**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, 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 SEPTEMBER 30,  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 STREET  CHATSWORTH, CALIFORNIA 91311**    |
| (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                  |
|                                                      |
| **(818) 739-6000**                                        |
| (REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE) |

 

INDICATEBY A CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED TO BEFILED BY SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANTWAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILINGREQUIREMENTS FOR THE PAST 90 DAYS.

YES  ý   NO  o

 

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

 

Indicatethe number of shares outstanding of the issuer’s common stock, as of the latestpracticable date:

 

| **Class**                     | ** ** | **November 2, 2004** |
|-------------------------------|------------|----------------------|
|                          |       |                 |
| Common stock, $0.01 par value |       | 13,358,112           |

 

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PART1. FINANCIAL INFORMATION

ITEM1. CONSOLIDATED FINANCIAL STATEMENTS

**Natrol, Inc.and Subsidiaries**

**Consolidated Balance Sheets**

(In thousands, except share and per share data)

(Unaudited)
| ** **                                                                                                                           | ** ** | **September 30, 2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                           | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                                           |       |                        |       |                        |       |
| Current assets:                                                                                                                      |       |                        |       |                        |       |
| Cash and cash equivalents                                                                                                            |       | $                           | 3,694      |                        | $          | 2,599 |   |
|                                                                                                                                 |       |                        |       |                        |       |
| Accounts receivable, net of allowances of $611 and $635 at  September 30, 2004 and December 31, 2003, respectively         |       | 8,913                       |       | 7,698                       |       |
| Inventory                                                                                                                            |       | 10,689                      |       | 9,053                       |       |
| Income taxes receivable                                                                                                              |       | 414                         |       | 349                         |       |
| Deferred income taxes                                                                                                                |       | 1,110                       |       | 1,110                       |       |
| Prepaid expenses and other current assets                                                                                            |       | 906                         |       | 914                         |       |
| Net assets of discontinued operations                                                                                                |       | —                      |       | 35                          |       |
| Total current assets                                                                                                                 |       | 25,726                      |       | 21,758                      |       |
| Property and equipment:                                                                                                              |       |                        |       |                        |       |
| Building and improvements                                                                                                            |       | 15,848                      |       | 15,612                      |       |
| Machinery and equipment                                                                                                              |       | 5,282                       |       | 5,215                       |       |
| Furniture and office equipment                                                                                                       |       | 3,150                       |       | 3,158                       |       |
|                                                                                                                                 |       | 24,280                      |       | 23,985                      |       |
| Accumulated depreciation                                                                                                             |       | (7,839                      | )          | (7,315                      | )          |
| Property and equipment, net                                                                                                          |       | 16,441                      |       | 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                                                                                                                         |       | 290                         |       | 83                          |       |
| Total assets                                                                                                                         |       | $                           | 53,385     |                        | $          | 51,439 |   |
|                                                                                                                                 |       |                        |       |                        |       |
| **Liabilities and stockholders’ equity**                                                                                        |       |                        |       |                        |       |
| Current liabilities:                                                                                                                 |       |                        |       |                        |       |
| Accounts payable                                                                                                                     |       | $                           | 4,803      |                        | $          | 5,601 |   |
| Accrued expenses                                                                                                                     |       | 1,841                       |       | 1,732                       |       |
| Accrued payroll and related liabilities                                                                                              |       | 1,721                       |       | 772                         |       |
| Current portion of long-term debt                                                                                                    |       | 346                         |       | 325                         |       |
| Total current liabilities                                                                                                            |       | 8,711                       |       | 8,430                       |       |
| Long-term debt, less current portion                                                                                                 |       | 7,189                       |       | 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-  14,275,607 and 14,054,309 at September 30, 2004 and December 31,  2003, respectively |       | 143                         |       | 141                         |       |
| Additional paid-in capital                                                                                                           |       | 62,699                      |       | 62,377                      |       |
| Accumulated deficit                                                                                                                  |       | (22,476                     | )          | (24,079                     | )          |
|                                                                                                                                 |       | 40,366                      |       | 38,439                      |       |
| Shares held in treasury, at cost - 921,900 shares at  September 30, 2004 and December 31, 2003                             |       | (2,881                      | )          | (2,881                      | )          |
| Total stockholders’ equity                                                                                                      |       | 37,485                      |       | 35,558                      |       |
| Total liabilities and stockholders’ equity                                                                                      |       | $                           | 53,385     |                        | $          | 51,439 |   |
|                                                                                                                                      |            |                             |            |                             |            |  |  |  |  |

See accompanying notes

 

2

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**Natrol, Inc.and Subsidiaries**

