                             |       | 184 |   | 116 |   |
| Interest expense                                            |       | (70                              | )          | (153                           | )          | (291 | ) | (307 | ) |
| Other (Loss)                                                |       | (35                              | )          | —                         |       | (35 | ) | — |   |
| Gain on sale of  property                                   |       | 6,062                            |       | —                         |       | 6,062 |   | 230 |   |
| Income before  taxes                                        |       | 6,845                            |       | 177                            |       | 7,400 |   | 295 |   |
| Income tax  provision                                       |       | 2,672                            |       | 77                             |       | 2,887 |   | 122 |   |
| Net income                                                  |       | $                                | 4,173      |                           | $          | 100 |   | $ | 4,513 |   | $ | 173 |   |
|                                                        |       |                             |       |                           |       |   |   |   |   |
| Income per  share:                                          |       |                             |       |                           |       |   |   |   |   |
| Basic                                                       |       | $                                | 0.29       |                           | $          | 0.01 |   | $ | 0.32 |   | $ | 0.01 |   |
| Diluted                                                     |       | $                                | 0.25       |                           | $          | 0.01 |   | $ | 0.28 |   | $ | 0.01 |   |
|                                                        |       |                             |       |                           |       |   |   |   |   |
| Weighted-average  shares outstanding—basic and diluted |       |                             |       |                           |       |   |   |   |   |
|                                                        |       |                             |       |                           |       |   |   |   |   |
| Basic                                                       |       | 14,153,601                       |       | 13,563,747                     |       | 14,149,355 |   | 13,557,115 |   |
| Diluted                                                     |       | 16,763,440                       |       | 13,914,763                     |       | 16,093,514 |   | 13,865,531 |   |

 

See accompanying notes

4

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**Natrol, Inc. and Subsidiaries**

**Consolidated CondensedStatements of Cash Flows**

**(In thousands)**

**(unaudited)**
| ** **                                                                               | ** ** | **Six months ended** | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                               | ** ** | **June 30,**              | ** ** |
| ** **                                                                               | ** ** | **2007**                       | ** ** | **2006** | ** ** |
|                                                                                     |       |                           |       |   |   |
| **Operating  activities**                                                                | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net income                                                                               |       | $                              | 4,513      |   | $ | 173 |   |
|                                                                                     |       |                           |       |   |   |
| Adjustments to  reconcile income to net cash provided by (used) in operating activities: |       |                           |       |   |   |
| Gain on sale of  property                                                                |       | (6,062                         | )          | — |   |
| Depreciation and  amortization                                                           |       | 605                            |       | 697 |   |
| Foreign currency  translation                                                            |       | 17                             |       | — |   |
| Provision for  bad debts                                                                 |       | 60                             |       | (37 | ) |
| Deferred income  taxes                                                                   |       | (5                             | )          | (128 | ) |
| Shares issued  for services                                                              |       | —                         |       | 32 |   |
| Option expense                                                                           |       | 264                            |       | 359 |   |
| Changes in  operating assets and liabilities:                                            |       |                           |       |   |   |
| Deferred benefit  from sale leaseback                                                    |       | 5,280                          |       | — |   |
| Accounts  receivable                                                                     |       | (4,849                         | )          | (781 | ) |
| Inventory                                                                                |       | (8,270                         | )          | (439 | ) |
| Income taxes  receivable/payable                                                         |       | 3,225                          |       | 205 |   |
| Prepaid expenses  and other current assets                                               |       | 579                            |       | 234 |   |
| Accounts payable                                                                         |       | 4,979                          |       | (3,102 | ) |
| Accrued expenses                                                                         |       | 522                            |       | 1439 |   |
| Accrued payroll  and related liabilities                                                 |       | 179                            |       | 238 |   |
| Net cash  provided by (used in) operating activities                                     |       | 1,037                          |       | (1,110 | ) |
| ** **                                                                               | ** ** | ** **                     | ** ** | ** ** | ** ** |
| **Investing  activities**                                                                | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Purchases of  property and equipment                                                     |       | (234                           | )          | (267 | ) |
| Proceeds from sale  of property                                                          |       | 26,000                         |       | — |   |
| Cash outlay for  acquisition                                                             |       | (8,235                         | )          | 759 |   |
| Other assets                                                                             |       | (629                           | )          | 12 |   |
| Net cash  provided by investing activities                                               |       | 16,902                         |       | 504 |   |
| ** **                                                                               | ** ** | ** **                     | ** ** | ** ** | ** ** |
| **Financing  activities**                                                                | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Repayment of  line of credit                                                             |       | (3,694                         | )          | — |   |
| Repayments on  long-term debt                                                            |       | (6,672                         | )          | (263 | ) |
| Proceeds from  issuance of common stock                                                  |       | 64                             |       | 34 |   |
| Net cash used in  financing activities                                                   |       | (10,302                        | )          | (229 | ) |
|                                                                                     |       |                           |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                    |       | 7,637                          |       | (835 | ) |
| Cash and cash  equivalents, beginning of period                                          |       | 1,003                          |       | 3,097 |   |
| Cash and cash  equivalents, end of period                                                |       | $                              | 8,640      |   | $ | 2,262 |   |

 

See accompanying notes

5

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**Natrol, Inc. andSubsidiaries**

**Notes to Consolidated Unaudited Financial Statements**

(In thousands,except share and per share data)

1. BASIS OF PRESENTATION

The accompanyingconsolidated condensed financial statements have been prepared by Natrol, Inc.(the “Company”), pursuant to the rules and regulations of the Securities andExchange Commission (SEC). This quarterly report on Form 10-Q should be read inconjunction with the Company’s annual report on Form 10-K for the year endedDecember 31, 2006. Certain information and footnote disclosures which arenormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to SEC rules and regulations. Theinformation reflects all normal and recurring adjustments which, in the opinionof the Company’s management, are necessary for a fair presentation of thefinancial position of the Company and its results of operations for the interimperiods set forth herein. The results for the three and six  months ended June 30, 2007 are notnecessarily indicative of the results to be expected for the full year or anyother period.

2. STOCK BASED COMPENSATION

Duringthe three and six month periods ended June 30, 2007, the Company grantedoptions to purchase 50,000 shares and 77,500 shares of common stock,respectively. During the three and six month periods ended June 30, 2006 theCompany granted options to purchase 497,499 and 6,786,999 shares of commonstock, respectively. Of these shares, 6,029,500 options were granted to WayneM. Bos upon his appointment as the Company’s CEO and President. This optionaward was approved by the stockholders of the Company at its 2006 annualmeeting of stockholders. The remaining options were granted to other employeesand directors. The options granted to Mr. Bos have certain service andperformance conditions which have been discussed in the Company’s prior SECfilings. These options were fully vested upon grant, and we recognized arelated expense of $0.3 million during the first quarter of 2006.

