**UnitedStates**

**Securitiesand Exchange Commission**

**Washington, D.C. 20549**

 

**Form10-Q**

 

**ý**           **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)OF THE SECURITIES AND EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30, 2004**

 

**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 BLVD.,  BROOMFIELD, COLORADO 80021**          |
| (Address of principal executive offices)                        |
|                                                            |                                  |
| **(303) 222-3600**                                              |
| (Registrant’s telephone number, including area code)       |

 

Indicate by check mark whetherthe registrant:  (1) has filed allreports required to be filed by Section 13 or 15 (d) of the Securities andExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports) and (2) has been subjectto such filing requirements for the past 90 days.

 

YES  ý          NO  o

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).      YES  ý          NO  o

 

Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latestpracticable date:

 

| **Class**                               | ** ** | **Shares outstanding as of October 27, 2004** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------|------------|
| Class A Common Stock ($.0001 par value) |       | 9,311,897                                     |       |
|                                    |       |                                          |       |
| Class B Common Stock ($.0001 par value) |       | 5,400,000                                     |       |

 

 

----

 

**INDEX TO FORM 10-Q**

 
| PART I. FINANCIAL  INFORMATION |                                                                                                      |
|--------------------------------|-----------------------------------------------------------------------------------------------------------|
|                           |                                                                                                      |   |
| Item 1.                        | Condensed Consolidated  Financial Statements (Unaudited)                                                  |   |
|                           | Condensed Consolidated  Balance Sheets at September 30, 2004 and December 31, 2003                        |   |
|                           | Condensed  Consolidated Statements of Operations for the three months ended September  30, 2004, and 2003 |   |
|                           | Condensed Consolidated  Statements of Operations for the nine months ended September 30, 2004, and  2003  |   |
|                           | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2004 and 2003   |   |
|                           | Notes  to Interim Condensed Consolidated Financial Statements                                             |   |
|                           |                                                                                                      |   |
| Item 2.                        | Management’s Discussion and Analysis of  Financial Condition and Results of Operations               |   |
|                           |                                                                                                      |   |
| Item 3.                        | Quantitative and Qualitative Disclosures  About Market Risk                                               |   |
|                           |                                                                                                      |   |
| Item 4.                        | Controls and Procedures                                                                                   |   |
|                           |                                                                                                      |   |
| PART II.                       | OTHER INFORMATION                                                                                         |   |
|                           |                                                                                                      |   |
| Item 1.                        | Legal Proceedings                                                                                         |   |
|                           |                                                                                                      |   |
| Item  2.                       | Changes  in Securities and Use of Proceeds                                                                |   |
|                           |                                                                                                      |   |
| Item 3.                        | Defaults Upon  Senior Securities                                                                          |   |
|                           |                                                                                                      |   |
| Item  4.                       | Submission  of Matters to a Vote of Security Holders                                                      |   |
|                           |                                                                                                      |   |
| Item 5.                        | Other Information                                                                                         |   |
|                           |                                                                                                      |   |
| Item 6.                        | Exhibits and  Reports on Form 8-K                                                                         |   |
|                           |                                                                                                      |   |
| Signatures                     |                                                                                                      |   |

 

FORWARD-LOOKING STATEMENTS

This report may containforward-looking statements that involve risks and uncertainties.  When used in this discussion, the words “anticipate,”“believe,” “plan,” “estimate,” “expect,” “strive,” “future,” “intend” andsimilar expressions as they relate to Gaiam or its management are intended toidentify such forward-looking statements. Gaiam’s actual results could differ materially from the resultsanticipated in these forward-looking statements as a result of certain factorsset forth under “Management’s Discussion and Analysis of Financial Conditionand Results of Operations,” “Market Risk” and elsewhere in this report.  Risks and uncertainties that could causeactual results to differ include, without limitation, general economicconditions, competition, loss of key personnel, pricing, brand reputation,acquisitions, security and information systems, legal liability for websitecontent, merchandise supply problems, failure of third parties to provideadequate service, reliance on centralized customer service, overstocks andmerchandise returns, reliance on a centralized fulfillment center, increases inpostage and shipping costs, e-commerce trends, future Internet related taxes, controlof Gaiam by its founder, fluctuations in quarterly operating results, consumertrends, customer interest in our products, the effect of government regulationand other risks and uncertainties included in Gaiam’s filings with theSecurities and Exchange Commission.  Wecaution you that no forward-looking statement is a guarantee of futureperformance, and you should not place undue reliance on these forward-lookingstatements which reflect our management’s view only as of the date of thisreport.  We undertake no obligation toupdate any forward-looking information.

 

2

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GAIAM, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share information)

