**SECURITIESAND EXCHANGE COMMISSION****WASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

 

**(Mark one)**

 
| **ý**                                                                                                                                                                                         | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                               |                                                                                           |
| **FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005**                                                                                                                                                  |
|                                                                                                                                                                                               |                                                                                           |
| **OR**                                                                                                                                                                                             |
|                                                                                                                                                                                               |                                                                                           |
| **o**                                                                                                                                                                                              | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                               |                                                                                           |
| **FOR THE TRANSITION PERIOD FROM               TO             ** |
| **COMMISSION FILE NO: 0-24567**                                                                                                                                                                    |

 

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

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

 

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

 

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

 

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

YES  ý   NO  o

 

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

 

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

 
| **Class**                     | ** ** | **May 9, 2005** |
|-------------------------------|------------|-----------------|
|                          |       |            |
| Common stock, $0.01 par value |       | 13,434,649      |

 

 

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PART1. FINANCIAL INFORMATION

ITEM1. CONSOLIDATED FINANCIAL STATEMENTS

**Natrol, Inc. andSubsidiaries**

**Consolidated Balance Sheets**

(Inthousands, except share and per share data)

 
| ** **                                                                                                           | ** ** | **March  31,**

**2005** | ** ** | **December  31,**

**2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                           | ** ** | **(Unaudited)**          | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                           |       |                     |       |                        |       |
| Current assets:                                                                                                      |       |                     |       |                        |       |
| Cash                                                                                                                 |       | $                        | 6,947      |                        | $          | 6,022 |   |
|                                                                                                                 |       |                     |       |                        |       |
| Accounts receivable, net of allowances of $404 and $421 at March 31,  2005 and December 31, 2004, respectively       |       | 7,705                    |       | 7,431                       |       |
| Inventory                                                                                                            |       | 9,009                    |       | 9,723                       |       |
| Income taxes receivable                                                                                              |       | 862                      |       | 956                         |       |
| Deferred income taxes                                                                                                |       | 814                      |       | 814                         |       |
| Prepaid expenses and other current assets                                                                            |       | 761                      |       | 793                         |       |
| Total current assets                                                                                                 |       | 26,098                   |       | 25,739                      |       |
| Property and equipment:                                                                                              |       |                     |       |                        |       |
| Land, building and improvements                                                                                      |       | 15,891                   |       | 15,891                      |       |
| Machinery and equipment                                                                                              |       | 5,460                    |       | 5,332                       |       |
| Furniture and office equipment                                                                                       |       | 3,114                    |       | 3,112                       |       |
|                                                                                                                 |       | 24,465                   |       | 24,335                      |       |
| Accumulated depreciation                                                                                             |       | (8,342                   | )          | (8,022                      | )          |
| Property and equipment, net                                                                                          |       | 16,123                   |       | 16,313                      |       |
|                                                                                                                 |       |                     |       |                        |       |
| Restricted cash                                                                                                      |       | 5,000                    |       | 5,000                       |       |
| Deferred income taxes                                                                                                |       | 3,628                    |       | 3,628                       |       |
| Goodwill, net of accumulated amortization and impairment charge of  $37,381                                          |       | 2,026                    |       | 2,026                       |       |
| Other assets                                                                                                         |       | 192                      |       | 218                         |       |
| Total assets                                                                                                         |       | $                        | 53,067     |                        | $          | 52,924 |   |
|                                                                                                                 |       |                     |       |                        |       |
| **Liabilities and stockholders’ equity**                                                                        |       |                     |       |                        |       |
| Current liabilities:                                                                                                 |       |                     |       |                        |       |
| Accounts payable                                                                                                     |       | $                        | 3,708      |                        | $          | 2,904 |   |
| Accrued expenses                                                                                                     |       | 2,917                    |       | 2,483                       |       |
| Accrued payroll and related liabilities                                                                              |       | 1,140                    |       | 1,589                       |       |
| Current portion of long-term debt                                                                                    |       | 510                      |       | 503                         |       |
| Total current liabilities                                                                                            |       | 8,275                    |       | 7,479                       |       |
| Long-term debt, less current portion                                                                                 |       | 7,566                    |       | 7,685                       |       |
| 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-14,310,715 and 14,281,928 at March 31,  2005 and December 31, 2004, respectively       |       | 143                      |       | 143                         |       |
| Additional paid-in capital                                                                                           |       | 62,766                   |       | 62,709                      |       |
| Accumulated deficit                                                                                                  |       | (22,802                  | )          | (22,211                     | )          |
|                                                                                                                 |       | 40,107                   |       | 40,641                      |       |
| Shares held in treasury, at cost-921,900 shares at March 31, 2005 and  December 31, 2004                             |       | (2,881                   | )          | (2,881                      | )          |
| Total stockholders’ equity                                                                                      |       | 37,226                   |       | 37,760                      |       |
| Total liabilities and stockholders’ equity                                                                      |       | $                        | 53,067     |                        | $          | 52,924 |   |

