**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

----

**FORM 10-Q**

**(Mark one)**
| **x**                                                                                                                                                                                               | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                |                                                                                           |
| **FOR THE  QUARTERLY PERIOD ENDED JUNE 30, 2006**                                                                                                                                                   |
|                                                                                                                                                                                                |                                                                                           |
| **OR**                                                                                                                                                                                              |
|                                                                                                                                                                                                |                                                                                           |
| **o**                                                                                                                                                                                               | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15  (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                |                                                                                           |
| **FOR THE  TRANSITION PERIOD FROM               TO             ** |
| ** **                                                                                                                                                                                          | ** **                                                                                     |
| **COMMISSION  FILE NO: 0-24567**                                                                                                                                                                    |

**NATROL, INC.**

(Exact name of registrant as specified in its charter)

| **DELAWARE**                                                    |   | **95-3560780**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**21411 PRAIRIE 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 markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12-B2 of the Exchange Act. (check one)
| Large  accelerated filer o |   | Accelerated  filer o |   | or  Non-accelerated filer x |
|----------------------------|--------|----------------------|--------|-----------------------------|

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

As ofAugust 9, 2006, 13,589,148 shares of the registrant’s common stock wereoutstanding.

 

----

**Natrol, Inc.**

**INDEX**
| PART I        | FINANCIAL  INFORMATION                                                                      | 3      |
|---------------|---------------------------------------------------------------------------------------------|--------|
|          |                                                                                        |   |
| Item 1.       | Consolidated Financial Statements                                                           | 3      |
|          |                                                                                        |   |
|          | Consolidated Balance Sheets                                                                 | 3      |
|          |                                                                                        |   |
|          | Consolidated Statements of Operations                                                       | 4      |
|          |                                                                                        |   |
|          | Consolidated Statements of Cash Flows                                                       | 5      |
|          |                                                                                        |   |
|          | Notes to Consolidated Unaudited Financial Statements                                        | 6      |
|          |                                                                                        |   |
| Item 2.       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations | 9      |
|          |                                                                                        |   |
| Item 3.       | Quantitative and Qualitative Disclosures About Market  Risk                                 | 14     |
|          |                                                                                        |   |
| Item 4.       | Controls and Procedures                                                                     | 15     |
|          |                                                                                        |   |
| PART  II.     | OTHER  INFORMATION                                                                          | 15     |
|          |                                                                                        |   |
| Item 1A.      | Risk Factors                                                                                | 15     |
|          |                                                                                        |   |
| Item 4.       | Submission of Matters to a Vote of Security Holders                                         | 16     |
|          |                                                                                        |   |
| Item 6.       | Exhibits                                                                                    | 17     |
|          |                                                                                        |   |
| Signature     |                                                                                        |
|          |                                                                                        |   |
| Exhibit Index |                                                                                        |

2

----

**PART 1 —FINANCIAL INFORMATION**

##### **ITEM1. FINANCIAL STATEMENTS**

**Natrol, Inc. andSubsidiaries**

**Consolidated Balance Sheets**

(In thousands, except share and per share data)
| ** **                                                                                                                                                 | ** ** | **June 30** | ** ** | **December 31** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|----------------------|------------|
| ** **                                                                                                                                                 | ** ** | **2006**         | ** ** | **2005**             | ** ** |
| ** **                                                                                                                                                 | ** ** | **(unaudited)**  | ** ** | ** **           | ** ** |
| **Assets**                                                                                                                                                 | ** ** | ** **       | ** ** | ** **           | ** ** |
| Current assets:                                                                                                                                            |       |             |       |                 |       |
| Cash                                                                                                                                                       |       | $                | 2,262      |                 | $          | 3,097 |   |
| Accounts receivable, net of allowances of $210 and  $247  at June 30, 2006 and December 31, 2005, respectively                                        |       | 7,541            |       | 6,723                |       |
| Inventory                                                                                                                                                  |       | 12,236           |       | 11,797               |       |
| Income taxes receivable                                                                                                                                    |       | 234              |       | 439                  |       |
| Deferred income taxes                                                                                                                                      |       | 2,021            |       | 2,021                |       |
| Prepaid expenses and other current assets                                                                                                                  |       | 491              |       | 726                  |       |
| Total current  assets                                                                                                                                      |       | 24,785           |       | 24,803               |       |
| Property and  equipment:                                                                                                                                   |       |             |       |                 |       |
| Building and improvements                                                                                                                                  |       | 14,936           |       | 14,930               |       |
| Machinery and equipment                                                                                                                                    |       | 5,777            |       | 5,754                |       |
| Furniture and office equipment                                                                                                                             |       | 3,138            |       | 2,900                |       |
|                                                                                                                                                       |       | 23,851           |       | 23,584               |       |
| Accumulated  depreciation and amortization                                                                                                                 |       | (9,376           | )          | (8,684               | )          |
| Property and  equipment, net                                                                                                                               |       | 14,475           |       | 14,900               |       |
|                                                                                                                                                       |       |             |       |                 |       |
| Property held  for sale, net                                                                                                                               |       | —           |       | 761                  |       |
|                                                                                                                                                       |       |             |       |                 |       |
| Restricted cash                                                                                                                                            |       | 5,000            |       | 5,000                |       |
| Deferred income  taxes                                                                                                                                     |       | 4,033            |       | 3,905                |       |
| Goodwill, net of  accumulated amortization and impairment charge of $37,381                                                                                |       | 2,026            |       | 2,026                |       |
| Other assets                                                                                                                                               |       | 53               |       | 67                   |       |
| Total assets                                                                                                                                               |       | $                | 50,372     |                 | $          | 51,462 |   |
| **Liabilities  and stockholders’ equity**                                                                                                             | ** ** | ** **       | ** ** | ** **           | ** ** |
| Current  liabilities:                                                                                                                                      |       |             |       |                 |       |
| Accounts payable                                                                                                                                           |       | $                | 1,750      |                 | $          | 4,647 |   |
| Accrued expenses                                                                                                                                           |       | 4,122            |       | 2,888                |       |
| Accrued payroll and related liabilities                                                                                                                    |       | 1,063            |       | 826                  |       |
| Current portion of long-term debt                                                                                                                          |       | 548              |       | 532                  |       |
| Total current  liabilities                                                                                                                                 |       | 7,483            |       | 8,893                |       |
| Long-term debt,  less current portion                                                                                                                      |       | 6,887            |       | 7,165                |       |
| Commitments and  contingencies                                                                                                                             |       |             |       |                 |       |
| Stockholders’  equity:                                                                                                                                |       |             |       |                 |       |
| Preferred stock, par value of $0.01 per share:                                                                                                             |       |             |       |                 |       |
| Authorized shares—2,000,000; Issued and outstanding  shares—none                                                                                 |       | —           |       | —               |       |
| Common stock, par value of $0.01 per share:                                                                                                                |       |             |       |                 |       |
| Authorized shares—50,000,000 Issued and outstanding  shares—13,575,648  and 13,535,837 at June 30, 2006 and December 31, 2005, respectively |       | 136              |       | 135                  |       |
| Additional paid-in capital                                                                                                                                 |       | 60,537           |       | 60,113               |       |
| Accumulated deficit                                                                                                                                        |       | (24,671          | )          | (24,844              | )          |
| Total  stockholders’ equity                                                                                                                           |       | 36,002           |       | 35,404               |       |
| Total liabilities and  stockholders’ equity                                                                                                           |       | $                | 50,372     |                 | $          | 51,462 |   |