**Consolidated Statements of Operations**

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

**(Unaudited)**

 
| ** **                                                 | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                 | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                                  |       | $                                          | 20,879     |                                      | $          | 17,398 |   | $ | 61,986 |   | $ | 55,259 |   |
| Cost of goods sold                                         |       | 12,214                                     |       | 10,588                                    |       | 36,147 |   | 33,716 |   |
| Gross profit                                               |       | 8,665                                      |       | 6,810                                     |       | 25,839 |   | 21,543 |   |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Selling and marketing expenses                             |       | 5,349                                      |       | 4,122                                     |       | 15,610 |   | 13,223 |   |
| General and administrative expenses                        |       | 2,539                                      |       | 2,461                                     |       | 7,139 |   | 7,827 |   |
| Total operating expenses                                   |       | 7,888                                      |       | 6,583                                     |       | 22,749 |   | 21,050 |   |
| Operating income from continuing operations                |       | 777                                        |       | 227                                       |       | 3,090 |   | 493 |   |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Interest income                                            |       | 25                                         |       | 2                                         |       | 69 |   | 16 |   |
| Interest expense                                           |       | (156                                       | )          | (162                                      | )          | (470 | ) | (486 | ) |
| Income from continuing operations before income taxes      |       | 646                                        |       | 67                                        |       | 2,689 |   | 23 |   |
| Income tax provision                                       |       | 262                                        |       | 42                                        |       | 1,086 |   | 16 |   |
| Income from continuing operations                          |       | 384                                        |       | 25                                        |       | 1,603 |   | 7 |   |
| Discontinued operations:                                   |       |                                       |       |                                      |       |   |   |   |   |
| Loss from operations                                       |       | —                                     |       | (641                                      | )          | — |   | (1,675 | ) |
| Income tax benefit                                         |       | —                                     |       | 224                                       |       | — |   | 602 |   |
| Loss on discontinued operations                            |       | —                                     |       | (417                                      | )          | — |   | (1,073 | ) |
| Net Income (loss)                                          |       | $                                          | 384        |                                      | $          | (392 | ) | $ | 1,603 |   | $ | (1,066 | ) |
| Basic income (loss) per share:                             |       |                                       |       |                                      |       |   |   |   |   |
| Income per share from continuing operations                |       | $                                          | .03        |                                      | $          | .00 |   | $ | .12 |   | $ | .00 |   |
| Loss per share from discontinued operations                |       | —                                     |       | (.03                                      | )          | — |   | (.08 | ) |
| Income (loss) per share                                    |       | $                                          | .03        |                                      | $          | (.03 | ) | $ | .12 |   | $ | (.08 | ) |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Diluted income (loss) per share:                           |       |                                       |       |                                      |       |   |   |   |   |
| Income per share from continuing operations                |       | $                                          | .03        |                                      | $          | .00 |   | $ | .11 |   | $ | .00 |   |
| Loss per share from discontinued operations                |       | —                                     |       | (.03                                      | )          | — |   | (.08 | ) |
| Income (loss) per share                                    |       | $                                          | .03        |                                      | $          | (.03 | ) | $ | .11 |   | $ | (.08 | ) |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Weighted-average shares outstanding—basic and diluted |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                      |       | 13,343,954                                 |       | 12,915,285                                |       | 13,248,797 |   | 12,892,196 |   |
| Diluted                                                    |       | 14,059,462                                 |       | 12,915,285                                |       | 14,063,781 |   | 12,892,196 |   |
|                                                            |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes

 

3

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# **Natrol, Inc.and Subsidiaries**

**Consolidated Statements of Cash Flows**

(In thousands)

(Unaudited)

 
| ** **                                                                                            | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                            | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| ** **                                                                                            | ** ** | ** **                           | ** ** | ** ** | ** ** |
| **Operating activities**                                                                              |       |                                 |       |   |   |
| Net Income (loss)                                                                                     |       | $                                    | 1,603      |   | (1,066 | ) |
| Loss from discontinued operations                                                                     |       | —                               |       | 1,073 |   |
| Income from continuing operations                                                                     |       | 1,603                                |       | 7 |   |
|                                                                                                  |       |                                 |       |   |   |
| Adjustments to reconcile income from continuing operations to net  cash used in operating activities: |       |                                 |       |   |   |
| Loss from discontinued operations                                                                     |       | —                               |       | (1,073 | ) |
| Change in net assets of discontinued operations                                                       |       | 35                                   |       | 80 |   |
| Depreciation and amortization                                                                         |       | 974                                  |       | 1,112 |   |
| Provision for bad debts                                                                               |       | 76                                   |       | 118 |   |
| Shares issued for services                                                                            |       | 2                                    |       | — |   |
| Changes in operating assets and liabilities:                                                          |       |                                 |       |   |   |
| Accounts receivable                                                                                   |       | (1,291                               | )          | (2,994 | ) |
| Inventory                                                                                             |       | (1,636                               | )          | 626 |   |
| Income taxes receivable/payable                                                                       |       | (65                                  | )          | (760 | ) |
| Prepaid expenses and other current assets                                                             |       | 8                                    |       | 77 |   |
| Accounts payable                                                                                      |       | (798                                 | )          | 663 |   |
| Accrued expenses                                                                                      |       | 109                                  |       | (956 | ) |
| Accrued payroll and related liabilities                                                               |       | 949                                  |       | 249 |   |
| Net cash used in operating activities                                                                 |       | (34                                  | )          | (2,851 | ) |
|                                                                                                  |       |                                 |       |   |   |
| **Investing activities**                                                                              |       |                                 |       |   |   |
| Purchases of property and equipment                                                                   |       | (745                                 | )          | (218 | ) |
| Increase in restricted cash                                                                           |       | —                               |       | (5,000 | ) |
| Reduction in goodwill                                                                                 |       | 2,000                                |       | — |   |
| Other assets                                                                                          |       | (207                                 | )          | (35 | ) |
| Net cash provided by (used in) investing activities                                                   |       | 1,048                                |       | (5,253 | ) |
|                                                                                                  |       |                                 |       |   |   |
| **Financing activities**                                                                              |       |                                 |       |   |   |
| Repayments on long-term debt                                                                          |       | (241                                 | )          | (226 | ) |
| Proceeds from issuance of common stock                                                                |       | 322                                  |       | 282 |   |
| Net cash provided by financing activities                                                             |       | 81                                   |       | 56 |   |
| Net increase (decrease) in cash and cash equivalents                                                  |       | 1,095                                |       | (8,048 | ) |
| Cash and cash equivalents, beginning of period                                                        |       | 2,599                                |       | 10,077 |   |
| Cash and cash equivalents, end of period                                                              |       | $                                    | 3,694      |   | 2,029 |   |
|                                                                                                  |       |                                 |       |   |   |
| **Supplemental disclosures of cash flow  information**                                                |       |                                 |       |   |   |
| Cash paid during the year for:                                                                        |       |                                 |       |   |   |
| Interest                                                                                              |       | $                                    | 472        |   | $ | 490 |   |
| Income taxes                                                                                          |       | $                                    | 1,128      |   | $ | 250 |   |

 

See accompanying notes 

 

4

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

(Unaudited)

 

1. BASIS OF PRESENTATION

 

Theaccompanying consolidated financial statements have been prepared by theCompany, pursuant to the rules and regulations of the Securities and ExchangeCommission (SEC).  This Report on Form 10-Q should be read in conjunctionwith the Company’s annual report on Form 10-K for the year endedDecember 31, 2003.  Certain information and footnote disclosureswhich are normally 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 months and ninemonths ended September 30, 2004 are not necessarily indicative of the resultsto be expected for the full year or any other future period.

