**United StatesSecurities and Exchange Commission**

**Washington, D.C. 20549**

 

**Form 10-K**

 

| **ý**                                            |   | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d)  OF THE  SECURITIES EXCHANGE ACT OF 1934**         |
|-------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------|
|                                                  |
| **For  the Fiscal Year Ended December 31, 2003** |
|                                                  |   |                                                                                                     |
| **or**                                                |
|                                                  |
| **o**                                                 |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15  (d) OF  THE SECURITIES AND EXCHANGE ACT OF 1934** |
|                                                  |
| **Commission  File Number 0-27517**                   |

 

| **GAIAM, INC.**                                                       |
|-----------------------------------------------------------------------|
| **(Exact  name of registrant as specified in its charter)**           |
|                                                                  |   |   |
| **COLORADO**                                                          |   | **84-1113527** |
| (State or other  jurisdiction of  incorporation or organization)      |   | (I.R.S. Employer  Identification No.) |
|                                                                  |   |   |
| **360  INTERLOCKEN BOULEVARD  BROOMFIELD, CO 80021**                  |
| (Address of  principal executive offices)                             |
|                                                                  |   |   |
| **(303)  222-3600**                                                   |
| (Registrant’s  telephone number, including area code)            |
|                                                                  |   |   |
| **Securities  registered pursuant to Section 12(b) of the Act:** |
| **None**                                                              |
|                                                                  |   |   |
| **Securities  registered pursuant to Section 12(g) of the Act:** |
| **Class  A Common Stock, $.0001 par value**                           |

 

Indicate by check mark whether the Registrant:  (1) has filed all reports required to befiled by Section 13 or 15 (d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the Registrantwas required to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.  YES ý  NO  o

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of the Registrant’s knowledge, in a definitiveproxy or information statement incorporated by reference in Part III of thisForm 10-K or any amendment to this Form 10-K ý

 

Indicate by check markwhether the Registrant is an accelerated filer (as defined in Rule 12b-2 of theAct). YES ý NO o

 

The aggregate marketvalue of the voting stock held by non-affiliates of the Registrant wasapproximately $38,570,310 as of June 30, 2003, based upon the closingprice on the NASDAQ National Market on this date.  The Registrant does not have non-voting common equity.

 

As of March 1, 2004,9,216,027 shares of the Registrant’s $.0001 par value Class A common stock and5,400,000 shares of the Registrant’s Class B common stock were outstanding.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

The following documents(or portions thereof) are incorporated by reference into the Parts of this Form10-K noted:

 

 

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Part III incorporates byreference from the definitive proxy statement for the Registrant’s 2004 AnnualMeeting of Stockholders to be filed with the Commission pursuant to Regulation14A not later than 120 days after the end of the fiscal year covered by thisForm.

 

# GAIAM, INC.

Annual Report onForm 10-K for the Fiscal Year Ended December 31, 2003

 
| PART I     |                                                                                        | 3      |
|------------|---------------------------------------------------------------------------------------------|--------|
| Item 1.    | Business                                                                                    | 3      |
| Item 2.    | Properties                                                                                  | 14     |
| Item 3.    | Legal  Proceedings                                                                          | 14     |
| Item  4.   | Submission  of Matters to a Vote of Security Holders                                        | 14     |
|       |                                                                                        |   |
| PART II    |                                                                                        | 14     |
| Item  5.   | Market  for Registrant’s Common Equity and Related Stockholder Matters                 | 14     |
| Item  6.   | Selected  Financial Data                                                                    | 15     |
| Item  7.   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 16     |
| Item 7A.   | Quantitative and Qualitative Disclosures About  Market Risk                                 | 23     |
| Item 8.    | Financial Statements and Supplementary Data                                                 | 23     |
| Item 9.    | Changes in and Disagreements with Accountants  on Accounting and  Financial Disclosure      | 41     |
|       |                                                                                        |   |
| Item 9A.   | Controls and Procedures                                                                     | 41     |
|       |                                                                                        |   |
| PART III   |                                                                                        | 42     |
| Item 10.   | Directors and Executive Officers of the  Registrant                                         | 42     |
| Item 11.   | Executive Compensation                                                                      | 42     |
| Item 12.   | Security Ownership of Certain Beneficial  Owners and Management                             | 42     |
| Item 13.   | Certain Relationships and Related Transactions                                              | 42     |
| Item 14.   | Principal Accounting Fees and Services                                                      | 42     |
|       |                                                                                        |   |
| PART IV    |                                                                                        | 42     |
| Item 15.   | Exhibits, Financial Statement Schedules, and  Reports on Form 8-K                           | 42     |
|       |                                                                                        |   |
| SIGNATURES |                                                                                        | 44     |

 

FORWARD-LOOKINGSTATEMENTS

This report may contain forward-looking statements that involve risksand uncertainties.  When used in thisdiscussion, the words “anticipate,” “believe,” “plan,” “estimate,” “expect,”“strive,” “future,” “intend” and similar expressions as they relate to Gaiam orits management are intended to identify such forward-looking statements.  Gaiam’s actual results could differmaterially from the results anticipated in these forward-looking statements asa result of certain factors set forth under “Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” “Market Risk” andelsewhere in this report.  Risks anduncertainties that could cause actual results to differ include, withoutlimitation, general economic conditions, competition, loss of key personnel, pricing,brand reputation, acquisitions, security and information systems, legalliability for website content, merchandise supply problems, failure of thirdparties to provide adequate service, reliance on centralized customer service,overstocks and merchandise returns, reliance on a centralized fulfillmentcenter, increases in postage and shipping costs, e-commerce trends, futureInternet related taxes, control of Gaiam by its founder, fluctuations inquarterly operating results, consumer trends, customer interest in ourproducts, the effect of government regulation and other risks and uncertaintiesincluded in Gaiam’s filings with the Securities and Exchange Commission.  We caution you that no forward-lookingstatement is a guarantee of future performance, and you should not place unduereliance on these forward-looking statements which reflect our management’sview only as of the date of this report. We undertake no obligation to update any forward-looking information.

 

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###### **Part I**

 

**Item 1.**                                                           **Business**

 

## **OUR BUSINESS**

 

**Gaiam**

 

Gaiam is a multi-channellifestyle company providing a broad selection of information, products andservices to customers who value natural health, personal development,ecological lifestyles and responsible media. We offer our customers the ability to make purchasing decisions based onthese values while providing a quality product at a price comparable toconventional alternatives.

 

Gaiam has establisheditself as a lifestyle brand, information resource and authority in theLifestyles of Health and Sustainability (LOHAS) market and seeks to become aunifying symbol of the emerging LOHAS lifestyle. Our lifestyle brand is builtaround our ability to develop and offer content, products and lifestylesolutions to consumers in the LOHAS market. Our content forms the basis of ourproprietary products, on which we realize our highest margins, which thendrives demand for parallel product and service offerings.  Gaiam’s operations are vertically integratedfrom content creation, through product development and sourcing, to customerservice and distribution.  We market ourproducts and services across two segments, business and direct-to-consumer, andthrough five sales channels: media, national retailers, corporate accounts,catalogs and the Internet. We distribute our products in each of these saleschannels from a single fulfillment center.

 

**The LOHAS Market**

 

The LOHAS market, whichrepresented $227 billion in sales in 2000 according to the Natural BusinessCommunication study, consists of five main sectors:

 

•                  ***Sustainable Economy***. Renewable energy, energy conservation, recycled goods, environmentalmanagement services, sustainable manufacturing processes and relatedinformation and services.

 

•                  ***Healthy Living***. Natural and organic foods, dietarysupplements, personal care products and related information and services.

 

•                  ***Alternative Healthcare***. Health and wellness solutionsand alternative health practices.

 

•                  ***Personal Development***. Solutions, information, productsand experiences relating to mind, body and spiritual development.

 

•                  ***Ecological Lifestyles***. Environmentally friendly cleaningand household products, organic cotton clothing and bedding, and eco-tourism.

 

Gaiam participates in allfive sectors of the LOHAS market.

 

**Our Content**

 

Gaiam’sbusiness model revolves around content creation**,**which forms the basis for our proprietary products**.**We have an “in house” production team thatproduces programs on a variety of topics including “how-to” and solutions basedprograms on mind-body fitness, wellness, and alternative healthcare. Ourprograms have won 22 Telly awards and several medals at the International NewYork Film Festival.  We developed a newline of children’s products during 2003, which was the recipient of severalParent’s Choice and Kids First Awards recognizing new products that help kidsgrow imaginatively, physically, and mentally. During 2003, we produced 44 new visual media programs. Gaiam alsodevelops and markets music and audio CDs and publishes printed content.

 

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**Our Products**

 

We currently stockapproximately 7,500 stock keeping units (SKUs) of which approximately 4,500 areproprietary products bearing the Gaiam brand. Our proprietary products constituted over 62% of our sales in 2003,compared to 53% in 2001, and 24% in 1999. Our visual media programs represent the largest part of our proprietaryproduct offering.  Our best sellingproducts, by LOHAS sector, are as follows:

 
| **Sustainable  Economy**      |   | **Healthy  Living**         |   | **Alternative  Healthcare**  |   | **Personal  Development**               |   | **Ecological  Lifestyles**         |
|-------------------------------|--------|-----------------------------|--------|------------------------------|--------|-----------------------------------------|--------|------------------------------------|
| Solar Panels and  Accessories |   | Air Filters                 |   | Natural Lighting             |   | Yoga Information and  Accessories       |   | Natural Cleaners                   |
| Energy Systems                |   | Water Filters               |   | Back and Neck Care  Products |   | Pilates Information and  Accessories    |   | Organic Cotton Bedding             |
| Energy Efficient  Lighting    |   | Personal Air Supply         |   | Massage Accessories          |   | Meditation Information  and Accessories |   | Organic Cotton Towels              |
| Energy Information            |   | UV Purifiers                |   | Stress Relief                |   | Fitness Accessories                     |   | Organic Cotton Clothing            |
| Evaporative Coolers           |   | Personal Care Products      |   | Allergy and Pain Relief      |   | Performance Wear                        |   | Recycled Household  Paper Products |
| Intertie Systems              |   | Natural Beauty Products     |   | Sleep Enhancers              |   | Personal Growth Information             |   | Natural Garden Products            |
| Composters                    |   | Whole Foods Brand  Products |   | Wellness Information         |   | Kids Fitness Products  and Information  |   | Non-Toxic Pest Control             |
| Air Dryers                    |   | Healthy Cooking             |   | Aroma Therapy                |   | Relaxation Music                        |   | Green Cotton Home  Accessories     |

 

# **Our Sales Channels**

#  

We conduct our businessacross two segments.  Our businesssegment customers are primarily national retailers, corporate accounts and themedia. We conduct our direct-to-consumer business through our catalogs and theInternet.  Approximately 93% of our 2003sales were made directly to retailers or end-users, and less than 7% werethrough distributors.

 

•                  *Media*

 

Gaiam develops andproduces information and programming targeted to consumers who value naturalhealth, personal development and spirituality. Gaiam has an award-winning library of titles that it sells to retailers,licenses to selected distributors operating outside of the United States, andlicenses or sublicenses for broadcast. Our current list of licensees includes Koch Vision, Universal Studios,Fine Living, Discovery Channel and Conscious Media.  All of our licensing arrangements require Gaiam branding to beprominent on the programming and are subject to our talent royalty agreements.  While our licensing of the rights to manufactureand distribute certain of our media lowers recognized revenue, contributionmargins are improved.

 

•                  *Retailers*

 

Since the inception ofour retailer channel in 1996, we have increased its breadth and diversity.  As of the end of 2003, Gaiam products may befound in over 30,000 stores in North America, plus in retailers located in theU.K. and Australia.  Gaiam products arecurrently sold across a variety of leading retailers, including bookstores suchas Barnes & Noble and Borders; music stores such as Musicland and VirginRecord Megastores; lifestyle stores such as Discovery Channel Stores; beautystores such as Ulta and Origins; home furnishing stores such as Bed, Bath andBeyond and Linens ‘n Things; natural food stores such as Whole Foods Market; sportinggoods stores such as Dick’s, REI and Galyan’s; mass merchants such as Targetand WalMart, e-tailers such as Amazon.com and Drugstore.com; and wholesaleclubs such as Costco.  Many of theseretailers display our products in store-within-store lifestyle presentationsthat utilize custom fixtures designed and produced by Gaiam. We implemented ourfirst store-within-store concept late in 2000 and the concept has grown to over3,650 stores by the end of 2003.

 

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Through distributorarrangements and acquisitions, Gaiam branded products may now be found in over3,500 international retail stores throughout Canada, the United Kingdom andAustralia.  Our media products are sold tointernational accounts under licensing agreements and the remaining productsare sold based on distributor relationships. During 2003, Gaiam acquired a 50.1% ownership interest in LeisureSystems International (“LSI”), a U.K. based distributor and marketer oflifestyle products.  The acquisition hasallowed our merchandising and product development groups to work closely withthe LSI team to modify and develop new lifestyle products that fit into thecultures of countries outside of North America.

 

•                  *Services*

 

Gaiam provides products andservices to businesses that desire renewable energy solutions or healthy andnatural alternatives to traditional products or processes and services such aseco-travel.  We have a design andconsulting service for corporate accounts that assesses energy needs and makesrecommendations for more efficient solutions. We also organize individual andfamily eco-travel trips and group eco-travel adventures for museums andzoological societies, schools and universities and conservation and corporategroups.  Integral to our completeeco-travel experience is imparting an understanding of, and having ourtravelers experience the critical nature and work needed to protect andpreserve our wildlife, wild places and environment. Clients of our lifestyleservices included The White House, NASA, Fetzer Winery, the U.S. Departments ofEnergy, the Government of Brazil, the Smithsonian Institution, and the WorldWildlife Fund.

 

**•**                  *Catalogs*

 

Gaiam offers a variety ofLOHAS products directly to the consumer through our catalogs and through someconsumer lifestyle publications. We produce catalogs for all aspects ofLOHAS.  The typical Gaiam directconsumer is female, has an average income of $75,000 and is well educated.

 

•                  *Internet*

 

We use the Internet tosell our products and to provide information on the LOHAS lifestyle.  We currently offer over 7,500 SKUs on ourwebsite, www.gaiam.com.  We promote ourwebsite through our visual media, catalogs, print publications, productpackaging and Internet Links.  A keycomponent of our Internet approach is to provide customer support for Internetsales from our in-house call center. According to a Jupiter Communications study, 90% of on-line customersprefer human interaction when they require customer service.  This is particularly important for Gaiambecause the use of many of our products is enhanced by the extensive producteducation and information that we make available online and through our wellinformed customer service personnel.

 

**Our Operations**

 

•                  *Product Development and Sourcing*

 

Gaiam branded productsare sold across our five sales channels. Non-proprietary products are only available through our catalogs andover the Internet, where we initially test products before we decide to developproducts under the Gaiam brand and distribute them through our other saleschannels.  Our products are designed toenhance customers’ lifestyles and experiences and provide healthy, naturalsolutions while being eco-friendly and promoting a sustainable economy.  Because we use a multi-channel approach toour business we are able to leverage our product development costs across allchannels of our business.

 

Our proprietary productsare designed by our product development team, sourced both domestically andinternationally by our merchandisers and produced by third party suppliers toour specifications.  We also screen theenvironmental and social responsibility of our suppliers.  In order to minimize risk we often identifyan alternate supplier for our products in a separate location.

 

•                  *CustomerService*

 

Gaiam focuses on buildingand maintaining customer relationships that thrive on loyalty and trust.  We maintain a “no-risk guarantee” policy,whereby a customer is provided a full refund for products that are returned atany time, for any reason.  In 2003, weestablished a most valued customer program, which extends added benefits to ourmost loyal catalog and Internet customers. Our in-house customer service department includes product

 

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specialists who havespecific product knowledge and assist customers in selecting products andsolutions that meet their needs.  Weemploy telephone routing software that directs each call to the appropriaterepresentative.  Our policy is to shiporders no later than the next business day, which we accomplish by stockinginventory that supports over 90% of our orders. We believe that by offeringexceptional customer service we encourage repeat purchases by our customers,enhance our brand identity and reputation and build stronger relationships withour customers.

 

•                  *EstablishedInfrastructure*

 

We operate a 208,000square foot fulfillment center near Cincinnati, Ohio, which providesfulfillment for a most of our current business needs and has the capacity tosupport the growth of our business. This central U.S. location allows us to achieve shipping costefficiencies to most locations.  Thecenter is also located within 30 minutes of several major shipping companyhubs.  We use a supply chain managementsystem that supports our entire operation, including fulfillment, inventorymanagement, and customer service.  Ourfulfillment center is connected to our other facilities by a state-of-the artvoice-over-Internet telecom network that allows us to maintain a high degree ofconnectivity within our organization.

 

**Our Growth Strategies**

 

•                  *Expand ourMedia Offering*

 

Proprietary and authenticcontent lies at the core of our business model. Our media offerings introducecustomers to Gaiam and helps establish Gaiam as an authority in the LOHASmarket.  Gaiam’s primary focus is onleveraging our content with branded lifestyle product offerings through variousmedia, catalogs, the Internet, and national retailers.  We believe that the content-centric strategyis a competitive advantage and the multi-channel approach allows us thebroadest possible consumer reach.

 

We will continue todevelop authentic content that caters to the LOHAS lifestyle in DVD and VHSformats and also accelerate our efforts in the music, broadcast and publishingcategories.  We have already expandedour visual media offerings internationally and plan to continue to leveragethis opportunity.

 

•                  *Strengthenour Lifestyle Brand*

 

Our goal is to maintainthe Gaiam brand as an authority in the LOHAS market and to establish Gaiam as aunifying symbol of the emerging LOHAS lifestyle.  Strategically, all proprietary products are now being marketedunder one unified brand, “Gaiam.” We plan to strengthen the Gaiam brand by growingour media, focusing on category management initiatives, increasing ourstore-within-store presence across national retailers, increasing our marketingefforts, and by aggressively developing and marketing proprietary productswhile maintaining our high level of customer service.

 

•                  *Expand our Proprietary Products*

 

Our proprietary products,which we introduced in 1997, represented 62% of our revenues in fiscal year2003.  These products carry a highermargin, provide for branding opportunity and distinguish us from many of ourcompetitors. We currently offer over 4,500 SKUs of proprietary products thatrange from media products to sleep, stress relief, yoga and pilates accessoriesto organic cotton bedding and bath products. We continue to develop and market proprietary products across each ofthe five LOHAS sectors.  We arestrengthening our supply chain globally by sourcing a greater number ofproducts offshore. We leverage our product development costs over all saleschannels.

 

•                  *Capitalizeon****our Multi-channel Approach*

 

Our multi-channel strategyaffords us the broadest possible customer reach. This approach makes purchasingour lifestyle products convenient regardless of the channel that a customerprefers. Additionally this diversified, strategic approach should provide forcontinued operating and business stability as we have the ability tocross-market lifestyle products and services regardless of the customerlocation or the channel to which we are marketing.  In our direct-to-consumer business we are open 24 hours a day,offering over 7,500 products on our Internet site.

 

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Inour business segment, we continue to expand our presence in nationalretailers and currently have placements in over 30,000 retail points in North America, plus in retailers located in theU.K. and Australia.  We also continue toexpand our store-within-store concept in a variety of stores, including WholeFoods Markets, Barnes & Noble Bookstores, Discovery Stores, Ulta, Dick’sSporting Goods, REI, Galyan’s and other national retailers.

 

•                  *Expand intoNew Product Categories in our Business Segment*

 

We have successfullyestablished Gaiam as one of the leaders in the mind-body health category.  In an effort to leverage and diversify ourstrong relationships with our customer base, we continue to offer productsacross an increasing number of lifestyle categories including functionalapparel, natural home and wellness.  Wecontinue to test products in our direct business for expansion opportunities atretailers.  We believe that the Gaiambrand can extend to all aspects of LOHAS in our business segment.