 
| ** **                                                                                                                                                                               | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                               | ** ** | **(Unaudited)**         | ** ** | ** **             | ** ** |
| **Assets**                                                                                                                                                                               |       |                    |       |                   |       |
| Current  assets:                                                                                                                                                                         |       |                    |       |                   |       |
| Cash and cash equivalents                                                                                                                                                                |       | $                       | 9,674      |                   | $          | 8,384 |   |
| Accounts receivable, net                                                                                                                                                                 |       | 9,292                   |       | 17,818                 |       |
| Income tax and other receivables                                                                                                                                                         |       | 4,817                   |       | 2,091                  |       |
| Inventory, less allowances                                                                                                                                                               |       | 17,259                  |       | 16,629                 |       |
| Deferred advertising costs                                                                                                                                                               |       | 3,408                   |       | 1,649                  |       |
| Other current assets                                                                                                                                                                     |       | 1,174                   |       | 1,280                  |       |
| Total current assets                                                                                                                                                                     |       | 45,624                  |       | 47,851                 |       |
|                                                                                                                                                                                     |       |                    |       |                   |       |
| Property and equipment, net                                                                                                                                                              |       | 8,957                   |       | 10,314                 |       |
| Investments                                                                                                                                                                              |       | 7,865                   |       | 7,865                  |       |
| Capitalized production costs, net                                                                                                                                                        |       | 6,013                   |       | 6,094                  |       |
| Media library, net                                                                                                                                                                       |       | 5,578                   |       | 6,084                  |       |
| Goodwill and other intangibles                                                                                                                                                           |       | 9,553                   |       | 9,509                  |       |
| Deferred tax assets                                                                                                                                                                      |       | 3,287                   |       | 3,488                  |       |
| Other assets                                                                                                                                                                             |       | 385                     |       | 655                    |       |
| Total assets                                                                                                                                                                             |       | $                       | 87,262     |                   | $          | 91,860 |   |
|                                                                                                                                                                                     |       |                    |       |                   |       |
| **Liabilities and stockholders’ equity**                                                                                                                                            |       |                    |       |                   |       |
| Current liabilities:                                                                                                                                                                     | ** ** | ** **              | ** ** | ** **             | ** ** |
| Accounts payable                                                                                                                                                                         |       | $                       | 11,021     |                   | $          | 12,459 |   |
| Accrued liabilities                                                                                                                                                                      |       | 4,919                   |       | 4,904                  |       |
| Income taxes payable                                                                                                                                                                     |       | 642                     |       | 902                    |       |
| Capital lease obligations, current                                                                                                                                                       |       | 7                       |       | 55                     |       |
| Total current liabilities                                                                                                                                                                |       | 16,589                  |       | 18,320                 |       |
|                                                                                                                                                                                     |       |                    |       |                   |       |
| Deferred tax liabilities                                                                                                                                                                 |       | 883                     |       | 735                    |       |
| Total liabilities                                                                                                                                                                        |       | 17,472                  |       | 19,055                 |       |
|                                                                                                                                                                                     |       |                    |       |                   |       |
| Minority interest                                                                                                                                                                        |       | 3,686                   |       | 3,320                  |       |
|                                                                                                                                                                                     |       |                    |       |                   |       |
| Commitments and contingencies                                                                                                                                                            |       |                    |       |                   |       |
|                                                                                                                                                                                     |       |                    |       |                   |       |
| Stockholders’ equity:                                                                                                                                                               |       |                    |       |                   |       |
| Class A common stock, $.0001 par value,  150,000,000 shares authorized, 9,311,897 and 9,203,056 shares issued and outstanding  at September 30, 2004 and December 31, 2003, respectively |       | 1                       |       | 1                      |       |
| Class B common stock, $.0001 par value,  50,000,000 shares authorized, 5,400,000 issued and outstanding at September  30, 2004 and December 31, 2003                                     |       | 1                       |       | 1                      |       |
| Additional paid-in capital                                                                                                                                                               |       | 54,394                  |       | 53,831                 |       |
| Deferred compensation                                                                                                                                                                    |       | (18                     | )          | (72                    | )          |
| Accumulated other comprehensive income                                                                                                                                                   |       | 601                     |       | 525                    |       |
| Retained earnings                                                                                                                                                                        |       | 11,125                  |       | 15,199                 |       |
| Total stockholders’ equity                                                                                                                                                          |       | 66,104                  |       | 69,485                 |       |
| Total liabilities and stockholders’ equity                                                                                                                                          |       | $                       | 87,262     |                   | $          | 91,860 |   |

 

*See accompanying notes to the condensed consolidated financialstatements.*

 

3

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GAIAM, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands,except per share amounts)

 
| ** **                                                                | ** ** | **For the Three Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                | ** ** | **2004**                                      | ** ** | **2003** | ** ** |
|                                                                      |       |                                          |       |   |   |
| Net revenue                                                               |       | $                                             | 21,023     |   | $ | 23,533 |   |
| Cost of goods sold                                                        |       | 11,196                                        |       | 11,263 |   |
| Gross profit                                                              |       | 9,827                                         |       | 12,270 |   |
|                                                                      |       |                                          |       |   |   |
| Expenses:                                                                 |       |                                          |       |   |   |
| Selling and operating                                                     |       | 10,270                                        |       | 10,445 |   |
| Corporate, general and administration                                     |       | 1,881                                         |       | 1,905 |   |
| Total expenses                                                            |       | 12,151                                        |       | 12,350 |   |
|                                                                      |       |                                          |       |   |   |
| Loss from operations                                                      |       | (2,324                                        | )          | (80 | ) |
|                                                                      |       |                                          |       |   |   |
| Other income (expense)                                                    |       | 83                                            |       | (14 | ) |
| Interest income                                                           |       | 55                                            |       | 17 |   |
| Total other income                                                        |       | 138                                           |       | 3 |   |
|                                                                      |       |                                          |       |   |   |
| Loss before income taxes and minority interest                            |       | (2,186                                        | )          | (77 | ) |
|                                                                      |       |                                          |       |   |   |
| Provision for income tax benefit                                          |       | (856                                          | )          | (44 | ) |
| Minority interest in net income of consolidated  subsidiaries, net of tax |       | (200                                          | )          | (168 | ) |
| Net loss                                                                  |       | $                                             | (1,530     | ) | $ | (201 | ) |
|                                                                      |       |                                          |       |   |   |
| Net loss per share:                                                       |       |                                          |       |   |   |
| Basic                                                                     |       | $                                             | (0.10      | ) | $ | (0.01 | ) |
| Diluted                                                                   |       | $                                             | (0.10      | ) | $ | (0.01 | ) |
| Shares used in computing net loss per  share:                             |       |                                          |       |   |   |
| Basic                                                                     |       | 14,712                                        |       | 14,601 |   |
| Diluted                                                                   |       | 14,712                                        |       | 14,601 |   |

 

*See accompanying notes to the condensed consolidated financialstatements.*

 

4

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GAIAM, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)

(In thousands, except per share amounts)

 
| ** **                                                                | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                | ** ** | **2004**                                     | ** ** | **2003** | ** ** |
|                                                                      |       |                                         |       |   |   |
| Net revenue                                                               |       | $                                            | 61,829     |   | $ | 66,857 |   |
| Cost of goods sold                                                        |       | 30,786                                       |       | 31,447 |   |
| Gross profit                                                              |       | 31,043                                       |       | 35,410 |   |
|                                                                      |       |                                         |       |   |   |
| Expenses:                                                                 |       |                                         |       |   |   |
| Selling and operating                                                     |       | 31,398                                       |       | 30,775 |   |
| Corporate, general and administration                                     |       | 5,932                                        |       | 6,297 |   |
| Total expenses                                                            |       | 37,330                                       |       | 37,072 |   |
|                                                                      |       |                                         |       |   |   |
| Loss from operations                                                      |       | (6,287                                       | )          | (1,662 | ) |
|                                                                      |       |                                         |       |   |   |
| Other income                                                              |       | 135                                          |       | 2 |   |
| Interest income                                                           |       | 135                                          |       | 44 |   |
| Total other income                                                        |       | 270                                          |       | 46 |   |
|                                                                      |       |                                         |       |   |   |
| Loss before income taxes and minority  interest                           |       | (6,017                                       | )          | (1,616 | ) |
|                                                                      |       |                                         |       |   |   |
| Provision for income tax benefit                                          |       | (2,269                                       | )          | (648 | ) |
| Minority interest in net income of consolidated  subsidiaries, net of tax |       | (326                                         | )          | (345 | ) |
| Net loss                                                                  |       | $                                            | (4,074     | ) | $ | (1,313 | ) |
|                                                                      |       |                                         |       |   |   |
| Net loss per share:                                                       |       |                                         |       |   |   |
| Basic                                                                     |       | $                                            | (0.28      | ) | $ | (0.09 | ) |
| Diluted                                                                   |       | $                                            | (0.28      | ) | $ | (0.09 | ) |
| Shares used in computing net loss per  share:                             |       |                                         |       |   |   |
| Basic                                                                     |       | 14,671                                       |       | 14,591 |   |
| Diluted                                                                   |       | 14,671                                       |       | 14,591 |   |

