**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON DC  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 28, 2003**                                                                                                                                                                                                                                                   |
|       |                                                                                                                                                                                                                                                                                                    |
| **OR**     |
|       |                                                                                                                                                                                                                                                                                                    |
| **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                      |
|       | **FOR  THE TRANSITION PERIOD FROM                         TO                       ** |

 

**Commissionfile number 0-22534-LA**

 

**MONTEREYPASTA COMPANY**

(Exact name ofregistrant as specified in its charter)

 
| **Delaware**                                                                                                                 |   | **77-0227341**                        |
|------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State of  incorporation)                                                                                                    |   | (IRS employer  identification number) |
|                                                                                                                         |   |                                  |
| **1528  Moffett Street  Salinas, California 93905  (831) 753-6262**                                                          |
| (Address,  including zip code, and telephone number, including area code,  of Registrant’s principal executive offices) |
|                                                                                                                         |   |                                  |
| Securities registered  pursuant to Section 12(b) of the Act:   **None**                                            |
| Securities registered  pursuant to Section 12(g) of the Act: **Common  Stock, $.001 par value**                         |

 

Indicate by check markwhether registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months, and (2) has been subject to such filing requirements forthe past 90 days.

 

Yes  ý                                          No o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to thisForm 10-K.  ý

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).

 

Yes  o                                          No ý

 

The approximate aggregatemarket value of the voting and non-voting common equity held by non-affiliatesof the issuer as of June 27, 2003****was $37,007,000.  The number of shares outstanding of the issuer’s common stock asof March 5, 2003 was 14,213,682.

 

**Documents Incorporated by reference**: PartII item 5 and Part III item 14 of this Report are incorporated by referencefrom the definitive Proxy Statement for the registrant’s 2004 annual meeting ofstockholders.

 

 

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**PART I**

 

**ITEM1.****                                                     BUSINESS**

 

**Introduction**

 

Monterey Pasta Company(“the Company”) began its business in 1989 as a producer and distributor ofrefrigerated gourmet pasta and sauces to restaurants and grocery stores in theMonterey, California area.  The Companyhas since expanded its operations to include a more diversified range ofgourmet refrigerated food products, which it provides to grocery and clubstores throughout the United States, as well as selected regions in Canada, theCaribbean, Latin America, and Asia Pacific. The Company’s overall strategy is to enhance the value of the MontereyPasta Company brand by distributing its gourmet food products through multiplechannels of distribution, while selectively participating in private labelpartnerships.

 

The Company currentlyproduces and markets premium quality refrigerated gourmet pastas, gnocchi,pasta sauces, stuffed pizzas and calzones, prepared foods, salsas, dips,hummus, and polenta, emphasizing superior flavors and innovative products.  It seeks to build brand recognition andcustomer loyalty by employing a marketing program that focuses on developingmultiple points of sale for the Company’s products, and increasing consumerawareness of the Company’s offerings. The Company markets and sells its products primarily through grocery andclub stores.

 

###### **The Companyoffers over 200 varieties of contemporary gourmet food products that areproduced using the Company’s proprietary recipes.  Some examples of the Company’s products are listed under“Products” on pages four, five, and six. In 2003, the Company introduced new prepared food items such as twovarieties of lasagna and stuffed manicotti. In addition, the Company introduceda line of reduced-carbohydrate pasta products under the CarbSmart Brand, alongwith several extensions of existing lines. In 2002, the Company purchased theoperating assets of Emerald Valley Kitchen (“Emerald Valley”) of Eugene,Oregon, a producer of refrigerated organic salsas, dips, hummus andsauces.  This acquisition marked theCompany’s entrance into the rapidly growing organic food business and new itemswere introduced in 2003 in this line as well. For further information, see “Liquidity, Capital Resources, and BusinessAcquisitions” on page 12.**

###### ** **

The Company sells itsproducts through leading grocery store chains including Albertson’s, KingSoopers, Safeway, Fred Meyer, Kroger, Raley’s, Trader Joe’s, Publix, Wegmans,HEB, Dominick’s, and QFC; and warehouse club stores including Costco Wholesale,Sam’s Club, a division of Wal-Mart, and BJ’s. As of December 28, 2003, approximately 9,000 grocery and clubstores offered Monterey Pasta’s products.

 

In 1998, the Companyadded a web site, www.montereypasta.com**,**to further support its brand by providingboth consumer and investor information The site provides a comprehensiveinsight into the Company’s profile, product offerings, financial strength, aswell as consumer tips for those interested in gourmet food.

 

The success of theCompany’s sales efforts will depend in large part on four key factors: (1)whether grocery and club store chains will continue to increase the number oftheir stores offering the Company’s products, (2) whether the Company cancontinue to increase the number of grocery and club store chains offering itsproducts, 3) whether the Company can continue to introduce new products thatmeet consumer acceptance and 4) whether the Company can diversify into othercomplementary businesses and leverage its strengths to continue to growrevenues and profits at levels attractive to its investors.  Grocery and club store chains continuallyre-evaluate the products carried in their stores, and no assurances can begiven that the chains currently offering the Company’s products will continueto do so in the future.

 

Monterey Pasta Companywas originally incorporated in California in June 1989 and wasreincorporated in Delaware in August 1996. The Company’s executive officesand principal facilities are located at 1538 Moffett Street, Salinas,California 93905.  The Company’stelephone number is (831) 753-6262. The Company’s World Wide Web site iswww.montereypasta.com. Investors can obtain copies of SEC filings from thissite free of charge, as well as from the SEC website at www.sec.gov.

 

This Form 10-K containsforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, and Section 21E of the Securities Exchange Act of 1934, thatinvolve substantial risks to the Company, including statements about theCompany’s past operating losses, the ability to attract and retain qualifiedmanagement, the impact of inflation, dependence on major customers, andmarketing and sales risks. Also risks associated with processing anddistributing refrigerated food products, changing customer preferences andintegration of acquired companies.  Inconnection therewith, please see the cautionary statements contained herein in“Business Risks” which identify important factors that could cause actualresults to differ materially from those in the forward-looking statements.

 

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**IndustryOverview**

 

The Company believes thatthe U.S. retail market for refrigerated pasta is large and fragmented. Although refrigerated pasta products are not new, fresh pasta and pasta saucewere essentially created as a national specialty food category in 1986 whenNestle Fresh Foods Co., a division of Nestle S.A. (“Nestle”), introduced itsContadinaâ (now Buitoniâ)brand of fresh pasta.  In 1990, Kraft General Foods, Inc., a division ofPhilip Morris (“Kraft”), now Kraft Foods, Inc (“KFT”) unveiled its DiGiornobrand of fresh pasta nationally.

 

The Company believes thatthe initial interest in the fresh pasta category was influenced by severalfactors including heavy advertising and promotion by Nestle and Kraft, thechanging consumer preference for freshly prepared healthy foods, and increasingconsumer demand for convenient, quick meal solutions.  The Company isfurther encouraged by industry research reports, which show that spending onrefrigerated gourmet, specialty foods by consumers appears to be growing.

 

No assurance can be giventhat the refrigerated foods industry will expand further.  Nor can therebe any assurance that current trends in healthy eating, perception of freshpasta and pasta sauce as a healthy eating alternative, consumer demand for mealsolutions, diet trends or consumer spending levels in the specialty foodcategory will continue in the future.  Additionally, as the Companyexpands into different geographic regions, it may encounter different consumerperceptions, attitudes and behavior.  This may adversely impact theCompany’s marketing and expansion strategy and cause it to incur greaterexpenses in the promotion of its products.

 

While the market forrefrigerated gourmet food products is fragmented, with a large number of national,regional and local competitors, the Company believes that it can be successfulin this market by offering higher quality, upscale products with superiorflavor profiles.  The Company alsoexpects to leverage its existing presence in club stores to gain distributionof its prepared food products.

 

The organic food businesshas been growing at a double-digit rate since the 1960s and has now reachedover $7 billion in retail sales, according to Nutrition Business Journal. New Federal standards, under the auspices of the United States Department ofFood and Agriculture (“USDA”), were adopted for the industry inOctober 2002.  The purpose of the new standards was to provide aframework for organic content of product with the use of the USDA seal for thoseproducts meeting the “organic” definition (95% organic content), and setstandards for product quality and food safety so as to improve the overallstrength of the organic foods industry and protect the consumer.  EmeraldValley and other credible producers who meet the standards to be labeled USDAorganic will be in an excellent position to participate in the future growth ofthe industry.  Currently all Emerald Valley products now qualify for theUSDA designation.  The Company’s future organic offerings will be producedand formulated with the objective of qualifying for the USDA designation.

 

No assurance can be giventhat the market for refrigerated gourmet food products will expand further andthat space will be made available at the store level to house refrigeratedproducts.  Nor can there be any assurance that current trends in healthygourmet eating, perception of many of the Company’s products as healthy gourmeteating alternatives, consumer demand for quick meal solutions, or consumer spendinglevels in the specialty food category will continue in the future. Additionally, as the Company expands into different geographic regions, it mayencounter different consumer perceptions, diet trends, attitudes andbehavior.  This may adversely impact the Company’s expansion strategy andcause it to incur greater expenses in the promotion of its products.

 

**Strategy**

 

Monterey Pasta’s overallobjective is to become a leading national supplier of refrigerated gourmet foodproducts through distribution of its products to grocery and club stores. The key elements of the Company’s strategy include the following:

 

•                                Expandmarket share through same-store revenue growth, addition of new grocery andclub stores, geographic diversification, and product line expansion, includingcreation of additional meal solutions using Monterey Pasta products.

 

•                                Introducenew products on a timely basis to maintain customer interest and to respond tochanging consumer tastes.  In order tomaximize its margins, the Company will focus its efforts on those new productsthat can be manufactured and distributed out of its Salinas, California orEugene, Oregon facilities, and will supplement and compliment its existingproduct lines.

 

•                                Reduceoperating costs as a percentage of sales through continual evaluation ofadministrative and production staffing and procedures.  The Company willconsider additional capital improvements at its manufacturing facilities inorder to increase production efficiencies and capacities, and to reduce theCompany’s cost of goods on a per unit basis.

 

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•                                Createbrand awareness by communicating to the consumer that Monterey Pasta provides ahealthful and nutritious line of products, and promote repeat business by reinforcingpositive experiences with the Company’s products.

 

•                                Seekto establish a presence with specific targeted accounts in the food servicedistribution channel.

 

•                                Considerthe acquisition of other compatible companies or product lines to expand retaildistribution, or the range of product offerings, or to accomplish othersynergies where the acquisition will create long-term stockholder value, and beaccretive to earnings in the first year.

 

The Company will continueto direct its advertising and promotional activities to specific programscustomized to suit its retail grocery and club store accounts as well as toreach target consumers.  These will include in-store demonstrations,coupon programs, temporary price reduction promotions, and other relatedactivities. There can be no assurance that the Company will be able to increaseits net revenues from grocery and club stores.  Because the Company willcontinue to make expenditures associated with the expansion of its business,the Company’s results of operations may be affected.

 

The success of theCompany’s acquisition strategy is dependent upon its ability to generate cashfrom current operations, attract new capital, find suitable acquisitioncandidates, and successfully integrate new businesses and operations. There is no assurance that acquisitions can be financed from current cash flow,and, if not, that outside sources of capital will be available to supplementinternally-generated funds.  There is no assurance that management can successfullyselect suitable acquisition candidates and that these new businesses can besuccessfully integrated to create long term stockholder value.

 

**Products**

 

The Companyproduces and markets a variety of gourmet refrigerated cut pasta; filled pastasincluding borsellini, ravioli, tortelloni, tortellini; gnocchi; pasta sauces;stuffed pizzas and calzones; salsas; dips; hummus; and polenta under theMonterey Pasta Company, Arthur’s, Emerald Valley Kitchen and Nate’s brands, aswell as private labels.  Arthur’s is a mid-pricedpasta and sauce label, which was acquired as part of the March 1999acquisition of San Antonio Texas-based Frescala Foods, Inc. (“Frescala”).  The Emerald Valley Kitchen brand wasacquired as part of the Emerald Valley acquisition in August 2002.  The Nate’s label was acquired inDecember 2000.  For furtherinformation, See “Liquidity, Capital Resources, and Business Acquisitions” onpage 12.

 

The Company iscommitted to diversifying its offerings with innovative new product lineextensions, complementary products, and other gourmet food products.  The Company’s product development chefs andproduct development consultants focus on creating new products thatinnovatively blend complementary tastes, food textures and ingredients whilestrictly adhering to the Company’s emphasis on freshness, healthfulness andquality.  As new products areintroduced, selected items will be discontinued to help ensure that the productline is focused on consumer demand, to maximize the Company’s return on itsshelf space in grocery and club stores, and to respond to changing trends andconsumer preferences.

 

The Company’srefrigerated products are packaged predominantly in clear lightweightcontainers, which reveal the fresh appearance of its products.  Monterey Pasta presents its products with acolorful logo, distinctive packaging, ingredient information and cookinginstructions to communicate the gourmet, fresh and healthful qualities of itsproducts.  All of the Company’s productsnow feature newly redesigned packaging to maximize shelf impact and generateincreased consumer interest in the products, with increased emphasis on quicklyinforming the consumer about the products. The Company will continue to emphasize innovative packaging techniquesto maximize appeal on the shelf.

 

The goal of theCompany is to introduce new products on a timely and regular basis to maintaincustomer interest and to respond to changing consumer tastes.  There can be no assurance that the Company’sefforts to achieve such a goal will result in successful new products orproduct lines or that new products can be developed and introduced on a timelyand regular basis.  If the Company’s newproducts are not successful, the Company’s grocery and club store sales may beadversely affected as customers seek new products.

 

**Production**

 

The Companycurrently produces its products in a 43,700 square foot Monterey County,California facility.  In 2003, theCompany completed the production facility at a new 41,300 square foot facilitywhich is located approximately three miles from principal productionfacility.  Within this new facility,8,000 square feet are currently being used for production, while the remaining33,300 square feet remains unoccupied and is available for future expansion.This new production facility is adjacent to its 19,800 square foot refrigerateddistribution center, 26,000 square feet of ambient storage, and 2,100 squarefeet of office space 

 

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for a total of 89,200square feet at this location.  Inaddition, the Company produces organic salsas, dips, and hummus at its 19,000square foot organically certified facility in Eugene, Oregon, which wasintegrated into the business as part of the Emerald Valley acquisition. Organicgrilling sauces are produced at an organically certified co-packer in ForestGrove, Oregon.  The Californiafacilities are strategically located in one of the largest produce-growingregions in the United States and are near several major vendors and food servicedistributors.  In 2004, the Companyannounced the purchase of an 80% interest in CIBO Naturals LLC which operatesout of a 17,500 square foot facility in Seattle, WA.  For further information, see Acquisitions on Page 13. BothCalifornia facilities are certified by the United States Department ofAgriculture (“USDA”) and utilize state of the art thermal processing, chillingand packaging processes.  The Companyemploys a total of approximately 338 persons at all locations, including 53administrative personnel, eight sales personnel, five drivers, and 272distribution and production personnel. For additional information, see “Employees” on page 8.

 

Refrigerated pastais manufactured at the California facilities using high quality ingredientssuch as Extra Fancy Durham wheat, whole eggs or egg whites, fresh herbs andIndividually Quick Frozen (“IQF”) herbs and spices, and local cheeses and milkproducts.  The ingredients are mixed inaccordance with the Company’s proprietary recipes.  After filling with fresh and unusual ingredients such as snowcrab, spinach, feta cheese, lobster, and Vermont cheddar cheese, the pastaproducts receive a prescribed thermal process, or pasteurization to insureproduct safety and to preserve flavor, quality and shelf life.  The products are then chilled immediatelyand packaged in controlled atmosphere trays. Pasta sauces are mixed and processed in individual batches in accordancewith the Company’s proprietary processes and recipes and then directly packedand sealed in plastic containers.  Pizzaand calzone products are baked in continuous process ovens before beingchilled, packed, and sealed using the same process as is used for pastaproducts. The new lasagna products are baked in new rotary tray ovens. Afterpreparation, processing, chilling and packaging, all pasta, baked products, andsauces are kept in cold storage to preserve quality and shelf life.

 

The Companyregularly reviews a variety of potential capital projects for the productiondepartment and in the past three years has spent approximately $10.6 million oncapital improvements. These included significant upgrades and improvements tothe pasta lines, two packaging lines, capacity for chunky ravioli, a new jarsauce filling line, two clean rooms, increased sauce capacity and efficiency, apizza/calzone line, and boiler and utility upgrades to accommodate capacityincreases..  Significant 2001expenditures included $1.2 million to double the capacity of the pizza/calzoneline and improve the overall process, an improved sauce labeling machine, twomachines and dies to produce borsellini, and an upgraded ingredients blendingarea.  The new production facility,which was utilized during 2003, added approximately 30 percent of additionalpasta manufacturing capacity at a cost, including leasehold improvements, ofapproximately $2.1 million.  In 2003,the Company added the ability to produce items in the rapidly growing preparedfoods category, and corresponding plant improvement to accommodate these newproducts. Also added were automated filling equipment that reduced operatingcosts. Future additions of assets will be evaluated for increased efficiency,flexibility and capacity needs.

 

###### **RawMaterials**

###### ** **

###### **TheCompany purchases its raw materials from vendors throughout the United Statesand the world, although over 90% by dollar volume come from domestic sources,and over 55% of the domestic ingredients come from California.  Vendor selection is based on ability to meetspecifications and pricing, in that order. Because the ingredients are agricultural products the Company uses acombination of contracts, all of which are one year or less in duration, aswell as open market purchases to minimize the pricing risks and uncertainty ofsupply.  The Company does have one long-termcontract with its liquid nitrogen provider**which expires November 30, 2007

###### ** **

###### **Themost important ingredients used are dairy-based ingredients, eggs, flour,cooked seafood and meats, spinach, basil, and spices.  Management is unaware of any current restrictions or otherfactors that would have a material adverse effect on the availability of theseraw materials.  The Company’s purchasingpolicies are designed to provide more than one credible source for all ingredients.**

###### ** **

###### **Distribution**

###### ** **

The Company’ssuccess depends upon an effective system of distribution for its products.   In Northern California, the Companymaintains three direct store delivery (“DSD”) routes to deliver its products toapproximately 140 stores. The Company also delivers product directly towarehouses for several Northern California chains.  To distribute its products to other customers and other parts ofthe country which is over 90% of its business, the Company uses commoncarriers.  The dependence on othercompanies for delivery of its products poses a risk to the Company.  While the common carrier method of deliveryhas been reliable and available at acceptable rates thus far, there can be noassurance that the Company will continue to be able to negotiate acceptablefreight rates in the future and that delivery will not be disrupted for reasonsincluding, but not limited to, adverse weather, natural disasters or labordisputes in the trucking industry.

 

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**Grocery Chain and Club Store Sales**

 

Monterey Pastasells its products to chain grocery and club stores with approximate number ofstores at each year-end listed below:

 
|                  |   | **Number of Stores Carrying Monterey Pasta Products** |   |
|-----------------------|--------|-------------------------------------------------------|--------|
|                  |   | **2001**                                              |   | **2002** | ** ** | **2003** | ** ** |
| Retail Grocery Stores |   | 5,640                                                 |   | 7,780 |   | 7,940 |   |
| Club Stores           |   | 780                                                   |   | 920 |   | 1,060 |   |
| **Total**             |   | 6,420                                                 |   | 8,700 |   | 9,000 |   |

 

For the years2001, 2002, and 2003 Costco accounted for 48%, 43%, and 34% of total netrevenues, while Sam’s Club stores, including Wal-Mart Supercenters, accountedfor 31%, 31% and 32% of revenues for the same years.  The Company currently sells its products to eight separate Costcoregions which make purchasing decisions independently of one another.  These regions re-evaluate, on a regularbasis, the products carried in their stores. During 2003, Costco made a decision to reduce the number of items thatit offers to its members, which caused a reduction in the number of items thatthe Company sold to Costco during 2003. There can be no assurance that theseCostco regions will continue to offer Monterey Pasta products in the future orcontinue to allocate Monterey Pasta the same amount of shelf space. The Companycurrently supplies its products to approximately 458 Sam’s Club stores, whichfeature expanded delis.  Purchasingdecisions for these affiliates are made at the company headquarters with inputfrom the store level.  While the Companyis in the seventh year of its relationship with Sam’s, there can be noassurance that Sam’s Club stores will continue to carry its products or allocateMonterey Pasta the same amount of shelf space. On February 2, 2004 the Company announced that approximately 1,100Wal-Mart Supercenters discontinued its private label program which the Companywas making since 2002.  Wal-MartSupercenter’s private label business represented $2,823,000 and $3,490,000 ofNet Sales in 2002 and 2003 respectively. The loss of either Costco or Sam’s could have a materially adverselyaffect the Company’s business operations.