 

•                  *Complementour Existing Business with Selective Strategic Acquisitions*

 

Our growth strategy isnot dependent on acquisitions.  However,we will consider those strategic acquisitions in the LOHAS market thatcomplement our existing business, increase our media and related productofferings, and expand our geographical reach. We especially focus on companies with a strong brand identity and withcustomer and product information databases that augment our existingdatabases.  Gaiam often allows some ofthe acquired company’s management team to retain responsibility for front-endbusiness functions such as creative presentation and marketing, whileconsolidating operational functions under Gaiam’s existing infrastructure wheneconomies of scale can be realized.

 

### **OurBusiness Segments**

 

We separate our businessinto two business segments:  thebusiness segment which includes sales to businesses, retailers, corporateaccounts and media outlets; and the direct-to-consumer segment, which includescatalogs, print advertising, and e-commerce.

 

Our business segmentprovides us with increased branding opportunities, higher operatingcontribution and potential growth in mainstream retail stores.  The business segment represented 51% of 2003revenues, while the direct to consumer segment represented 49% ofrevenues.  See Note 11 to ourconsolidated financial statements for further information on our segments.

 

**Our Intellectual Property**

 

Our tradename Gaiam andvarious product and Internet domain names are subject to trademark or pendingtrademark applications of Gaiam or a Gaiam company.  We believe these trademarks are significant assets to our business.

 

**Our Competitive Position**

 

We believe thatfragmented supplier and distribution networks characterize the LOHAS market,and we are not aware of a dominant leader. Gaiam’s goal is to establish itself as the market leader.

 

Our business is evolvingand competitive.  Larger andbetter-established entities may acquire, invest in or form joint ventures withour competitors.  Many of these entitieshave longer operating histories and have greater financial and marketingresources than we have.  Increasedcompetition from these or other competitors could reduce our revenue andprofits.  In addition, the smallerbusinesses we compete against may be able to more effectively personalize theirrelationships with customers.

 

BecauseGaiam uses multi-channel distribution for our products, we compete with variousproducers of similar products and services. Our competitors include GoodtimesHome Media, Anchor Bay, Ventura, PPI Entertainment, Goldhill Media, Nike,Reebok, thousands of small, local and regional businesses, and product lines oritems that are offered by large retailers, manufacturers, publishers and mediaproducers.

 

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We believe the principalcompetitive factors in the LOHAS market are authenticity of information,distinctiveness of products and services, quality of product, brand recognitionand price, and in media offerings, unique content and distributioncapabilities.  We believe we competefavorably on all these relevant factors.

 

We expect industryconsolidation to increase competition. As our competitors grow, they may adoptaggressive pricing or inventory policies, which could result in reducedoperating margins and loss of market share.

 

Our success also dependsupon the willingness of consumers to purchase goods and services that promotethe values we espouse. While we believe our business plan and assumptions arereasonable, the demographic trends on which they are based may change and thecurrent consumption levels may not be sustained. The decrease of consumerinterest in purchasing goods and services that promote the values we espousewould materially and adversely affect our customer base and revenues and,accordingly, our financial prospects.

 

**OurEmployees**

 

As of March 1, 2004,Gaiam and the Gaiam companies employed approximately 285 persons.  None of our employees are covered by acollective bargaining agreement.

 

**Regulatory Matters**

 

There are a number ofdifferent bills under consideration by Congress and various state legislaturesthat would restrict disclosure of consumers’ personal information, which maymake it more difficult for Gaiam to generate additional names for its directmarketing, and restrict a company’s right to send unsolicited electronic mailor printed materials.  Although Gaiambelieves it is generally in compliance with current laws and regulations andthat these laws and regulations have not had a significant impact on ourbusiness to date, it is possible that existing or future regulatoryrequirements will impose a significant burden on us.

 

The Gaiam companiesgenerally collect sales taxes only on sales to residents of states in whichGaiam has locations.  Currently, Gaiamcollects sales taxes in sales to residents of California, Colorado and Ohio.  A number of legislative proposals have beenmade at the federal, state and local level, and by foreign governments, thatwould impose additional taxes on the sale of goods and services over theInternet and certain states have taken measures to tax Internet-relatedactivities.  If legislation is enactedthat requires Gaiam to collect sales taxes on sales to residents of otherstates or jurisdictions, sales in our direct-to-consumer businesses may beadversely affected.

 

Our business is alsosubject to a number of other governmental regulations, including the Mail or TelephoneOrder Merchandise Rule and related regulations of the Federal TradeCommission.  These regulations prohibitunfair methods of competition and unfair or deceptive acts or practices inconnection with mail and telephone order sales and require sellers of mail andtelephone order merchandise to conform to certain rules of conduct with respectto shipping dates and shipping delays. We are also subject to regulations ofthe U.S. Postal Service and various state and local consumer protectionagencies relating to matters such as advertising, order solicitation, shipmentdeadlines and customer refunds and returns. In addition, merchandise importedby Gaiam is subject to import and customs duties and, in some cases, importquotas.

 

**Seasonality**

 

See the Quarterly andSeasonal Fluctuations section of Item 7, Management’s Discussion andAnalysis of Financial Condition and Results of Operations, for informationpertaining to the seasonal aspects of our business.

 

**Available Information**

 

Our corporate website atwww.gaiam.com/corporate provides information about Gaiam, its history, goalsand philosophy, as well as certain financial reports and corporate pressreleases.  Our www.gaiam.com websitefeatures a library of information and articles on personal development, healthylifestyles and environmental issues, along with an extensive offering ofproducts and services.  We believe ourwebsite provides us with an opportunity to deepen our relationships with ourcustomers and investors, educate them on a variety of issues, and improve ourservice.  As part of this commitment, wehave added a link on our corporate website to our Securities and ExchangeCommission filings, including our reports on Form 10-K, 10-Q and 8-K and allamendments to such reports.  Thosereports are available through our website, free of charge, as soon asreasonably practicable after these reports are filed with the Securities andExchange Commission.

 

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We have included ourwebsite addresses only as inactive textual reference, and the informationcontained on our website is not incorporated by reference into the Form 10-K.

 

**Factors That May Affect Future Results**

 

We wish to caution youthat there are risks and uncertainties that could cause our actual results tobe materially different from those indicated by forward looking statements thatwe make from time to time in filings with the Securities and ExchangeCommission, news releases, reports, proxy statements, registration statementsand other written communications as well as oral forward looking statementsmade from time to time by our representatives. These risks and uncertainties include, but are not limited to, thoserisks described below.  Additional risksand uncertainties not presently known to us or those we currently deemimmaterial also may impair our business operations and historical results arenot necessarily an indication of the future results.  The cautionary statements below discuss important factors thatcould cause our business, financial condition, operating results and cash flowsto be materially adversely affected.

 

*Changesin general economic conditions could have a material impact on our business*

 

Ourresults of operations could be impacted by changes in overall economic conditionsthat impact consumer spending.  Futureeconomic conditions affecting disposable income such as employment levels,consumer confidence, business conditions, stock market volatility, weatherconditions, acts of terrorism, threats of war, and interest and tax rates couldreduce consumer spending or cause consumers to shift their spending to ourcompetitors.  If the current economicconditions and performance of the retail and media environment do not improve,or worsen, we may experience material adverse impacts on our business,operating results and financial condition.

 

*Increased competition could impact our financial results*

 

We believe that the LOHASmarket has thousands of small, local and regional businesses. Some smallerbusinesses may be able to more effectively personalize their relationships withcustomers, thereby gaining a competitive advantage. Although we believe that wedo not compete directly with any single company that offers our entire range ofmerchandise, within each merchandise category we have competitors and we mayface competition from new entrants. Some of our competitors or our potentialcompetitors may have greater financial and marketing resources. In addition,larger, well-established and well-financed entities may acquire, invest in orform joint ventures with our competitors. Increased competition from these orother competitors could negatively impact our business.

 

*Changing consumer preferences may have an adverse effect onour business*

 

Our business is targetedat consumers who assign high value to personal development, healthy lifestyles,responsible media, renewable energy and the environment. A decrease of consumerinterest in purchasing goods and services that promote the values we espousewould materially and adversely affect our customer base and sales revenues and,accordingly, our financial prospects. Further, consumer preferences aredifficult to predict. Our future success depends in part on our ability toanticipate and respond to changes in consumer preferences and we may notrespond in a timely or commercially appropriate manner to such changes. Failureto anticipate and respond to changing consumer preferences could lead to, amongother things, lower sales of our products, increased merchandise returns and lowermargins, which would have a material adverse effect on our business.

 

*We may face quarterly and seasonal fluctuations that couldharm our business*

 

Our revenue and resultsof operations have fluctuated and will continue to fluctuate on a quarterlybasis as a result of a number of factors, including the timing of catalogofferings, timing of orders from retailers, recognition of costs or net salescontributed by new merchandise and catalog offerings, fluctuations in responserates, fluctuations in paper, production and postage costs and expenses,merchandise returns, adverse weather conditions that affect distribution orshipping, shifts in the timing of holidays and changes in our merchandise mix.In particular, our net sales and profits have historically been higher duringthe fourth quarter holiday season. We believe that this seasonality willcontinue in the future.

 

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*Our strategy of offering branded products could lead toinventory risk and higher costs*

 

An important part of ourstrategy is to feature branded products. These products are sold under ourbrand names and are manufactured to our specifications. We expect our relianceon branded merchandise to increase. The use of branded merchandise requires usto incur costs and risks relating to the design and purchase of products,including submitting orders earlier and making longer initial purchasecommitments.

 

In addition, the use ofbranded merchandise limits our ability to return unsold products to vendors,which can result in higher markdowns in order to sell excess inventory. Ourcommitment to customer service typically results in us keeping a high level ofmerchandise in stock so we can fill orders immediately. Consequently, we runthe risk of having excess inventory, which may also contribute to highermarkdowns. Our failure to successfully execute a branded merchandise strategyor to achieve anticipated profit margins on these goods, or a higher thananticipated level of overstocks, may materially adversely affect our revenues.

 

We offer our customersliberal merchandise return policies. Our consolidated financial statementsinclude a reserve for anticipated merchandise returns, which is based onhistorical return rates. It is possible that actual returns may increase as aresult of factors such as the introduction of new merchandise, changes inmerchandise mix or other factors. Any increase in our merchandise returns willcorrespondingly reduce our revenues.

 

*Acquisitions may harm our financial results*

 

Acquisitions have beenpart of our growth and may continue to be part of our growth in thefuture.  These acquisitions may be ofentire companies, controlling interests in companies or of minority interestsin companies where we intend to invest as part of a strategic alliance. If weare not successful in integrating companies that we acquire or are not able togenerate adequate sales from the acquired entities, our business could bematerially and adversely affected

 

*The loss of the services of our key personnel could disruptour business*

 

We depend on thecontinued services and performance of our senior management and other keypersonnel, particularly Jirka Rysavy and Lynn Powers.  Our strategy of allowing the management teams of some acquiredcompanies to continue to exercise significant management responsibility forthose companies makes it important that we retain key employees, particularlythe sales and creative teams, of the companies we might acquire.

 

*Our founder and chief executive officer Jirka Rysavycontrols Gaiam*

 

Mr. Rysavy holds 100% ofGaiam’s 5,400,000 outstanding shares of class B common stock and also owns2,136,200 shares of class A common stock. The shares of class B common stockare convertible into shares of class A common stock at any time. Each share ofclass B common stock has ten votes per share, and each share of class A commonstock has one vote per share. Consequently, Mr. Rysavy is able to vote a majority of our stock, andwill be able to exert substantial influence over Gaiam and to control mattersrequiring approval by the shareholders of Gaiam, including the election ofdirectors, increasing our authorized capital stock, or a merger or sale of ourassets. As a result of Mr. Rysavy’s control, no change of control of Gaiam canoccur without Mr. Rysavy’s consent.

 

*Our success depends on the value of the Gaiam brand*

 

Because of our relianceon sales of proprietary products, our success depends on the Gaiam brand.Building and maintaining recognition of the Gaiam brand are important toattracting and expanding our customer base. If the value of the Gaiam brandwere adversely affected, we cannot be certain that we will be able to attractnew customers, retain existing customers or encourage repeat purchases, and ifthe value of our brand were to diminish, our revenues, results of operationsand prospects would be adversely affected.

 

*Disputes concerning media content and intellectual propertymay adversely affect us*

 

Most of our media contentis subject to arrangements with third parties pursuant to which we havelicensed certain rights to use and distribute media content owned by thirdparties or have licensed to third parties certain rights to use and distributemedia content that we own.  In addition,we have a number of agreements with third parties concerning the use of ourmedia content and intellectual property, including agreements regardingroyalties, distribution, duplication, etc. Allegations that we do not haverights to use media content and other disputes arising from such arrangementscan be costly and may have a material adverse impact on our results.

 

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*We are dependent on third party suppliers for the success ofour proprietary products*

 

We are dependent on thesuccess of our proprietary products, and we rely on a select group ofmanufacturers to provide us with sufficient quantities to meet our customer’sdemands in a timely manner, produce these products in a humane and safeenvironment for both their workers and the planet, maintain quality standardsconsistent with the Gaiam brand, and meet certain pricing guarantees.  Our sourcing of these products overseascontinues to increase, and these arrangements carry risks associated withrelying on products manufactured outside of the U.S., including politicalunrest and trade restrictions, currency fluctuations, transportationdifficulties, work stoppages, and other uncertainties.  In addition, a number of our suppliers aresmall companies, and some of these vendors may not have sufficient capital,resources or personnel to increase their sales to us or to meet our needs forincreased commitments from them. The failure of our suppliers to providesufficient quantities of our proprietary products could decrease our revenues,increase our costs, and damage our customer service reputation.

 

*We rely on communications and shipping networks to deliverour products*

 

Given our emphasis oncustomer service, the efficient and uninterrupted operation of order-processingand fulfillment functions is critical to our business. To maintain a high levelof customer service, we rely heavily on a number of different outside serviceproviders, such as printers, telecommunications companies and deliverycompanies. Any interruption in services from our principal outside serviceproviders, including delays or disruptions resulting from labor disputes, poweroutages, human error, adverse weather conditions or natural disasters, couldmaterially adversely affect our business. In addition, products that we source overseas must be shipped to ourdistribution center by freight carriers, and a work stoppage or politicalunrest could adversely affect our ability to fulfill our customer orders.

 

*Information systems upgrades or integrations may disrupt ouroperations or financial reporting*

 

We continually evaluateand upgrade our management information systems, which are critical to ourbusiness. These systems assist in processing orders, managing inventory,purchasing and shipping merchandise on a timely basis, responding to customerservice inquiries, and gathering and analyzing operating data by businesssegment, customer, and SKU (a specific identifier for each different product).We are required to continually update these systems. Furthermore, if we acquireother companies, we will need to integrate the acquired companies’ systems withours, a process that could be time-consuming and costly. If our systems cannotaccommodate our growth or if they fail, we could incur substantial expenses.

 

Additionally, our successin e-commerce will depend upon our ability to provide a compelling andsatisfying shopping experience. To remain competitive, we must continue toenhance and improve the responsiveness, functionality and features of ouronline technology.

 

*A material security breach could cause us to lose sales,damage our reputation or result in liability to us*

 

Our computer servers maybe vulnerable to computer viruses, physical or electronic break-ins and similardisruptions. We may need to expend significant additional capital and otherresources to protect against a security breach or to alleviate problems causedby any breaches. Our relationships with our customers may be adversely affectedif the security measures that we use to protect personal information such ascredit card numbers are ineffective. We currently rely on security andauthentication technology that we license from third parties. We may notprevent all security breaches.

 

*Our systems may fail or limit user traffic, which wouldcause us to lose sales*

 

We support most of ourbusiness through our call center in Broomfield, Colorado. Even though we haveback up arrangements, we are dependent on our ability to maintain our computerand telecommunications equipment in this center in effective working order andto protect against damage from fire, natural disaster, power loss,telecommunications failure or similar events. In addition, growth of ourcustomer base may strain or exceed the capacity of our computer andtelecommunications systems and lead to degradations in performance or systemsfailure. We have experienced capacity constraints and failure of informationsystems in the past that have resulted in decreased levels of service deliveryor interruptions in service to customers for limited periods of time. Althoughwe continually review and consider upgrades to our technical infrastructure andprovide for system redundancies and backup power to limit the likelihood ofsystems overload or failure, substantial damage to our systems or a systemsfailure that causes interruptions for a number of days could adversely affectour business. Additionally, if we are

 

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unsuccessful in updatingand expanding our infrastructure, including our call center, our ability togrow may be constrained.

 

*If the protection of our Internet domain names isinadequate, our brand recognition could be impaired and we could lose customers*

 

We currently hold variousInternet domain names relating to our brand, including www.gaiam.com andwww.gaia.com. The acquisition and maintenance of domain names is regulated bygovernmental agencies and their designees. The regulation of domain names inthe U.S. and in foreign countries is changing and is expected to continue tochange in the future. As a result, we may not be able to acquire or maintainthe domain names we want in all countries in which we seek to conduct business.Furthermore, we may be unable to prevent third parties from acquiring domainnames whose similarity decreases the value of our trademarks and proprietaryrights. Loss of our Internet domain names could adversely affect our ability todevelop brand recognition.

 

*Government regulation of the Internet and E-commerce isevolving and unfavorable changes could harm our business*

 

We are subject to generalbusiness regulations and laws, as well as regulations and laws specificallygoverning the Internet and E-commerce. Such existing and future laws andregulations may impede the growth of the Internet or other online services.  These regulations and laws may covertaxation, user privacy, pricing, content, copyrights, distribution, consumerprotection, the provision of online payment services and quality of productsand services.  There is lack of clarityon how existing laws governing issues such as property ownership, sales andother taxes and personal privacy apply to the Internet and E-commerce.  Unfavorable resolution of these issues mayharm our business.

 

*We may face legal liability for the content contained on ourwebsite*

 

We could face legalliability for defamation, negligence, copyright, patent or trademarkinfringement, personal injury or other claims based on the nature and contentof materials that we publish or distribute on our website. If we are held liablefor damages for the content on our website, our business may suffer. Further,one of our goals is for www.gaiam.com to be a trustworthy and dependableprovider of information and services. Allegations of impropriety, even ifunfounded, could therefore have a material adverse effect on our reputation andour business.

 

*Relying on our centralized fulfillment center could exposeus to losing revenue*

 

Prompt and efficientfulfillment of our customers’ orders is critical to our business. Our facilityin Cincinnati, Ohio handles our fulfillment functions and some customer-servicerelated operations, such as returns processing. A majority of our orders arefilled and shipped from the Cincinnati facility. The balance is shippeddirectly from suppliers. Because we rely on a centralized fulfillment center,our fulfillment functions could be severely impaired in the event of fire,extended adverse weather conditions, transportation difficulties or naturaldisasters. Because we recognize revenue only when we ship orders, interruptionof our shipping would diminish our revenues.

 

*Postage and shipping costs may increase and thereforeincrease our expenses*

 

We ship our products,catalogs, and lifestyle publications to consumers and the cost of shipping is amaterial expenditure. Postage and shipping prices increase periodically and canbe expected to increase in the future. Any inability to secure suitable orcommercially favorable prices or other terms for the delivery of ourmerchandise and catalogs could have a material adverse effect on our financialcondition and results of operations.

 

*Our business is subject to reporting requirements that arecurrently evolving and, once established, could substantially increase ouroperating expenses.*

 

Because our common stockis publicly traded, we are subject to certain rules and regulations of federal,state and financial market exchange entities charged with the protection ofinvestors and the oversight of companies whose securities are publicly traded.  These entities, including the Public CompanyAccounting Oversight Board, the SEC and the Nasdaq, have recently issued newrequirements and regulations and are currently developing additionalregulations and requirements in response to recent laws enacted by Congress,most notably the Sarbanes-

 

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Oxley Act of 2002.  As certain rules are not yet finalized, wedo not know the level of resources we would have to commit in order to be incompliance.  Our compliance with currentand proposed rules, such as Section 404 of the Sarbanes-Oxley Act, islikely to require the commitment of significant financial and managerialresources and additional expense to Gaiam.