 

*See accompanying notes to the condensed consolidated financialstatements.*

 

5

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GAIAM, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited – In thousands)

 
| ** **                                                                       | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                                     | ** ** | **2003** | ** ** |
| **Operating activities**                                                         | ** ** | ** **                                   | ** ** | ** ** | ** ** |
| Net loss                                                                         |       | $                                            | (4,074     | ) | $ | (1,313 | ) |
| Adjustments to reconcile net loss to net  cash provided by operating activities: |       |                                         |       |   |   |
| Depreciation                                                                     |       | 2,131                                        |       | 1,966 |   |
| Amortization                                                                     |       | 528                                          |       | 535 |   |
| Stock compensation                                                               |       | 54                                           |       | 54 |   |
| Minority interest in consolidated  subsidiaries                                  |       | 326                                          |       | 345 |   |
| Deferred tax expense                                                             |       | 330                                          |       | 100 |   |
| Changes in operating assets and  liabilities, net of effects from acquisitions:  |       |                                         |       |   |   |
| Accounts receivable                                                              |       | 5,896                                        |       | 8,269 |   |
| Inventory                                                                        |       | (606                                         | )          | (783 | ) |
| Deferred advertising costs                                                       |       | (1,758                                       | )          | (815 | ) |
| Capitalized production costs                                                     |       | 81                                           |       | (1,171 | ) |
| Other current assets                                                             |       | 107                                          |       | (361 | ) |
| Other assets                                                                     |       | 254                                          |       | 151 |   |
| Accounts payable                                                                 |       | (1,628                                       | )          | (1,707 | ) |
| Accrued liabilities                                                              |       | 251                                          |       | (1,878 | ) |
| Income taxes payable                                                             |       | (271                                         | )          | (1,718 | ) |
| Net cash provided by operating activities                                        |       | 1,621                                        |       | 1,674 |   |
|                                                                             |       |                                         |       |   |   |
| **Investing activities**                                                         |       |                                         |       |   |   |
| Purchase of property, equipment and media  rights                                |       | (755                                         | )          | (1,335 | ) |
| Payments for acquisitions, net of cash  acquired                                 |       | —                                       |       | (3,787 | ) |
| Net cash used in investing activities                                            |       | (755                                         | )          | (5,122 | ) |
|                                                                             |       |                                         |       |   |   |
| **Financing activities**                                                         |       |                                         |       |   |   |
| Principal payments on capital leases                                             |       | (48                                          | )          | (244 | ) |
| Proceeds from issuance of common stock                                           |       | 427                                          |       | 122 |   |
| Net cash provided by (used in) financing  activities                             |       | 379                                          |       | (122 | ) |
|                                                                             |       |                                         |       |   |   |
| Effects of exchange rates on cash and cash  equivalents                          |       | 45                                           |       | — |   |
| Net change in cash and cash equivalents                                          |       | 1,290                                        |       | (3,570 | ) |
| Cash and cash equivalents at beginning of  period                                |       | 8,384                                        |       | 11,422 |   |
| Cash and cash equivalents at end of period                                       |       | $                                            | 9,674      |   | $ | 7,852 |   |
|                                                                             |       |                                         |       |   |   |
| **Supplemental cash flow information**                                           |       |                                         |       |   |   |
| Interest paid                                                                    |       | $                                            | —     |   | $ | 40 |   |
| Common stock issued for acquisitions                                             |       | —                                       |       | 348 |   |
| Income taxes paid                                                                |       | 615                                          |       | 1,033 |   |

 

*See accompanying notes to the condensed consolidated financialstatements.*

 

6

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Gaiam, Inc.

Notes to Interim Condensed Consolidated Financial Statements

(Unaudited)

September 30, 2004

 

1.                                       Interim Condensed Consolidated FinancialStatements

 

Organization and Nature of Operations

 

Gaiam, Inc. is a multi-channel lifestyle company providing a broadselection of information, products and services to customers who value naturalhealth, personal development, ecological lifestyles and responsible media.  Gaiam was incorporated under the laws of theState of Colorado on July 7, 1988.

 

Theaccompanying consolidated financial statements include the accounts of Gaiamand its subsidiaries in which Gaiam’s ownership is greater than 50% and thesubsidiary is considered to be under Gaiam’s control.  All material intercompany accounts andtransaction balances have been eliminated in consolidation.

 

Preparation of Interim Condensed Consolidated Financial Statements

 

Theinterim condensed consolidated financial statements included herein have beenprepared by the management of Gaiam pursuant to the rules and regulations ofthe United States Securities and Exchange Commission, and, in the opinion ofmanagement, contain all adjustments (consisting of only normal recurringadjustments) necessary to present fairly Gaiam’s consolidated financial positionas of September 30, 2004, the interim results of operations for the three andnine months ended September 30, 2004 and 2003, and cash flows for the ninemonths ended September 30, 2004 and 2003. These interim statements have not been audited.  The balance sheet as of December 31, 2003 wasderived from Gaiam’s audited consolidated financial statements included inGaiam’s annual report on Form 10-K.

 

Certaininformation and footnote disclosures normally included in consolidatedfinancial statements prepared in accordance with accounting principles generallyaccepted in the United States have been condensed or omitted pursuant to suchrules and regulations.  Accountingpolicies followed by Gaiam are described in Note 1 to the audited financialstatements for the fiscal year ended December 31, 2003 included in Gaiam’sannual report on Form 10-K.  Theconsolidated financial statements contained herein should be read inconjunction with Gaiam’s audited financial statements, including the notesthereto, for the year ended December 31, 2003.

