**SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

 

**(Mark one)**

 
| **ý**                                                                                                                                                                                         | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                               |                                                                                            |
| **FOR THE QUARTERLY PERIOD ENDED MARCH 31,  2004**                                                                                                                                                 |
|                                                                                                                                                                                               |                                                                                            |
| **OR**                                                                                                                                                                                             |
|                                                                                                                                                                                               |                                                                                            |
| **o**                                                                                                                                                                                              | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                                                                                                                                                               |                                                                                            |
| **FOR THE TRANSITION PERIOD FROM               TO             ** |
| **COMMISSION FILE NO: 0-24567**                                                                                                                                                                    |

 

**NATROL, INC.**(Exact name of registrant as specified in its charter)

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

 

**21411 PRAIRIE STREETCHATSWORTH, CALIFORNIA 91311******(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

 

**(818) 739-6000**(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

 

INDICATE BY A CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALLREPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGEACT OF 1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THEREGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCHFILING REQUIREMENTS FOR THE PAST 90 DAYS.

YES  ý   NO  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Exchange Act Rule  12b-2). Yes o No ý

 

Indicate the number of shares outstanding of the issuer’s common stock,as of the latest practicable date:

 
| **Class**                     |   | **May 10,  2004** |
|-------------------------------|--------|-------------------|
|                          |   |              |
| Common stock, $0.01 par value |   | 13,222,969        |

 

 

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PART 1. FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

 

**Natrol, Inc. andSubsidiaries**

**Consolidated Balance Sheets**

(In thousands, except share and per share data)

(Unaudited)

 
|                                                                                                                  |   | **March 31,  2004** |   | **December  31,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
|                                                                                                                  |   |                |   |                    |   |
| **Assets**                                                                                                            |   |                |   |                    |   |
| Current assets:                                                                                                       |   |                |   |                    |   |
| Cash and cash equivalents                                                                                             |   | $                   | 5,432  |                    | $      | 2,599 |   |
|                                                                                                                  |   |                |   |                    |   |
| Accounts receivable, net of allowances of  $683 and $635 at March 31, 2004 and December 31, 2003, respectively        |   | 9,163               |   | 7,698                   |   |
| Inventory                                                                                                             |   | 10,534              |   | 9,053                   |   |
| Income taxes receivable                                                                                               |   | 61                  |   | 349                     |   |
| Deferred income taxes                                                                                                 |   | 1,110               |   | 1,110                   |   |
| Prepaid expenses and other current assets                                                                             |   | 978                 |   | 914                     |   |
| Net assets of discontinued operations                                                                                 |   | 86                  |   | 35                      |   |
| Total current assets                                                                                                  |   | 27,364              |   | 21,758                  |   |
| Property and equipment:                                                                                               |   |                |   |                    |   |
| Building and improvements                                                                                             |   | 15,626              |   | 15,612                  |   |
| Machinery and equipment                                                                                               |   | 5,154               |   | 5,215                   |   |
| Furniture and office equipment                                                                                        |   | 2,872               |   | 3,158                   |   |
|                                                                                                                  |   | 23,652              |   | 23,985                  |   |
| Accumulated depreciation                                                                                              |   | (7,224              | )      | (7,315                  | )      |
| Property and equipment, net                                                                                           |   | 16,428              |   | 16,670                  |   |
| Restricted cash                                                                                                       |   | 5,000               |   | 5,000                   |   |
| Deferred income taxes                                                                                                 |   | 3,902               |   | 3,902                   |   |
| Goodwill, net of accumulated amortization  and impairment charge of $37,381                                           |   | 2,026               |   | 4,026                   |   |
| Other assets                                                                                                          |   | 119                 |   | 83                      |   |
| Total assets                                                                                                          |   | $                   | 54,839 |                    | $      | 51,439 |   |
|                                                                                                                  |   |                |   |                    |   |
| **Liabilities and stockholders’ equity**                                                                         |   |                |   |                    |   |
| Current liabilities:                                                                                                  |   |                |   |                    |   |
| Accounts payable                                                                                                      |   | $                   | 8,063  |                    | $      | 5,601 |   |
| Accrued expenses                                                                                                      |   | 1,794               |   | 1,732                   |   |
| Accrued payroll and related liabilities                                                                               |   | 1,169               |   | 772                     |   |
| Current portion of long-term debt                                                                                     |   | 332                 |   | 325                     |   |
| Total current liabilities                                                                                             |   | 11,358              |   | 8,430                   |   |
| Long-term debt, less current portion                                                                                  |   | 7,364               |   | 7,451                   |   |
| Commitments and contingencies                                                                                         |   |                |   |                    |   |
| Stockholders’ equity:                                                                                            |   |                |   |                    |   |
| Preferred stock, par value of $0.01 per  share:  Authorized shares—2,000,000; Issued and outstanding shares-none |   |                |   |                    |   |
| Common stock, par value of $0.01 per share:  Authorized shares—50,000,000                                        |   |                |   |                    |   |
| Issued and outstanding shares-14,127,536  and 14,054,309 at March 31, 2004 and December 31, 2003, respectively        |   | 141                 |   | 141                     |   |
| Additional paid-in capital                                                                                            |   | 62,486              |   | 62,377                  |   |
| Accumulated deficit                                                                                                   |   | (23,629             | )      | (24,079                 | )      |
|                                                                                                                  |   | 38,998              |   | 38,439                  |   |
| Shares held in treasury, at cost-921,900  shares at March 31, 2004 and December 31, 2003                              |   | (2,881              | )      | (2,881                  | )      |
| Total stockholders’ equity                                                                                       |   | 36,117              |   | 35,558                  |   |
| Total liabilities and stockholders’ equity                                                                       |   | $                   | 54,839 |                    | $      | 51,439 |   |

