**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

 

**(Mark one)**

 
| **ý**                                                                                                                                                                                         | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                               |                                                                                            |
| **FOR THE QUARTERLY PERIOD ENDED MARCH 31, 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 asspecified in its charter)

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

 

**21411PRAIRIE STREETCHATSWORTH, CALIFORNIA 91311******(Address of principal executive offices)

 

**(818)739-6000**(Registrant’s telephone number, including area code)

 

Indicateby a check mark whether the registrant (1) has filed all reports required to befiled by section 13 or 15 (d) of the securities exchange act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. YES  ý   NO  o

 

Indicateby check mark whether the registrant is a large 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 |   | an accelerated filer o |   | or an non-accelerated filer ý |
|---------------------------|--------|------------------------|--------|------------------------------------|

 

Indicate by check mark whetherthe registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o  No ý

 

As of May 3, 2006, 12,559,648 shares of the registrant’s common stockwere outstanding.

 

 

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**Natrol, Inc.**

 

**INDEX**

 
| PART I   | FINANCIAL INFORMATION                                                                       |   | 3      |
|----------|---------------------------------------------------------------------------------------------|--------|--------|
|     |                                                                                        |   |   |
| Item 1.  | 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 Risks                                 |   | 13     |
|     |                                                                                        |   |   |
| Item 4.  | Controls  and Procedures                                                                    |   | 13     |
|     |                                                                                        |   |   |
| PART II. | OTHER INFORMATION                                                                           |   | 14     |
|     |                                                                                        |   |   |
| Item 6.  | Exhibits                                                                                    |   | 14     |
|     |                                                                                        |   |   |
|     | SIGNATURES                                                                                  |   | 15     |
|     |                                                                                        |   |   |
|     | Exhibit Index                                                                               |   |   |

 

2

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PART 1. FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

 

**Natrol, Inc. andSubsidiaries**

**ConsolidatedBalance Sheets**

(In thousands, except share and per sharedata)

 
| ** **                                                                                                                                                  | ** ** | **March 31** | ** ** | **December 31** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                                                                                                                                                  | ** ** | **2006**          | ** ** | **2005**             | ** ** |
| ** **                                                                                                                                                  | ** ** | **(unaudited)**   | ** ** | ** **           | ** ** |
| **Assets**                                                                                                                                                  |       |              |       |                 |       |
| Current assets:                                                                                                                                             |       |              |       |                 |       |
| Cash                                                                                                                                                        |       | $                 | 3,478      |                 | $          | 3,097 |   |
| Accounts receivable, net of allowances of  $220 and $247 at March 31, 2006 and December 31, 2005, respectively                                         |       | 7,942             |       | 6,723                |       |
| Inventory                                                                                                                                                   |       | 12,763            |       | 11,797               |       |
| Income taxes receivable                                                                                                                                     |       | 305               |       | 439                  |       |
| Deferred income taxes                                                                                                                                       |       | 2,021             |       | 2,0211               |       |
| Prepaid expenses and other current assets                                                                                                                   |       | 572               |       | 726                  |       |
| Total current assets                                                                                                                                        |       | 27,081            |       | 24,803               |       |
| Property and equipment:                                                                                                                                     |       |              |       |                 |       |
| Building and improvements                                                                                                                                   |       | 14,933            |       | 14,930               |       |
| Machinery and equipment                                                                                                                                     |       | 5,777             |       | 5,754                |       |
| Furniture and office equipment                                                                                                                              |       | 3,096             |       | 2,900                |       |
|                                                                                                                                                        |       | 23,806            |       | 23,584               |       |
| Accumulated depreciation and amortization                                                                                                                   |       | (9,028            | )          | (8,684               | )          |
| Property and equipment, net                                                                                                                                 |       | 14,778            |       | 14,900               |       |
|                                                                                                                                                        |       |              |       |                 |       |
| Property held for sale, net                                                                                                                                 |       |              |       | 761                  |       |
|                                                                                                                                                        |       |              |       |                 |       |
| Restricted cash                                                                                                                                             |       | 5,000             |       | 5,000                |       |
| Deferred income taxes                                                                                                                                       |       | 4,008             |       | 3,905                |       |
| Goodwill, net of accumulated amortization  and impairment charge of $37,381                                                                                 |       | 2,026             |       | 2,026                |       |
| Other assets                                                                                                                                                |       | 27                |       | 67                   |       |
| Total assets                                                                                                                                                |       | $                 | 52,920     |                 | $          | 51,462 |   |
| **Liabilities and stockholders’ equity**                                                                                                               |       |              |       |                 |       |
| Current liabilities:                                                                                                                                        |       |              |       |                 |       |
| Accounts payable                                                                                                                                            |       | $                 | 4,311      |                 | $          | 4,647 |   |
| Accrued expenses                                                                                                                                            |       | 3,958             |       | 2,888                |       |
| Accrued payroll and related liabilities                                                                                                                     |       | 1,281             |       | 826                  |       |
| Current portion of long-term debt                                                                                                                           |       | 540               |       | 532                  |       |
| Total current liabilities                                                                                                                                   |       | 10,090            |       | 8,893                |       |
| Long-term debt, less current portion                                                                                                                        |       | 7,026             |       | 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—14,481,548 and 14,457,737 at March 31, 2006 and  December 31, 2005, respectively |       | 145               |       | 145                  |       |
| Additional paid-in capital                                                                                                                                  |       | 63,310            |       | 62,984               |       |
| Accumulated deficit                                                                                                                                         |       | (24,770           | )          | (24,844              | )          |
|                                                                                                                                                        |       | 38,685            |       | 38,285               |       |
| Shares held in treasury, at cost—921,900  shares at March 31, 2006 and December 31, 2005                                                          |       | (2,881            | )          | (2,881               | )          |
| Total stockholders’ equity                                                                                                                             |       | 35,804            |       | 35,404               |       |
| Total liabilities and stockholders’ equity                                                                                                             |       | $                 | 52,920     |                 | $          | 51,462 |   |

