**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

----

 

**FORM 10-Q**

** **

**(Markone)**

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

 

**FOR THETRANSITION PERIOD FROM           TO           **

 

**COMMISSIONFILE 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)

 

**Not Applicable**

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

 

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  x   No  o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12-B2 of the Exchange Act. (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 ofNovember 5, 2007, 14,261,544 shares of the registrant’s common stock wereoutstanding.

 

 

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**TABLE OF CONTENTS**

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

 

2

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**PART 1—FINANCIAL INFORMATION**

 

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

#####  

**Natrol, Inc.and Subsidiaries**

**ConsolidatedCondensed Balance Sheets**

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

** **
| ** **                                                                                                                                                                                                    | ** ** | **September 30  2007** | ** ** | **December 31  2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                    | ** ** | **(unaudited)**             | ** ** | ** **                 | ** ** |
| **Assets**                                                                                                                                                                                                    |       |                        |       |                       |       |
| Current assets:                                                                                                                                                                                               |       |                        |       |                       |       |
| Cash and cash  equivalents                                                                                                                                                                                    |       | $                           | 5,891      |                       | $          | 1,003 |   |
| Accounts  receivable, net of allowances of $244 and $181 at September 30, 2007 and  December 31, 2006, respectively                                                                                           |       | 7,494                       |       | 6,485                      |       |
| Inventory                                                                                                                                                                                                     |       | 18,593                      |       | 11,788                     |       |
| Income taxes  receivable                                                                                                                                                                                      |       | 2,345                       |       | 375                        |       |
| Deferred income  taxes                                                                                                                                                                                        |       | 1,636                       |       | 1,630                      |       |
| Prepaid expenses  and other current assets                                                                                                                                                                    |       | 603                         |       | 1,743                      |       |
| Total current assets                                                                                                                                                                                          |       | 36,562                      |       | 23,024                     |       |
| Property and  equipment:                                                                                                                                                                                      |       |                        |       |                       |       |
| Building and  improvements                                                                                                                                                                                    |       | —                      |       | 14,953                     |       |
| Machinery and  equipment                                                                                                                                                                                      |       | 6,142                       |       | 5,757                      |       |
| Furniture and  office equipment                                                                                                                                                                               |       | 3,042                       |       | 3,013                      |       |
|                                                                                                                                                                                                          |       | 9,184                       |       | 23,723                     |       |
| Accumulated  depreciation and amortization                                                                                                                                                                    |       | (7,576                      | )          | (9,912                     | )          |
| Property and  equipment, net                                                                                                                                                                                  |       | 1,608                       |       | 13,811                     |       |
|                                                                                                                                                                                                          |       |                        |       |                       |       |
| Restricted cash                                                                                                                                                                                               |       | 5,337                       |       | 5,000                      |       |
| Deferred income  taxes                                                                                                                                                                                        |       | 4,265                       |       | 4,265                      |       |
| Goodwill, net of  accumulated amortization and impairment charge                                                                                                                                              |       | 2,026                       |       | 2,026                      |       |
| Trademarks                                                                                                                                                                                                    |       | 5,730                       |       | 5,730                      |       |
| Other assets                                                                                                                                                                                                  |       | 984                         |       | 744                        |       |
| Total assets                                                                                                                                                                                                  |       | $                           | 56,512     |                       | $          | 54,600 |   |
|                                                                                                                                                                                                          |       |                        |       |                       |       |
| **Liabilities  and stockholders’ equity**                                                                                                                                                                |       |                        |       |                       |       |
| Current  liabilities:                                                                                                                                                                                         |       |                        |       |                       |       |
| Line of credit                                                                                                                                                                                                |       | $                           | —     |                       | $          | 3,694 |   |
| Accounts payable                                                                                                                                                                                              |       | 5,608                       |       | 3,058                      |       |
| Accrued expenses                                                                                                                                                                                              |       | 4,888                       |       | 2,558                      |       |
| Accrued payroll  and related liabilities                                                                                                                                                                      |       | 1,608                       |       | 1,185                      |       |
| Current portion  of long-term debt                                                                                                                                                                            |       | 11                          |       | 414                        |       |
| Total current  liabilities                                                                                                                                                                                    |       | 12,115                      |       | 10,909                     |       |
|                                                                                                                                                                                                          |       |                        |       |                       |       |
| Long-term debt,  less current portion                                                                                                                                                                         |       | 30                          |       | 6,301                      |       |
| Deferred benefit  from sale leaseback                                                                                                                                                                         |       | 5,003                       |       | —                     |       |
|                                                                                                                                                                                                          |       |                        |       |                       |       |
| Commitments and  contingencies                                                                                                                                                                                |       | —                      |       | —                     |       |
|                                                                                                                                                                                                          |       |                        |       |                       |       |
| Stockholders’  equity:                                                                                                                                                                                   |       |                        |       |                       |       |
| Preferred stock,  par value of $0.01 per share: Authorized shares—2,000,000; Issued and  outstanding shares—none                                                                                    |       | —                      |       | —                     |       |
| Common stock,  par value of $0.01 per share: Authorized shares—50,000,000, Issued and  outstanding shares—14,155,544 and 14,116,148 at September 30, 2007 and  December 31, 2006, respectively |       | 143                         |       | 141                        |       |
| Additional  paid-in capital                                                                                                                                                                                   |       | 62,219                      |       | 61,638                     |       |
| Accumulated  deficit                                                                                                                                                                                          |       | (23,061                     | )          | (24,409                    | )          |
| Accumulated  other comprehensive income                                                                                                                                                                       |       | 63                          |       | 20                         |       |
| Total  stockholders’ equity                                                                                                                                                                              |       | 39,364                      |       | 37,390                     |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                              |       | $                           | 56,512     |                       | $          | 54,600 |   |

 

See accompanyingnotes

 

3

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**Natrol, Inc.and Subsidiaries**

**ConsolidatedCondensed Statements of Operations**

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

**(unaudited)**

** **
| ** **                                                  | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                  | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Net sales                                                   |       | $                                                    | 19,206     |                                                | $          | 15,660 |   | $ | 57,460 |   | $ | 49,171 |   |
| Cost of goods  sold                                         |       | 13,156                                               |       | 8,972                                               |       | 33,340 |   | 28,395 |   |
| Gross profit                                                |       | 6,050                                                |       | 6,688                                               |       | 24,120 |   | 20,776 |   |
|                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Selling and marketing  expenses                             |       | 5,951                                                |       | 3,848                                               |       | 16,527 |   | 12,031 |   |
| General and  administrative expenses                        |       | 5,050                                                |       | 2,688                                               |       | 11,064 |   | 8,337 |   |
| Total operating  expenses                                   |       | 11,001                                               |       | 6,536                                               |       | 27,591 |   | 20,368 |   |
| Operating income  (loss)                                    |       | (4,951                                               | )          | 152                                                 |       | (3,471 | ) | 408 |   |
|                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Interest income                                             |       | 113                                                  |       | 70                                                  |       | 296 |   | 186 |   |
| Interest expense                                            |       | (18                                                  | )          | (149                                                | )          | (309 | ) | (456 | ) |
| Other                                                       |       | (26                                                  | )          | —                                              |       | (60 | ) | — |   |
| Gain on sale of  property                                   |       | —                                               |       | —                                              |       | 6,062 |   | 230 |   |
| Income (loss)  before taxes                                 |       | (4,882                                               | )          | 73                                                  |       | 2,518 |   | 368 |   |
| Income tax  provision (benefit)                             |       | (1,717                                               | )          | 33                                                  |       | 1,171 |   | 155 |   |
| Net income  (loss)                                          |       | $                                                    | (3,165     | )                                                   | $          | 40 |   | $ | 1,347 |   | $ | 213 |   |
|                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Net income  (loss) per share:                               |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                       |       | $                                                    | (.22       | )                                                   | $          | .00 |   | $ | .10 |   | $ | .02 |   |
| Diluted                                                     |       | $                                                    | (.22       | )                                                   | $          | .00 |   | $ | .08 |   | $ | .02 |   |
|                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted-average  shares outstanding—basic and diluted |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                       |       | 14,160,244                                           |       | 13,604,572                                          |       | 14,171,714 |   | 13,573,108 |   |
| Diluted                                                     |       | 14,160,244                                           |       | 13,711,047                                          |       | 16,598,985 |   | 13,931,927 |   |