TheCompany used a Monte Carlo method to simulate stock price paths over the termof the 6,029,500 options awarded to Mr. Bos. All other options were valuedusing a Black-Scholes model. The Monte Carlo method, which is one acceptablevaluation method per Statement of Financial Accounting Standard 123R, was useddue to many factors which make utilizing a Black-Scholes model inappropriatefor a block of options of this magnitude. These factors include but are notlimited to the size of the grant in relation to the total shares outstanding,the trading volume of the Company’s stock and the holder’s ability to resellthe shares, and the control factor, which the size of the grant implies. TheCompany used the services of a well-credentialed group of valuation experts toperform the valuation of Mr. Bos’ options. This group developed multiplescenarios, including continuing operation and sale scenarios, to assess thepotential to create shareholder value over the term of the options. Theresulting Monte Carlo analysis gave rise to a range of fair values for whichthe mean amount was utilized in valuing the options for Mr. Bos.

Allother stock options were valued using a Black-Scholes model. Under SFAS 123R,the Company will continue to utilize the Black-Scholes model to estimate thefair market value related to employee stock options granted, modified,cancelled or repurchased after January 1, 2006, unless such method is clearlyinappropriate for a significant block of stock options, such as were granted toMr. Bos. The Company’s assessment of the estimated compensation charges forthese other stock options is affected by its stock price as well as assumptionsregarding a number of complex and subjective variables and the related taximpact. These variables include, but are not limited to, the Company’s stockprice volatility and expected employee stock option behavior.  The Company recorded option expenses of$133,000 and $265,000 for the three  andsix month periods ended June 30, 2007 and $67,000 and $359,000 for the threeand six month periods ended June 30, 2006, respectively.

6

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The following summarizes the Company’s stock option activity for thesix months ended June 30, 2007:

 
| ** **                      | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **    | ** ** |
|---------------------------------|------------|------------|------------|--------------|------------|-----------------|------------|---------------|------------|
| ** **                      | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                      | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**     | ** ** |
| Number of option  shares:       |       |       |       |         |       |            |       |          |       |
| Outstanding at  January 1, 2007 |       | 8,618,256  |       | $            | 2.32       |            |       |          |       |   |
| Granted                         |       | 77,500     |       | 3.44         |       |            |       |          |       |
| Exercised                       |       | 21,817     |       | 1.39         |       |            |       |          |       |
| Canceled or  expired            |       | 63,500     |       | 2.23         |       |            |       |          |       |
| Outstanding at  June 30, 2007   |       | 8,610,439  |       | $            | 2.33       |            | 4.21       |          | $          | 0.0 |   |
| Exercisable at June 30,  2007   |       | 7,645,429  |       | $            | 2.33       |            | 3.92       |          | $          | 0.0 |   |

 

Thetotal fair value of unvested options as of June 30, 2007 was $882,508. Theaggregate intrinsic value of unvested options as of June 30, 2007 was $0.0.

Thefollowing summarizes the fair value of the Company’s unvested stock optionsthat vested during the six months ended June 30, 2007.
| ** **                   | ** ** | **Shares** | ** ** | **Weighted  Average  Fair  Value** | ** ** |
|------------------------------|------------|------------|------------|------------------------------------|------------|
| Unvested at  January 1, 2007 |       | 1,231,574  |       | $                                  | 0.91       |   |
| Granted                      |       | 77,500     |       | 1.11                               |       |
| Canceled or  expired         |       | 53,500     |       | 1.21                               |       |
| Vested                       |       | 290,564    |       | 0.91                               |       |
| Unvested at June 30,  2007   |       | 965,010    |       | $                                  | 0.91       |   |

 

TheBlack-Scholes option-pricing model is used by the Company to determine theweighted average fair value of options, except for the options granted to WayneBos. The fair value of options at date of grant and the assumptions utilized todetermine such values are indicated in the following table:
| ** **                                                                                              | ** ** | **Six months ended** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                              | ** ** | **June 30,**              | ** ** |
| ** **                                                                                              | ** ** | **2007**                       | ** ** | **2006** | ** ** |
|                                                                                                    |       |                           |       |   |   |
| Weighted average  fair value at date of grant for options granted during the period using  Black-Sholes |       | $                              | 1.11       |   | $ | 1.39 |   |
| Risk-free  interest rates                                                                               |       | 4.45                           | %          | 4.51 | % |
| Expected stock  price volatility                                                                        |       | 59.72                          |       | 60.82 |   |
| Expected dividend yield                                                                                 |       | 0.0                            | %          | 0.0 | % |
|                                                                                                         |            |                                |            |  |  |  |  |

 

Theseassumptions resulted in a weighted-average fair value of $1.11 and $1.39respectively, for each stock option valued using the Black-Scholes method andgranted in each of the six-month periods ended June 30, 2007 and 2006.

3. INVENTORY

Inventoriesconsist of the following:
| ** **                           | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                           | ** ** | **(In thousands)** | ** ** |
| Raw material and  packaging supplies |       | $                       | 9,920      |                        | $          | 6,778 |   |
| Finished goods                       |       | 10,137                  |       | 5,010                       |       |
| Total inventory                      |       | $                       | 20,057     |                        | $          | 11,788 |   |

 

7

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4. SHIPPING AND HANDLINGCOSTS

The Company records all amountscharged to customers for shipping and handling as revenue. All outboundshipping and fulfillment costs are classified as selling and marketing expensesand totaled approximately $0.9 and $1.7 million for the three and sixmonth periods ending June 30, 2007 and approximately $0.8 and $1.6 millionin the three and six month periods ended June 30, 2006.

5. EARNINGS PER SHARE

TheCompany calculates income per share in accordance with Statement of FinancialAccounting Standard No. 128, *Earningsper Share*. Basic earnings per share have been computed by dividingnet income by the weighted average number of common shares outstanding duringthe period. Diluted earnings per share have been computed by dividing netincome by the weighted average number of common shares and dilutive commonstock equivalents (stock options), when dilutive.

Asof the three and six month periods ending June 30, 2007 and 2006, the followingoptions were outstanding and considered anti-dilutive.
|                       | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **            | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
|                  |       |                                                |       |                                              |       |   |   |   |   |
| Options  outstanding  |       | 8,610,439                                           |       | 9,039,756                                         |       | 8,610,439 |   | 9,039,756 |   |
|                  |       |                                                |       |                                              |       |   |   |   |   |
| Anti-dilutive options |       | 5,005,849                                           |       | 8,688,740                                         |       | 6,170,033 |   | 8,733,840 |   |

 

6.SENIOR CREDIT FACILITY

TheCompany is party to a loan and security agreement with Wachovia Capital Finance(Western), as agent, the lenders party thereto, Prolab Nutrition, the Company’swholly owned subsidiary, and certain of its other subsidiaries, as guarantors.The loan agreement provides for a three-year secured revolving credit facilityof up to $10.0 million. Borrowings under the credit facility may be usedfor ongoing working capital purposes and certain future acquisitions. At June 30,2007, the Company had no borrowings outstanding under the credit facility.