 

## **MANAGEMENT**

## ** **

## **Directorsand Executive Officers**

 

Our executive officers and directors, their respective ages as ofDecember 31, 2003 and their positions are as follows:

 
| **NAME**                    |   | **AGE** |   | **POSITION**                                                |
|-----------------------------|--------|---------|--------|-------------------------------------------------------------|
| Jirka Rysavy                |   | 49      |   | Founder, Chairman of  the Board and Chief Executive Officer |
| Lynn Powers                 |   | 54      |   | President, Director and  CEO of North American operations   |
| James Argyropoulos (1)  (2) |   | 59      |   | Director                                                    |
| Barnet M. Feinblum (1)  (2) |   | 56      |   | Director                                                    |
| Barbara Mowry (1) (2)       |   | 56      |   | Director                                                    |
| Paul H. Ray  (1)       |   | 64      |   | Director                                                    |

 

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(1)          Member of theCompensation Committee

(2)          Member of the AuditCommittee

 

JIRKA RYSAVY – Founder,Chairman and Chief Executive Officer of Gaiam. He has been Chairman sinceGaiam’s inception and became the full-time Chief Executive Officer inDecember 1998.  In 1986, Mr. Rysavyfounded Corporate Express, Inc., which, under his leadership, grew to become aFortune 500 company supplying office and computer products and services.  He was its Chairman and Chief ExecutiveOfficer until September 1998.  Mr.Rysavy also founded and served as Chairman and Chief Executive Officer ofCrystal Market, a health foods market, which was sold in 1987 to become thefirst Wild Oats Markets store.

 

LYNN POWERS – President,Director and Chief Executive Officer of North American operations ofGaiam.  Ms. Powers has been Presidentand a Director since February 1996. From February 1996 until September 2001, she was ChiefOperating Officer, when she was promoted to Chief Executive Officer of NorthAmerican operations.  From 1992 to 1996,she was Chief Executive Officer of La Scelta, an importer of natural fiberclothing products. Before that, Ms. Powers was Senior Vice PresidentMarketing/Strategic Development and Vice President Merchandising of Miller’sOutpost, a specialty retailer.

 

JAMES ARGYROPOULOS –Director since May 2002. Mr. Argyropoulos is the founder and Chairman of TheWalking Company, a lifestyle specialty retailer. Previously Mr. Argyropoulosserved as Chairman and Chief Executive Officer of The Cherokee Group Inc., ashoe manufacturing and apparel business he founded in 1972.

 

BARNET M. FEINBLUM –Director since October 1999.  Mr.Feinblum is the President and Chief Executive Officer of Organic Vintners, amarketer of organic wines.  Mr. Feinblumwas the President, Chief Executive Officer and Director of Horizon OrganicDairy from May 1995 to January 2000. From July 1993 through March 1995, Mr. Feinblum was thePresident of Natural Venture Partners, a private investment company.  From August 1976 untilAugust 1993, Mr. Feinblum held various positions at Celestial Seasonings,Inc., including President, Chief Executive Officer, and Chairman of theBoard.  Mr. Feinblum is also a directorof Seventh Generation, Inc.

 

BARBARA MOWRY – Directorsince October 1999.  Since 2003,Ms. Mowry has been CEO of Silver Creek Systems, Inc., a provider of dataquality management software. From November 1997 until February 2001,Ms. Mowry was the President and Chief Executive Officer of RequisiteTechnology, a business-to-business e-commerce company specializing in thecreation and management of electronic content and catalogs.  Prior to joining Requisite Technology, Ms.Mowry was an officer of Telecommunications, Inc. (cable television) from 1995to 1997.  In 1990, Ms. Mowry founded,and until 1995 served as Chief Executive Officer of The Mowry Company, arelationship marketing firm focusing on the development of long-term customerrelationships for businesses.

 

PAUL H. RAY – Directorsince October 1999.  Since 2000,Mr. Ray has been the Chief Executive Officer of Integral Partnerships LLC, aconsulting firm specializing in Cultural Creative topics.  From November 1986 until

 

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December 2000, hewas Executive Vice President of American LIVES, Inc., a market research andopinion-polling firm.  Prior to joiningAmerican LIVES, Mr. Ray was Chief of Policy Research on Energy Conservation atthe Department of Energy, Mines and Resources of the Government of Canada from1981 to 1983. From 1973 to 1981, Mr. Ray was Associate Professor of UrbanPlanning at the University of Michigan. He is the author of “The Integral Culture Survey,” which firstidentified the Cultural Creatives subculture.

 

Each directorserves a one-year term. Each officer serves at the discretion of the Board ofDirectors. There are no family relationships among any of the directors orofficers of Gaiam.

 

### **Item 2.**                                                           Properties

 

Ourprincipal executive offices are located in Broomfield, Colorado.  Our fulfillment center is located in theCincinnati, Ohio area. This facility houses most of our fulfillment functions.We selected the Cincinnati site after considering the availability and cost offacilities and labor, proximity to major highways, air delivery hubs andsupport of local government of new businesses. We also believe that Cincinnatiis ideal for providing the low cost shipping available from a single centralpoint to a customer base that conforms to the overall U.S. population.

 

Thefollowing table sets forth certain information relating to our primaryfacilities, all of which are leased:

 
| **Primary Locations** |   | **Size**        |   | **Use**                           |   | **Lease  Expiration** |
|-----------------------|--------|-----------------|--------|-----------------------------------|--------|-----------------------|
|                  |   |            |   |                              |   |                  |
| Broomfield, CO        |   | 36,000 sq. ft.  |   | Headquarters and customer service |   | May 2005              |
| Cincinnati, OH        |   | 208,000 sq. ft. |   | Fulfillment center                |   | March 2006       |
| Venice, CA            |   | 800 sq. ft.     |   | Media/sales office                |   | July 2005        |
| Hopland, CA           |   | 12 acres        |   | Renewable energy demo site        |   | Owned                 |

 

Wehave options to renew the leases for our headquarters and our fulfillmentcenter.  We believe our facilities areadequate to meet our current needs and that suitable additional facilities willbe available for lease or purchase when, and as, we need them.

 

### **Item 3.**                                                           Legal Proceedings

 

From time to time,Gaiam is involved in legal proceedings that we consider to be in the normalcourse of business.  We do not believethat any of these proceedings will have a material adverse effect on ourbusiness.

 

##### **Item 4.**                                                           Submission of Matters to a Vote ofSecurity Holders

 

No matters were brought to a vote of our stockholders in the fourthquarter of the fiscal year ended December 31, 2003.

 

###### **PartII**

 

##### **Item 5.**                                                           Market for Registrant’s Common Equityand Related Stockholder Matters

 

Stock Price History

 

Gaiam’s Class A common stock has been quoted on the NASDAQ under thesymbol “GAIA” since our initial public offering on October 29, 1999.  On February 27, 2003 we had 8,687stockholders of record and 9,216,027 shares of $.0001 par value Class A commonstock outstanding. We have 5,400,000 shares of $.0001 par value Class B commonstock outstanding, held by one shareholder.

 

The following table sets forth certain sales price and trading volumedata for Gaiam’s Class A common stock for the period indicated:

 

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|            |   | **High Bid** |   | **Low Bid** |   | **Close** |   | **Average  Daily  Volume** |   |
|-----------------|--------|--------------|--------|-------------|--------|-----------|--------|----------------------------|--------|
|            |   |         |   |        |   |      |   |                       |   |
| Fiscal  2003:   |   |         |   |        |   |      |   |                       |   |
| Fourth  Quarter |   | $            | 6.16   |        | $      | 4.90      |   | $                          | 5.95   |   | 10,917 |   |
| Third  Quarter  |   | $            | 7.10   |        | $      | 4.77      |   | $                          | 5.77   |   | 20,852 |   |
| Second  Quarter |   | $            | 6.75   |        | $      | 4.40      |   | $                          | 5.92   |   | 32,598 |   |
| First  Quarter  |   | $            | 11.24  |        | $      | 4.00      |   | $                          | 5.37   |   | 50,411 |   |
|            |   |         |   |        |   |      |   |                       |   |
| Fiscal  2002:   |   |         |   |        |   |      |   |                       |   |
| Fourth  Quarter |   | $            | 12.11  |        | $      | 9.40      |   | $                          | 10.37  |   | 26,031 |   |
| Third  Quarter  |   | $            | 15.22  |        | $      | 8.05      |   | $                          | 11.47  |   | 32,811 |   |
| Second  Quarter |   | $            | 18.45  |        | $      | 13.00     |   | $                          | 14.64  |   | 42,002 |   |
| First  Quarter  |   | $            | 23.81  |        | $      | 15.00     |   | $                          | 18.42  |   | 53,027 |   |

 

# Dividend Policy

 

Gaiam has neverdeclared or paid any cash dividends on its capital stock.  Gaiam currently intends to retain earningsto support its growth strategy and does not anticipate paying cash dividends inthe foreseeable future.  In addition,our bank credit agreement prohibits payment of any dividends to ourshareholders.

 

Sales of UnregisteredSecurities

 

InJanuary 2003, Gaiam acquired a 50.1% interest in Leisure SystemsInternational, Ltd., a U.K. based distributor and marketer of lifestyleproducts, for approximately $4.3 million in cash and 50,000 shares of GaiamClass A common stock, which were issued to Leisure System’s sellingshareholders.  These shares were issuedpursuant to an exemption from registration under Section 4(2) of theSecurities Act of 1933.

 

Equity Compensation PlanInformation

 
| **Plan Category**                                           |   | **Number of  securities  to be issued upon  exercise of outstanding  options, warrants and rights** |   | **Weighted-average  exercise price of  outstanding options,  warrants and rights** |   | **Number of  securities  remaining available for  future issuance under  equity compensation plans** |    |
|-------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------|---------|
| Equity  compensation plans approved by security holders     |   | 1,704,680                                                                                           |   | $                                                                                  | 7.52   |                                                                                                 | 395,320 |   |
| Equity  compensation plans not approved by security holders |   | —                                                                                              |   | —                                                                             |   | —                                                                                               |    |
| Total                                                       |   | 1,704,680                                                                                           |   | $                                                                                  | 7.52   |                                                                                                 | 395,320 |   |

 

**Item 6.**                                                           Selected Financial Data

 

The selectedstatement of operations for the years ended December 31, 2003, 2002 and2001 and balance sheet data as of December 31, 2003 and 2002 set forthbelow are derived from Gaiam’s audited consolidated financial statements whichare included elsewhere in this Form 10-K. The selected statement of operations for the years endedDecember 31, 2000 and 1999 and balance sheet data as of December 31,2001, 2000 and 1999 set forth below are derived from Gaiam’s auditedconsolidated financial statements which are not included in this Form 10-K.  The historical operating results are notnecessarily indicative of the results to be expected for any other period.  The data set forth below should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and Gaiam’s consolidated financial statements andrelated notes, included elsewhere in this Form 10-K.

 

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**GAIAM,INC.**

**SELECTEDFINANCIAL DATA**

(Amounts inthousands, except per share data)

 
|                                                                           |   | **Year Ended  December 31,** |    |
|--------------------------------------------------------------------------------|--------|-----------------------------------|---------|
|                                                                           |   | **2003**                          |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                           |   |                              |    |   |   |   |   |   |   |   |   |
| **Statement of Operations Data**                                               |   |                              |    |   |   |   |   |   |   |   |   |
| Net  revenues                                                                  |   | $                                 | 102,000 |   | $ | 111,406 |   | $ | 98,737 |   | $ | 60,588 |   | $ | 45,725 |   |
| Cost  of goods sold                                                            |   | 48,927                            |    | 45,475 |   | 39,276 |   | 23,793 |   | 18,176 |   |
| Gross  profit                                                                  |   | 53,073                            |    | 65,931 |   | 59,461 |   | 36,795 |   | 27,549 |   |
| Selling,  operating, general and administrative expenses                       |   | 54,355                            |    | 57,180 |   | 52,849 |   | 32,367 |   | 25,425 |   |
| Operating  income (loss)                                                       |   | (1,282                            | )       | 8,751 |   | 6,612 |   | 4,428 |   | 2,124 |   |
| Other  income (loss)                                                           |   | 546                               |    | (261 | ) | 346 |   | (283 | ) | 606 |   |
| Income  (loss) before income taxes and minority interest                       |   | (736                              | )       | 8,490 |   | 6,958 |   | 4,145 |   | 2,730 |   |
| Income  tax (benefit) expense                                                  |   | (461                              | )       | 3,002 |   | 2,498 |   | 1,556 |   | 1,063 |   |
| Minority  interest in net (income) loss of consolidated subsidiary, net of tax |   | (697                              | )       | (40 | ) | (404 | ) | 60 |   | 51 |   |
| Net  income (loss)                                                             |   | $                                 | (972    | ) | $ | 5,448 |   | $ | 4,056 |   | $ | 2,649 |   | $ | 1,718 |   |
| Net  income (loss) per share:                                                  |   |                              |    |   |   |   |   |   |   |   |   |
| Basic                                                                          |   | $                                 | (0.07   | ) | $ | 0.39 |   | $ | 0.33 |   | $ | 0.24 |   | $ | 0.20 |   |
| Diluted                                                                        |   | $                                 | (0.07   | ) | $ | 0.38 |   | $ | 0.32 |   | $ | 0.23 |   | $ | 0.19 |   |
| Shares  outstanding:                                                           |   |                              |    |   |   |   |   |   |   |   |   |
| Basic                                                                          |   | 14,594                            |    | 14,107 |   | 12,396 |   | 10,858 |   | 8,785 |   |
| Diluted                                                                        |   | 14,594                            |    | 14,489 |   | 12,809 |   | 11,525 |   | 9,119 |   |

 
|                                        |   | **December 31,** |   |
|---------------------------------------------|--------|-----------------------|--------|
|                                        |   | **2003**              |   | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** |   |
|                                        |   |                  |   |   |   |   |   |   |   |   |   |
| **Balance Sheet Data**                      |   |                  |   |   |   |   |   |   |   |   |   |
| Cash                                        |   | $                     | 8,384  |   | $ | 11,422 |   | $ | 22,244 |   | $ | 8,579 |   | $ | 3,877 |   |
| Working  capital                            |   | 29,531                |   | 33,944 |   | 41,403 |   | 15,269 |   | 5,911 |   |
| Total  assets                               |   | 91,860                |   | 91,167 |   | 87,884 |   | 48,353 |   | 27,260 |   |
| Long-term  debt (net of current maturities) |   | —                |   | 55 |   | 238 |   | 5,770 |   | 2,109 |   |
| Stockholders’  equity                  |   | 69,485                |   | 69,371 |   | 58,633 |   | 18,111 |   | 14,951 |   |
|                                             |        |                       |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Item 7.****                                                           Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

The followingdiscussion and analysis of Gaiam’s financial condition and results ofoperations should be read in conjunction with the consolidated financialstatements and related notes included elsewhere in this document.* *This section is designed toprovide information that will assist readers in understanding Gaiam’sconsolidated financial statements, changes in certain items in those statementsfrom year to year, the primary factors that caused those changes and howcertain accounting principles, policies and estimates affect the consolidatedfinancial statements.

 

# Overview and Outlook

 

Gaiam is amulti-channel lifestyle company providing information, goods and services tocustomers who value personal development, healthy living, ecological lifestylesand responsible media. Gaiam was incorporated in Boulder, Colorado in 1988 tosupport “Conscious Commerce,” the practice of making purchasing decisions basedon lifestyle and personal values.  In1995, Gaiam began to expand nationally. In 1996, Gaiam made a large investment in infrastructure and operatingsystems to support rapid growth. From 1997 to 2003, Gaiam’s revenues increasedfrom $19.9 million to $102 million, representing a compound annual growth rateof 31.3%.

 

Gaiam’s revenuesdeclined 8.4% to $102 million in 2003, as compared to $111.4 million in2002.  The decline in revenues wasprimarily attributable to a decline of 34%, or $19 million, in sales toretailers.  During 2003, sales todistributors declined $11.8 million as a result of the exclusion of our HealingArts branded accessories in the fitness pallet in Costco for Holiday, and thetransition of Bed, Bath and Beyond from a distributor relationship to

 

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direct.  This required Gaiam to take back inventoryfrom our distributor and reset the floor for Bed, Bath and Beyond.  Additionally, Gaiam’s sales to mall-basedstores, such as the Discovery Channel Stores, declined approximately $4.2million.  These declines took place inour business segment, which has had higher operating contributions in prioryears than our direct to consumer segment. With more of the revenue contributed by those divisions with lower grossmargins, the overall gross margin declined to 52%.  Gaiam used 2003 as a transition year in order to make adjustmentsto our business strategy by doubling our sales force, adding new productcategories, launching sales to additional retail chains within the businesssegment, and consolidating our operations and reducing expenses in order tofocus on profitability in all segments in the future.  Although Gaiam reported a net loss of approximately $972 thousandin 2003, its first net loss since becoming a public company, Gaiam generated$3.7 million in cash provided by operations, compared to $1 million cashprovided by operations in 2002, when Gaiam had net income of $5.4 million.

 

Gaiam hasincreased its focus on its media and national retailer channels, whichstrategically provides increased branding opportunities, higher operatingcontribution and greater mainstream penetration.  In 2003, our business segment was 51% of total revenues, up from13% in 1998.  During 2004, Gaiam willfocus on selling directly to retailers through the “store-within-store” conceptand building this segment through a combination of new media releases and newproduct opportunities in soft goods and spa products, along with an expansionin mass market retailers and bookstores, and new launches into the grocery andthe professional markets.

 

As part of ourstrategy to grow the business segment, in 2003 Gaiam acquired a 50.1% interestin Leisure Systems International (“LSI”), a distributor of wellness productsbased in the U.K.  Total considerationfor the acquisition was approximately $4,300,000 in cash and 50,000 shares ofGaiam Class A common stock.  Resultsfrom operations of LSI are included in the Consolidated Financial Statements ofGaiam from the effective acquistion date of January 1, 2003.  It is anticipated that LSI will be able tolaunch our media and employ a sales strategy in the U.K. retail market that issimilar to Gaiam’s “store-within-store” presentation in the U.S.

 

The direct toconsumer segment continues to be an integral part of Gaiam’s outreach.  This segment accounted for 49%, orapproximately $50.5 million, of Gaiam’s revenues during 2003.  Revenues for the Gaiam’s catalog and websiteoperations remained relatively flat as compared to 2002.  Although this segment did not see muchgrowth in 2003, it remains the base for Gaiam. Circulation of 15 million catalogs provides branding, a sounding boardfor new product testing, promotional opportunities and customer feedback onGaiam’s and the LOHAS industry’s focus and future.

 

Even with theshift to our business segment, Gaiam’s gross margin remained strong at 52%primarily because of our continued focus on higher margin proprietaryproducts.  In 2003, over 62% of oursales were comprised of proprietary products, up from 53% in 2001.

 

Gaiam anticipatesboth a return to positive internal growth and a return to profitability in2004.  The negative internal growthexperienced during 2003 has subsided and we anticipate that the internal growthrate will be approximately 5 to 10% in the first quarter of 2004 and finish theyear around 10%.  Gaiam’s revenues willcontinue to be heavily weighted to the second half of the calendar year, so themajority of our earnings will continue to be generated during the third andfourth quarters.  Please see “Quarterlyand Seasonal Fluctuations.”

#  

# Critical Accounting Policies

 

The consolidatedfinancial statements are prepared in conformity with accounting principlesgenerally accepted in the United States, which require management to makejudgments, estimates and assumptions that affect the amounts reported inGaiam’s consolidated financial statements and accompanying notes.  Note 1 to the consolidated financialstatements in Item 8 of this Form 10-K summarizes the significant accountingpolicies and methods used in the preparation of Gaiam’s consolidated financialstatements.