 

During the pasttwelve months less than 3.4% of sales were to foreign customers, with Canadaand Mexico accounting for over 97% of those sales, and the remainder going toAsia Pacific.  Listed below is a tabledepicting sales by country of origin for the last three fiscal years:

 
|         |   | **Sales by  Foreign Country** |   |
|--------------|--------|-------------------------------|--------|
| **(000s $)** |   | **2001**                      |   | **2002** |   | **2003** |   |
| Canada       |   | $                             | 896    |   | $ | 1,032 |   | $ | 984 |   |
| Mexico       |   | 527                           |   | 768 |   | 1,005 |   |
| Taiwan       |   | 85                            |   | 59 |   | 70 |   |
| Japan        |   | 16                            |   | 7 |   | — |   |
| Singapore    |   | 20                            |   | — |   | — |   |
| **Total**    |   | $                             | 1,544  |   | $ | 1,866 |   | $ | 2,059 |   |

 

**Marketing**

 

The Company’smarketing strategy is to create and sell innovative premium quality products inthe categories in which it competes and to communicate to consumers thatMonterey Pasta Company provides a gourmet quality nutritious line of productsand to promote repeat business by reinforcing positive experiences with theCompany’s products.  The Company’sapproach includes the introduction of new products on a timely basis tomaintain customer interest and to respond to changing consumer tastes.  Additionally, the Company will continue toexpand its sales into those geographic regions that will best support thepurchase of the Company’s upscale premium grade products.

 

**Competition**

 

The Company’sbusiness is subject to significant competition.  The fresh pasta and pasta sauce industry is highly competitiveand is dominated by two very large multinational companies, Nestle, with itsBuitoniâ brand, and Kraft,with its

 

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DiGiornoâbrand.   There are also a number ofsmaller regional competitors, such as Michael Angelo’sâand Olivieriâ owned by Maple Leaf Foods of Toronto, OntarioCanada.  Multinational competitors havesignificantly more brand name recognition, marketing personnel, and cashresources than the Company.  Moreover,competition for shelf space in grocery stores is intense and poses greatdifficulty for smaller food companies.

 

To date, theCompany has benefited indirectly from the marketing efforts of Nestle and Kraftin the pasta and sauce business.  Thesecompanies committed significant financial resources towards advertisement,promotion and development of the fresh pasta and sauce market and therefrigerated gourmet foods category which have contributed to the rapidexpansion of these markets and to the increased consumer attention to thecategory. No assurance, however, can be given that these companies willcontinue to expend such resources in the future or that the Company willcontinue to enjoy such benefits. In the future, the Company may be required toincur significantly greater expenses for promotion, advertisement andmarketing, which could adversely affect profitability.  There can be no assurance that the Companywill be able to continue to commit sufficient funds to promotion, advertisementand marketing while operating profitably.

 

The Company hasdeveloped several products for which there is no material competition currentlyin the refrigerated sector including borsellini, gnocchi and stuffedgnocchi.  It will continue to try toproduce distinctive products, which fill specific niches where there is littleor no national competition.

 

Competitivefactors in the refrigerated food market include brand awareness, productquality and taste, perceived healthfulness, price and availability of groceryand club store shelf space. The Company’s suggested retail prices are slightlyhigher than its competitors’ prices on most items due to higher qualityingredients and to emphasize the premium quality of its product line.  The Company believes the excellent quality,taste and perceived healthfulness of its products are superior to that of itscompetitors..  The Company also believesthat the quality of its products and the variety of its product lines provide acompetitive advantage over many companies which market more traditional products.

 

**Management**

 

Informationrelating to directors and executive officers of the Company is set forth inPart III of this report.

 

**Government Regulation**

 

The Company issubject to the regulations of the U.S. Food and Drug Administration (“FDA”),USDA, state, local, and organic industry regulations relating to cleanliness,maintenance of food production equipment, food storage, cooking and coolingtemperatures, food handling, and organic ingredient content of products, and issubject to unannounced on-site inspections of production facilities.  Regulations in new markets, new regulationsin existing markets, and future changes in existing regulations may adverselyimpact the Company by raising the cost of production and delivery of itsproducts and/or by affecting the perceived healthfulness of the Company’sproducts.  A failure to comply with oneor more regulatory requirements could result in a variety of sanctions,including fines and the withdrawal of the Company’s products from storeshelves.  The Company is not aware ofany currently existing facts or circumstances that it is not addressing whichwould cause it to fail to comply with any of the regulations to which it iscurrently subject.

 

**Employees**

 

As ofDecember 28, 2003, the Company employed a total of approximately 338persons at all locations, including 53 administrative personnel, eight salespersonnel, five drivers, and 272 distribution and production personnel.  None of the Company’s employees are representedby a labor union and the Company believes its relations with its employees aregood.

 

**Trademarks and Service Marks**

 

The Company hasregistered the “Monterey Pasta Company” name and corresponding logo design withthe United States Patent and Trademark Office. There can be no assurance that competitors will not adopt similar namesor logo designs outside the protection of the Company’s trademark registration.In March of 1999, the Company acquired the right to use the “Arthur’s”label with its acquisition of the Frescala Foods, Inc. business.  In December 2000, it acquired the rightto use the “Nate’s” label through its acquisition of the Nate’s polentabusiness (See “Liquidity, Capital Resources, and Business Acquisitions,” page12). In January 2001 the Company applied for registration with the UnitedStates Patent and Trademark Office for the “Borsellini” trademark namecurrently used for its filled pasta of the same name.  Additionally, In November 2001, the United States Patent andTrademark Office approved the “Homestyle-Fresh” trademark currently used in theCompany’s soup line.  During 2002 the 

 

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Company acquired therights to two unregistered trademarks, “Isabella’s Kitchen”, and “EmeraldValley Organics”, as part of acquisitions of businesses of the same names.

 

**ITEM2.****                                                     PROPERTIES**

 

During 2003, theCompany leased an additional 41,300 square feet of space at its offsitedistribution complex to accommodate plant expansion and to provide for futuregrowth.  The added space has been only partiallydeveloped with two new production lines used in the second quarter of 2003,thereby leaving the space and flexibility for future expansion.  The Company now leases approximately 133,000square feet in Salinas, California, comprised of 43,700 at its headquartersfacility and 89,200 at its distribution facility three miles from itsheadquarters. The headquarters facility is dedicated to manufacturingoperations, offices and its test kitchen. The distribution complex is comprised of 19,800 feet of refrigeratedcold storage, 2,100 of office space, 26,000 of ambient storage, and the newlease for 41,300 sq. ft., which will be dedicated to production space andstorage, with approximately 8,000 square feet currently used for production.The current production facilities/headquarters lease expires inOctober 2004 with two ten-year options for renewal.  The lease for the distribution center andadjacent production and storage facilities expires in June 2007 with twofive-year renewal options.

 

On January 2,2003 the Company entered into a three-year lease for an additional 1,200 squarefeet of office space next door to its headquarters facility in Salinas,California.  The lease commencedMarch 1, 2003 and expires February 28, 2006. In 2004, the Companyannounced the purchase of an 80% interest in CIBO Naturals LLC which operatesout of a 17,500 square foot leased facility in Seattle, WA which expires in May2005.

 

The Companyacquired a lease for the 19,000 square foot production facility and offices aspart of its acquisition of Emerald Valley. The lease expires December 31, 2007, with three five-year renewaloptions.

 

Management feelsthat its facilities are adequate to support sales growth for at least 24 monthsunless an acquisition is made.  Afterthat time production and office space could be expanded at its distributioncomplex or additional space could be leased in California to support itsSalinas operations or in Eugene, Oregon to support its Oregon operations.

 

**ITEM3.****                                                     LEGALPROCEEDINGS**

 

TheCompany and two of its officers and directors have been named as defendants intwo consolidated purported securities class action cases filed in the NorthernDistrict of California:  Wietschner v.Monterey Pasta Company et al., No. C 03-00632 MJJ filed on February 13,2003; Moore-Warner v. Monterey Pasta Company et al., No. C 03-1072 MJJ filed onMarch 12, 2003.  The cases purportto be brought on behalf of a class of all persons who purchased the commonstock of the Company from July 11, 2002 through December 16,2002.  The complaints allege thatdefendants issued false statements regarding expected earnings and revenues, inviolation of Sections 10(b) and/or 20(a) of the Securities Exchange Act of1934.  No specific amount of damages isclaimed.  On July 11, 2003, leadplaintiffs filed a consolidated complaint. The Company moved to dismiss, and that motion was heard onOctober 21, 2003.  OnNovember 5, 2003 the court granted the Company’s and the defendants’demurrers (Motion to dismiss) with 20 days to amend the complaint.  On January 5, 2004, the Company filed amotion to dismiss for failure to prosecute. Accordingly, the lawsuit has concluded.

 

OnFebruary 20, 2003, a purported shareholder derivative complaint was filedin the Superior Court, County of Monterey, Imperial County Employees’Retirement System v. Hewitt et al., No. M63679.  The complaint alleges claims for breach of fiduciary duty, grossnegligence, waste, and abuse of control against the directors of the Company,based in substantial part on the same allegations as the securities classaction complaints.  On June 13,2003, the Court granted the Company’s and the individual defendants’ demurrersto the case without leave to amend. After judgment was entered, plaintiff fileda notice of appeal. The parties subsequently agreed that the appeal would bedismissed, with each side to bear its own costs.  The stipulation to this effect has been filed with the SuperiorCourt.  Accordingly, the lawsuit hasconcluded.

 

OnFebruary 18, 2004, a complaint was filed by BC-USA, Inc. a/k/a BongrainCheese USA against the Company, James M. Williams, its Chief Executive Officer,and CIBO Naturals, LLC in the King County Superior Court, State ofWashington.  Mr. Williams was ChiefExecutive Officer of Bongrain Cheese USA prior to his employment by theCompany.  The complaint pleads severalcauses of action based principally upon an allegation that Mr. Williams, byparticipating in the acquisition of CIBO naturals, LLC by Monterey PastaCompany, breached agreements between himself and Bongrain Cheese USA. Thecomplaint seeks preliminary and permanent injunctive relief enjoining thedefendants from using or disclosing confidential, proprietary or trade secretinformation of Bongrain Cheese USA, plus unspecified damages.  Management believes that plaintiffs’allegations are without merit and intends to contest the case vigorously.

 

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TheCompany will incur legal fees in defending these lawsuits. At this time, theCompany cannot estimate the amount of fees that will be incurred.  There are no other material legalproceedings pending to which the Company is a party or to which any of itsproperty is subject.  The Company is aparty to ordinary routine litigation incidental to the Company’s business.

 

**ITEM4.****                  SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS**

 

No matters weresubmitted to vote during the fourth quarter of 2003.

 

**PART II**

 

**ITEM5.****                 MARKET FOR THEREGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

 

**Price Range of Common Stock**

 

The Company wentpublic on December 7, 1993 at a price to the public of $6.00 pershare.  Since that date, the Company’sCommon Stock has traded on the NASDAQ National Market System under the symbol“PSTA.”  The table on the following pagesets forth in decimals for the period indicated the high and low sales pricesof shares of the Common Stock on the NASDAQ National Market System.

 
|              |   | **High** |   | **Low** |   |
|-------------------|--------|----------|--------|---------|--------|
| Fiscal year 2002: |   |     |   |    |   |
| First quarter     |   | $        | 9.00   |    | $      | 6.50 |   |
| Second quarter    |   | 10.42    |   | 7.75    |   |
| Third quarter     |   | 9.44     |   | 4.25    |   |
| Fourth quarter    |   | 7.28     |   | 3.65    |   |
|              |   |     |   |    |   |
| Fiscal year 2003: |   |     |   |    |   |
| First quarter     |   | $        | 4.99   |    | $      | 2.93 |   |
| Second quarter    |   | 4.90     |   | 2.99    |   |
| Third quarter     |   | 5.05     |   | 3.55    |   |
| Fourth quarter    |   | 4.13     |   | 3.31    |   |

 

As ofFebruary 6, 2004, there were 227 stockholders of record of the CommonStock and approximately 4,600****investors with shares in street name.

 

**Dividend Policy**

 

The Company hasnot paid any cash dividends to Common stockholders, except to certain holdersof private placement common stock in 1997, which represented guaranteed yieldfor the period from stock issuance in April, 1997 until the RegistrationStatement on Form S-3 was effective on October 24, 1997.  The Company’s line of credit currentlyprohibits the payment of dividends.  Inaddition, the Company intends to retain future earnings in its business anddoes not anticipate paying cash dividends on the outstanding Common stock inthe near future.

 

**Equity Compensation Plan**

 

The informationregarding stock plans approved by Shareholders and not approved by Shareholdersrequired by this Item is incorporated by reference to the Company’s ProxyStatement under the heading “Stock Options” and also is found in Item 7 of“Notes to Financial Statements” attached to the Financial Statements withinthis document.

 

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**ITEM6.****                                                     SELECTEDDATA**

 

The followingtable sets forth consolidated financial data for the Company.  These data should be read in conjunctionwith the consolidated financial statements and related notes included elsewherein Form 10-K.

 
|                                         |   | **Years Ended**                                     |   |
|----------------------------------------------|--------|-----------------------------------------------------|--------|
|                                         |   | **1999**                                            |   | **2000** |   | **2001** |   | **2002** |   | **2003** |   |
|                                         |   | **(dollar amounts in thousands except share data)** |   |
| **Consolidated  Statements of Income Data:** |   |                                                |   |   |   |   |   |   |   |   |   |
| Net revenues                                 |   | $                                                   | 34,898 |   | $ | 46,090 |   | $ | 56,987 |   | $ | 61,679 |   | $ | 60,490 |   |
| Net income                                   |   | $                                                   | 7,027  |   | $ | 6,141 |   | $ | 4,429 |   | $ | 9,491 |   | $ | 1,034 |   |
| Basic net income per common share            |   | $                                                   | 0.55   |   | $ | 0.46 |   | $ | 0.33 |   | $ | 0.68 |   | $ | 0.07 |   |
| Diluted income per common share              |   | $                                                   | 0.54   |   | $ | 0.44 |   | $ | 0.31 |   | $ | 0.65 |   | $ | 0.07 |   |
|                                         |   |                                                |   |   |   |   |   |   |   |   |   |
| Weighted average basic shares outstanding    |   | 12,711,801                                          |   | 13,222,062 |   | 13,491,177 |   | 14,039,902 |   | 14,206,627 |   |
| Weighted average diluted shares outstanding  |   | 13,074,776                                          |   | 13,835,384 |   | 14,254,248 |   | 14,664,762 |   | 14,414,931 |   |
|                                         |   |                                                |   |   |   |   |   |   |   |   |   |
| **Consolidated  Balance Sheet Data:**        |   |                                                |   |   |   |   |   |   |   |   |   |
| Working capital                              |   | $                                                   | 4,128  |   | $ | 9,799 |   | $ | 14,934 |   | $ | 16,880 |   | $ | 16,704 |   |
| Total assets                                 |   | $                                                   | 18,666 |   | $ | 25,189 |   | $ | 31,596 |   | $ | 43,799 |   | $ | 44,204 |   |
| Total debt and capital lease obligations     |   | $                                                   | 761    |   | $ | 73 |   | $ | 49 |   | $ | 17 |   | $ | 3 |   |
| Stockholders’ equity                    |   | $                                                   | 14,610 |   | $ | 21,663 |   | $ | 27,981 |   | $ | 38,941 |   | $ | 40,034 |   |

 

**ITEM7.****                 MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The followingdiscussion should be read in conjunction with the financial statements andrelated notes and other information included in this report.  The financial results reported herein do notindicate the financial results that may be achieved by the Company in anyfuture period.

 

**Background**

 

Monterey PastaCompany was incorporated in June 1989 as a producer and wholesaler ofrefrigerated gourmet pasta and sauces to restaurants and grocery stores in theMonterey, California area.  The Companyhas since expanded its operations to provide a variety of gourmet refrigeratedfood products to grocery and club stores throughout the United States, selectedregions in Canada, the Caribbean, Latin America, and Asia Pacific.  The Company’s overall strategic plan is toenhance the value of the Monterey Pasta Company brand name by distributing itsgourmet products through multiple channels of distribution.

 

The Company’sproduct distribution to grocery and club stores increased from approximately 25stores as of December 1989, to approximately 9,000 stores byDecember 28, 2003.  During recent yearsthe Company added profitable retail and club distribution through internalgrowth and through the Frescala Foods, Nate’s and Emerald Valley acquisitions.On February 2, 2004, the Company announced that approximately 1,100Wal-Mart Supercenters discontinued it private label refrigerated pasta andpasta sauce program which the Company was making since 2002.  However, with the introduction ofCarb-Smart, low carbohydrate pasta products, the number of stores through whichthe Company continues to distribute its products exceeds 9,000 total stores.

 

The success of theCompany’s efforts to increase revenue will depend on five key factors: (1)whether grocery and club store chains will continue to increase the number oftheir stores offering the Company’s products, (2) whether the Company cancontinue to increase the number of grocery and club store chains offering itsproducts, (3) continued introduction of new products that meet consumeracceptance and (4) whether the Company can diversify into other complementarybusinesses through new product offerings or acquisitions and leverage itsstrengths to continue to grow revenues at levels attractive to itsinvestors.  Grocery and club storechains continually re-evaluate the products carried in their stores, and noassurances can be given that the chains currently offering the Company’sproducts will continue to do so in the future or that such chains will notreduce the number of stores carrying the Company’s products.  During 2003, Costco chose to reduce the numberof items it carries from many of its suppliers, which caused a reduction ofsales from the Company to Costco.

 

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The Companybelieves that access to substantially greater capital resources, increased salesto offset the higher fixed overhead, coupled with continued reduction of itsadministrative and production costs as a percent of sales revenue, will be keyrequirements in the Company’s efforts to enhance its competitive position andincrease its market penetration.  Inorder to support its expansion program, the Company has developed, and iscontinuing to develop new products for consumers and revised advertising andpromotional activities for its retail grocery and club store accounts. Therecan be no assurance that the Company will be able to increase its net revenuesfrom grocery and club stores.  Becausethe Company will continue to make expenditures associated with the expansion ofits business, the Company’s results of operations may be affected.