 

See accompanying notes

 

4

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**Natrol, Inc.and Subsidiaries**

**ConsolidatedCondensed Statements of Cash Flows**

**(In thousands)**

**(unaudited)**

** **

 
| ** **                                                                               | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2007**                                       | ** ** | **2006** | ** ** |
|                                                                                     |       |                                           |       |   |   |
| **Operating  activities**                                                                | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Net income                                                                               |       | $                                              | 1,347      |   | $ | 213 |   |
|                                                                                     |       |                                           |       |   |   |
| Adjustments to  reconcile income to net cash provided by (used in) operating activities: |       |                                           |       |   |   |
| Depreciation and  amortization                                                           |       | 879                                            |       | 1,048 |   |
| Foreign currency  translation                                                            |       | 43                                             |       | 5 |   |
| Provision for  bad debts                                                                 |       | 63                                             |       | (50 | ) |
| Deferred income  taxes                                                                   |       | (6                                             | )          | (167 | ) |
| Shares issued  for services                                                              |       | —                                         |       | 32 |   |
| Option expense                                                                           |       | 386                                            |       | 460 |   |
| Gain on sale of  property                                                                |       | (6,062                                         | )          | — |   |
| Changes in  operating assets and liabilities:                                            |       |                                           |       |   |   |
| Accounts  receivable                                                                     |       | (1,072                                         | )          | 90 |   |
| Inventory                                                                                |       | (6,807                                         | )          | 1,750 |   |
| Income taxes  receivable/payable                                                         |       | (1,970                                         | )          | 243 |   |
| Prepaid expenses  and other current assets                                               |       | 1,140                                          |       | (434 | ) |
| Accounts payable                                                                         |       | 2,548                                          |       | (2,135 | ) |
| Accrued expenses                                                                         |       | 2,329                                          |       | 797 |   |
| Accrued payroll  and related liabilities                                                 |       | 423                                            |       | 526 |   |
| Net cash  provided by (used in) operating activities                                     |       | (6,759                                         | )          | 2,378 |   |
|                                                                                     |       |                                           |       |   |   |
| **Investing  activities**                                                                | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Purchases of  property and equipment                                                     |       | (258                                           | )          | (272 | ) |
| Proceeds from  sale of property                                                          |       | 26,000                                         |       | 759 |   |
| Net cash outlay  for acquisition of MRI                                                  |       | (3,232                                         | )          | — |   |
| Other assets                                                                             |       | (692                                           | )          | (103 | ) |
| Net cash  provided by investing activities                                               |       | 21,818                                         |       | 384 |   |
|                                                                                     |       |                                           |       |   |   |
| **Financing  activities**                                                                | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Repayment of  line of credit                                                             |       | (3,694                                         | )          | — |   |
| Repayments on  long-term debt                                                            |       | (6,674                                         | )          | (884 | ) |
| Proceeds from  issuance of common stock                                                  |       | 197                                            |       | 126 |   |
| Net cash used in  financing activities                                                   |       | (10,171                                        | )          | (758 | ) |
| Net increase  (decrease) in cash and cash equivalents                                    |       | 4,888                                          |       | 2,004 |   |
| Cash and cash  equivalents, beginning of period                                          |       | 1,003                                          |       | 3,097 |   |
| Cash and cash  equivalents, end of period                                                |       | $                                              | 5,891      |   | $ | 5,101 |   |
|                                                                                     |       |                                           |       |   |   |
| **Supplemental  cash flow information**                                                  | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Cash paid during  the year for:                                                          |       |                                           |       |   |   |
| Interest **                                                                              |       | $                                              | 3,683      |   | $ | 457 |   |
| Income taxes                                                                             |       | $                                              | 149        |   | $ | 79 |   |

** **

----

****Includes defeasance paid to retire real estate loans**

 

See accompanying notes

 

5

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**Natrol, Inc. and Subsidiaries**

**Notes to Consolidated Unaudited Financial Statements**

(In thousands, exceptshare and per share data)

 

1. BASIS OF PRESENTATION

 

The accompanyingconsolidated condensed financial statements have been prepared by Natrol, Inc.(the “Company”), pursuant to the rules and regulations of the Securities andExchange Commission (SEC). This quarterly report on Form 10-Q should be read inconjunction with the Company’s annual report on Form 10-K for the year endedDecember 31, 2006. The balance sheet as of December 31, 2006 is derived fromaudited financial statements. The balance sheet as of September 30, 2007 aswell as the income statements and cash flow statements for the periodspresented are unaudited. Certain information and footnote disclosures which arenormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to SEC rules and regulations. Theinformation reflects all normal and recurring adjustments which, in the opinionof the Company’s management, are necessary for a fair presentation of thefinancial position of the Company and its results of operations for the interimperiods set forth herein. The results for the three and nine months endedSeptember 30, 2007 are not necessarily indicative of the results to be expectedfor the full year or any other period.

 

2. STOCK BASED COMPENSATION

 

During the three and ninemonth periods ended September 30, 2007, the Company granted options to purchase60,000 shares and 137,500 shares of common stock, respectively. During thethree and nine month periods ended September 30, 2006 the Company grantedoptions to purchase 610,000 and 7,399,999shares of common stock, respectively. Of these shares, 6,029,500options were granted to Wayne M. Bos upon his appointment as the Company’s CEOand President. This option award was approved by the stockholders of theCompany at its 2006 annual meeting of stockholders. The remaining options weregranted to other employees and directors. The options granted to Mr. Bos havecertain service and performance conditions which have been discussed in theCompany’s prior SEC filings. These options were fully vested upon grant, and werecognized a related expense of $0.3 million during the first quarter of2006.

 

The Company used a MonteCarlo method to simulate stock price paths over the term of the 6,029,500options awarded to Mr. Bos. All other options were valued using a Black-Scholesmodel. The Monte Carlo method, which is one acceptable valuation method perStatement of Financial Accounting Standard 123R, was used due to many factorswhich make utilizing a Black-Scholes model inappropriate for a block of optionsof this magnitude. These factors include but are not limited to the size of thegrant in relation to the total shares outstanding, the trading volume of theCompany’s stock and the holder’s ability to resell the shares, and the controlfactor, which 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.

 

All other stock options werevalued using a Black-Scholes model. Under SFAS 123R, the Company will continueto utilize the Black-Scholes model to estimate the fair market value related toemployee stock options granted, modified, cancelled or repurchased afterJanuary 1, 2006, unless such method is clearly inappropriate for a significantblock of stock options, such as were granted to Mr. Bos. The Company’sassessment of the estimated compensation charges for these other stock optionsis affected by its stock price as well as assumptions regarding a number ofcomplex and subjective variables and the related tax impact. These variablesinclude, but are not limited to, the Company’s stock price volatility andexpected employee stock option behavior. The Company recorded option expensesof $122,622 and $387,403 for the three and nine month periods ended September30, 2007 and $101,614 and $460,409 for the three and nine month periods endedSeptember 30, 2006, respectively.