Underthe credit facility, the Company may borrow up to the lesser of$10.0 million or the borrowing base (calculated based upon eligibleinventory and eligible accounts). The interest rate on borrowings under thecredit facility is equal to: (1) agent’s publicly announced prime rate forprime rate loans or (2) 2.25% plus the applicable Eurodollar rate for anyEurodollar rate loans. Interest is payable monthly in arrears not later than thefirst day of each calendar month. The agent’s prime rate as of June 30, 2007was 8.25%. The credit facility requires that all principal be repaid in August2009. Additionally, borrowings under the credit facility must be repaid whenthe borrowings exceed the borrowing base.

Thecredit facility is secured by a first priority lien on all of the Company’sassets and properties (which includes the assets and properties of ProlabNutrition, the guarantors and the Company’s future subsidiaries), subject to certainexceptions. The obligations under the credit facility are guaranteed by NatrolProducts, Inc., Natrol Acquisition Corp. and Natrol Direct, Inc. and by each ofthe Company’s future subsidiaries.

Thecredit facility contains covenants restricting the Company’s ability to, amongother things: (1) incur or guarantee additional debt; (2) engage in any mergersor acquisitions (subject to certain exceptions); (3) engage in any asset salesor dispose of any assets (other than in the ordinary course); (4) engage intransactions with affiliates; (5) incur liens; (6) make any loans orinvestments; and (7) declare or pay dividends or redeem or repurchase capitalstock.

Thecredit facility also provides for customary events of default, includingnon-payment defaults, covenant defaults and cross-defaults to the Company’sother material indebtedness.

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Asof June 30, 2007, the Company was in default under certain   covenants in the credit facility related toinvestments in new businesses.  TheCompany cannot borrow under the line of credit until Wachovia agrees to waivethe event of default and forbear from exercising its default rights.  Wachovia is now reviewing the acquisition ofMedical Research Institute (MRI) on June 1, 2007, which triggered the event ofdefault.  We expect the Company’s abilityto borrow against the line of credit to be reinstated in the normal courseof  review.

7. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS.

TheFinancial Accounting Standards Board (“FASB”) issued InterpretationNo. 48, *Accounting for Uncertainty inIncome Taxes* (“FIN 48”) in June 2006. The interpretationclarifies the accounting for uncertainty in income taxes recognized infinancial statements in accordance with Statement of Financial AccountingStandard 109. FIN 48 is effective for fiscal years beginning afterDecember 15, 2006. We adopted the provisions of FASB Interpretation No.48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASBStatement No. 109 (“FIN 48”), on January 1, 2007. FIN 48 clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financialstatements in accordance with FASB Statement 109, “Accounting for Income Taxes”,and prescribes a recognition threshold and measurement process for financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return. FIN 48 also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods,disclosure and transition.

Basedon our evaluation, we have concluded that there are no significant uncertaintax positions requiring recognition in our financial statements. Our evaluationwas performed for the tax years ended December 31, 2003, 2004, 2005 and 2006,the tax years which remain subject to examination by major tax jurisdictions asof June 30, 2007.

Wemay from time to time be assessed interest or penalties by major taxjurisdictions, although any such assessments historically have been minimal andimmaterial to our financial results. In the event we received an assessment forinterest and/or penalties, it was classified in the financial statements as “selling,general and administrative expense”.

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

**In February 2007, the FASB issued Statement of FinancialStandard No. 159, “****The Fair Value Option for Financial Assetsand Financial Liabilities Including an Amendment of FASB Statement No. 115****”(“SFAS 159”).  SFAS 159 permits entities to choose to measure manyfinancial instruments and certain other items at fair value, with unrealizedgains and losses related to these financial instruments reported in earnings ateach subsequent reporting date.  SFAS 159 is effective for fiscal yearsbeginning after November 15, 2007.  We are currently evaluating the impactthis Statement will have on our consolidated financial statements.**

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*8. FINAL RULE FOR CURRENT GOOD MANUFACTURING PRACTICES FORDIETARY SUPPLEMENTS*

*On June 22, 2007, the Food andDrug Administration (“FDA”) issued its final regulations establishing theminimum*Current GoodManufacturing Practices (“CGMPs”) necessary for activities related tomanufacturing, packaging, labeling, or holding operations for dietarysupplements.  The final rule applies toall dietary supplements sold or offered for sale in the United States andrequires manufacturers to evaluate the identity, purity, strength, andcomposition of their dietary supplements.  An Interim Final Rule has also been issued to allow manufacturers to petitionthe FDA for an exemption to the 100 percent identity testing requirement fordietary ingredients to be used in dietary supplements; provided that theydemonstrate that less than 100 percent identity testing does not materiallydiminish the assurance that the dietary ingredient is correctlyidentified.  The final CGMP and theinterim final rule are effective August 24, 2007 and the compliance date isJune 2008, except that businesses like the Company that employ fewer than 500but at least 20 or more full-time equivalent employees have until June 2009 tocomply with the regulation.   We arecurrently evaluating the potential impact that the new regulations and anyapplicable exemptions may have on the Company’s financial position, results ofoperations, or cash flows.

*9. ACQUISITION OF MEDICAL RESEARCH INSTITUTE, INC. (MRI)*

*On June 1, 2007, we acquired allof the outstanding stock of MRI for $8.6 million of cash and up to anadditional $80.0 million in cash based upon the Earnings Before Interest andTaxes (EBIT), as defined, of MRI during the three years after the acquisitiondate.  The Company allocated the purchaseprice per SFAS 141 to the fair value of the assets acquired, net of liabilitiesassumed.  Because the net assets acquiredwere greater than the cash paid, the value of certain fixed assets wereadjusted per SFAS 141.  These assets willbe adjusted should any additional payments be made to the former owners of MRI.*

*The only consideration used toacquire MRI was cash.*

*The following table summarizes theallocations of the consideration to the assets acquired net of liabilitiesassumed.*
|                                  | ** ** | **(000)** | ** ** |
|----------------------------------|------------|-----------|------------|
| Cash and cash  equivalents       |       | $         | 5,105      |   |
| Accounts  Receivable             |       | 2,514     |       |
| Inventory                        |       | 4,068     |       |
| Other Current  assets            |       | 98        |       |
| Property, Plant  & Equipment |       | 114       |       |
| Patents                          |       | 258       |       |
| Total Assets acquired            |       | 12,157    |       |
| Less Liabilities  assumed        |       | 3,531     |       |
| Total  Consideration             |       | 8,626     |       |
|                                  |            |           |            |  |