See accompanying notes

 

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**Natrol, Inc. andSubsidiaries**

**ConsolidatedStatements of Operations**

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

** **
| ** **                                 | ** ** | **Three  Months Ended March 31,** | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|
| ** **                                 | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| ** **                                 | ** ** | **(Unaudited)**                   | ** ** |
| Net sales                                  |       | $                                 | 17,669     |   | $ | 20,425 |   |
| Cost of goods sold                         |       | 11,404                            |       | 12,595 |   |
| Gross profit                               |       | 6,265                             |       | 7,830 |   |
| Selling and marketing expenses             |       | 4,185                             |       | 4,619 |   |
| General and administrative expenses        |       | 2,917                             |       | 2,325 |   |
| Total operating expenses                   |       | 7,102                             |       | 6,944 |   |
| Operating income (loss)                    |       | (837                              | )     | 886 |   |
| Interest income                            |       | 42                                |       | 22 |   |
| Interest expense                           |       | (160                              | )          | (158 | ) |
| Income (loss) before income taxes          |       | (955                              | )     | 750 |   |
| Income tax (benefit) provision             |       | (363                              | )          | 300 |   |
| Net Income (loss)                          |       | $                                 | (592       | )  | $ | 450 |   |
| Basic and Diluted income (loss) per share: |       |                              |       |   |   |
| Income (loss) per share                    |       | $                                 | (0.04      | )  | $ | 0.03 |   |
|                                       |       |                              |       |   |   |
| Weighted-average shares outstanding:       |       |                              |       |   |   |
| Basic                                      |       | 13,384,419                        |       | 13,162,459 |   |
| Diluted                                    |       | 13,384,419                        |       | 14,175,061 |   |

 

See accompanying notes

 

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# **Natrol, Inc.and Subsidiaries**

**Consolidated Statements of Cash Flows**

(Inthousands)

* *
| ** **                                                                                | ** ** | **Three  Months Ended   March 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| ** **                                                                                | ** ** | **(Unaudited  )**                   | ** ** |
| **Operating activities**                                                                  |       |                                |       |   |   |
| Net Income (loss)                                                                         |       | $                                   | (592       | )  | $ | 450 |   |
|                                                                                      |       |                                |       |   |   |
| Adjustments to reconcile net income (loss) to net cash provided by  operating activities: |       |                                |       |   |   |
| Change in net assets of discontinued operations                                           |       | —                              |       | (51 | ) |
| Depreciation and amortization                                                             |       | 319                                 |       | 319 |   |
| Loss on disposal of property and equipment                                                |       | —                              |       | 2 |   |
| Provision for bad debts                                                                   |       | 17                                  |       | 48 |   |
| Changes in operating assets and liabilities:                                              |       |                                |       |   |   |
| Accounts receivable                                                                       |       | (291                                | )          | (1,513 | ) |
| Inventory                                                                                 |       | 714                                 |       | (1,481 | )  |
| Income taxes receivable/payable                                                           |       | 94                                  |       | 288 |   |
| Prepaid expenses and other current assets                                                 |       | 32                                  |       | (64 | )  |
| Accounts payable                                                                          |       | 804                                 |       | 2,462 |   |
| Accrued expenses                                                                          |       | 434                                 |       | 62 |   |
| Accrued payroll and related liabilities                                                   |       | (449                                | )     | 397 |   |
| Net cash provided by operating activities                                                 |       | 1,082                               |       | 919 |   |
|                                                                                      |       |                                |       |   |   |
| **Investing activities**                                                                  |       |                                |       |   |   |
| Purchases of property and equipment                                                       |       | (130                                | )          | (79 | ) |
| Reduction in goodwill                                                                     |       | —                              |       | 2,000 |   |
| Other assets                                                                              |       | 28                                  |       | (36 | )  |
| Net cash provided by (used in) investing activities                                       |       | (102                                | )     | 1,885 |   |
|                                                                                      |       |                                |       |   |   |
| **Financing activities**                                                                  |       |                                |       |   |   |
| Repayments on long-term debt                                                              |       | (112                                | )          | (80 | ) |
| Proceeds from issuance of common stock                                                    |       | 57                                  |       | 109 |   |
| Net cash (used in) provided by financing activities                                       |       | (55                                 | )     | 29 |   |
| Net increase in cash and cash equivalents                                                 |       | 925                                 |       | 2,833 |   |
| Cash and cash equivalents, beginning of period                                            |       | 6,022                               |       | 2,599 |   |
| Cash and cash equivalents, end of period                                                  |       | $                                   | 6,947      |   | $ | 5,432 |   |