 

See accompanying notes

 

3

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**Natrol, Inc. andSubsidiaries**

**ConsolidatedStatements of Operations**

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

 
| ** **                           | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **(Unaudited)**                                      | ** ** |
| Net sales                            |       | $                                                    | 16,923     |   | $ | 17,669 |   |
| Cost of goods sold                   |       | 10,029                                               |       | 11,404 |   |
| Gross profit                         |       | 6,894                                                |       | 6,265 |   |
| Selling and marketing expenses       |       | 4,091                                                |       | 4,185 |   |
| General and administrative expenses  |       | 2,525                                                |       | 2,917 |   |
| Option expense                       |       | 292                                                  |       | — |   |
| Total operating expenses             |       | 6,908                                                |       | 7,102 |   |
| Operating loss                       |       | (14                                                  | )          | (837 | ) |
|                                 |       |                                                 |       |   |   |
| Interest income                      |       | 56                                                   |       | 42 |   |
| Interest expense                     |       | (154                                                 | )          | (160 | ) |
| Gain on sale of property             |       | 230                                                  |       | — |   |
| Income (loss) before income taxes    |       | 118                                                  |       | (955 | ) |
| Income tax (benefit) provision       |       | 45                                                   |       | (363 | ) |
| Net Income (loss)                    |       | $                                                    | 73         |   | $ | (592 | ) |
| Income (loss) per share:             |       |                                                 |       |   |   |
| Basic                                |       | $                                                    | 0.01       |   | $ | (0.04 | ) |
| Diluted                              |       | 0.01                                                 |       | (0.04 | ) |
|                                 |       |                                                 |       |   |   |
| Weighted-average shares outstanding: |       |                                                 |       |   |   |
| Basic                                |       | 13,534,237                                           |       | 13,384,419 |   |
| Diluted                              |       | 13,805,234                                           |       | 13,384,419 |   |

 

See accompanying notes

 

4

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# **Natrol, Inc.and Subsidiaries**

**ConsolidatedStatements of Cash Flows**

(In thousands)