 

See accompanying notes

 

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**Natrol, Inc. andSubsidiaries**

**Consolidated Statements of Operations**

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

** **
|                                                   |   | **Three  Months Ended March 31,** |   |
|--------------------------------------------------------|--------|-----------------------------------|--------|
|                                                   |   | **2004**                          |   | **2003** |   |
|                                                   |   | **(Unaudited)**                   |   |
| Net sales                                              |   | $                                 | 20,425 |   | $ | 18,995 |   |
| Cost of goods sold                                     |   | 12,595                            |   | 10,866 |   |
| Gross profit                                           |   | 7,830                             |   | 8,129 |   |
| Selling and marketing expenses                         |   | 4,619                             |   | 4,969 |   |
| General and administrative expenses                    |   | 2,325                             |   | 2,639 |   |
| Total operating expenses                               |   | 6,944                             |   | 7,608 |   |
| Operating income from continuing operations            |   | 886                               |   | 521 |   |
| Interest income                                        |   | 22                                |   | 10 |   |
| Interest expense                                       |   | (158                              | )      | (162 | ) |
| Income from continuing operations before  income taxes |   | 750                               |   | 369 |   |
| Income tax provision                                   |   | 300                               |   | 141 |   |
| Income from continuing operations                      |   | 450                               |   | 228 |   |
| Discontinued operations:                               |   |                              |   |   |   |
| (Loss) from operations                                 |   | —                            |   | (573 | ) |
| Income tax benefit                                     |   | —                            |   | 221 |   |
| Loss on discontinued operations                        |   | —                            |   | (352 | ) |
| Net Income (loss)                                      |   | $                                 | 450    |   | $ | (124 | ) |
| Basic and Diluted income (loss) per share:             |   |                              |   |   |   |
| Income (loss) per share from continuing  operations    |   | $                                 | 0.03   |   | $ | 0.02 |   |
| Loss per share from discontinued operations            |   | $                                 | — |   | $ | (0.03 | ) |
| Income (loss) per share                                |   | $                                 | 0.03   |   | $ | (0.01 | ) |
|                                                   |   |                              |   |   |   |
| Weighted-average shares outstanding:                   |   |                              |   |   |   |
| Basic                                                  |   | 13,162,459                        |   | 12,870,598 |   |
| Diluted                                                |   | 14,175,061                        |   | 12,879,181 |   |

 

See accompanying notes

 

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# **Natrol, Inc.and Subsidiaries**

**Consolidated Statements of Cash Flows**

(In thousands)