 

See accompanying notes

 

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

 

1.BASIS OF PRESENTATION

 

Theaccompanying consolidated financial statements have been prepared by theCompany, pursuant to the rules and regulations of the Securities and ExchangeCommission (SEC).  This Report on Form 10-Q should be read in conjunctionwith the Company’s annual report on Form 10-K for the year ended December 31,2004.  Certain information and footnote disclosures which are normallyincluded in financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America have beencondensed or omitted pursuant to SEC rules and regulations.  Theinformation reflects all normal and recurring adjustments which, in the opinionof the Company’s management, are necessary for a fair presentation of thefinancial position of the Company and its results of operations for the interimperiods set forth herein.  The results for the three months ended March31, 2005 are not necessarily indicative of the results to be expected for thefull year or any other period.

 

2.               STOCK BASEDCOMPENSATION

 

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

 
| ** **                                                                                                                                                                   | ** ** | **3 Months  Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                                                   | ** ** | **2005**                       | ** ** | **2004** | ** ** |
|                                                                                                                                                                         |       |                           |       |   |   |
| Net Income (loss)                                                                                                                                                            |       | $                              | (592       | )  | $ | 450 |   |
| Total  stock-based employee compensation expense determined under the fair  value-based method for all awards, net of related tax benefits (“Stock  Compensation”) |       | (26                            | )          | (27 | ) |
| Net Income (loss)—pro forma                                                                                                                                             |       | (618                           | )     | 423 |   |
| Income (loss) per share:                                                                                                                                                     |       |                           |       |   |   |
| Basic—as reported                                                                                                                                                       |       | $                              | (0.04      | )  | $ | 0.03 |   |
| Diluted—as reported                                                                                                                                                     |       | $                              | (0.04      | )  | $ | 0.03 |   |
| Basic—pro forma                                                                                                                                                         |       | $                              | (0.05      | )  | $ | 0.03 |   |
| Diluted—pro forma                                                                                                                                                       |       | $                              | (0.05      | )  | $ | 0.03 |   |

 

Duringthe three months ended March 31, 2005, 50,000 stock options were granted toemployees with an average exercise price of $3.02 which equaled the fair marketvalue of the underlying common stock on the dates of grant.

 

The fair value of the options is estimated using a Black-Scholesoption-pricing model with the following weighted-averageassumptions for grants:

 

| ** **                       | ** ** | **Quarter  Ended March 31,** | ** ** |
|----------------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **2005**                     | ** ** | **2004** | ** ** |
|                             |       |                         |       |   |   |
| Expected dividend yield          |       | 0.0                          | %          | 0.0 | % |
| Expected stock price  volatility |       | 63.62                        |       | 68.31 |   |
| Risk free interest rate          |       | 3.72                         | %          | 2.81 | % |
| Expected life of options         |       | 5 years                      |       | 5 years |   |

 

These assumptions resulted in weighted-average fairvalues of $1.71, and $0.67 for each stock option granted in the quarters endedMarch 31, 2005 and 2004 respectively.