* *
| ** **                                                                                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| ** **                                                                                          | ** ** | **(Unaudited)**                                  | ** ** |
| **Operating activities**                                                                            |       |                                             |       |   |   |
| Net Income (loss)                                                                                   |       | $                                                | 73         |   | $ | (592 | ) |
|                                                                                                |       |                                             |       |   |   |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |                                             |       |   |   |
| Depreciation and amortization                                                                       |       | 348                                              |       | 319 |   |
| Provision for bad debts                                                                             |       | (27                                              | )          | 17 |   |
| Deferred income taxes                                                                               |       | (104                                             | )          |   |   |
| Option Expense                                                                                      |       | 292                                              |       |   |   |
| Changes in operating assets and  liabilities:                                                       |       |                                             |       |   |   |
| Accounts receivable                                                                                 |       | (1,192                                           | )          | (291 | ) |
| Inventory                                                                                           |       | (966                                             | )          | 714 |   |
| Income taxes receivable/payable                                                                     |       | 134                                              |       | 94 |   |
| Prepaid expenses and other current assets                                                           |       | 154                                              |       | 32 |   |
| Accounts payable                                                                                    |       | (335                                             | )          | 804 |   |
| Accrued expenses                                                                                    |       | 1,069                                            |       | 434 |   |
| Accrued payroll and related liabilities                                                             |       | 455                                              |       | (449 | ) |
| Net cash provided by (used in) operating  activities                                                |       | (99                                              | )          | 1,082 |   |
|                                                                                                |       |                                             |       |   |   |
| **Investing activities**                                                                            |       |                                             |       |   |   |
| Purchases of property and equipment                                                                 |       | (222                                             | )          | (130 | ) |
| Sale of property                                                                                    |       | 759                                              |       | — |   |
| Other assets                                                                                        |       | 40                                               |       | 28 |   |
| Net cash provided by (used in) investing  activities                                                |       | 577                                              |       | (102 | ) |
|                                                                                                |       |                                             |       |   |   |
| **Financing activities**                                                                            |       |                                             |       |   |   |
| Repayments on long-term debt                                                                        |       | (132                                             | )          | (112 | ) |
| Proceeds from issuance of common stock                                                              |       | 35                                               |       | 57 |   |
| Net cash (used in) provided by financing  activities                                                |       | (97                                              | )          | (55 | ) |
|                                                                                                |       |                                             |       |   |   |
| Net increase in cash and cash equivalents                                                           |       | 381                                              |       | 925 |   |
| Cash and cash equivalents, beginning of  period                                                     |       | 3,097                                            |       | 6,022 |   |
| Cash and cash equivalents, end of period                                                            |       | $                                                | 3,478      |   | $ | 6,947 |   |

 

See accompanying notes

 

5

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

 

1.     BASIS OF PRESENTATION

 

Theaccompanying consolidated financial statements have been prepared by theCompany, pursuant to the rules and regulations of the Securities and ExchangeCommission (SEC).  This Report on Form 10-Q should be read in conjunctionwith the Company’s annual report on Form 10-K for the year ended December 31,2005.  Certain information and footnote disclosures which are normallyincluded in financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America have beencondensed or omitted pursuant to SEC rules and regulations.  Theinformation reflects all normal and recurring adjustments which, in the opinionof the Company’s management, are necessary for a fair presentation of thefinancial position of the Company and its results of operations for the interimperiods set forth herein.  The results for the three months ended March31, 2006 are not necessarily indicative of the results to be expected for thefull year or any other period.

 

2.     STOCK BASED COMPENSATION

 

Through the end of 2005, the Company measured compensation forstock-based incentive programs utilizing the intrinsic value method prescribedby Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees,*and relatedinterpretations. Under this method, the Company did not record compensationexpense when stock options were granted to eligible participants as long as theexercise price was not less that the fair market value of the stock when theoption was granted. In accordance with Statement of Financial AccountingStandards (SFAS) No. 123, *Accounting forStock-Based Compensation*, (SFAS 123) and SFAS No. 148, *Accounting for Stock-Based Compensation – Transitionand Disclosure*, the Company disclosed the pro forma net income pershare as if the fair value-based method had been applied in measuringcompensation expense for stock-based incentive awards. No stock-basedcompensation cost was recognized in the Consolidated Statement of Income forthe three months ended March 31, 2005 for options granted under the Company’sstock option plan as all unvested options granted had an exercise price equalto the fair market value of the underlying common stock on the date of grant.

 

In December 2004, the Financial Accounting Standards Board (FASB)issued SFAS 123R, *Share Based Payment: AnAmendment of FASB Statements No. 123 and 95* (SFAS 123R). Thisstatement requires that the cost resulting from all share-based paymenttransactions be recognized in the Company’s consolidated financial statements.In addition, in March 2005 the SEC released SEC Staff Accounting Bulletin No.107, *Share-Based Payment* (SAB107). SAB 107 provides the SEC’s staff’s position regarding the application ofSFAS 123R and certain SEC rules and regulations, and also provides the staff’sviews regarding 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.