See accompanying notes

3

----

**Natrol, Inc. andSubsidiaries**

**Consolidated Statements of Operations**

(In thousands, except share and per share data)

(unaudited)
| ** **                                                  | ** ** | **Three months ended   June 30,** | ** ** | **Six months ended   June 30,** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                  | ** ** | **2006**                                              | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                        |       |                                                  |       |                                                |       |   |   |   |   |
| Net sales                                                   |       | $                                                     | 16,587     |                                                | $          | 19,604 |   | $ | 33,511 |   | $ | 37,273 |   |
| Cost of goods sold                                          |       | 9,394                                                 |       | 12,076                                              |       | 19,423 |   | 23,480 |   |
| Gross profit                                                |       | 7,193                                                 |       | 7,528                                               |       | 14,088 |   | 13,793 |   |
|                                                        |       |                                                  |       |                                                |       |   |   |   |   |
| Selling and marketing  expenses                             |       | 4,091                                                 |       | 4,860                                               |       | 8,183 |   | 9,045 |   |
| General and  administrative expenses                        |       | 2,765                                                 |       | 2,086                                               |       | 5,290 |   | 5,003 |   |
| Option expenses                                             |       | 67                                                    |       | —                                              |       | 359 |   | — |   |
| Total operating  expenses                                   |       | 6,923                                                 |       | 6,946                                               |       | 13,832 |   | 14,048 |   |
| Operating income (loss)                                     |       | 270                                                   |       | 582                                                 |       | 256 |   | (255 | ) |
|                                                        |       |                                                  |       |                                                |       |   |   |   |   |
| Interest income                                             |       | 60                                                    |       | 48                                                  |       | 116 |   | 90 |   |
| Interest expense                                            |       | (153                                                  | )          | (160                                                | )          | (307 | ) | (320 | ) |
| Gain on sale of  property                                   |       | —                                                |       | —                                              |       | 230 |   | — |   |
| Income (loss) before  taxes                                 |       | 177                                                   |       | 470                                                 |       | 295 |   | (485 | ) |
| Income tax provision  (benefit)                             |       | 77                                                    |       | 179                                                 |       | 122 |   | (184 | ) |
| Net Income (loss)                                           |       | $                                                     | 100        |                                                | $          | 291 |   | $ | 173 |   | $ | (301 | ) |
|                                                        |       |                                                  |       |                                                |       |   |   |   |   |
| Income (loss) per  share:                                   |       |                                                  |       |                                                |       |   |   |   |   |
| Basic                                                       |       | $                                                     | .01        |                                                | $          | .02 |   | $ | .01 |   | $ | (.02 | ) |
| Diluted                                                     |       | $                                                     | .01        |                                                | $          | .02 |   | $ | .01 |   | $ | (.02 | ) |
|                                                        |       |                                                  |       |                                                |       |   |   |   |   |
| Weighted-average shares  outstanding—basic and diluted |       |                                                  |       |                                                |       |   |   |   |   |
|                                                        |       |                                                  |       |                                                |       |   |   |   |   |
| Basic                                                       |       | 13,563,747                                            |       | 13,453,164                                          |       | 13,557,115 |   | 13,418,981 |   |
| Diluted                                                     |       | 13,914,763                                            |       | 14,178,075                                          |       | 13,865,531 |   | 13,418,981 |   |

See accompanying notes

4

----

# **Natrol, Inc.and Subsidiaries**

**Consolidated Statements of Cash Flows**

(In thousands)

(unaudited)
| ** **                                                                        | ** ** | **Six months ended   June 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
|                                                                              |       |                                                |       |   |   |
| **Operating activities**                                                          |       |                                                |       |   |   |
| Net income (loss)                                                                 |       | $                                                   | 173        |   | $ | (301 | ) |
|                                                                              |       |                                                |       |   |   |
| Adjustments to  reconcile income (loss) to net cash used in operating activities: |       |                                                |       |   |   |
| Depreciation and  amortization                                                    |       | 697                                                 |       | 643 |   |
| Provision for  bad debts                                                          |       | (37                                                 | )          | 179 |   |
| Deferred income  taxes                                                            |       | (128                                                | )          | — |   |
| Shares issued  for services                                                       |       | 32                                                  |       | — |   |
| Option expense                                                                    |       | 359                                                 |       | — |   |
| Changes in  operating assets and liabilities:                                     |       |                                                |       |   |   |
| Accounts  receivable                                                              |       | (781                                                | )          | (1,906 | ) |
| Inventory                                                                         |       | (439                                                | )          | (824 | ) |
| Income taxes  receivable/payable                                                  |       | 205                                                 |       | 228 |   |
| Prepaid expenses  and other current assets                                        |       | 234                                                 |       | 115 |   |
| Accounts payable                                                                  |       | (3,102                                              | )          | 235 |   |
| Accrued expenses                                                                  |       | 1,439                                               |       | 608 |   |
| Accrued payroll and  related liabilities                                          |       | 238                                                 |       | (754 | ) |
| Net cash used in  operating activities                                            |       | (1,110                                              | )          | (1,777 | ) |
|                                                                              |       |                                                |       |   |   |
| **Investing activities**                                                          |       |                                                |       |   |   |
| Purchases of property  and equipment                                              |       | (267                                                | )          | (380 | ) |
| Sale of property                                                                  |       | 759                                                 |       | — |   |
| Other assets                                                                      |       | 12                                                  |       | 25 |   |
| Net cash provided by  (used in) investing activities                              |       | 504                                                 |       | (355 | ) |
|                                                                              |       |                                                |       |   |   |
| **Financing activities**                                                          |       |                                                |       |   |   |
| Repayments on long-term  debt                                                     |       | (263                                                | )          | (236 | ) |
| Proceeds from issuance  of common stock                                           |       | 34                                                  |       | 200 |   |
| Net cash used in  financing activities                                            |       | (229                                                | )          | (36 | ) |
|                                                                              |       |                                                |       |   |   |
| Net decrease in cash  and cash equivalents                                        |       | (835                                                | )          | (2,168 | ) |
| Cash and cash  equivalents, beginning of period                                   |       | 3,097                                               |       | 6,022 |   |
| Cash and cash equivalents, end of period                                          |       | $                                                   | 2,262      |   | $ | 3,854 |   |

See accompanying notes

5

----

**NATROL, INC.**

**NOTES TO CONSOLIDATED UNAUDITEDFINANCIAL STATEMENTS**

(In thousands, exceptshare and per share data)

1.               BASIS OFPRESENTATION

Theaccompanying consolidated financial statements have been prepared by Natrol,Inc. (the “Company”), pursuant to the rules and regulations of the Securitiesand Exchange Commission (SEC).  This quarterly report on Form 10-Q shouldbe read in conjunction with the Company’s annual report on Form 10-K for theyear ended December 31, 2005.  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 andregulations.  The information reflects all normal and recurringadjustments which, in the opinion of the Company’s management, are necessaryfor a fair presentation of the financial position of the Company and itsresults of operations for the interim periods set forth herein.  Theresults for the three months and six months ended June 30, 2006 are notnecessarily indicative of the results to be expected for the full year or anyother period.