 

3.   INVENTORY

 

Inventoriesconsist of the following:

 
| ** **                          | ** ** | **March  31,  2005** | ** ** | **December  31,  2004** | ** ** |
|-------------------------------------|------------|----------------------|------------|-------------------------|------------|
|                                |       |                 |       |                    |       |
| Raw material and packaging supplies |       | $                    | 4,970      |                    | $          | 5,357 |   |
| Finished goods                      |       | 4,039                |       | 4,366                   |       |
| Total Inventory                     |       | $                    | 9,009      |                    | $          | 9,723 |   |

 

4.SHIPPING AND HANDLING COSTS

 

TheCompany records all amounts charged to customers for shipping and handling asrevenue. All outbound shipping and 

 

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fulfillment costs are classified as selling andmarketing expenses and totaled $811,000 and $858,000 for three months endedMarch 31, 2005 and 2004 respectively.

 

5.EARNINGS PER SHARE

 

The Company calculatesincome (loss) per share in accordance with SFAS No. 128, *Earnings per Share*. Basic earningsper share have been computed by dividing net income (loss) by the weightedaverage number of common shares outstanding during the period. Diluted earningsper share have been computed by dividing net income (loss) by the weightedaverage number of common shares and dilutive common stock equivalents (stockoptions), when dilutive.

 

Stock options to purchase 2,461,281 and 2,649,454shares of common stock in the quarters ended March 31, 2005 and 2004,respectively, were outstanding and of these shares, 530,000, and 542,500 wererespectively considered anti-dilutive.

 

6. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

 

                InNovember 2004, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards (“SFAS”) No. 151, “InventoryCosts” an amendment of Accounting Research Bulletin (“ARB”) No. 43, toclarify the accounting for abnormal amounts of idle facility expense, freight,handling costs, and wasted material (spoilage). This SFAS requires that thoseitems be recognized as current-period charges regardless of whether they meetthe criterion of “so abnormal”. In addition, this SFAS requires that allocationof fixed production overheads to the costs of conversion be based on the normalcapacity of the production facilities. Companies are required to adopt theprovisions of this Statement for fiscal years beginning after June 15,2005. The Company does not believe there will be a material effect on itsconsolidated financial position or results of operations from the adoption ofthis standard.

 

In December2004, the FASB issued SFAS No.153, “Exchanges of Nonmonetary Assets, anamendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.” Theamendments made by Statement 153 are based on the principle that exchanges ofnonmonetary assets should be measured based on the fair value of the assetsexchanged. Further, the amendments eliminate the narrow exception fornonmonetary exchanges of similar productive assets and replace it with abroader exception for exchanges of nonmonetary assets that do not havecommercial substance. Previously, Opinion 29 required that the accounting foran exchange of a productive asset for a similar productive asset or anequivalent interest in the same or similar productive asset should be based onthe recorded amount of the asset relinquished. Opinion 29 provided an exceptionto its basic measurement principle (fair value) for exchanges of similarproductive assets. The Board believes that exception required that somenonmonetary exchanges, although commercially substantive, be recorded on acarryover basis. By focusing the exception on exchanges that lack commercialsubstance, the Board believes that SFAS 153 produces financial reporting thatmore faithfully represents the economics of the transactions. SFAS 153 iseffective for nonmonetary asset exchanges occurring in fiscal periods beginningafter June 15, 2005. Earlier application is permitted for nonmonetary assetexchanges occurring in fiscal periods beginning after the date of issuance. Theprovisions of this Statement shall be applied prospectively. The Company hasevaluated the impact of the adoption of SFAS 153, and does not believe theimpact will be significant to the Company’s overall results of operations orfinancial position.

In December 2004, the FASB issued SFAS No.123 “Share-BasedPayment”. SFAS 123(R) will provide investors and other users of financialstatements with more complete and neutral financial information by requiringthat the compensation cost relating to share-based payment transactions berecognized in financial statements. That cost will be measured based on thefair value of the equity or liability instruments issued. SFAS 123(R) covers awide range of share-based compensation arrangements including share options,restricted share plans, performance-based awards, share appreciation rights,and employee share purchase plans. SFAS 123(R) replaces FASB Statement No. 123,Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25,Accounting for Stock Issued to Employees. Statement 123, as originally issuedin 1995, established as preferable a fair-value-based method of accounting forshare-based payment transactions with employees. However, that Statementpermitted entities the option of continuing to apply the guidance in Opinion25, as long as the footnotes to financial statements disclosed what net incomewould have been had the preferable fair-value-based method been used. Publicentities (other than those filing as small business issuers) will be requiredto apply Statement 123(R) as of the first interim or annual reporting periodthat begins after June 15, 2005. The Company has evaluated the impact of theadoption of SFAS 123(R), and does not believe the impact will be significant tothe Company’s overall results of operations or financial position.