 

Managementbelieves the following to be critical accounting policies whose application hasa material impact on Gaiam’s financial presentation, and involve a higherdegree of complexity, as they require management to make judgments andestimates about matters that are inherently uncertain.

 

*Provision for Doubtful Accounts*

 

Gaiam records aprovision for doubtful accounts for all receivables not expected to becollected.  Gaiam generally does notrequire collateral.  Gaiam evaluates thecollectibility of the accounts receivable based on a combination offactors.  In circumstances when we areaware of a specific customer’s inability to meet its financial

 

17

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obligations (e.g.bankruptcy filings), Gaiam records a specific reserve for bad debts againstamounts due.  For all other instances,Gaiam recognizes reserves based on historical experience and review ofindividual accounts outstanding.

 

*Inventory*

 

Inventory consistsprimarily of finished goods held for sale and is stated at the lower of cost(first-in, first-out method) or market. Gaiam identifies its inventory items towrite down for obsolescence based on the item’s current sales status andcondition.  If the item is discontinuedor slow moving, it is written down based on an estimate of the markdown toretail price needed to sell through its current stock level.

 

*Investments*

 

Investments forwhich Gaiam does not have the ability to exercise significant influence, areaccounted for under the cost method. Under the cost method of accounting,investments in private companies are carried at cost and are adjusted only forother-than-temporary declines in fair value. Investments under the cost method are included on the accompanyingconsolidated balance sheet in “Investments.”

 

*CapitalizedProduction Costs*

 

Capitalizedproduction costs include costs incurred to produce informational media productsmarketed by Gaiam to retail marketers and direct-mail customers.  These costs are deferred for financialreporting purposes until the media is released, then amortized over succeedingperiods on the basis of estimated sales. Historical sales statistics are the principal factor used in estimatingthe amortization rate.

 

*Revenues*

 

Revenue from thesale of products is recognized at the time merchandise is shipped to thecustomer.  Revenue for servicesprovided, such as design consultation for solar installations, is recognizedwhen the services are rendered. Licensing revenue is recognized upon delivery of the medialicensed.  Amounts billed to customersfor postage and handling charges are recognized as revenue at the time that therevenues on the product shipments are recognized.

 

*Goodwill*

 

Goodwillrepresents the excess of the purchase consideration over the fair value ofassets acquired less liabilities assumed in a business acquisition.  In accordance with SFAS No. 142, “Goodwilland Other Intangible Assets,” goodwill is no longer amortized but is reviewedfor impairment annually, or more frequently if impairment indicators arise, ona reporting unit level.  The fair valueof a reporting unit is compared with its carrying amount, includinggoodwill.  If the fair value of areporting unit exceeds its carrying amount, goodwill of the reporting unit isconsidered not impaired.

 

If the carryingamount of a reporting unit exceeds its fair value, the goodwill impairment testis performed to measure the amount of impairment loss.  Gaiam has allocated goodwill to tworeporting units, and uses a market value method for the purposes of testing forpotential impairment.  The annual reviewrequires extensive use of financial judgment and estimates.  Application of alternative assumptions anddefinitions, such as a change in the composition of a reporting unit, couldyield significantly different results

 

# Results of Operations

 

The following table setsforth certain financial data as a percentage of revenues for the periodsindicated:

 

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|                                                                           |   | **For the  Year Ended December 31,** |   |
|--------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                           |   | **2003**                                  |   | **2002** |   | **2001** |   |
| Net  revenue                                                                   |   | 100.0                                     | %      | 100.0 | % | 100.0 | % |
| Cost  of goods sold                                                            |   | 48.0                                      | %      | 40.8 | % | 39.8 | % |
| Gross  profit                                                                  |   | 52.0                                      | %      | 59.2 | % | 60.2 | % |
| Expenses:                                                                      |   |                                      |   |   |   |   |   |
| Selling  and operating                                                         |   | 44.3                                      | %      | 42.9 | % | 45.5 | % |
| Corporate,  general and administrative                                         |   | 9.0                                       | %      | 8.4 | % | 8.0 | % |
| Total  expenses                                                                |   | 53.3                                      | %      | 51.3 | % | 53.5 | % |
| Income  (loss) from operations                                                 |   | -1.3                                      | %      | 7.9 | % | 6.7 | % |
| Other  income (expense), net                                                   |   | 0.6                                       | %      | -0.3 | % | 0.3 | % |
| Income  (loss) before income taxes and minority interest                       |   | -0.7                                      | %      | 7.6 | % | 7.0 | % |
| Income  tax (benefit) expense                                                  |   | -0.5                                      | %      | 2.7 | % | 2.5 | % |
| Minority  interest in net (income) loss of consolidated subsidiary, net of tax |   | -0.7                                      | %      | 0.0 | % | -0.4 | % |
| Net  income(loss)                                                              |   | -0.9                                      | %      | 4.9 | % | 4.1 | % |

 

# Year ended December 31, 2003 compared to yearended December 31, 2002

 

Revenues declined8.4% to $102 million in 2003 from $111.4 million in 2002.  The decrease is primarily attributable to adecline in sales to distributors of $11.8 million for 2003, which is more fullydiscussed above under “Overview and Outlook.” As a result, business segment revenues declined 15% to $51.5 million in2003 from $60.6 million in 2002.  Thedirect to consumer segment revenues remained flat at $50.5 million for 2003compared to $50.8 million in 2002.

 

Gross profit,which consists of revenue less cost of sales (primarily merchandise acquisitioncosts and in-bound freight), decreased 19.5% to $53.1 million in 2003 from$65.9 million in 2002.  As a percentageof revenue, gross profit was 52% in 2003 compared to 59.2% in 2002.  This was primarily attributable to a shiftin sales composition to our lower margin divisions, and from margin contractionin the business segment primarily due to a product shift to accessories.

 

Selling andoperating expenses, which consist primarily of sales and marketing costs,commissions and fulfillment expenses decreased 5.6% to $45.2 million in 2003from $47.8 million in 2002.  As a percentageof revenues selling and operating expenses increased to 44.3% in 2003 from42.9% in 2002 primarily due to the lower revenue base, coupled with the cost ofdoubling the business segment sales force, which is expected to add incrementalvalue in 2004.  Gaiam also completed itsrequisite warehouse management system conversion and the majority of itsfulfillment consolidation from outside providers into its distribution facilityin Ohio.

 

Corporate, generaland administrative expenses decreased to $9.2 million for 2003 from $9.3million in 2002, as a result of staffing reduction implemented in the firsthalf of 2003.  As a percentage ofrevenues, general and administrative expenses increased to 9% in 2003 from 8.4%in 2002 due to the lower sales base.

 

As a result of thefactors described above, Gaiam posted an operating loss of $1.3 million for2003, as compared to operating income of $8.8 million for 2002.

 

Gaiam recorded$546 thousand in other income during 2003, as compared to other expense of $261thousand in 2002.  In 2003, other incomeresulted primarily from a gain on the purchase of stock rights and interestincome generated on available cash. Minority interest expense, net of income taxes, increased from $40thousand in 2002 to $697 thousand in 2003 primarily due to positive operatingresults generated by Leisure Systems International, in which Gaiam purchased a50.1% interest in January 2003.

 

Gaiam recorded anincome tax benefit of $461 thousand on a pretax loss of $736 thousand for 2003,as compared to income tax expense of $3.0 million on pretax income of $8.5million in 2002.

 

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2003 was a year inwhich Gaiam focused on consolidating and improving its operations, refocusedand restructured its sales efforts in its business segment, and positioned itsmedia and product offerings for expansion into new markets. As a result of theabove factors, Gaiam recorded a net loss of $972 thousand in 2003.  Despite this loss, Gaiam’s cash generated byoperations grew to $3.7 million in 2003, from $1 million in 2002, when Gaiamrecorded net income of $5.4 million.

 

# Year ended December 31, 2002 compared to yearended December 31, 2001

 

Revenues increased13% to $111.4 million in 2002 from $98.7 million in 2001.  Increased sales to national retail chainsand proprietary products contributed towards Gaiam’s internal growth rate of18% for the year.  The closure of somecatalog operations and the multi-store retail operation we acquired inconnection with the Real Goods transaction lowered our year-over-year salesgrowth comparison even after factoring in acquisition contribution.  During fiscal 2002 we reduced catalogcirculation 14% as planned.  Businesssegment revenues increased to $60.6 million or 54% of sales in 2002, up from$47.5 million or 48% in 2001.

 

During 2002 Gaiamconverted some distribution arrangements to licensing agreements and expandedlicensing of its visual media assets for broadcast and pay per view in order toincrease brand exposure and generate revenues. In fiscal 2002, Gaiam recognized approximately $6 million in licensingrevenues from Universal Studios, Koch, Conscious Media and DiscoveryChannel.  Our Canadian distributor Kochwas converted to a media licensee.  Ifwe had not converted Koch to a licensee, we would have recognized approximately$3 million in additional revenues in fiscal 2002. Costs to convert our visualmedia library for broadcast and licensing, including international conversionand formatting, and the cost to repurchase rights from Universal for Europe andAsia were expensed.

 

Gross profitincreased 10.9% to $65.9 million in 2002 from $59.5 million during 2001.  As a percentage of revenue, gross profit was59.2% in 2002 compared to 60.2 % in 2001. The decline in gross profit percentage was primarily attributable toproduct mix diversification in our business segment and as a result of thebusiness segment representing a greater percentage of total sales.  This segment carries lower gross margin butthe operating contribution is higher. Gaiam continues to pursue growth of its proprietary product offerings,on which Gaiam has better margins.

 

Selling andoperating expenses increased 6.5%, which is less than the revenue increase of13%, to $47.8 million in 2002 from $44.9 million in 2001.  As a percentage of revenues selling andoperating expenses decreased to 42.9% in 2002 from 45.5% in 2001 primarily dueto leverage associated with the increased percentage of sales from our businesssegment.

 

Corporate, generaland administrative expenses increased to $9.3 million for 2002 from $7.9million in 2001 mainly due to expansion to support Gaiam’s growth.  As a percentage of revenues, general andadministrative expenses increased to 8.4% in 2002 from 8.0% in 2001.

 

Operating income,as a result of the factors described above, increased 32% to $8.8 million or7.9% of sales up from $6.6 million or 6.7% of sales in 2001.  Excluding the charges described aboveoperating income for fiscal 2002 and 2001 was 9.4% and 8.1% of sales in 2002and 2001, respectively.

 

Gaiam recorded$261 thousand in other expense during 2002, compared to other income of $346thousand in 2001.  This was partlyattributable to the loss of $182 thousand associated with the sales commissionand other expenses paid on the sale of the Gaiam Yoga Center in 2002.  Minority interest share of net income was$40 thousand in 2002 and $404 thousand in 2001.  Minority interest changed year-over-year primarily due to Gaiam’spurchase of the remaining minority interests in Gaiam.com, Gaiam’s organicclothing business and two renewable energy businesses.

 

Gaiam’s income taxprovision increased to $3.0 million in 2002, from $2.5 million in 2001 due toincreased profits.

 

Net income, as aresult of the factors described above, increased 34% to $5.4 million in 2002from $4.1 million during 2001.

 

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Quarterly and SeasonalFluctuations

 

The following table sets forth our unaudited quarterly results ofoperations for each of the quarters in 2003 and 2002.  In management’s opinion, this unaudited financial informationincludes all adjustments, consisting solely of normal recurring accruals andadjustments, necessary for a fair presentation of the results of operations forthe quarters presented.  This financialinformation should be read in conjunction with our consolidated financialstatements and related notes included elsewhere in this Form 10-K.  The results of operations for any quarterare not necessarily indicative of future results of operations.

 
|                                         |   | **Fiscal  2003** |   |
|----------------------------------------------|--------|-----------------------|--------|
|                                         |   | **First  Quarter**    |   | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |   |
|                                         |   |                  |   |   |   |   |   |   |   |
| Net  revenue                                 |   | $                     | 22,971 |   | $ | 20,352 |   | $ | 23,534 |   | $ | 35,143 |   |
| Gross  profit                                |   | 12,324                |   | 10,815 |   | 12,270 |   | 17,663 |   |
| Operating  income (loss)                     |   | (400                  | )      | (989 | ) | 16 |   | 91 |   |
| Net  income (loss)                           |   | (353                  | )      | (759 | ) | (201 | ) | 341 |   |
| Diluted  net income (loss) per share         |   | $                     | (0.02  | ) | $ | (0.06 | ) | $ | (0.01 | ) | $ | 0.02 |   |
| Weighted  average shares outstanding-diluted |   | 14,579                |   | 14,594 |   | 14,601 |   | 14,695 |   |

 
|                                         |   | **Fiscal  2002** |   |
|----------------------------------------------|--------|-----------------------|--------|
|                                         |   | **First  Quarter**    |   | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |   |
|                                         |   |                  |   |   |   |   |   |   |   |
| Net  revenue                                 |   | $                     | 24,284 |   | $ | 24,067 |   | $ | 25,794 |   | $ | 37,261 |   |
| Gross  profit                                |   | 14,269                |   | 14,182 |   | 15,030 |   | 22,450 |   |
| Operating  income                            |   | 1,175                 |   | 1,677 |   | 2,246 |   | 3,653 |   |
| Net  income                                  |   | 736                   |   | 1,003 |   | 1,395 |   | 2,314 |   |
| Diluted  net income (loss) per share         |   | $                     | 0.05   |   | $ | 0.07 |   | $ | 0.10 |   | $ | 0.16 |   |
| Weighted  average shares outstanding-diluted |   | 14,532                |   | 14,468 |   | 14,376 |   | 14,622 |   |

 

Note:  The aggregate of certain of the aboveamounts differs from that reported for the full fiscal year due to the effectsof rounding.

 

Quarterly fluctuations in Gaiam’s revenues and operating results aredue to a number of factors, including the timing of new product introductionsand mailings to customers, advertising, acquisitions (including costs ofacquisitions and expenses related to integration of acquisitions), competition,pricing of products by vendors and expenditures on our systems andinfrastructure.  The impact on revenueand operating results, due to the timing and extent of these factors, can besignificant.  Our sales are alsoaffected by seasonal influences.  On anaggregate basis, Gaiam generates its strongest revenues and net income in the fourthquarter due to increased holiday spending.

 

Liquidity and CapitalResources

 

Gaiam’s capital needs arise from working capital required to fund ouroperations, capital expenditures related to replacements, expansions andimprovements to Gaiam’s infrastructure, development of e-commerce, acquisitionsof new businesses, and anticipated future growth.  These capital requirements depend on numerous factors, includingthe rate of market acceptance of Gaiam’s product offerings, the ability toexpand Gaiam’s customer base, the cost of ongoing upgrades to Gaiam’s productofferings, the level of expenditures for sales and marketing, the level ofinvestment in distribution and other factors. The timing and amount of these capital requirements cannot accurately bepredicted.  Additionally, Gaiam willcontinue to evaluate possible investments in businesses, products andtechnologies, and currently plans to expand sales and marketing programs andconduct more aggressive brand promotions.

 

In 2002 Gaiam executed a new credit agreement with Wells Fargo, whichexpires during 2005, and permits borrowings of up to $15 million based upon thecollateral value of Gaiam’s accounts receivable, inventory and certain propertyand equipment.  Borrowings under thecredit agreement bear interest at the lower of prime rate less 50 basis pointsor LIBOR plus 275 basis points. Borrowings are secured by a pledge of Gaiam’s assets, and the agreementcontains various financial covenants, including covenants prohibiting thepayment of cash dividends to

 

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Gaiamshareholders and requiring maintenance of certain financial ratios.  At December 31, 2003, Gaiam had noamounts outstanding under this agreement, and was in compliance with all of thefinancial covenants.

 

Gaiam’s operating activities generated net cash of $3.7 million and$1.0 million in 2003 and 2002, respectively. Gaiam’s net cash generated from operating activities for 2003 isprimarily attributable to a decrease in accounts receivable of $5.9 million andnon-cash charges for depreciation and amortization of $3.1 million, which wereoffset by the net loss of $972 thousand and the decreases in income taxespayable of $1.6 million and accrued liabilities of $1.8 million.  Gaiam’s net cash generated from operating activitiesfor 2002 arose from net income of $5.4 million, a decrease in inventory of $679thousand, and an increase in accounts payable of $2.2 million, which was offsetprimarily by an increase in accounts receivable of $5.6 million (associatedwith the growth in the business segment and increased sales to major nationalretailers) and an increase in capitalized production costs of $1.4 million.

 

Gaiam’s investing and acquisition activitiesused net cash of $6.7 million and $11.4 million during 2003 and 2002,respectively.  In January 2003,Gaiam acquired a 50.1% interest in Leisure Systems International, a distributorof wellness products based in the U.K. Total consideration for the acquisition was approximately $4.3 millionin cash and 50,000 shares of Gaiam Class A common stock.  In 2002, Gaiam acquired a majority interestin a catalog company for $600,000. Gaiam also acquired the 49.9% interest in its Internet subsidiaryGaiam.com that it did not own previously and redeemed $6,000,000 of Gaiam.com’sredeemable preferred stock for $2,000,000 in cash and 500,000 shares of GaiamClass A common stock.  Strategically,Gaiam exited the retreat and conference service business in 2002 by selling theGaiam Yoga Center for $2.7 million. Gaiam invested $7.8 million to acquire a minority interest in ConsciousMedia, Inc., (a multimedia company) as part of efforts to build brand equitythrough broadcast media.  A requirementof the Conscious Media investment stipulates that Conscious Media willbroadcast content licensed from Gaiam under the Gaiam brand.

 

Gaiam’s financing activities used net cash of $218 thousand and $400thousand in 2003 and 2002, respectively, primarily for payments undercapitalized leases or repayment of other debt, which was partially offset byfunds generated by the exercise of stock options.

 

We believe our availablecash, cash expected to be generated from operations, and borrowing capabilitiesof $15 million (unused line of credit) should be sufficient to fund ouroperations on both a short-term and long-term basis.  However, our projected cash needs may change as a result ofacquisitions, unforeseen operational difficulties or other factors.

 

In the normal course ofour business, we investigate, evaluate and discuss acquisition, joint venture,minority investment, strategic relationship and other business combinationopportunities in the LOHAS (Lifestyles of Health and Sustainability)market.  For any future investment,acquisition or joint venture opportunities, we may consider using then-availableliquidity, issuing equity securities or incurring additional indebtedness.

 

*Contractual Obligations*

 

Gaiam has commitments pursuant to lease and debt agreements, but doesnot have any commitments pursuant to long-term debt obligations or purchaseobligations.  The following table showsour commitments to make future payments under operating and capital leases:

 
|                                |   | **Total** |      | **< 1  year** |   | **1-3 years** |   | **3-5 years** |      | **> 5 yrs** |   |
|-------------------------------------|--------|-----------|-----------|------------------|--------|---------------|--------|---------------|-----------|----------------|--------|
| Operating  lease obligations        |   | $         | 3,271,210 |             | $      | 1,823,914     |   | $             | 1,447,296 |           | $      | — |   | $ | — |   |
| Capital  lease obligations          |   | 54,528    |      | 54,528           |   | —        |   | —        |      | —         |   |
| Total  contractual cash obligations |   | $         | 3,325,738 |             | $      | 1,878,442     |   | $             | 1,447,296 |           | $      | — |   | $ | — |   |

 

*Off-Balance Sheet Arrangements*

 

Gaiam does not participate in transactionsthat generate relationships with unconsolidated entities or financial partnerships,such as special purpose entities (“SPEs”) or variable interest entities(“VIEs”), which have been established for the purpose of facilitatingoff-balance sheet arrangements or other limited purposes.  As of December 31, 2003, Gaiam is notinvolved in any unconsolidated SPEs or VIEs.