 

**Operations for 2001, 2002 and 2003**

 

Net revenues were$56,987,000, $61,679,000 and $60,490,000 for 2001, 2002 and 2003, respectively,reflecting an annual increase in sales of 8% for 2002, when compared to 2001,and a 2% decrease for 2003 when compared to 2002. The change in net revenues isa result of shipping more/less product and is not a result of price changes forthe Company’s products. The 2002 increase resulted from same store salesgrowth, increased store numbers in the grocery and club stores by year-end of2002. The acquisition of Emerald Valley Kitchen in late August 2002contributed approximately 2% of the overall 2002 sales growth of 8% from itseighteen weeks of sales through 2002 fiscal year end.  The 2003 sales decline of 2% is a result a sales decline atCostco of 23.9% for the year.    At thebeginning of 2003, Costco made a decision to reduce the number of items that itoffers to its members, which caused a reduction in the number of items that theCompany sold to Costco during 2003.  Costco’sdecision to reduce the number of items purchased from the Company byapproximately 50% resulted in a reduction of sales to Costco of $6,521,000 whencomparing 2003 sales to 2002.  Thereduction in sales to Costco is offset by an increase in retail sales of 25% ofwhich Emerald Valley Kitchen sales represented 16% of the 25% increase.  On February 2, 2004 the Companyannounced that approximately 1,100 Wal-Mart Supercenters discontinued itsprivate label refrigerated pasta and pasta sauce program which the Company wasmaking since 2002.  The Company does notsell any other products to Wal-Mart Supercenters.  Wal-Mart Supercenter’s private label business represented$2,823,000 and $3,490,000 of Net Sales in 2002 and 2003 respectively.

 

Gross margin for 2001,2002, and 2003 was 36.0%, 36.1% and 30.7%, respectively.   The slight increase in 2002 over 2001 wasdue to lower ingredient prices, especially dairy ingredients.  The gross profit decline in 2003 compared to2002 was a function of increased fixed costs in anticipation of increased saleswhich have not grown at the level expected, increased costs involving thedevelopment and design of new packaging, and higher costs associated with thenew packaging concept. During 2003, the Company wrote off or charged toreserves $528,000 of obsolete packaging inventory. In addition,  the rapid rollout of the new package to theCompany’s second largest club store customer, where the customer chose todeplete from its shelves the inventory of the old packaging before orderingproduct in the new packaging, caused expenses to exceed expectations.  This caused a dramatic slowdown inproduction followed by rapid production causing high expenditures all of whichcontributed to the decline in gross margin.

 

Selling, General andAdministrative expense (“SG&A”) increased to $17,161,000 in 2003, up$1,507,000 or 10% from $15,654,000 in 2002, which had increased $2,372,000****or18% from 2001. SG&A expense as a percent of Net Revenues was 28.4% comparedto 25.4% in 2002 and 23.3% in 2001.  Theincreases in 2003 compared to 2002 are related to additional staffing in thesales and marketing area, ($350,000 increase) increased freight cost due tofuel surcharges and less efficient loads related to increased retail sales,($976,000 increase), and increased marketing and selling costs attributable tospending levels geared to higher sales growth expectation than was achievedduring the year ($423,000 increase). Demonstration costs as a percent of NetSales are 7.0%, 8.3% and 9.1% for the years 2001, 2002, and 2003 respectively.In light of the decrease in sales at Costco, management is examining the levelof product demonstration expenses to determine the most cost-effective levelrelative to sales revenue Management believes that the current level ofSG&A expenses is needed to support future sales growth

 

Depreciation andamortization expense, included in cost of sales and SG&A with approximately85% in cost of sales, increased to $2,082,000, or 3.4% of net revenues in 2003,compared to $1,720,000 or 2.8% of net revenues in 2002, and $1,661,000 or 2.9%in 2001.  The increases over the pasttwo years relate primarily to capacity expansion and equipment upgrades in theSalinas, California production facilities and the addition of Emerald Valleykitchen businesses.  See “Liquidity,Capital Resources and Business Acquisitions”, page 12.  Depreciation increased by $246,000 in 2003,to $1,839,000 from $1,593,000, and $1,443,000 in 2001. The increase is a resultof depreciation related to the 2002 and 2003 asset additions.  Amortization expense was $243,000 for 2003,$127,000 in 2002, and $218,000 in 2001. The 2003 increase of $196,000 was related mainly to the Emerald ValleyKitchen acquisition. The 2002 decrease was associated with Statement of FinancialAccounting Standards 142 (See “New Accounting Pronouncements” on page 36.)

 

Net interestincome of $71,000 was recognized in 2003 compared to income of $110,000 in 2002and $108,000 in 2001.  The 2003, 2002and 2001 interest income was generated from investment in short-term moneyfunds from operating cash flow in the absence of bank debt.   At year-end 2003, the Company had no bankdebt.  See “Consolidated Balance Sheets”page 29.

 

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Income tax benefit(expense) for 2001, 2002, and 2003 was ($2,936,000), $2,838,000, and($444,000), respectively.  The 2001expense resulted from a more normalized tax rate, since net operating losscarryforwards (“NOLs”) utilized in 2000 were not reserved.  Thus, during 2001, deferred tax assets wereutilized to offset State and Federal income tax with only $231,000 in cashtaxes paid.  During 2002, another$5,196,000 of the remaining reserves against deferred tax assets were releasedand offset against income tax since, after a comprehensive study of the natureof the NOLs and their likelihood of being utilized, management concluded thatit was more likely than not that they would be utilized.  This benefit, together with permanentdifferences and other current tax effects resulted in a net income tax benefitof $2,838,000 for 2002.  Utilization ofthese NOLs and other deferred tax assets offset substantially all of the cashfederal income taxes otherwise payable for 2002.  The 2003 tax expense was $444,000, or 30.0% of pre-tax income.

 

Additionally, the Companyrealized additional tax benefits as a result of the exercise of non-qualifiedstock options and the exercise and subsequent sale of certain incentive stockoptions or disqualifying dispositions in 2001, 2002, and 2003. For financialreporting purposes, any resulting reduction in actual income tax obligations asa result of these disqualifying dispositions is credited to additional paid-incapital.  See “Liquidity, Capital Resourcesand Business Acquisition: Deferred Tax Assets” on page 12, and Note 8 to theconsolidated financial statements****on page 42.

 

###### **Liquidity,Capital Resources, and Business Acquisitions**

###### ** **

During the twelvemonths ended December 28, 2003, $1,511,000 of cash was provided by theCompany’s operations, compared to $9,494,000 provided in 2002 and $7,416,000 in2001.  The 2003 net income of $1,034,000plus depreciation and amortization of $2,082,000 and deferred tax asset of$313,000 were offset by a $1,917,000 change in operating assets andliabilities. The 2003 reduction in cash provided by operations compared to 2002is a result of lower net income.

 

The Companycurrently has a credit facility, which was renegotiated in August 2001 andhas been refined each year for $10.0 million in aggregate borrowings which hasbeen unused since September 2000, and has a zero balance outstanding atDecember 28, 2003. See Note 4 to the financial statements.  The $1.5 million working capital portion ofthe facility is priced at LIBOR, plus 200 basis points.  The working capital commitment expiresOctober 31, 2004.  The $8.5 millionnon-revolving term portion of the facility pricing is at either prime rate orLIBOR plus premiums 225 basis points over LIBOR.  The term loan facility is subject to annual review ifunused.  If used, it converts to an84-month term loan. This access to capital provides the Company with flexibleworking capital, which occasionally may be needed in the normal course ofbusiness, and the opportunity to grow the business through acquisitions or developthe existing infrastructure through capital investment.  A Letter of Credit in the amount of $500,000was negotiated during January 2003 and increased to $900,000 in favor ofan insurance company to support a deductible worker’s compensation program initiatedby the Company on January 1, 2003 and continuing into 2004.

 

In addition tooperating cash flows, the Company also received cash proceeds of $989,000,$985,000, and $58,000 from the exercise of employee stock options and sales ofstock under the Company’s stock purchase Plan during 2001, 2002, and 2003,respectively.

 

Cash balance atthe end of 2003 was $5,285,000 compared with $6,838,000.  The cash from operations in 2003 and cashbalances from prior year was used primarily to purchase $3,029,000 of plant andequipment during the year.  In 2003, theCompany added the ability to produce items in the rapidly growing preparedfoods category, including a lasagna line and corresponding plant improvement toaccommodate these new products. Also added were automated filling equipmentthat reduced operating costs of the Company. Many other smaller projects were completed to support growth, improveprocesses, support administrative systems, or assist in compliance issues.

 

The cash from operationsin 2002, combined with the cash proceeds from stock sales and option exercisesand accumulated cash balances, was used principally to fund $4.8 million ofplant expansion and improvement projects, and to fund the $5,744,000 in cashpaid for the acquisition of the operating assets and inventory of EmeraldValley, and acquisition related costs of $188,000.  The capital projects funded in 2002 included approximately $2.1million for a plant expansion at its distribution center.  Other significant projects included a newjar line for sauce packing, a new chunky ravioli line, a new pasta packing lineand labeler, a spiral chiller, and an electrical upgrade improved packagingequipment.

 

The Company invested $2.6million in capital assets in 2001. Major projects included approximately $900,000 for expansion of andimprovements in the pizza/calzone line, approximately $300,000 for ingredientsblending upgrade, and over $250,000 for the borsellini dies and pastamachines.  The Company also investedover $500,000 in facility improvements to enhance sanitation and supportgrowth, and $150,000 in new or improved packaging equipment, as well as manyother capital projects designed to support growth, improve processes, or assistin compliance issues.

 

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The Company anticipatescapital expenditures in 2004 to be approximately $2.0 million which is lessthan the $3.1 million the Company spent in 2003.  The Company does not plan further plant capacity expansion, whichis the principal reason for the reduction in the capital required.  All future capital expenditures are expectedto be funded with a combination of cash flow from operations or the use of theCompany’s credit facility.

 

Managementbelieves that cash on hand of $5.3 million at December 28, 2003, projected2004 cash flows from operations, and availability under the CreditFacility,  less the funds used topurchase an 80% interest in CIBO, is sufficient to fund working capital needs,anticipated capital expenditures, and future acquisitions. During 2003, theCompany invested cash on hand in highly liquid short-term investments yieldingapproximately 1.5% interest.

 

**Contractual Obligations**

 

The Company has no rawmaterial contracts exceeding one year in duration.  However, it does have one long-term contract with its liquidnitrogen provider, which expires November 30, 2007. In addition, theCompany leases production, warehouse and corporate office space as well ascertain equipment under both a month-to-month and non-cancelable operatinglease agreement.  All building leaseshave renewal options and all include cost of living adjustments.  No employees have employment agreements. Thefollowing table summarizes the estimated annual obligations.

 
|                                                                                     |   | **Payments due by period** |      |
|------------------------------------------------------------------------------------------|--------|----------------------------|-----------|
| **Contractual Obligations**                                                              |   | **Total**                  |      | **Less than 1 year** |   | **1-3 years** |   | **3-5 years** |   | **More than 5 years** |   |
| Long-Term  Debt                                                                          |   | $                          | —    |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Capital  Lease Obligations                                                               |   | 3,000                      |      | 2,000 |   | 1,000 |   | — |   | — |   |
| Operating  Leases                                                                        |   | 2,091,000                  |      | 798,000 |   | 1,293,000 |   | — |   | — |   |
| Purchase  Obligations                                                                    |   | 2,997,000                  |      | 695,000 |   | 2,302,000 |   | — |   | — |   |
| Other  Long-Term Liabilities Reflected on the Registrant’s Balance Sheet under GAAP |   | —                     |      | — |   | — |   | — |   | — |   |
| Total                                                                                    |   | $                          | 5,091,000 |   | $ | 1,495,000 |   | $ | 3,596,000 |   | $ | — |   | $ | — |   |

 

In addition, the Companyhas a standby letter of credit in favor of an insurance company which wasraised on January 1, 2004 to $900,000 from $500,000, and expires onDecember 31, 2004.

 

**Off-Balance Sheet Arrangements**

 

The Company does not haveany off-balance sheet arrangements that are material to its financial positionor results of operations.  See Note 4and 5 to the Consolidated Financial Statements for information regardingcapitalized leases and operating leases.

 

**Business Acquisitions**

 

On August 23,2002, the Company purchased the operating assets and inventory of EmeraldValley Kitchen, Inc. a Eugene, Oregon based producer of organic fresh salsas,dips, hummus, and sauces with over 90% retail chain distribution. The Companyconsidered this purchase an opportunity to enter the rapidly growing organicfood market.  The consideration to thesellers consisted of $5,744,000 in cash. Additionally, the Emerald Valley owners are eligible to receive an earn-outbased upon Emerald Valley Earnings before Interest, Taxes, Depreciation, andAmortization (“EBITDA”) above predetermined levels starting at $979,000 for thefirst five years after the acquisition date. In 2003, the Company paid $79,000 as a result of the earn-out.  The earn-out will be calculated annually atthe end of successive twelve-month periods following acquisition.  Funding for the transaction came fromexisting cash balances.

 

No acquisitions occurredin 2003, however, the Company announced on January 28, 2004 theacquisition of an 80% interest in CIBO Naturals LLC (“CIBO”), a leadingmanufacturer of premium sauces and spreads located in Seattle, Washington.  The Company paid CIBO and its members $6.0million cash for 80% of CIBO and loaned CIBO $1.0 million.  Additionally, the 

 

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acquisition agreementprovides for the purchase of the remaining 20% ownership after four years at apredetermined calculation based on earnings before taxes.  The cash came partly from the Company’s cashbalances and from its credit facilities.

 

CIBO produces a varietyof refrigerated gourmet sauces and spreads including fresh pesto sauces,flavored cheeses, bruschetta toppings and tapenade spreads.  Their products are sold nationally throughclub stores, specialty food stores, and regionally in supermarket delis. CIBOfits well with the Company’s growth strategy in premium refrigeratedfoods.  CIBO through its “CIBO Naturals”brand sells unique, high quality products and has developed a strong position inits markets which has great growth potential in both expanded distribution andin new products.

 

**Deferred Tax Assets**

 

Due to the prior historyof losses, valuation allowances against deferred tax assets have been providedin all years, as management could not determine that it was more likely thannot that all of them could be used.

 

During 2002, managementcompleted a comprehensive study of the nature of certain NOLs arising inconnection with previously owned subsidiary Upscale Food Outlets, Inc. (“UFO”)and their likelihood of their being utilized.  Management concluded that it was more likely than not that they would beutilized.  As a result, reserves againstthese specific deferred tax assets totaling $5,196,000 were released during2002 and offset against income tax expense. This credit, together with permanent differences and other current taxeffects resulted in an income tax benefit of $2,838,000 for 2002.  In 2003 tax expense was $444,000 whichapproaches a more normalized tax rate. As of December 28, 2003, remaining net deferred tax assetsavailable to offset future cash taxes are $3,485,000 short term and $1,036,000long term.

 

As a result of thisevaluation and resulting release of reserves and the Company continuing to beprofitable, the Company expects that future income tax expense will be accruedat a more “normalized” combined Federal and State rate approaching statutoryrates less certain tax credits and timing differences.  The future disallowance of any previous UFONOL usage, if it occurs, would increase both income tax expense and amountsactually payable.

 

**Sales and Marketing**

 

The Company’ssales and marketing strategy is twofold, and targets sustainable growth indistribution of its products and the introduction of innovative new products tokeep the Company positioned as the gourmet refrigerated category leader in themarketplace.  Its focus is on increasingsales through expansion of its club store and retail grocery business.

 

Expansion of theCompany’s club store business took on an international flavor during 2001 withthe introduction of the Company’s products into the Eastern Canada division ofCostco, as well as Costco locations in Mexico, and in Asia.  The Company’s products are now found inapproximately 330 Costco Wholesale locations. Distribution of the Company’s products also continues to grow with thenational expansion of Sam’s Club, and the introduction of the Company’sproducts into Sam’s Club locations in Mexico. Monterey Pasta’s products are now found in approximately 458 Sam’s Clublocations.

 

During 2001, theCompany’s retail business increased significantly with an additional 279Albertson’s stores including 75 in the metro Phoenix market, and 204 inNorthern California, over 50 Dominick’s stores in the metro Chicago market, and14 Jerry’s Enterprises stores in the upper Midwest, which average 75,000 squarefeet in size. The Company also acquired significant retail business with itspurchase of the Nate’s Polenta brand in late 2000.  The Nate’s Polenta business added distribution to over 700 retailoutlets.  At end of 2001, the Companyhad distribution in over 5,600 retail outlets.

 

In 2001, theCompany continued its emphasis on bringing innovative new products to themarketplace with the introduction of two new product lines: Veil-thin pasta andItalian Classic sauces.  Veil-thin pastafeatures a delicate dough that is significantly thinner than traditionalrefrigerated pasta doughs.  TheCompany’s first offering in the Veil-thin line is its Borsellini, which wrapsgourmet fillings in small pouches of veil-thin dough.  The product line has enjoyed considerable success in both retailand club store accounts.  The ItalianClassics sauce line expands the Company’s sauce offerings, and features threevarieties of Traditional-style Italian sauces. Italian Classics sauces can be found in both retail and club storeaccounts.  In addition, the Company alsoadded significantly to its existing line of refrigerated, fresh calzones duringthe year, and was successful in introducing them to both retail and club storeaccounts.

 

During 2002 theCompany launched three new product lines: stuffed potato gnocchi with threeflavors, a new line of premium sauces in plastic jars with several selectionsand Pezzo Grandi Chunky Stuffed Ravioli with three flavors initially.  Several extensions of existing lines werealso marketed.

 

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The Company madesignificant distribution gains during 2002 with over 600 Albertson’s stores,1,100 Wal-Mart Supercenters, 140 BJ’s club stores and 260 Publix Super Marketsadded to its distribution base.  TheEmerald Valley acquisition also added over 100 stores not formerly served bythe Company.

 

The Companypurchased the operating assets of Emerald Valley Kitchen of Eugene, Oregon, aproducer of refrigerated organic salsas, dips, hummus and sauces.  The August 2002 acquisition marked theCompany’s formal expansion into the rapidly growing organic food business andwill be used as a platform for additional offerings in the future.

 

In 2003, the Companyfocused on revitalizing its products and the packaging of its products andintroducing new products to accommodate the changing lifestyles ofconsumers.  Pasta is a staple of theNorth American diet.  It is widelyrecognized that pasta is a convenient and nutritious food.  The USDA places pasta on the foundationlevel of its pyramid of recommended food groups and pasta supports consumers’lifestyle demands for convenient at-home meals.

 

In 2003, the companyrelaunched its retail gourmet refrigerated pasta and sauce lines with improvedformulations and innovative new packaging. The Company’s signature products have been updated with new doughs andfillings.  The distinctive new packaginguses a sleeve to wrap the inner package, and incorporates color graphics andproduct photography in a contemporary new look.  The new dough is made from 100% Extra Fancy Durum flour and wholeeggs, which gives the pasta a classic appearance and richer flavor – as well asa noticeably improved “al dente” or firm texture.  This also gave the Company the opportunity to refine several ofits ravioli and tortelloni fillings. These improvements include creamier textures and enhanced flavors.  The package is the Company’s most importantpoint of communication with the consumer, and the package has been redesignedwith the consumer in mind.  Thephotography emphasizes appetite appeal, and the package highlights key productbenefits to the consumer to generate point-of-sale purchases.  This new package is designed to bothstrengthen the Monterey Pasta Company brand recognition and reinforce itspositioning as a premium quality product.

 

In 2003, the companyintroduced CARB smart, a line of reduced carbohydrate fresh pastas, sauces andprepared entrees with about half the carbohydrates of regular pasta. SevenCARB-SMARTTM items are now shipping to supermarkets and club stores nation wideincluding three ravioli varieties – Spinach Ricotta, Four Cheese & Chive,and Seafood – as well as Spinach & Cheese Tortelloni, Classic Egg Linguine,and Classic Egg Fettuccine.  CARB-SMARTTMFour Cheese Sauce, with genuine Gorgonzola, Asiago, Swiss and Fontina cheeses,is the low-carbohydrate companion to the pasta line. The Company is respondingto the Low-Carbohydrate Diet trend by delivering the flavor and convenience oftraditional fresh pasta.

 

In addition, the Companyis currently introducing additional quick preparation entrees under both theCARB-SMARTTM and the Monterey Pasta brands. These items include Seafood Lasagna, Cheese Manicotti, Chicken Cannelloni,and additional varieties of lasagna.