 

InJuly 2004, the Emerging Issues Task Forces (“EITF”) published its consensus onIssue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments.” EITF Issue No. 03-1 addresses the meaningof other-than-temporary impairment and its application to debt and equitysecurities within the scope of Statement of Financial Accounting Standards(“SFAS”) No. 115, certain debt and equity securities within the scope of SFASNo. 124, and equity securities that are not subject to the scope of SFAS No.115 and not accounted for under the equity method of accounting. In September2004, the Financial Accounting Standard Board (“FASB”) issued FASB StaffPosition (“FSP”) Emerging Issues Task Force (EITF) Issue 03-1-b, Effective Dateof Paragraphs 10-20 of EITF Issue No. 03-1, which delays the effective date forthe recognition and measurement guidance in EITF Issue No. 03-1. In addition,the FASB has issued a proposed FSP to consider whether further applicationguidance is necessary for securities analyzed for impairment under EITF IssueNo. 03-1-a. Adoption of this standard did not have an impact on the Company’sconsolidated financial statements.

 

In December 2004 theFinancial Accounting Standards Board issued two FASB Staff Positions—FSP FAS109-1, Application of FASB Statement 109 “Accounting for Income Taxes” to theTax Deduction on Qualified Production Activities Provided by the American JobsCreation Act of 2004, and FSP FAS 109-2 Accounting and Disclosure Guidance forthe Foreign Earnings Repatriation Provision within the American Jobs CreationAct of 2004. Neither of these affected the Company as it does not participatein the related activities.

 

7. LITIGATION SETTLEMENT

 

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

 

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reduction ofgoodwill.

 

During May 2005, the Company settled litigation relative to Andro-based  products lastsold by Prolab in August 2002.  Thisresulted in a $265,000 expense and the accrual of a corresponding liabilityduring the quarter ending March 31, 2005.

 

**ITEM 2****: MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

                This report contains “forward looking statements.”Natrol, Inc., a Delaware corporation organized in 1980, the “Company” or “Natrol”,is including this statement for the express purpose of availing itself ofprotections of the safe harbor provided by the Private Securities LitigationReform Act of 1995 with respect to all such forward looking statements.Examples of forward looking statements include, but are not limited to, the useof forward-looking terminology such as “believes,” “expects,” “may,” “will,”“should,” “intend,” “estimate,” “assume,” “plan,” or “anticipates” or thenegative thereof, other variations thereon, or comparable terminology, or bydiscussions of strategy that predict or indicate future events or trends orthat are not historical facts. The Company cannot assure the future results oroutcome of the matters described in these statements; rather, these statementsmerely reflect its current expectations of the approximate outcome of thematter discussed. The Company does not undertake any obligation and does notcurrently intend to update any such statements at any time in the future.

 

                The Company’s ability to predict results or theeffect of certain events on the Company’s operating results is inherentlyuncertain. Forward-looking statements should not be unduly relied onsince they involve known and unknown risks, uncertainties and other factors, someof which are beyond the Company’s control. These risks, uncertainties and otherfactors may cause actual results, performance or achievements to differmaterially from the anticipated future results, performance or achievementsexpressed or implied by such forward-looking statements. Therefore, theCompany wishes to caution each reader of this report to carefully consider thefollowing factors and factors discussed in other past reports. The factorsdiscussed herein may not be exhaustive. Therefore, the factors contained hereinshould be read together with other reports and documents that are filed by theCompany with the SEC from time to time, which may supplement, modify, supersedeor update the factors listed in this document.