 

Inthe first quarter of 2006, the Company adopted the fair value recognitionprovisions of SFAS 123R utilizing the modified-prospective-transition method,as prescribed by SFAS 123R. Under the transition method, compensation costrecognized during the three months ended March 31, 2006 includes: (a)compensation cost for all share-based payments granted prior to, but not yetvested as of January 1, 2006, based on the grant date fair value estimated inaccordance with SFAS 123, and (b) compensation expense for all share-basedpayments granted subsequent to January 1, 2006, based on the grant-date fairvalue estimated in accordance with the provisions of SFAS 123R. Under themodified-prospective-transition method, results for the prior periods have notbeen restated.

 

During the three months ended March 31, 2006, 6,289,500 options weregranted. Of this number, 6,029,500 options were awarded to Wayne Bos, theCompany’s CEO and President and 260,000 options were granted to other employees.The options granted to Mr. Bos have certain service and performance conditionswhich have been delineated in the Company’s other filings. For the three monthsended March 31, 2006, the Company recognized an expense of $292,000 as a resultof the adoption SFAS 123R with $272,000 of this expense being for Mr. Bos’options and $20,000 being for the options granted to other employees.

 

The effect of the change in applying the original provisions of SFAS123 resulted in lowering operating income, income before taxes, net income andbasic and diluted earnings per share as follows:

 

6

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| ** **                               | ** ** | **As per SFAS** | ** ** | **As per SFAS** | ** ** |
|------------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                               | ** ** | **123R**                  | ** ** | **123**                   | ** ** |
| Operating Income                         |       | (14                       | )          | 278                       |       |
| Income before provision for income taxes |       | 118                       |       | 410                       |       |
| Net income                               |       | 73                        |       | 254                       |       |
| Net income per share:                    |       |                      |       |                      |       |
| Basic                                    |       | $                         | 0.01       |                      | $          | 0.02 |   |
| Diluted                                  |       | $                         | 0.01       |                      | $          | 0.02 |   |

 

TheCompany used a Monte Carlo method to simulate stock price paths over the termof the 6,029,500 options awarded to Mr. Bos. All other options were valued usinga Black-Scholes model. The Monte Carlo method, which is one acceptablevaluation method per SFAS 123R, was used due to many factors which makeutilizing a Black-Scholes model inappropriate for a block of options of thismagnitude. These factors include but are not limited to the size of the grantin relation to the total shares outstanding, the trading volume of Natrol’sstock and the holder’s ability to resell the shares, and the control factorwhich the size of the grant implies. The Company used the services of awell-credentialed group of valuation experts to perform the valuation of Mr.Bos’ options. This group developed multiple scenarios including continuingoperation and sale scenarios, to assess the potential to create shareholdervalue over the term of the options. The resulting Monte Carlo analysis gaverise to a range of fair values for which the mean amount was utilized invaluing the options for Mr. Bos.

 

Allother options were valued using a Black-Scholes model. Under SFAS 123R, theCompany will continue to utilize the Black-Scholes model to estimate the fairmarket value related to employee stock options after January 1, 2006, unlesssuch method is clearly inappropriate for a significant block of options, suchas were granted to Mr. Bos. The Company’s assessment of the estimatedcompensation charges for these other options is affected by its stock price aswell as assumptions regarding a number of complex and subjective variables andthe related tax impact. These variables include, but are not limited to theCompany’s stock price volatility and expected employee stock option behavior.

 

The following summarizes the activity of the Company’s stock options,not including the Bos options which were valued at $272,000 using the MonteCarlo method,  for the three months endedMarch 31, 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                        |       | 260,000    |       | 2.12                                       |       |                                                |       |                            |       |
| Exercised                      |       | 14,563     |       | 1.42                                       |       |                                                |       |                            |       |
| Canceled or expired            |       | 42,500     |       | 5.04                                       |       |                                                |       |                            |       |
| Outstanding at March 31, 2006  |       | 2,513,757  |       | $                                          | 3.00       |                                                | 5.16       |                            | $          | 0.0 |   |
| Exercisable at March 31, 2006  |       | 2,170,714  |       | $                                          | 3.12       |                                                | 4.45       |                            | $          | 0.0 |   |

 