 

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*If the operating results of MRI had been includedsince the beginning the three and six month periods ended June 30, 2007 and2006, the pro forma revenues, net income and net income per share would be asfollows:*

* *
|                                                             | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months ended June 30,** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                  | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenues                                                    |       | $                                                   | 26,404     |                                              | $          | 20,869 |   | $ | 49,545 |   | $ | 47,384 |   |
| Net income                                                  |       | 5,174                                               |       | (856                                              | )          | 5,232 |   | 2,497 |   |
| Net income per  share                                       |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                       |       | $                                                   | 0.37       |                                              | $          | (0.06 | ) | $ | 0.37 |   | $ | 0.18 |   |
| Diluted                                                     |       | $                                                   | 0.31       |                                              | $          | (0.06 | ) | $ | 0.33 |   | $ | 0.18 |   |
| Weighted-average  shares outstanding—basic and diluted |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                       |       | 14,153,601                                          |       | 13,563,747                                        |       | 14,149,355 |   | 13,557,115 |   |
| Diluted                                                     |       | 16,763,440                                          |       | 13,914,763                                        |       | 16,093,514 |   | 13,865,531 |   |

 

*Our prime reason for acquiring MRIwas MRI’s premiere position in the sports nutrition marketplace, allowing us tostrengthen our position within this area of the nutraceutical business.*

*As of June 30, 2007, the balancesheet of MRI is consolidated with our balance sheet.  The statement of income of MRI for the 30 dayperiod from June 1, 2007 to June 30, 2007 is consolidated with our statement ofincome for the three and six month periods ended June 30, 2006.  The statement of cash flows for MRI for theperiod from June 1, 2007 to June 30, 2007 is included with our statement ofcash flows for the six months ended June 30, 2007.*

*10.  ACQUISITIONCOMMITMENTS*

*Nu Hair and Shen Min Brands*

Considerationfor the acquisition of the NuHair and Shen Min brands includes potentialincentive payments based upon the net amount of invoiced sales of the NuHairand Shen Min products during fiscal 2007, 2008 and 2009.  For 2007, the Company is obligated to pay theseller of the brands $1.00 (one dollar) for every dollar of net invoiced salesin excess of $7.6 million, calculated on a quarterly basis. ** ** The potential incentive payment for 2007 maynot exceed $2.0 million.  For 2008, theCompany is obligated to pay the seller 15% of the amount by which net invoicedsales exceed $11.4 million.  For 2009,the Company is obligated to pay the Seller 15% of the amount by which netinvoiced sales exceed $13.68 million.  Asof June 30, 2007, we do not believe that any potential incentive payments to theformer owners of the NuHair and Shen Min brands will be material.

*Promensil and Trinoven*

Considerationfor the license of the exclusive U.S. rights to the Promensil and Trinovenbrands includes a royalty on net sales revenue that exceeds $2.0 million.  Until 2014, the Company is obligated to payNovogen a royalty equal to 5.0% of annual net sales between $2.0 to $3.0million and a royalty equal to 7.5% of annual net sales in excess of $3.0million.  After 2014, the Company isobligated to pay Seller a royalty equal to 2% of annual net sales between $2.0to $3.0 million and a royalty equal to 3.0% of annual net sales in excess of$3.0 million.  During the six monthsended June 30, 2007, net sales revenue of the Promensil and Trinoven brandsamounted to $1.2 million and, as a result we do not believe that any potentialincentive payments to the licensor will be material.

*Medical Research Institute*

Considerationfor the acquisition of MRI, includes incentive payments that would allow theformer owners of MRI to earn an additional $80.0 million if the earnoutconditions are met.

Year one incentives.

If earnings before interest and taxes priorto general corporate allocations for the twelve (12) month period following theClosing Date (“Year One EBIT”) is between $2.5 million and $4.0 million,the former owners of MRI will be paid an incentive payment of between $4.7million and $7.5 million.  As of June 30,2007 we believe that it is highly likely that 

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an incentive payment will be made and thatthe amount will be at the mid to higher end of the range.

Also, if Year One EBITreaches $5.0 million, additional incentives may be earned by the former ownersof MRI.  These incentives begin at $5.0million and could exceed $21.5 million depending upon EBIT performance.  As of June 30, 2007, it is uncertain as towhether the $5.0 EBIT level will be reached and, as such it is uncertain as towhether an additional incentive payment will be made.

*Year two and three incentives.*

Year two and year three incentive payments are describedmore fully in our other filings with the SEC. In order to earn incentives in year two, EBIT for year two, as defined,must reach $6.5 million. In order to earn incentives in year three, EBIT foryear three as defined must reach $14.0 million. Total incentive payments forthe three years in which incentives can be earned could total as much as $80.0million if all incentive payment conditions are met.

11. SALE AND LEASEBACKTRANSACTION

InApril 2007, the company sold its manufacturing and distribution facilities inChatsworth, California for $26 million, giving rise to a gain of approximately$12 million. Since the facilities are leased back from the buyer, $5.5million of the gain is deferred and recognized over the lease term, inaccordance with SFAS No. 13 and 98. The $6.1 million balance of the gainin excess of the net present value of the lease payments, was recognized uponthe sale.

**Item 2.****          ****Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

**ForwardLooking Statements and Certain Risks**

Thestatements contained in this report that are not purely historical are “forward-lookingstatements” within the meaning of Section 21E of the Securities ExchangeAct. These statements are based on our expectations, hopes, beliefs,commitments, intentions, and strategies regarding the future. They may beidentified by the use of words or phrases, such as “believe”, “expect”, “anticipate”,“should”, “could”, “would”, “will”, “might”, “may”, “plan,” “estimate,” and “potential,”among others. Forward-looking statements include, but are not limited to,statements contained in this Item 2 regarding our financial performance,revenue and expense levels in the future, and the sufficiency of our existingassets to fund future operations and capital spending needs. Actual resultscould differ materially from the anticipated results or other expectationsexpressed in these forward-looking statements as a result of the risks,uncertainties and contingencies discussed below and in our annual report onForm 10-K for the year ended December 31, 2006. The fact that some of therisks, uncertainties and contingencies may be the same or similar to pastreports we have filed with the SEC means only that the risks are present inmultiple periods.