 

**Business Risks**

 

Certain characteristicsand dynamics of the Company’s business and of financial markets generallycreate risks to the Company’s long-term success and to predictable quarterlyresults.  These risks include:

 

•                  NoAssurance of Continued Profitability. In the second quarter of 1994, the Company reported its first operatingloss from continuing operations.  Subsequent to that quarter the Company incurred losses through the firstquarter of 1997, after which it regained profitability, which continued throughtwenty-five consecutive quarters until losses were recorded in the third andfourth quarters of 2003.  AtDecember 28, 2003 the Company had an accumulated deficit of$4,557,000.  There can be no assurancethat the Company will generate profits in the short or long term.

 

•                  Liquidity:  Need for Additional Capital.   Management believes that its current cashbalances, operations, and existing bank lines of credit will provide adequateliquidity to meet the Company’s planned capital and operating requirements fornormal operations and capital expenditures through the next twelve months.  See Note 4 to the financial statements for adescription of the credit facility.  Theuse of the UFO NOLs through 2003 is approximately $14 million.  If the Company’s operations do not providecash sufficient to fund its operations, and the Company seeks outsidefinancing, there can be no assurance that the Company will be able to obtainsuch financing when needed, on acceptable terms, or at all.  In addition, any future equity financing orconvertible debt financing could cause the Company’s stockholders to incurdilution in net tangible book value per share of Common Stock.

 

•                  Hiringand Retention of Key Personnel.  Thesuccess of the Company depends on its ability to retain key executives, and tomotivate and retain other key employees and officers. On October 6, 2003,Mr. Stephen L. Brinkman announced his resignation as the Company’s ChiefFinancial Officer.  Scott Wheeler, thecurrent Corporate Controller was named as Chief 

 

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Financial Officereffective October 27, 2003. The Company currently has a key man insurancepolicy with a face amount of $500,000 for James Williams, President andCEO.  There can be no assurance thatsignificant management turnover will not occur in the future, which coulddisrupt the Company’s operations, and business may suffer as a result.

 

•                  Impactof Inflation.  Dairy ingredients hada material inflationary impact on the Company’s operations during 2001, but didnot have an impact during 2002 or 2003. Freight rate increases related to fuel surcharges impacted 2003 byapproximately $700,000 when compared with the same period in 2002.  Substantial increases in labor, employeebenefits, freight, ingredients and packaging, rents and other operatingexpenses, as well as increases in dairy ingredients could adversely affect theoperations of the Company’s business in future periods.  The Company cannot predict whether suchincreases will occur in the future, or their magnitude.

 

•                  RisksInherent in Food Production.  TheCompany faces all of the risks inherent in the production and distribution ofrefrigerated food products, including contamination, adulteration, andspoilage, and the associated risks of product liability litigation, which maybe associated with even an isolated event. Although the Company has modern production facilities, it employs whatit believes are the necessary processes and equipment in order to insure foodsafety, and has obtained USDA approval for its California productionfacilities, there can be no assurance that the Company’s procedures will beadequate to prevent the occurrence of such events.

 

•                  Dependenceon Major Customers.  During 2003,two of the Company’s customers, Costco and Wal-Mart, Inc including itssubsidiary, Sam’s Club, accounted for 34% and 32%, respectively, of theCompany’s total revenues.  The Companycurrently sells its products to eight separate Costco regions which currentlymake purchasing decisions independently of one another.  These regions re-evaluate, on a regularbasis, the products carried in their stores. There can be no assurance thatthese Costco regions will continue to offer Monterey Pasta products in thefuture or continue to allocate Monterey Pasta the same amount of shelfspace.  For 2003, the Company suppliedits products to Sam’s Club stores, and 1,100 Wal-Mart Supercenters andNeighborhood Markets. On February 2, 2004 the Company announced that Wal-MartSupercenters discontinued its private label refrigerated pasta and pasta sauceprogram. The Company does not sell any other products to Wal-MartSupercenters.  During 2003 the Companysold $3,490,000 to Wal-Mart Supercenters. There can be no assurance that Sam’s Club will continue to carry itsproducts.  Loss of either of thesecustomers, Costco or Sam’s Club, or a significant reduction in sales to either,would have a material adverse effect on the Company.  Additionally, liberalized pricing or allowance terms would createdownward pressure on gross margins.

 

•                  ChangingConsumer Preferences.   Consumerpreferences evolve over time and the success of the company’s food productsdepends on the company’s ability to identify the tastes and dietary habits ofconsumers and offer products that appeal to their preferences.  The company introduces new products andimproved products and incurs development and marketing costs associated withnew products.  If the company’s productsfail to meet consumer preferences, then the company’s strategy to grow salesand profits with new products will be less successful.  Recent attention to low carbohydrate dietsby certain segments of the U.S. population has impacted the consumption ofpasta, and as a percent of grocery sales in the U.S. pasta sales havedeclined.   As American consumers seeknew ways to reduce their intake of carbohydrates, Monterey Pasta Company hasdeveloped products to address these changing preferences.  However, there can be no assurance thatthese new products will meet the changing demands of the consumer.

 

•                  Seasonalityand Quarterly Results.  TheCompany’s grocery and club store accounts are expected to experience seasonalfluctuations to some extent.  TheCompany’s business in general may also be affected by a variety of otherfactors, including but not limited to general economic trends, competition,marketing programs, and special or unusual events.

 

•                  Competitionand Dependence on Common Carriers. The Company’s business continues to bedominated by several very large competitors, who have significantly greaterresources than the Company; such competitors can outspend the Company andnegatively affect the Company’s market share and results of operations.  The Company also continues to be dependenton common carriers to distribute its products. Any disruption in its distribution system or increase in the coststhereof could have a material adverse impact on the Company’s business.

 

•                  CaliforniaEnergy Supply and Pricing. During 2001, California experienced an energycrisis that increased the Company’s energy expenses and could have disruptedthe Company’s operations.  In the eventof an acute power shortage, when power reserves for California fall below 1.5%,electricity providers have on some occasions implemented, and may in the futureimplement, rolling blackouts.  Ifblackouts interrupt the power supply to the Company’s production facilities,such facilities would temporarily be unable to continue production.  Any such interruption could result in a lossof revenue as a result of reduced production and spoilage of foodproducts.  In addition, related to theenergy crisis, many of the electricity and natural gas suppliers raised theirrates substantially during the first six months of 2001. Because the Companyhas most of its 

 

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operations in California,its operating costs are affected by an increase in electricity and natural gasprices. As a result, the Company’s operating results could be affected in somemeasure in the future by fluctuations in the price or supply of energy.  Electricity prices are similar to the sameperiod a year ago.  Natural gas priceshave progressively increased during 2003 and prices on average for the year are55% higher than the average for the prior year.  This impacted operating cost by approximately $110,000 during2003.  Management cannot predict thelevel of future energy prices or supply with certainty.

 

•                  Volatilityof Stock Price.  The market price ofthe Company’s common stock has fluctuated substantially since the initialpublic offering of the Company’s common stock in December 1993.  Such volatility may, in part, beattributable to the Company’s operating results or to changes in the directionof the Company’s expansion efforts.  Inaddition, changes in general conditions in the economy, the financial marketsor the food industry, natural disasters or other developments affecting theCompany or its competitors could cause the market price of the Company’s commonstock to fluctuate substantially.  Inaddition, in recent years, the stock market has experienced extreme price andvolume fluctuations.  This volatilityhas had a significant effect on the market prices of securities issued by manycompanies, including the Company, for reasons sometimes unrelated to theoperating performance of these companies. Any shortfall in the Company’s net sales or earnings from levelsexpected by securities analysts or the market could have an immediate andsignificant adverse effect on the trading price of the Company’s common stockin any given period.  Additionally, theCompany may not learn of such shortfalls until late in the fiscal quarter. Thiscould result in an even more immediate and significant adverse impact on thetrading price of the Company’s common stock upon announcement of the shortfallor quarterly operating results.

 

•                  Marketingand Sales Risks.  The future successof the Company’s efforts will depend on a number of factors, including whethergrocery and club store chains will continue to expand the number of theirindividual stores offering the Company’s products and whether allowances andother incentives will expand retail distribution.  Expansion into new markets increases the risk of significantproduct returns resulting from the Company’s supply of slower selling items toits customers.  In addition, grocery andclub store chains continually re-evaluate the products carried in their storesand no assurances can be given that the chains currently offering the Company’sproducts will continue to do so in the future, either in the same measure or atall.  Should these channels choose toreduce or eliminate products, the Company could experience a significantreduction in its product sales.  TheCompany remains dependent on the use of slotting allowances and otherincentives to expand retail distribution.

 

•                  DairyIngredients Prices.  During thefirst ten months of 2001 average price of certain dairy ingredients increasedover 40% compared with the average of the prior twelve months, as measured bybutterfat prices published by the State of California Department of Food andAgriculture.  Because the Companyutilizes various dairy ingredients in many of its products, its operating costswill be affected by an increase in the price of those ingredients. TheCompany’s operating results were affected in the first eleven months of 2001.Although dairy ingredient prices have declined significantly sinceNovember 2001, they have started to increase in the third quarter 2003,but have not as yet materially impacted operating margins.  Continued increases in dairy prices, if theyoccur, will have a negative impact on operating results in the future.  Dairy ingredients historically tend to becyclical in nature and subject to declines in price as well as increases.  Management cannot predict with certainty theduration or magnitude of the current price cycle.

 

•                  Compliancewith laws applicable to its business. The company’s facilities and products are subject to many laws andregulations administered by the United States Department of Agriculture, theFederal Food and Drug Administration, and other federal, state, local, andforeign governmental agencies relating to the processing, packaging, storage,distribution, advertising, labeling, quality, and safety of foodproducts.  The company’s failure to comply with applicable laws andregulations could subject it to administrative penalties and injunctive relief,civil remedies, including fines, injunctions and recalls of its products. Failure to comply with these regulations can have serious consequences,including civil and administrative penalties and negative publicity.

 

•                  DeductibleWorker’s Compensation Program.  TheCompany entered into a deductible worker’s compensation program for fiscal year2003 and will continue the program into 2004. This program, which features a fixed annual payment, a deductible of$250,000 per occurrence, and a $500,000 letter of credit in favor of the insurancecompany, creates a maximum exposure of approximately $2.1 million for claimsreported in 2003.  A competitive“guaranteed cost” program would have cost the Company approximately $1.5million.  Management believes that itscurrent safety program and its safety record will provide the foundation toenable the Company to realize the premium savings deductible programs aredesigned to achieve.  The Company’smaximum additional exposure in the event of adverse experience is approximately$600,000.  The maximum potentialreduction of expense from the proposed guaranteed cost program is as much as$1.1 million.   During 2003 the Companyrecorded total workers compensation expense of $579,000, saving the Companyapproximately $921,000 over the guaranteed cost program.  There can be no assurances that thesesavings will continue.

 

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**Critical Accounting Policies and Management Judgments**

 

***Accounts Receivable and Allowances***

 

The Company providesallowances for estimated credit losses, product returns, spoilage, andadjustments at a level deemed appropriate to adequately provide for known andinherent risks related to such amounts. The allowances are based on reviews of loss, return, spoilage,adjustment history, contractual relationships with customers, current economicconditions, and other factors that deserve recognition in estimating potentiallosses.  While management uses the bestinformation available in making its determination, the ultimate recovery of recordedaccounts, notes, and other receivables is also dependent on future economic andother conditions that may be beyond management’s control.

 

***Sales Incentives and Advertising Costs***

 

The Company expensesadvertising costs as incurred or when the related campaign commences whichevercomes first.  Sales incentives paid orcredited to club stores and grocery chains for shelf space allocations areamortized between six and twelve months depending on the nature of the chainprogram or agreement.  The Company didnot pay any sales incentives in order to obtain the Wal-Mart private labelbusiness and therefore was not required to accelerate the expensing of theseincentives.  Sales incentives are usedto attract new customers or to increase volume.  Loss of a major account could create the need to expense theremaining prepaid asset relating to that account in a specific quarter, therebypotentially affecting the results of that quarter.  In addition, sales incentives could increase thereby adverselyaffecting gross margins.

 

***Goodwill/Intangible Assets***

 

Intangible assets, otherthan goodwill, consist of trade names and other intangibles and are recorded atcost, net of accumulated amortization. These intangibles are amortized over their respective useful lives, ifdeterminate, ranging from three to ten years. Goodwill and intangibles with indeterminate useful lives are assessedfor impairment at least annually. The valuation of these intangibles isgenerally determined based upon valuations performed by third party specialistsand management’s best estimates of fair value. As a result, the ultimate value and recoverability of these assets issubject to the validity of the assumptions used.  The Company cannot predict the occurrence of events that mightadversely affect the reported value of goodwill that totaled $4.7 million atDecember 28, 2003.  However, thecurrent fair market value of acquired assets is in excess of carrying valuesand, accordingly, management believes that only significant changes in cashflow assumptions would result in impairment.

 

***Income Taxes***

 

The Company accounts forcorporate income taxes in accordance with SFAS 109, “Accounting for IncomeTaxes*”*,which requires an asset and liability approach.  This approach results in the recognition of deferred tax assets(future tax benefits) and liabilities for the expected future tax consequencesof temporary timing differences between the book carrying amounts and the taxbasis of assets and liabilities.  Futuretax benefits are subject to a valuation allowance to the extent of the likelihoodthat the deferred tax assets may not be realized.

 

***Deferred Tax Asset Valuation Allowance***

 

TheCompany has significant deferred tax assets, which include significant amountsof NOLs from the Company’s former restaurant operating subsidiary UFO. TheseNOLs were previously fully reserved based upon management’s best estimate ofultimate realizeability.  During 2002,based upon new evidence and management’s judgments these reserves weresubstantially reduced.  The amount of the reserve is significantly dependenton management’s assumptions regarding future taxable income and theavailability of these NOLs to offset future taxable income. The effect on theCompany’s net income is significant whenever the estimate of realizeabilitychanges, as it did in 2002. The Company expects to utilize most of theremaining NOLs in fiscal year 2004 and 2005.

 

**Recently Issued Accounting Standards**

 

InJanuary 2003, the FASB issued Interpretation No. 46, “Consolidation ofVariable Interest Entities,” which requires the consolidation of certainspecial purpose or variable interest entities. FIN No. 46 is applicable tofinancial statements issued after 2002, however, disclosures are requiredcurrently if the Company expects to consolidate any variable interest entities.The Company has no variable interest entities and therefore, there are noentities that will be consolidated with the Company’s financial statements as aresult of FIN No. 46.

 

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In May 2003, the FASBissued SFAS 150, “Accounting For Certain Financial Instruments withCharacteristics of Both Liabilities and Equity” which establishes standards forhow an issuer of financial instruments classifies and measures certainfinancial instruments with characteristics of both liabilities and equity. Itrequires that an issuer classify a financial instrument that is within itsscope as a liability (or an asset in some circumstances) if, at inception, themonetary value of the obligation is based solely or predominantly on a fixedmonetary amount known at inception, variations in something other than the fairvalue of the issuer’s equity shares or variations inversely related to changesin the fair value of the issuer’s equity shares. SFAS 150 is effective forfinancial instruments entered into or modified after May 31, 2003, andotherwise is effective at the beginning of the first interim period beginningafter June 15, 2003. The adoption of SFAS 150 is not expected to have amaterial impact on the Company’s financial position or results of operations.

 

**ITEM 7A.****                                            QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

*Market RiskDisclosure*

 

The Company does not holdmarket risk-sensitive trading instruments, nor does it use financialinstruments for trading purposes.  All sales,operating items and balance sheet data are denominated in U.S. dollars;therefore, the Company has no foreign currency exchange rate risk.

 

In the ordinary course ofits business the Company enters into commitments to purchase raw materials overa period of time, generally six months to one year, at contracted prices.  At December 28, 2003 these futurecommitments were not at prices in excess of current market, or in quantities inexcess of normal requirements.  TheCompany does not utilize derivative contracts either to hedge existing risks orfor speculative purposes.

 

*Interest RateRisk*

 

The Company has fixed and variable income investments consisting of cashequivalents.  The magnitude of theinterest income generated by these cash equivalents is affected by marketinterest rates.  Management does not usemarketable securities nor derivative financial instruments in its investmentportfolio.

 

Theinterest payable on the Company’s bank line of credit is based on variableinterest rates and therefore affected by changes in market interest rates.  The Company had no bank debt at the end of2003 and has not had bank debt since the third quarter of 2000.

 

*Currency Risk*

 

During 2003, the Companysold $60,000 of product in currency other than US dollars.  These sales have terms of net 30 days fromshipment.  The Company believes that itscurrency exposure is not material and has chosen not to hedge these sales.

 

**ITEM8.****                  FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 

The financial statementsand supplementary data of the Company required by this item are set forth atthe pages indicated at Item 15(a).

 

**ITEM9.****                  CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None

 

**ITEM 9A.****               CONTROLSAND PROCEDURES**

 

Under the supervision andwith the participation of our management, including our chief executive officerand chief financial officer, we evaluated the effectiveness of our disclosurecontrols and procedures, as such term is defined in Rule 13a-15(e) promulgatedunder the Securities Exchange Act of 1934, as amended. Based on thisevaluation, our chief executive officer and chief financial officer concludedthat our disclosure controls and procedures were effective as of the end of theperiod covered by this annual report in providing reasonable assurance thatinformation required to be disclosed by Monterey Pasta Company in 

 

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reports that it filesunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in Securities and Exchange Commission rules andforms. No significant changes were made to Monterey Pasta’s internal controlsduring the registrant’s most recent quarter that have materially affected, orare reasonably likely to materially affect, the registrant’s internal controlsover financial reporting.

 

##### **PART III**

##### ** **

**ITEM 10.****                                              DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

As of March 5, 2004,the directors, executive officers, and other significant employees of theCompany are as follows:

 

**Directors and Executive Officers:**

 
| **Name**                   |   | **Age** |   | **Position**                                     |
|----------------------------|--------|---------|--------|--------------------------------------------------|
| Charles B. Bonner (1)      |   | 61      |   | Director                                         |
|                       |   |    |   |                                             |
| F. Christopher Cruger  (2) |   | 69      |   | Director                                         |
|                       |   |    |   |                                             |
| James M. Williams          |   | 54      |   | Chief Executive  Officer, President and Director |
|                       |   |    |   |                                             |
| R. Lance Hewitt            |   | 64      |   | Chairman of the Board  and Director              |
|                       |   |    |   |                                             |
| Michael P. Schall (1)      |   | 50      |   | Director                                         |
|                       |   |    |   |                                             |
| Van Tunstall (2) (3)       |   | 57      |   | Director                                         |
|                       |   |    |   |                                             |
| James Wong (2) (3)         |   | 56      |   | Director                                         |
|                       |   |    |   |                                             |
| Walter L Henning  (1) |   | 59      |   | Director                                         |
|                       |   |    |   |                                             |
| Scott Wheeler              |   | 49      |   | Chief Financial Officer  and Corporate Secretary |

 

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(1)          Member of AuditCommittee

(2)          Member of CompensationCommittee

(3)          Member of NominatingCommittee

 

**Other significant employees:**

 
| **Name**          |   | **Age** |   | **Position**                 |
|-------------------|--------|---------|--------|------------------------------|
|              |   |    |   |                         |
| Dan Brown         |   | 44      |   | Vice President -  Operations |
|              |   |    |   |                         |
| Carl Anderson PhD |   | 52      |   | Director-Quality  Assurance  |
|              |   |    |   |                         |
| Joseph Stirlacci  |   | 43      |   | National Sales Manager       |

 

Normally each director iselected for a period of one year and serves until the stockholders duly electhis or her successor.  Directors may beelected by the Board to fill a vacancy between annual stockholder meetingelections.  The principal occupations ofeach director and executive officer of the Company, for at least the past fiveyears, are as follows:

 

**Charles B. Bonner, Director.**  Mr. Bonner served as a Director of the Companyfrom 1993 through January 1995, and was reappointed as a Directoreffective September 1995.  Mr.Bonner is Principal and Founder of Pacific Resources, Inc., a mergers andacquisitions advisory firm, a position he has held sinceSeptember 1989.  Mr. Bonner alsoserves as a director for Everything Metal Imaginable, Inc., and ScripAdvantage, Inc,

 

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**F. Christopher Cruger, Director.**  Mr. Cruger was elected to the Board ofDirectors in December of 2001.  Heis a retired investor and former senior manager or executive of severalconsumer product companies.  He waspresident and CEO of Tone Brothers, Inc from 1985 to 1995. Mr. Cruger joinedMcCormick and Company, a public company in 1995.  He was President and CEO of Tone Brothers from 1985 to 1995.  Mr. Cruger joined McCormick and Company in1995 and served until 1999 as Vice-President and General Manager of the FoodService Group and as Chairman of McCormick’s Global Food Service Council.  He is a Director of Kemin Industries, Inc,and The Graham Group, Inc.