* *
|                                                                                                                |   | **Three  Months Ended   March 31,** |       |
|---------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------|------------|
|                                                                                                                |   | **2004**                            |       | **2003** |   |
|                                                                                                                |   | **(Unaudited  )**                   | ** ** |
| **Operating activities**                                                                                            |   |                                |       |   |   |
| Net Income (loss)                                                                                                   |   | $                                   | 450        |   | $ | (124 | ) |
| Loss from discontinued operations                                                                                   |   | —                              |       | 352 |   |
| Income (loss) from continuing operations                                                                            |   | 450                                 |       | 228 |   |
|                                                                                                                |   |                                |       |   |   |
| Adjustments to reconcile income from  continuing operations to net cash provided by (used in) operating activities: |   |                                |       |   |   |
| Loss from discontinued operations                                                                                   |   | —                              |       | (352 | ) |
| Change in net assets of discontinued  operations                                                                    |   | (51                                 | )          | (305 | ) |
| Depreciation and amortization                                                                                       |   | 319                                 |       | 372 |   |
| Loss on disposal of property and equipment                                                                          |   | 2                                   |       | — |   |
| Provision for bad debts                                                                                             |   | 48                                  |       | 55 |   |
| Shares issued for services                                                                                          |   | —                              |       | 15 |   |
| Changes in operating assets and liabilities:                                                                        |   |                                |       |   |   |
| Accounts receivable                                                                                                 |   | (1,513                              | )          | (1,220 | ) |
| Inventory                                                                                                           |   | (1,481                              | )          | 150 |   |
| Income taxes receivable/payable                                                                                     |   | 288                                 |       | 12 |   |
| Prepaid expenses and other current assets                                                                           |   | (64                                 | )          | 14 |   |
| Accounts payable                                                                                                    |   | 2,462                               |       | 1,348 |   |
| Accrued expenses                                                                                                    |   | 62                                  |       | (1,299 | ) |
| Accrued payroll and related liabilities                                                                             |   | 397                                 |       | (86 | ) |
| Net cash provided by (used in) operating  activities                                                                |   | 919                                 |       | (1,068 | ) |
|                                                                                                                |   |                                |       |   |   |
| **Investing activities**                                                                                            |   |                                |       |   |   |
| Purchases of property and equipment                                                                                 |   | (79                                 | )          | (68 | ) |
| Reduction in goodwill                                                                                               |   | 2,000                               |       | — |   |
| Other assets                                                                                                        |   | (36                                 | )          | — |   |
| Net cash provided by (used in) investing  activities                                                                |   | 1,885                               |       | (68 | ) |
|                                                                                                                |   |                                |       |   |   |
| **Financing activities**                                                                                            |   |                                |       |   |   |
| Repayments on long-term debt                                                                                        |   | (80                                 | )          | (76 | ) |
| Proceeds from issuance of common stock                                                                              |   | 109                                 |       | — |   |
| Net cash (used in) provided by financing  activities                                                                |   | 29                                  |       | (76 | ) |
| Net (decrease) increase in cash and cash  equivalents                                                               |   | 2,833                               |       | (1,212 | ) |
| Cash and cash equivalents, beginning of  period                                                                     |   | 2,599                               |       | 10,077 |   |
| Cash and cash equivalents, end of period                                                                            |   | $                                   | 5,432      |   | $ | 8,865 |   |

 

See accompanying notes

 

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NATROL, INC.NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS(ALL AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

 

1. BASIS OF PRESENTATION

 

The accompanying consolidated financial statementshave been prepared by the Company, pursuant to the rules and regulations of theSecurities and Exchange Commission (SEC).  This Report on Form 10Q shouldbe read in conjunction with the Company’s annual report on Form 10K for theyear ended December 31, 2003.  Certain information and footnotedisclosures which are normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to SEC rules and regulations. The information reflects all normal and recurring adjustments which, in theopinion of the Company’s management, are necessary for a fair presentation ofthe financial position of the Company and its results of operations for theinterim periods set forth herein.  The results for the three months endedMarch 31, 2004 are not necessarily indicative of the results to be expected forthe full year or any other period.

 

2.               STOCK BASED COMPENSATION

 

The Company accounts for its employee stock option plan under theintrinsic value method prescribed by Accounting Principles Board Opinion No.25, *Accounting for Stock Issued toEmployees,*and related interpretations.  The Company has a stock-based compensation plan.  The Company’s operating results do notinclude a compensation charge related to this plan, as all options granted hadan exercise price equal to the market value of the underlying common stock onthe date of grant.  The following tableillustrates the effect on the operating results and per share amounts if thefair value recognition provisions of Statement of Financial AccountingStandards No. 123, *Accounting forStock-Based compensation, had been applied to stock-based employeecompensation:*