Ourability to predict results or the effect of certain events on our futureoperating results is inherently uncertain. Forward-looking statements shouldnot be unduly relied on, since they involve known and unknown risks,uncertainties and other factors, which in many cases are beyond our control andcannot be predicted or quantified. Therefore, we wish to caution you tocarefully consider the following factors, which are  not exhaustive,  together with disclosures in other reportsand documents  filed  with the SEC by the Company from time to timeand which may supplement, modify, supersede or update the factors listed inthis report. The Company is subject to all of the business risks facing publiccompanies, including business cycles and trends in the general economy, marketconditions, potential loss of key personnel, government legislation andregulation and natural causes. Additional factors that could cause or contribute to our actual resultsdiffering materially from those discussed herein include, but are not limitedto:

·                  ourability to develop and execute our business plans;

 

·                  our ability to replace our Ester-C® business once we have used the remaininginventory of Ester-C®;

 

·                  adverse publicity regarding our products andany similar products distributed by others;

 

·                  our ability to manage the risks and costsassociated with our acquisition strategy, including managing the integration ofMRI;

 

·                  our ability to retain and attract talentedmanagement and key employees;

 

·                  our insurance coverage or third partyindemnification rights may be insufficient to cover losses that we incur;

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·                  we may experience greater than expectedproduct returns;

 

·                  our failure to adequately anticipate salesneeds;

 

·                  any shortage in the supply of key rawmaterials;

 

·                  our ability to protect our intellectualproperty;

 

·                  our exposure to product liability claims, aswell as the limits of our self insurance program for products liability claims;

 

·                  our sales and earnings volatility;

 

·                  our ability to engage in many transactions prohibitedby our senior credit facility;

 

·                  legal actions brought by federal, state andlocal governmental authorities and private parties;

 

·                  increased competition from existingcompetitors and new market entrants, including from private label house brands;and

 

·                  the impact of natural disasters on ourmanufacturing facility.

Theforward-looking statements contained in this report are made as of the date ofthis report, and we assume no obligation to update or revise them to reflectchanged assumptions, the occurrence of unanticipated events or changes tofuture operating results over time or to update the reasons why actual resultscould differ from those projected in these forward-looking statements.

**OVERVIEW**

**General**

Wemanufacture and market branded, high-quality dietary supplements, herbal teas,and sports nutrition products under seven primary brands: Natrol®, Laci LeBeau®, Prolab®, Nu Hair® , Shen Min®, Promensil® and MRI. Through ourEssentially Pure Ingredients® (EPI) division we also sell nutraceutical gradeingredients to other manufacturers of nutrition products and provide contractmanufacturing services to companies within the nutraceutical industry.

Themajority of our dietary supplements are sold under the Natrol brand, but we arecontinuing to acquire new brands that we expect will eventually contributesignificantly to our product mix sales. Our Natrol brand focuses on supplementsthat are in high demand as well as specialty niche and proprietary formulationsthat have potentially strong margins. These supplements include vitamins,minerals, hormonal supplements, herbal products and specialty combinationformulas that contribute to an individual’s physical and mental well-being. OnJune 1, 2007, we acquired MRI which develops and markets products under the MRIbrand. Our MRI brand supplies high-quality sports nutrition products includingCE2®, NO2®, Pro-NosTM and Anabolic SwitchTM. These products are primarilydesigned to enhance the workout performance of athletes.

The key elements of our businessstrategy are to

·                  Controlour cost and improve margins;

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

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

·                  Improvethe marketing of our products.

**Management Overview**

Weconcluded the second quarter of 2007 with approximately $4.2 of net incomewhich included proceeds from the sale of our property and the acquisition ofMRI. This was our sixth successive profitable quarter.

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We sold our properties as partof our growth strategy.  The salesallowed us to eliminate our debt and fund the acquisition of MRI.  MRI concluded calendar 2006 with more than$21.0 million in net revenue and more than $3.0 million of net income and weanticipate that MRI will contribute positively to our revenue and net income inthe future.

Weacquired MRI for $8.6 million including adjustments for working capital and apotentially substantial earnout based on MRI’s ability to meet certain revenuebenchmarks. MRI supplies high-quality sports nutrition products, such as CE2®,NO2®, Pro-NosTM and Anabolic SwitchTM, which are primarily designed to enhancework-out performance. The MRI brand carries a premier position in the sportsnutrition market. The brand identity is underpinned by a reputation forinnovative science. Notably, MRI was the first company to launch nitric oxidebased products in the sports nutrition market. MRI’s products are primarilydistributed through the retail chain of GNC. We feel that MRI will assist us inour goal of growing the business and creating a new platform to make additionalacquisitions. This acquisition will help accelerate our corporate developmentplan by creating scale, synergies, and new avenues for growth.

Animportant part of our business strategy is to develop or acquire new productswith strong margins that can capitalize upon our infrastructure.  Seniormanagement is focused on this effort.  Our policy is not to announce anypotential acquisition until an acquisition agreement has been signed.

Ournet sales for the three months ended June 30, 2007 grew 17.8% or$3.0 million more than our net sales for the same period in 2006. Theprime reason for the increase in net revenue was the acquisition of the NuHair,Shen Min and Promensil brands in October 2006 and the acquisition of MRI in June2007.  The core Natrol business has beenimpacted from the loss of Ester-C sales. As we have discussed in prior filings, Ester-C is the only product linewhich accounted for more than 10% of our revenue in 2006.  We will no longer be able to sell Ester-C afterMarch 2008 due to the sale of our supplier to a competitor who will notcontinue to supply Ester-C to the Company once our supply contract expires. Asa result, Ester-C sales are declining rapidly. We shipped $0.9 million  less ofEster-C products during the three months ended June 30, 2007 than in the sameperiod of 2006.

Thenewly acquired brands have high gross margins. Due to the favorable effects ofthe new product mix, as well as increased manufacturing efficiency, our grossmargin in the quarter ended June 30, 2007 increased to 47.4% from 43.3% in thequarter ended June 30, 2006, and the gross margin for the second quarter of2007 is also more than the 43.4% recorded for the year ended December 31, 2006.

Duringthe quarter we controlled our costs of administration.  General andadministrative expenses increased $166.0 thousand in absolute dollar terms butdeclined in percentage terms, from 17.1% of net revenue in the quarter endedJune 30, 2006 to 15.3% for the quarter ended June 30, 2007.  These percentage savings were achieveddespite the increased administrative costs of our acquisitions and increasedadministrative costs resulting from the establishment of a subsidiary in theUnited Kingdom during the third-quarter of 2006.

Totalselling and marketing costs increased as a percentage of revenue. The increase was driven by additional cooperative advertising and mediaexpenditures as well as the addition of some personnel to support our newbrands as well as our operations in the United Kingdom. We spent approximately$1.5 million more in the second quarter of 2007 than the second quarter of 2006on sales and marketing expenses, which increased the percent of net revenuespent on sales and marketing from  24.7%to 28.4%.

Thelargest immediate challenges are to manage through the decline of our Ester-Cbusiness and to fully integrate MRI.  Wewill continue to work to improve internal efficiencies and to strengthen ourcore business though complementary acquisitions that improve our businessplatform.