The following summarizes the activity of the Company’s stock optionsthat have not vested for the three months ended March 31, 2006:

 
| ** **                   | ** ** | **Shares** | ** ** | **Weighted  Average Fair  Value** | ** ** | ** ** |   |   |   |   |
|------------------------------|------------|------------|------------|-----------------------------------|------------|------------|--------|--------|--------|--------|
| Nonvested at January 1, 2006 |       | 99,501     |       | $                                 | 1.48       |       |   |   |   |   |   |
| Granted                      |       | 260,000    |       | 1.14                              |       |       |   |   |   |   |
| Vested                       |       | 16,458     |       | $                                 | 1.36       |       |   |   |   |   |   |
| Nonvested at March 31,2006   |       | 343,043    |       | $                                 | 1.23       |       |   |   |   |   |   |

 

As of March 31, 2006, there was $403,660 of total unrecognizedcompensation cost related to nonvested share-based compensation arrangementsgranted under existing stock option plans. This cost is expected to berecognized over a weighted-average period of 9.65 years. The total measurementfair value of shares vested during the three-months ended March 31, 2006 was$16,278.

 

7

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The Black-Scholes option pricing model is used by the Company todetermine the weighted average fair value of options. The fair value of optionsat date of grant and the assumptions utilized to determine such values areindicated in the following table:

 
| ** **                                                                          | ** ** | **Three Months Ended March  31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
|                                                                                |       |                                             |       |   |   |
| Weighted average fair value at date of  grant for options granted during the period |       | $                                                | 1.14       |   | $ | 1.71 |   |
|                                                                                |       |                                             |       |   |   |
| Risk-free interest rates                                                            |       | 4.70                                             | %          | 3.72 | % |
| Expected stock price volatility                                                     |       | 60.74                                            |       | 63.62 |   |
| Expected dividend yield                                                             |       | 0.0                                              | %          | 0.0 | % |
|                                                                                     |            |                                                  |            |  |  |  |  |

 

The following table illustrates the effect on net income and earningsper share if the Company had applied the Fair Value recognition provisions ofSFAS 123R for the three months ended March 31, 2005

 
| ** **                                                                                                                                                                  | ** ** | **March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **2005**           | ** ** |
|                                                                                                                                                                        |       |               |       |
| Net Income (loss)                                                                                                                                                           |       | $                  | (592       | ) |
| Total stock-based employee compensation  expense determined under the fair value-based method for all awards, net of  related tax benefits (“Stock Compensation”) |       | (26                | )          |
| Net Income (loss)—pro forma                                                                                                                                            |       | (618               | )          |
| Income (loss) per share:                                                                                                                                                    |       |               |       |
| Basic—as reported                                                                                                                                                      |       | $                  | (0.04      | ) |
| Diluted—as reported                                                                                                                                                    |       | $                  | (0.04      | ) |
| Basic—pro forma                                                                                                                                                        |       | $                  | (0.05      | ) |
| Diluted—pro forma                                                                                                                                                      |       | $                  | (0.05      | ) |

 

These assumptions resulted in weighted-average fair valuesof $1.14, and $1.71 for each stock option valued under the Black- Scholesmethod and granted in the quarters ended March 31, 2006 and 2005, respectively.

 

8

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3. INVENTORY

 

Inventories consist of the following:

 
| ** **                          | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                |       |                     |       |                        |       |
| Raw material and packaging supplies |       | $                        | 7,792      |                        | $          | 7,547 |   |
| Finished goods                      |       | 4,971                    |       | 4,250                       |       |
| Total Inventory                     |       | $                        | 12,763     |                        | $          | 11,797 |   |

 

4. SHIPPING AND HANDLING COSTS

 

TheCompany records all amounts charged to customers for shipping and handling asrevenue. All outbound shipping and fulfillment costs are classified as sellingand marketing expenses and totaled $810,500 and $811,000 for three months endedMarch 31, 2006 and 2005, respectively.

 

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

 

Stockoptions to purchase 2,513,717 and 2,461,281 shares of common stock in thequarters ended March 31, 2006 and 2005, respectively, were outstanding. Duringthe quarter ended March 31, 2006, 1,120,000 shares were consideredanti-dilutive. Since the Company was not profitable in the quarter ended March31, 2005  all of the option shares inthat quarter were considered anti-dilutive.