 
|                                                                                                                                                                        |   | **3 Months  Ended  March 31,** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------|--------|
|                                                                                                                                                                        |   | **2004**                       |   | **2003** | ** ** |
|                                                                                                                                                                        |   |                           |   |   |   |
| Income (loss) from continuing operations                                                                                                                                    |   | $                              | 450    |   | $ | 228 |   |
| Total stock-based employee compensation  expense determined under the fair value-based method for all awards, net of  related tax benefits (“Stock Compensation”) |   | (27                            | )      | (40 | ) |
| Income (loss) from continuing  operations—pro forma                                                                                                                    |   | 423                            |   | 188 |   |
| Loss from discontinued operations                                                                                                                                           |   | —                         |   | (352 | ) |
| Net Income (loss)—pro forma                                                                                                                                            |   | 423                            |   | (164 | ) |
| Income per share from continuing  operations:                                                                                                                               |   |                           |   |   |   |
| Basic—as reported                                                                                                                                                      |   | $                              | 0.03   |   | $ | 0.02 |   |
| Diluted—as reported                                                                                                                                                    |   | $                              | 0.03   |   | $ | 0.02 |   |
| Basic—pro forma                                                                                                                                                        |   | $                              | 0.03   |   | $ | 0.01 |   |
| Diluted—pro forma                                                                                                                                                      |   | $                              | 0.03   |   | $ | 0.01 |   |
| Net loss per share:                                                                                                                                                         |   |                           |   |   |   |
| Basic—as reported                                                                                                                                                      |   | $                              | 0.03   |   | $ | (0.01 | ) |
| Diluted—as reported                                                                                                                                                    |   | $                              | 0.03   |   | $ | (0.01 | ) |
| Basic—pro forma                                                                                                                                                        |   | $                              | 0.03   |   | $ | (0.01 | ) |
| Diluted—pro forma                                                                                                                                                      |   | $                              | 0.03   |   | $ | (0.01 | ) |

 

Duringthe three months ended March 31, 2004, 35,000 stock options were granted withan exercise price of $3.04 which equaled the fair value of the underlyingCommon Stock on the date of grant.

 

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3.   INVENTORY

 

Inventories consist of the following:

 
|                                |   | **March 31,  2004** |   | **December  31,  2003** |   |
|-------------------------------------|--------|---------------------|--------|-------------------------|--------|
|                                |   |                |   |                    |   |
| Raw material and packaging supplies |   | $                   | 4,704  |                    | $      | 3,736 |   |
| Finished goods                      |   | 5,830               |   | 5,317                   |   |
| Raw material and packaging supplies |   | $                   | 10,534 |                    | $      | 9,053 |   |

 

4. SHIPPING AND HANDLING COSTS

 

TheCompany records all amounts charged to customers for shipping and handling asrevenue. All outbound shipping and fulfillment costs are classified as sellingand marketing expenses and totaled $858,000 and $797,000 for three months endedMarch 31, 2004 and 2003 respectively.

 

5. EARNINGS PER SHARE

 

Basic earnings per share have been computed by dividing net income(loss) by the weighted average number of common shares outstanding during theperiod. Diluted earnings per share have been computed by dividing net income(loss) by the weighted average number of common shares and dilutive commonstock equivalents (stock options), when dilutive.

 

6.  RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

 

In January 2003, the FASBissued FASB Interpretation No. 46, “Consolidation of Variable InterestEntities (“FIN 46”). In December 2003, FIN 46 was replaced by FASBinterpretation No. 46(R) “Consolidation of Variable Interest Entities.” FIN46(R) clarifies the application of Accounting Research Bulletin No. 51,“Consolidated Financial Statements,” to certain entities in which equityinvestors do not have the characteristics of a controlling financial interestor do not have sufficient equity at risk for the entity to finance itsactivities without additional subordinated financial support from otherparties. FIN 46(R) requires an enterprise to consolidate a variable interestentity if that enterprise will absorb a majority of the entity’s expectedlosses, is entitled to receive a majority of the entity’s expected residualreturns, or both. FIN 46(R) is effective for entities being evaluated under FIN46(R) for consolidation no later than the end of the first reporting periodthat ends after March 15, 2004. The Company does not currently have any variableinterest entities that will be impacted by adoption of FIN 46(R).