 

Theconsolidated financial position, results of operations and cash flows for the interimperiods disclosed in this report are not necessarily indicative of futurefinancial results.

 

Useof Estimates

 

Thepreparation of the consolidated financial statements in conformity withaccounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues and expenses and disclosure of contingentassets and liabilities at the date of the consolidated financialstatements.  Actual results could differfrom those estimates.

 

Reclassifications

 

Certainreclassifications have been made to prior period amounts to conform to thecurrent period presentations.

 

7

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Adoption of Accounting Standards

 

InDecember 2003, the Financial Accounting Standards Board (“FASB”) issued arevised FASB Interpretation No. 46, “Consolidation of Variable InterestEntities,” (“FIN 46R”).  FIN 46R modifiesFIN 46 to include (1) a deferral of the effective date of the provisionsrelated to certain variable interests, (2) additional scope exceptions forcertain other variable interests, (3) clarifications on the impact of troubleddebt restructurings, and (4) additional guidance on what constitutes a variableinterest.  Adoption of FIN 46R isrequired in the financial statements of public entities that have interests inspecial purposes entities (“SPEs”) for periods ending after December 15,2003.  Adoption by public entities thathave interests in all other types of variable interest entities (“VIEs”) isrequired in financial statements for periods ending after March 15, 2004.  Gaiam believes that it has no entities qualifyingas SPEs or VIEs, therefore, the adoption of FIN 46R has had no effect on Gaiam’sfinancial position, results of operations or cash flows.

 

Stock-BasedCompensation

 

Gaiamaccounts for its stock-based compensation arrangements under the provisions ofAccounting Principles Board Opinion No. 25, *Accounting for StockIssued to Employees* (“APB No. 25”) and related interpretations,including FASB Interpretation No. 44, *Accountingfor Certain Transactions Involving Stock Compensation*, rather thanthe alternative fair value accounting allowed by SFAS No. 123, *Accounting for Stock Based Compensation*.  Accordingly, no compensation expense is recognizedin Gaiam’s consolidated financial statements in connection with stock optionsgranted to employees with exercise prices not less than fair value.  Deferred compensation for options granted toemployees is determined as the difference between the fair market value ofGaiam’s common stock on the date options were granted and the exerciseprice.  For purposes of this pro-formadisclosure, the estimated fair value of options is assumed to be amortized toexpense over the options’ vesting periods.

 

Compensationexpense for options granted to non-employees has been determined in accordancewith SFAS No. 123 as the fair value of the consideration received or the fairvalue of the equity instruments issued, whichever is more reliably measured.  Had compensation cost for Gaiam’s stock-basedcompensation plan been determined under the fair value methodology under SFASNo. 123, Gaiam’s net income (loss) and income (loss) per share would have beenas follows (in thousands, except per share data):

 
| ** **                                                                                                                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                            | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss as reported                                                                                                                  |       | $                                     | (1,530     | )                                    | $          | (201 | ) | $ | (4,074 | ) | $ | (1,313 | ) |
| Add: Stock-based compensation expense  included in reported net loss, net of related tax effects                                      |       | 18                                    |       | 18                                   |       | 54 |   | 54 |   |
| Deduct: Total stock-based compensation  expenses determined under fair value based method for all awards, net of  related tax effects |       | (125                                  | )          | 125                                  |       | (454 | ) | (302 | ) |
| Pro forma                                                                                                                             |       | $                                     | (1,637     | )                                    | $          | (58 | ) | $ | (4,474 | ) | $ | (1,561 | ) |
| Net loss per common share                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| As reported                                                                                                                           |       | $                                     | (0.10      | )                                    | $          | (0.01 | ) | $ | (0.28 | ) | $ | (0.09 | ) |
| Pro forma                                                                                                                             |       | $                                     | (0.11      | )                                    | $          | — |   | $ | (0.30 | ) | $ | (0.11 | ) |
| Fully diluted net loss per common share                                                                                               |       |                                  |       |                                 |       |   |   |   |   |
| As reported                                                                                                                           |       | $                                     | (0.10      | )                                    | $          | (0.01 | ) | $ | (0.28 | ) | $ | (0.09 | ) |
| Pro forma                                                                                                                             |       | $                                     | (0.11      | )                                    | $          | — |   | $ | (0.30 | ) | $ | (0.11 | ) |

 

8

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2.                                       Stockholders’Equity

 

During the first quarter of 2004, Gaiam issued a total of 11,251 sharesof Class A common stock to Gaiam’s independent directors, in lieu of cashcompensation, for services rendered in 2003. In addition, for the nine monthsended September 30, 2004, Gaiam issued 97,590 shares of Class A common stockupon exercise of options granted under Gaiam’s 1999 Long-Term Incentive Plan.

 

3.                                       Comprehensive Income (Loss)

 

Gaiam’s comprehensive income (loss) is comprised of net income (loss)and foreign currency translation adjustment, net of income taxes.  Comprehensive income (loss), net of relatedtax effects, was as follows (in thousands):

 
| ** **                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                    | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss                                      |       | $                                     | (1,530     | )                                    | $          | (201 | ) | $ | (4,074 | ) | $ | (1,313 | ) |
| Foreign currency translation adjustment,  net |       | (9                                    | )          | —                               |       | 76 |   | — |   |
| Comprehensive loss, net of taxes              |       | $                                     | (1,539     | )                                    | $          | (201 | ) | $ | (3,998 | ) | $ | (1,313 | ) |

 

4.                                       Earnings (Loss) per Share

 

Basicearnings (loss) per share excludes any dilutive effects of options, warrantsand dilutive securities.  Basic earnings(loss) per share 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 of 142 thousand and94 thousand are excluded from the computation of diluted earnings per share forthe three and nine months ended September 30, 2004 and 2003, respectively,because their effect is antidilutive.