 

2. STOCK BASED COMPENSATION

 

TheCompany accounts for its employee stock option plan under the intrinsic valuemethod prescribed by Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees,*andrelated interpretations.  The Company hasa stock-based compensation plan.  TheCompany’s operating results do not include a compensation charge related tothis plan, as all options granted had an exercise price equal to the market valueof the underlying common stock on the date of grant.  The following table illustrates the effect onthe operating results and per share amounts if the fair value recognitionprovisions of Statement of Financial Accounting Standards No. 123, *Accounting for Stock-Based compensation,*hadbeen applied to stock-based employee compensation:

 
| ** **                                                                                                                                                                  | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **2004**                                  | ** ** | **2003**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| Income from  continuing operations as reported:                                                                                                                             |       | $                                         | 384        |                                     | $          | 25 |   | $ | 1,603 |   | $ | 7 | ** ** |
|                                                                                                                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| Total stock-based employee compensation expense determined under the  fair value-based method for all awards, net of related tax benefits (“Stock  Compensation”) |       | 23                                        |       | 43                                       |       | 51 |   | 119 |   |
| Income (loss) from continuing operations—pro forma                                                                                                                     |       | $                                         | 361        |                                     | $          | (18 | ) | $ | 1,552 |   | $ | (112 | ) |
| Loss from discontinued operations                                                                                                                                           |       | —                                    |       | (417                                     | )          | — |   | (1,073 | ) |
| Net Income (loss)—pro forma                                                                                                                                            |       | $                                         | 361        |                                     | $          | (435 | ) | $ | 1,552 |   | $ | (1,185 | ) |
|                                                                                                                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| Income (Loss) per share from continuing operations:                                                                                                                         |       |                                      |       |                                     |       |   |   |   |   |
| Basic—as reported                                                                                                                                                      |       | $                                         | .03        |                                     | $          | .00 |   | $ | .12 |   | $ | .00 |   |
| Diluted—as reported                                                                                                                                                    |       | $                                         | .03        |                                     | $          | .00 |   | $ | .11 |   | $ | .00 |   |
| Basic—pro forma                                                                                                                                                        |       | $                                         | .03        |                                     | $          | .00 |   | $ | .12 |   | $ | (.01 | ) |
| Diluted—pro forma                                                                                                                                                      |       | $                                         | .03        |                                     | $          | .00 |   | $ | .11 |   | $ | (.01 | ) |
|                                                                                                                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| Net income (loss) per share:                                                                                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Basic—as reported                                                                                                                                                      |       |                                      |       |                                     |       |   |   |   |   |
| Diluted—as reported                                                                                                                                                    |       | $                                         | .03        |                                     | $          | (.03 | ) | $ | .12 |   | $ | (.08 | ) |
| Basic—pro forma                                                                                                                                                        |       | $                                         | .03        |                                     | $          | (.03 | ) | $ | .11 |   | $ | (.08 | ) |
| Diluted—pro forma                                                                                                                                                      |       | $                                         | .03        |                                     | $          | (.03 | ) | $ | .12 |   | $ | (.09 | ) |
|                                                                                                                                                                        |       | $                                         | .03        |                                     | $          | (.03 | )  | $ | .11 |   | $ | (.09 | ) |
|                                                                                                                                                                             |            |                                           |            |                                          |            |  |  |  |  |  |  |  |  |  |

 

Duringthe nine months ended September 30, 2004, 90,000 stock options weregranted with exercise prices ranging between $2.67 and $3.04, which equaled thefair value of the underlying common stock on the date of grant.

 

5

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3. INVENTORY

 

Inventoriesconsist of the following:

 
| ** **                           | ** ** | **September 30,  2004** | ** ** | **December 31 2003** | ** ** |
|--------------------------------------|------------|------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| Raw material and  packaging supplies |       | $                            | 4,941      |                           | $          | 3,736 | ** ** |
| Finished goods                       |       | 5,748                        |       | 5,317                          |       |
| Total Inventory                      |       | $                            | 10,689     |                           | $          | 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 $2,763 and $2,352 for nine months endedSeptember 30, 2004 and 2003 respectively.

 

5.EARNINGS PER SHARE

 

Basicearnings per share has been computed by dividing net income (loss) by theweighted average number of common shares outstanding during the period. Dilutedearnings per share has been computed by dividing net income (loss) by theweighted average number of common shares and common stock equivalents (stockoptions), when dilutive.  Stock optionsto purchase 557,500  and 532,500 common sharesfor the three and nine months ended September 30, 2004, and stock optionsto purchase 660,000 and 1,716,250 common shares for the three and nine monthsended September 30, 2003 were outstanding but considered to beanti-dilutive.