 

Thefollowing summarizes the Company’s stock option activity for the nine monthsended September 30, 2007:

 

6

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| ** **                         | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **    | ** ** |
|------------------------------------|------------|------------|------------|--------------|------------|-----------------|------------|---------------|------------|
| ** **                         | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                         | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**     | ** ** |
| Number of option  shares:          |       |       |       |         |       |            |       |          |       |
| Outstanding at  January 1, 2007    |       | 8,618,256  |       | $            | 2.32       |            |       |          |       |   |
| Granted                            |       | 137,500    |       | 3.72         |       |            |       |          |       |
| Exercised                          |       | 127,817    |       | 1.28         |       |            |       |          |       |
| Canceled or  expired               |       | 69,000     |       | 2.15         |       |            |       |          |       |
| Outstanding at  September 30, 2007 |       | 8,558,939  |       | $            | 2.36       |            | 3.96       |          | $          | 0.0 |   |
| Exercisable at  September 30, 2007 |       | 7,671,023  |       | $            | 2.34       |            | 3.70       |          | $          | 0.0 |   |

 

The total fair value ofunvested options as of September 30, 2007 was $753,947. The aggregate intrinsicvalue of unvested options as of September 30, 2007 was $0.0.

 

The following summarizes thefair value of the Company’s unvested stock options that vested during the ninemonths ended September 30, 2007.

 
| ** **                      | ** ** | **Shares** | ** ** | **Weighted  Average  Fair Value** | ** ** |
|---------------------------------|------------|------------|------------|----------------------------------------|------------|
| Unvested at  January 1, 2007    |       | 1,231,574  |       | $                                      | 0.91       |   |
| Granted                         |       | 137,500    |       | 1.30                                   |       |
| Canceled or  expired            |       | 53,500     |       | 1.21                                   |       |
| Vested                          |       | 427,658    |       | 0.89                                   |       |
| Unvested at  September 30, 2007 |       | 887,916    |       | $                                      | 0.85       |   |

 

The Black-Scholesoption-pricing model is used by the Company to determine the weighted averagefair value of options, except for the options granted to Wayne Bos. The fair valueof options at date of grant and the assumptions utilized to determine suchvalues are indicated in the following table:

 
| ** **                                                                                              | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
|                                                                                                    |       |                                                |       |   |   |
| Weighted average  fair value at date of grant for options granted during the period using  Black-Sholes |       | $                                                   | 1.30       |   | $ | 0.89 |   |
| Risk-free  interest rates                                                                               |       | 4.47                                                | %          | 5.03 | % |
| Expected stock  price volatility                                                                        |       | 59.42                                               |       | 59.73 |   |
| Expected  dividend yield                                                                                |       | 0.0                                                 | %          | 0.0 | % |
|                                                                                                         |            |                                                     |            |  |  |  |  |

 

These assumptions resultedin a weighted-average fair value of $1.30 and $0.89 respectively, for eachstock option valued using the Black-Scholes method and granted in each of thenine month periods ended September 30, 2007 and 2006.

 

3. INVENTORY

 

Inventories consist of thefollowing:

 
| ** **                           | ** ** | **(In thousands)**      | ** ** |
|--------------------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
| Raw material and  packaging supplies |       | $                            | 9,765      |   | $ | 6,778 |   |
| Finished goods                       |       | 8,828                        |       | 5,010 |   |
| Total inventory                      |       | $                            | 18,593     |   | $ | 11,788 |   |

 

The value of inventory in the quarter was affected bya write down of the value of hoodia material of approximately $800,000.

 

7

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4. SHIPPING AND HANDLINGCOSTS

 

The Company records all amountscharged to customers for shipping and handling as revenue. All outboundshipping and fulfillment costs are classified as selling and marketing expensesand totaled approximately $0.8 and $2.4 million for the three and nine monthperiods ending September 30, 2007 and approximately $0.9 and $2.5 million inthe three and nine month periods ended September 30, 2006.

 

5. EARNINGS PER SHARE

 

The Company calculatesincome per share in accordance with Statement of Financial Accounting StandardNo. 128, *Earnings per Share*.Basic earnings per share have been computed by dividing net income by theweighted average number of common shares outstanding during the period. Dilutedearnings per share have been computed by dividing net income by the weightedaverage number of common shares and dilutive common stock equivalents (stockoptions), when dilutive.

 

As of the three and ninemonth periods ending September 30, 2007 and 2006, the following options wereoutstanding and considered anti-dilutive.

 
| ** **             | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **             | ** ** | **2007**                                                 | ** ** | **2006**                                                | ** ** | **2007** | ** ** | **2006** | ** ** |
| Options  outstanding   |       | 9,430,256                                                |       | 9,430,256                                               |       | 8,558,939 |   | 9,430,256 |   |
|                   |       |                                                     |       |                                                    |       |   |   |   |   |
| Anti-dilutive  options |       | 9,234,205                                                |       | 9,323,781                                               |       | 6,131,668 |   | 9,234,205 |   |

 

Forthe three months ended September 30, 2007, all outstanding options wereconsidered anti-dilutive because of the Company’s net loss for the period.

 

6. SENIOR CREDIT FACILITY

 

The Company is party to aloan and security agreement with Wachovia Capital Finance (Western), as agent,the lenders party thereto, Prolab Nutrition, the Company’s wholly ownedsubsidiary, and certain of its other subsidiaries, as guarantors. The loanagreement provides for a three-year secured revolving credit facility of up to$10.0 million. Borrowings under the credit facility may be used forongoing working capital purposes and certain future acquisitions. At September30, 2007, the Company had no borrowings outstanding under the credit facility.

 

Under the credit facility,the Company may borrow up to the lesser of $10.0 million or the borrowingbase (calculated based upon eligible inventory and eligible accounts). Theinterest rate on borrowings under the credit facility is equal to: (1) agent’spublicly announced prime rate for prime rate loans or (2) 2.25% plus theapplicable Eurodollar rate for any Eurodollar rate loans. Interest is payablemonthly in arrears not later than the first day of each calendar month. Theagent’s prime rate as of September 30, 2007 was 8.25%. The credit facilityrequires that all principal be repaid in August 2009. Additionally, borrowingsunder the credit facility must be repaid when the borrowings exceed theborrowing base.

 

The credit facility issecured by a first priority lien on all of the Company’s assets and properties(which includes the assets and properties of Prolab Nutrition, the guarantorsand the Company’s future subsidiaries), subject to certain exceptions. Theobligations under the credit facility are guaranteed by Natrol Products, Inc.,Natrol Acquisition Corp. and Natrol Direct, Inc. and by each of the Company’sfuture subsidiaries.

 

The credit facility containscovenants restricting the Company’s ability to, among other things: (1) incuror guarantee additional debt; (2) engage in any mergers or acquisitions(subject to certain exceptions); (3) engage 

 

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in any asset sales or disposeof any assets (other than in the ordinary course); (4) engage in transactionswith affiliates; (5) incur liens; (6) make any loans or investments; and (7)declare or pay dividends or redeem or repurchase capital stock.

 

The credit facility alsoprovides for customary events of default, including non-payment defaults,covenant defaults and cross-defaults to the Company’s other materialindebtedness.

 

As of September 30, 2007,the Company was in default under certain covenants in the credit facility relatedto investments in new businesses. The Company cannot borrow under the line ofcredit until Wachovia agrees to waive the event of default and forbear fromexercising its default rights. We expect the Company’s ability to borrowagainst the line of credit to be reinstated in the normal course of review.