 

**ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Forward Looking Statements and Certain Risks**

 

Thestatements contained in this report that are not purely historical are “forward-lookingstatements” within the meaning of Section 21E of the Securities ExchangeAct. These statements are based on our expectations, hopes, beliefs,commitments, intentions, and strategies regarding the future. They may beidentified by the use of words or phrases, such as “believe,” “expect,” “anticipate,”“should,” “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 factors, some of which are beyond our control.Therefore, we wish to caution you to carefully consider the following factorsdiscussed in our other SEC reports. The factors discussed herein may not beexhaustive. Therefore, the factors contained herein should be read togetherwith our other reports and documents which are filed by us with the SEC from timeto time, which may supplement, modify, supersede or update the factors listedin this report.

 

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Factors that could causeor contribute to our actual results differing materially from those discussedherein include, but are not limited to:

 

•      industrytrends, including a general downturn or slowing of the growth of the dietarysupplement industry;

•      increasedcompetition from current competitors and new market entrants, including fromprivate label house brands supported by retailers;

•      adversepublicity regarding the dietary supplement industry or our products;

•      exposureto product liability claims, as well as a limited amount of insurance coverageincluding a lack of earthquake insurance;

•      ourability to develop new products;

•      ourability to manage inventory;

•      ourability to gain or expand or maintain distribution and new or existing channelsof trade;

•      anincrease in the cost of obtaining and maintaining shelf space with majornational retailers;

•      adversechanges in government regulation or changes in local, state or national laws;

•      ourdependence on significant customers;

•      ourability to keep and attract members of management and key employees;

•      ourability to manage our growth, execute our business plan and manage changingmarket conditions;

•      ourability to consummate future acquisitions and integrate acquired businesses;

•      theabsence of conclusive clinical studies for many of our products;

•      ourability to obtain raw materials;

•      oursales and earnings volatility;

•      ourability to manufacture products efficiently;

•      ourreliance on independent brokers to sell our products;

•      ourability to protect our intellectual property;

•      ageneral downturn in the national economy as a whole;

•      continuedmarket acceptance of our supplements, Laci Le BeauÒteas, ProlabÒ sports nutrition products, and Essentially PureIngredient’s raw material products; and

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

 

**OVERVIEW**

 

Natrol isas a quality manufacturer and marketer of nutritional supplements.

 

Ourcore brands include NatrolÒsupplements,  Prolab sports nutritionproducts and the Laci Le Beau line of dieters’ teas. The Natroland Laci Le Beau brands are sold in health food stores, in mass-market drug,food and retail chains as well as club stores. Prolab products are sold throughdistributors who in turn service retail accounts. Prolab’s distributor networkfocuses on health food stores, health clubs and fitness facilities that caterto body builders and other individuals seeking a high level of fitness. We arecontinually trying to expand the distribution of our best selling items toadditional retail outlets and to create promotional opportunities for our productswithin our existing customer base. We are also seeking to expandinternationally as selected distribution opportunities arise.

 

We also provide contractmanufacturing services to other supplement companies and sell a limited numberof raw material ingredients to other nutraceutical companies but theseactivities are not core to the business.

 

Key issues formanagement include product development and acquisitions, product introductions,the marketing of current and new products, inventory management, and controllingthe cost of doing business in our various channels of trade.

 

The nutritionalsupplement business is dependent upon access to new products and newdistribution channels. New products are important for growth and to replacevolume lost by products reaching the end of their product life cycles. Forthese reasons, we continually research potential new products. Developing asingle new product can be a multi-year effort depending upon the complexity ofthe product and the amount of testing that must be completed to validate theproduct concept. We also are continuously looking for new channels in which todistribute our products both in the United States and in foreign markets.

 

Product introductions donot come without risk. Product launches can require substantial marketingsupport. Oftentimes retailers demand slotting fees or other up-frontexpenditures. If a product launch is not as successful as anticipated,additional promotional expenditures may be needed to sustain sales and reducepossible returns. Most vendors retain certain rights as they relate to productreturns. A broad product launch, one in which a new product is introduced intothousands of retail

 

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outlets, can cause astrain on corporate resources since inventories must be produced and delivered.The resulting sales increase also leads to an increase in accounts receivablewith customers.

 

Another avenue for newproducts is to acquire existing brands or products. We purchased the Laci LeBeaubrand of teas and the Prolab brand of sports nutrition products, which nowaccount for approximately 25% of our business. We may acquire other products orbrands in the future.