2.               STOCK BASEDCOMPENSATION

Throughthe end of 2005, the Company measured compensation for stock-based incentiveprograms utilizing the intrinsic value method prescribed by AccountingPrinciples Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees,*and related interpretations. Underthis method, the Company did not record compensation expense when stock optionswere granted to eligible participants as long as the exercise price was notless than the fair market value of the stock when the option was granted. Inaccordance with Statement of Financial Accounting Standards (SFAS) No. 123, *Accounting for Stock-Based Compensation*,(SFAS 123) and SFAS No. 148, *Accounting forStock-Based Compensation — Transition and Disclosure*, the Companydisclosed the pro forma net income per share as if the fair value-based methodhad been applied in measuring compensation expense for stock-based incentiveawards. No stock-based compensation cost was recognized in the ConsolidatedStatement of Operations for the three months and six months ended June 30, 2005for options granted under the Company’s stock option plan, as all unvestedoptions granted had an exercise price equal to or greater than the fair marketvalue of the underlying common stock on the date of grant.

InDecember 2004, the Financial Accounting Standards Board (FASB) issued SFAS123R, *Share Based Payment: An Amendment ofFASB Statements No. 123 and 95* (SFAS 123R). This statement requiresthat the cost resulting from all share-based payment transactions be recognizedin the Company’s consolidated financial statements. In addition, in March 2005the SEC released SEC Staff Accounting Bulletin No. 107, *Share-Based Payment* (SAB 107). SAB 107provides the SEC’s staff’s position regarding the application of SFAS 123R andcertain SEC rules and regulations, and also provides the staff’s viewsregarding the valuation of share-based payment arrangements for publiccompanies. Generally, the approach in SFAS 123R is similar to the approachdescribed in SFAS 123. However, SFAS 123R requires all share-based payments toemployees, including grants of employee stock options, to be recognized in thestatement of operations based on their fair values. Pro forma disclosure offair value recognition, as prescribed under SFAS 123, is no longer analternative.

In 2006, the Company adopted the fair value recognition provisions ofSFAS 123R utilizing the modified-prospective-transition method, as prescribedby SFAS 123R. Under the transition method, compensation cost recognized duringthe three and six months ended June 30, 2006 includes: (a) compensation costfor all share-based payments granted prior to, but not yet vested as of January1, 2006, based on the grant date fair value estimated in accordance with SFAS123, and (b) compensation expense for all share-based payments grantedsubsequent to January 1, 2006, based on the grant-date fair value estimated inaccordance with the provisions of SFAS 123R. Under themodified-prospective-transition method, results for the prior periods have notbeen restated.

Duringthe three months and six months ended June 30, 2006, the Company grantedoptions to purchase 497,499 and 6,786,999 shares of common stock. Of the6,786,999 shares, 6,029,500 options were granted  to Wayne M. Bos upon his appointment as theCompany’s CEO and President.  This optionaward was approved by the stockholders of the Company at its 2006 annualmeeting of stockholders.  The remaining757,499 options were granted to other employees and directors. The optionsgranted to Mr. Bos have certain service and performance conditions which havebeen discussed in the Company’s proxy statement for the 2006 annual meeting ofstockholders. These options were fully vested upon grant, and we recognized arelated expense of $0.3 million during the first quarter of 2006.  During the three and six months ended June30, 2006, we recognized expenses of $0.1 million and $0.4 million as a resultof the adoption of SFAS 123R.

The effect of the changein applying the original provisions of SFAS 123 resulted in lowering operatingincome, income before taxes, net income and basic and diluted earnings pershare as follows:

6

----

 
|                                           | ** ** | **Three months ended** | ** ** | **Six months ended**        | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|---------------------------------------|------------|
| ** **                                | ** ** | **June 30, 2006**      | ** ** | **June 30,2006**                 | ** ** |
| ** **                                | ** ** | **As per SFAS  123R**  | ** ** | **Change to  three months** | ** ** | **As per SFAS  123R** | ** ** | **Change to six  months** | ** ** |
| Operating income                          |       | $                                | 270        |                                  | $          | (67 | ) | $ | 256 |   | $ | (359 | ) |
| Income before  provision for income taxes |       | 177                              |       | $                                     | (67        | ) | 295 |   | $ | (359 | ) |
| Net income                                |       | 100                              |       | $                                     | (42        | ) | 173 |   | $ | (231 | ) |
| Net income per  share:                    |       |                             |       |                                  |       |   |   |   |   |
| Basic                                     |       | $                                | 0.01       |                                  | —     |   | $ | 0.01 |   | $ | (0.02 | ) |
| Diluted                                   |       | $                                | 0.01       |                                  | —     |   | $ | 0.01 |   | $ | (0.02 | ) |

The Company used a Monte Carlomethod to simulate stock price paths over the term of the 6,029,500 optionsawarded to Mr. Bos. All other options were valued using a Black-Scholes model.The Monte Carlo method, which is one acceptable valuation method per SFAS 123R,was used due to many factors which make utilizing a Black-Scholes modelinappropriate for a block of options of this magnitude. These factors includebut are not limited to the size of the grant in relation to the total sharesoutstanding, the trading volume of the Company’s stock and the holder’s abilityto resell the shares, and the control factor which the size of the grantimplies. The Company used the services of a well-credentialed group ofvaluation experts to perform the valuation of Mr. Bos’ options. This group developedmultiple scenarios including continuing operation and sale scenarios, to assessthe potential to create shareholder value over the term of the options. Theresulting Monte Carlo analysis gave rise to a range of fair values for whichthe mean amount was utilized in valuing the options for Mr. Bos.

All other stock options were valued using a Black-Scholes model. UnderSFAS 123R, the Company will continue to utilize the Black-Scholes model toestimate the fair market value related to employee stock options after January1, 2006, unless such method is clearly inappropriate for a significant block ofstock options, such as were granted to Mr. Bos. The Company’s assessment of theestimated compensation charges for these other stock options is affected by itsstock price as well as assumptions regarding a number of complex and subjectivevariables and the related tax impact. These variables include, but are notlimited to the Company’s stock price volatility and expected employee stockoption behavior.