 

Areconciliation of basic and diluted shares is as follows:

 
| ** **                                                                                    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2004**                                  | ** ** | **2003**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| Weighted average  number of common shares outstanding during the period                       |       | 13,343,954                                |       | 12,915,285                               |       | 13,248,797 |   | 12,892,196 | ** ** |
|                                                                                          |       |                                      |       |                                     |       |   |   |   |   |
| Common share equivalents resulting from the assumed exercise of stock  options                |       | 715,508                                   |       | —                                   |       | 814,984 |   | — |   |
| Weighted average number of common and common equivalent shares  outstanding during the period |       | 14,059,462                                |       | 12,915,285                               |       | 14,063,781 |   | 12,892,196 |   |

 

 

6.RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

 

InJanuary 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities (“FIN46”). In December 2003, FIN 46 was replaced by FASB interpretation No.46(R) “Consolidation of Variable Interest Entities.” FIN 46(R) clarifies theapplication of Accounting Research Bulletin No. 51, “Consolidated FinancialStatements,” to certain entities in which equity investors do not have thecharacteristics of a controlling financial interest or do not have sufficientequity at risk for the entity to finance its activities without additionalsubordinated financial support from other parties. FIN 46(R) requires anenterprise to consolidate a variable interest entity if that enterprise willabsorb a majority of the entity’s expected losses, is entitled to receive amajority of the entity’s expected residual returns, or both. FIN 46(R) iseffective for entities being evaluated under FIN 46(R) for consolidation nolater than the end of the first reporting period that ends after March 15,2004. The Company did not have any variable interest entities that wereimpacted by adoption of FIN 46(R).

 

7.DISCONTINUED OPERATIONS

 

In December 2003, the Companydiscontinued its Annasa and Tamsol units. Annasa, a subsidiary of Natrol and a multi-level marketer of proprietarynutritional products 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 “DiscontinuedOperations” in the accompanying consolidated financial statements.

 

 

6

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Summarizedfinancial information for the discontinued operations is as follows:

 
| ** **                 | ** ** | **Three Months Ended September 30, 2003** | ** ** | **Nine Months Ended September 30, 2003** | ** ** |
|----------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| Annasa:                    |       |                                           |       |                                          | ** ** |
| Revenue                    |       | $                                              | 198        |                                          | $          | 465 | ** ** |
| Gross Margin               |       | 114                                            |       | 304                                           |       |
|                       |       |                                           |       |                                          |       |
| Selling and Marketing      |       | 339                                            |       | 794                                           |       |
| General and Administrative |       | 296                                            |       | 924                                           |       |
| Loss From Operations       |       | (521                                           | )          | (1,414                                        | )          |
| Income Tax Benefit         |       | 176                                            |       | 498                                           |       |
| Net Loss                   |       | $                                              | (345       | )                                             | $          | (916 | ) |
|                       |       |                                           |       |                                          |       |
| Tamsol:                    |       |                                           |       |                                          |       |
| Revenue                    |       | $                                              | 2          |                                          | $          | 30 |   |
| Gross Margin               |       | 2                                              |       | 30                                            |       |
|                       |       |                                           |       |                                          |       |
| Selling and Marketing      |       | 52                                             |       | 85                                            |       |
| General and Administrative |       | 70                                             |       | 208                                           |       |
| Loss From Operations       |       | (120                                           | )          | (261                                          | )          |
| Income Tax Benefit         |       | 48                                             |       | 104                                           |       |
| Net Loss                   |       | $                                              | (72        | )                                             | $          | (157 | ) |

 
| ** **                              | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Net assets of  discontinued operations: | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| Current assets                          |       | $                           | 0          |                       | $          | 116 |   |
| Total assets                            |       | 0                           |       | 151                        |       |
| Current liabilities                     |       | 0                           |       | 116                        |       |
| Net assets of discontinued operations   |       | 0                           |       | 35                         |       |
|                                         |            |                             |            |                            |            |  |  |

 

8. LITIGATION SETTLEMENT

 

During March 2004, the Company settledits litigation with the former owners of Prolab Nutrition, Inc.  The Company received $2 million in cash,which has been reflected as a reduction in goodwill in the accompanyingSeptember 30, 2004 balance sheet.

 

During the quarter ended September 30, 2004,the Company incurred charges of $250,000 related to the resolution of twoactions filed by the Napa County, Solano County and Sonoma County DistrictAttorney’s Offices in California concerning its Chitosan-based dietarysupplements. The Company also maintains an accrual for outstanding litigation,the ultimate settlement of which is not expected to have a material impact onthe company's financial condition or results of operations.

 

ITEM2:

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

 

Thisreport contains “forward looking statements.” Natrol, a Delaware corporationorganized in 1980, is including this statement for the express purpose ofavailing itself of protections of the safe harbor provided by the PrivateSecurities Litigation Reform Act of 1995 with respect to all such forwardlooking statements. Examples of forward looking statements include, but are notlimited 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 comparable terminology,or by discussions of strategy that predict or indicate future events or trendsor that are not historical facts. The Company cannot assure the future resultsor outcome of the matters described in these statements; rather, thesestatements merely reflect its current expectations of the approximate outcomeof the matter discussed. The Company does not undertake any obligation and doesnot currently intend to update any such statements at any time in the future.

 

TheCompany’s ability to predict results or the effect of certain events on theCompany’s operating results is inherently uncertain. Forward-looking statementsshould not be unduly relied on since they involve known and unknown risks,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 thatare filed by the Company with the SEC from time to time, which may supplement,modify, supersede or update the factors listed in this document.