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**Results of Operations**

**THREE MONTHS ENDED JUNE 30, 2007 AND JUNE 30, 2006**

NET SALES. We recognize revenue fromsales only after product is shipped. We have no consignment sales. Net salesrepresent product shipped less actual and estimated future returns, spoilageallowances, allowances for product deemed to be unsaleable by customers, freegoods shipped to customers for promotional or other purposes, rebates, slottingfees and other promotional expenditures. Estimates and allowances are basedupon known claims and an estimate of additional returns when the amount offuture returns from customers can be reasonably estimated.

Net sales increased 17.8%, or $2.9million, to $19.5 million for the three months ended June 30, 2007 from $16.6million for the three months ended June 30, 2006. Increased sales of $4.2million from the acquired NuHair, Shen Min, Promensil and MRI brands and anincrease in Prolab product sales of approximately $0.2 million  were partially offset by a decline of $0.4million in EPI revenue and a decline of approximately $1.1 million in theremaining Natrol segment business. The decline in Natrol revenue was primarilydue to a fall off in Ester-C sales, which were $0.9 million less in the threemonths ended June 30, 2007 than in the three months ended June 30, 2006.  Ester-C is being discontinued because thesupplier of Ester-C will no longer sell raw material to us after March 2008.

GROSS PROFIT. Gross profit increased29.1%, or $2.1 million, to $9.3 million for the three months ended June 30,2007, from $7.2 million for the three months ended June 30, 2006. Gross marginincreased to 47.4% for the three months ended June 30, 2007, from 43.4% for thethree months ended June 30, 2006. The increase in gross margin was primarilydue to product mix as well as improved manufacturing efficiency.  Thechange in product mix was due to the acquisition of the NuHair, Shen Min,Promensil and MRI brands.

SELLING AND MARKETING EXPENSES. Sellingand marketing expenses consist primarily of advertising and promotionalexpenses, costs of distribution, and related payroll expenses and commissions.Selling and marketing expenses increased 35.6%, or $1.5 million, to $5.6million for the three months ended June 30, 2007, from $4.1 million for thethree months ended June 30, 2006.  Selling expenses increasedapproximately $0.8 million due to increased staffing and promotion required byour acquisitions and the establishment of a subsidiary in the UnitedKingdom.  Marketing expenses increased approximately $0.6 million due toincreased expenditures on traditional media and trade shows.

GENERAL AND ADMINISTRATIVE EXPENSES.General and administrative expenses consist primarily of personnel costsrelated to general management functions, finance, accounting and information systems,as well as professional fees related to legal, audit and tax matters anddepreciation. General and administrative expenses increased 5.9%, or $0.2million to $3.0 million for the three months ended June 30, 2007 from $2.8million for the three months ended June 30, 2006. The reason for the increasewas the infrastructure and payroll necessary to support our acquisitions andour subsidiary in the United Kingdom.

INTEREST EXPENSE. We recorded interestexpense of $70,000 for the three months ended June 30, 2007 as compared tointerest expense of $153,000 for the three months ended June 30, 2006. The decrease was due to the pay off of all of the existing debt in April 2007.Proceeds from the sale/leaseback transaction were used to pay off the debt.

INCOME TAX EXPENSE. Our effective taxrate was 39.0 % in the three months ended June 30, 2007 and 43.7% in the threemonths ended June 30, 2006.  The differences are primarily due to thedifferent levels of income.  When incomeis low the effect of non-deductible expenses on the final tax rate are greaterthan when income is high.

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## ***SIX MONTHS ENDED JUNE 30, 2007 COMPARED TOJUNE 30, 2006***

Net sales increased 14.2%, or $4.7million, to $38.3 million for the six months ended June 30, 2007, from $33.5million for the six months ended June 30, 2006. Sales of $6.7 million from theacquired NuHair, Shen Min, Promensil and MRI brands were partially offset by adecline of $0.8 million in EPI revenue, a decline of approximately $0.3 millionof Prolab revenue and a decline of approximately $0.9 million of remainingNatrol segment net revenue.

GROSS PROFIT. Gross profit increased28.3%, or $4.0 million, to $18.1 million for the six months ended June 30, 2007,from $14.1 million for the six months ended June 30, 2006. Gross marginincreased to 47.2% for the six months ended June 30, 2007 from 42.0% for thesix months ended June 30, 2006. The increase in gross margin was primarily dueto product mix as well as improved manufacturing efficiency.  The changein product mix was due to the acquisition of the NuHair, Shen Min, Promensiland MRI brands, each of which maintain higher gross margin percentages than theaverage of all of our products.

SELLING AND MARKETING EXPENSES. Sellingand marketing expenses consist primarily of advertising and promotionalexpenses, costs of distribution, and related payroll expenses and commissions.Selling and marketing expenses increased 29.2%, or $2.4 million, to $10.6million for the six months ended June 30, 2007, from $8.2 million for the six monthsended June 30, 2006.  Selling expenses increased approximately $1.1million due to increased cooperative adverting promotion and additionalstaffing required by our acquisitions and the establishment of a subsidiary inthe United Kingdom.  Marketing expenses increased approximately $1.3million due to increased expenditures on traditional media and trade shows.

GENERAL AND ADMINISTRATIVE EXPENSES.General and administrative expenses consist primarily of personnel costsrelated to general management functions, finance, accounting and informationsystems, as well as professional fees related to legal, audit and tax mattersand depreciation. General and administrative expenses increased 6.5%, or $0.4million to $6.0 million for the six months ended June 30, 2007 from $5.6million for the six months ended June 30, 2006. The reason for the increase wasthe infrastructure and payroll necessary to support our acquisitions and oursubsidiary in the United Kingdom.

INTEREST EXPENSE. We recorded interestexpense of $291,000 for the six months ended June 30, 2007 as compared tointerest expense of $307,000 for the six months ended June 30, 2006.  Thedecrease was due to the pay off of all of the existing debt in April 2007.Proceeds from the sale/leaseback transaction were used to pay off the debt.

INCOME TAX EXPENSE. Our effective taxrate was 39.0% in the three months ended June 30, 2007 and 41.4% in the threemonths ended June 30, 2006. The difference is primarily due to the differentlevels of income.  When income is low theeffect of non-deductible expenses on the final tax rate are greater than whenincome is high.

SALE OF BUILDINGS. During the first sixmonths of 2006, we  sold a building we owned in Bloomfield, Connecticutthat was formerly used as a shipping facility for our Prolab brand.  Theapproximate net book value of the property, plant and plant improvements thatwere sold was $759,000 and the gain, net of brokerage, legal and other relatedexpenses was approximately $230,000.

In April 2007, we sold our 94,000square foot manufacturing, distribution and office facility and our 132,000square foot shipping facility both located in Chatsworth, California.  Thesales price for the properties was $26.0 million.  After paying expensesassociated with the transaction, taxes, and extinguishing the mortgage debt onthe buildings, we netted approximately $12.0 million in cash. We recorded again of approximately $6.1 million and a future lease benefit of $5.5 million,which will be amortized over 5 years.