The followingsummarizes the Company’s stock option activity, not including the Wayne Bosstock options, for the six months ended June 30, 2006:

|                                 | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|---------------------------------|------------|------------|------------|--------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| Number of shares  under option: |       |       |       |                                       |       |                                                |       |                            |       |
| Outstanding at  January 1, 2006 |       | 2,310,820  |       | $                                          | 3.13       |                                                |       |                            |       |   |
| Granted                         |       | 757,499    |       | 2.28                                       |       |                                                |       |                            |       |
| Exercised                       |       | 15,563     |       | 1.43                                       |       |                                                |       |                            |       |
| Canceled or  expired            |       | 42,500     |       | 5.04                                       |       |                                                |       |                            |       |
| Outstanding at  June 30, 2006   |       | 3,010,256  |       | $                                          | 2.90       |                                                | 5.6        |                            | $          | 0.0 |   |
| Exercisable at June 30,  2006   |       | 2,222,921  |       | $                                          | 3.10       |                                                | 4.3        |                            | $          | 0.0 |   |

The following summarizesthe Company’s stock option activity, including the Wayne Bos stock options, for the six months ended June 30,2006:

|                                 | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|---------------------------------|------------|------------|------------|--------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| Number of option  shares:       |       |       |       |                                       |       |                                                |       |                            |       |
| Outstanding at  January 1, 2006 |       | 2,310,820  |       | $                                          | 3.13       |                                                |       |                            |       |   |
| Granted                         |       | 6,786,999  |       | 2.28                                       |       |                                                |       |                            |       |
| Exercised                       |       | 15,563     |       | 1.43                                       |       |                                                |       |                            |       |
| Canceled or  expired            |       | 42,500     |       | 5.04                                       |       |                                                |       |                            |       |
| Outstanding at  June 30, 2006   |       | 9,039,756  |       | $                                          | 2.49       |                                                | 5.0        |                            | $          | 0.0 |   |
| Exercisable at June 30,  2006   |       | 8,252,421  |       | $                                          | 2.50       |                                                | 4.6        |                            | $          | 0.0 |   |

 

7

----

Thefollowing summarizes the fair value of the Company’s stock options for the sixmonths ended June 30, 2006, not including the Wayne Bos stock options.
|                               | ** ** | **Shares** | ** ** | **Weighted  Average Fair  Value** | ** ** |
|-------------------------------|------------|------------|------------|----------------------------------------|------------|
| Nonvested at  January 1, 2006 |       | 99,501     |       | $                                      | 1.48       |   |
| Granted                       |       | 757,499    |       | $                                      | 1.39       |   |
| Vested                        |       | 69,165     |       | $                                      | 1.24       |   |
| Nonvested at June 30,  2006   |       | 787,335    |       | $                                      | 1.14       |   |

The following summarizesthe fair value of the Company’s stock options for the six months ended June 30,2006, including the Wayne Bos stock options.
|                               | ** ** | **Shares** | ** ** | **Weighted  Average Fair  Value** | ** ** |
|-------------------------------|------------|------------|------------|----------------------------------------|------------|
| Nonvested at  January 1, 2006 |       | 99,501     |       | $                                      | 1.48       |   |
| Granted                       |       | 6,786,999  |       | $                                      | .16        |   |
| Vested                        |       | 6,098,665  |       | $                                      | .06        |   |
| Nonvested at June 30,  2006   |       | 787,335    |       | $                                      | 1.14       |   |

As of June 30, 2006,there was $0.9 million of total unrecognized compensation cost related tononvested share-based compensation arrangements granted under existing stockoption plans. This cost is expected to be recognized over a weighted-averageperiod of 2.72 years. The total measurement fair value of shares vested duringthe six-months ended June 30, 2006 was $0.4 million.

TheBlack-Scholes option pricing model is used by the Company to determine theweighted average fair value of options except for the Wayne Bos options.  The fair value of options at date of grantand the assumptions utilized to determine such values are indicated in thefollowing table:
|                                                                                                         | ** ** | **Six months ended June 30** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
|                                                                                                    |       |                                             |       |   |   |
| Weighted average  fair value at date of grant for options granted during the period using  Black-Sholes |       | $                                                | 1.39       |   | $ | 1.71 |   |
|                                                                                                    |       |                                             |       |   |   |
| Risk-free interest  rates                                                                               |       | 4.51                                             | %          | 3.72 | % |
| Expected stock  price volatility                                                                        |       | 60.82                                            |       | 63.62 |   |
| Expected dividend yield                                                                                 |       | 0.0                                              | %          | 0.0 | % |
|                                                                                                         |            |                                                  |            |  |  |  |  |

Theseassumptions resulted in a weighted-average fair value of $1.71 for each stockoption valued under the Black- Scholes method and granted in the six monthsended June 30, 2005.

The following table illustrates the effect on netincome and earnings per share if the Company had applied the fair valuerecognition provisions of SFAS 123R for the three and six month periods endedJune 30, 2005.
|                                                                                                                                                                              | ** ** | **Three months**                  | ** ** | **Six months** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------|------------|
| ** **                                                                                                                                                                   | ** ** | **ended June 30, 2005** | ** ** |
| Net income  (loss)                                                                                                                                                           |       | $                                      | 291        |                | $          | (301 | ) |
|                                                                                                                                                                         |       |                                   |       |                |       |
| Total  stock-based employee compensation expense determined under the fair  value-based method for all awards, net of related tax benefits (“Stock  Compensation”) |       | 25                                     |       | 35                  |       |
| Net Income  (loss) — pro forma                                                                                                                                          |       | $                                      | 266        |                | $          | (336 | ) |
|                                                                                                                                                                         |       |                                   |       |                |       |
| Net income (loss) per share:                                                                                                                                                 |       |                                   |       |                |       |
| Basic—as reported                                                                                                                                                       |       | $                                      | .02        |                | $          | (.02 | ) |
| Diluted—as reported                                                                                                                                                     |       | $                                      | .02        |                | $          | (.02 | ) |
| Basic—pro forma                                                                                                                                                         |       | $                                      | .02        |                | $          | (.03 | ) |
| Diluted—pro  forma                                                                                                                                                      |       | $                                      | .02        |                | $          | (.03 | ) |

8

----

3. INVENTORY

Inventoriesconsist of the following:
| ** **                           | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                 |       |                    |       |                        |       |
| Raw material and  packaging supplies |       | $                       | 5,890      |                        | $          | 7,547 |   |
| Finished goods                       |       | 6,346                   |       | 4,250                       |       |
| Total inventory                      |       | $                       | 12,236     |                        | $          | 11,797 |   |

4. SHIPPING AND HANDLINGCOSTS

The Company records all amounts charged to customers for shipping andhandling as revenue. All outbound shipping and fulfillment costs are classifiedas selling and marketing expenses and totaled approximately $1.6 million in  both of the six month periods ended June 30,2006 and 2005.

5.EARNINGS PER SHARE

TheCompany calculates income (loss) per share in accordance with SFASNo. 128, *Earnings per Share*.Basic earnings per share have been computed by dividing net income (loss) bythe weighted average number of common shares outstanding during the period.Diluted earnings per share have been computed by dividing net income (loss) bythe weighted average number of common shares and dilutive common stockequivalents (stock options), when dilutive.

As ofJune 30, 2006 and June 30, 2005, options to purchase 9,039,756  and 2,355,679 shares of common stock,respectively, were, outstanding. For the three months ended June 30, 2006,8,688,740  options were considered to beanti-dilutive. For the six month period ended June 30, 2006, 8,733,840 optionswere considered anti-dilutive. For the three months ended June 30, 2005,1,630,768 options were considered anti-dilutive.  All options outstanding at June 30, 2005, were considered anti-dilutive during thesix months ended June 30, 2005 due to the Company’s loss during the period.