 

7.  DISCONTINUED OPERATIONS

 

In December 2003, the Company discontinued its Annasa and Tamsolunits.  Annasa, a subsidiary of Natroland a multi-level marketer of proprietary nutritional products began operationsin 2002.  Tamsol, was also formed in2002, to generate direct-to-consumer sales via radio, television, direct mailand other non retail venues.  The Companyhas reclassified its financial statements to segregate the revenues, directcosts and expenses (excluding allocated costs), assets and liabilities and cashflows of the discontinued operations. The net operating results, net assets and net cash flows of thesebusinesses have been reported as “Discontinued Operations” in the accompanyingconsolidated financial statements.

 

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Summarized financialinformation for the discontinued operations is as follows:

 
|                           |   | **Three  Months Ended March 31,** |   |
|--------------------------------|--------|-----------------------------------|--------|
|                           |   | **2004**                          |   | **2003** |   |
| Annasa:                        |   |                              |   |   |   |
| Revenue                        |   | —                            |   | $ | 150 |   |
| Gross Margin                   |   | —                            |   | 112 |   |
|                           |   |                              |   |   |   |
| Selling and Marketing expenses |   | —                            |   | 330 |   |
| General and administrative     |   | —                            |   | 291 |   |
| Loss from operations           |   | —                            |   | (509 | ) |
| Income tax benefit             |   | —                            |   | 196 |   |
| Net loss                       |   | —                            |   | $ | (313 | ) |
|                           |   |                              |   |   |   |
| Tamsol:                        |   |                              |   |   |   |
| Revenue                        |   | —                            |   | $ | 22 |   |
| Gross Margin                   |   | —                            |   | 22 |   |
|                           |   |                              |   |   |   |
| Selling and Marketing expenses |   | —                            |   | 19 |   |
| General and administrative     |   | —                            |   | 67 |   |
| Loss from operations           |   | —                            |   | (64 | ) |
| Income tax benefit             |   | —                            |   | 25 |   |
| Net loss                       |   | —                            |   | $ | (39 | ) |

 
|                                   |   | **March 31,  2004** |   | **December  31,  2003** |   |
|----------------------------------------|--------|---------------------|--------|-------------------------|--------|
| Net assets of discontinued operations: |   |                |   |                    |   |
| Current assets                         |   | $                   | 75     |                    | $      | 116 |   |
| Total assets                           |   | 87                  |   | 151                     |   |
| Current liabilities                    |   | 1                   |   | 116                     |   |
| Net assets of discontinued operations  |   | 86                  |   | 35                      |   |
|                                        |        |                     |        |                         |        |  |  |

 

8. LITIGATION SETTLEMENT

 

During March 2004, the Company settled its litigation with the formerowners of Prolab Nutrition, Inc.  TheCompany received $2 million in cash, which was reflected in the financialstatements for the quarter ending March 31, 2004 as a reduction of goodwill.

 

ITEM2:

MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This report contains “forward looking statements.” Natrol, a Delawarecorporation organized in 1980, is including this statement for the expresspurpose of availing itself of protections of the safe harbor provided by thePrivate Securities Litigation Reform Act of 1995 with respect to all suchforward looking statements. Examples of forward looking statements include, butare not limited to, the use of forward-looking terminology such as “believes,”“expects,” “may,” “will,” “should,” “intend,” “estimate,” “assume,” “plan,” or“anticipates” or the negative thereof, other variations thereon, or comparableterminology, or by discussions of strategy that predict or indicate futureevents or trends or that are not historical facts. The Company cannot assurethe future results or outcome of the matters described in these statements;rather, these statements merely reflect its current expectations of theapproximate outcome of the matter discussed. The Company does not undertake anyobligation and does not currently intend to update any such statements at anytime in the future.

 

The Company’s ability to predict results or the effect of certainevents on the Company’s operating results is inherently uncertain. Forward-lookingstatements should not be unduly relied on since they involve known and unknownrisks, uncertainties and other factors, some of which are beyond the Company’scontrol. These risks, uncertainties and other factors may cause actual results,performance or achievements to differ materially from the anticipated futureresults, performance or achievements expressed or implied by suchforward-looking statements. Therefore, the Company wishes to caution eachreader of this report to carefully consider the following factors and certainother factors discussed herein and factors discussed in other past reports. Thefactors discussed herein may not be exhaustive. Therefore, the factorscontained herein should be read together with other reports and documents that arefiled by the Company with the SEC from time to time, which may supplement,modify, supersede or update the factors listed in this document.