 

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**Item 7A****.****                Quantitative and QualitativeDisclosures About Market Risk**

 

Weare exposed to market risks, which include changes in U.S. interest rates andforeign exchange rates.  We do notengage in financial transactions for trading or speculative purposes.

 

Anyborrowings we might make under our bank credit facility would bear interest atthe lower of prime rate less 50 basis points or LIBOR plus 275 basispoints.  Gaiam does not have any amountsoutstanding under its credit line, so any unfavorable change in interest rateswould not have a material impact on Gaiam’s results from operations or cashflows unless Gaiam made borrowings in the future.

 

Gaiampurchases a significant amount of inventory from vendors outside of the U.S. intransactions that are primarily U.S. dollar transactions.  A small percentage of our internationalpurchases are denominated in currencies other than the U.S. dollar.  Any currency risks related to thesetransactions are immaterial to Gaiam.  Adecline in the relative value of the U.S. dollar to other foreign currenciescould, however, lead to increased purchasing costs.  In order to mitigate this exposure, Gaiam makes virtually all ofits purchase commitments in U.S. dollars.

 

In2003, Gaiam purchased a 50.1% interest in Leisure Systems InternationalLimited, a U.K. based distributor. Because Leisure Systems’ revenues are primarily denominated in foreigncurrencies, this investment exposes Gaiam to accounting risk associated withforeign currency exchange rate fluctuations. However, we have determined that there was no material market riskexposure to our consolidated financial position, results of operations or cashflows as of December 31, 2003.

 

**Item 8****.****                         Financial Statements andSupplementary Data**

 
|                                                       |     |
|------------------------------------------------------------|----------|
| **Index to Financial Statements**                          | **Page** |
|                                                       |     |
| Report of Independent  Auditors                            | 24       |
| Consolidated Financial  Statements:                        | –   |
| Consolidated Balance Sheets                                | 25       |
| Consolidated  Statements of Operations                     | 26       |
| Consolidated  Statements of Stockholders’ Equity      | 27       |
| Consolidated  Statements of Cash Flows                     | 28       |
| Notes to  Consolidated Financial Statements                | 29       |
|                                                       |     |
| **Financial  Statement Schedule:**                         |     |
| Schedule II –  Valuation and Qualifying Accounts | 41       |

 

23

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**REPORT OF INDEPENDENT AUDITORS**

 

Stockholders and Board ofDirectors

Gaiam, Inc.

 

We have audited theaccompanying consolidated balance sheets of Gaiam, Inc. (the Company) as ofDecember 31, 2003 and 2002, and the related consolidated statements ofoperations, stockholders’ equity, and cash flows for each of the three years inthe period ended December 31, 2003. Our audits also included the financial statement schedule II.  These financial statements andschedule are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements and schedule based on our audits.

 

We conducted our auditsin accordance with auditing standards generally accepted in the UnitedStates.  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the consolidated financial position of Gaiam, Inc. atDecember 31, 2003 and 2002 and the consolidated results of its operationsand its cash flows for each of the three years in the period endedDecember 31, 2003, in conformity with accounting principles generallyaccepted in the United States.  Also, inour opinion, the related financial statement schedule, when considered inrelation to the basic financial statements taken as a whole, presents fairly inall material respects the information set forth therein.

 
|                   |   |   |   | /s/ Ernst & Young  LLP |   |
|------------------------|--------|--------|--------|----------------------------|--------|
|                   |   |   |   |                       |   |   |
| Denver, Colorado       |   |   |   |                       |   |
| February 19, 2004 |   |   |   |                       |   |

 

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GAIAM, INC.

CONSOLIDATED BALANCESHEETS

 
|                                                                                                                                                                             |   | **December 31,** |       |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|------------|
|                                                                                                                                                                             |   | **2003**              | ** ** | **2002** | ** ** |
| **Assets**                                                                                                                                                                       |   |                  |       |   |   |
| Current  assets:                                                                                                                                                                 |   |                  |       |   |   |
| Cash  and cash equivalents                                                                                                                                                       |   | $                     | 8,383,934  |   | $ | 11,422,435 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $801,182 in 2003 and  $854,131 in 2002                                                                           |   | 17,818,513            |       | 20,950,394 |   |
| Income  tax and other receivables                                                                                                                                                |   | 2,090,785             |       | 1,949,832 |   |
| Inventory,  less allowances                                                                                                                                                      |   | 16,629,078            |       | 14,768,045 |   |
| Deferred  advertising costs                                                                                                                                                      |   | 1,648,560             |       | 2,417,211 |   |
| Other  current assets                                                                                                                                                            |   | 1,280,461             |       | 1,194,484 |   |
| Total  current assets                                                                                                                                                            |   | 47,851,331            |       | 52,702,401 |   |
|                                                                                                                                                                             |   |                  |       |   |   |
| Property  and equipment, net                                                                                                                                                     |   | 10,313,835            |       | 9,543,231 |   |
| Investments                                                                                                                                                                      |   | 7,865,192             |       | 7,865,192 |   |
| Capitalized  production costs, net                                                                                                                                               |   | 6,094,295             |       | 4,983,824 |   |
| Media  library, net                                                                                                                                                              |   | 6,083,556             |       | 5,262,586 |   |
| Goodwill  and other intangibles                                                                                                                                                  |   | 9,508,837             |       | 6,326,894 |   |
| Deferred  tax assets                                                                                                                                                             |   | 3,487,820             |       | 3,714,845 |   |
| Other  assets                                                                                                                                                                    |   | 655,363               |       | 768,043 |   |
| Total  assets                                                                                                                                                                    |   | $                     | 91,860,229 |   | $ | 91,167,016 |   |
|                                                                                                                                                                             |   |                  | ** ** |   | ** ** |
| **Liabilities  and stockholders’ equity**                                                                                                                                   |   |                  |       |   |   |
| Current  liabilities:                                                                                                                                                            |   |                  |       |   |   |
| Accounts  payable                                                                                                                                                                |   | $                     | 12,459,035 |   | $ | 11,998,087 |   |
| Accrued  liabilities                                                                                                                                                             |   | 4,904,465             |       | 5,204,438 |   |
| Capital  lease obligations, current                                                                                                                                              |   | 54,528                |       | 269,290 |   |
| Income  taxes payable                                                                                                                                                            |   | 902,420               |       | 1,286,558 |   |
| Total  current liabilities                                                                                                                                                       |   | 18,320,448            |       | 18,758,373 |   |
|                                                                                                                                                                             |   |                  |       |   |   |
| Capital  lease obligations, long-term                                                                                                                                            |   | —                |       | 54,529 |   |
| Deferred  tax liabilities                                                                                                                                                        |   | 735,103               |       | 848,653 |   |
| Other  Liabilities                                                                                                                                                               |   | —                |       | 1,962,000 |   |
| Total liabilities                                                                                                                                                                |   | 19,055,551            |       | 21,623,555 |   |
|                                                                                                                                                                             |   |                  |       |   |   |
| Minority  interest                                                                                                                                                               |   | 3,319,872             |       | 172,481 |   |
|                                                                                                                                                                             |   |                  |       |   |   |
| Commitments  and contingencies :                                                                                                                                                 |   |                  |       |   |   |
| Stockholders’  equity:                                                                                                                                                      |   |                  |       |   |   |
| Class  A common stock, $.0001 par value, 150,000,000 shares authorized, 9,203,056  and 9,134,098 shares issued and outstanding at December 31, 2003 and  2002, respectively |   | 920                   |       | 913 |   |
| Class  B common stock, $.0001 par value, 50,000,000 shares authorized, 5,400,000  shares issued and outstanding at December 31, 2003 and 2002,  respectively                |   | 540                   |       | 540 |   |
| Additional  paid-in capital                                                                                                                                                      |   | 53,831,750            |       | 53,343,046 |   |
| Deferred  compensation                                                                                                                                                           |   | (71,865               | )          | (143,865 | ) |
| Accumulated  other comprehensive income                                                                                                                                          |   | 524,870               |       | — |   |
| Retained  earnings                                                                                                                                                               |   | 15,198,591            |       | 16,170,346 |   |
| Total  stockholders’ equity                                                                                                                                                 |   | 69,484,806            |       | 69,370,980 |   |
| Total  liabilities and stockholders’ equity                                                                                                                                 |   | $                     | 91,860,229 |   | $ | 91,167,016 |   |

 

See accompanyingnotes to the consolidated financial statements.

 

25

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GAIAM, INC.

CONSOLIDATED STATEMENTSOF OPERATIONS

 
|                                                                                    |   | **Years  ended December 31,** |        |
|-----------------------------------------------------------------------------------------|--------|------------------------------------|-------------|
|                                                                                    |   | **2003**                           |        | **2002** |   | **2001** |   |
|                                                                                    |   |                               | ** **  |   | ** ** |   | ** ** |
| Net  revenue                                                                            |   | $                                  | 102,000,103 |   | $ | 111,406,313 |   | $ | 98,737,148 |   |
| Cost  of goods sold                                                                     |   | 48,926,933                         |        | 45,475,702 |   | 39,275,985 |   |
| Gross  profit                                                                           |   | 53,073,170                         |        | 65,930,611 |   | 59,461,163 |   |
|                                                                                    |   |                               |        |   |   |   |   |
| Expenses:                                                                               |   |                               |        |   |   |   |   |
| Selling  and operating                                                                  |   | 45,183,955                         |        | 47,845,850 |   | 44,933,062 |   |
| Corporate,  general and administration                                                  |   | 9,171,414                          |        | 9,333,937 |   | 7,916,629 |   |
| Total  expenses                                                                         |   | 54,355,369                         |        | 57,179,787 |   | 52,849,691 |   |
|                                                                                    |   |                               |        |   |   |   |   |
| Income  (loss) from operations                                                          |   | (1,282,199                         | )           | 8,750,824 |   | 6,611,472 |   |
|                                                                                    |   |                               |        |   |   |   |   |
| Other  income (expense)                                                                 |   | 471,768                            |        | (445,056 | ) | 407,092 |   |
| Interest  income (expense)                                                              |   | 73,965                             |        | 184,436 |   | (60,854 | ) |
| Other  income (expense)                                                                 |   | 545,733                            |        | (260,620 | ) | 346,238 |   |
|                                                                                    |   |                               |        |   |   |   |   |
| Income  (loss) before income taxes and minority interest                                |   | (736,466                           | )           | 8,490,204 |   | 6,957,710 |   |
|                                                                                    |   |                               |        |   |   |   |   |
| Income  tax (benefit) expense                                                           |   | (461,356                           | )           | 3,001,773 |   | 2,497,817 |   |
| Minority  interest in net (income) loss of consolidated subsidiary, net of income taxes |   | (696,645                           | )           | (40,443 | ) | (404,305 | ) |
| Net  income (loss)                                                                      |   | $                                  | (971,755    | ) | $ | 5,447,988 |   | $ | 4,055,588 |   |
|                                                                                    |   |                               |        |   |   |   |   |
| Net  income (loss) per share:                                                           |   |                               |        |   |   |   |   |
| Basic                                                                                   |   | $                                  | (0.07       | ) | $ | 0.39 |   | $ | 0.33 |   |
| Diluted                                                                                 |   | $                                  | (0.07       | ) | $ | 0.38 |   | $ | 0.32 |   |
|                                                                                    |   |                               |        |   |   |   |   |
| Shares  used in computing net income (loss) per share:                                  |   |                               |        |   |   |   |   |
| Basic                                                                                   |   | 14,594,089                         |        | 14,107,390 |   | 12,395,907 |   |
| Diluted                                                                                 |   | 14,594,089                         |        | 14,488,783 |   | 12,808,631 |   |

 

See accompanyingnotes to the consolidated financial statements.

 

26

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GAIAM, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

 
|                                                                                                  |   |             |   |             |   |           |      |         |   |              |   |             |       | **Accumulated** |   |         |   |       |    |
|-------------------------------------------------------------------------------------------------------|--------|------------------|--------|------------------|--------|----------------|-----------|--------------|--------|-------------------|--------|------------------|------------|-----------------|--------|--------------|--------|------------|---------|
|                                                                                                  |   | **Class A**      |   | **Class B**      |   | **Additional** |      |         |   | **Other**         |   |             |       |            |   |
|                                                                                                  |   | **Common Stock** |   | **Common Stock** |   | **Paid-In**    |      | **Deferred** |   | **Comprehensive** |   | **Retained**     |       |            |   |
|                                                                                                  |   | **Shares**       |   | **Amount**       |   | **Shares**     |      | **Amount**   |   | **Capital**       |   | **Compensation** |       | **Income**      |   | **Earnings** |   | **Total**  |    |
|                                                                                                  |   |             |   |             |   |           |      |         |   |              |   |             |       |            |   |         |   |       |    |
| Balance  at December 31, 2000                                                                    |   | 5,473,184        |   | $                | 547    |           | 5,400,000 |         | $      | 540               |   | $                | 11,865,734 |            | $      | (422,826     | )      | $          | —  |   | $ | 6,666,770 |   | $ | 18,110,765 |   |
|                                                                                                  |   |             |   |             |   |           |      |         |   |              |   |             |       |            |   |         |   |       |    |
| Return  of capital to shareholder through purchase of SelfCare, Inc. and Earthlings,  Inc.            |   | —           |   | —           |   | —         |      | —       |   | (3,073,061        | )      | —           |       | —          |   | —       |   | (3,073,061 | )       |
| Issuance  of common stock in conjunction with acquisitions and compensation                           |   | 578,622          |   | 58               |   | —         |      | —       |   | 7,892,474         |   | 70,500           |       | —          |   | —       |   | 7,963,032  |    |
| Shares  issued in connection with secondary offering, including the underwriter’s  overallotment |   | 2,530,000        |   | 253              |   | —         |      | —       |   | 31,576,055        |   | —           |       | —          |   | —       |   | 31,576,308 |    |
| Net  income                                                                                           |   | —           |   | —           |   | —         |      | —       |   | —            |   | —           |       | —          |   | 4,055,588    |   | 4,055,588  |    |
|                                                                                                  |   |             |   |             |   |           |      |         |   |              |   |             |       |            |   |         |   |       |    |
| Balance  at December 31, 2001                                                                    |   | 8,581,806        |   | 858              |   | 5,400,000      |      | 540          |   | 48,261,202        |   | (352,326         | )          | —          |   | 10,722,358   |   | 58,632,632 |    |
|                                                                                                  |   |             |   |             |   |           |      |         |   |              |   |             |       |            |   |         |   |       |    |
| Issuance  of common stock in conjunction with acquisitions and compensation                           |   | 552,292          |   | 55               |   | —         |      | —       |   | 5,081,844         |   | 208,461          |       | —          |   | —       |   | 5,290,360  |    |
| Net  income                                                                                           |   | —           |   | —           |   | —         |      | —       |   | —            |   | —           |       | —          |   | 5,447,988    |   | 5,447,988  |    |
|                                                                                                  |   |             |   |             |   |           |      |         |   |              |   |             |       |            |   |         |   |       |    |
| Balance  at December 31, 2002                                                                    |   | 9,134,098        |   | 913              |   | 5,400,000      |      | 540          |   | 53,343,046        |   | (143,865         | )          | —          |   | 16,170,346   |   | 69,370,980 |    |
|                                                                                                  |   |             |   |             |   |           |      |         |   |              |   |             |       |            |   |         |   |       |    |
| Issuance  of common stock in conjunction with acquisitions and compensation                           |   | 68,958           |   | 7                |   | —         |      | —       |   | 488,704           |   | 71,999           |       | —          |   | —       |   | 560,710    |    |
| Comprehensive  loss:                                                                                  |   |             |   |             |   |           |      |         |   |              |   |             |       |            |   |         |   |       |    |
| Net  loss                                                                                             |   | —           |   | —           |   | —         |      | —       |   | —            |   | —           |       | —          |   | (971,755     | )      | (971,755   | )       |
| Foreign  currency translation adjustment, net of income taxes of $144,314                             |   | —           |   | —           |   | —         |      | —       |   | —            |   | —           |       | 524,870         |   | —       |   | 524,870    |    |
| Comprehensive  loss                                                                                   |   | —           |   | —           |   | —         |      | —       |   | —            |   | —           |       | —          |   | —       |   | (446,885   | )       |
|                                                                                                  |   |             |   |             |   |           |      |         |   |              |   |             |       |            |   |         |   |       |    |
| Balance  at December 31, 2003                                                                    |   | 9,203,056        |   | $                | 920    |           | 5,400,000 |         | $      | 540               |   | $                | 53,831,750 |            | $      | (71,866      | )      | $          | 524,870 |   | $ | 15,198,591 |   | $ | 69,484,805 |   |

 

See accompanyingnotes to the consolidated financial statements.

 

27

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GAIAM, INC.

CONSOLIDATED STATEMENTSOF CASH FLOWS

 
|                                                                                                |   | **Years  ended December 31,** |       |
|-----------------------------------------------------------------------------------------------------|--------|------------------------------------|------------|
|                                                                                                |   | **2003**                           |       | **2002** |   | **2001** |   |
| **Operating activities**                                                                            |   |                               | ** ** |   | ** ** |   | ** ** |
| Net income (loss)                                                                                   |   | $                                  | (971,755   | ) | $ | 5,447,988 |   | $ | 4,055,588 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |   |                               |       |   |   |   |   |
| Depreciation                                                                                        |   | 2,594,262                          |       | 1,966,127 |   | 2,225,312 |   |
| Amortization                                                                                        |   | 486,507                            |       | 345,191 |   | 638,617 |   |
| Website impairment charge                                                                           |   | —                             |       | — |   | 1,350,000 |   |
| Stock compensation                                                                                  |   | 72,000                             |       | 324,670 |   | 390,912 |   |
| Minority interest in consolidated subsidiaries                                                      |   | 984,818                            |       | 40,443 |   | 404,305 |   |
| Non-cash gain on Gaiam.com stock redemption                                                         |   | (866,000                           | )          | (189,334 | ) | — |   |
| Deferred tax expense                                                                                |   | 94,633                             |       | 162,088 |   | 32,160 |   |
| Changes  in operating assets and liabilities, net of effects from acquisitions:                     |   |                               |       |   |   |   |   |
| Accounts  receivable                                                                                |   | 5,919,176                          |       | (5,366,885 | ) | (8,179,622 | ) |
| Inventory                                                                                           |   | (573,744                           | )          | 679,389 |   | (6,716,208 | ) |
| Deferred  advertising costs                                                                         |   | 768,651                            |       | (637,768 | ) | (45,511 | ) |
| Capitalized  production costs                                                                       |   | (1,110,471                         | )          | (1,432,346 | ) | (894,812 | ) |
| Other  current assets                                                                               |   | (251,674                           | )          | (704,638 | ) | 664,226 |   |
| Other  assets                                                                                       |   | 73,004                             |       | (592,676 | ) | (42,359 | ) |
| Accounts  payable                                                                                   |   | (57,883                            | )          | 2,215,574 |   | (2,302,266 | ) |
| Accrued  liabilities                                                                                |   | (1,845,333                         | )          | (1,705,901 | ) | 1,101,376 |   |
| Income  taxes payable                                                                               |   | (1,603,241                         | )          | 474,495 |   | 753,498 |   |
| Net  cash provided by (used in) operating activities                                                |   | 3,712,950                          |       | 1,026,417 |   | (6,564,784 | ) |
|                                                                                                |   |                               |       |   |   |   |   |
| **Investing  activities**                                                                           |   |                               |       |   |   |   |   |
| Purchase  of property, equipment, and media rights                                                  |   | (2,861,872                         | )          | (3,658,356 | ) | (1,232,321 | ) |
| Purchase  of investments and stock rights                                                           |   | (115,000                           | )          | (7,865,192 | ) | — |   |
| Proceeds  from the sale of property and equipment                                                   |   | —                             |       | 2,748,292 |   | — |   |
| Proceeds  from sale (purchase) of stock in subsidiary                                               |   | —                             |       | (2,000,000 | ) | — |   |
| Payments  for acquisitions, net of cash acquired                                                    |   | (3,725,583                         | )          | (672,684 | ) | (4,457,718 | ) |
| Net  cash used in investing activities                                                              |   | (6,702,455                         | )          | (11,447,940 | ) | (5,690,039 | ) |
|                                                                                                |   |                               |       |   |   |   |   |
| **Financing  activities**                                                                           |   |                               |       |   |   |   |   |
| Principal  payments on capital leases                                                               |   | (347,571                           | )          | (213,407 | ) | (144,358 | ) |
| Proceeds  from issuance of common stock                                                             |   | 129,715                            |       | 178,041 |   | 31,576,308 |   |
| Net  payments on borrowings                                                                         |   | —                             |       | (364,323 | ) | (5,512,148 | ) |
| Net  cash (used in) provided by financing activities                                                |   | (217,856                           | )          | (399,689 | ) | 25,919,802 |   |
|                                                                                                |   |                               |       |   |   |   |   |
| Effects  of exchange rates on cash and cash equivalents                                             |   | 168,860                            |       | — |   | — |   |
|                                                                                                |   |                               |       |   |   |   |   |
| Net  (decrease) increase in cash and cash equivalents                                               |   | (3,038,501                         | )          | (10,821,212 | ) | 13,664,979 |   |
| Cash  and cash equivalents at beginning of year                                                     |   | 11,422,435                         |       | 22,243,647 |   | 8,578,668 |   |
| Cash  and cash equivalents at end of year                                                           |   | $                                  | 8,383,934  |   | $ | 11,422,435 |   | $ | 22,243,647 |   |
|                                                                                                |   |                               |       |   |   |   |   |
| **Supplemental  cash flow information**                                                             |   |                               |       |   |   |   |   |
| Interest  paid                                                                                      |   | $                                  | 46,031     |   | $ | 44,614 |   | $ | 388,996 |   |
| Income  taxes paid                                                                                  |   | 1,033,400                          |       | 3,088,500 |   | 1,630,000 |   |
| Common  stock issued for acquisitions                                                               |   | 347,500                            |       | 4,905,000 |   | 6,664,834 |   |
| Property  and equipment acquired under capital lease                                                |   | —                             |       | — |   | 201,197 |   |

 

See accompanyingnotes to the consolidated financial statements.