 

                Factors that could cause or contribute to the Company’sactual results differing materially from those discussed herein or for theCompany’s stock price to be affected adversely include, but are not limited to:(i) industry trends, including a general downturn or slowing of the growthof the dietary supplement industry; (ii) increased competition fromcurrent competitors and new market entrants including but not limited toincreased competition from private label house brands supported by retailersseeking to increase the market share of their proprietary house brands. Privatelabel brands control the largest share of the vitamin, mineral and supplement(VMS) sector; (iii) adverse publicity regarding the dietary supplementindustry or the Company’s products; (iv) exposure to product liabilityclaims, in particular because the Company has chosen to self-insure againstproduct liability claims due to the high price of product liability insurance,the inability to secure occurrence based coverage, as well as the limitedamount of coverage provided by insurers willing to provide insurance at highprices; (v) exposure to and the expense of defending and resolvingpotential product liability claims that are left uncovered by insurance as wellas the expense of defending and resolving other litigation which may or may notbe covered by insurance; (vi) the Company’s dependence upon its ability todevelop new products; (vii)  returns of the Company’s products which maybe returned by customers at any time due to lack of sell through to consumersor because competitors have convinced the Company’s customers that Natrol’sproducts should be replaced with competitor products; (viii) the Company’sability to manage inventory or sell its inventory before such inventory becomesoutdated, (ix) the Company’s ability to gain or expand or maintaindistribution within new or existing customers and new or existing channels oftrade; (x) an increase in the cost of obtaining and maintaining shelfspace with major national retailers who demand various forms of incentives fromtheir suppliers such as slotting fees, coop advertising, or rebates;(xi) adverse changes in government regulation or changes in local ornational laws; (xii) dependence on significant customers; (xiii) theCompany’s ability to keep and attract key management employees; (xiv) theCompany’s inability to manage growth and execute its business plan, or theCompany’s ability to modify its business plan in response to market conditions,including, but not limited to, its ability to enter into new businesses andcapitalize upon new business opportunities or to divest itself of businessesthat are not profitable or do not deliver sufficient profit to meet thatCompany’s goals; (xv) the Company’s ability to consummate futureacquisitions and its ability to integrate acquired businesses; (xvi) theabsence of conclusive clinical studies for many of the Company’s products;(xvii) the Company’s inability to obtain raw materials that are in shortsupply (xviii) sales and earnings volatility, (xix) volatility of thestock market; (xx) the Company’s ability to manufacture its productsefficiently; (xxi) the Company’s reliance on independent 

 

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brokers to sell itsproducts; (xxii) the inability of the Company to protect its intellectualproperty; (xxiii) control of the Company by principal shareholders,(xxiv) the possible sale of large amounts of stock by controllingstockholders; (xxv) a general downturn in the national economy as a whole;(xxvi) continued market acceptance of Natrol supplements, Laci Le Beauteas, Prolab’s sports nutrition products, and EPI’s raw material products,(xxvii) increases in the cost of borrowings; (xxviii)  theunavailability of additional debt or equity capital; (xix) legal actionsbrought forth by federal, state and local governmental and private parties; and(xxx) the introduction of new federal, state, local or foreign legislation orregulation or adverse determinations by regulators anywhere in the world(including the banning of products).

 

**OVERVIEW**

TheCompany’s business plan has been to focus on its core Natrol, Prolab sportsnutrition and Laci Le Beau tea brands. The Natrol and Laci Le Beau brands are sold in health food stores, inmass-market drug, food and retail chains as well as club stores.   Prolab products are sold throughdistributors who in turn service retail accounts.  Prolab’s distributor network focuses onhealth food stores, health clubs and fitness facilities that cater to bodybuilders and other individuals seeking a high level of fitness.   Historically, more than 40% of Prolab sales are to distributors who sell Prolab productsoutside the United States.  The Companyis continually seeking to expand the distribution of its best selling items toadditional retail outlets and to create promotional opportunities for itsproducts within its existing customer base.

TheCompany provides contract manufacturing services to other supplement companies.However, contract manufacturing is not a prime focus of the Company.

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

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

Productintroductions do not come without risk. Product launches can require substantial marketing support. Oftentimesretailers demand slotting fees or other up front expenditures. If a productlaunch is not as successful as anticipated, additional promotional expendituresmay be needed to sustain sales and reduce possible returns.  Most vendors retain certain rights as theyrelate to product returns. A broad product launch, one in which a new productis introduced into thousands of retail outlets, can cause a strain on corporateresources since inventories must be produced and delivered.  The resulting sales increase also leads to anincrease in accounts receivable with customers.