 

Factorsthat could cause or contribute to the Company’s actual results differing materiallyfrom those discussed herein or for the Company’s stock price to be affectedadversely include, but are not limited to: (i) industry trends, includinga general downturn or slowing of the growth of the dietary supplement industry;(ii) increased competition from current competitors and new marketentrants including but not limited to increased competition from private labelhouse brands supported by retailers seeking to increase the market share oftheir proprietary house brands because private label brands control the largestshare of the vitamin, mineral and supplement (VMS) sector; (iii) adversepublicity regarding the dietary supplement industry or the Company’s products;(iv) exposure to product liability claims, in particular because theCompany beginning in July, 2003 has chosen to self-insure against productliability claims due to the high price of product liability insurance, theinability to secure occurrence-based coverage, as well as the limited amount ofcoverage provided by insurers willing to provide insurance at high prices;(v) exposure to and the expense of resolving and defending potentialproduct liability claims that are left uncovered by insurance includingpotential claims involving ephedrine based products which the company soldprior to April, 2003; (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 

 

 

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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.

 

OVERVIEW

Sincedivesting itself of its unprofitable multi-level marketing and direct marketingunits in 2003 (see discontinued operations), the Company’s business plan hasbeen to focus on its core Natrol, Prolab sports nutrition and Laci Le Beau teabrands.  The Natrol and Laci Le Beaubrands are sold in health food stores, in mass-market drug, food and retailchains as well as club stores.   Prolabproducts are sold through distributors who in turn service retail accounts.  Prolab’s distributor network focuses onhealth food stores, health clubs and fitness facilities that cater to bodybuilders and other individuals seeking a high level of fitness.   With the integration of Prolab as a brand withinNatrol, Natrol’s health food oriented sales professionals have becomeresponsible for presenting appropriate Prolab products to health foodretailers, who in turn, order from distributors who carry Prolab product. Inaddition, more than 40% of Prolab sales are to distributors who sell Prolabproducts outside the United States.  TheCompany is continually seeking to expand the distribution of its best sellingitems to additional retail outlets and to create promotional opportunities forits products within its existing customer base.

TheCompany also provides contract manufacturing services to other supplementcompanies.

Keyissues for the Company’s management include product development, productintroductions, inventory management, and controlling the cost of doing businessin its various channels of trade.

Thenutritional supplement business is dependent upon new product introductions forboth growth and to replace volume lost by products reaching the end of theirproduct life cycles.  As such, theCompany is continually researching potential new products for placement intothe marketplace. Developing a single new product can be a multi-year effortdepending upon the complexity of the product and the amount of testing thatmust be completed to validate the product concept.

Productintroductions do not come without risk. Product launches can require substantial marketing support. Oftentimesretailers demand slotting fees or other up front expenditures.  If a product launch is not as successful asanticipated, additional promotional expenditures may be needed to sustain salesand reduce possible returns.  Mostvendors retain certain rights as they relate to product returns. A broadproduct launch, one in which a new product is introduced into thousands ofretail outlets, can cause a strain on corporate resources since inventoriesmust be produced and delivered.  Theresulting sales increase also leads to an increase in accounts receivable withcustomers.

Nutritionalsupplements must maintain potency levels during their selling life.  As a result, products must be stamped with anexpiration date and retailers will not accept product with limited shelf lifeinto their warehouses.  Shelf life issuesrequire a high degree of supply chain management of raw materialsand finished goods to ensure that shelf life is maximized and that theout-of-date inventory is minimized.

 

Thecompetition for shelf space at retailers is intense. Natrol has ongoingdiscussions with its retail customers with regards to the allocation of shelfspace and the level of promotional support for products.  Retailers look to their vendors forpromotional support for the products on their shelves in order to maximizesales.  Vendors such as Natrol look toretailers for advantageous placement of their products and promotion of theirproducts within stores and within a retailer’s promotional media such asnewspaper advertisements placed by retailers. The cost of promotions and support to the retailer on the part ofvendors such as Natrol can be very high and Management must continually reviewits promotional efforts with retailers to ensure that sales are profitable.

Throughthe first three quarters of 2004, the Company’s overall strategy ofconcentrating on its core business has been successful and year-to-date andquarterly results in 2004 have been positive when measured against performancein 2003.

Futurechallenges include maintaining the current positive trends for the Companyacross all product lines as well as developing new innovative products anddelivery systems that will capture the support of consumers and sustain thegrowth experienced in 2004.  As notedearlier the supplement business is characterized by trends in which someproducts fall out of favor presenting companies in the nutritional supplementbusiness with the challenge of introducing new products which can replacebusiness lost from products that are waning.

 

 

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TheCompany continues to believe that additional opportunities for growth exist asit seeks to improve its position with retailers and consumers. Management seeksto capitalize on these opportunities in what remains a very competitivemarketplace.

RESULTSOF OPERATIONS

Thefollowing discussion of the results of operations and the financial conditionof the Company should be read in conjunction with the response to Part 1 Item 1of this report.

THREEMONTHS ENDED SEPTEMBER 30, 2004 AND SEPTEMBER 30, 2003

NETSALES. The Company recognizes revenue from sales only after product is shippedand title is transferred. Net sales represent product shipped less actual andestimated future returns, spoilage allowances, allowances for product deemed tobe unsaleable by customers, free goods shipped to customers for promotional orother purposes and slotting fees. Estimates and allowances are based upon knownclaims and an estimate of additional returns when the amount of future returnsfrom customers can be reasonably estimated.