**ITEM 2. MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**Forward Looking Statements andCertain Risks**

The statements contained in this report that are not purely historicalare “forward-looking statements” within the meaning of Section 21E of theSecurities Exchange Act. These statements are based on our expectations, hopes,beliefs, commitments, intentions, and strategies regarding the future. They maybe identified by the use of words or phrases, such as “believe,” “expect,” “anticipate,”“should,” “plan,” “estimate,” and “potential,” among others. Forward-lookingstatements include, but are not limited to, statements contained in this Item 2regarding our financial performance, revenue and expense levels in the future,and the sufficiency of our existing assets to fund future operations andcapital spending needs. Actual results could differ materially from theanticipated results or other expectations expressed in these forward-lookingstatements as a result of the risks, uncertainties and contingencies discussedbelow and in our annual report on Form 10-K for the year ended December 31,2005. The fact that some of the risks, uncertainties and contingencies may bethe same or similar to past reports we have filed with the SEC means only thatthe risks are present in multiple periods. We believe that many of the risks,uncertainties and contingencies detailed here are part of doing business in theindustry in which we operate and will likely be present in all periodsreported. The fact that certain risks, uncertainties and contingencies areendemic to the industry does not lessen their significance. The forward-lookingstatements contained in this report are made as of the date of this report, andwe assume no obligation to update them or to update the reasons why actualresults could differ from those projected in these forward-looking statements.

Ourability to predict results or the affect of certain events on our futureoperating results is inherently uncertain. Forward-looking statements shouldnot be unduly relied on since they involve known and unknown risks,uncertainties and other

9

----

factors,some of which are beyond our control. Therefore, we wish to caution you tocarefully consider the following factors discussed in our other SEC reports.The factors discussed herein may not be exhaustive. Therefore, the factorscontained herein should be read together with our other reports and documentswhich are filed by us with the SEC from time to time, which may supplement,modify, supersede or update the factors listed in this report.

Factors that couldcause or contribute to our actual results differing materially from thosediscussed herein include, but are not limited to:

·                  industry trends, including a generaldownturn or slowing of the dietary supplement industry;

·                  increased competition from currentcompetitors and new market entrants, including from private label house brandssupported by retailers;

·                  our ability to develop and executeour business plans;

·                  adverse publicity regarding thedietary supplement industry or our brands or products;

·                  exposure to product liability claims,as well as a limited amount of insurance coverage including a lack ofearthquake insurance;

·                  the effectiveness of our productdevelopment program and our need to develop new products that receive a highdegree of consumer acceptance;

·                  the effectiveness of ourmanufacturing, quality control and inventory control measures;

·                  our ability to gain or expand ormaintain distribution and new or existing channels of trade;

·                  an increase in the cost of obtainingand maintaining shelf space with major national retailers;

·                  adverse changes in governmentregulation or changes in local, state or national laws;

·                  our dependence on certain largecustomers;

·                  our ability to retain and attracttalented management and key employees;

·                  our ability to manage our growth,execute our business plan and manage changing market conditions;

·                  our ability to consummate andintegrate future acquisitions;

·                  the absence of conclusive clinicalstudies for many of our products;

·                  our sales and earnings volatility;

·                  our reliance on independent brokersto sell our products;

·                  our ability to protect ourintellectual property;

·                  continued market acceptance of oursupplements, Laci Le BeauÒ herbal teas,ProlabÒ sports nutrition products and Essentially PureIngredient®’s raw material products; and

·                  legalactions brought by federal, state and local governmental authorities andprivate parties.

**OVERVIEW**

We manufacture and market branded, high-qualitydietary supplements, herbal teas, and sports nutrition products under threelabels: the Natrol® brand, the Laci Le Beau® brand of herbal teas, and theProlab® sports nutrition brand. To a limited degree, we also market a fewnutraceutical ingredients to other manufacturers of supplements or fortifiedfoods through our Essentially Pure Ingredients® (EPI) raw material supplydivision, which also sells contract-manufacturing services to companies withinthe nutraceutical industry.

Our core Natrol brand focuses on supplements that arein high demand as well as specialty niche and proprietary formulations thathave potentially strong margins. We position Natrol as a premium brand ofsupplements rather than as a value brand.

The majority of the dietary supplements we sell aresold under the Natrol brand. These supplements include vitamins, minerals,hormonal supplements, herbal products and specialty combination formulas thatcontribute to an individual’s physical and mental well being. We sell ourproducts through multiple distribution channels throughout the United States.These channels include domestic health food stores and mass-market drug, clubs,retail and grocery store chains. We also sell our products through independentcatalogs, Internet shopping sites, and within approximately 40 foreigncountries through international distributors. Our Natrol brand strategyemphasizes building strong recognition of the Natrol brand across multipledistribution channels through a marketing strategy that includes print,television, radio and coop advertising and public relations campaigns that aredesigned to build consumer awareness and increase the purchase of our productsby consumers.

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

10

----

multiple distribution channels.

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

We also sell nutraceutical grade ingredients such asgarlic and arabinogalactan to other manufacturers through our EPI division. TheEPI division also markets Natrol’s manufacturing capabilities to othernutraceutical businesses that need contract manufacturing support. EPI sharesall of Natrol’s resources including Natrol’s headquarters facility, itsmanufacturing and research and development personnel and expertise, itsfinancial resources, as well as accounting and management resources.

Natrol’s consumer products fall into the generaldefinition of vitamin, minerals, herbs and dietary supplements. Each year, westrive to broaden our product offerings so as to increase revenue and grossprofits while lessening dependence upon any one product. We divide ourbusiness, other than the EPI business, into approximately 50 productcategories. The products in these categories are packaged into approximately500 stock keeping units (SKUs).

Key issues for management include:

·                  productdevelopment and acquisitions;

·                  expanding thedistribution of our products to new markets including international markets;

·                  productintroductions;

·                  the marketing ofcurrent and new products;

·                  inventorymanagement; and

·                  controllingthe cost of doing business in our various channels of trade.

The nutritional supplement business is dependent uponaccess to new products and new distribution channels. New products are importantfor growth and to replace volume lost by products reaching the end of theirproduct life cycles. For these reasons, we continually research potential newproducts. Developing a single new product can be a multi-year effort dependingupon the complexity of the product and the amount of testing that must becompleted to validate the product concept. We also are continuously looking fornew channels in which to distribute our products both in the United States andin foreign markets.

Productintroductions do not come without risk. Product launches can requiresubstantial marketing support. Oftentimes retailers demand slotting fees orother up-front expenditures. If a product launch is not as successful asanticipated, additional promotional expenditures may be needed to sustain salesand reduce possible returns. Most vendors retain certain rights as they relateto product returns. A broad product launch, one in which a new product isintroduced into thousands of retail outlets, can cause a strain on corporateresources since inventories must be produced and delivered. The resulting salesincrease also leads to an increase in accounts receivable with customers.

Another avenue for new products is to acquire existingbrands or products. We purchased the Laci LeBeau brand of herbal teas and theProlab brand of sports nutrition products, which now account for approximately25% of our business. We may acquire other products or brands in the future.

Nutritional supplements must maintain potency levelsduring their selling life. As a result, products are stamped with an expirationdate and retailers will not accept product with limited shelf life into theirwarehouses. Shelf life issues require a high degree of supply chain managementof raw materials and finished goods to ensure that shelf life is maximized andthat the out-of-date inventory is minimized.