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

 

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

Futurechallenges include the development of new, innovative products and deliverysystems that will capture the support of consumers and recapture the growthexperienced in 2004.

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

 

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**RESULTS OF OPERATIONS**

 

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

 

**THREE MONTHS ENDED MARCH 31, 2005 AND MARCH 31, 2004**

 

NET SALES. The Company recognizesrevenue from sales only after product is shipped and title is transferred. Netsales represent product shipped less actual and estimated future returns,spoilage allowances, allowances for product deemed to be unsaleable bycustomers, free goods shipped to customers for promotional or other purposesand slotting fees. Estimates and allowances are based upon known claims and anestimate of additional returns when the amount of future returns from customerscan be reasonably estimated.

Net sales decreased 13.5%, or $2.7 million,to $17.7 million for the three months ended March 31, 2005 from $20.4 millionfor the three months ended March 31, 2004. One product within the Natrol brand, a weight loss product, declinedapproximately $2.0 million during the first quarter of 2005 when compared withthe first quarter of 2004 due to the falling out-of-favor of low-carb dietswith consumers.  The Company has alsobeen more selective in its contract manufacturing business, eliminating theproduction of low margin items.  As aresult, revenue from contract manufacturing declined approximately$500,000.  Sales of the Prolab brand declined $1.1 million when compared to thefirst quarter of 2004.  These declineswere partially offset by growth of the Natrol brand’s other products.

 

GROSSPROFIT.  Gross profitdecreased 20.0%, or $1.6 million, to $6.3 million for the three months endedMarch 31, 2005 from $7.8 million for the three months ended March 31, 2004.Gross margin decreased to 35.5% for the three months ended March 31, 2005 from38.3% for the three months ended March 31, 2004.  The decrease in gross margin was primarilydue to a shift in product mix as well as some increased cost in the price ofraw materials.  The weight loss productthat declined by $2 million during the first quarter had a substantially highermargin in 2004 than the average Natrol product. In order to maintain sales in 2005,  the Company reduced the price of theproduct which in addition to reduced sales, reduced the margin on remaining sales.  The price of whey, a raw material componentcontained in a majority of Prolab products, werehigher in 2005 than in 2004.  And CoQ 10,which accounts for a little more than 5% of the Company’s business, alsoexperienced sharp price increases as well as short supply.

 

SELLINGAND MARKETING EXPENSES.  Selling and marketing expenses consistprimarily of advertising and promotional expenses, cost of distribution, andrelated payroll expenses and commissions. Selling and marketing expensesdecreased 9.4%, or $0.4 million, to $4.2 million for the three months endedMarch 31, 2005 from $4.6 million for the three months ended March 31, 2004. Thedecrease was due to lower payroll and shipping expenses in first quarter 2005than in first quarter of 2004 which were partially offset by increases inpromotional support.

 

GENERALAND ADMINISTRATIVE EXPENSES.  General and administrative expenses consistprimarily of personnel costs related to general management functions, finance,accounting and information systems, as well as professional fees related tolegal, audit and tax matters and depreciation. General and administrativeexpenses increased 25.5%, or $592,000 to $2.9 million for the three monthsended March 31, 2005 from $2.3 million for the three months ended March 31,2004. Legal expenditures were approximately $554,000 more in the first quarter2005 than in the first quarter 2004. The increase was due to the timing oflitigation and a $265,000 accrual related to a legal settlement relative toAndro-based  productslast sold by Prolab in August 2002.

 

INTEREST EXPENSE.  The Company recorded interest expense of$160,000 for the three months ended March 31, 2005 as compared to interestexpense of $158,000 for the three months ended March 31, 2004.

 

INCOMETAX PROVISION. For the three months ended March 31, 2005 theCompany’s effective tax rate was approximately 38.0%.  For the three months ended March 31, 2004 theCompany’s effective tax rate was 40.0%.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

Asof March 31, 2005, the Company had working capital of $17.8 million as comparedto $18.3 million in working capital at December 31, 2004. The Company’scash balance at March 31, 2005 was approximately $6.9 million.