 

**James M. Williams**, **President,Chief Executive Officer and Director. ** Mr. Williams joined the Company as PresidentOctober 1, 2002 and elected to the Board of Directors on October 29,2002.  On January 3, 2002 he waspromoted to Chief Executive Officer. Prior to his employment with the CompanyMr. Williams served the prior 12 years as President and CEO of BongrainCheese-USA, a division of the French company Bongrain SA, a world-wide publiccompany focusing on specialty cheeses. Previously he held executive positions with the Hillshire Farms divisionof Sara Lee Corporation, a public company for twelve years.

 

**R. Lance Hewitt, President, ChiefExecutive Officer and Director.**  Mr. Hewitt joined the Company in June 1997 as President andDirector.  He was named Chief ExecutiveOfficer in August 1997.  He retiredfrom day-to-day activities and assumed the position of Chairman of the Board ofDirectors effective January 2, 2003. Mr. Hewitt was President of Carriage House Fruit Company, a publiccompany, from 1995 to 1997.  He wasChief Operating Officer of Ingro Mexican Foods from 1988 to 1995.  Hewitt also served as Vice President ofMarketing and Sales for the Lawry’s Foods division of Thomas J. Lipton, Inc., asubsidiary of Unilever, a public company, and spent fifteen years withMcCormick Schilling, Inc., a public company, in various executive capacities.

 

**MichaelP. Schall, Director. **Mr. Schall was elected to theBoard of Directors in December of 2001.   Mr.. Schall iscurrently President of Strategic Marketing Methods, a consulting and advisoryfirm providing sales and marketing, business development advisory and newproduct expertise to the food and foodservice industries.  FromJanuary 2002 until March 2003, he served as Senior VicePresident of Sales, Marketing, and DSD for Wise Foods.   From 2000until January of 2002 he was President and CEO of The B. ManischewitzCompany, LLC, one of the nation’s largest kosher food companies.  Prior tothat Mr. Schall was President and CEO of Guiltless Gourmet from 1994until it’s acquisition by Manischewitz.  Mr. Schall held executive orsenior management positions with Carnation Company (now Nestle S.A. aPublic Company), Lawry’s Foods Inc. (a division of Unilever U.S., a PublicCompany) and Prepared Products Co.

 

**Van Tunstall, Director. **Mr. Tunstall was electedto the Board of Directors****in February 1997.  Since 1997, he has served as President ofthe Central Coast Group, a strategic consulting and business servicesfirm.  He has been an independentconsultant with a variety of companies since 1997.  Mr. Tunstall was a senior executive with Gilroy Foods, Inc., aninternational manufacturer of various food product ingredients, from 1977 to1995.  He served as President andChairman of the Board from 1991 through 1995.  Previously, Mr. Tunstall held several executive positions with McCormick& Company, Inc a public company.

 

**James Wong, Director.**  Mr. Wong was elected to the Board ofDirectors in March 1997.  Since 1988,he has worked on five continents as an entrepreneur and management consultantfacilitating strategic alliances and technology transfers projects.  Mr. Wong is currently Chairman and aDirector of Restaurant Connections International, Inc. a company he co-foundedin September 1998, which owns and operates a chain of restaurants inBrazil; until September 2001, he was also President and CEO.  From March 2000 to March 2002, Mr.Wong served as CEO and a Director of Service Interactive, In., a service turnaroundmanager for PepsiCo, a public company and General Motors a public company.

 

**Walter L. Henning, Director. **Mr. Henning was elected tothe Board of Directors in December 1999. He is currently Plant Manager of the Salinas Plant, McCormick &Company, Inc., a public company, a position he has held since early 1999.  Mr. Henning began his career with McCormickand Company in 1971 as Manager, Technical Services.  He subsequently was promoted several times to other positions intechnical and plant management before leaving the company in 1983 to accept theposition of Vice President of Operations with Tone Spices, a publiccompany.  Following the sale of Tone,Mr. Henning returned to a subsidiary of McCormick and Company, Gilroy Foods,Inc. in 1995 as Vice President of Operations. Mr. Henning remained with Gilroy Foods, Inc. in the same capacity afterit was purchased by ConAgra Foods Inc. a public company, in 1996, beforeultimately returning to McCormick & Company in 1999.

 

**Scott Wheeler, Chief Financial Officerand Corporate Secretary**. Mr. Wheeler, joined the company in April 2003 as  Corporate Controller, and was promoted toChief Financial Officer, effective October 27, 2003.  His most recent position was Vice Presidentand Financial Officer of KBC Edible Beans Division of ConAgra Foods, Inc. apublic company, where he worked for three years.  Prior to that he worked for Mallard’s Food Products both when itwas an independent company and after it was 

 

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sold to Tyson Foods, Inc,a public company.  He began his careerat Mallard’s Food Products in 1994 as Chief Financial Officer until 1999 whenhe was promoted to General Manager until joining KBC in April of 2000.  Prior to joining Mallard’s, Mr. Wheeler helda variety of positions with Basic American Foods over a thirteen-yearperiod.  He is a CPA with an MBA infinance from Golden Gate University in San Francisco, CA.

 

Below are principaloccupations of certain other significant employees of the Company.

 

**Dan Brown, Vice President -Operations. **Mr. Brownjoined the Company as Director of Operations in May 2001.  Prior to that, Mr. Brown was with GilroyFoods, Inc, a division of McCormick and Co, a public company, and its successorGilroy Foods (under new ownership), a division of ConAgra Foods, Inc, a publiccompany,  from 1986 until 2001 where heserved in a variety of technical and operations positions, ultimately beingpromoted to Manager of Plant Operations in 1997.  He also served as a Logistics Supervisor with Frito Lay, a publiccompany, from 1984-86.

 

**Carl Anderson, Director, QualityAssurance**.  CarlAnderson joined Monterey Pasta Company in August, 2003.  Prior to joining Monterey Pasta, Carl wasDirector Quality Assurance for ConAgra Food Ingredients a division of ConAgraFoods, a public company, with operations in California, Nevada, Oregon, NewMexico, Illinois and New Jersey. Responsibilities included quality assurance, regulatory affairs andquality systems management for the primary companies within ConAgra FoodIngredients, Gilroy Foods and Spice Tec. From 1991 to 1999, Carl held positions as Senior Microbiologist,Principal Scientist and Director of Quality Assurance for Gilroy Foods adivision of McCormick a public company. From 1983 to 1991, Carl worked at Del Monte/Nabisco, a public company,as Principal Scientist and Group Leader heading up thermal processing andmicrobiology for all canned and aseptic processing operations. Carl receivedhis Ph.D. in Food Science and Microbiology from the University of Illinois.

 

**Joseph Stirlacci, Vice President -Sales.**  Mr. Stirlacciserved as Western Zone Manager since December 1995 untilDecember 1999 when he was promoted to Senior Sales Manager-West.  In January 2001 he was promoted to VicePresident, Sales.  His primaryresponsibility is to manage, maintain and secure club store and retailaccounts.  Mr. Stirlacci has been in thefood and beverage industry since 1981, serving seven years with Young’s Marketmanaging wholesale liquor and wine from 1988 to 1995, after six years as theaccount executive for four large grocery chains.

 

**Compliance with Section 16(a) of the Securities ExchangeAct of 1934**

 

Section 16(a) of theSecurities Exchange Act of 1934, as amended, requires the Company’s directorsand executive officers, and persons who own more than 10% of a registered classof the Company’s equity securities, to file with the SEC initial reports ofownership and reports of changes in ownership of Common Stock and other equitysecurities of the Company.  Officers,directors and greater than 10% beneficial owners are required by SECregulations to furnish the Company with copies of all reports they file underSection 16(a).  To the Company’sknowledge, based solely on its review of the copies of such reports furnishedto the Company and written representations that no other reports were required,all Section 16(a) filing requirements applicable to its officers,directors and greater than 10% beneficial owners were complied with during thefiscal year ended December 28, 2003, except that Messrs. Bonner, Cruger,Schall, Henning, Hewitt and Wheeler each filed one late report covering onetransaction.

 

**Audit Committee Composition**

 

Among the committeesidentified above, the Company has a separately designated standing auditcommittee established in accordance with Section 3(a)(58)(A) of theSecurities Exchanges Act of 1934, as amended. Charles B. Bonner, Michael P. Schall and Walter L. Henning are membersof the audit committee.  The Company’sBoard of Directors has determined that all members of the Company’s AuditCommittee are “independent” as defined in Rules 1400(a)(14) of the NASDAQlisting standards.

 

**Audit Committee Expert**

 

The Company’s Board ofDirectors has determined that Charles B. Bonner, because of his experience inmergers and acquisitions, extensive experience in financial transactions andknowledge of business operations is the Boards designated financialexpert.  The Company’s Board ofDirectors has also determined that Mr. Bonner is independent.

 

22

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**Code of Ethics**

 

The Company has adopted aCode of Ethics as defined in Item 406 of Regulation S-K that applies to itsprincipal executive and financial officers and the persons performing similar functions.  Monterey Pasta Company will provide a copyof its Code of Ethics, without charge, to any investor that requests it.  Requests should be addressed in writing toMr. Scott Wheeler, Corporate Secretary, 1528 Moffett Street, Salinas, CA 93905

 

**ITEM 11.****                                              EXECUTIVECOMPENSATION**

 

**SUMMARYCOMPENSATION TABLE**

 
|                             |   |     |   | **Annual Compensation** |    |        |   | **Long Term Compensation**      |   |
|----------------------------------|--------|----------|--------|-------------------------|---------|-------------|--------|---------------------------------|--------|
| **Name and  Principal Position** |   | **Year** |   | **Salary $**            |    | **Bonus $** |   | **Other  Annnual Compensation** |   | **Securities  Underlying Options (#)** |   | **All Other  Comensaton** |   |
|                             |   |     |   |                    |    |        |   |                            |   |   |   |   |   |
| **James M. Williams**            |   | 2003     |   | $                       | 292,453 | (1)         | $      | —                          |   | $ | 9,000 | (1) | 50,000 | (1) | $ | 27,708 | (1) |
| President  and CEO               |   | 2002     |   | $                       | 60,231  | (1)         | $      | —                          |   | $ | 2,250 | (1) | 50,000 | (1) | $ | 67,030 | (1) |
|                             |   | 2001     |   | $                       | —  | (1)         | $      | —                          |   | — | (1) | — | (1) | $ | — | (1) |
|                             |   |     |   |                    |    |        |   |                            |   |   |   |   |   |
| **Stephen L. Brinkman**          |   | 2003     |   | $                       | 141,482 | (2)         | $      | 23,205                          |   | $ | 13,725 | (2) | — | (2) | $ | — |   |
| Chief  Financial Officer         |   | 2002     |   | $                       | 154,699 | (2)         | $      | 41,371                          |   | $ | — |   | 30,000 | (2) | $ | — |   |
|                             |   | 2001     |   | $                       | 140,884 | (2)         | $      | 39,700                          |   | $ | — |   | 60,000 | (2) | $ | — |   |

 

Notes:  (“options” in all cases refer to an optionto purchase one share of common stock for each option granted)

 

----

(1)                                  Mr.Williams was appointed President October 1, 2002.  On December 28, 2002 he was promoted toChief Executive Officer to succeed Mr. Hewitt who retired from day-todayactivities and accepted the position of Chairman of the Board ofDirectors.  On October 1, 2002, Mr.Williams was granted 50,000 options which vested in full on October 1,2003.  He received no bonus for 2002performance, as the fourth quarter results did not meet the criteria for bonusaward.  On October 1, 2003, Mr.Williams was granted 50,000 options which will vest on October 1, 2004 ifhe is still employed by the Company.  Hewas also eligible to receive a bonus of up to 50% of his annual salary based onthe achievement of certain sales growth and net income goals for 2003.  The portion of Mr. Williams’ compensationlisted as “All Other Compensation” was relocation expense reimbursement in 2002and a housing allowance in 2003. Mr. Williams also received an auto allowanceof $750 per month, which is included in “Other Annual Compensation.”

 

(2)                                  Mr.Brinkman was appointed Chief Financial Officer in September 1997. Duringhis tenure as Chief Financial Officer Mr. Brinkman received bonuses based onthe Company’s performance based on Net Income and also specific objectivesobtained during each year.  Each year,except in 2003, Mr. Brinkman received stock options that would vest 50% oneyear after issued and 50% after two years from the date it issued.  As of December 28, 2003, Mr. Brinkman owned250,666 options that are outstanding and exercisable. Mr. Brinkman left theCompany on October 27, 2003; however, he may still provide some consultingservices on an hourly basis to insure a smooth transition of his duties.

 

**Option Grants in Last fiscal Year**

 

The Board granted 50,000options to Mr. Williams for the year 2003 which will vest based on employmentstatus (see Notes 1 and 3 under “Executive Compensation”).

 

23

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**Individual Grants**

 
| **Name**           |   | **Number of  Securities Underlying Options Granted** |   | **% of Total  Options Granted to Employees In 2003** |   | **Exercise  Or Base Price** |   | **Expiration  Date** |                     | **Potential  Realizable Value On 12/29/03 Alternative Grant Date Value** |   |
|--------------------|--------|------------------------------------------------------|--------|------------------------------------------------------|--------|-----------------------------|--------|----------------------|--------------------------|--------------------------------------------------------------------------|--------|
|               |   |                                                 |   |                                                 |   |                        |   |                 |                     |                                                                     |   |
| James  M. Williams |   | 50,000                                               |   | 12.78                                                |   | $                           | 3.76   |                 | September 30,  2013 |                                                                     | $      | 119,395 |   |
|                    |        |                                                      |        |                                                      |        |                             |        |                      |                          |                                                                          |        |  |  |

 

 

The AlternativeGrant-Date Value of Mr. Williams options was calculated using a Black-Scholesoption pricing model assuming no dividends, a weighted average risk-freeinterest rate of 4.7% and a weighted-average volatility of 65.8%.

 

**Aggregated Option Exercises in Last Fiscal Year andFiscal Year-End Option Values**

 

 
|                 |   | **# of  Securities Underlying Options Exercised During 2003** |            | **Number of  Securities Underlying Unexercised Options at December 29, 2003** |              | **Value of  Unexercised In-the-Money Options at December 29, 2003** |            |
|----------------------|--------|---------------------------------------------------------------|-----------------|------------------------------------------------------------------------------------|-------------------|--------------------------------------------------------------------------|-----------------|
|                 |   |                                                          |            |                                                                               |
|                 |   |                                                          |            |                                                                               |
| **Name**             |   |                                                          | **Exercisable** |                                                                               | **Unexercisable** |                                                                     | **Exercisable** |   | **Unexercisable** |   |
|                 |   |                                                          |            |                                                                               |              |                                                                     |            |   |   |   |   |
| James  M. Williams   |   | —                                                        |            | 50,000                                                                             |              | 50,000                                                                   |            | $ | — |   | $ | — |   |
|                 |   |                                                          |            |                                                                               |              |                                                                     |            |   |   |   |   |
| Stephen  L. Brinkman |   | —                                                        |            | 250,666                                                                            |              | 30,000                                                                   |            | $ | 142,207 |   | $ | — |   |

 

 

**Employment Contracts**

 

The Company does not haveany employment contracts with any of its executive officers.

 

**Compensationof Directors**

 

During the fiscal yearended December 28, 2003, non-employee directors received 15,000 stockoptions to purchase shares of the Company’s Common Stock.  The exercise price may not be less than thefair market value of a share of Common Stock on the date of grant.  The option vests in two approximately equalannual installments commencing one year after the date of grant of the option,provided that the director has continuously served as director or employee fromthe date of grant.

 

Outside directors arealso reimbursed for out-of-pocket travel expenses related to Board Meetings andreceive a stipend of $1,000 for each Board meeting attended.

 

**CompensationCommittee Interlocks and Insider Participation**

 

During the fiscal yearended December 28, 2003, executive compensation was administered by theCompensation Committee comprised of two outside directors of the Board ofDirectors, Van Tunstall and James Wong.

 

**ITEM 12.****                                              SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT**

 

The****table below sets forth as ofDecember 31, 2003  (except as notedin the footnotes to the table), certain information with respect to thebeneficial ownership of the Company’s Common Stock by  (i) all persons known by the Company to be the beneficial ownersof more than 5% of the outstanding Common Stock of the Company,  (ii) each director and director-nominee of theCompany,  (iii) the Chief ExecutiveOfficer as of February 1, 2004, and (iv) all executive officers and directors of the Company for fiscal year2003 through****February 1, 2004, as a group.

 

24

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|                                                                                            |   | **Shares Owned**      |   |
|-------------------------------------------------------------------------------------------------|--------|-----------------------|--------|
| **Name and Address of Beneficial  Owner (1)**                                                   |   | **Number of  Shares** |   | **Percentage  of Class** |   |
| Gruber and McBaine  Capital Management (2)  50 Osgood Place, Penthouse  San Francisco, CA 94133 |   | 2,441,900             |   | 15.7 | % |
| Fidelity Investments  (3)  82 Devonshire Street  Boston, MA 02109                               |   | 1,420,700             |   | 9.1 | % |
| T Rowe Price  Associates, Inc. (4)  100 East Pratt Street  Baltimore, MD 21202                  |   | 1,134,800             |   | 7.3 | % |
| Wellington Management  Company, LLP (5)  75 State Street 19th Floor  Boston, MA 02109           |   | 1,250,000             |   | 8.0 | % |
| F. Christopher Cruger  (6)                                                                      |   | 27,500                |   |   | * |
| Van Tunstall (7)                                                                                |   | 103,740               |   |   | * |
| Michael P. Schall (8)                                                                           |   | 27,500                |   |   | * |
| James Wong (9)                                                                                  |   | 43,500                |   |   | * |
| R. Lance Hewitt (10)                                                                            |   | 238,985               |   | 1.5 | % |
| Charles B. Bonner (11)                                                                          |   | 146,227               |   |   | * |
| Scott Wheeler (12)                                                                              |   | —                |   |   | * |
| Walter L. Henning (13)                                                                          |   | 76,200                |   |   | * |
| All Officers and  Directors as a group (8 persons) (14)                                         |   | 718,152               |   | 4.6 | % |

 

----

* Represents less than 1%

 

(1)              Beneficial ownershipis determined in accordance with the rules of the Securities and ExchangeCommission.  In computing the number ofshares beneficially owned by a person and the percentage ownership of thatperson, shares of Common Stock subject to options or warrants held by thatperson that are currently exercisable or will become exercisable within sixty(60) days after February 1, 2003 are deemed outstanding, while such sharesare not deemed outstanding for purposes of computing percentage ownership ofany other person.  Options granted underthe Company’s First Amended and Restated 1993 Stock Option Plan (the “1993Stock Option Plan”) generally become exercisable as the underlying sharesvest.  Unless otherwise indicated in thefootnotes below, the persons and entities named in the table have sole votingand investment power with respect to all shares beneficially owned, subject tocommunity property laws where applicable. Unless otherwise indicated, the address of each of the individualslisted in the table is: c/o Monterey Pasta Company, 1528 Moffett Street,Salinas, CA  93905.