 

The following table sets forth the computation of basic and dilutedearnings per share (in thousands, except per share data):

 
| ** **                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Numerator for basic and diluted loss per  share               |       | $                                     | (1,530     | )                                    | $          | (201 | ) | $ | (4,074 | ) | $ | (1,313 | ) |
| Denominator:                                                  |       |                                  |       |                                 |       |   |   |   |   |
| Weighted average shares for basis loss per  share             |       | 14,712                                |       | 14,601                               |       | 14,671 |   | 14,591 |   |
| Effect of dilutive securities:                                |       |                                  |       |                                 |       |   |   |   |   |
| Weighted average of common stock, stock  options and warrants |       | —                                |       | —                               |       | — |   | — |   |
| Denominators for diluted loss per share                       |       | 14,712                                |       | 14,601                               |       | 14,671 |   | 14,591 |   |
|                                                          |       |                                  |       |                                 |       |   |   |   |   |
| Net loss per share - basic                                    |       | $                                     | (0.10      | )                                    | $          | (0.01 | ) | $ | (0.28 | ) | $ | (0.09 | ) |
| Net loss per share - diluted                                  |       | $                                     | (0.10      | )                                    | $          | (0.01 | ) | $ | (0.28 | ) | $ | (0.09 | ) |

 

5.                                       Segment Information

 

Gaiam manages its business and aggregates its operational and financialinformation in accordance with two reportable segments.  The direct to consumer segment containsGaiam’s catalog and Internet

 

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saleschannels, while the business segment comprises the retailer, media and corporateaccount channels.

 

Although Gaiam is able to track revenues by sales channel, management,allocation of resources and analysis and reporting of expenses is solely on acombined basis, at the reportable segment level.

 

Contribution margin is defined as net sales, less cost of goods soldand direct expenses. Financial information for Gaiam’s business segments was asfollows (in thousands):

 
| ** **                                                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net revenue:                                                              |       |                                  |       |                                 |       |   |   |   |   |
| Direct to consumer                                                        |       | $                                     | 11,347     |                                 | $          | 11,579 |   | $ | 33,776 |   | $ | 33,041 |   |
| Business                                                                  |       | 9,676                                 |       | 11,954                               |       | 28,053 |   | 33,816 |   |
| Consolidated net revenue                                                  |       | 21,023                                |       | 23,533                               |       | 61,829 |   | 66,857 |   |
| Contribution margin:                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Direct to consumer                                                        |       | 38                                    |       | 195                                  |       | (464 | ) | 343 |   |
| Business                                                                  |       | (2,362                                | )          | (275                                 | )          | (5,823 | ) | (2,005 | ) |
| Consolidated contribution loss                                            |       | $                                     | (2,324     | )                                    | $          | (80 | ) | $ | (6,287 | ) | $ | (1,662 | ) |
| Reconciliation of contribution margin loss  to net loss:                  |       |                                  |       |                                 |       |   |   |   |   |
| Other income                                                              |       | 138                                   |       | 3                                    |       | 270 |   | 46 |   |
| Income tax benefit                                                        |       | (856                                  | )          | (44                                  | )          | (2,269 | ) | (648 | ) |
| Minority interest in net income of  consolidated subsidiaries, net of tax |       | (200                                  | )          | (168                                 | )          | (326 | ) | (345 | ) |
| Net loss                                                                  |       | $                                     | (1,530     | )                                    | $          | (201 | ) | $ | (4,074 | ) | $ | (1,313 | ) |

 

**Item 2.****                                                           Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

The following discussion and analysis ofGaiam’s financial condition and results of operations should be read inconjunction with the condensed consolidated financial statements and relatednotes included elsewhere in this document.

 

Overview andOutlook

 

Gaiam is a multi-channel lifestyle company providing information, goodsand services to customers who value personal development, healthy living,ecological lifestyles and responsible media. Gaiam was incorporated in Boulder,Colorado in 1988 to support “Conscious Commerce,” the practice of makingpurchasing decisions based on lifestyle and personal values.   In 1995, Gaiam began to expandnationally.  In 1996, Gaiam made a largeinvestment in infrastructure and operating systems to support rapid growth.From 1997 to 2003, Gaiam’s revenues increased from $19.9 million to $102million, representing a compounded annual growth rate of 31.3%.

 

The direct to consumersegment continues to be an integral part of Gaiam’s outreach and a solid baseof business.  This segment accounted for49%, or approximately $50.5 million, of Gaiam’s revenues during 2003.  During the first nine months of 2004, revenuesin this segment were $33.8 million, an increase of 2% over 2003, and represented55% of total revenue.  Through itsdiverse media reach, the direct to consumer segment provides branding, asounding board for new product testing, promotional opportunities, consumereducation and customer feedback on Gaiam’s and the LOHAS (Lifestyles of Healthand Sustainability) industry’s focus and future.

 

With the inception of our business segment in 1998, Gaiam started tosell directly to retailers, both domestically and abroad.  As of the end of 2003, Gaiam products wereavailable in over 30,000 stores in North America, plus in retailers located inthe U.K. and Australia.  Gaiam introducedits “store-within-store” lifestyle

 

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presentations,which utilize custom fixtures designed and produced by Gaiam, in late 2000, andthe placement of this concept grew to over 3,650 stores by the end of2003.  In 1998, revenues generated by thebusiness segment were $3.8 million.  In2003, revenues in this segment, which were driven by media sales to retailers,topped $50 million, representing a compound annual growth rate of approximately68%, but became difficult to sustain without grass roots development.  Gaiam is diversifying its approach to includea grass roots rollout to the community-based retail and specialty markets, alongwith more outreach to professional establishments, fitness clubs, and wellnessprofessionals.  Gaiam believes thisapproach will provide a solid base for expansion and a spring board for newproduct launches.  Gaiam is also focusingon new media releases, along with an expansion in mass market retailers andbookstores, and new launches into the grocery market.  During the third quarter of 2004, Gaiam receivedan additional eight feet of shelf space in Target’s fall planagram set, which tripledthe existing space.  Inventory for thisexpansion started shipping in August 2004, and the full impact of the expansionis expected to be realized in the fourth quarter of 2004.