 

7. RECENTLY ISSUEDACCOUNTING PRONOUNCEMENTS.

 

The Financial AccountingStandards Board (“FASB”) issued Interpretation No. 48, *Accounting for Uncertainty in Income Taxes*(“FIN 48”) in June 2006. The interpretation clarifies the accounting foruncertainty in income taxes recognized in financial statements in accordancewith Statement of Financial Accounting Standard 109. FIN 48 is effective forfiscal years beginning after December 15, 2006. We adopted the provisionsof FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-aninterpretation of FASB Statement No. 109 (“FIN 48”), on January 1, 2007. FIN 48clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with FASB Statement 109, “Accountingfor Income Taxes”, and prescribes a recognition threshold and measurementprocess for financial statement recognition and measurement of a tax positiontaken or expected to be taken in a tax return. FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition.

 

Based on our evaluation, wehave concluded that there are no significant uncertain tax positions requiringrecognition in our financial statements. Our evaluation was performed for thetax years ended December 31, 2003, 2004, 2005 and 2006, the tax years whichremain subject to examination by major tax jurisdictions as of September 30,2007.

 

We may from time to time beassessed interest or penalties by major tax jurisdictions, although any suchassessments historically have been minimal and immaterial to our financialresults. In the event we received an assessment for interest and/or penalties,it was classified in the financial statements as “selling, general andadministrative expense”.

 

**InFebruary 2007, the FASB issued Statement of Financial Standard No. 159, “****The Fair ValueOption for Financial Assets and Financial Liabilities Including an Amendment ofFASB Statement No. 115****” (“SFAS 159”). SFAS 159permits entities to choose to measure many financial instruments and certainother items at fair value, with unrealized gains and losses related to thesefinancial instruments reported in earnings at each subsequent reporting date. SFAS159 is effective for fiscal years beginning after November 15, 2007. Weare currently evaluating the impact this Statement will have on ourconsolidated financial statements.**

 

8.FINAL RULE FOR CURRENT GOOD MANUFACTURING PRACTICES FOR DIETARY SUPPLEMENTS

 

On June 22, 2007, the Foodand Drug Administration (“FDA”) issued its final regulations establishing theminimum Current Good Manufacturing Practices (“CGMPs”) necessary for activitiesrelated to manufacturing, packaging, labeling, or holding operations fordietary supplements. The final rule applies to all dietary supplements sold oroffered for sale in the United States and requires manufacturers to evaluatethe identity, purity, strength, and composition of their dietary supplements. AnInterim Final Rule has also been issued to allow manufacturers to petition theFDA for an exemption to the 100 percent identity testing requirement fordietary ingredients to be used in dietary supplements; provided that theydemonstrate that less than 100 percent identity testing does not materiallydiminish the assurance that the dietary ingredient is correctly identified. Thefinal CGMP and the interim final rule are effective August 24, 2007 and thecompliance date is June 2008, except 

 

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that businesses like theCompany that employ fewer than 500 but at least 20 or more full-time equivalentemployees have until June 2009 to comply with the regulation. We are currentlyevaluating the potential impact that the new regulations and any applicableexemptions may have on the Company’s financial position, results of operations,or cash flows.

 

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

* *

*On June 1, 2007, we acquired all of the outstanding stock ofMedical Research Institute, Inc. for $8.6 million of cash and up to anadditional $80.0 million in cash based upon the Earnings Before Interest andTaxes (EBIT), as defined, of MRI during the three years after the acquisitiondate. The Company allocated the purchase price per SFAS 141 to the fair valueof the assets acquired, net of liabilities assumed. Because the net assetsacquired were greater than the cash paid, the value of certain fixed assetswere adjusted per SFAS 141. These assets will be adjusted should any additionalpayments be made to the former owners of MRI.*

* *

*The only consideration used to acquire MRI was cash.*

* *

*The following table summarizes the allocations of theconsideration to the assets acquired net of liabilities assumed.*

* *
| ** **                       | ** ** | **(000)** | ** ** |
|----------------------------------|------------|-----------|------------|
| Cash and cash  equivalents       |       | $         | 5,105      |   |
| Accounts  Receivable             |       | 2,514     |       |
| Inventory                        |       | 4,068     |       |
| Other Current  assets            |       | 98        |       |
| Property, Plant  & Equipment |       | 114       |       |
| Patents                          |       | 258       |       |
| Total Assets  acquired           |       | 12,157    |       |
| Less Liabilities  assumed        |       | 3,531     |       |
| Total  Consideration             |       | $         | 8,626      |   |

 

*If theoperating results of MRI had been included since the beginning the nine monthperiod ended September 30, 2007 and 2006, the pro forma revenues, net incomeand net income per share would be as follows:*

* *
| ** **                                                  | ** ** | **Nine Months ended September 30,** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                  | ** ** | **2007**                                                | ** ** | **2006** | ** ** |
| Revenues                                                    |       | $                                                       | 66,300     |   | $ | 68,370 |   |
| Net income                                                  |       | 1,721                                                   |       | 2,846 |   |
| Net income per  share                                       |       |                                                    |       |   |   |
| Basic                                                       |       | $                                                       | 0.12       |   | $ | 0.21 |   |
| Diluted                                                     |       | $                                                       | 0.10       |   | $ | 0.20 |   |
| Weighted-average  shares outstanding—basic and diluted |       |                                                    |       |   |   |
| Basic                                                       |       | 14,171,714                                              |       | 13,573,108 |   |
| Diluted                                                     |       | 16,598,885                                              |       | 13,931,927 |   |

 

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*Our prime reason for acquiring MRI was MRI’s premiereposition in the sports nutrition marketplace, allowing us to strengthen ourposition within this area of the nutraceutical business.*

* *

*The balance sheet of MRI is consolidated with our balancesheet. The statement of income of MRI for the period from June 1, 2007 toSeptember 30, 2007 is consolidated with our statement of income for the threeand nine month periods ended September 30, 2007. The statement of cash flowsfor MRI for the period from June 1, 2007 to September 30, 2007 is included withour statement of cash flows for the nine months ended September 30, 2007.*

* *

*10. ACQUISITION COMMITMENTS*

* *

*Nu Hair and Shen Min Brands*

 

Consideration for the acquisition of the NuHair and Shen Min brandsincludes potential incentive payments based upon the net amount of invoicedsales of the NuHair and Shen Min products during fiscal 2007, 2008 and 2009. For2007, the Company is obligated to pay the seller of the brands $1.00 (onedollar) for every dollar of net invoiced sales in excess of $7.6 million,calculated on a quarterly basis. The potential incentive payment for 2007 maynot exceed $2.0 million. For 2008, the Company is obligated to pay the seller15% of the amount by which net invoiced sales exceed $11.4 million. For 2009,the Company is obligated to pay the Seller 15% of the amount by which netinvoiced sales exceed $13.7 million. As of September 30, 2007, we do notbelieve that the incentive payments to the former owners of the NuHair and ShenMin brands will be material as net invoiced sales for the nine months endedSeptember 30, 2007 amounted to slightly less than $5.8 million.

 

*Promensil and Trinovin*

 

Consideration for thelicense of the exclusive U.S. rights to the Promensil and Trinovin brandsincludes a royalty on net sales revenue that exceeds $2.0 million. Until 2014,the Company is obligated to pay Novogen a royalty equal to 5.0% of annual net salesbetween $2.0 to $3.0 million and a royalty equal to 7.5% of annual net sales inexcess of $3.0 million. After 2014, the Company is obligated to pay Seller aroyalty equal to 2% of annual net sales between $2.0 to $3.0 million and aroyalty equal to 3.0% of annual net sales in excess of $3.0 million. During thenine months ended September 30, 2007, net sales revenue of the Promensil andTrinovin brands amounted to $1.7 million and, as a result we do not believethat the incentive payments to the licensor will be material.