 

(2)              Jon D. Gruber and J.Patterson McBaine are the only managers of, and hold all executive offices of,Gruber and McBaine Capital Management LLC (“GMCM”), an investment advisor.  GMCM is the general partner of LagunitasPartners, L.P. (“Lag”), a California investment limited partnership.  As of December 31, 2003, GMCM had sharedvoting and investment power over 1,889,300 shares; Mr. Gruber has sole votingand investment power over 272,000 shares and shared voting and investment powerover 1,889,300 shares; Mr. McBaine has sole voting and investment power over280,600 shares and shared voting and investment power over 1,889,300 shares;Lag has sole voting and investment power over 1,007,600 shares; and Mr. EricSwergold, an investment manager, has shared voting and investment power over1,889,300 shares.

 

(3)              As ofDecember 31, 2003, FMR Corp. on behalf of certain of its direct andindirect subsidiaries, and Fidelity International Limited on behalf of certainof its direct and indirect subsidiaries (collectively “Fidelity”), indirectlyheld 1,420,700 shares of Company stock. The beneficial ownership of PSTA shares arises in the context of passiveinvestment activities only by the various investment accounts managed byFidelity on a discretionary basis (the “Fidelity Accounts”).  Neither Fidelity nor the Fidelity Accountsparticipate in the Management of the Company, direct the policies of thecompany, or serve on the Board of Directors of the Company.  In addition, no Fidelity officer serves asan executive officer of the Company.

 

(4)              As ofDecember 31, 2003, T. Rowe Price Associates, Inc (“Price Associates”) hassole dispositive power for an entire holding of 1,134,800 shares and solevoting power over 299,800 shares.  Thesesecurities are owned by various individual and institutional investors forwhich Price Associates serves as investment advisor with power to directinvestments and/or sole power to vote the securities.  For purposes of the reporting requirements of the SecuritiesExchange Act of 1934, Price Associates expressly disclaims that it is, in fact,the beneficial owner of such securities.

 

(5)              As ofDecember 31, 2003, Wellington Management Company, LLP (“WMC”), in its capacity of investment advisor, may bedeemed to have beneficial ownership of 1,250,000 shares of the common stock ofthe Company.  Such shares are owned bynumerous investment advisory clients of WMC, none of which is known to havebeneficial ownership of more than 5%

 

25

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of that class ofsecurities of the Company.  As ofDecember 31, 2003, WMC had voting power and/or dispositive power over suchshares as follows:

 

| Sole voting power:         | -0-       | shares |
|----------------------------|-----------|--------|
| Shared voting power:       | 620,000   | shares |
| Sole dispositive power:    | -0-       | shares |
| Shared dispositive  power: | 1,250,000 | shares |

 

(6)              Includes 27,500shares subject to options granted under the 1993 Stock Option Plan which areexercisable within sixty (60) days of February 1, 2004.

 

(7)              Includes 82,500shares subject to options granted under the 1993 Stock Option Plan which areexercisable within sixty (60) days of February 1, 2004.

 

(8)              Includes 22,500shares subject to options granted under the 1993 Stock Option Plan which areexercisable within sixty (60) days of February 1, 2004.

 

(9)              Includes 37,500shares subject to options granted under the 1993 Stock Option Plan which areexercisable within sixty (60) days of February 1, 2004.

 

(10)        Includes 223,985 sharessubject to options granted under the 1993 Stock Option Plan which areexercisable within sixty (60) days of February 1, 2004.

 

(11)        Includes 87,500 sharessubject to options granted under the 1993 Stock Option Plan which areexercisable within sixty (60) days of February 1, 2004.

 

(12)        Includes 0 shares subjectto options granted under the 1993 Stock Option Plan which are exercisablewithin sixty (60) days of February 1, 2004.

 

(13)        Includes 6,200 shares heldin an IRA account in the name of Teresa A. Henning to which Mr. Henning claimsbeneficial ownership, and 47,500 shares subject to options granted under the1993 Stock Option Plan which are exercisable within sixty (60) days ofFebruary 1, 2003.

 

(14)        Includes 573,952 sharessubject to options granted under the 1993 Stock Option Plan which areexercisable within sixty (60) days of February 1, 2004.

 

**ITEM 13.****                                              CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

 

None

 

**ITEM 14.****                                              CERTAINPRINCIPAL ACCOUNTING FEES AND SERVICES**

 

The informationconcerning principal accountant fees and services required by this Item isincorporated by reference to the Company’s Proxy Statement under the heading“Audit and Non-Audit Fees”.

 

The informationconcerning pre-approval policies for audit and non-audit services required bythis Item is incorporated by reference to the Company’s Proxy Statement underthe heading “Audit Committee Pre-Approval of Audit and Permissible Non-AuditServices of Independent Auditors”.

 

##### **PART IV**

##### ** **

**ITEM 15.****                                              EXHIBITS,FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K**

 
| (a)(1) – (2) | Consolidated Financial  Statements of Monterey Pasta Company:    |   |   |
|-------------------|------------------------------------------------------------------|--------|--------|
|              |                                                             |   |   |
|              | Report  of Independent Certified Public Accountants              |   |   |
|              | Consolidated Balance Sheets: Year-End 2002 and  2003             |   |   |
|              | Consolidated Income Statements: Years  Ended 2001, 2002 and 2003 |   |   |
|                   |                                                                  |        |        |  |

 

26

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|   | Consolidated  Statements of Stockholders’ Equity: Years Ended 2001, 2002 and 2003 |   |   |
|--------|----------------------------------------------------------------------------------------|--------|--------|
|   | Consolidated  Statements of Cash Flows:  Years Ended  2001, 2002 and 2003         |   |   |
|   | Summary  of Significant Accounting Policies                                            |   |   |
|   | Notes to  Consolidated Financial Statements                                            |   |   |
|   | Schedule II - Valuation and Qualifying  Accounts                                  |   |   |

 
|   | All other schedules  have been omitted since the required information is contained in the  Consolidated Financial Statements or because such schedules are not required. |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

(a)(3)                    Exhibits:  See Index to Exhibits on page 49.  The Exhibits listed in the accompanyingIndex of Exhibits are filed or incorporated by reference as part of thisreport.  Exhibit Nos. 4.7, 10.1, 10.2,10.12, 10.13, 10.15, and 10.16****are management contracts or compensatoryplans or arrangements.

 

(b)                                 Reportson Form 8-K filed in the fourth quarter of 2003:

 

Form 8-K reporting thirdquarter 2003 financial results.

 

27

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**REPORTOF INDEPENDENT****CERTIFIED PUBLIC ACCOUNTANTS**

 

 

To the Stockholders andBoard of Directors of

Monterey Pasta Company

 

We have audited theaccompanying consolidated balance sheets of Monterey Pasta Company as ofDecember 29, 2002 and December 28, 2003 and the related consolidatedstatements of income, stockholders’ equity and cash flows for each of the threeyears in the period ended December 28, 2003. We have also audited theschedule listed in the accompanying index at Item 15(a).  These financial statements and theschedule are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements and the schedule based on our audits.

 

We conducted our auditsin accordance with auditing standards generally accepted in the United Statesof America.  These standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements and schedule are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements and schedule.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall presentation of thefinancial statements and schedule.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Monterey Pasta Company at December 29,2002 and December 28, 2003, and the results of its operations and its cashflows for each of the three years in the period ended December 28, 2003,in conformity with accounting principles generally accepted in the United Statesof America.

 

Also, in our opinion, theschedule presents fairly, in all material respects, the information setforth therein.

 

 

BDO Seidman, LLP

San Francisco, California

February 2, 2004

 

28

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**MONTEREY****PASTACOMPANY**

**CONSOLIDATEDBALANCE SHEETS**

 
|                                                                                                                                                                            |   | **December 29,  2002** |       | **December 28,  2003** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|------------|-----------------------------|--------|
| **ASSETS**                                                                                                                                                                      |   |                        |       |                        |   |
|                                                                                                                                                                            |   |                        |       |                        |   |
| Current  assets:                                                                                                                                                                |   |                        |       |                        |   |
| Cash  and cash equivalents                                                                                                                                                      |   | $                           | 6,838,244  |                        | $      | 5,285,484 |   |
| Accounts  receivable, less allowances of $527,349 and $440,564                                                                                                                  |   | 6,058,710                   |       | 6,312,920                   |   |
| Inventories                                                                                                                                                                     |   | 3,723,072                   |       | 4,323,308                   |   |
| Deferred  tax assets – short term                                                                                                                                          |   | 4,068,400                   |       | 3,484,553                   |   |
| Prepaid  expenses and other                                                                                                                                                     |   | 1,048,120                   |       | 1,465,489                   |   |
| Total  current assets                                                                                                                                                           |   | 21,736,546                  |       | 20,871,754                  |   |
|                                                                                                                                                                            |   |                        |       |                        |   |
| Property  and equipment, net                                                                                                                                                    |   | 14,254,574                  |       | 15,444,789                  |   |
| Deferred  tax assets – long term                                                                                                                                           |   | 765,300                     |       | 1,036,442                   |   |
| Goodwill,  net                                                                                                                                                                  |   | 4,669,254                   |       | 4,748,389                   |   |
| Other  intangible assets, net                                                                                                                                                   |   | 2,239,113                   |       | 1,995,760                   |   |
| Deposits  and other                                                                                                                                                             |   | 134,694                     |       | 106,423                     |   |
| Total  assets                                                                                                                                                                   |   | $                           | 43,799,481 |                        | $      | 44,203,557 |   |
|                                                                                                                                                                            |   |                        |       |                        |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                   |   |                        |       |                        |   |
|                                                                                                                                                                            |   |                        |       |                        |   |
| Current  liabilities:                                                                                                                                                           |   |                        |       |                        |   |
| Accounts  payable                                                                                                                                                               |   | $                           | 3,201,470  |                        | $      | 2,849,890 |   |
| Accrued  payroll and related benefits                                                                                                                                           |   | 843,422                     |       | 875,255                     |   |
| Accrued  liabilities                                                                                                                                                            |   | 796,496                     |       | 441,312                     |   |
| Current  portion of notes, loans, and capitalized leases payable                                                                                                                |   | 14,964                      |       | 1,784                       |   |
| Total  current liabilities                                                                                                                                                      |   | 4,856,352                   |       | 4,168,241                   |   |
|                                                                                                                                                                            |   |                        |       |                        |   |
| Notes,  loans, and capitalized leases payable, less current portion                                                                                                             |   | 1,785                       |       | 837                         |   |
| Total  liabilities                                                                                                                                                              |   | 4,858,137                   |       | 4,169,078                   |   |
|                                                                                                                                                                            |   |                        |       |                        |   |
| Commitments  and contingencies                                                                                                                                                  |   |                        |       |                        |   |
|                                                                                                                                                                            |   |                        |       |                        |   |
| Stockholders’  equity:                                                                                                                                                     |   |                        |       |                        |   |
| Preferred  Stock,$.001 par value, 1,000,000 shares authorized, none outstanding Common  stock, $.001 par value, 70,000,000 shares authorized, 14,196,391 and  14,213,682 issued |   | 14,196                      |       | 14,213                      |   |
| Additional  paid-in capital                                                                                                                                                     |   | 44,518,855                  |       | 44,577,570                  |   |
| Accumulated  deficit                                                                                                                                                            |   | (5,591,707                  | )          | (4,557,304                  | )      |
|                                                                                                                                                                            |   |                        |       |                        |   |
| Total  stockholders’ equity                                                                                                                                                |   | 38,941,344                  |       | 40,034,479                  |   |
|                                                                                                                                                                            |   |                        |       |                        |   |
| Total  liabilities and stockholders’ equity                                                                                                                                |   | $                           | 43,799,481 |                        | $      | 44,203,557 |   |

 

See accompanying summaryof significant accounting policies and notes to consolidated financialstatements

 

29

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**MONTEREY PASTA****COMPANY**

**CONSOLIDATEDSTATEMENTS OF INCOME**

 
|                                      |   | **Years Ended** |       |
|-------------------------------------------|--------|-----------------|------------|
|                                      |   | **2001**        |       | **2002** |   | **2003** |   |
|                                      |   |            |       |   |   |   |   |
| Net revenues                              |   | $               | 56,986,912 |   | $ | 61,678,747 |   | $ | 60,489,567 |   |
|                                      |   |            |       |   |   |   |   |
| Cost of sales                             |   | 36,469,186      |       | 39,417,027 |   | 41,921,023 |   |
|                                      |   |            | ** ** |   | ** ** |   | ** ** |
| Gross profit                              |   | 20,517,726      |       | 22,261,720 |   | 18,568,544 |   |
|                                      |   |            | ** ** |   | ** ** |   | ** ** |
| Selling, general and  administrative      |   | 13,281,791      |       | 15,653,711 |   | 17,160,518 |   |
| Gain (loss) on  disposition of assets     |   | 20,330          |       | (67,880 | ) | — |   |
| Operating income                          |   | 7,256,265       |       | 6,540,129 |   | 1,408,026 |   |
|                                      |   |            | ** ** |   | ** ** |   | ** ** |
| Other income (expense),  net              |   | 1,278           |       | 2,566 |   | (1,380 | ) |
| Interest income  (expense), net           |   | 107,779         |       | 110,190 |   | 72,030 |   |
|                                      |   |            | ** ** |   | ** ** |   | ** ** |
| Income before provision  for income taxes |   | 7,365,322       |       | 6,652,885 |   | 1,478,676 |   |
|                                      |   |            | ** ** |   | ** ** |   | ** ** |
| Income tax benefit  (provision)           |   | (2,936,332      | )          | 2,838,320 |   | (444,273 | ) |
|                                      |   |            |       |   |   |   |   |
| Net income                                |   | $               | 4,428,990  |   | $ | 9,491,205 |   | $ | 1,034,403 |   |
|                                      |   |            |       |   |   |   |   |
| Net income per common  share              |   |            | ** ** |   | ** ** |   | ** ** |
| Basic income per common  share            |   | $               | 0.33       |   | $ | 0.68 |   | $ | 0.07 |   |
|                                      |   |            |       |   |   |   |   |
| Diluted income per  common share          |   | $               | 0.31       |   | $ | 0.65 |   | $ | 0.07 |   |
|                                      |   |            | ** ** |   | ** ** |   | ** ** |
| Basic shares  outstanding                 |   | 13,491,177      |       | 14,039,902 |   | 14,206,627 |   |
| Diluted shares  outstanding               |   | 14,254,248      |       | 14,664,762 |   | 14,414,931 |   |

 

Seeaccompanying summary of significant accounting policies and notes toconsolidated financial statements

 

30

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**MONTEREYPASTA COM****PANY**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

**FOR THE YEARS ENDED 2001, 2002, and 2003**

 
|                                                         |   | **Common Stock** |   | **Additional** |   | **Accumulated**     |   |        |   |
|--------------------------------------------------------------|--------|------------------|--------|----------------|--------|---------------------|--------|-------------|--------|
| **See Notes 6, 7, 8 and 15**                                 |   | **Shares**       |   | **Amount**     |   | **Paid-in Capital** |   | **Deficit** |   | **Total** |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Balance,  end of 2000                                        |   | 13,313,021       |   | $              | 13,313 |                | $      | 41,162,031  |   | $ | (19,511,902 | ) | $ | 21,663,442 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Issuance  of common stock under Employee Stock Purchase Plan |   | 5,875            |   | 6              |   | 19,824              |   | —      |   | 19,830 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Issuance  of common stock in net warrant exercise            |   | 523              |   | 1              |   | (1                  | )      | —      |   | — |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Exercise  of stock options for cash                          |   | 447,273          |   | 447            |   | 968,862             |   | —      |   | 969,309 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Net  settlement from investor 16(b) violation                |   | —           |   | —         |   | 14,299              |   | —      |   | 14,299 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Tax  benefit of disqualifying dispositions                   |   | —           |   | —         |   | 562,200             |   | —      |   | 562,200 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Stock-based  compensation                                    |   | —           |   | —         |   | 322,768             |   | —      |   | 322,768 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Net  income for the year                                     |   | —           |   | —         |   | —              |   | 4,428,990   |   | 4,428,990 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Balance,  end of 2001                                        |   | 13,766,692       |   | 13,767         |   | 43,049,983          |   | (15,082,912 | )      | 27,980,838 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Issuance  of common stock under Employee Stock Purchase Plan |   | 7,670            |   | 8              |   | 35,812              |   | —      |   | 35,820 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Issuance  of common stock in net warrant exercise            |   | 47,414           |   | 47             |   | (47                 | )      | —      |   | — |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Exercise  of stock options for cash                          |   | 374,615          |   | 375            |   | 953,180             |   | —      |   | 953,555 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Net  settlement from investor 16(b) violation                |   | —           |   | —         |   | (4,154              | )      | —      |   | (4,154 | ) |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Tax  benefit of disqualifying dispositions                   |   | —           |   | —         |   | 484,080             |   | —      |   | 484,080 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Net  income for the year                                     |   | —           |   | —         |   | —              |   | 9,491,205   |   | 9,491,205 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Balance,  end of 2002                                        |   | 14,196,391       |   | 14,197         |   | 44,518,854          |   | (5,591,707  | )      | 38,941,344 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Issuance  of common stock under Employee Stock Purchase Plan |   | 15,695           |   | 14             |   | 53,561              |   | —      |   | 53,575 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Exercise  of stock options for cash                          |   | 1,596            |   | 2              |   | 4,064               |   | —      |   | 4,066 |   |
| Tax  benefit of disqualifying dispositions                   |   | —           |   | —         |   | 1,091               |   | —      |   | 1,091 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Net  income for the year                                     |   | —           |   | —         |   | —              |   | 1,034,403   |   | 1,034,403 |   |
|                                                         |   |             |   |           |   |                |   |        |   |   |   |
| Balance,  end of 2003                                        |   | 14,213,682       |   | $              | 14,213 |                | $      | 44,577,570  |   | $ | (4,557,304 | ) | $ | 40,034,479 |   |

 

Seeaccompanying summary of significant accounting policies and noted toconsolidated financial statements

 

31

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**MONTEREY PASTA COMPANY**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
|                                                                               |   | **Years Ended** |      |
|------------------------------------------------------------------------------------|--------|-----------------|-----------|
|                                                                               |   | **2001**        |      | **2002** |   | **2003** |   |
| Cash flows from  operating activities:                                             |   |            |      |   |   |   |   |
| Net Income                                                                         |   | $               | 4,428,990 |   | $ | 9,491,205 |   | $ | 1,034,403 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |   |            |      |   |   |   |   |
| Deferred income taxes                                                              |   | 2,183,500       |      | (3,258,236 | ) | 312,705 |   |
| Depreciation and  amortization                                                     |   | 1,661,327       |      | 1,720,433 |   | 2,081,761 |   |
| Provision for  allowances for bad debt, returns, adjustments, and spoils           |   | 1,331,337       |      | 2,564,897 |   | 3,281,796 |   |
| Provision for inventory  reserves                                                  |   | 111,000         |      | 42,000 |   | 509,541 |   |
| Tax benefit of  disqualifying dispositions                                         |   | 562,200         |      | 484,080 |   | 1,091 |   |
| Loss (gain) on  disposition and writedown of property and equipment                |   | (20,330         | )         | 67,880 |   | — |   |
| Stock based  compensation                                                          |   | 322,768         |      | — |   | — |   |
| Changes in assets and  liabilities:                                                |   |            |      |   |   |   |   |
| Accounts receivable                                                                |   | (2,412,651      | )         | (2,598,284 | ) | (3,499,898 | ) |
| Inventories                                                                        |   | (136,582        | )         | (352,374 | ) | (1,145,885 | ) |
| Prepaid expenses and  other assets                                                 |   | (728,558        | )         | 57,534 |   | (389,098 | ) |
| Accounts payable                                                                   |   | (526,676        | )         | 1,588,379 |   | (351,580 | ) |
| Accrued liabilities                                                                |   | 639,914         |      | (313,221 | ) | (323,351 | ) |
| Net cash provided by  operations                                                   |   | 7,416,239       |      | 9,494,293 |   | 1,511,485 |   |
|                                                                               |   |            |      |   |   |   |   |
| Cash flows from  investing activities:                                             |   |            |      |   |   |   |   |
| Purchase of property  and equipment                                                |   | (2,638,833      | )         | (4,759,756 | ) | (3,028,623 | ) |
| Proceeds from sale of  property and equipment                                      |   | 28,559          |      | — |   | — |   |
| Acquisition of business  operating assets                                          |   | —          |      | (6,081,634 | ) | (79,135 | ) |
| Net cash used in  investing activities                                             |   | (2,610,274      | )         | (10,841,390 | ) | (3,107,758 | ) |
|                                                                               |   |            |      |   |   |   |   |
| Cash flows from  financing activities:                                             |   |            |      |   |   |   |   |
| Repayment of long-term  debt and capital lease obligations                         |   | (34,774         | )         | (32,008 | ) | (14,128 | ) |
| Section 16(b)  settlement less legal fees                                     |   | 14,299          |      | (4,154 | ) | — |   |
| Proceeds from issuance  of common stock                                            |   | 989,139         |      | 989,375 |   | 57,641 |   |
| Net cash provided by  financing activities                                         |   | 968,664         |      | 953,213 |   | 43,513 |   |
| Net increase (decrease)  in cash and cash equivalents                              |   | 5,774,629       |      | (393,884 | ) | (1,552,760 | ) |
| Cash and cash  equivalents, beginning of year                                      |   | 1,457,499       |      | 7,232,128 |   | 6,838,244 |   |
| Cash and cash  equivalents, end of year                                            |   | $               | 7,232,128 |   | $ | 6,838,244 |   | $ | 5,285,484 |   |

 

See accompanying summaryof significant accounting policies and notes to consolidated financialstatements.