 

Netcash provided by operating activities was $1.1 million for the three monthsended March 31, 2005 versus net cash 

 

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provided ofapproximately $0.9 million for the three months ended March 31, 2004. Cashprovided by operating activities during the three months ended March 31, 2005consisted primarily of cash provided by non-cash charges of $0.3 million andcash provided by changes in operating assets and liabilities of $1.3 millionoffset by the Company’s loss of $.6 million. The increases in cash provided byoperating assets and liabilities consisted primarily of a decrease in inventoryof $0.7 million, a reduction in income taxes receivable of $0.1 million and anet increase in accounts payable and other accrued expenses of $1.2 millionoffset by a reduction of $0.4 million in accrued payroll and an increase inaccounts receivable of $0.3 million.  Thedecrease in accrued payroll was due to timing and the payout of approximately$.6 million bonus incentive compensation accrued as an expense in 2004 but paidin the first quarter of 2005.

 

Netcash used by investing activities was $0.1 million for the three months endedMarch 31, 2005 versus net cash provided of $1.9 million during the three monthsended March 31, 2004.  During the firstquarter of 2005, investment activities consisted primarily of the acquisitionof equipment.  During the first quarterof 2004, the settlement of the litigation with the former owners of ProlabNutrition, Inc., which was recorded as a reduction of goodwill, provided $2.0million of cash which was offset by investment in equipment.

 

Netcash used by financing activities was $55,000 for the three months ended March31, 2005 as opposed to cash provided of $29,000 during the three months endedMarch 31, 2004. During the three months ended March 31, 2004, the Company madeprincipal payments of $80,000 on its long-term debt and received $109,000 fromthe exercise of stock options and the purchase of stock through the Company’sEmployee Stock Purchase Plan.

 

Asof March 31, 2005, the Company had $8.1 million of outstanding debt.  The company has a $3.0 million line of creditin place which, as of the end of the quarter, was unused.

 

TheCompany believes that its cash balance together with cash generated fromoperations and its line of credit should be sufficient to fund its anticipatedworking capital needs and planned capital expenditures for the nexttwelve months. However, if the Company fails to meet certain covenantsrelated to its line of credit, the line of credit may not be available to fundthe Company’s future needs.

 

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

 

## **CRITICAL ACCOUNTING POLICIES**

## ** **

Management’s beliefs regarding significant accounting policies have notchanged significantly from those discussed in Item 7 of the Company’s AnnualReport on Form 10-K for the year ended December 31, 2004.

 

CONTRACTUAL OBLIGATIONS

 

Contractual obligations have not changed significantly from thosediscussed in Item 7 of the Company’s Annual Report on Form 10-K for the yearended December 31, 2004.

 

## **ITEM3**. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

There has been no material change during thethree months ended March 31, 2005 from the disclosures about market riskprovided in Item 7a of the Company’s Annual Report on Form 10-K for the yearended December 31, 2004.

 

**ITEM 4****.****CONTROLS**

 

## **Anevaluation was conducted under the supervision and with the participation ofthe Company’s management, including the Chief Executive Officer and ChiefFinancial Officer, of the effectiveness of the Company’s disclosure controlsand procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934) as of March 31, 2005.  Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer have concluded that the Company’sdisclosure controls and procedures are, to the best of their knowledge,effective to ensure that information**

## ** **

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## **requiredto be disclosed by the Company in reports that it files or submits under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in Securities and Exchange Commission rules and forms. Therewere no significant changes in the Company’s internal control over financialreporting that occurred during the fiscal quarter covered by this report thathave materially affected or are reasonably likely to materially affect theCompany’s internal control over financial reporting.**

 

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**PART II**

OTHER INFORMATION

 

ITEM1.  LEGALPROCEEDINGS

 

None

 

ITEM2.  UNREGISTEREDSALES OF SECURITIES AND USE OF PROCEEDS

 

None

 

ITEM3.  DEFAULTSUPON SENIOR SECURITIES

 

None

 

ITEM4.  SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

 

None

 

ITEM5.  OTHERINFORMATION

 

None

 

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

 

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

 

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SIGNATURES

 

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

 
|                | NATROL,  INC. |
|---------------------|---------------|
|                |          |   |
| Date:  May 13, 2005 | By:           | /s/  Elliott Balbert |   |
|                |          | Chairman,  President and Chief Executive  Officer |
|                |          |   |
| Date:  May 13, 2005 | By:           | /s/  Dennis R. Jolicoeur |   |
|                |          | Chief  Financial Officer and Executive  Vice President |

 

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