 

*MedicalResearch Institute*

 

Consideration for theacquisition of MRI, includes incentive payments that would allow the formerowners of MRI to earn an additional $80.0 million if the earnout conditions aremet.

 

*Yearone incentives.*

 

If earnings before interestand taxes prior to general corporate allocations for the twelve (12) monthperiod following the Closing Date (“Year One EBIT”) is between $2.5million and $4.0 million, the former owners of MRI will be paid an incentivepayment of between $4.7 million and $7.5 million. As of September 30, 2007 webelieve that it is highly likely that an incentive payment will be made andthat the amount will be at the mid to higher end of the range.

 

Also,if Year One EBIT reaches $5.0 million, additional incentives may be earned bythe former owners of MRI. These incentives begin at $5.0 million and couldexceed $21.5 million depending upon EBIT performance. As of September 30, 2007,it is uncertain as to whether the $5.0 EBIT level will be reached and, as suchit is uncertain as to whether an additional incentive payment will be made.

 

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*Yeartwo and three incentives.*

 

Yeartwo and year three incentive payments are described more fully in our otherfilings with the SEC. In order to earn incentives in year two, EBIT for yeartwo, as defined, must reach $6.5 million. In order to earn incentives in yearthree, EBIT for year three as defined must reach $14.0 million. Total incentivepayments for the three years in which incentives can be earned could total asmuch as $80.0 million if all incentive payment conditions are met.

 

11.SALE AND LEASEBACK TRANSACTION

 

In April 2007 the companysold its manufacturing and distribution facilities in Chatsworth, Californiafor $26 million, giving rise to a gain of approximately $12 million. Since thefacilities are leased back from the buyer, $5.5 million of the gain is deferredand recognized over the lease term, in accordance with SFAS No. 13 and 98. The$6.1 million balance of the gain in excess of the net present value of thelease payments, was recognized upon the sale. During the three months endedSeptember 30, 2007, we offset approximately $92,000 of the future leasebenefits against our lease expense, thereby lowering our lease expense.

 

**Item 2.    Management’s Discussion and Analysis of Financial Condition andResults of Operations**

 

**Forward Looking Statementsand Certain Risks**

** **

The statements contained inthis report that are not purely historical are “forward-looking statements”within the meaning of Section 21E of the Securities Exchange Act. Thesestatements are based on our expectations, hopes, beliefs, commitments,intentions, and strategies regarding the future. They may be identified by theuse of words or phrases, such as “believe”, “expect”, “anticipate”, “should”, “could”,“would”, “will”, “might”, “may”, “plan,” “estimate,” and “potential,” amongothers. Forward-looking statements include, but are not limited to, statementscontained in this Item 2 regarding our financial performance, revenue andexpense levels in the future, and the sufficiency of our existing assets tofund future operations and capital spending needs. Actual results could differmaterially from the anticipated results or other expectations expressed inthese forward-looking statements as a result of the risks, uncertainties andcontingencies discussed below and in our annual report on Form 10-K for theyear ended December 31, 2006. The fact that some of the risks,uncertainties and contingencies may be the same or similar to past reports wehave filed with the SEC means only that the risks are present in multipleperiods.

 

Our ability to predictresults or the effect of certain events on our future operating results isinherently uncertain. Forward-looking statements should not be unduly reliedon, since they involve known and unknown risks, uncertainties and otherfactors, which in many cases are beyond our control and cannot be predicted orquantified. Therefore, we wish to caution you to carefully consider thefollowing factors, which are not exhaustive, together with disclosures in otherreports and documents filed with the SEC by the Company from time to time andwhich may supplement, modify, supersede or update the factors listed in thisreport. The Company is subject to all of the business risks facing publiccompanies, including business cycles and trends in the general economy, marketconditions, potential loss of key personnel, government legislation andregulation and natural causes. Additional factors that could cause orcontribute to our actual results differing materially from those discussedherein include, but are not limited to:

 

•                  ourability to develop and execute our business plans;

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

•                  adversepublicity regarding our products and any similar products distributed byothers;

•                  ourability to manage the risks and costs associated with our acquisition strategy,including managing the integration of MRI;

•                  ourability to retain and attract talented management and key employees;

•                  sufficiencyof our insurance coverage or third party indemnification rights to cover lossesthat we incur;

•                  greaterthan expected product returns;

•                  ourfailure to adequately anticipate sales needs;

 

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•                  anyshortage in the supply of key raw materials;

•                  ourability to protect our intellectual property;

•                  ourexposure to product liability claims, as well as the limits of our selfinsurance program for products liability claims;

•                  oursales and earnings volatility;

•                  ourability to engage in many transactions prohibited by our senior creditfacility;

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

•                  increasedcompetition from existing competitors and new market entrants, including fromprivate label house brands; and

•                  theimpact of natural disasters on our manufacturing facility.

 

The forward-looking statementscontained in this report are made as of the date of this report, and we assumeno obligation to update or revise them to reflect changed assumptions, theoccurrence of unanticipated events or changes to future operating results overtime or to update the reasons why actual results could differ from thoseprojected in these forward-looking statements.

 

**OVERVIEW**

 

**General**

 

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

 

Themajority of our dietary supplements are sold under the Natrol brand, but we arecontinuing to acquire new brands that we expect will eventually contributesignificantly to our product mix sales. Our Natrol brand focuses on supplementsthat are in high demand as well as specialty niche and proprietary formulationsthat have potentially strong margins. These supplements include vitamins,minerals, hormonal supplements, herbal products and specialty combinationformulas that contribute to an individual’s physical and mental well-being. OnJune 1, 2007, we acquired Medical Research, Inc, (MRI) which develops andmarkets products under the MRI brand. Our MRI brand supplies high-qualitysports nutrition products including CE2®, NO2®, Pro-Nos(TM) and AnabolicSwitch(TM). These products are primarily designed to enhance the workoutperformance of athletes.

 

The key elements of our businessstrategy are to

 

•                  Controlour cost and improve margins;

 

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

 

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

 

•                  Improvethe marketing of our products.

 

**Management Overview**

 

Duringthe third quarter of 2007, we recorded a net loss of approximately $3.2 million.There are many reasons for the loss, but the most significant causes reflectspecific events that management considers uncommon in the ordinary course ofbusiness.

 

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In2006, we entered into an exclusive manufacturing and distribution arrangementwith H57 Nutrition for Original South African H57TM Hoodia (“H57”). During 2007,sales of H57 were far less than anticipated and we made the decision to limitfuture losses by immediately taking steps to reduce the Company’s exposure inconnection with the hoodia business. As a result, we expensed approximately$2.3 million during the quarter related to the promotional cost of reducinginventories at customer locations, anticipated future returns, impairmentcharges for raw material inventory with current value less than when purchased,and the write off of an advance payment to the owners of H57 Nutrition that wehave concluded is not collectible. These expenses reduced our gross marginapproximately $1.7 million or 7.0% and increased our general and administrativeexpenses by $620,000.

 

Duringthe third quarter we also increased our reserves by approximately $1.8 millionbecause one of our larger customers reduced our product set. The reductionnegatively affects revenue by approximately $2.0 million on an annualized basisor 2.5% of our business. The reserves are for anticipated returns andpromotional expenses we expect to incur in connection with the elimination ofinventory at the retailer. This expense reduced our gross margin in the thirdquarter by approximately 5.9%.