 

28

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GAIAM, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

 

**1. Summary of Significant Accounting Policies**

 

*Organization*

 

Gaiam,Inc. (“Gaiam”) was incorporated under the laws of the State of Colorado onJuly 7, 1988.  Gaiam is amulti-channel lifestyle company providing a broad selection of information,products and services to clients who value natural health, personaldevelopment, ecological lifestyles and responsible media.

 

*Basis of Consolidation*

 

The accompanyingconsolidated financial statements include the accounts of Gaiam and itssubsidiaries in which Gaiam’s ownership is greater than 50% and the subsidiaryis considered to be under Gaiam’s control. All material intercompany accounts and transaction balances have beeneliminated in consolidation.

 

*Cash and Cash Equivalents*

 

Cash and cash equivalentsinclude demand deposit accounts with financial institutions and all highlyliquid investments, which mature within three months of date of purchase.  Cash equivalents are carried at cost, whichapproximate fair value.

 

*Provision for Doubtful Accounts*

 

Gaiam records a provisionfor doubtful accounts for all receivables not expected to be collected.  Gaiam generally does not requirecollateral.  Gaiam evaluates thecollectibility of the accounts receivable based on a combination of factors.  In circumstances when we are aware of aspecific customer’s inability to meet its financial obligations (e.g.bankruptcy filings), Gaiam records a specific reserve for bad debts againstamounts due.  For all other instances,Gaiam recognizes reserves based on historical experience and review ofindividual accounts outstanding.

 

*Inventory*

 

Inventory consistsprimarily of finished goods held for sale and is stated at the lower of cost(first-in, first-out method) or market. Gaiam identifies its inventory items towrite down for obsolescence based on the item’s current sales status andcondition.  If the item is discontinuedor slow moving, it is written down based on an estimate of the markdown toretail price needed to sell through its current stock level.  The reserve for obsolescence was $818thousand in 2003 and $772 thousand in 2002.

 

*AdvertisingCosts*

 

Deferred advertisingcosts relate to the preparation, printing and distribution of catalogs.  Such costs are deferred for financialreporting purposes until the catalogs are distributed, then amortized oversucceeding periods on the basis of estimated sales.  Seasonal catalogs are amortized within seven months, while theamortization period for annual catalogs does not exceed one year.  Historical sales statistics are the principalfactor used in estimating the amortization rate.  Other advertising and promotional costs are expensed as incurred.

 

In accordance withEmerging Issues Task Force (“EITF”) Issue No. 01-9, *Accounting for Consideration Given by a Vendor to a Customer (Includinga Reseller of the Vendor’s Products)*, Gaiam records sales discountsor other sales incentives as a reduction to revenues.  Gaiam identifies and records as expense those cooperativeadvertising expenses paid by Gaiam, which are for advertisements meeting theseparable benefit and fair value tests, as part of selling and operatingexpense.

 

Amounts recorded asadvertising expense, including those related to Gaiam's catalogs were $13.1million, $13.4 million, and $11.2 million for the period ended December 31,2003, 2002 and 2001, respectively, and is included in selling and operatingexpense in the consolidated statement of operations.

 

29

----

 

*Property and Equipment*

 

Property and equipmentare stated at cost less accumulated depreciation and amortization, whichincludes the amortization of assets recorded under capital leases.  Included in property and equipment is thecost of internal-use software, including software used in connection withGaiam’s websites.  Gaiam expenses allcosts related to the development of internal-use software other than thoseincurred during the application development stage in accordance with Statementof Position No. (“SOP”) 98-1, *Accounting forCosts of Computer Software Developed or Obtained for Internal Use*.  Costs incurred during the application developmentstage are capitalized and amortized over the estimated useful life of thesoftware (generally five years). Depreciation of property and equipment is computed on the straight-linemethod over estimated useful lives (generally five to ten years).  Property and equipment purchased undercapital leases are amortized on a straight-line basis over the lesser of theestimated useful life of the asset or the lease term.

 

*Investments*

 

In 2002, Gaiam invested $7.8 millionfor a 15% interest in Conscious Media, Inc., a multimedia company.  Gaiam does not have significant influenceover the management of Conscious Media, Inc. and accordingly has accounted forthe investment on a cost basis in all reported periods.  Under the cost method of accounting,investments in private companies are carried at cost.  Gaiam evaluates its long-lived assets, including investments, onat least an annual basis to test for impairment or valuation issues, andconcluded that, as of December 31, 2003 and 2002, no indicators of impairmentwere present.

 

*Capitalized Production Costs*

 

In accordance with SOPNo. 00-2, “Accounting by Producers or Distributors of Films,” capitalizedproduction costs consists of costs incurred to produce media content, net ofaccumulated amortization.  These costs,as well as participations costs, are recognized as operating expenses on anindividual film basis in the ratio that the current year’s gross revenues bearto management’s estimate of total ultimate gross revenues from all sources tobe earned over a seven year period. Capitalized production costs are stated at the lower of unamortized costor estimated fair value on an individual film basis.  Revenue forecasts are continually reviewed by management andrevised when warranted by changing conditions.  When estimates of total revenues and other events or changes incircumstances indicate that a film has a fair value that is less than itsunamortized cost, an impairment loss is recognized in the current period forthe amount by which the unamortized cost exceeds the film’s fair value.  For all periods presented, there have beenno impairment losses recorded.

 

As of December 31,2003, capitalized production costs for released films were approximately $2.4million, and for those films not yet released was approximately $395thousand.  Additionally, as ofDecember 31, 2003, Gaiam estimates that approximately $2.1 million inparticipation expenses and approximately $1.2 million or 21% of the unamortizedcosts for released films will be amortized during 2004, and approximately 64%of the unamortized costs for released films will be amortized within the nextthree years.  Accumulated amortizationat December 31, 2003 and 2002 was approximately $4.4 million and $3.3 million,respectively.  Amortization expense forthe years ending December 31, 2003, 2002 and 2001 was $1.2 million, $1.2million, and $533 thousand, respectively. Based on the capitalized video production costs at December 31, 2003 andassuming no subsequent impairment of the underlying assets or a materialincrease in video productions, the annual amortization expense for the nextfive years is expected to approximate amounts recorded in historical periods.

 

*MediaLibrary*

 

The media libraryasset represents both the cost of the library of produced videos acquiredthrough a business combination, and the purchase price of media rights to bothvideo and audio titles.  The medialibrary is presented net of accumulated amortization of approximately $1.9million and $1.4 million at December 31, 2003 and 2002, and it is beingamortized over the estimated useful life of the titles, which range from fiveto fifteen years.  Amortization expensefor the years ending December 31, 2003, 2002 and 2001 was $492 thousand, $345thousand, and $244 thousand, respectively. Based upon the acquired and capitalized media library costs at December31, 2003 and assuming no subsequent impairment of the underlying assets ormaterial additions thereto, the annual amortization expense for the next fiveyears is expected to approximate $686 thousand per annum.

 

*Goodwill*

 

Gaiam adopted Statementof Financial Accounting Standards (“SFAS”) No. 142*, Goodwill and Other Intangible Assets*,effective January 1, 2002.

 

The new standard requiresthat goodwill no longer be amortized, but tested for impairment at leastannually.  These tests will be performedmore frequently if there is a triggering event indicating potentialimpairment.  Prior to adoption of SFASNo. 142, goodwill was amortized on a straight-line basis over lives rangingfrom 10 to 20 years.  In 2001, goodwillamortization was approximately $401 thousand, or $0.02 per share.

 

30

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SFAS No. 142 prescribes atwo-step method for determining goodwill impairment.  In the first step, the fair value of the reporting unit isdetermined using a comparable companies market multiple approach.  If the net book value of the reporting unitexceeds the fair value, then the second part of the impairment test would becompleted.  This involves an allocationof the reporting unit’s fair value to all of its assets and liabilities in amanner similar to a purchase price allocation, with any residual fair valuebeing allocated to goodwill.  The fairvalue of the goodwill is then compared to its carrying amount to determineimpairment.  An impairment charge willbe recognized only when the implied fair value of a reporting unit’s goodwillis less than its carrying amount.

 

Gaiam has allocated allof its goodwill balance of $9.5 million at December 31, 2003 to its tworeporting units, business and direct to consumer in the amounts of $4 millionand $5.5 million, respectively.  AtDecember 31, 2002, Gaiam allocated goodwill in the amounts of $862thousand and $5.5 million, respectively, to its business and direct to consumerreporting units.  Goodwill is allocatedto reporting units at the time of acquisition.

 

Gaiam completed itsannual goodwill tests, using comparable company market multiples to establishthe fair value of the reporting units, and found no goodwill impairment ineither of its reporting units for 2003 and 2002.

 

*Long-Lived Assets*

 

Gaiam evaluatesimpairment of its long-lived assets, other than goodwill, in accordance withSFAS No. 144, *Accounting for the Impairmentor Disposal of Long-Lived Assets,*which was adopted by Gaiam as ofJanuary 1, 2002.  Adoption of SFAS144 had no effect on Gaiam’s financial position or its results ofoperations.  The carrying value of long-livedassets held and used, other than goodwill, is evaluated when events or changesin circumstances indicate the carrying value may not be recoverable.  The carrying value of a long-lived asset isconsidered impaired when the total projected undiscounted cash flows from suchasset are separately identifiable and are less than the carrying value.  In that event, a loss is recognized based onthe amount by which the carrying value exceeds the fair market value of thelong-lived asset.  Fair market value isdetermined primarily using the projected cash flows from the asset discountedat a rate commensurate with the risk involved. Losses on long-lived assets held for sale, other than goodwill, aredetermined in a similar manner, except that fair market values are reduced fordisposal costs.

 

At December 31,2001, it was determined that the Interworld platform of the Gaiam.com websitewas impaired.  As a result, animpairment charge of $1.35 million was recorded in the direct to consumersegment.

 

*Income Taxes*

 

Gaiam provides for incometaxes pursuant to the liability method as prescribed in Statement of FinancialAccounting Standards (SFAS) No. 109, *Accounting for Income Taxes*.  The liability method requires recognition ofdeferred income taxes based on temporary differences between financialreporting and income tax bases of assets and liabilities, using currentlyenacted income tax rates and regulations.

 

*Revenues*

 

Revenue from thesale of products is recognized at the time merchandise is shipped to thecustomer.  Revenue for servicesprovided, such as design consultation for solar installations, is recognizedwhen services are rendered.  Licensingrevenue is recognized upon delivery of the media licensed.  Amounts billed to customers for postage andhandling charges, which approximate $4.1million for 2003, $4.5 million for2002, and $4.7 million for 2001 are recognized as revenue at the time that therevenues arising from the product being shipped are recognized.  Postage and handling costs, whichapproximate $3.6 million for 2003, $5.8 million for 2002, and $5.2 million for2001, are included in selling and operating expense along with otherfulfillment costs incurred to warehouse, package and deliver products tocustomers.  Gaiam provides a reserve forexpected future returns at the time the sale is recorded based upon historicalexperience and future expectations.

 

*Fair Value of Financial Instruments*

 

The carrying amounts of Gaiam’s financial instruments, including cash,cash equivalents and trade receivables and payables, approximate their fairvalues.

 

31

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*Use of Estimates*

 

The preparation ofconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the amounts reported in our consolidated financialstatements and accompanying notes including the valuation of stated accountsreceivable and inventory balances. Actual results could differ from those estimates.

 

*Stock-Based Compensation*

 

Gaiam accounts for itsstock-based compensation arrangements under the provisions of AccountingPrinciples Board Opinion No. 25, *Accounting for Stock Issued to Employees*(“APB No. 25”) and related interpretations, including FASB Interpretation No.44, *Accounting for Certain TransactionsInvolving Stock Compensation*, rather than the alternative fair valueaccounting allowed by SFAS No. 123, *Accounting for Stock Based Compensation*.  Accordingly, no compensation expense isrecognized in Gaiam’s consolidated financial statements in connection withstock options granted to employees with exercise prices not less than fairvalue.  Deferred compensation foroptions granted to employees is determined as the difference between the deemedfair market value of Gaiam’s common stock on the date options were granted andthe exercise price.  For purposes ofthis pro-forma disclosure, the estimated fair value of options is assumed to beamortized to expense over the options’ vesting periods.

 

Compensation expense foroptions granted to non-employees has been determined in accordance with SFASNo. 123 as the fair value of the consideration received or the fair value ofthe equity instruments issued, whichever is more reliably measured.  Compensation expense for options granted tonon-employees is periodically re-measured as the underlying options vest (inthousand, except per share data).

 
|                                                                                                                                       |   | **For the  Years Ended  December 31,** |       |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|------------|
|                                                                                                                                       |   | **2003**                                    |       | **2002** | ** ** | **2001** | ** ** |
| Net income (loss) as reported                                                                                                              |   | $                                           | (971,755   | ) | $ | 5,447,988 |   | $ | 4,055,588 |   |
| Add: Stock-based compensation expense included in  reported net income (loss), net of related tax effects                                  |   | 72,000                                      |       | 208,461 |   | 70,500 |   |
| Deduct:   Total stock-based compensation expenses determined under fair value  based method for all awards net of related tax effects |   | (160,721                                    | )          | (926,942 | ) | (577,644 | ) |
| Pro  forma                                                                                                                                 |   | $                                           | (1,060,476 | ) | $ | 4,729,507 |   | $ | 3,548,444 |   |
| Net  income (loss) per common share                                                                                                        |   |                                        |       |   |   |   |   |
| As  reported                                                                                                                               |   | $                                           | (0.07      | ) | $ | 0.39 |   | $ | 0.33 |   |
| Pro  forma                                                                                                                                 |   | $                                           | (0.07      | ) | $ | 0.34 |   | $ | 0.29 |   |
| Fully  diluted net income (loss) per common share:                                                                                         |   |                                        |       |   |   |   |   |
| As reported                                                                                                                                |   | $                                           | (0.07      | ) | $ | 0.38 |   | $ | 0.32 |   |
| Pro  forma                                                                                                                                 |   | $                                           | (0.07      | ) | $ | 0.33 |   | $ | 0.30 |   |

 

*Defined Contribution Plan*

 

In 1999, Gaiamadopted a defined contribution retirement plan under Section 401(k) of theInternal Revenue Code, which covers substantially all employees.  Eligible employees may contribute amounts tothe plan, via payroll withholding, subject to certain limitations.  The 401(k) plan permits, but does notrequire, additional matching contributions to the 401(k) plan by Gaiam onbehalf of all participants in the 401(k) plan. To date, Gaiam has not made any matching contributions to the 401(k)plan.

 

32

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*Foreign Currency Translation*

 

Our foreign subsidiariesuse their local currency as their functional currency.  Assets and liabilities are translated intoU.S. dollars at exchange rates in effect at the balance sheet date.  Income and expense accounts are translatedat the average monthly exchange rates during the year.  Resulting translation adjustments, net ofincome taxes, are recorded as a separate component of accumulated othercomprehensive income.

 

*Comprehensive Loss*

 

SFAS No. 130, *Reporting onComprehensive Income* (“FASB No. 130”) establishes standards forreporting and display of comprehensive income and its components in theconsolidated financial statements. Comprehensive income includes all changes in equity during a period fromnon-owner sources.   These includeforeign currency translation adjustments, net of income taxes.

 

*Reclassifications*

 

Certain reclassificationshave been made to prior period amounts to conform to the current periodpresentations.

 

*Earnings (Loss) Per Share*

 

Basic earnings (loss) pershare excludes any dilutive effects of options, warrants and dilutivesecurities.  Basic earnings (loss) pershare is computed using the weighted average number of common sharesoutstanding during the period.  Dilutedearnings per share is computed using the weighted average number of common andcommon stock equivalent shares outstanding during the period.  Common equivalent shares are excluded fromthe computation of diluted earnings per share for the year endedDecember 31, 2003 because their effect is antidilutive.  All earnings per share amounts for allperiods have been presented and conform to the SFAS No. 128 requirements.

 

The following table setsforth the computation of basic and diluted earnings per share:

 
|                                                           |   | **2003**   |     | **2002**   |   | **2001**   |   |
|----------------------------------------------------------------|--------|------------|----------|------------|--------|------------|--------|
|                                                           |   |       |     |       |   |       |   |
| Numerator  for basic and diluted earnings (loss) per share     |   | $          | (971,755 | )          | $      | 5,447,988  |   | $ | 4,055,588 |   |
|                                                           |   |       |     |       |   |       |   |
| Denominator:                                                   |   |       |     |       |   |       |   |
| Weighted  average shares for basic earnings (loss) per share   |   | 14,594,089 |     | 14,107,390 |   | 12,395,907 |   |
|                                                           |   |       |     |       |   |       |   |
| Effect  of dilutive securities:                                |   |       |     |       |   |       |   |
| Weighted  average of common stock, stock options, and warrants |   | —     |     | 381,393    |   | 412,724    |   |
|                                                           |   |       |     |       |   |       |   |
| Denominators  for diluted earnings (loss) per share            |   | 14,594,089 |     | 14,488,783 |   | 12,808,631 |   |
|                                                           |   |       |     |       |   |       |   |
| Net  income (loss) per share–basic                        |   | $          | (0.07    | )          | $      | 0.39       |   | $ | 0.33 |   |
| Net  income (loss) per share–diluted                      |   | $          | (0.07    | )          | $      | 0.38       |   | $ | 0.32 |   |

 

**2.****                                      Mergersand Acquisitions**

 

On January 5, 2001,Gaiam acquired all of the stock of Earthlings, Inc. and Self Care, Inc.,companies under common ownership with the Chief Executive Officer of Gaiam, athis company’s net investment cost plus transaction expenses.  As these companies were under commoncontrol, the purchase was accounted for using historical costs, similar to apooling transaction.  The total combinedpurchase price for both companies was approximately $3.8 million.