 

32

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**MONTEREY PASTA COMPANY**

**SUMMARY OF SIGNIFICANT****ACCOUNTINGPOLICIES**

 

***Principles of Consolidation and Nature of Operations***

 

The consolidatedfinancial statements include the accounts of Monterey Pasta Company (a producerand distributor of pasta, pasta sauces, soups, salsa, dips, hummus, and relateditems), together with its wholly owned subsidiary, Monterey Pasta DevelopmentCompany (a franchiser of restaurants - inactive).  All significant intercompany accounts and transactions have beeneliminated in consolidation. Collectively, Monterey Pasta Company and Monterey Pasta DevelopmentCompany are referred to as the “Company.”

 

The Company’s productionfacilities and distribution center are located in Salinas (Monterey County),California, and Eugene, Oregon.  Itsproducts are available throughout the United States as well as selecteddistribution areas in Canada, the Caribbean, Latin America, and AsiaPacific.  The principal customers areretail groceries and club stores.  TheCompany offers credit and payment terms to its customers in line with industrypractices, generally calling for unsecured trade accounts receivable.

 

***Accounting Periods***

 

For quarterly reportingpurposes the Company employs a 4-week, 4-week, 5-week reporting period.  The fiscal year ends on the last Sunday ofeach calendar year (52/53-week year). The 2001 fiscal year contained 52 weeksand ended on December 30, the 2002 fiscal year contained 52 weeks andended on December 29 and the 2003 fiscal year contained 52 weeks and endedon December 28.

 

***Cash and Cash Equivalents***

 

The Company considers allhighly liquid investments purchased with an original maturity of three months orless to be cash equivalents.  TheCompany’s cash equivalents consist primarily of money market accounts.

 

***Accounts Receivable and Allowances***

 

The Company providesallowances for estimated credit losses, product returns, spoilage, andadjustments at a level deemed appropriate to adequately provide for known andinherent risks related to such amounts. The allowances are based on reviews of loss, return, spoilage,adjustment history, contractual relationships with customers, current economicconditions, and other factors that deserve recognition in estimating potentiallosses.  While management uses the bestinformation available in making its determination, the ultimate recovery ofrecorded accounts, notes, and other receivables is also dependent on futureeconomic and other conditions that may be beyond management’s control.

 

***Inventories***

 

Inventories are stated atthe lower of cost (using the first-in, first-out method) or market and consistprincipally of component ingredients to the Company’s refrigerated pasta andsauces, finished goods, and packaging materials.

 

***Sales Incentives and Advertising Costs***

 

The Company expensesadvertising costs as incurred or when the related campaign commences.  Sales incentives paid or credited to clubstores and grocery chains for shelf space allocations are amortized between sixand twelve months depending on the nature of the chain program or agreement,and are netted against revenues.  TheCompany spent $272,000, $210,000 and $145,000 on advertising during 2001, 2002,and 2003 respectively.

 

33

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***Property and Equipment***

 

Property and equipmentare recorded at cost.  Depreciation isprovided for on the straight-line method over the estimated useful lives of theassets (or lease term for leasehold improvements if shorter):

 
| Leasehold improvements          |   | 7 to 12 years |
|---------------------------------|--------|---------------|
| Machinery and equipment         |   | 7 to 12 years |
| Office furniture and  equipment |   | 5 to 15 years |
| Computer and software           |   | 3 to 5 years  |
| Vehicles                        |   | 5 to 7 years  |

 

Long-lived assets, includingintangible assets, are assessed for possible impairment whenever events orchanges in circumstances indicate that the carrying amounts may not berecoverable, or whenever management has committed to a plan to dispose of theassets.  Assets to be held and usedaffected by such an impairment loss are depreciated or amortized at their newcarrying amount over the remaining estimated life; assets to be sold orotherwise disposed of are not subject to further depreciation or amortization.

 

***Goodwill and Intangible Assets***

 

Intangible assets otherthan goodwill consist of tradenames, customer lists, and non-competes and otherintangibles and are recorded at cost, net of accumulated amortization.  Intangibles are amortized over their respectiveuseful lives, if determinate, ranging from 3 to 10 years.  Goodwill and certain trademarks withindeterminate useful lives are assessed for impairment at least annually. Thevaluation of these intangibles is determined based upon valuations performed bythird party specialists and management’s best estimates of fair value.  As a result the ultimate value andrecoverability of these assets is subject to the validity of the assumptionsused.

 

***Income Taxes and Deferred Tax Asset Valuation Allowance***

 

The Company accounts forcorporate income taxes in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 109, *Accounting for Income Taxes*, whichrequires an asset and liability approach. This approach results in the recognition of deferred tax assets (futuretax benefits) and liabilities for the expected future tax consequences oftemporary timing differences between the book carrying amounts and the taxbasis of assets and liabilities.  Futuretax benefits are subject to a valuation allowance to the extent of thelikelihood that the deferred tax assets may not be realized.

 

TheCompany has significant deferred tax assets comprised principally of NetOperating Losses (“NOLs”) from the Company’s former restaurant operatingsubsidiary Upscale Food Outlets, Inc. (“UFO”). These NOLs were previously fully reserved based upon management’s bestestimate of ultimate realizeability. During 2002, based upon new evidence andmanagement’s judgments these reserves were substantially reduced.  Theamount of the reserve is significantly dependent on management’s assumptionsregarding future taxable income and the availability of these NOLs to offsetfuture taxable income. The effect on the Company’s net income can besignificant whenever the estimate of realizeability changes. The Companyexpects to fully utilize all of the remaining NOLs in fiscal 2004 and 2005.

 

***Revenue Recognition***

 

The Company recognizesrevenues through sales of pasta and sauce products primarily to grocery andclub store chains.  Revenues arerecognized once there is evidence of an arrangement (such as a customerpurchase order), product has shipped and in some instances, not until theproduct has been delivered, the price and terms are finalized, andcollectibility is reasonably assured. Accordingly, sales are recorded when goods are shipped or for onecustomer, when the product is delivered, at which time title and risk of losshave passed to the customer, consistent with the freight terms for mostcustomers.  Title and risk of loss passupon delivery to retail locations for the Direct Store Delivery program, asthat product is transported in the Company’s own vehicles.  Potential returns, adjustments and spoilageallowances are provided for in accounts receivable allowances and accruals.

 

The Company recordsshipping cost for product delivered to customers in selling expense.  These costs were approximately  $2,211,000, $2,609,000 and $3,158,000 for2001, 2002 and 2003 respectively.  Anyamounts charged to customers for freight and deliveries are included inrevenues.  Certain incentives granted tocustomers such as promotions, trade ads, slotting fees, and coupons arerecorded as offsets to revenues.

 

34

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***Stock-based Compensation***

 

As permitted under theprovisions of SFAS 123, *Accounting for Stock-Based Compensation*,the Company continues to account for employee stock-based transactions underAccounting Principles Board Opinion (“APB”) No. 25, *Accounting for Stock Issued toEmployees*.  However, SFAS 123requires the Company to disclose pro forma net income and earnings per share asif the fair value method had been adopted. Under the fair value method, compensation cost is measured at the grantdate based on the fair value of the award and is recognized over the serviceperiod, which is usually the vesting period. For non-employees, cost is also measured at the grant date, using thefair value method, but is actually recognized in the financial statements overthe vesting period, or immediately if no further services are required.

 

If the Company hadelected the fair value method of accounting for stock-based compensation,compensation cost would be accrued at the estimated fair value of stock optiongrants over the service period, regardless of later changes in stock prices andprice volatility.  The fair value atdate of grant for options granted in 2001, 2002, and 2003 have been estimatedbased on a modified Black-Scholes pricing model with the assumptions identifiedin the following table.

 
|                      |   | **2001** |   | **2002** |   | **2003** |   |
|---------------------------|--------|----------|--------|----------|--------|----------|--------|
|                      |   |     |   |     |   |     |   |
| Dividend  Yield           |   | —   |   | —   |   | —   |   |
|                      |   |     |   |     |   |     |   |
| Volatility                |   | 48.0     | %      | 75.0     | %      | 66.0     | %      |
|                      |   |     |   |     |   |     |   |
| Risk-Free  Interest Rates |   | 4.18     | %      | 3.81     | %      | 4.60     | %      |
|                      |   |     |   |     |   |     |   |
| Expected  Lives in Years  |   | 5        |   | 5        |   | 5        |   |

 

The table below shows netincome per share for 2001, 2002, and 2003 as if the Company had elected thefair value method of accounting for stock options.

 
|                                                                                                                                        |   | **2001** |      | **2002** |   | **2003**   |       |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|-----------|----------|--------|------------|------------|
| Net  income as reported                                                                                                                     |   | $        | 4,428,990 |     | $      | 9,491,205  |       | $ | 1,034,403 |   |
|                                                                                                                                        |   |     |      |     |   |       |       |
| Add:  stock-based employee compensation included in reported net income, net of  related tax effects                                        |   | 193,661  |      | —   |   | —     |       |
| Deduct:  total stock-based employee compensation   determined under fair value method for all awards,  net of related tax effects |   | (174,564 | )         | (830,285 | )      | (1,393,100 | )          |
|                                                                                                                                        |   |     |      |     |   |       | ** ** |
| Proforma  net income, as adjusted                                                                                                           |   | $        | 4,448,087 |     | $      | 8,660,920  |       | $ | (358,697 | ) |
|                                                                                                                                        |   |     |      |     |   |       |       |
| Earnings  per share:                                                                                                                        |   |     |      |     |   |       | ** ** |
| Basic,  as reported                                                                                                                         |   | $        | 0.33      |     | $      | 0.68       |       | $ | 0.07 |   |
| Basic,  as adjusted                                                                                                                         |   | $        | 0.33      |     | $      | 0.62       |       | $ | (0.03 | ) |
|                                                                                                                                        |   |     |      |     |   |       | ** ** |
| Diluted,  as reported                                                                                                                       |   | $        | 0.31      |     | $      | 0.65       |       | $ | 0.07 |   |
| Diluted,  as adjusted                                                                                                                       |   | $        | 0.31      |     | $      | 0.59       |       | $ | (0.03 | ) |

 

***Use of Estimates***

 

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amount of assets and liabilities, disclosure of contingent assetsand liabilities at the date of the financial statements, and the reportedamounts of revenues and expenses during the period.  Actual results could differ from those estimates.  The most significant estimates made by theCompany are those related to accounts receivable and deferred tax allowances,allocation of purchase price of acquired businesses, depreciation of fixedassets, amortization of acquired intangible assets, and impairment judgmentsmade for intangibles.

 

35

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***New Accounting Pronouncements***

 

InNovember 2002, the FASB issued FASB Interpretation (“FIN”) No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including Indirect Guaranteesof Indebtedness of Others*. FIN 45 requires a guarantor to recognize,at the inception of a qualified guarantee, a liability for the fair value ofthe obligation undertaken in issuing the guarantee. FIN 45 is effective on aprospective basis for qualified guarantees issued or modified afterDecember 31, 2002.  The adoption ofthis Interpretation did not have a material impact on the Company’s financialcondition or results of operations.

 

Pursuant to its bylaws,the Company has agreed to indemnify its officers and directors for certainevents or occurrences arising as a result of the officer or director serving insuch capacity. The term of the indemnification period is for the officer’s ordirector’s lifetime. To date, the Company has not incurred any costs as therehave been no lawsuits or claims that would invoke these indemnificationagreements. Accordingly, the Company has no liabilities recorded for theseagreements as of December 28, 2003.

 

The Company enters intoindemnification provisions under (i) its agreements with other companies in itsordinary course of business, typically with business partners, contractors andcustomers, its sublandlord and (ii) its agreements with investors. Under theseprovisions the Company has agreed to generally indemnify and hold harmless theindemnified party for losses suffered or incurred by the indemnified party as aresult of the Company’s activities or, in some cases, as a result of theindemnified party’s activities under the agreement. These indemnificationprovisions often include indemnifications relating to representations made bythe Company with regard to intellectual property rights. These indemnificationprovisions generally survive termination of the underlying agreement. Themaximum potential amount of future payments the Company could be required tomake under these indemnification provisions is unlimited. To date, the Companyhas not incurred any costs as there have been no lawsuits or claims related tothese indemnification agreements. Accordingly, the Company has no liabilitiesrecorded for these agreements as of December 28, 2003.

 

InJanuary 2003, the FASB issued Interpretation No. 46, *Consolidation of Variable InterestEntities*, which requires the consolidation of certain specialpurpose or variable interest entities. FIN 46 is applicable to financialstatements issued after 2002, however, disclosures are required currently ifthe Company expects to consolidate any variable interest entities. The Companyhas no variable interest entities and therefore, there are no entities thatwill be consolidated with the Company’s financial statements as a result of FIN46.

 

In May 2003, the FASBissued SFAS 150, *Accounting For Certain Financial Instruments with Characteristics ofBoth Liabilities and Equity*, which establishes standards for how anissuer of financial instruments classifies and measures certain financialinstruments with characteristics of both liabilities and equity. It requiresthat an issuer classify a financial instrument that is within its scope as aliability (or an asset in some circumstances) if, at inception, the monetaryvalue of the obligation is based solely or predominantly on a fixed monetaryamount known at inception, variations in something other than the fair value ofthe issuer’s equity shares or variations inversely related to changes in thefair value of the issuer’s equity shares. SFAS 150 is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning afterJune 15, 2003. The adoption of SFAS 150 did not have a material impact onthe Company’s financial position or results of operations.

 

***Reclassification****s*

 

Certain of the prior yearfinancial statement amounts have been reclassified to conform to the currentyear presentation.  Thesereclassifications had no impact on previously reported income or accumulateddeficit.

 

**MONTEREY PASTA COMPANY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**1.**                                      **Concentrationof Credit Risk**

 

Financial instruments,which potentially subject the Company to concentration of credit risk, includecash, cash equivalents, and accounts receivable.   The Company maintains its cash accounts in Comerica Bank inFresno, California.  The bank cashbalances are insured by the Federal Deposit Insurance Corporation up to$100,000.   At December 28, 2003uninsured cash balances totaled $5,052,000. As of December 28, 2003, approximately 65% of the Company’saccounts receivable are concentrated with two major customers (See Note 10).

 

36

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**2.****                                      Inventories**

 
|                                     |   | **2002**  |      | **2003**  |   |
|------------------------------------------|--------|-----------|-----------|-----------|--------|
| Inventories  consisted of the following: |   |      |      |      |   |
|                                     |   |      |      |      |   |
| Production  – Ingredients           |   | $         | 1,280,970 |      | $      | 1,911,675 |   |
| Production  – Finished goods        |   | 1,538,465 |      | 1,204,513 |   |
| Paper  goods and packaging materials     |   | 940,960   |      | 1,170,108 |   |
| Operating  supplies                      |   | 32,177    |      | 44,229    |   |
|                                     |   | 3,792,572 |      | 4,374,754 |   |
| Allowances  for spoils and obsolescence  |   | (69,500   | )         | (51,446   | )      |
|                                     |   | $         | 3,723,072 |      | $      | 4,323,308 |   |

 

**3.****                   Propertyand Equipment**

 
|                                                |   | **2002**   |       | **2003**   |   |
|-----------------------------------------------------|--------|------------|------------|------------|--------|
|                                                |   |       |       |       |   |
| Property  and equipment consisted of the following: |   |       |       |       |   |
|                                                |   |       |       |       |   |
| Leasehold  improvements                             |   | $          | 4,970,075  |       | $      | 5,024,606 |   |
| Machinery  and equipment                            |   | 15,965,796 |       | 18,605,196 |   |
| Computers,  office furniture and equipment          |   | 724,198    |       | 845,974    |   |
| Vehicles                                            |   | 363,747    |       | 364,433    |   |
|                                                |   | 22,023,816 |       | 24,840,209 |   |
| Less  accumulated depreciation and amortization     |   | (7,989,339 | )          | (9,827,747 | )      |
|                                                |   | 14,034,477 |       | 15,012,462 |   |
| Construction  in progress                           |   | 220,097    |       | 432,327    |   |
|                                                |   | $          | 14,254,574 |       | $      | 15,444,789 |   |

 

Construction in progressat December 28, 2003 includes deposits for equipment on order or yet to beinstalled.  Depreciation expense for2001, 2002, and 2003 was $1,443,000, $1,593,000 and $1,839,000, respectively.

 

**4.**              **Notes, Loans, and Capitalized Leases Payable**

 

***Capitalized Leases***

 

The Company leasescertain equipment under capitalized leases, including office equipment, a vanand truck with book values of $15,900 and $3,000 in 2002 and 2003,respectively.  Future minimum leasepayments consist of:

 
| **Year**                            |   | **Total** |   |
|-------------------------------------|--------|-----------|--------|
| 2004                                |   | 2,916     |   |
|                                |   | 2,916     |   |
|                                |   |      |   |
| Less  amounts representing interest |   | 295       |   |
|                                |   |      |   |
| Capitalized  leases payable         |   | 2,621     |   |
| Less  current portion               |   | 1,784     |   |
| Long  term portion                  |   | $         | 837    |   |
|                                     |        |           |        |  |

 

***Credit Facility***

 

On August 1, 2001Imperial Bank (now Comerica Bank) provided a new multi-year credit facility tothe Company.  The existing accountsreceivable and inventory revolver was amended to expire October 31, 2004with a commitment of $1.5 million and interest at either prime rate or LIBORplus 200 basis points.  In addition, theCompany’s lender approved an $8.5 million non-revolving term facility in theevent of a need for major capital expenditures and acquisitions, which expiresOctober 31, 2009.  The term loanfacility is subject to annual review if unused.  If used, it converts to an 84-month term loan.  Pricing is at either prime rate or LIBORplus 225 basis points over LIBOR.  Thetotal credit facility is $10.0 million.

 

The terms of the CreditFacility prohibit the payment of cash dividends (except with written approval)on the Company’s capital stock and restricts payments for, among other things,repurchasing shares of its capital stock. Other terms of the Credit 

 

37

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Facility limit theCompany with respect to, among other things, (i) incurring additionalindebtedness,  (ii) adversely changingthe capital structure, and (iii) acquiring assets other than in the normalcourse of business including specific limits on annual capital expenditures(currently $4.25 million).  As ofDecember 28, 2003, there were no violations of any loan covenants and noloans outstanding.