 

Asnoted in our past filings our customers generally do not have an absolute rightto return product, but, as a practical business matter, we often work withcustomers and accept returns as we try to obtain new placements for differentproducts that can replace revenue lost due to discontinuations. We regularlymonitor our historical patterns of returns from customers as well as currentand ongoing sales to customers and, when information is available, consumerpurchases of the Company’s products from our customers.

 

Inorder to reduce the amount of subjectivity when analyzing sales trends andreserving for future returns, we perform a detailed analyses of trends at eachof our major customers, i.e., those customers who have historically accountedfor the bulk of returns. This analyses takes into account sales patterns ofindividual products at each customer on a customer-by-customer basis as wellas: inventory levels at the customer, scheduled promotional events, and theprobability that items will be discontinued. And, we believe that this analysisprovides appropriate estimates of necessary future reserves. The Company’s useof the term returns includes estimates of its liability for damaged andoutdated product within its channels of trade.

 

Unfortunately,the reduction in the product set that occurred during the third quarter of2007, did not, in our estimation, follow patterns that have been wellestablished for many years. However, in following our policy of reserving forthe impact of negative financial events as soon as the impact is estimatable,we expensed the full impact of the item discontinuations in the third quarterof 2007.

 

Athird factor affecting the quarter was legal expenses. The Company settled itslast unresolved suit involving ephedrine-based products and incurred legalcosts in connection with that case, as well as in connection with a number ofbusiness transactions involving the Company during the third quarter. Combined,those events resulted in legal expenses of approximately $725,000. Our policyis to expense the cost of legal settlements as soon as they can be reasonablyestimated and attorney’s fees and costs as soon as incurred.

 

Despitethe Company’s poor overall performance, gross shipments in the quarterincreased 47.4% when compared to the third quarter of 2006, or $8.6 million. Approximately$6.5 million of the increase was due to the acquisition of MRI. Natrol’s grossshipments declined $1.4 million due to a decrease of $1.9 million in Ester-Csales, a product line we will be unable to sell after March 2008. Prolabshipments, including the sales of Prolab products by our subsidiary in theUnited Kingdom, increased approximately $1.3 million in the quarter. Thebalance of the growth in shipments was due to the NuHair, Shen Min, Promensiland Trinovin brands that were acquired in October of 2006.

 

Comparedto the third quarter of 2006, net sales revenue in the quarter grew 24.3%,versus the 47.4% increase in shipments, due to the expenses recorded for H57and the reduction in our vitamin set described above.

 

Asnoted, our gross margins were reduced approximately 10.9% due to theabove-described events. We expect our margins to return to historical norms infuture quarters.

 

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Overall,general and administrative expenses increased $2.3 million when compared to thethird quarter of 2006. Approximately $1.0 million of the increase was due tothe acquisition of MRI. Net of the $0.7 million extra legal cost outlined aboveand the $0.6 million charge for H57, general and administrative expenses wereapproximately the same during the third quarter of 2007 as in the third quarterof 2006, despite the addition of the NuHair, Shen Min, Promensil and Trinovinbrands.

 

Totalselling and marketing expense were $2.0 million greater in the third quarter of2007 than in the third quarter of 2006. Approximately $0.6 million was due tothe acquisition of MRI, $0.5 million was due to the acquisition of the NuHair,Shen Min and Promensil brands, $0.3 million was due to increased Prolabexpenditures in the UK and the United States, and the remainder was due toincreased advertising and coop spending on the Natrol brands.

 

Thelargest immediate challenges for our business include: continuing to managingthrough the loss of our Ester-C business; to replace the revenue lost from thereset of our shelf space noted above; to fully integrate MRI; and, to identifyproducts and product lines that would positively affect the business ifacquired or developed internally. We will continue to work to improve internalefficiencies and to strengthen our core business by following our businessplan.

 

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**Results of Operations**

 

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

 

NET SALES. Werecognize revenue from sales only after product is shipped. We have noconsignment sales. Net sales represent product shipped less actual andestimated future returns, spoilage allowances, allowances for product deemed tobe unsaleable by customers, free goods shipped to customers for promotional orother purposes, rebates, slotting fees and other promotional expenditures.Estimates and allowances are based upon known claims and an estimate ofadditional returns when the amount of future returns from customers can bereasonably estimated.

 

Net salesincreased 22.3%, or $3.5 million, to $19.2 million for the three months endedSeptember 30, 2007 from $15.7 million for the three months ended September 30,2006. Increased sales of $7.3 million from the acquired NuHair, Shen Min,Promensil and MRI brands and an increase in Prolab product sales ofapproximately $1.2 million were partially offset by a decline in the remainingNatrol segment business. Natrol’s net revenue was affected by returns in thequarter, accruals for promotional activity instituted to reduce the economicimpact of returns, as well as a decline of $1.9 million in Ester-C sales. Ester-Cis being discontinued because the supplier of Ester-C will no longer sell rawmaterial to us after March 2008. Returns were $2.3 million more in the thirdquarter of 2007 than in the third quarter of 2006. The primary reason is areduction of the number of items that will be carried by one of our customersin 2008. The items involved, accounted for approximately 2.5% of invoicedrevenue during the 12 months ended September 30, 2007. A second, but importantreason for the high returns were accruals for the eventual return of H-57hoodia.

 

GROSS PROFIT.Gross profit declined 9.0%, or $0.6 million, to $6.1 million for the threemonths ended September 30, 2007, from $6.7 million for the three months endedSeptember 30, 2006. Gross margin decreased to 31.5% for the three months endedSeptember 30, 2007, from 42.7% for the three months ended September 30,2006. The decrease was primarily due to the large difference in the quarterbetween gross revenue and net revenue caused by large accruals promotionalexpenditures and returns for the reasons noted in the overview section of thisdocument. Those accruals due to H57 hoodia reduced the gross margin 7.0% andaccruals due to the reduction of the number of items being carried from asignificant customer reduced the gross margin by 5.9%.

 

SELLING ANDMARKETING EXPENSES. Selling and marketing expenses consist primarily of advertisingand promotional expenses, costs of distribution, and related payroll expensesand commissions. Selling and marketing expenses increased 54.7%, or $2.1million, to $5.9 million for the three months ended September 30, 2007, from$3.8 million for the three months ended September 30, 2006. Selling andmarketing expenses increased approximately $1.2 million due to increasedstaffing and promotion required by our MRI, NuHair, Shen Min, and Promensilacquisitions and the establishment of a subsidiary in the United Kingdom. Theremainder of the increase was primarily due to additional cooperativeadvertising expenditures in the mass market channel of trade.

 

GENERAL ANDADMINISTRATIVE EXPENSES. General and administrative expenses consist primarilyof personnel costs related to general management functions, finance, accountingand information systems, as well as professional fees related to legal, auditand tax matters and depreciation. General and administrative expenses increased88.3%, or $2.3 million to $5.0 million for the three months ended September 30,2007 from $2.7 million for the three months ended September 30, 2006. Thesettlement of the last of the ephedrine based lawsuits against the Company andother transactional legal fees accounted for $0.7 million of the increase; thewrite down as a bad debt of an advance payment to the owners of the H-57 brandaccounted for $0.6 million of the increase; and, the acquisition of NuHair,Shen Min, Promensil, and MRI accounted for a $1.1 million increase in generaland administrative expenses. These increase were offset slightly bymiscellaneous other savings.