 

On January 29, 2001,Gaiam completed its merger with Real Goods Trading Corporation.  In the tax-free stock-for-stock transaction,Real Goods shareholders received one share of Gaiam Class A common stock inexchange for ten shares of Real Goods stock owned.  The merger was accounted for using the purchase method ofaccounting, and $3.8 million of goodwill was recorded.

 

33

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On April 1, 2001,Gaiam purchased the remaining 30% equity interest in an organic clothingmanufacturer, and on September 30, 2001 Gaiam purchased the remaining49.9% interest in its two renewable energy businesses that it did not ownpreviously.  Total consideration paid byGaiam for these acquisitions was approximately $350 thousand in cash and 50,000shares of Class A common stock, and as a result of the acquisitions, $1.1million of goodwill was recorded.

 

In the third quarter of2002, Gaiam acquired a majority interest in a catalog company for $600thousand.  This acquisition wasaccounted for using the purchase method of accounting, and, since this companyhad negative net worth (liabilities exceeded assets), Gaiam recorded $2.9million of goodwill.

 

Results from operationsof these acquired companies are included in the consolidated financial statementsof Gaiam from the effective acquisition dates. The operating results for the 2002 and 2001 acquisitions were notsignificant to the overall consolidated Gaiam operations.

 

On January 20, 2003,Gaiam acquired a 50.1% interest in Leisure Systems International (“LSI”) Ltd.,a U.K. based distributor and marketer of lifestyle products.  The total purchase price consists of thefollowing (in thousands):

 
| Cash                                            |   | $   | 4,301  |   |
|-------------------------------------------------|--------|-----|--------|--------|
| Gaiam Class A common stock – 50,000 shares |   | 348 |   |
| Acquisition, legal and accounting costs         |   | 393 |   |
| Total purchase price                            |   | $   | 5,042  |   |

 

At the acquisition date,LSI met the accounting criteria to be considered a business combination asoutlined in SFAS No. 141, *Business Combinations*.  Accordingly, Gaiam recorded the excesspurchase price over the already allocated fair value of net assets acquired andintangible assets as goodwill.  The fairvalue assigned to intangible assets acquired was determined through establishedvaluation techniques.

 

The following is asummary of the purchase price allocation (in thousands):

 
| Tangible  assets less liabilities |   | $     | 2,122  |   |
|-----------------------------------|--------|-------|--------|--------|
| Intangible  assets                |   | 50    |   |
| Goodwill                          |   | 2,870 |   |
| Total  purchase price             |   | $     | 5,042  |   |

 

The results of operationsof Leisure Systems International are included in the consolidated financialstatements of Gaiam from the effective acquisition date of January 1,2003.  The revenue generated by thisacquisition for the twelve months ended December 31, 2003 wasapproximately $14.4 million.

 

**3. Property and Equipment**

 

Property and equipment,stated at cost, consists of the following:

 
|                                       |   | **2003**    |       | **2002**   |   |
|--------------------------------------------|--------|-------------|------------|------------|--------|
| Land                                       |   | $           | 3,100,000  |       | $      | 3,100,000 |   |
| Buildings                                  |   | 1,719,529   |       | 1,545,161  |   |
| Furniture,  fixtures and equipment         |   | 3,890,281   |       | 2,358,888  |   |
| Leasehold  improvements                    |   | 1,563,826   |       | 855,373    |   |
| Website  development costs                 |   | 3,761,262   |       | 3,761,262  |   |
| Computer  and telephone equipment          |   | 5,320,579   |       | 4,093,594  |   |
| Vehicles                                   |   | 711,074     |       | 71,463     |   |
| Warehouse  equipment                       |   | 710,155     |       | 590,861    |   |
|                                       |   | 20,776,706  |       | 16,376,602 |   |
| Accumulated  depreciation and amortization |   | (10,462,871 | )          | (6,833,371 | )      |
|                                       |   | $           | 10,313,835 |       | $      | 9,543,231 |   |

 

In 2001, Gaiam.comrecorded an impairment charge of $1.35 million against the Interworld platformof its website, which is recorded in selling and operating expenses.

 

34

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In the secondquarter of 2002, Gaiam sold the Gaiam Yoga Center, with a net book value of$2.9 million, for net proceeds of $2.7 million.

 

**4. Leases**

 

At December 31, 2003and 2002, Gaiam’s property held under capital leases consisted of thefollowing, which is included in property and equipment:

 
|                              |   | **December 31,** |    |
|-----------------------------------|--------|-----------------------|---------|
|                              |   | **2003**              |    | **2002** | ** ** |
|                              |   |                  |    |   |   |
| Warehouse  equipment              |   | $                     | —  |   | $ | 40,229 |   |
| Computer  and telephone equipment |   | 349,050               |    | 810,187 |   |
|                              |   | 349,050               |    | 850,416 |   |
| Accumulated  amortization         |   | (191,350              | )       | (490,293 | ) |
|                              |   | $                     | 157,700 |   | $ | 360,123 |   |

 

Amortizationexpense for property held under capital leases was $137 thousand in 2003, $138thousand in 2002 and $118 thousand in 2001.

 

Gaiam leasesequipment and office, retail, and warehouse space through capital and operatingleases.   Gaiam has renewal clauses insome of these leases, which range from 1 to 3 years.  The following schedule represents the annual future minimumpayments, as of December 31, 2003:

 
|                                            |   | **Capital** |     | **Operating** |      |
|-------------------------------------------------|--------|-------------|----------|---------------|-----------|
|                                            |   |        | * * |          | * *  |
| 2004                                            |   | $           | 56,435   |          | $         | 1,823,914 |   |
| 2005                                            |   | —      |     | 1,237,718     |      |
| 2006                                            |   | —      |     | 209,578       |      |
| Total  minimum lease payments                   |   | 56,435      |     | $             | 3,271,210 |   |
| Less  portion related to interest               |   | (1,907      | )        |          |      |
| Present  value of future minimum lease payments |   | 54,528      |     |          |      |
| Less  current portion                           |   | (54,528     | )        |          |      |
|                                            |   | $           | —   |          |      |   |

 

Gaiam incurred rentexpense of $1.8 million $1.9 million and $2.4 million for the years endedDecember 31, 2003, 2002 and 2001, respectively.

 

**5. Line of Credit**

 

Gaiam is party to arevolving line of credit agreement with a financial institution, which expiresduring 2005.  The credit agreementpermits borrowings up to the lesser of $15 million or Gaiam’s borrowing basewhich is calculated based upon the collateral value of Gaiam’s accountsreceivable, inventory, and certain property and equipment.  Borrowings under this agreement bearinterest at the lower of prime rate less 50 basis points or LIBOR plus 275basis points.  Borrowings are secured bya pledge of Gaiam’s cash and investments held at the financial institution,accounts receivable, inventory and certain property and equipment.  The credit agreement contains variousfinancial covenants, including covenants prohibiting the payment of cashdividends to Gaiam’s shareholders and requiring the maintenance of certainfinancial ratios.  At December 31,2003, Gaiam had no amounts outstanding under this agreement, and was incompliance with all the financial covenants.

 

**6. Income Taxes**

 

The provision for incometaxes is comprised of the following:

 

35

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|          |   | **2003** |     | **2002**  |   | **2001**  |   |
|---------------|--------|----------|----------|-----------|--------|-----------|--------|
| Current:      |   |     |     |      |   |      |   |
| Federal       |   | $        | (686,202 | )         | $      | 2,452,369 |   | $ | 2,104,877 |   |
| State         |   | (121,711 | )        | 387,316   |   | 360,780   |   |
| International |   | 511,339  |     | —    |   | —    |   |
|          |   | (296,574 | )        | 2,839,685 |   | 2,465,657 |   |
| Deferred:     |   |     |     |      |   |      |   |
| Federal       |   | (141,505 | )        | 153,132   |   | 27,441    |   |
| State         |   | (23,277  | )        | 8,956     |   | 4,719     |   |
|          |   | (164,782 | )        | 162,088   |   | 32,160    |   |
| Total         |   | $        | (461,356 | )         | $      | 3,001,773 |   | $ | 2,497,817 |   |

 

Variations from thefederal statutory rate are as follows:

 
|                                                                                     |   | **2003** |     | **2002** |   | **2001**  |   |
|------------------------------------------------------------------------------------------|--------|----------|----------|----------|--------|-----------|--------|
|                                                                                     |   |     |     |     |   |      |   |
| Expected  federal income tax expense at statutory rate of 34%                            |   | $        | (262,230 | )        | $      | 2,886,669 |   | $ | 2,365,621 |   |
| Effect  of other permanent differences                                                   |   | 44,116   |     | 32,967   |   | 28,362    |   |
| State  income tax expense, net of federal benefit and utilization of net operating  loss |   | (91,456  | )        | 82,137   |   | 103,834   |   |
| Effect  of differences between U.S. taxation and foreign taxation                        |   | (153,125 | )        | —   |   | —    |   |
| Other                                                                                    |   | 1,339    |     | —   |   | —    |   |
| Income  tax expense                                                                      |   | $        | (461,356 | )        | $      | 3,001,773 |   | $ | 2,497,817 |   |

 

Deferred income taxesreflect net tax effects of temporary differences between the carrying amountsof assets and liabilities for financial reporting purposes and the amounts usedfor income tax purposes.  The componentsof the net accumulated deferred income tax asset as of December 31, 2003and 2002 are as follows:

 
|                             |   | **December 31,** |      |
|----------------------------------|--------|-----------------------|-----------|
|                             |   | **2003**              |      | **2002** | ** ** |
| Deferred  tax assets:            |   |                  |      |   |   |
| Provision  for doubtful accounts |   | $                     | 260,642   |   | $ | 321,204 |   |
| Capitalized  inventory           |   | 4,303                 |      | 67,277 |   |
| Website  costs                   |   | 1,130,100             |      | 1,130,100 |   |
| Net  operating loss carryforward |   | 2,092,775             |      | 2,196,264 |   |
| Total  deferred tax assets       |   | $                     | 3,487,820 |   | $ | 3,714,845 |   |
| Deferred  tax liabilities:       |   |                  |      |   |   |
| Amortization                     |   | 762                   |      | 507 |   |
| Deferred  advertising costs      |   | (291,667              | )         | (743,864 | ) |
| Depreciation                     |   | (299,884              | )         | (105,296 | ) |
| Foreign exchange rate gain       |   | (144,314              | )         | — |   |
| Total deferred tax  liabilities  |   | $                     | (735,103  | ) | $ | (848,653 | ) |

 

At December 31, 2003, noprovision had been made for U.S. federal and state income taxes onapproximately $845 thousand of undistributed foreign earnings, which areexpected to be reinvested outside of the U.S. indefinitely.  Upon distribution of those earnings in theform of dividends or otherwise, Gaiam would be subject to U.S. income taxes(subject to an adjustment for foreign tax credits), state income taxes, andwithholding taxes payable to the various foreign countries.  Determination of the amount of unrecognizeddeferred U.S. income tax liability is not practicable because of thecomplexities associated with its hypothetical calculation.  Gaiam’s foreign subsidiaries generatedincome before minority interest and income taxes of approximately $2.0 millionin 2003.  Such income was negligible in2002.

 

At December 31, 2003 Gaiam hadnet operating loss (NOL) carry forwards of approximately $5.6 million acquiredas part of the Real Goods acquisition, which may be used to offset futuretaxable income.  These carryforwardsexpire beginning in 2019.  The InternalRevenue Service Code contains provisions that limit the NOL available for usein any given year upon the occurrence of certain events, including significantchanges in ownership interest.  A changein ownership of a company of greater than 50% within a three-year periodresults in an annual limitation on the utilization of NOL carryforwards fromtax periods prior to the ownership changes. Gaiam’s NOL carryforwards as of December 31, 2003 are subject toannual limitations due to changes in****ownership.

 

36

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Gaiamexpects the deferred tax assets at December 31, 2003 to be fullyrecoverable and the deferred tax liabilities at December 31, 2003 to befully satisfied through the reversal of taxable temporary differences in futureyears as a result of normal business activities.  Accordingly, no valuation allowances for deferred tax items wereconsidered necessary as of December 31, 2003 or 2002.

 

**7. Stockholders’ Equity**

 

In 2001, Gaiamissued approximately 481,000 shares of Class A common stock as a result ofGaiam’s merger with Real Goods, 50,000 shares of Class A common stock inconjunction with the acquisition of the 49.9% interest in its renewable energybusinesses, 42,153 shares of Class A common stock upon exercise of optionsgranted under the 1999 Long-Term Incentive Plan and 5,045 shares of commonstock to four directors, in lieu of cash compensation.

 

On August 3,2001, Gaiam completed a secondary offering of 2,200,000 shares of Class Acommon stock, plus an overallotment of 330,000 shares, at an offering price of$13.75 per share.  Net proceeds toGaiam, after deducting commissions and expenses associated with the offering,were $31.6 million.

 

In 2002, Gaiamissued 24,000 shares of Class A common stock upon exercise of warrants, 28,292shares of Class A common stock upon exercise of options granted under the 1999Long-Term Incentive Plan, and 500,000 shares of Class A common stock inconjunction with the purchase of the remaining 49.9% equity interest inGaiam.com.  Gaiam also recorded acontingent liability, in other liabilities for 2002 and accrued liabilities in2003, for the issuance of up to an additional 200,000 shares of Class A commonstock in connection with the Gaiam.com transaction, which would be triggeredbased on the trading price of Gaiam’s Class A common stock at November 1,2004.  In 2003, Gaiam repurchased therights to 100,000 of these shares.

 

In 2003, Gaiamissued 50,000 shares of Class A common stock in conjunction with theacquisition of 50.1% of Leisure Systems International Ltd. and 3,750 shares ofClass A common stock to four directors in lieu of cash compensation.  In addition, Gaiam issued 15,208 shares ofClass A common stock upon exercise of options granted under the 1999 Long-TermIncentive Plan.

 

As ofDecember 31, 2003, Gaiam had the following Class A common shares reservedfor future issuance:

 
| Conversion of Class B common  shares            |   | 5,400,000 |   |
|-------------------------------------------------|--------|-----------|--------|
| Awards under the 1999 Long-Term  Incentive Plan |   | 1,704,680 |   |
| Total  shares reserved for future issuance      |   | 7,104,680 |   |

 

Each holder of shares of Class A common stockis entitled to one vote for each share held on all matters submitted to a voteof shareholders. Each share of Class B common stock is entitled to ten votes onall matters submitted to a vote of shareholders. There are no cumulative votingrights. All holders of shares of Class A common stock and shares of Class Bcommon stock vote as a single group on all matters that are submitted to theshareholders for a vote. Accordingly, holders of a majority of the votes of theshares of Class A common stock and shares of Class B common stock entitled tovote in any election of directors may elect all of the directors who stand for election.  As a result of voting rights describedabove, the holder of the Class B common stock has effective control ofGaiam.  As of December 31, 2003 and2002, all Class B common stock was held by the Chief Executive Officer ofGaiam.

 

Shares of Class A common stock and shares ofClass B common stock are entitled to equal dividends, if any, as may bedeclared by the Board of Directors out of legally available funds. In the eventof a liquidation, dissolution or winding up of Gaiam, the shares of Class A commonstock and shares of Class B common stock would be entitled to share ratably inGaiam’s assets remaining after the payment of all of Gaiam’s debts and otherliabilities. Holders of shares of Class A common stock and shares of Class Bcommon stock have no preemptive, subscription or redemption rights, and thereare no redemption or sinking fund provisions applicable to the shares of ClassA common stock and Class B common stock. The outstanding shares of Class Acommon stock and shares of Class B common stock are fully paid andnon-assessable.

 

The Class B common stockmay not be transferred unless converted into shares of Class A common stock,other than certain transfers to affiliates, family members, and charitableorganizations. The shares of Class B common stock are convertible one-for-oneinto shares of Class A common stock, at the option of the holder of the sharesof Class B common stock.

 

37

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**8. Stock Option Plans**

 

On June 1, 1999,Gaiam adopted its 1999 Long-Term Incentive Plan (“the Plan”), which providesfor the granting of options to purchase up to 2.1 million shares of Gaiam’scommon stock.  Both incentive stockoptions and non-qualified stock options may be issued under the provisions ofthe Plan.  Employees of Gaiam and itsaffiliates, members of the Board of Directors, consultants and certain keyadvisors are eligible to participate in the plan, which shall terminate nolater than June 1, 2009.  Theseoptions granted under the Plan generally vest and become exercisable at 2% permonth for the 50 months beginning in the eleventh month after date ofgrant.  Grants generally expire 7 yearsfrom the date of grant.

 

Gaiam’s deferredcompensation was $72 thousand $144 thousand and $352 thousand in 2003, 2002 and2001, respectively.  In 2000, deferredcompensation was recorded in connection with: acquisitions made by Gaiam in which options were issued to employees ofan acquired company; options issued to employees whereby the grant pricediffered from the deemed fair value of Gaiam’s common stock; and options issuedto non-employees for services to be provided over the related terms of theirrespective agreements.

 

In calculating deferredcompensation for each equity award granted to non-employees, Gaiam used theBlack Scholes option pricing model, with the following weighted-averageassumptions used for grants in 2003, 2002 and 2001:  risk-free interest rates ranging from 2.26% to 6.00%; expecteddividend yield of zero; expected option lives of 5 years, and expectedvolatility of 0.70, 0.54 and 0.47, respectively.  The amortization of deferred compensation is charged tooperations over the vesting period of the options, which is typically 5 years.  Total amortization expense recognized in2003 and 2002 related to deferred compensation was $72 thousand and $208thousand respectively.