 

Despite the net loss of $4.1 million for the first nine months of 2004,Gaiam generated cash from operating activities of $1.6 million for the ninemonths ended September 30, 2004, and ended the quarter with $9.7 million incash, up from $8.4 million at December 31, 2003, no debt and an unused $15million line of credit

 

Results ofOperations

 

The following table sets forth certainfinancial data as a percentage of revenues for the periods indicated:

 
| ** **                                                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net revenue                                                               |       | 100.0                                 | %          | 100.0                                | %          | 100.0 | % | 100.0 | % |
| Cost of goods sold                                                        |       | 53.3                                  | %          | 47.9                                 | %          | 49.8 | % | 47.0 | % |
| Gross profit                                                              |       | 46.7                                  | %          | 52.1                                 | %          | 50.2 | % | 53.0 | % |
| Expenses:                                                                 |       |                                  |       |                                 |       |   |   |   |   |
| Selling and operating                                                     |       | 48.9                                  | %          | 44.4                                 | %          | 50.8 | % | 46.0 | % |
| Corporate, general and administration                                     |       | 8.9                                   | %          | 8.1                                  | %          | 9.6 | % | 9.4 | % |
| Total expenses                                                            |       | 57.8                                  | %          | 52.5                                 | %          | 60.4 | % | 55.4 | % |
| Loss from operations                                                      |       | -11.1                                 | %          | -0.4                                 | %          | -10.2 | % | -2.4 | % |
| Other income                                                              |       | 0.7                                   | %          | 0.0                                  | %          | 0.4 | % | 0.1 | % |
| Income tax benefit                                                        |       | -4.1                                  | %          | -0.2                                 | %          | -3.7 | % | -1.0 | % |
| Minority interest in net income of  consolidated subsidiaries, net of tax |       | -1.0                                  | %          | -0.7                                 | %          | -0.5 | % | -0.5 | % |
| Net loss                                                                  |       | -7.3                                  | %          | -0.9                                 | %          | -6.6 | % | -2.0 | % |

 

Three monthsended September 30, 2004 versus September 30, 2003

 

Revenues of $21million for the three months ended September 30, 2004 decreased 10.7% from$23.5 million for the three months ended September 30, 2003.  Gaiam’s decrease in revenues was due to a decreasein the business segment of $2.3 million, or 19.1% for the quarter.  This shortfall resulted from lower sales volumesin the U.S. trade business, primarily in VHS sales which declined more than 80%over 2003 levels, and an increase in markdowns and returns associated with thechange out of VHS format for DVD format. Direct to consumer segment revenues were $11.3 million for the threemonths ended September 30, 2004, compared to $11.6 million for the same periodin 2003, as Gaiam suspended distribution of one of its catalog titles for theSpring/Summer seasons.  This titlegenerated $604 thousand in revenue during the third quarter of 2003.  Internal revenue growth in both the internetand international operations was 22% for the third quarter.

 

Gross profit,which consists of revenues less cost of sales (primarily merchandiseacquisition costs and in-bound freight), decreased to $9.8 million for the thirdquarter of 2004 from $12.3 million during the same period in 2003.  As a percentage of revenue, gross profitdeclined to 46.7% in 2004 from 52.1% in 2003. This was primarily attributable to declines in the business segmentgross margin associated with a change in product mix to accessories with lowergross profit margins than media, increased markdowns given to incentsell-through of VHS inventories, and the write-down of VHS inventory,components and packaging.

 

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Selling andoperating expenses (which consist primarily of sales and marketing costs,commission and fulfillment expenses) decreased to $10.3 million for the threemonths ended September 30, 2004 as compared to $10.4 million in the same periodof 2003, primarily resulting from lower catalog and e-commerce expenses in thedirect to consumer segment.  As apercentage of revenues, selling and operating expenses increased to 48.9% in2004 from 44.4% in 2003 due to the lower sales base in 2004.

 

Corporate, general and administrationexpenses remained constant at $1.9 million for the third quarter of 2004compared to the same 2003 period, but increased to 8.9% of revenues in 2004from 8.1% of revenues in 2003 due to the lower sales base in 2004.

 

Operating losses were $2.3million for the three months ended September 30, 2004 compared to $80 thousandfor the three months ended September 30, 2003, primarily due to revenuedecreases and lower gross profit margins.

 

Gaiam recorded $138 thousandand $3 thousand in other income for the three months ended September 30, 2004and 2003, respectively.  The share of netincome associated with minority interest was $200 thousand during the thirdquarter of 2004, compared to the share of net income of $168 thousand for thecomparable 2003 period.

 

Gaiam recorded an income tax benefit of $856 thousand for the threemonths ended September 30, 2004 compared to an income tax benefit of $44thousand for the three months ended September 30, 2003.  Gaiam’s consolidated effective tax ratefluctuates based upon the distribution of earnings/losses between its domesticand foreign operations.

 

As a result of the factorsdescribed above, Gaiam’s net loss was $1.5 million for the three months endedSeptember 30, 2004 compared to a net loss of $201 thousand recorded for the threemonths ended September 30, 2003.

 

Nine monthsended September 30, 2004 versus September 30, 2003

 

Revenues of $61.8million for the nine months ended September 30, 2004 decreased 7.5% from $66.9million for the nine months ended September 30, 2003.  Gaiam’s decrease in revenues was due to adecrease in the business segment of $5.4 million, or 16% for the first ninemonths of 2004.  This shortfall resultedfrom lower sales volumes in the U.S. trade business, particularly in VHS, andan increase in markdowns and returns associated with the change out of VHSformat for DVD format.  Three of ourdistributors who service the clubs, Wal-Mart, and the Canadian market generatednegative comparative sales of over $2.1 million from 2003, as these retailersmoved to convert their media inventories from the VHS format and re-positiontheir offerings.   Direct to consumersegment revenues were $33.8 million for the nine months ended September 30,2004, compared to $33.0 million for the same period in 2003.  Internal revenue growth in our internet andinternational businesses was 14% and 12.6%, respectively, for the first ninemonths of the year.

 

Gross profit decreased to$31 million for the first nine months of 2004 from $35.4 million during thesame period in 2003.  As a percentage ofrevenue, gross profit declined to 50.2% in 2004 from 53% in 2002.  This was primarily attributable to a declineof 500 basis points in the business segment gross margin associated with markdownsand other expenses incurred with the changeover from VHS to DVD products.  This was partially offset by a favorablechange in sales mix from the business segment to the direct to consumersegment, where Gaiam has better overall margins.

 

Selling and operatingexpenses increased to $31.4 million for the nine months ended September 30,2004 as compared to $30.8 million in the same period of 2003, primarilyresulting from increased sales and marketing efforts in our business segment,both domestically and in our U.K. subsidiary, and in our direct to consumersegment, to support the revenue increases described above.  As a percentage of revenues, selling and operatingexpenses increased to 50.8% in 2004 from 46% in 2003.

 

Corporate, general andadministration expenses decreased to $5.9 million for the nine months endedSeptember 30, 2004 from $6.3 million in the comparable 2003 period, anddecreased to 9.6% of revenues in 2004 from 9.4% of revenues in 2003.  This expense reduction is generallyattributable to cost savings negotiated with

 

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service providers and othersavings generated by the consolidation of administrative services into Gaiam’sColorado headquarters.