 

INTERESTEXPENSE. We recorded interest expense of $18,000 for the three months endedSeptember 30, 2007 as compared to interest expense of $149,000 for the threemonths ended September 30, 2006. The decrease was due to the low level of debtduring the quarter.

 

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INCOME TAXEXPENSE. Our effective tax rate was 35.2 % in the three months ended September 30,2007 and 45.2% in the three months ended September 30, 2006. The differencesare primarily due to the different levels of income and loss and the relativedifferences in deductible and non-deductible items relative to the overalllevel of income or loss.

 

## ***NINE MONTHS ENDED SEPTEMBER 30, 2007COMPARED TO SEPTEMBER 30, 2006***

##  

Net salesincreased 16.9%, or $8.3 million, to $57.5 million for the nine months endedSeptember 30, 2007 from $49.2 million for the nine months ended September 30,2006. Sales of $14.0 million from the acquired NuHair, Shen Min, Promensil andMRI brands and an increase in our Prolab business of $0.8 million, werepartially offset by a declines in other segments of our business. We sold $2.6 millionless Ester-C during the first three quarters of 2007 and in the first threequarters of 2006. During the same period, net sales from our EPI division hasfallen

 

GROSS PROFIT.Gross profit increased 16.1%, or $3.3 million, to $24.1 million for the ninemonths ended September 30, 2007 from $20.8 million for the nine months endedSeptember 30, 2006. Gross margin decreased to 42.0% for the nine months endedSeptember 30, 2007 from 42.3% for the nine months ended September 30,2006. Although the gross margin for the nine months ended September 30,2007 was essentially the same as for the nine months ended September 30, 2006,it is substantially lower than the gross margin for the six months ended June30, 2007 due to the events of the third quarter when return and promotionalexpenses increased the difference between gross sales and net revenue. Alsoaffecting our gross margin was the write down of our hoodia inventory whichcaused us to expense $1.1 million to cost of goods sold during the nine monthsended September 30, 2007.

 

SELLING ANDMARKETING EXPENSES. Selling and marketing expenses increased 37.4%, or $4.5million, to $16.5 million for the nine months ended September 30, 2007 from$12.0 million for the nine months ended September 30, 2006. Selling andmarketing expenses increased approximately $2.8 million due to our acquisitionsand the establishment of a subsidiary in the United Kingdom. Prolab marketingexpenditures increased $0.4 million and the balance of the increase was aresult of increased cooperative advertising for the Natrol brand.

 

GENERAL ANDADMINISTRATIVE EXPENSES. General and administrative expenses increased 32.8%,or $2.7 million to $11.0 million for the nine months ended September 30,2007 from $8.3 million for the nine months ended September 30, 2006. Legalexpenses during the third quarter accounted for $0.7 million of the increaseand expenses for H-57 including the bad debt of $0.6 million recorded in thethird quarter also accounted for $0.7 million. Our acquisitions and theestablishment of a subsidiary in the UK accounted for another $1.6 million ofadditional expenditures. These increases were offset by savings in other areas.

 

INTERESTEXPENSE. We recorded interest expense of $309,000 for the nine months endedSeptember 30, 2007 as compared to interest expense of $456,000 for the ninemonths ended September 30, 2006. The decrease was due to the reduction of ourdebt.

 

INCOME TAXEXPENSE. Our effective tax rate was 46.5% in the nine months ended September30, 2007 and 42.2% in the nine months ended September 30, 2006. The differencesare primarily due to the different levels of income and loss and the relativedifferences in deductible and non-deductible items relative to the overalllevel of income or loss.

 

SALE OFBUILDINGS. During the first nine months of 2006, we sold a building we owned inBloomfield, Connecticut that was formerly used as a shipping facility for ourProlab brand. The approximate net book value of the property, plant and plantimprovements that were sold was $759,000 and the gain, net of brokerage, legaland other related expenses was approximately $230,000.

 

In April2007, we sold our 94,000 square foot manufacturing, distribution and officefacility and our 132,000 square foot shipping facility both located inChatsworth, California. The sales price for the properties was $26.0 million. Afterpaying expenses associated with the transaction, taxes, and extinguishing themortgage debt on the 

 

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buildings, wenetted approximately $12.0 million in cash. We recorded a gain of approximately$6.1 million and a future lease benefit of $5.5 million, which will beamortized over 5 years.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

Asof September 30, 2007, we had working capital of $24.6 million as compared to$12.1 million in working capital at December 31, 2006. Our cash balance atSeptember 30, 2007 was approximately $5.9 million.

 

**Operating Activities**

 

Netcash used by operating activities was $6.8 million for the nine monthsended September 30, 2007 compared to net cash provided of approximately$2.4 million for the nine months ended September 30, 2006. Cash used byoperating activities during the nine months ended September 30, 2007 consistedof our profit of $1.3 million offset by non-cash charges of $4.7 million andby cash used because of changes in operating assets and liabilities of$3.4 million.

 

Duringthe nine months ended September 30, 2007, non-cash charges for depreciation andamortization had the effect of providing $0.9 million of cash, theexpensing of stock options provided $0.4 million of cash, and a small increasein the provision for bad debts and foreign currency translation had the effectof providing $0.1 million. The gain on the sale of our property of $6.1 millionhad the effect of using cash. This use was offset by the proceeds for the saleof the property of $26.0 million described under investing activities.

 

Cashused by operating assets and liabilities consisted primarily of an increase inaccounts payable of $2.5 million, an increase in accrued expenses of $2.3million, an increase in accrued payroll of $0.4 million, and a decrease inprepaid expenses of $1.1 million, each of which provided cash, offset by adecrease of $2.0 million in income taxes payable, an increase in accountsreceivable of $1.1 million and an increase in inventory of $6.8 million. Thelarge changes in accounts receivable, accounts payable and inventory wereprimarily due to the acquisition of MRI.

 

**Investing Activities**

 

Netcash provided by investing activities was $21.8 million for the ninemonths ended September 30, 2007 compared to net cash provided of$0.4 million during the nine months ended September 30, 2006. During thenine months ended September 30, 2007, we invested $0.2 million in new equipmentand realized $26.0 from the sale of property which was partially offset by anet cash outlay of $3.2 million for the acquisition of MRI. The acquisition ofother assets used $0.7 million of cash.

 

**Financing Activities**

 

Netcash used by financing activities was $10.2 million for the nine monthsended September 30, 2007 compared to cash used of $0.8 during the nine monthsended September 30, 2006. During the nine months ended September 30, 2007, werepaid $3.7 million of our line of credit and $6.7 million of our long-term debt.During the nine months ended September 30, 2007, we received $0.2 million fromthe exercise of stock options. All of our long and short-term debt wasextinguished during the nine months ended September 30, 2007 other than a smallautomobile loan acquired as part of the MRI transaction.

 

**Senior Credit Facility**

 

InAugust 2006, we entered into a loan and security agreement with WachoviaCapital Finance (Western), as agent, the lenders party thereto, ProlabNutrition, our wholly owned subsidiary, and certain of our other subsidiaries,as guarantors. The loan agreement provides for a three-year, secured, revolvingcredit facility of up to $10.0 million. Borrowings under the facility willbe used for ongoing outstanding working capital purposes and certain futureacquisitions. At September 30, 2007, we had no borrowings under the facility.

 

Underthe credit facility, we may borrow up to the lesser of $10.0 million orthe borrowing base 

 

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(calculatedbased upon eligible inventory and eligible accounts). The interest rate onborrowings under the credit facility is equal to: (1) agent’s publiclyannounced prime rate for prime rate loans or (2) 2.25% plus the applicableEurodollar rate for any Eurodollar rate loans. Interest is payable monthly inarrears not later than the first day of each calendar month.