Thecompetition for shelf space at retailers is intense. Our sales people haveongoing discussions with our retail customers with regards to the allocation ofshelf space and the level of promotional support for products. Retailers lookto their vendors for promotional support for the products on their shelves inorder to maximize sales. Vendors such as us look to retailers for advantageousplacement of their products and promotion of their products within stores andwithin a retailer’s promotional media such as newspaper advertisements placedby retailers. The cost of promotions and support to the retailer on the part ofvendors such as Natrol can be substantial and management must continuallyreview promotional efforts with retailers to ensure that sales are profitable.

11

----

**RESULTS OF OPERATIONS**

**Three months ended June 30, 2006compared to June 30, 2005**

NET SALES. We recognize revenue from sales only afterproduct is shipped. We have no consignment sales. Net sales represent productshipped less actual and estimated future returns, spoilage allowances,allowances for product deemed to be unsaleable by customers, goods shipped tocustomers for promotional or other purposes, rebates, slotting fees and otherpromotional expenditures. Estimates and allowances are based upon known claimsand an estimate of additional returns when the amount of future returns fromcustomers can be reasonably estimated.

Netsales decreased 15.4%, or $3.0 million, to $16.6 million for the three monthsended June 30, 2006 from $19.6 million for the three months ended June 30,2005.

In thesecond quarter of 2005, we shipped approximately $2.0 million of new Natrolbrand products.  Shipments of Natrolproducts in the second quarter of 2006 did not include significant productintroductions. As a result, net revenue for the Natrol brand (which includesLaci Le Beau herbal tea sales) were $1.3 million less in the second quarter of2006 than the second quarter of 2005.

Netsales of our Prolab products were approximately $1.3 million less in the secondquarter of 2006 compared to the second quarter of 2005.  Approximately $950,000 of this amount was dueto decreased sales to international distributors.  We are currently establishing a subsidiary inthe United Kingdom in order to enhance our sales position in Europe.  In late 2005, we decided to limit businesswith our Canadian distributor.  Decreasedsales in Canada represented approximately half of the decrease in Prolab’sinternational business.

Approximately$0.5 million of the decline in net sales was due to a reduction in our EPIdivision’s contract manufacturing business. During the third quarter of 2005, we decided to discontinue certainunprofitable contract manufacturing accounts. EPI’s contract manufacturing revenue has fallen as a result of thisdecision.

Grossshipments, which reflect sales prior to deductions for promotional activities,returns, and payment discounts, fell less than net revenue.  Gross shipments were $2.3 million less in thesecond quarter of 2006 than the second quarter of 2005.  The reason for the difference between thedecline in gross and net sales was an increase in estimated returns ofapproximately $0.5 million in the quarter as well as an increase in promotionalspending that is recorded as a reduction of revenue of approximately $0.2million.

GROSSPROFIT. Gross profit decreased 4.4%, or $0.3 million, to $7.2 million for thethree months ended June 30, 2006 from $7.5 million for the three months endedJune 30, 2005. The decrease resulted from lower sales volume during thequarter.  Gross margin increased to 43.4%for the three months ended June 30, 2006 from 38.4% for the three months endedJune 30, 2005.  We increased gross marginduring 2006 by reducing materials cost and improving efficiency within ourmanufacturing, planning and procurement areas.

SELLINGAND MARKETING EXPENSES. Selling and marketing expenses consist primarily ofadvertising and promotional expenses, cost of distribution, and related payrollexpenses and commissions. Selling and marketing expenses decreased 15.8%, or$0.8 million, to $4.1 million for the three months ended June 30, 2006 from$4.9 million for the three months ended June 30, 2005. The higher expendituresin 2005 were directly related to the introduction of new products during thesecond quarter of 2005.

GENERALAND ADMINISTRATIVE EXPENSES. General and administrative expenses consistprimarily of personnel costs related to general management functions, finance,accounting and information systems, as well as professional fees related tolegal, audit and tax matters and depreciation. General and administrativeexpenses increased 32.6%, or $0.7 million to $2.8 million for the three monthsended June 30, 2006 from $2.1million for the three months ended June 30, 2005.Payroll during the second quarter of 2006 was approximately $0.4 million morethan in the second quarter of 2005 due to increased staffing at the executivelevel. During the second quarter of 2005, the Company also benefited from a$0.2 million legal settlement.  Thisreceipt was recorded as an offset to legal expenses and lowered general &administrative expenses in 2005 relative to 2006. The remainder of the increasewas primarily due to additional consulting expenses related to theestablishment of a European subsidiary in the United Kingdom as well as a $0.1million stock option expense due to the adoption of FASB 123R.

INTEREST EXPENSE. We recorded interest expense of $153,000 for thethree months ended June 30, 2006 as compared to interest expense of $160,000for the three months ended June 30, 2005.

INCOME TAX EXPENSE. Our effective tax rate was 43.7% for the threemonths ended June 30, 2006 and 38.0% for the

12

----

three months ended June 30, 2005. We do not consider this difference tobe material due to the small amount of income earned.  In periods when income is low, thedifferences between taxable income and reported income can, in percentageterms, become greater causing the period’s reported tax rate to increase.

## **Sixmonths ended June 30, 2006 compared to June 30, 2005**

NET SALES. Netsales decreased 10.1%, or $3.8 million, to $33.5 million for the six monthsended June 30, 2006 from $37.3 million for the six months endedJune 30, 2005.

Netsales of the Natrol brand (which includes Laci Le Beau tea sales) were $1.2million less in the first half of 2006 than the first half of 2005.

In thefirst half of 2005, we shipped approximately $2.4 of new Natrol brandproducts.  Shipments of Natrol productsduring the first half of 2006 did not include significant productintroductions.  Even so, gross shipmentsof the Natrol brand during the first half of 2006 were approximately equal togross shipments in 2005.  However,estimated returns during the first half of 2006 were approximately $1.3 millionhigher than estimated returns in the first half of 2005.  Estimated returns reduce gross revenue whencalculating net sales.

Netsales of our Prolab products were approximately $1.6 million less in the firsthalf of 2006 than in the first half of 2005. Approximately $1.0 million of thisamount was due to decreased sales to international distributors.  We are currently establishing a subsidiary inthe United Kingdom in order to enhance our sales position in Europe.  Decreased sales in Canada was responsible forapproximately one-quarter of the decline in Prolab’s international business.The remainder of the decline was due to decreased domestic sales of Prolabproducts during the first six months of 2006.

Approximately$1.0 million of the decline in net sales was due to a reduction in our EPIdivision’s contract manufacturing business. During the third quarter of 2005, we made the decision to discontinuecertain unprofitable contract manufacturing accounts.  EPI’s contract manufacturing revenue hasdecreased as a result of this decision.

GROSS PROFIT.  Gross profit increased 2.1% or $0.3 million,to $14.1 million for the six months ended June 30, 2006 from $13.8 millionfor the six months ended June 30, 2005 in spite of the decrease in salesdue to the improvement in gross margin. Gross margin increased to 42.0% for thesix months ended June 30, 2006 from 37.0% for the six months endedJune 30, 2005.  During 2006, we havebeen focused on reducing material cost and improving efficiency within ourmanufacturing, planning and procurement areas.