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**LIQUIDITY AND CAPITAL RESOURCES**

As of June 30, 2007, we hadworking capital of $27.4 million as compared to $12.1 million in workingcapital at December 31, 2006.  Our cash balance at June 30, 2007 wasapproximately $8.6 million.

**Operating Activities**

Net cash provided by operatingactivities was $1.8 million for the six months ended June 30, 2007compared to net cash used of approximately $1.1 million for the six monthsended June 30, 2006. Cash provided by operating activities during the sixmonths ended June 30, 2007 consisted primarily of cash provided by non-cashcharges of $0.9 million and cash used because of changes in operatingassets and liabilities of $3.6 million and by our profit of$4.5 million.

During the six months ended June30, 2007, non-cash charges for depreciation and amortization had the effect ofproviding $0.6 million of cash, the expensing of stock options provided$0.3 million of cash, and, increasing the provision for bad debts had theeffect of providing $0.1 million.  These non-cash sources of cash wereoffset by a small decrease in foreign currency translation and a small increasein deferred income taxes.

Cash provided by operatingassets and liabilities consisted primarily of an increase in accounts payableof $5.0 million, an increase in accrued expenses of $0.5 million, anincrease in accrued payroll of $0.2 million, an increase of $3.2 million inincome taxes payable, and, a decrease in prepaid expenses of $0.6 million,offset by an increase in accounts receivable of $4.8 million and an increase ininventory of $8.3 million,.  The large changes in accounts receivable,accounts payable and inventory were primarily due to the acquisition of MRI.

**Investing Activities**

Net cash provided by investingactivities was $16.1 million for the six months ended June 30, 2007compared to net cash provided of $0.5 million during the six months endedJune 30, 2006. During the six months ended June 30, 2007, we invested $0.2million in new equipment and realized $11.7 from the sale of property and $5.3million net from the creation of a deferred lease benefit which is related tothe real estate transaction.  Theacquisition of other assets used $0.6 million of cash.

**Financing Activities**

Net cash used by financingactivities was $10.3 million for the six months ended June 30, 2007compared to cash used of $0.2 during the six months ended June 30, 2006. Duringthe six months ended June 30, 2007, we repaid $3.7 million of our line ofcredit and $6.7 million of our long-term debt. During the six months ended June30, 2007, we received $0.1 million from the exercise of stock options. All ofour long and short-term debt was extinguished during the six months ended June30, 2007 other than a small automobile loan acquired as part of the MRItransaction.

**Senior Credit Facility**

In August 2006, we entered intoa loan and security agreement with Wachovia Capital Finance (Western), asagent, the lenders party thereto, Prolab Nutrition, our wholly ownedsubsidiary, and certain of our other subsidiaries, as guarantors. The loanagreement provides for a three-year, secured, revolving credit facility of upto $10.0 million. Borrowings under the facility will be used for ongoingoutstanding working capital purposes and certain future acquisitions. At June30, 2007, we had no borrowings under the facility.

Under the credit facility, wemay borrow up to the lesser of $10.0 million or the borrowing base(calculated based upon eligible inventory and eligible accounts). The interestrate on borrowings under the credit facility is equal to: (1) agent’s publiclyannounced prime rate for prime rate loans or (2) 2.25% plus the applicableEurodollar rate for any Eurodollar rate loans. Interest is payable monthly inarrears not later than the first day of each calendar month.

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The credit facility requiresthat all principal be repaid in full on the third anniversary of the closingdate. Additionally, borrowings under the credit facility must be repaid whenthe borrowings exceed the borrowing base.

The credit facility is securedby a first priority lien on all our assets and properties (which includes theassets and properties of Prolab Nutrition, the guarantors and our futuresubsidiaries), subject to certain exceptions. The obligations under the creditfacility are guaranteed by Natrol Products, Inc., Natrol Acquisition Corp. andNatrol Direct, Inc. and by each of our future subsidiaries.

The credit facility containscovenants restricting our ability to, among other things: (1) incur orguarantee additional debt; (2) engage in any mergers or acquisitions (subjectto certain exceptions); (3) engage in any asset sales or dispose of any assets(other than in the ordinary course); (4) engage in transactions withaffiliates; (5) incur liens; (6) make any loans or investments; and (7) declareor pay dividends or redeem or repurchase capital stock.

The credit facility alsoprovides for customary events of default, including non-payment defaults,covenant defaults and cross-defaults to our other material indebtedness.

Asof June 30, 2007, the Company was in default under certain covenants in itscredit facility related to investments in new businesses and cannot borrowunder the line of credit until Wachovia agrees to waive the event of defaultand forbear from exercising its default rights. Wachovia is now reviewing theacquisition of MRI on June 1, 2007, which triggered the event of default.  The Company expects its ability to borrowagainst the line of credit to be reinstated in the normal course of review.

In order to meet our long-termliquidity needs, which include the potential payment of certain incentivesrelated to our acquisitions,  we may berequired to incur additional indebtedness or issue additional equity and debtsecurities, subject to market and other conditions. There can be no assurancethat such additional financing will be available on terms acceptable to us orat all. The failure to raise the funds necessary to finance our future cashrequirements or consummate future acquisitions could adversely affect ourability to pursue new acquisitions and could negatively affect our operationsin future periods.

We believe that our cash balancetogether with cash generated from operations and the potential to borrow fundsand raise capital should be sufficient to fund our anticipated working capitalneeds and planned capital expenditures for the next 12 months. However, if wedo not meet our operating plan, we may be required to obtain additionalborrowings to fund working capital needs.

**NewAccounting Standards**

TheFinancial Accounting Standards Board (“FASB”) issued InterpretationNo. 48, *Accounting for Uncertainty inIncome Taxes* (“FIN 48”) in June 2006. The interpretationclarifies the accounting for uncertainty in income taxes recognized infinancial statements in accordance with Statement of Financial AccountingStandard 109. FIN 48 is effective for fiscal years beginning afterDecember 15, 2006. We have not determined the effect, if any, the adoptionof FIN 48 will have on our consolidated financial statements. We adoptedthe provisions of FASB Interpretation No. 48, “Accounting for Uncertainty inIncome Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), onJanuary 1, 2007. FIN 48 clarifies the accounting for uncertainty in incometaxes recognized in an enterprise’s financial statements in accordance withFASB Statement 109, “Accounting for Income Taxes”, and prescribes a recognitionthreshold and measurement process for financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN 48 also provides guidance on derecognition, classification, interest andpenalties, accounting in interim periods, disclosure and transition.

Basedon our evaluation, we have concluded that there are no significant uncertaintax positions requiring recognition in our financial statements. Our evaluationwas performed for the tax years ended December 31, 2003, 

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2004, 2005 and 2006, the tax years which remainsubject to examination by major tax jurisdictions as of June 30, 2007.