 

Nutritional supplementsmust maintain potency levels during their selling life. As a result, productsmust be stamped with an expiration date and retailers will not accept productwith limited shelf life into their warehouses. Shelf life issues require a highdegree of supply chain management of raw materials and finished goods to ensurethat shelf life is maximized and that the out-of-date inventory is minimized.

 

The competition for shelf space at retailers is intense. Our salespeople have ongoing discussions with our retail customers with regards to theallocation of shelf space and the level of promotional support for products.Retailers look to their vendors for promotional support for the products ontheir shelves in order to maximize sales. Vendors such as Natrol look toretailers for advantageous placement of their products and promotion of theirproducts within stores and within a retailer’s promotional media such asnewspaper advertisements placed by retailers. The cost of promotions andsupport to the retailer on the part of vendors such as Natrol can be very highand management must continually review promotional efforts with retailers toensure that sales are profitable.

 

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**RESULTS OF OPERATIONS**

 

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

 

**THREE MONTHS ENDED MARCH 31, 2006 AND MARCH31, 2005**

 

NET SALES. We recognizerevenue from sales only after product is shipped. We have no consignment sales.Net sales represent product shipped less actual and estimated future returns,spoilage allowances, allowances for product deemed to be unsaleable bycustomers, free goods shipped to customers for promotional or other purposes,rebates, slotting fees and other promotional expenditures. Estimates andallowances are based upon known claims and an estimate of additional returnswhen the amount of future returns from customers can be reasonably estimated.

 

Net sales decreased 4.2%, or $0.8 million, to $16.9 million for thethree months ended March 31, 2006 from $17.7 million for the three months endedMarch 31, 2005. When compared to the first quarter of 2005, gross shipments ofthe Natrol and Laci LeBeau brands increased approximately 5.4% or $0.8 millionin the first quarter of 2006. However, shipments of the Prolab brand declined nearly $0.4 million and sales ofraw materials and contract manufacturing declined $0.6 million. Furtherreducing net sales were higher than anticipated returns in the quarter.

 

GROSS PROFIT. Gross profit increased 10.0%, or $0.6 million, to $6.9million for the three months ended March 31, 2006 from $6.3 million for thethree months ended March 31, 2005. Gross margin increased to 40.7% for thethree months ended March 31, 2006 from 35.5% for the three months ended March31, 2005. The increase in gross margin was primarily due to lower materialscosts during the quarter. Gross margins during the first quarter of 2005 werenegatively affected by sharp rises in the price of certain raw materials, inparticular Coenzyme Q10.

 

SELLING AND MARKETING EXPENSES. Selling and marketing expenses consistprimarily of advertising and promotional expenses, cost of distribution, andrelated payroll expenses and commissions. Selling and marketing expensesdecreased 2.2%, or $0.1 million, to $4.1 million for the three months endedMarch 31, 2006 from $4.2 million for the three months ended March 31, 2005. Thechange is not considered material.

 

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrativeexpenses consist primarily of personnel costs related to general managementfunctions, finance, accounting and information systems, as well as professionalfees related to legal, audit and tax matters and depreciation. General andadministrative expenses decreased 13.4%, or $0.4 million to $2.5 million forthe three months ended March 31, 2006 from $2.9 million for the three monthsended March 31, 2005. Legal expenditures were approximately $0.3 million lessin the first quarter 2006 than in the first quarter 2005. The decrease was dueto less litigation expense. Administrative payroll during the first quarter of2006 was approximately $0.1 million less than in the first quarter of 2005.

 

INTEREST EXPENSE. The Company recorded interest expense of $154,000 forthe three months ended March 31, 2006 as compared to interest expense of$160,000 for the three months ended March 31, 2005.

 

INCOME TAX EXPENSE. The Company’s effective tax rate was 38.0% in thethree months ended March 31, 2006 and 2005.

 

SALEOF BUILDING. During the first quarter of 2006, the Company sold a building itowned in Bloomfield, Connecticut that was formerly used as a shipping facilityfor its Prolab brand. The approximate net book value of the property, plant andplant improvements that were sold was $759,000 and the gain, net of brokerage,legal and other related expenses was approximately $230,000.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

As of March 31, 2006, the Company had working capital of $17.0 millionas compared to $17.8 million in working capital at December 31, 2005. TheCompany’s cash balance at March 31, 2006 was approximately $3.5 million.