SELLINGAND MARKETING EXPENSES.  Selling andmarketing expenses decreased 9.5%, or $0.8 million, to approximately $8.2million for the six months ended June 30, 2006 from $9.0 million for thesix months ended June 30, 2006. The higher expenditures in 2005 weredirectly related to the introduction of new products during the second quarterof 2005.

GENERAL ANDADMINISTRATIVE EXPENSES.  General andadministrative expenses increased 12.9%, or $0.6 million to $5.6 million forthe six months ended June 30, 2006 from $5.0 million for the six monthsended June 30, 2005.  Approximately$0.4 million of the increase was due to the recording of option expenses as weadopted FASB 123R in January 2006.  Theremainder of the increase was primarily due to additional payroll expendituresfor executives.

INTEREST EXPENSE.  We recordedinterest expense of $307,000 for the six months ended June 30, 2006 as comparedto interest expense of $320,000 for the three months ended June 30, 2005.

INCOME TAXEXPENSE. Our effective tax rate was 41.4% for the six months ended June 30,2006 and 38.0% for the six months ended June 30, 2005. We do not consider thisdifference to be material due to the small amount of income earned.  In periods when income is low, thedifferences between taxable income and reported income can, in percentageterms, become greater causing the period’s reported tax rate to vary.

SALE OF BUILDING. During the first six months of 2006, we  sold a building we owned in Bloomfield,Connecticut that was formerly used as a shipping facility for our Prolabbrand.  The approximate net book value ofthe property, plant and plant improvements that were sold was $759,000 and thegain, net of brokerage, legal and other related expenses was approximately$230,000.

**LIQUIDITY AND CAPITAL RESOURCES**

As ofJune 30, 2006, we had working capital of $17.3 million as compared to $15.9million in working capital at

13

----

December 31,2005.  Our cash balance at June 30, 2006was approximately $2.2 million.

## **OperatingActivities**

Netcash used by operating activities was $1.1 million for the six months endedJune 30, 2006 versus net cash used of approximately $1.8 million for the sixmonths ended June 30, 2005. Cash used by operating activities during the sixmonths ended June 30, 2006 consisted primarily of cash provided by non-cashcharges of $0.9 million and cash used because of changes in operating assetsand liabilities of $2.2 million offset by the Company’s profit of $0.2 million.

Duringthe six months ended June 30, 2006 we implemented SFAS 123R and expensed stockoptions awarded to employees. This expense amounted to $0.4 million, but was anon-cash charge.  Depreciation andamortization provided $0.7 million of cash. These non-cash sources of cash wereoffset by an increase in deferred tax assets of $0.1 million and a decrease inallowances for bad debts.  Cash used byoperating assets and liabilities consisted primarily of an increase in accountsreceivable of $0.8 million, an increase in inventory of $0.4 million, and adecrease in accounts payable of $3.1 million offset by an increase in accruedexpenses of $1.4 million, an increase in accrued payroll of $0.2 million and anincrease in prepaid expenses and income taxes receivable of $0.4 million. Theincrease in accounts receivable was due to the level and timing of sales.  Accounts payables were reduced consistentwith normal terms from our vendors.

## **InvestingActivities**

Netcash provided by investing activities was $0.5 million for the six months endedJune 30, 2006 compared to net cash used of $0.3 million during the six monthsended June 30, 2005.  During the half of2006, we sold our warehouse in Bloomfield, Connecticut.  The net book value of the property sold wasapproximately $0.8 million.  Otherinvestment activity consisted primarily of the acquisition of $0.3 million ofequipment.

## **FinancingActivities**

Netcash used by financing activities was $0.2 million for the six months endedJune 30, 2006 as opposed to cash used of $36,000 during the six months endedJune 30, 2005.  During the six monthsended June 30, 2006, we repaid $0.3 million of long-term debt.

As ofJune 30, 2006, we had $7.4 million of outstanding debt.

Wecurrently do not have a line of credit established.  We are, however, attempting to secure a lineof credit.  Although we believe that aline of credit is obtainable, there is no guarantee that financial institutionswill be willing to provide capital to us. Also, in providing us with additional funds, potential lenders may seekto impose covenants restricting us from certain activities and if we believe itis necessary to borrow funds with these restrictions in place, we may find thatour ability to compete effectively in our market sector is hindered.

Inorder to meet our long-term liquidity needs, we may be required to incuradditional indebtedness or issue additional equity and debt securities, subjectto market and other conditions. There can be no assurance that such additionalfinancing will be available on terms acceptable to us or at all. The failure toraise the funds necessary to finance its future cash requirements or consummatefuture acquisitions could adversely affect our ability to pursue newacquisitions and could negatively affect our operations in future periods.

Webelieve that our cash balance together with cash generated from operations andthe potential to borrow duns and raise capital should be sufficient to fund ouranticipated working capital needs and planned capital expenditures for the next12 months.  However, if we do not meetour operating plan, we may be required to obtain additional borrowings to fundworking capital needs.

##### **CRITICALACCOUNTING POLICIES**

Management’s beliefs regarding significant accounting policies have notchanged significantly from those discussed in Item 7 of our annual report onForm 10-K for the year ended December 31, 2005.

**ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

Our exposure tomarket risks is limited to interest rate risks. The risks related to foreigncurrency exchange rates are immaterial and we do not use derivative financialinstruments.

We are subjectto interest rate market risk associated with our bank debt. Even so, we do notbelieve the risk associated with such borrowing is significant. Additionally,we do not believe that the risk is significant for our long-term debt due tothe low

14

----

fixed rates andrelative insignificance of the fixed long-term debt to our balance sheet. Ourlong-term debt is comprised of two fixed rate notes with a total principalbalance of approximately $6.9 million collateralized by our headquartersbuilding and our shipping facility and one variable rate note with a principalbalance of approximately $0.5 million collateralized by our general assets. Theinterest rate on the fixed rate notes associated with our real estate average8.0%.  The interest rate in the variablerate note is equal to the Prime Lending Rate plus 0.75%.

## **ITEM 4.CONTROLS AND PROCEDURES**

*Evaluationof Disclosure Controls and Procedures.  *Wemaintain disclosure controls and procedures that are designed to ensure thatinformation required to be disclosed in our Exchange Act reports is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms and that such information is accumulated and communicatedto our management, including our principal executive and principal financialofficers, as appropriate, to allow for timely decisions regarding required disclosure.

In designing andevaluating the disclosure controls and procedures, we recognize that anycontrols and procedures, no matter how well designed and operated, can provideonly reasonable assurance of achieving the desired control objectives, and weare required to apply our judgment in evaluating the cost-benefit relationshipof possible controls and procedures.

As required by SECRule 13a-15(b), we carried out an evaluation, under the supervision andwith the participation of our management, including our principal executive andprincipal financial officers, of the effectiveness of the design and operationof our disclosure controls and procedures as of the end of the period coveredby this report. Based on the foregoing, our principal executive and principalfinancial officers have concluded that our disclosure controls and procedureswere effective.

*Changesin Internal Control Over Financial Reporting.  *Therewere no changes in our internal control over financial reporting that occurredduring the last fiscal quarter that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

**PART II**-**OTHER INFORMATION**

**ITEM 1A.  RISK FACTORS**

Informationconcerning certain risks and uncertainties appears in Part I, Item 1A “RiskFactors” of our annual report on Form 10-K for the year ended December 31, 2005(as updated below in this Item 1A).  Youshould carefully consider these risks and uncertainties before making aninvestment decision with respect to shares of our common stock.  Such risks and uncertainties could materiallyadversely affect our business, financial condition or operating results.