 

Operating lossesincreased to $6.3 million for the nine months ended September 30, 2004 from$1.7 million for the nine months ended September 30, 2003, primarily due torevenue decreases and lower gross profit margins.

 

Gaiam recorded $270 thousandand $46 thousand in other income, primarily from interest income, for the ninemonths ended September 30, 2004 and 2003, respectively.  The share of net income associated withminority interest was $326 thousand for the first nine months of 2004, comparedto the share of net income of $345 thousand for the comparable 2003 period.

 

Gaiam recorded an income taxbenefit of $2.3 million for the nine months ended September 30, 2004 compared toan income tax benefit of $648 thousand for the nine months ended September 30,2003.

 

As a result of the factorsdescribed above, Gaiam’s net loss was $4.1 million for the nine months endedSeptember 30, 2004 compared to a net loss of $1.3 million recorded for the ninemonths ended September 30, 2003.  Despitethese losses, Gaiam’s cash generated by operations was $1.6 million for thefirst nine months of 2004, and Gaiam’s cash position increased to $9.7 millionat September 30, 2004, from $8.4 million at December 31, 2003.

 

Liquidity andCapital Resources

 

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 future growth. These capital requirements depend on numerous factors, including therate of market acceptance of Gaiam’s product offerings, the ability to expandGaiam’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 are variable and cannotaccurately be predicted.  Additionally,Gaiam will continue to evaluate possible investments in businesses, productsand technologies, and increase its sales and marketing programs and brandpromotions as needed.

 

Gaiamhas a credit agreement with Wells Fargo, which permits borrowings of up to $15million based upon the collateral value of Gaiam’s accounts receivable,inventory and certain property and equipment. Borrowings under the credit agreement bear interest at the lower ofprime rate less 50 basis points or LIBOR plus 275 basis points.  Borrowings are secured by a pledge of Gaiam’sassets, and the agreement contains various financial covenants, includingcovenants prohibiting the payment of cash dividends to Gaiam shareholders andrequiring compliance with certain financial ratios.  At September 30, 2004, Gaiam had no amountsoutstanding under this agreement and complied with all of the financialcovenants.

 

Gaiam’s operating activities generated net cash of $1.6 million and $1.7million for the nine months ended September 30, 2004 and 2003,respectively.  Gaiam’s net cash generatedfrom operating activities for both periods is primarily attributable to adecrease in accounts receivable of $5.9 million in 2004 and $8.3 million in 2003,which was partially offset by decreases in accounts payable of $1.6 million in 2004and $1.7 million in 2003.  Cash used fordeferred advertising costs associated primarily with the holiday catalogsincreased to $1.8 million in 2004 from $815 thousand for the nine months endedSeptember 30, 2003.  For the nine monthsended September 30, 2003, Gaiam also used cash to reduce accrued expenses andincome taxes payable a combined $3.6 million. Non-cash charges to net income were $3.4 million and $3 million for the ninemonths ended September 30, 2004 and 2003, respectively.

 

Gaiam’sinvesting and acquisition activities used net cash of $755 thousand and $5.1million during the first nine months of 2004 and 2003, respectively.  Expenditures for property, equipment andmedia rights were $755 thousand for the first six months of 2004, as comparedto $1.3 million for the same period in 2003. In January 2003, Gaiam acquired a 50.1% interest in Leisure SystemsInternational Ltd., a distributor of wellness products based in the U.K.  Total consideration for the acquisition wasapproximately $4.3 million in cash and 50,000 shares of Gaiam Class A commonstock.

 

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Gaiam’sfinancing activities generated net cash of $379 thousand and used cash of $122thousand for the nine months ended September 30, 2004 and 2003,respectively.  The cash generated byfinancing activities results primarily from the exercise of stock options underGaiam’s 1999 Long Term Incentive Program. Cash is used to fund principal payments under capitalized leases.

 

We believe our availablecash, cash expected to be generated from operations, and borrowing capabilitieson our unused $15 million line of credit should be sufficient to fund ouroperations on both a short-term and long-term basis.  However, our projected cash needs may changeas a result of acquisitions, unforeseen operational difficulties or otherfactors.

 

In the normal course of ourbusiness, we investigate, evaluate and discuss acquisition, joint venture,minority investment, strategic relationship and other business combination opportunitiesin the LOHAS market.  For any futureinvestment, acquisition or joint venture opportunities, we may consider usingthen-available liquidity, issuing equity securities or incurring additionalindebtedness.

 

ContractualObligations

 

Gaiamhas commitments pursuant to lease and debt agreements, but does not have anylong-term debt obligations or purchase obligations.  The following table shows our commitments tomake future payments under operating and capital leases as of September 30,2004 (in thousands):

 
| ** **                         | ** ** | **Total** | ** ** | **< 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **> 5 yrs** | ** ** |
|------------------------------------|------------|-----------|------------|-----------------|------------|---------------|------------|---------------|------------|----------------|------------|
| Operating lease obligations        |       | $         | 3,625      |            | $          | 1,500         |       | $             | 2,125      |           | $          | — |   | $ | — |   |
| Capital lease obligations          |       | 7         |       | 7               |       | —        |       | —        |       | —         |       |
| Total contractual cash obligations |       | $         | 3,632      |            | $          | 1,507         |       | $             | 2,125      |           | $          | — |   | $ | — |   |

 

Off-BalanceSheet Arrangements

 

Gaiam does not participate in transactions thatgenerate relationships with unconsolidated entities or financial partnerships,such as special purpose entities (“SPEs”) or variable interest entities (“VIEs”)established for the purpose of facilitating off-balance sheet arrangements orother limited purposes.  As of September30, 2004, Gaiam was not involved with any unconsolidated SPEs or VIEs.

 

CriticalAccounting Policies

 

Management believes thefollowing to be critical accounting policies whose application have a materialimpact on Gaiam’s financial presentation and involve a higher degree ofcomplexity, as they require management to make judgments and estimates aboutmatters that are inherently uncertain.

 

*Provisions for Doubtful Accountsand Returns*

 

Gaiam records a provisionfor doubtful accounts for all receivables not expected to be collected.  Gaiam generally does not requirecollateral.  Gaiam evaluates thecollectibility of 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.

 

Gaiam records a provisionfor product returns to be received in future periods at the time the originalsale is recognized.  The amount of thereturns provision is based upon historical experience and future expectations.

 

*Inventory*

 

Inventory consists primarilyof finished goods held for sale and is stated at the lower of cost (first-in,first-out method) or market. Gaiam identifies the inventory items to be writtendown 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 of the item.