Asummary of net sales by product line is as follows:
| ** **                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                     | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales                      | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Natrol (including Laci-LeBeau) |       | $                                          | 14,638     |                                      | $          | 10,639 |   | $ | 42,099 |   | $ | 34,689 |   |
| EPI                            |       | 1,405                                      |       | 1,737                                     |       | 5,008 |   | 5,365 |   |
| Prolab                         |       | 4,836                                      |       | 5,022                                     |       | 14,879 |   | 15,205 |   |
| Total net sales                |       | $                                          | 20,879     |                                      | $          | 17,398 |   | $ | 61,986 |   | $ | 55,259 |   |
|                                |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

Netsales increased 20.0%, or $3.5 million, to $20.9 million for the third quarterof 2004 from $17.4 million in the third quarter of 2003.  The growth came from the Company’s Natrolbrand.  Net sales of the Natrol brandincreased approximately 37.6% over the comparable three-month period in2003.  The increase was due to manyfactors including broader distribution of certain products, promotional effortsmade by the Company, and strong consumer demand for certain Natrolproducts.  Net sales of Prolab brandproducts decreased 3.7% and net sales of the Company’s EPI division, whichalong with manufacturing Natrol products, sells raw materials and contractmanufacturing services, decreased 19.2%. The majority of the decrease in EPI sales was due to a reduction in thesale of garlic powders. The reduction in the sale of garlic powders waspartially offset by a higher level of contract manufacturing.  Contract manufacturing sales, however,generally have lower gross margins than does the sale of garlic powders. TheCompany estimates that the weakness in the sale of garlic powders may continuethrough the end of 2004 and perhaps longer due to negative industry trends andstrong competition amongst suppliers.

GROSSPROFIT.  Gross profit increased 27.2%, or$1.9 million, to $8.7 million for the three months ended September 30,2004 from $6.8 million for the three months ended September 30, 2003.Gross margin increased to 41.5% for the three months ended September 30,2004 from 39.1% for the three months ended September 30, 2003.  The increase in gross margin and gross profitwas due, in part, to overall favorable product mix which resulted in a lowercost of products. In addition, there was an approximately 13.6% reduction inthe amount of deductions given to customers that reduced revenue fromapproximately $2.6 million in the third quarter of 2003 to approximately $2.3million in the third quarter of 2004. These deductions include returns,allowances for damages and outdates, slotting fees, rebates, and otherpromotional expenses.

SELLING AND MARKETING EXPENSES.  Selling and marketing expenses consistprimarily of advertising and promotional expenses, cost of distribution, andrelated payroll expenses and commissions. Selling and marketing expensesincreased 29.8%, or $1.2 million, to $5.3 million for the three months endedSeptember 30, 2004 from $4.1 million for the three months endedSeptember 30, 2003.  Shipping expensesare included in selling and marketing expenditures. Shipping expenses increased$160,000 in the third quarter of 2004, rising to $960,000 from $800,000 in thethird quarter of 2003.  Freight out andlabor increased due to increased freight cost caused by higher fuel prices andincreased volume due to higher sales levels. Approximately 85% of the remaining increase was due to increasedspending on coop advertising, and various forms of media including brochures,public relations, celebrity endorsements, radio, television and advertising inpublications.  The remainder of theincrease was due to personnel costs as well a general increase in expendituresnecessary to support the increase in the selling and marketing efforts of theCompany.

 

GENERAL AND ADMINISTRATIVE EXPENSES.  General and administrative expenses consistprimarily of personnel costs related to general management functions, productdevelopment, finance, accounting and information systems, as well asprofessional fees related to legal, audit and tax matters and depreciation.General and administrative expenses increased 3.2%, or approximately $78,000 to$2.54 million for the three months ended September 30, 2004 from $2.46million for the three months ended September 30, 2003.  Legal expenditures were $448,000 higher inthe third quarter of 2004 than the third quarter of 2003 due to the settlementof litigation with certain district attorneys in California and legal expensesrelated to this and other matters. General and administrative expenses also increased $195,000 during thequarter due to accruals related to the establishment of the Company’s incentivebonus program in January 2004.  Thisprogram was not in effect in 2003. During the third quarter of 2004, expenses for the product developmentdepartment were to $131,000. This department was not established until thefourth quarter of 2003. The increase in legal 

 

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expenditures,incentives and product development were partially offset by a $117,000 decreasein the cost of general and product liability insurance in the third quarter2004 when compared to the third quarter 2003 due to the implementation of theCompany’s self insurance program in the third quarter of 2003, a $146,000savings in general corporate development expenditures as well as a $427,000decrease payroll related expenditures that were not part of productdevelopment. The consolidation of Prolab’s administrative functions into Natrol’scorporate headquarters at the beginning of the fourth quarter of 2003 was thelargest reason for the payroll savings.

INTEREST EXPENSE.  Interest expense was $156,000 for the threemonths ended September 30, 2004 as compared to $162,000 for the threemonths ended September 30, 2003. The Company pays interest on approximately$7.5 million of long-term mortgage debt.

INCOMETAX PROVISION. For the three months ended September 30, 2004 andSeptember 30, 2003 the Company’s effective tax rate on continuingoperations was approximately 40.6% and 62.7%. Thedifference was due primarily to the fact that some of the Company’s expensescannot be expensed for tax purposes. When earnings are at a low level, as they were in 2003, these permanentadjustments to taxable income have a proportionately greater impact on theCompany’s effective income tax rate

 

DISCONTINUEDOPERATIONS. In December 2003, the Company discontinued its Annasa andTamsol units.  Annasa, a subsidiary ofNatrol, a multi-level marketer of proprietary nutritional products beganoperations in 2002.  Tamsol was alsoformed in 2002, to generate direct-to-consumer sales via radio, television,direct mail and other non-retail venues. The Company has reclassified its financial statements to segregate therevenues, direct costs and expenses (excluding allocated costs), assets andliabilities and cash flows of the discontinued operations.  The net operating results, net assets and netcash flows of these businesses have been reported as “Discontinued Operations”in the accompanying consolidated financial statements. As the operations wereshut down as of the end of calendar 2003, the Company had no revenue orexpenses from discontinued operations in the third quarter of 2004.  During the third quarter of 2003, the Companyhad a net loss of approximately $417,000 from discontinued operations.