 

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Factors that could cause or contribute to the Company’s actual resultsdiffering materially from those discussed herein or for the Company’s stockprice to be affected adversely include, but are not limited to:(i) industry trends, including a general downturn or slowing of the growthof the dietary supplement industry; (ii) increased competition fromcurrent competitors and new market entrants including but not limited toincreased competition from private label house brands supported by retailersseeking to increase the market share of their proprietary house brands becauseprivate label brands control the largest share of the vitamin, mineral andsupplement (VMS) sector; (iii) adverse publicity regarding the dietarysupplement industry or the Company’s products; (iv) exposure to productliability claims, in particular because the Company beginning in July, 2003 haschosen to self-insure against product liability claims due to the high price ofproduct liability insurance, the inability to secure occurrence based coverage,as well as the limited amount of coverage provided by insurers willing toprovide insurance at high prices; (v) exposure to and the expense ofresolving and defending potential product liability claims that are leftuncovered by insurance; (vi) the Company’s dependence upon its ability todevelop new products; (vii)  returns of the Company’s products which maybe returned by customers at any time due to lack of sell through to consumersor because competitors have convinced the Company’s customers that Natrol’sproducts should be replaced with competitor products; (viii) the Company’sability to manage inventory or sell its inventory before such inventory becomesoutdated, (xix) the Company’s ability to gain or expand or maintaindistribution within new or existing customers and new or existing channels oftrade; (x) an increase in the cost of obtaining and maintaining shelfspace with major national retailers who demand various forms of incentives fromtheir suppliers such as slotting fees, coop advertising, or rebates;(xi) adverse changes in government regulation or changes in local ornational laws; (xii) dependence on significant customers; (xiii) theCompany’s ability to keep and attract key management employees; (xiv) theCompany’s inability to manage growth and execute its business plan, or theCompany’s ability to modify its business plan in response to market conditions,including, but not limited to, its ability to enter into new businesses andcapitalize upon new business opportunities; (xv) the Company’s ability toconsummate future acquisitions and its ability to integrate acquiredbusinesses; (xvi) the absence of conclusive clinical studies for many ofthe Company’s products; (xvii) the Company’s inability to obtain rawmaterials that are in short supply including its ability to obtain garlicpowders or arabinogalactan for its EPI raw material sales division;(xviii) sales and earnings volatility, (xix) volatility of the stockmarket; (xx) the Company’s ability to manufacture its productsefficiently; (xxi) the Company’s reliance on independent brokers to sellits products; (xxii) the inability of the Company to protect itsintellectual property; (xxiii) control of the Company by principalshareholders, (xxiv) the possible sale of large amounts of stock bycontrolling stockholders; (xxv) a general downturn in the national economyas a whole; (xxvi) continued market acceptance of Natrol supplements, LaciLe Beau teas, Prolab’s sports nutrition products, and EPI’s raw materialproducts, (xxvii) increases in the cost of borrowings; (xxviii) and,the unavailability of additional debt or equity capital; (xix) legalactions brought forth by federal, state and local governmental and privateparties.

 

RESULTS OF OPERATIONS

 

The following discussion of the results of operations and the financialcondition of the Company should be read in conjunction with the response toPart 1 Item 1 of this report.

 

THREE MONTHS ENDED MARCH 31, 2004 AND MARCH 31, 2003

 

NET SALES. The Company recognizes revenue from sales only after productis shipped and title is transferred. Net sales represent product shipped lessactual and estimated future returns, spoilage allowances, allowances forproduct deemed to be unsaleable by customers, free goods shipped to customersfor promotional or other purposes and slotting fees. Estimates and allowancesare based upon known claims and an estimate of additional returns, however, theamount of future returns can be reasonably estimated.

 

Net sales increased 7.5%, or$1.4 million, to $20.4 million for the three months ended March 31, 2004 from$19.0 million for the three months ended March 31, 2003.  Approximately 63% of the increase in netsales during the quarter was from sales of Natrol products and another 6% ofthe increase in net sales was due to sales of Prolab branded products.  The Company’s EPI raw material and contractpackaging division accounted for the remainder of the increase in net sales.