 

Thecredit facility requires that all principal be repaid in full on the thirdanniversary of the closing date. Additionally, borrowings under the credit facilitymust be repaid when the borrowings exceed the borrowing base.

 

Thecredit facility is secured by a first priority lien on all our assets andproperties (which includes the assets and properties of Prolab Nutrition, theguarantors and our future subsidiaries), subject to certain exceptions. Theobligations under the credit facility are guaranteed by Natrol Products, Inc.,Natrol Acquisition Corp. and Natrol Direct, Inc. and by each of our futuresubsidiaries.

 

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

 

Thecredit facility also provides for customary events of default, includingnon-payment defaults, covenant defaults and cross-defaults to our othermaterial indebtedness.

 

As of September 30, 2007,the Company was in default under certain covenants in its credit facilityrelated to investments in new businesses and cannot borrow under the line ofcredit until Wachovia agrees to waive the event of default and forbear fromexercising its default rights. Wachovia is now reviewing the acquisition ofMedical Research Institute, Inc. on June 1, 2007, which triggered the event ofdefault. The Company expects its ability to borrow against the line of creditto be reinstated in the normal course of review.

 

Inorder to meet our long-term liquidity needs which include the potential paymentof certain incentives related to our acquisitions, 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 our 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 funds and raise capital should be sufficient to fundour anticipated working capital needs and planned capital expenditures for thenext 12 months. However, if we do not meet our operating plan, we may berequired to obtain additional borrowings to fund working capital needs.

 

**New Accounting Standards**

** **

The Financial AccountingStandards Board (“FASB”) issued Interpretation No. 48, *Accounting for Uncertainty in Income Taxes*(“FIN 48”) in June 2006. The interpretation clarifies the accounting foruncertainty in income taxes recognized in financial statements in accordancewith Statement of Financial Accounting Standard 109. FIN 48 is effective forfiscal years beginning after December 15, 2006. We adopted theprovisions of FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes-an interpretation of FASB Statement No. 109 (“FIN 48”), on January 1,2007. FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement 109, “Accounting for Income Taxes”, and prescribes a recognitionthreshold and measurement process for financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN 48 also provides guidance on derecognition, classification, interest andpenalties, accounting in interim periods, disclosure and transition.

 

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Based on our evaluation, wehave concluded that there are no significant uncertain tax positions requiringrecognition in our financial statements. Our evaluation was performed for thetax years ended December 31, 2003, 2004, 2005 and 2006, the tax years whichremain subject to examination by major tax jurisdictions as of September 30,2007.

 

We may from time to time beassessed interest or penalties by major tax jurisdictions, although any suchassessments historically have been minimal and immaterial to our financialresults. In the event we received an assessment for interest and/or penalties,it was classified in the financial statements as “selling, general andadministrative expense”.

 

**InFebruary 2007, the FASB issued Statement of Financial Standard No. 159, “****The Fair Value Optionfor Financial Assets and Financial Liabilities Including an Amendment of FASBStatement No. 115****” (“SFAS 159”). SFAS 159permits entities to choose to measure many financial instruments and certainother items at fair value, with unrealized gains and losses related to thesefinancial instruments reported in earnings at each subsequent reporting date. SFAS159 is effective for fiscal years beginning after November 15, 2007. Weare currently evaluating the impact this Statement will have on our consolidatedfinancial statements.**

 

**Critical Accounting Policies**

** **

Management’s beliefsregarding significant accounting policies have not changed significantly fromthose discussed in Item 7 of our annual report on Form 10-K for the yearended December 31, 2006.

 

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

** **

Our exposure to market risksis limited to interest rate risks. The risks related to foreign currencyexchange rates are immaterial and we do not use derivative financialinstruments.

 

We are subject to interestrate market risk associated with our bank debt. Even so, we do not believe therisk associated with such borrowing is significant. We currently have nolong-term debt other than for a small automobile loan and, as of September 30,2007, we had no borrowings under our line of credit. The line of credit iscollateralized by our general assets.

 

**Item 4.**                          Controls and Procedures

** **

*Evaluationof Disclosure Controls and Procedures.*We maintain disclosure controls andprocedures that are designed to ensure that information required to bedisclosed in our Exchange Act reports is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and formsand that such information is accumulated and communicated to our management,including our principal executive and principal financial officers, asappropriate, to allow for timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, we recognizethat any controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving the desired control objectives,and we are required to apply our judgment in evaluating the cost-benefitrelationship of possible controls and procedures.

 

As required byRules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, wecarried out an evaluation, under the supervision and with the participation ofour management, including our principal executive and principal financial officer,of the effectiveness of the design and operation of our disclosure controls andprocedures and internal controls over financial reporting as of the end of theperiod covered by this report. Based on the foregoing, our principal executiveand principal financial officer have concluded that, as of the period coveredby this report, our disclosure controls and procedures were effective.

 

*Changes inInternal Control Over Financial Reporting.*There were no changes in our internal controlover financial reporting that occurred during the last fiscal quarter that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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Attachedas exhibits to this Form 10-Q are certifications of the Company’s ChiefExecutive Officer and Chief Financial Officer, which are required in accordancewith Rule 13a-14 of the Securities Exchange Act of 1934. This “Controls andProcedures” section includes information concerning the controls and evaluationthereof referred to in the attached certifications, and it should be read inconjunction with the attached certifications for a more complete understandingof the topics presented.

 

**PART II-OTHER INFORMATION**

** **

**Item 1A.**                 Risk Factors

** **

Information concerningcertain risks and uncertainties appears in Part I, Item 1A “Risk Factors” ofour annual report on Form 10-K for the year ended December 31, 2006. You shouldcarefully consider these risks and uncertainties before making an investmentdecision with respect to shares of our common stock. Such risks anduncertainties could materially adversely affect our business, financialcondition or operating results.

 

During the three monthsended June 30, 2007, there has been no material change from the risk factorspreviously disclosed in our annual report on Form 10-K for the year endedDecember 31, 2006.

 

# **Item 5.    OtherInformation**

#  

Our2007 annual meeting of stockholders was delayed by more than 30 days from June8, 2007, the anniversary date of the 2006 annual meeting of stockholders andhas been scheduled to occur on December 3, 2007 as announced in the Form 8-Kfiled on September 17, 2007 and in the Notice of Annual Meeting and ProxyStatement sent to shareholders on or after November 2, 2007.

 

**Item 6.    Exhibits**

** **

(a)           Indexto Exhibits

 
| Exhibit No.  | ** ** | **Description**                                                                                                                                                            |
|--------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit 31.1 |       | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act  of 1934, as adopted by Section 302 of the Sarbanes-Oxley Act of 2002. |
| Exhibit 31.2 |       | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act  of 1934, as adopted by Section 302 of the Sarbanes-Oxley Act of 2002. |
| Exhibit 32.1 |       | Certification of Chief  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted by  Section 906 of the Sarbanes-Oxley Act of 2002.                           |
| Exhibit 32.2 |       | Certification of Chief  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted by  Section 906 of the Sarbanes-Oxley Act of 2002.                           |

 

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**SIGNATURE**

** **

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
| Date: November 14, 2007 | NATROL, INC. |
|-------------------------|--------------|
|                    |         |
|                    | By:          | /s/ Dennis R. Jolicoeur |
|                    |         | Dennis R. Jolicoeur |
|                    |         | Chief Financial  Officer, Treasurer and Executive  Vice President (Duly Authorized Officer and   Principal Financial and Accounting Officer) |

 

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