Wemay from time to time be assessed interest or penalties by major taxjurisdictions, although any such assessments historically have been minimal andimmaterial to our financial results. In the event we received an assessment forinterest and/or penalties, it was classified in the financial statements as “selling,general and administrative expense”.

InSeptember 2006, the FASB issued Statement of Financial AccountingStandarad No. 157 (“FAS 157”), “Fair*Value Measurements*,” which defines fair value, establishesguidelines for measuring fair value and expands disclosures regarding fairvalue measurements. FAS 157 does not require any new fair value measurementsbut rather eliminates inconsistencies in guidance found in various prioraccounting pronouncements. Statement of Financial Accouting Standard 157is effective for fiscal years beginning after November 15, 2007. Earlieradoption is permitted, provided the company has not yet issued financialstatements, including for interim periods, for that fiscal year. The Company iscurrently evaluating the impact of FAS 157, but does not expect the adoptionof FAS 157 to have a material impact on its consolidated financialposition, results of operations or cash flows.

InFebruary 2007, the FASB issued statement of Financial Accounting Standard No.159, “*The Fair Value Option for Financial Assets andFinancial Liabilities Including an Amendment of FASB Statement No. 115*”(“SFAS 159”). Statement of Accounting Standard 159 permits entities to chooseto measure many financial instruments and certain other items at fair value,with unrealized gains and losses related to these financial instrumentsreported in earnings at each subsequent reporting date. SFAS 159 is effectivefor fiscal years beginning after November 15, 2007. We are currently evaluatingthe impact this Statement will have on our consolidated financial statements.

**Critical Accounting Policies**

Management’sbeliefs regarding significant accounting policies have not changedsignificantly from those discussed in Item 7 of our annual report on Form 10-Kfor the year ended December 31, 2006.

**Item 3.**                          Quantitative and Qualitative DisclosuresAbout Market Risk

Ourexposure to market risks is limited to interest rate risks. The risks relatedto foreign currency exchange rates are immaterial and we do not use derivativefinancial instruments.

Weare subject to interest rate market risk associated with our bank debt. Evenso, we do not believe the risk associated with such borrowing is significant.We currently have no long-term debt other than for a small automobile loan and,as of June 30, 2007, we had no borrowings under our line of credit. The line ofcredit is collateralized by our general assets.

**Item4.**                          Controls and Procedures

*Evaluation of Disclosure Controlsand Procedures.  *We maintain disclosure controls and procedures that are designed toensure that information required to be disclosed in our Exchange Act reports isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms and that such information is accumulated andcommunicated to our management, including our principal executive and principalfinancial officers, as appropriate, to allow for timely decisions regardingrequired disclosure. In designing and evaluating the disclosure controls andprocedures, we recognize that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving thedesired control objectives, and we are required to apply our judgment inevaluating the cost-benefit relationship of possible controls and procedures.

Asrequired by Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Actof 1934, we carried out an evaluation, under the supervision and with theparticipation of our management, including our principal executive andprincipal financial officer,

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of the effectiveness of the design and operation ofour disclosure controls and procedures and internal controls over financialreporting as of the end of the period covered by this report. Based on theforegoing, our principal executive and principal financial officer haveconcluded that, as of the period covered by this report,  our disclosure controls and procedures wereeffective.

*Changes in Internal Control OverFinancial Reporting.  *There were no changes in our internal control over financial reportingthat occurred during the last fiscal quarter that have materially affected, orare reasonably likely to materially affect, our internal control over financialreporting.

Attached as exhibits to this Form 10-Q are certifications ofthe Company’s Chief Executive Officer and Chief Financial Officer, which arerequired in accordance with Rule 13a-14 of the Securities Exchange Act of1934.  This “Controls and Procedures” section includes informationconcerning the controls and evaluation thereof referred to in the attachedcertifications, and it should be read in conjunction with the attachedcertifications for a more complete understanding of the topics presented.

**PART II—OTHER INFORMATION**

**Item 1A.**                 Risk Factors

Information concerning certain risks anduncertainties appears in Part I, Item 1A “Risk Factors” of our annual report onForm 10-K for the year ended December 31, 2006. You should carefully considerthese risks and uncertainties before making an investment decision with respectto shares of our common stock. Such risks and uncertainties could materiallyadversely affect our business, financial condition or operating results.

During the three months ended June 30, 2007, therehas been no material change from the risk factors previously disclosed in ourannual report on Form 10-K for the year ended December 31, 2006.

# **Item 5.****                         ****Other Information**

Our 2007 annual meeting ofstockholders has been delayed by more than 30 days from June 8, the anniversarydate of the 2006 annual meeting of stockholders.  Our board of directors has not yet determinedthe date of the 2007 annual meeting of stockholders.  We will provide all required informationabout the 2007 annual meeting of stockholders when it becomes available.

**Item 6.**                          Exhibits

(a)                                  Indexto Exhibits
| Exhibit No.  | ** ** | **Notes** | ** ** | **Description**                                                                                                                                                                                                   |
|--------------|------------|-----------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit 10.1 |       | (1)       |       | Stock Purchase Agreement dated as of June 1, 2007  among Natrol, Inc., the shareholders of Medical Research Institute, a  California corporation, and Medical Research Institute, a California  corporation. |
| Exhibit 10.2 |       | (2)       |       | Natrol Inc. 2007 Bonus Incentive Compensation Plan                                                                                                                                                                |
| Exhibit 10.3 |       | (2)       |       | Summary of Amendment to Change of Control Bonus Plan                                                                                                                                                              |
| Exhibit 31.1 |       | *         |       | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted by Section  302 of the Sarbanes-Oxley Act of 2002.                                        |
| Exhibit 31.2 |       | *         |       | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted by Section  302 of the Sarbanes-Oxley Act of 2002.                                        |
| Exhibit 32.1 |       | *         |       | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                  |
| Exhibit 32.2 |       | *         |       | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                  |

 

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Notes:

*                             Filed with this report on Form10Q.

 

(1)                       Previously filed with theCompany’s Form 8-K, filed June 1, 2007 and incorporated herein by thisreference.

 

(2)                       Previously filed with theCompany’s Form 8-K, filed May 9, 2007 and incorporated herein by thisreference.

 

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**SIGNATURE**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
| Date: August 14, 2007 |   | NATROL, INC. |
|-----------------------|--------|--------------|
|                  |   |         |   |   |
|                  |   | By:          |   | /s/ Dennis R. Jolicoeur |
|                  |   |         |   | Dennis R. Jolicoeur |
|                  |   |         |   | Chief Financial Officer, Treasurer and Executive  Vice President (Duly Authorized Officer and  Principal Financial and Accounting Officer) |

 

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