 

NINEMONTHS ENDED SEPTEMBER 30, 2004 AND SEPTEMBER 30, 2003

NETSALES. Net sales increased 12.2%, or $6.7 million, to $62.0 million for thenine months ended September 30, 2004 from $55.3 million for the ninemonths ended September 30, 2003. The growth came from the Company’s Natrol brand.  Net sales of the Natrol brand increased 21.4%when comparing the first nine months of 2004 to the first nine months of2003.  The increase was due to manyfactors including broader distribution of certain products, promotional effortsmade by the Company, and strong consumer demand for Natrol products. Net salesof Prolab brand products decreased 2.1% during the same comparison period andnet sales of the Company’s EPI division, which along with manufacturing Natrolproducts, sells raw materials and contract manufacturing services decreased6.7% during the same time frame.  Thedecrease was due to weak sales of garlic powders due to negative industrytrends and strong competition amongst suppliers.  The Company estimates that the weakness inthe sale of garlic powders may continue through the end of 2004 and perhapslonger.

GROSSPROFIT.  Gross profit increased 19.9%, or$4.3 million, to $25.8 million for the nine months ended September 30,2004 from $21.5 million for the nine months ended September 30, 2003.Gross margin increased to 41.7% for the nine months ended September 30,2004 from 39.0% for the nine months ended September 30, 2003.  The increase in gross margin and gross profitwas due, in part, to overall favorable product mix which resulted in a lowercost of products as well as an approximately 9.6% reduction in the amount ofdeductions given to customers that reduce revenue.  These deductions include returns, allowancesfor damages and outdates, slotting fees, rebates, and other promotionalexpenses.  Additionally, during thesecond quarter of 2003, the Company had an unusually large, $1.3 millionwrite-down of inventory which had a significant impact on gross margins for thenine months ended September 30, 2003. Ongoing gross margins can be impacted byproduct mix. Additionally, periodic short-term changes in demand for certainraw materials can result in fluctuating prices which can also have an impact ongross margins.  Currently, prices forwhey, an important raw material included in many Prolab products, have risenrapidly, which will in turn affect the margin on whey products sold under theProlab brand name.

SELLINGAND MARKETING EXPENSES.  Selling andmarketing expenses increased 18.1%, or $2.4 million, to $15.6 million for thenine months ended September 30, 2004 from $13.2 million for the ninemonths ended September 30, 2003. Approximately 61% of the increase was dueto increased spending on coop advertising, and various forms of media includingbrochures, public relations, celebrity endorsements, radio, television andadvertising in publications. Approximately 17% of the increase was due to increased shippingcosts.  These expenditures rose due tothe higher level of sales as well as higher costs of freight caused in part byhigher fuel prices.  Approximately 18% ofthe increase was due to personnel costs. The remainder was due to a general increase in expenditures necessary tosupport the selling and marketing efforts of the Company.

GENERALAND ADMINISTRATIVE EXPENSES.  General andadministrative expenses consist primarily of personnel costs related to generalmanagement functions, finance, accounting and information systems, as well asprofessional fees related to legal, audit and tax matters and depreciation. Generaland administrative expenses decreased 8.8%, or $688,000 to $7.1 million for thenine months ended September 30, 2004 from $7.8 million for the nine monthsended September 30, 2003. During the third quarter of 2004, legalexpenditures were $448,000 higher in the third quarter of 2004 than the thirdquarter of 2003 due to the settlement of litigation with certain districtattorneys in California and legal expenses related to this and othermatters.  However, for the nine monthsended September 30, 2004, legal expenses were $44,000 less than legal expensesrecorded during the nine months ended September 30, 2003.  The cost of general and product liabilityinsurance was approximately $714,000 less in nine months endedSeptember 30, 2004 

10

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thanin nine months ended September 30, 2003 due to the implementation of theCompany’s self insurance program in July of 2003. Payroll and payrollrelated expenditures were also $790,000 less in the nine months ended September20, 2004 than in the nine months ended September 20, 2003.   A majority of the savings in payrollexpenditures was due to the consolidation of Prolab’s administrative functionsinto the Natrol headquarters facility at the beginning of the fourth quarter of2003. The Company also experienced savings of $224,000 in  general corporate development expenditures.Offsetting these savings was an accrual of $625,000 for bonuses to be paidpursuant to the bonus incentive program adopted by the Company in January 2004.During the fourth quarter of 2003, the Company also established a productdevelopment department During the nine months ended September 30, 2004,expenses for this product development department amounted to $552,000. Tax andaudit fees were $114,000 higher in the first nine months of 2004 than in thefirst nine months of 2003.  This increasewas in part due the requirements of the Sarbanes-Oxley law.

 

INTEREST EXPENSE.  Interest expense was $470,000 for the ninemonths ended September 30, 2004 as compared to $486,000 for the ninemonths ended September 30, 2003. The Company pays interest onapproximately $7.5 million of long-term mortgage debt.

INCOMETAX PROVISION. For the nine months ended September 30, 2004 the Company’seffective tax rate was approximately 40.4%. For the nine months ended September 30, 2003 the Company’seffective tax rate for continuing operations was 69.5%. The difference was due primarily to the fact that the some of theCompany’s expenses cannot be expensed for tax purposes.  When earnings are at a low level, as theywere in 2003, these permanent adjustments to taxable income have aproportionately greater impact on the Company’s effective tax rate.

DISCONTINUEDOPERATIONS. In December 2003, the Company discontinued its Annasa andTamsol units.  Annasa, a subsidiary ofNatrol, a multi-level marketer of proprietary nutritional products beganoperations in 2002.  Tamsol was alsoformed in 2002, to generate direct-to-consumer sales via radio, television,direct mail and other non-retail venues. The Company has reclassified its financial statements to segregate therevenues, direct costs and expenses (excluding allocated costs), assets andliabilities and cash flows of the discontinued operations.  The net operating results, net assets and netcash flows of these businesses have been reported as “Discontinued Operations”in the accompanying consolidated financial statements. As the operations wereshut down as of the end of calendar 2003, the Company had no revenue orexpenses from discontinued operations in the second quarter of 2004.  During the nine months endedSeptember 30, 2003, the Company had a net loss of $1,073,000 fromdiscontinued operations.