 

A summary of stockoption activity and weighted average exercise prices for the years endedDecember 31, 2003 and 2002 follows:

 
|                                                                   |   | **2003**   |       | **2002**                               |       |
|------------------------------------------------------------------------|--------|------------|------------|----------------------------------------|------------|
|                                                                   |   | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding  at beginning of year                                      |   | 1,727,562  |       | $                                      | 9.14       |   | 1,513,756 |   | $ | 8.27 |   |
| Granted:                                                               |   |       |       |                                   |       |   |   |   |   |
| Price equal to fair value                                              |   | 490,000    |       | $                                      | 5.37       |   | 318,500 |   | $ | 12.98 |   |
| Exercised                                                              |   | (15,208    | )          | $                                      | 4.63       |   | (28,292 | ) | $ | 5.75 |   |
| Forfeited                                                              |   | (497,674   | )          | $                                      | 11.09      |   | (76,402 | ) | $ | 9.14 |   |
| Outstanding  at end of year                                            |   | 1,704,680  |       | $                                      | 7.52       |   | 1,727,562 |   | $ | 9.14 |   |
| Exercisable  at end of year                                            |   | 778,778    |       | $                                      | 6.78       |   | 581,424 |   | $ | 6.58 |   |
|                                                                   |   |       |       |                                   |       |   |   |   |   |
| Shares  available on December 31, for options that may be granted |   | 395,320    |       | 372,438                                |       |

 

A summary of stockoptions outstanding as of December 31, 2003 follows:

 
|                          |   | **Outstanding  Stock Options** |       | **Exercisable  Stock Options**                 |   |
|-------------------------------|--------|--------------------------------|------------|------------------------------------------------|--------|
| **Range of  Exercise Prices** |   | **Shares  Outstanding**        | ** ** | **Weighted  Average  Remaining  Life (Years)** |   | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $4.00  - $4.99                |   | 569,720                        |       | 2.4                                            |   | $ | 4.38 |   | 494,688 |   | $ | 4.38 |   |
| $5.00  - $5.99                |   | 546,120                        |       | 6.1                                            |   | $ | 5.28 |   | 65,840 |   | $ | 5.00 |   |
| $6.00  - $6.99                |   | 9,500                          |       | 6.1                                            |   | $ | 6.72 |   | 50 |   | $ | 6.95 |   |
| $7.00  - $7.99                |   | 10,520                         |       | 4.4                                            |   | $ | 7.35 |   | 4,180 |   | $ | 7.19 |   |
| $9.00  - $9.99                |   | 11,500                         |       | 5.6                                            |   | $ | 9.62 |   | 1,380 |   | $ | 9.62 |   |
| $10.00  - $10.99              |   | 247,400                        |       | 4.7                                            |   | $ | 10.23 |   | 93,590 |   | $ | 10.17 |   |
| $12.00  - $12.99              |   | 32,000                         |       | 4.2                                            |   | $ | 12.38 |   | 14,720 |   | $ | 12.38 |   |
| $14.00  - $14.99              |   | 5,000                          |       | 5.5                                            |   | $ | 14.81 |   | 700 |   | $ | 14.81 |   |
| $15.00  - $15.99              |   | 263,260                        |       | 4.6                                            |   | $ | 15.32 |   | 97,950 |   | $ | 15.32 |   |
| $16.00  - $16.99              |   | 7,000                          |       | 3.8                                            |   | $ | 16.35 |   | 3,820 |   | $ | 16.30 |   |
| $17.00  - $17.99              |   | 2,000                          |       | 3.6                                            |   | $ | 17.18 |   | 1,200 |   | $ | 17.18 |   |
| $18.00  - $18.99              |   | 660                            |       | 5.2                                            |   | $ | 18.30 |   | 660 |   | $ | 18.30 |   |
|                          |   | 1,704,680                      |       | 4.4                                            |   | $ | 7.52 |   | 778,778 |   | $ | 6.78 |   |

 

38

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In estimating the proforma compensation expense for each equity award granted during the year, Gaiamused the Black Scholes option pricing model, with the followingweighted-average assumptions used for grants in 2003, 2002 and 2001,respectively:  risk-free interest ratesranging from 2.26% and 6.00%, expected dividend yield of zero; expected optionlives of 5 years, and expected volatility of 0.70, 0.54 and 0.47,respectively.  Options granted prior toGaiam’s initial public offering were valued using the minimum value method and,therefore, volatility was not applicable.

 
|                                                             |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Weighted-average  fair value of options granted during the year: |   |     |   |     |   |     |   |
| Price  equal to fair value                                       |   | $        | 3.21   |     | $      | 6.29     |   | $ | 5.02 |   |
| Price  less than fair value                                      |   | $        | — |     | $      | —   |   | $ | — |   |

 

Option valuationmodels such as the minimum value and Black-Scholes methods described aboverequire the input of highly subjective assumptions.  Because Gaiam’s employee stock options have characteristicssignificantly different from those of traded options, and because changes inthe subjective input assumptions can materially affect the fair value estimate,in management’s opinion, the existing models do not necessarily provide areliable single measure of the fair value of its employee stock options.

 

**9. Related Party Transactions**

 

In the first quarter of2001, Gaiam acquired all of the stock of Earthlings, Inc. and Self Care, Inc.,companies under common ownership with the Chief Executive Officer of Gaiam, athis company’s net investment cost plus transaction expenses.  As these companies were under commoncontrol, the purchase was accounted for using historical costs, similar to apooling transaction.  The total combinedpurchase price for both companies was approximately $3.8 million.

 

**10.Segment and Geographic Information**

 

Gaiam manages itsbusiness and aggregates its operational and financial information in accordancewith two reportable segments.  Thedirect to consumer segment contains the catalog and Internet sales channels,while the business segment comprises the retailers, media and corporate accountchannels.

 

Although Gaiam is able totrack revenues by sales channel, the management, allocation of resources andanalysis and reporting of expenses is solely on a combined basis, at thereportable segment level.

 

39

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Contribution margin isdefined as net sales, less cost of goods sold and direct expenses.  Financial information for Gaiam’s businesssegments was as follows:

 

Segment Information

 
|                                                                                    |   | **Year Ended  December 31,** |       |
|-----------------------------------------------------------------------------------------|--------|-----------------------------------|------------|
|                                                                                    |   | **2003**                          |       | **2002** |   | **2001** |   |
| Net  revenue:                                                                           |   |                              |       |   |   |   |   |
| Direct  to consumer                                                                     |   | $                                 | 50,456,814 |   | $ | 50,781,776 |   | $ | 51,259,303 |   |
| Business                                                                                |   | 51,543,289                        |       | 60,624,537 |   | 47,477,845 |   |
| Consolidated  net revenue                                                               |   | 102,000,103                       |       | 111,406,313 |   | 98,737,148 |   |
| Contribution  margin:                                                                   |   |                              |       |   |   |   |   |
| Direct  to consumer                                                                     |   | 593,543                           |       | 930,920 |   | 462,140 |   |
| Business                                                                                |   | (1,875,742                        | )          | 7,819,904 |   | 6,149,332 |   |
| Consolidated  contribution margin                                                       |   | (1,282,199                        | )          | 8,750,824 |   | 6,611,472 |   |
| Reconciliation  of contribution margin to net income (loss):                            |   |                              |       |   |   |   |   |
| Other  income (expense)                                                                 |   | 545,733                           |       | (260,620 | ) | 346,238 |   |
| Income  tax (benefit) expense                                                           |   | (461,356                          | )          | 3,001,773 |   | 2,497,817 |   |
| Minority  interest in net (income) loss of consolidated subsidiary, net of income taxes |   | (696,645                          | )          | (40,443 | ) | (404,305 | ) |
| Net  income (loss)                                                                      |   | $                                 | (971,755   | ) | $ | 5,447,988 |   | $ | 4,055,588 |   |

 

The direct to consumersegment had allocated long-lived assets of $15.7 million, $16.2 million, and$18.9 million at December 31, 2003, 2002, and 2001, respectively.  The business segment had allocatedlong-lived assets of $20.4 million, $14.2 million, and $11.2 million atDecember 31, 2003, 2002 and 2001, respectively.  Gaiam held approximately $7.9 million, $8.1 million, and $310thousand in long-lived assets at December 31, 2003, 2002, and 2001,respectively, which were not utilized in, or allocable to, either segment.

 

Major Customer

 

Sales to our largestcustomer for 2003, 2002 and 2001 accounted for approximately 10.9%, 9.2% and5.9%        of total   revenue, respectively, during these periods.

 

Geographic Information

 

Gaiam has three majorgeographic territories where it sells and distributes essentially the sameproducts.  The geographic territoriesare the U.S., Canada and the United Kingdom. The following represents geographical data for Gaiam’s operations:

 
|            |   | **2003**   |        | **2002**    |   | **2001**    |   |
|-----------------|--------|------------|-------------|-------------|--------|-------------|--------|
| Revenue:        |   |       |        |        |   |        |   |
| Canada          |   | $          | 2,201,211   |        | $      | 2,142,542   |   | $ | 716,729 |   |
| United  Kingdom |   | 14,484,220 |        | 540,790     |   | 224,066     |   |
| United  States  |   | 85,314,672 |        | 108,722,981 |   | 97,796,353  |   |
|            |   | $          | 102,000,103 |        | $      | 111,406,313 |   | $ | 98,737,148 |   |

 
| Long-Lived Assets: |   |       |       |       |   |       |   |
|--------------------|--------|------------|------------|------------|--------|------------|--------|
| The  Netherlands   |   | $          | 863,333    |       | $      | 1,025,000  |   | $ | — |   |
| United  Kingdom    |   | 4,891,654  |       | —     |   | —     |   |
| United  States     |   | 38,253,911 |       | 37,439,615 |   | 30,393,269 |   |
|               |   | $          | 44,008,898 |       | $      | 38,464,615 |   | $ | 30,393,269 |   |

 

**11.Quarterly Results of Operations(Unaudited)**

 

The following is asummary of the quarterly results of operations for the years endedDecember 31, 2003 and 2002 (in thousands, except for per share data):

 
|                                         |   | **Fiscal  2003**   |   |
|----------------------------------------------|--------|--------------------|--------|
|                                         |   | **First  Quarter** |   | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |   |
|                                         |   |               |   |   |   |   |   |   |   |
| Net  revenue                                 |   | $                  | 22,971 |   | $ | 20,352 |   | $ | 23,534 |   | $ | 35,143 |   |
| Gross  profit                                |   | 12,324             |   | 10,815 |   | 12,270 |   | 17,663 |   |
| Operating  income (loss)                     |   | (400               | )      | (989 | ) | 16 |   | 91 |   |
| Net  income (loss)                           |   | (353               | )      | (759 | ) | (201 | ) | 341 |   |
| Diluted  net income (loss) per share         |   | $                  | (0.02  | ) | $ | (0.06 | ) | $ | (0.01 | ) | $ | 0.02 |   |
| Weighted  average shares outstanding-diluted |   | 14,579             |   | 14,594 |   | 14,601 |   | 14,695 |   |

 
|                                         |   | **Fiscal  2002**   | ** ** |
|----------------------------------------------|--------|--------------------|------------|
|                                         |   | **First  Quarter** |       | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
|                                         |   |               |       |   |   |   |   |   |   |
| Net  revenue                                 |   | $                  | 24,284     |   | $ | 24,067 |   | $ | 25,794 |   | $ | 37,261 |   |
| Gross  profit                                |   | 14,269             |       | 14,182 |   | 15,030 |   | 22,450 |   |
| Operating  income                            |   | 1,175              |       | 1,677 |   | 2,246 |   | 3,653 |   |
| Net  income                                  |   | 736                |       | 1,003 |   | 1,395 |   | 2,314 |   |
| Diluted  net income (loss) per share         |   | $                  | 0.05       |   | $ | 0.07 |   | $ | 0.10 |   | $ | 0.16 |   |
| Weighted  average shares outstanding-diluted |   | 14,532             |       | 14,468 |   | 14,376 |   | 14,622 |   |

 

Note:                   The aggregateof certain of the above amounts differs from that reported for the full fiscalyear due to the effects of rounding.

 

 

40

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**Financial Statement Schedule II**

 

**Gaiam,Inc.**

**Schedule II- Consolidated Valuation and Qualifying Accounts**

**YearsEnded December 31,  2003, 2002 and2001**

(in thousands)

 
|                              |   | **Balance at  beginning of Year** |   | **Additions  Charged to  costs and expenses** |   | **Deductions** |   | **Balance at  end  of Year** |   |
|-----------------------------------|--------|-----------------------------------|--------|-----------------------------------------------|--------|----------------|--------|------------------------------|--------|
|                              |   |                              |   |                                          |   |           |   |                         |   |
| Allowance  for Doubtful Accounts: |   |                              |   |                                          |   |           |   |                         |   |
| 2003                              |   | $                                 | 854    |                                          | $      | 1,048          |   | $                            | 1,210  |   | $ | 692 |   |
| 2002                              |   | $                                 | 570    |                                          | $      | 1,617          |   | $                            | 1,333  |   | $ | 854 |   |
| 2001                              |   | $                                 | 302    |                                          | $      | 1,331          |   | $                            | 1,063  |   | $ | 570 |   |
|                              |   |                              |   |                                          |   |           |   |                         |   |
| Reserve  for Sales Returns:       |   |                              |   |                                          |   |           |   |                         |   |
| 2003                              |   | $                                 | 931    |                                          | $      | 608            |   | $                            | 406    |   | $ | 1,133 |   |
| 2002                              |   | $                                 | 796    |                                          | $      | 437            |   | $                            | 302    |   | $ | 931 |   |
| 2001                              |   | $                                 | 458    |                                          | $      | 776            |   | $                            | 438    |   | $ | 796 |   |

##### ** **

##### **Item 9.**                                                           Changesin and Disagreements with Accountants on Accounting and Financial Disclosures

 

Not applicable.

 

##### **Item 9A.**                                                  Controlsand Procedures.

 

EffectiveAugust 2002, the Securities and Exchange Commission adopted rulesrequiring reporting companies to maintain disclosure controls and procedures toprovide reasonable assurance that a registrant is able to record, process,summarize and report the information required in the registrant’s quarterly andannual reports under the Securities Exchange Act of 1934 (the “Exchange Act”).

 

Gaiam’s chief executiveoffice and chief financial officer conducted an evaluation of the effectivenessof the design and operation of Gaiam’s disclosure controls and procedures, asdefined in Rules 13a-15(e) and Rule 15d-15(e) under the Exchange Act.  Based upon their evaluation as ofDecember 31, 2003, they have concluded that those disclosure controls andprocedures are effective.

 

There have been nochanges in Gaiam’s internal control over financial reporting that havematerially affected, or are reasonably likely to affect, Gaiam’s internalcontrol over financial reporting.

 

41

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**Part III**

 

**Item 10.**                                                    Directorsand Executive Officers of the Registrant

 

For information withrespect to the executive officers of the Registrant, See Item 1 – “Directorsand Executive Officers of the Registrant” at the end of Item 1 of thisreport.  The information required bythis Item concerning the Directors of Gaiam is incorporated herein by referenceto Gaiam’s Proxy Statement for its Annual Meeting of Stockholders, to be heldon May 18, 2004, to be filed with the Commission pursuant to Regulation 14A.

 

Code of Ethics

 

We have adopted a Code ofEthics applicable to our employees, including our principal executive officer,principal financial officer, principal accounting officer and personsperforming similar functions.  We haveposted a copy of our Code of Ethics on the corporate section of ourInternet website at www.gaiam.com/corporate. Any waivers of the Code of Ethics must be approved, in advance, by ourfull Board of Directors.  Any amendmentsor waivers from the Code of Ethics that apply to our executive officers anddirectors will be posted on the corporate section of our Internet websitelocated at www.gaiam.com/corporate.

 

**Item 11.**                                                    ExecutiveCompensation

 

The information requiredby this Item is incorporated herein by reference to Gaiam’s Proxy Statement forits Annual Meeting of Stockholders, to be held on May 18, 2004, to be filedwith the Commission pursuant to Regulation 14A.

** **

**Item 12.**                                                    SecurityOwnership of Certain Beneficial Owners and Management

 

The information requiredby this Item is incorporated herein by reference to Gaiam’s Proxy Statement forits Annual Meeting of Stockholders to be held on May 18, 2004, to be filed withthe Commission pursuant to Regulation 14A.

 

**Item 13.**                                                    CertainRelationships and Related Transactions

 

The information requiredby this Item is incorporated herein by reference to Gaiam’s Proxy Statement forits Annual Meeting of Stockholders to be held on May 18, 2004, to be filed withthe Commission pursuant to Regulation 14A.

 

**Item 14.**                                                    PrincipalAccounting Fees and Services

 

The information requiredby this Item is incorporated herein by reference to Gaiam’s Proxy Statement forits Annual Meeting of Stockholders to be held on May 18, 2004, to be filed withthe Commission pursuant to Regulation 14A.

 

**PART IV**

 

**Item 15.**                                                    Exhibits,Financial Statement Schedules, and Reports on Form 8-K

 

(A)                              Documentsfiled as part of this report are as follows:

 

1.               ConsolidatedFinancial Statements.

 

See listing ofConsolidated Financial Statements included as part of this Form 10-K in Item 8of Part II.

 

2.               Financial StatementSchedules.

 

Schedule IIConsolidated Valuation and Qualifying Accounts.

 

3.               Exhibits

 

See Item 14 (c) below

 

42

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(B)                                On October 29, 2003, Gaiam filed areport on Form 8-K relating to its earnings press              release for third quarter 2003.

 

(C)                                Exhibits:

 

1.                                       Thefollowing exhibits are incorporated by reference or are filed or furnished withthis report as indicated below:

 
| **Exhibit No.** |   | **Description**                                                                                                                                                                                                                                      |
|-----------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |   |                                                                                                                                                                                                                                                 |
| 3.1             |   | Amended and  Restated Articles of Incorporation of Gaiam, Inc. (incorporated by reference  to Exhibit 3.1 of Gaiam’s Registration Statement on Form S-1 (No.  333-83283)).                                                                      |
| 3.2             |   | Bylaws of Gaiam,  Inc. (incorporated by reference to Exhibit 3.2 of Gaiam’s Registration  Statement on Form S-1 (No. 333-83283)).                                                                                                               |
| 4.1             |   | Form of Gaiam,  Inc. Stock Certificate (incorporated by reference to Exhibit 4.1 of Gaiam’s  Registration Statement on Form S-1 (No. 333-83283)).                                                                                               |
| 10.1            |   | Loan Agreement,  dated as of December 31, 2002, between Gaiam, Inc. and Wells Fargo Bank  West, N.A. (incorporated by reference to exhibit 10.1 of Gaiam’s annual  report on Form 10-K for the year ended December 31, 2002).         |
| 10.2            |   | Gaiam, Inc. 1999  Long-Term Incentive Plan (incorporated by reference to Exhibit 10.1 of  Gaiam’s Registration Statement on Form S-1 (No. 333-63488)).                                                                                          |
| 10.3            |   | Lease, dated  December 16, 1999, between Gaiam, Inc. and Duke-Weeks Realty Limited  Partnership (incorporated by reference to Exhibit 10.2 of Gaiam’s  Registration Statement on Form S-4 (No. 333-50560)).                                |
| 10.4            |   | First Lease  Amendment, dated March 1, 2000, between Gaiam, Inc. and Duke-Weeks  Realty Limited Partnership (incorporated by reference to exhibit 10.4 of  Gaiam’s annual report on Form 10-K for the year ended December 31,  2002). |
| 21.1            |   | List of Gaiam  Subsidiaries (filed herewith).                                                                                                                                                                                                        |
| 23.1            |   | Consent letter  from Ernst and Young (filed herewith).                                                                                                                                                                                               |
| 31.1            |   | Certification of  the Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities  Exchange Act of 1934 (filed herewith).                                                                                                                |
| 31.2            |   | Certification of  the Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities  Exchange Act of 1934 (filed herewith).                                                                                                                |
| 32              |   | Certification  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 (furnished herewith).                                                                                             |

 

43

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SIGNATURES

 

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities and Exchange Act of1934, the Registrant has caused this report to be signed on its behalf by theundersigned, thereunto duly authorized, in the City of Broomfield, State ofColorado, on this 10th day of March, 2004.

 
|   |   | GAIAM, INC. |
|--------|--------|-------------|
|   |   |        |   |   |
|   |   | By:         | /s/ Jirka Rysavy |   |   |
|   |   |        | Jirka Rysavy |   |
|   |   |        | Chief Executive Officer |   |
|        |        |             |  |  |  |

 
| **Signature**          |                          | **Title**                    |   | **Date**            |
|------------------------|-------------------------------|------------------------------|--------|---------------------|
|                   |                          |                         |   |
| /s/ Jirka Rysavy       |                          | Chairman of the Board  and   |   | March 10, 2004 |
| Jirka Rysavy           | Chief Executive Officer       |                         |   |
|                   |                          |                         |   |
|                   |                          |                         |   |
| /s/ Lynn Powers        |                          | President, Secretary  and    |   | March 10, 2004 |
| Lynn Powers            | Director                      |                         |   |
|                   |                          |                         |   |
|                   |                          |                         |   |
|                   |                          | Director                     |   | March 10, 2004 |
| James Argyropolous     |                          |                         |   |
|                   |                          |                         |   |
|                   |                          |                         |   |
| /s/ Barnet M. Feinblum |                          | Director                     |   | March 10, 2004 |
| Barnet M. Feinblum     |                          |                         |   |
|                   |                          |                         |   |
|                   |                          |                         |   |
| /s/ Barbara Mowry      |                          | Director                     |   | March 10, 2004 |
| Barbara Mowry          |                          |                         |   |
|                   |                          |                         |   |
| /s/ Paul H. Ray        |                          | Director                     |   | March 10, 2004 |
| Paul H. Ray            |                          |                         |   |
|                   |                          |                         |   |
|                   |                          |                         |   |
| /s/ Janet Mathews      |                          | Chief Financial Officer  and |   | March 10, 2004 |
| Janet Mathews          | Principal  Accounting Officer |                         |   |
|                        |                               |                              |        |                     |  |  |  |  |  |  |  |

 

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