 

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*Goodwill*

 

Goodwill represents theexcess of the purchase consideration over the fair value of assets acquiredless 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, on areporting unit level.  The fair value ofa reporting unit is compared with its carrying amount, including goodwill.  If the fair value of a reporting unit exceedsits carrying amount, goodwill of the reporting unit is considered not impaired.

 

If the carrying amount of areporting unit exceeds its fair value, the goodwill impairment test isperformed to measure the amount of impairment loss.  Gaiam has allocated goodwill to two reportingunits, and uses a market value method for the purposes of testing for potentialimpairment.  The annual review requiresextensive 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

 

*Investments*

 

Investments in entities overwhich 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 methodare included on the accompanying consolidated balance sheet in “Investments.”

 

*CapitalizedProduction Costs*

 

Capitalized production costsinclude costs incurred to produce informational media products marketed byGaiam 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.

 

Gaiam has not had any significant changes in itscritical accounting policies from its Form 10-K filing for the fiscal yearended December 31, 2003.

 

Risk Factors

 

We wish to caution you that there are risks anduncertainties that could cause our actual results to be materially differentfrom those indicated by forward-looking statements that we make from time totime in filings with the Securities and Exchange Commission, news releases,proxy statements, annual reports, registration statements and other writtencommunications, as well as oral forward-looking statements made from time totime by representatives of Gaiam.  Theserisks and uncertainties include, but are not limited to, those listed in Gaiam’sAnnual Report on Form 10-K for the year ended December 31, 2003.  These risks and uncertainties and additionalrisks and uncertainties not presently known to us or that we currently deemimmaterial may cause our business, financial condition, operating results andcash flows to be materially adversely affected. Except for the historical information contained herein, the mattersdiscussed in this analysis are forward-looking statements that involve risk anduncertainties, including, but not limited to, general economic and businessconditions, competition, pricing, brand reputation, consumer trends, and otherfactors which are often beyond our control. Gaiam does not undertake any obligation to update forward-lookingstatements except as required by law.

 

**Item 3.****                                                           Quantitativeand Qualitative Disclosures About Market Risk**

 

We are exposed to market risks, which include changes in U.S. interestrates and foreign exchange rates.  We donot engage in financial transactions for trading or speculative purposes.

 

Any borrowings we might makeunder our bank credit facility would bear interest at the lower of prime rateless 50 basis points or LIBOR plus 275 basis points.  Gaiam does not have any amounts outstandingunder its credit line, so any unfavorable change in interest rates would nothave a material impact on Gaiam’s results from operations or cash flows unlessGaiam makes borrowings in the future.

 

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Gaiam purchases asignificant amount of inventory from vendors outside of the U.S. intransactions that are primarily U.S. dollar denominated transactions.  Because the percentage of our internationalpurchases denominated in currencies other than the U.S. dollar is small, anycurrency risks related to these transactions are immaterial to Gaiam.  A decline in the relative value of the U.S.dollar to other foreign currencies could, however, lead to increased purchasingcosts.  In order to mitigate thisexposure, Gaiam makes virtually all of its purchase commitments in U.S.dollars.

 

In 2003, Gaiam purchased a50.1% interest in Leisure Systems International Limited, a U.K. baseddistributor.  Because Leisure Systems’revenues are primarily denominated in foreign currencies, this investmentexposes Gaiam to accounting risk associated with foreign currency exchange ratefluctuations.  However, we havedetermined that there was no material market risk exposure to our consolidated financialposition, results of operations or cash flows as of September 30, 2004.

 

**Item 4.****                                                          ****Controls and Procedures**

 

Gaiam maintains disclosurecontrols and procedures designed to ensure that the information Gaiam mustdisclose in its filings with the Securities and Exchange Commission isrecorded, processed, summarized and reported on a timely basis.  Gaiam’s chief executive officer and chieffinancial officer conducted an evaluation of the effectiveness of the designand operation of Gaiam’s disclosure controls and procedures, as defined inRules 13a-15(e) and 15d-15(e) under the Exchange Act.  Based upon their evaluation as of September30, 2004, they have concluded that those disclosure controls and procedures areeffective for the purpose of ensuring that material information required to beincluded in this quarterly report is made known to them by others on a timelybasis.

 

Gaiam is continuouslyseeking to improve the efficiency and effectiveness of its businesses and ofits internal controls.  This results inrefinements to processes throughout Gaiam’s operations.  However, there has been no change in Gaiam’sinternal control over financial reporting during the most recent fiscal quarterthat has materially affected, or is reasonably likely to materially affect,Gaiam’s internal control over financial reporting.

 

**PART II.****                OTHERINFORMATION**

 

**Item 1.****                    LegalProceedings**

 

From time to time, Gaiam is involved in legalproceedings that we consider to be in the normal course of business. We do notbelieve that any of these proceedings will have a material adverse effect onour business.

 

**Item 2.****                    Changesin Securities and Use of Proceeds**

 

None.

 

**Item 3.****                    DefaultsUpon Senior Securities**

 

None.

 

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

 

None.

 

**Item 5.****                    Other Information.**

 

None.

 

**Item 6.****                    Exhibits and Reports on Form 8-K.**

 

a)                                      Exhibits

 

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| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                           |
| 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).                                          |
| 32.1            |       | Certification  of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished  herewith). |
| 32.2            |       | Certification  of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished  herewith). |

 

b)                                     Reports on Form 8-K.

 

OnOctober 15, 2004, Gaiam filed a report on Form 8-K under Item 4.01, “Changes inRegistrant’s Accountant” announcing a change in Registrant’s independentaccountants.

 

OnOctober 27, 2004, Gaiam filed a report on Form 8-K relating to its earningspress release for the third quarter 2004.

 

17

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**Signatures**

 

In accordance with the requirements of theSecurities and Exchange Act, the registrant caused this report to be signed onits behalf, by the undersigned, thereunto duly authorized.

 

 
|   | Gaiam, Inc.       |
|--------|-------------------|
|   | (Registrant)      |
|   | October 27,  2004 |
|   |              |
|   |              |
|   | By:               | /s/ | Jirka Rysavy |   |
|   |              |   | Jirka Rysavy |
|   |              |   | Chief  Executive Officer |
|   |              |
|   |              | /s/ | Janet  Mathews |   |
|   |              |   | Janet  Mathews |
|   |              |   | Chief  Financial Officer |
|        |                   |  |  |  |  |  |  |

 

18

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