 

LIQUIDITY AND CAPITAL RESOURCES

Asof September 30, 2004, the Company had working capital of $17.0 million ascompared to $13.3 million in working capital at December 31, 2003. TheCompany’s cash balance at September 30, 2004 was approximately $3.7million.  The increase in working capitalwas primarily due to income earned during the 2004 period and the $2.0 millioncash received from settling litigation with the former owners of ProlabNutrition, Inc. The cash received in the settlement was recorded as a reductionof goodwill.

Netcash used by operating activities was $34,000 for the nine months endedSeptember 30, 2004 versus net cash used of $2,851,000 for the nine monthsended September 30, 2003. Cash used by operating activities during thenine months ended September 30, 2004 consisted primarily of cash used bychanges in operating assets and liabilities of $2,724,000 which wassubstantially offset by $2,690,000 million of cash provided by net income andnon-cash charges.  The increases in cashused by operating assets and liabilities consisted principally of an increasein accounts receivable of $1,291,000, an increase in inventory of $1,636,000and a decrease in accounts payable and accrued expenses of $689,000 offset byan increase in accrued payroll and related liabilities of $949,000. Theincrease in accounts receivable is due to the higher level of sales and thetiming of those sales.  The increase ininventory levels is also due to the higher level of sales.  The increase in accrued payroll is due to thetiming of payroll and accruals for bonus payments to support the Company’sbonus plan, which was filed as an exhibit to the Company’s 10-K for the yearended December 31, 2003.  Cashprovided by net income and non-cash charges consisted principally of $1.6million of net income and depreciation of $975,000.

Netcash provided by investing activities was $1.0 million for the nine monthsended September 30, 2004 versus net cash used of approximately $5.3million during the nine months ended September 30, 2003. The settlement ofthe litigation with the former owners of Prolab Nutrition, Inc., which wasrecorded as a reduction of goodwill, provided $2.0 million of cash which wasoffset by an increase in investment in property and equipment and other assets.During the 2003 period, the Company deposited of $5 million with an insurancecompany in order to establish the Company’s self insurance program.  At the end of the self-insurance program the$5 million in restricted cash will be returned to the Company.  The cash earns interest at an annual rate of1.65%

Netcash provided by financing activities was approximately $81,000 for the ninemonths ended September 30, 2004 as opposed to approximately $56,000provided by financing activities during the nine months endedSeptember 30, 2003. During the nine months ended September 30, 2004,the Company made principal payments of approximately $241,000 on its long-termmortgage debt and received approximately $322,000 from the exercise of stockoptions and the purchase of stock through the Company’s Employee Stock PurchasePlan.

Asof September 30, 2004, the Company had $7.5 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.While the Company has no line of credit in place, the Company has negotiated a$3 million line of credit and a $750,000 term debt facility with a bank lenderwhich it expects to finalize during the fourth quarter of 2004.

 

 

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TheCompany believes that its cash balance together with cash generated fromoperations and the credit facilities that have been negotiated should besufficient to fund its anticipated working capital needs and planned capitalexpenditures for the next twelve months. However, if the Company does notmeet its operating plan it may also need additional borrowings to fund workingcapital needs.

Inorder to meet its long-term liquidity needs, the Company may be required toincur additional indebtedness or issue additional equity and debt securities,subject to market and other conditions. There can be no assurance that suchadditional financing will be available on terms acceptable to the Company or atall. The failure to raise the funds necessary to finance its future cashrequirements or consummate future acquisitions could adversely affect theCompany’s ability to pursue new acquisitions and could negatively affect itsoperations in future periods.

 

## **CRITICALACCOUNTING POLICIES**

 

Management’s beliefs regarding significantaccounting policies have not changed significantly from those discussed in Item7 of the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2003.

 

CONTRACTUAL OBLIGATIONS

 

Contractual obligations have not changedsignificantly from those discussed in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2003.

 

ITEM3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Therehas been no material change during the nine months ended September 30,2004 from the disclosures about market risk provided in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2003.

 

ITEM4. 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) underthe Securities Exchange Act of 1934) as of September 30, 2004.  Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer have concluded that the Company’sdisclosure controls and procedures are, to the best of their knowledge,effective to ensure that information required to be disclosed by the Company inreports that it files or submits under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in Securities andExchange Commission rules and forms. There were no significant changes in theCompany’s internal control over financial reporting that occurred during thefiscal quarter covered by this report that have materially affected or arereasonably likely to materially affect the Company’s internal control overfinancial reporting.

 

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PART II

 

OTHERINFORMATION

 

ITEM1.  LEGAL PROCEEDINGS

None

 

ITEM2.  UNREGISTERD SALES OF EQUITYSECURITIES AND USE OF PROCEEDS

None

 

ITEM3.  DEFAULTS UPON SENIOR SECURITIES

None

 

ITEM4:SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

                None

 

ITEM5.  OTHER INFORMATION

None

 

ITEM6.  EXHIBITS

 

 
| 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  |

 

 

SIGNATURES

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|            | NATROL,  INC. |
|-----------------|---------------|
|            |          |   |
| Date:  11/15/04 | By:           | /s/  Elliott Balbert |
|            |          | Chairman,  President and Chief Executive Officer |
|            |          |   |
| Date:  11/15/04 | By:           | /s/  Dennis R. Jolicoeur |
|            |          | Chief  Financial Officer and Executive  Vice President |

 

 

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