 

GROSS PROFIT.  Gross profitdecreased 3.7%, or $0.3 million, to $7.8 million for the three months endedMarch 31, 2004 from $8.1 million for the three months ended March 31, 2003.Gross margin decreased to 38.3% for the three months ended March 31, 2004 from42.8% for the three months ended March 31, 2003.  The decrease in gross margin was primarily due to a shift inproduct mix at the Company’s EPI division. The EPI division sells raw materialingredients as well as contract manufacturing services.  The contract manufacturing margins are lowerthan the gross margin for raw material sales. During the first quarter 2004 the division’s sales revenue was derivedprimarily from contract manufacturing business which negatively affected theoverall gross margin for the Company.

 

SELLING AND MARKETING EXPENSES. Selling and marketing expenses consist primarily of advertising andpromotional expenses, cost of distribution, and related payroll expenses andcommissions. Selling and marketing expenses decreased 7.0%, or $0.3 million, to$4.6 million for the three months ended March 31, 2004 from $4.9 million forthe three months ended March 31, 2003. The

 

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decrease was due to lower media and public relations expenditures infirst quarter 2004 than in first quarter 2003 which were partially offset byincreases in payroll and shipping costs.

 

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 decreased 11.9%, or $0.3million to $2.3 million for the three months ended March 31, 2004 from $2.6million for the three months ended March 31, 2003.  The cost of general and product liability insurance was $0.3million less in first quarter 2004 than in first quarter 2003 due to theimplementation of the Company’s self insurance program in July of 2003. Legalexpenditures were also $0.3 million less in the first quarter 2004 than in thefirst quarter 2003.  The decrease wasdue to a number of factors including a greater proportional use of in-housecounsel as opposed to outside counsel. These savings in 2004 were partiallyoffset by higher payroll costs and other administration expenses.

 

INTEREST EXPENSE.  The Companyrecorded interest expense of $158,000 for the three months ended March 31, 2004as compared to interest expense of $162,000 for the three months ended March31, 2003. The Company pays interest on approximately $7.7 million of long-termmortgage debt.

 

INCOME TAX PROVISION. For the three months ended March 31, 2004 theCompany’s effective tax rate was approximately 40.0%.  For the three months ended March 31, 2003 the Company’s effectivetax rate was 38.2%.

 

DISCONTINUED OPERATIONS. In December 2003, the Company discontinued itsAnnasa and Tamsol units.  Annasa, asubsidiary of Natrol, a multi-level marketer of proprietary nutritionalproducts began operations in 2002. Tamsol, was also formed in 2002, to generate direct-to-consumer sales viaradio, television, direct mail and other non retail venues.  The Company has reclassified its financialstatements to segregate the revenues, direct costs and expenses (excludingallocated costs), assets and liabilities and cash flows of the discontinuedoperations.  The net operating results,net assets and net cash flows of these businesses have been reported as“Discontinued Operations” in the accompanying consolidated financialstatements. As the operations were shut down as of the end of calendar 2003,the Company had no revenue or expenses from discontinued operations in thefirst quarter of 2004.  During the firstquarter of 2003, the Company had a net loss of $352,000 from discontinuedoperations.

 

LIQUIDITY AND CAPITAL RESOURCES

 

As of March 31, 2004, the Company had working capital of $16.0 millionas compared to $13.3 million in working capital at December 31, 2003. TheCompany’s cash balance at March 31, 2004 was approximately $5.4 million.  The increase in working capital wasprimarily due to the receipt of $2.0 million from settling litigation with theformer owners of Prolab Nutrition, Inc. The cash receipt was recorded as areduction of goodwill.

 

Net cash provided by operatingactivities was $0.9 million for the three months ended March 31, 2004 versusnet cash used of $1.1 million for the three months ended March 31, 2003. Cashprovided by operating activities during the three months ended March 31, 2004consisted of $450,000 of net income earned during the quarter, an increase inaccounts payable and other accrued expenses of $2.9 million, and increase inincome taxes payable of $0.3 million, depreciation of $0.3 million offset by anincrease in accounts receivable of $1.5 million and an increase in inventory of$1.5 million.  The increase in inventorywas due to additional purchases of raw materials and the stocking higher levelsof finished goods inventory in anticipation of improving service levels withcustomers. The increase in accounts receivable was largely due to the timing ofsales. The increase in accounts payables was also due to the timing of certainpayments.

 

Net cash provided by investing activities was $1.9 million for thethree months ended March 31, 2004 versus net cash used of $68,000 during thethree months ended March 31, 2003. The settlement of the litigation with theformer owners of Prolab Nutrition, Inc., which was recorded as a reduction ofgoodwill, provided $2.0 million of cash which was offset by investment inproperty and equipment.  All of theinvestment in the three months ended March 31, 2003 was in property andequipment.