 

Net cash used by operating activities was $0.1 million for the threemonths ended March 31, 2006 versus net cash provided of approximately $1.1million for the three months ended March 31, 2005. Cash provided by operatingactivities during the three months ended March 31, 2006 consisted primarily ofcash provided by non-cash charges of $0.5 million and cash used because ofchanges in operating assets and liabilities of $0.7 million offset by theCompany’s profit of $0.1 million.

 

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During the three months ended March 31, 2006 the Company implementedSFAS 123R and expensed stock options awarded to employees. This expenseamounted to $0.3 million but was a non-cash charge. Depreciation andamortization provided $0.3 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 by operating assets and liabilitiesconsisted primarily of an increase in accounts receivable of $1.2 million, anincrease in inventory of $1.0 million, and a decrease in accounts payable of$0.3 million offset by an increase in accrued expenses of $1.1 million, anincrease in accrued payroll of $0.5 million and an increase in prepaid expensesand income taxes receivable of $0.3 million. The increase in accountsreceivable was due to the level and timing of sales.

 

Net cash provided by investing activities was $0.6 million for thethree months ended March 31, 2006 versus net cash used of $0.1 million duringthe three months ended March 31, 2005. During the first quarter of 2006, theCompany sold the warehouse it owned in Bloomfield, Connecticut. The net bookvalue of the property sold was approximately $0.8 million. Other investmentactivity consisted primarily of the acquisition of $0.2 million of equipment.

 

Net cash used by financing activities was $0.1 million for the threemonths ended March 31, 2006 as opposed to cash provided of $0.1 million duringthe three months ended March 31, 2005. The company received cash from theexercise of stock options and repaid more than $0.1 million of long-term debt.

 

As of March 31, 2006, the Company had $7.5 million of outstanding debt.

 

The Company did not have a line of credit in place during the firstquarter of 2006 but may seek to establish a line of credit with its bank.

 

The Company believes that its cash balance together with cash generatedfrom operations and should be sufficient to fund its anticipated workingcapital needs and planned capital expenditures for the next twelve months.

 

In order to meet its long-term liquidity needs, the Company may berequired to incur additional indebtedness or issue additional equity and debtsecurities, subject to market and other conditions. There can be no assurancethat such additional financing will be available on terms acceptable to theCompany or at all. The failure to raise the funds necessary to finance itsfuture cash requirements or consummate future acquisitions could adverselyaffect the Company’s ability to pursue new acquisitions and could negativelyaffect its operations in future periods.

 

CRITICAL ACCOUNTING POLICIES

** **

Management’s beliefs regarding significant accounting policies have notchanged significantly from those discussed in Item 7 of the Company’s AnnualReport on Form 10-K for the year ended December 31, 2005.

 

CONTRACTUAL OBLIGATIONS

 

Contractual obligations have not changed significantly from thosediscussed in Item 7 of the Company’s Annual Report on Form 10-K for the yearended December 31, 2005.

 

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

 

There has been no material change during the three months ended March31, 2006 from the disclosures about market risk provided in Item 7a of theCompany’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

**ITEM 4. CONTROLS**

 

An evaluation was conductedunder the supervision and with the participation of the Company’s management,including the Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the Company’s disclosure controls and procedures (as definedin Exchange Act Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934) as of March 31, 2006. Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer have concluded that the Company’sdisclosure controls and procedures are, to the best of their knowledge,effective to ensure that information required to be disclosed by the Company inreports that it files or submits under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in SEC rules andforms. There were no significant changes in the Company’s internal control overfinancial reporting that occurred during the fiscal quarter covered by thisreport that have materially affected or are reasonably likely to materiallyaffect the Company’s internal controls over financial reporting.

 

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**PARTII**

 

OTHER INFORMATION

 

ITEM1. LEGAL PROCEEDINGS

 

None

 

ITEM 2. UNREGISTERED SALES OF SECURITIES ANDUSE OF PROCEEDS

 

None

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

 

None

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS

 

None

 

ITEM 5. OTHER INFORMATION

 

None

 

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

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

 

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SIGNATURES

 

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

 
|               | NATROL, INC. |
|--------------------|--------------|
|               |         |
| Date: May 15, 2006 | By:          | /s/ Wayne Bos |   |
|               |         | President and Chief Executive  Officer |
|               |         |   |
| Date: May 15, 2006 | By:          | /s/ Dennis R. Jolicoeur |   |
|               |         | Chief Financial Officer and Executive  Vice President |
|                    |              |  |  |  |

 

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