Duringthe period covered by this quarterly report, there has been no material changefrom the risk factors previously disclosed in our annual report on Form 10-Kfor the year ended December 31, 2005, except for the addition of the followingrisk factors:

**Wehave new senior members of our management team whose experience is outside ofthe nutraceutical industry.**

In March 2006, our boardof directors appointed Wayne M. Bos, as our new president and chief executiveofficer.  In April 2006, our board ofdirectors appointed Craig Cameron as our chief operating officer.  While Messrs. Bos and Cameron have extensiveexperience, neither has experience in our industry.  If Messrs. Bos and Cameron are unable toadapt successfully to the unique challenges of the nutritional supplementindustry or to define or execute our business strategies, our results ofoperation and financial condition may be adversely affected.

**Ifwe fail to successfully implement our business strategies, our ability toincrease our revenues and operating profits could be adversely affected and ouroverall business could be harmed.**

Our current businessstrategies involve (1) developing Natrol as a solid, profitable growth company,(2) expanding our international operations and (3) making opportunisticacquisitions.   Our business strategiesinclude realizing cost savings from operational efficiency improvements byimplementing processes designed to improve the efficiency level of ourmanufacturing facilities.  We may have toincur costs to achieve our potential cost savings.  These costs not fully achieve our expectedcost savings and efficiency improvements.

15

----

We are planning to expandour international operations.  Operationsin foreign markets may be affected by currency fluctuations, different consumerpreferences, government regulation and local market conditions.  To the extent that we open new internationaloperations in foreign markets, we may not experience the operating margins weexpect, and our expected growth in our results of operations may be negativelyimpacted.

Additionally, there canbe no assurance that we will be able to find new international markets whichmeet our criteria, or if we find such markets, that we will successfullyimplement our expansion goals.

**Ourfailure to appropriately respond to changing consumer preferences and demandfor new products could significantly harm our customer relationships andproduct sales.**

The nutritionalsupplement industry is characterized by rapid and frequent changes in demandfor products and new product introductions. Our failure to accurately predict these trends could negatively impactconsumer opinion of us as a source for the latest products, which in turn couldharm our customer relationships and cause decreases in our net sales.  The success of our new product offeringsdepends upon a number of factors, including our ability to:

·                  accurately anticipate customer needs;

·                  innovate and develop new products;

·                  successfully commercialize newproducts in a timely manner;

·                  price our products competitively;

·                  manufacture and deliver our productsin sufficient volumes and in a timely manner; and

·                  differentiateour product offerings from those of our competitors.

**If weare unable to retain key personnel, our ability to manage our businesseffectively and continue our growth could be negatively impacted.**

Key managementemployees include Wayne M. Bos, Craig Cameron, Dennis Jolicoeur and certainother employees.  These key managementemployees are primarily responsible for our day-to-day operations, and webelieve our success depends in large part on our ability to retain them and tocontinue to attract additional qualified individuals to our managementteam.  We do not have an employmentagreement with any of our key management employees other than Wayne M.Bos.  The loss or limitation of theservices of any of our key management employees or the inability to attractadditional qualified management personnel could have a material adverse effecton our business, financial condition, and result of operations.

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

Our2006 annual meeting of stockholders was held on June 8, 2006.

a)                                      At the annual meeting, the following directorwas re-elected to our board of directors:

|             | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|-------------|------------|--------------------|------------|-------------------------|------------|
| Ralph Simon |       | 11,268,307         |       | 2,215,105               |       |

The following individuals are members of our board ofdirectors whose terms of office as directors continued after the annualmeeting.
|   | Elliott Balbert      |
|--------|----------------------|
|   | Wayne M. Bos         |
|   | Dennis DeConcini     |
|   | Thomas Doorley,  III |
|   | Dennis R.  Jolicoeur |

b)                                                     Atthe annual meeting the stockholders considered and voted upon a proposal toadopt the Natrol, Inc. 2006 Stock Option and Incentive Plan.  The following vote was recorded:

| For              |   | 7,690,785 |   |
|------------------|--------|-----------|--------|
| Against          |   | 3,546,473 |   |
| Abstain          |   | 4,347     |   |
| Broker non-votes |   | 2,241,807 |   |

 

16

----

c)                                      Atthe annual meeting the stockholders considered and voted upon a proposal toapprove the award of options to purchase 6,029,500 shares of common stock toWayne Bos, our president and chief executive officer.  The following vote was recorded:

| For              |   | 7,675,684 |   |
|------------------|--------|-----------|--------|
| Against          |   | 3,563,871 |   |
| Abstain          |   | 2,350     |   |
| Broker non-votes |   | 2,241,807 |   |

##### **ITEM6. EXHIBITS**

| Exhibit 10.1 |   | 2006 Bonus Incentive Compensation Plan(1)                                                                    |
|--------------|--------|--------------------------------------------------------------------------------------------------------------|
| Exhibit 10.2 |   | Natrol, Inc. 2006 Stock Option and Incentive Plan(2)                                                         |
| Exhibit 10.3 |   | Form of Non-Qualified Stock Option Agreement under  the Natrol, Inc. 2006 Stock Option and Incentive Plan(2) |
| Exhibit 31.1 |   | Certification of Chief Executive Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002          |
| Exhibit 31.2 |   | Certification of Chief Financial Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002          |
| Exhibit 32.1 |   | Certification of Chief Executive Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002          |
| Exhibit 32.2 |   | Certification of Chief Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002          |

----

(1)  Incorporated by reference toour current report on Form 8-K filed with the SEC on May 1, 2006.

(2)  Incorporated by reference to our currentreport on Form 8-K filed with the SEC on July 7, 2006

17

----

SIGNATURE

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: August 14,  2006 | By:          | /s/ Dennis R. Jolicoeur |   |
|                   |         | Chief Financial Officer, Treasurer and Executive |
|                   |         | Vice President |
|                   |         | (Duly Authorized Officer and  Principal Financial and Accounting Officer) |

 

18

----

**Exhibit Index**

## **ExhibitNo.            Exhibit Description**

| Exhibit 10.1 |   | 2006 Bonus Incentive Compensation Plan(1)                                                                    |
|--------------|--------|--------------------------------------------------------------------------------------------------------------|
| Exhibit 10.2 |   | Natrol, Inc. 2006 Stock Option and Incentive Plan(2)                                                         |
| Exhibit 10.3 |   | Form of Non-Qualified Stock Option Agreement under  the Natrol, Inc. 2006 Stock Option and Incentive Plan(2) |
| Exhibit 31.1 |   | Certification of Chief Executive Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002          |
| Exhibit 31.2 |   | Certification of Chief Financial Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002          |
| Exhibit 32.1 |   | Certification of Chief Executive Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002          |
| Exhibit 32.2 |   | Certification of Chief Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002          |

----

(1)  Incorporated by reference toour current report on Form 8-K filed with the SEC on May 1, 2006.

(2)  Incorporated by reference to our currentreport on Form 8-K filed with the SEC on July 7, 2006

19

----