 

Net cash provided by financingactivities was $29,000 for the three months ended March 31, 2004 as opposed to$76,000 used in financing activities during the three months ended March 31,2003. During the three months ended March 31, 2004, the Company made principalpayments of $80,000 on its long-term mortgage debt and received $109,000 fromthe exercise of stock options and the purchase of stock through the Company’sEmployee Stock Purchase Plan.  Duringthe three months ended March 31, 2003 the Company made principal payments of$76,000 on its long-term mortgage debt.

 

As of March 31, 2004, the Company had $7.7 million of outstanding debtall of which is the result of long-term mortgage debt on the Company’smanufacturing/headquarters facility and on the Company’s shipping facility. TheCompany has no line of credit in place.

 

The Company believes that its cash balance together with cash generatedfrom operations should be sufficient to fund its anticipated working capitalneeds and planned capital expenditures for the next twelve months.However, if the Company does not meet its operating plan it may also needadditional borrowings to fund working capital needs.

 

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The Company currently has no outstanding debt on its books other thanthe mortgage debt on its properties. In order to meet current financing needsfor working capital, the Company may need to open bank lines of credit.  In order to meet its long-term liquidityneeds, the Company may be required to incur additional indebtedness or issueadditional equity and debt securities, subject to market and other conditions.There can be no assurance that such additional financing will be available onterms acceptable to the Company or at all. The failure to raise the fundsnecessary to finance its future cash requirements or consummate futureacquisitions could adversely affect the Company’s ability to pursue newacquisitions and could negatively affect its operations in future periods.

 

## **CRITICAL ACCOUNTING POLICIES**

## ** **

Management’s beliefs regarding significant accounting policies have notchanged significantly from those discussed in Item 7 of the Company’s AnnualReport on Form 10-K for the year ended December 31, 2003.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

There has been no materialchange during the three months ended March 31, 2004 from the disclosures aboutmarket risk provided in the Company’s Annual Report on Form 10-K for the yearended December 31, 2003.

 

ITEM 4. CONTROLS AND PROCEDURES

 

## **Anevaluation was conducted under the supervision and with the participation ofthe Company’s management, including the Chief Executive Officer and ChiefFinancial Officer, of the effectiveness of the Company’s disclosure controlsand procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)14(c)under the Securities Exchange Act of 1934) as of the end of the period coveredby this report.  Based on thisevaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that the Company’s disclosure controls and procedures are, to thebest of their knowledge, effective to ensure that information required to bedisclosed by the Company in reports that it files or submits under the ExchangeAct is recorded, processed, summarized and reported within the time periodsspecified in Securities and Exchange Commission rules and forms. There were nosignificant changes in the Company’s internal control over financial reportingthat occurred during the fiscal quarter covered by this report that havematerially affected or are reasonably likely to materially affect the Company’sinternal control over financial reporting.**

 

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PART II

 

OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

None

 

ITEM 2.  CHANGES IN SECURITIES, USE OF PROCEEDS ANDISSUER PURCHASES OF EQUITY SECURITIES

 

None

 

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

 

None

 

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS

 

None

 

ITEM 5.  OTHER INFORMATION

 

## **CODE OFETHICS**

## ** **

The Company has not, as of thefiling of this document, adopted a Code of Ethics.  The Company intends to adopt such a plan prior to the annualshareholders’ meeting in June 2004.

 

ITEM 6.  EXHIBITS AND REPORTS ONFORM 8-K

 

Form 8-K filed on March 31, 2004

 
| Exhibit 31.1 |   | Certification of Chief Financial Officer |
|--------------|--------|------------------------------------------|
| Exhibit 31.2 |   | Certification of President/CEO/Chairman  |
| Exhibit 32.1 |   | Certification of Chief Financial Officer |
| Exhibit 32.2 |   | Certification of President/CEO/Chairman  |

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|          | NATROL, INC. |
|---------------|--------------|
|          |         |   |
| Date: 5/17/04 | By:          | /s/ Elliott Balbert |   |
|          |         | Chairman, President and Chief Executive  Officer |
|          |         |   |
| Date: 5/17/04 | By:          | /s/ Dennis R. Jolicoeur |   |
|          |         | Chief Financial Officer and Executive  Vice President |

 

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