 

Effective January 1,2003, the Company initiated a $500,000 Letter of Credit in favor of SentryInsurance as required collateral for a deductible worker’s compensationprogram.   On January 1, 2004, theLetter of Credit was increased to $900,000 in favor of the same insurancecompany.  The new letter of creditexpires December 31, 2004.

 

**5**.                                      **OperatingLeases**

 

The Company currentlyleases production, warehouse and corporate office space as well as certainequipment in Monterey County, California under both month-to-month andnon-cancelable operating lease agreements, expiring at various times through2007.  The terms of the leases generallyrequire the Company to pay common area maintenance, taxes, insurance, andcertain other costs.  All buildingleases have renewal options (see Item 2 “Properties” on page 10) and allinclude cost of living adjustments.

 

Future minimum annuallease payments due under non-cancelable operating leases with terms of morethan one year are as follows:

 
| **Year** |   | **Lease  Amount** |      |
|----------|--------|-------------------|-----------|
| 2004     |   | $                 | 797,597   |   |
| 2005     |   | 531,378           |      |
| 2006     |   | 506,283           |      |
| 2007     |   | 255,172           |      |
|     |   | $                 | 2,090,430 |   |

 

Gross rent expense underthe leases for 2001, 2002, and 2003 was $584,451, $711,010, and $804,861 respectively.

 

**6**.                                      **Stockholders’Equity**

 

***Preferred Stock***

 

The Company has 1,000,000Preferred Shares at $.001 par value authorized, however none are issued.

 

***Common Stock***

 

In 2001, employee anddirector options representing 297,684 shares of common stock were exercised forproceeds of $620,767. Non-plan options representing 149,589 shares of commonstock granted to the shareholders and plant manager of Frescala Foods, Inc. aspart of the March 1999 acquisition were also exercised at $2.33 per shareresulting in proceeds of $348,542.  Inaddition, warrants representing 3,786 potential shares with an exercise priceof $6.50 and an expiration date of May 1, 2003, were exercised.  Since the warrants were converted into stockas a net exercise, only 523 shares of common stock were issued.  These warrants were originally issued inconnection with a July 1996 private placement in which the Company issuedwarrants to purchase up to 400,750 shares of common stock.  Additionally during 2001, 5,875 employeestock purchase plan shares were issued.

 

During 2002, employee anddirector options representing 224,204 shares of common stock were exercised forproceeds of $603,099.  Non-plan optionsrepresenting 150,411 shares of common stock granted to the shareholders andplant manager of Frescala Foods, Inc. as part of the March 1999acquisition were also exercised, resulting in proceeds of $350,456.  In addition, warrants with an exercise priceof $6.50 and an expiration date of May 1, 2003, representing 47,414 shares ofCompany common stock were exercised as parts of net exercises, with no cashproceeds to the Company.  These warrantswere originally issued in connection with a July 1996 private placement inwhich the Company issued warrants to purchase up to 400,750 shares of commonstock.  Additionally, 7,670 employeestock purchase plan shares were issued with proceeds of $35,820 in 2002.

 

Warrants representing upto 242,171 shares of common stack issued in connection with the July 1996private placement expired unexercised in 2003 and at December 28, 2003,there were no remaining warrants outstanding.

 

During 2003 employee anddirector options representing 1,596 shares of common stock were exercised forproceeds of $4,066 and 15,695 employee stock purchase plan shares were issuedfor proceeds of $53,575.

 

38

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***Employee Stock Purchase Plan***

 

In October 1994, theCompany’s Board of Directors adopted a qualified employee stock purchaseplan.  Under the purchase plan, eligibleemployees (those who have completed one year of continuous employment with theCompany) may purchase shares of the Company’s common stock through payrolldeductions not to exceed 10% of gross wages. The Company has reserved 200,000 shares of its common stock for issuanceunder the purchase plan, which remains in effect until terminated by theCompany’s Board of Directors, or until all of the shares reserved for under thepurchase plan have been issued.  Unlessthe Board has otherwise provided a higher amount prior to the commencement ofan offering period, the offering exercise price for each purchase period is 85%of the lesser of (a) the fair market value of the shares on the offering dateof such offering period or (b) the fair market value of the shares on the givenpurchase date.  There were 5,875, 7,670and 1,596 shares of common stock issued under the plan in 2001, 2002 and 2003,respectively.  At December 28,2003, there were 175,795 available shares remaining under the plan.

 

***Earnings per Share***

 

Basic earnings per shareare based on earnings available to common stockholders divided by theweighted-average number of common shares actually outstanding during theperiod.  Diluted earnings per share alsoinclude the incremental effect of any dilutive common stock equivalents assumedto be outstanding during the period. Because of equivalent shares includable in different periods or atdifferent amounts, per-share amounts for the four quarters do not necessarilyequal per-share amounts for the entire year.

 

Options to purchase1,527,250, 1,528,385 and 1,872,739 shares of common stock were outstanding atyear-end 2001, 2002, and 2003, respectively (see Note 7).  During 2001, a total of 1,465,250 optionswere included in the computation of diluted earnings per share, with 62,000excluded, because of exercise prices. At 2002 year-end a total of 1,423,885 options were included in thecomputation of diluted earnings per share, with 104,500 excluded, because ofexercise prices. At 2003 year-end a total of 649,739 options were included inthe computation of diluted earnings per share, with 1,223,000 excluded, becauseof exercise prices.

 

Warrants to purchase396,964, 242,171 and -0- shares were outstanding at year-end 2001, 2002, and2003, respectively.  At year-end 2001 nowarrants representing shares on common stock were included, with warrantsrepresenting 396,964 shares of common stock excluded, because of exerciseprices.  At year-end 2002 no warrantsrepresenting shares on common stock were included, with warrants representing242,171 shares of common stock excluded, because of exercise prices.  At year-end 2003 no warrants representingshares on common stock were included because they expired.

 

**7.****                                      StockOptions**

 

Effective August 31,1993, the Company’s Board of Directors adopted a stock option plan (the“Plan”), subsequently amended and restated, which provides for the granting ofincentive stock options or non-qualified stock options to eligible employees,consultants and outside directors.  TheCompany initially reserved 1,200,000 shares of its common stock for issuanceunder the Plan and in subsequent years increased the total shares reserved to1,500,000.  The Plan provides that theoption price shall not be less than the fair market value of the shares on thedate of grant; therefore, no compensation expense is recorded for employees,unless the market price exceeds the strike price on the day of grant.  Compensation or other expense is recordedfor any non-employee grants at fair value of the option award.  Options generally vest over a period of oneto three years and may be exercised for a period of up to ten years.  During 2001, the Company issued additional optionsto purchase up to 155,200 shares outside of the Plan (the “Nonstatutory Plan”).  As amended, the Plan expires April 30,2012.  As of December 28, 2003, theCompany had 1,646,328 shares available under the Plan, and 33,800 available aspart of the Nonstatutory Plan.

 

The following table showsactivity in outstanding options during 2001, 2002, and 2003:

 

39

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|                                                            |   | **2001**      |       | **2002**                            |       | **2003**   |          |
|-----------------------------------------------------------------|--------|---------------|------------|-------------------------------------|------------|------------|---------------|
|                                                            |   | **Shares**    |       | **Weighted Average Exercise Price** |       | **Shares** |          | **Weighted Average Exercise Price** |   | **Shares** |   | **Weighted Average Exercise Price** |   |
|                                                            |   |          |       |                                |       |       |          |   |   |   |   |   |   |
| Outstanding at  beginning of year                               |   | 1,500,890     |       | $                                   | 2.54       |       | 1,527,250     |   | $ | 3.91 |   | 1,528,385 |   | $ | 4.90 |   |
| Granted                                                         |   | 532,200       |       | 6.41                                |       | 400,800    |          | 6.47 |   | 391,200 |   | 3.82 |   |
| Exercised                                                       |   | (447,273      | )          | 2.17                                |       | (374,615   | )             | 2 54 |   | (1,596 | ) | 2.55 |   |
| Canceled or expired                                             |   | (58,567       | )          | 4.67                                |       | (25,050    | )             | 5.30 |   | (45,250 | ) | 6.69 |   |
| Outstanding at end of  year                                     |   | **1,527,250** | ** ** | **$**                               | **3.91**   | ** ** | **1,528,385** | ** ** | **$** | **4.90** | ** ** | **1,872,739** | ** ** | **$** | **4.63** | ** ** |
|                                                            |   |          | ** ** |                                | ** ** |       | ** **    |   | ** ** |   | ** ** |   | ** ** |
| Options exercisable at  year end                                |   | 847,634       |       | $                                   | 2.47       |       | 951,485       |   | $ | 3.96 |   | 1,338,639 |   | $ | 4.65 |   |
|                                                            |   |          | ** ** |                                | ** ** |       | ** **    |   | ** ** |   | ** ** |   | ** ** |
| Weighted average fair  value of options granted during the year |   |          |       | $                                   | 3.00       |       |          |   | $ | 4.26 |   |   |   | $ | 3.82 |   |

 

The following table showsinformation for options outstanding or exercisable as of December 28, 2003

 
|                         |   | **Options  Outstanding** |   | **Options  Exercisable**                         |   |
|------------------------------|--------|--------------------------|--------|--------------------------------------------------|--------|
| **Range of Exercise Prices** |   | **Number of  Shares**    |   | **Weighted  Average Remaining Contractual Life** |   | **Weighted  Average Exercise Price** |   | **Number of  Shares** |   | **Weighted  Average Remaining Contractual Life** |   | **Weighted  Average Exercise Price** |   |
| $1.13  – 1.87           |   | 195,666                  |   | 3.4 years                                        |   | $ | 1.71/share |   | 195,666 |   | 3.4 years |   | $ | 1.71/share |   |
| $2.00  – 3.34           |   | 359,073                  |   | 5.7 years                                        |   | $ | 2.90/share |   | 350,073 |   | 5.6 years |   | $ | 2.89/share |   |
| $3.39  – 3.71           |   | 95,000                   |   | 9.0 years                                        |   | $ | 3.54/share |   | 16,000 |   | 6.2 years |   | $ | 3.57/share |   |
| $3.76  – 3.76           |   | 222,700                  |   | 9.8 years                                        |   | $ | 3.76/share |   | — |   | — |   | — |   |
| $3.79  – 5.20           |   | 192,500                  |   | 8.1 years                                        |   | $ | 4.52/share |   | 113,050 |   | 7.1 years |   | $ | 4.62/share |   |
| $5.25  - 6.05                |   | 327,550                  |   | 8.2 years                                        |   | $ | 5.95/share |   | 238,900 |   | 8.0 years |   | $ | 5.93/share |   |
| $6.20  - 6.43                |   | 14,000                   |   | 7.3 years                                        |   | $ | 6.40/share |   | 14,000 |   | 7.4 years |   | $ | 6.40/share |   |
| $5.55  - 6.55                |   | 273,950                  |   | 7.8 years                                        |   | $ | 6.55/share |   | 273,950 |   | 7.8 years |   | $ | 6.55/share |   |
| $6.25  – 8.08           |   | 188,250                  |   | 7.9 years                                        |   | $ | 7.38/share |   | 135,000 |   | 7.6 years |   | $ | 7.25/share |   |
| $8.37  - 9.25                |   | 4,000                    |   | 8.3 years                                        |   | $ | 8.84/share |   | 2,000 |   | 8.3 years |   | $ | 8.84/share |   |
| Total                        |   | 1,872,739                |   | 7.3 years                                        |   | $ | 4.63/share |   | 1,338,639 |   | 6.5 years |   | $ | 4.65/share |   |

 

The following tableprovides information about our common stock that may be issued upon theexercise of options, warrants and rights under all of our existing equitycompensation plans as of December 28, 2003, including the Monterey PastaCompany 1993 Stock Option Plan, the Monterey Pasta Company 1995 Employee StockPurchase Plan (See Note 6) and the Monterey Pasta Company 2001 NonstatutoryStock Option Plan.

 

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| **Plan category**                                           |   | **Number of  securities to be issued upon exercise of outstanding options, warrants and  rights  (a)** |   | **Weighted-average  exercise price of outstanding options, warrants and rights  (b)** |   | **Number of  securities remaining available for future issuance under equity compensation  plans (excluding securities reflected in column (a))  (c)** |      |
|-------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------|-----------|
| Equity  compensation plans approved by security holders     |   | 1,723,039                                                                                              | (1)    | $                                                                                     | 4.48   |                                                                                                                                                   | 1,646,328 |   |
| Equity  compensation plans not approved by security holders |   | 133,950                                                                                                | (2)    | $                                                                                     | 6.65   |                                                                                                                                                   | 33,800    |   |
| Total                                                       |   | 1,872,739                                                                                              |   | $                                                                                     | 4.63   |                                                                                                                                                   | 1,680,128 |   |

 

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(1)          Issuedunder the Monterey Pasta Company 1993 Stock Option Plan and the Monterey PastaCompany 1995 employee Stock Purchase Plan

 

(2)          Issuedto Company employees under the Monterey Pasta Company 2001 Nonstatutory StockOption Plan (154,200 at $6.55)

 

**8.**                                      **Income Taxes**

 

The Company’s income taxbenefit (provision) consists of:

 
|                       |   | **2001**   |       | **2002**  |   | **2003**  |   |
|----------------------------|--------|------------|------------|-----------|--------|-----------|--------|
| Current:                   |   |       |       |      |   |      |   |
|                       |   |       |       |      |   |      |   |
| Federal                    |   | $          | (618,100   | )         | $      | (263,088  | )      | $ | (829 | ) |
| State                      |   | (134,732   | )          | (156,828  | )      | (130,739  | )      |
| Total                      |   | (752,832   | )          | (419,916  | )      | (131,568  | )      |
|                       |   |       |       |      |   |      |   |
| Deferred:                  |   |       |       |      |   |      |   |
|                       |   |       |       |      |   |      |   |
| Federal                    |   | (1,919,400 | )          | 3,366,239 |   | (372,943  | )      |
| State                      |   | (264,100   | )          | (108,003  | )      | 60,238    |   |
| Total                      |   | 2,183,500  |       | 3,258,236 |   | (312,705  | )      |
|                       |   |       |       |      |   |      |   |
| Net  tax benefit (expense) |   | $          | (2,936,332 | )         | $      | 2,838,320 |   | $ | (444,273 | ) |

 

A reconciliation betweenthe Company’s effective tax rate and U.S. Federal income tax rate on loss fromcontinuing operations follows:

 
|                                                       |   | **2001** |   | **2002** |   | **2003** |   |
|------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Federal  statutory rate                                    |   | 34.0     | %      | 34.0     | %      | 34.0     | %      |
|                                                       |   |     |   |     |   |     |   |
| State  income taxes, net of effect on Federal income taxes |   | 2.8      |   | 1.5      |   | (3.7     | )      |
|                                                       |   |     |   |     |   |     |   |
| Reversal  of Federal and State valuation allowances        |   | —   |   | (78.6    | )      | —   |   |
|                                                       |   |     |   |     |   |     |   |
| Other                                                      |   | 3.1      |   | .4       |   | (0.3     | )      |
|                                                       |   |     |   |     |   |     |   |
| Effective  income tax rate                                 |   | 39.9     | %      | (42.7    | )%     | 30.0     | %      |

 

The valuation allowancefor 2001, 2002, and 2003 was increased (reduced) by $6,008,000, ($5,196,000),and $0, respectively.  During 2002, theCompany completed its evaluation of the likelihood of realizing certain netoperating losses (“NOLs”) arising in connection with its previously-ownedsubsidiary Upscale Food Outlets, Inc. (“UFO”). As a result, reserves against these deferred tax assets totaling $5,196,000were released and offset against income tax expense in 2002.  This benefit, together with permanentdifferences and other current tax effects, resulted in a 2002 income taxbenefit of $2,838,000.  Utilization

 

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of these NOLs and otherdeferred tax assets offset substantially all of the federal taxes otherwisepayable for 2002.  As ofDecember 28, 2003, remaining net deferred tax assets available to offsetfuture cash tax liabilities are $3,485,000 short term and $1,036,000 longterm.  The future disallowance of anyprevious UFO NOL usage, if it occurs, would increase both income tax expenseand amounts actually payable.

 

Deferred income taxesreflect the net tax effects of temporary differences between the carryingamounts of assets and liabilities for financial reporting purposes and theamounts used for income tax purposes. Significant components of the Company’s deferred tax assets are asfollows:

 

 
|                                                                     |   | **2002**  |      | **2003**  |   |
|--------------------------------------------------------------------------|--------|-----------|-----------|-----------|--------|
| Federal  loss carryforwards                                              |   | $         | 4,209,700 |      | $      | 3,615,000 |   |
| Accumulated  depreciation and Amortization                               |   | 194,300   |      | 342,000   |   |
| Alternative  minimum tax credit carryovers                               |   | 252,000   |      | 273,600   |   |
| State  income and franchise taxes, net of effect on Federal income taxes |   | 444,200   |      | 402,600   |   |
| Reserves  against receivables                                            |   | 179,300   |      | 149,800   |   |
| Other                                                                    |   | 295,800   |      | 479,600   |   |
|                                                                     |   | 5,575,300 |      | 5,262,600 |   |
| Less  valuation allowance                                                |   | (741,600  | )         | (741,600  | )      |
|                                                                     |   |      |      |      |   |
| Net  deferred tax assets                                                 |   | $         | 4,833,700 |      | $      | 4,521,000 |   |

 

As of December 28,2003, the Company has Federal NOLs totaling $11.2 million, which expire invarying amounts through 2012.  Should more than a 50% change in Companyownership occur within a three-year period, utilization of these losses toreduce future years’ taxable income would be further limited. State income andfranchise deferred tax assets include approximately $166,000 in CaliforniaManufacturer’s Tax Credits available to offset future California income taxes,expiring in varying amounts through 2012.

 

The Company realizes taxbenefits as a result of the exercise of non-qualified stock options and theexercise and subsequent sale of certain incentive stock options (disqualifyingdispositions). For financial reporting purposes, any reduction in income taxobligations as a result of these tax benefits is credited to additional paid-incapital. In the years 2001, 2002, and 2003 tax benefits of disqualifyingdispositions totaling $562,200, $494,080, and $1,091 respectively have been credited to stockholders’equity.

 

**9**.                                      **Litigationand Contingencies**

 

TheCompany and two of its officers and directors have been named as defendants intwo consolidated purported securities class action cases filed in the NorthernDistrict of California:  Wietschner v.Monterey Pasta Company et al., No. C 03-00632 MJJ filed on February 13,2003; Moore-Warner v. Monterey Pasta Company et al., No. C 03-1072 MJJ filed onMarch 12, 2003.  The cases purportto be brought on behalf of a class of all persons who purchased the commonstock of the Company from July 11, 2002 through December 16,2002.  The complaints allege thatdefendants issued false statements regarding expected earnings and revenues, inviolation of Sections 10(b) and/or 20(a) of the Securities Exchange Act of1934.  No specific amount of damages isclaimed.  On July 11, 2003, leadplaintiffs filed a consolidated complaint. The Company moved to dismiss, and that motion was heard onOctober 21, 2003.  OnNovember 5, 2003 the court granted the Company’s and the defendants’demurrers (Motion to dismiss) with 20 days to amend the complaint.  On January 5, 2004, the Company filed amotion to dismiss for failure to prosecute. Accordingly, the lawsuit has concluded

 

OnFebruary 20, 2003, a purported shareholder derivative complaint was filedin the Superior Court, County of Monterey, Imperial County Employees’Retirement System v. Hewitt et al., No. M63679.  The complaint alleges claims for breach of fiduciary duty, grossnegligence, waste, and abuse of control against the directors of the Company,based in substantial part on the same allegations as the securities classaction complaints.  On June 13,2003, the Court granted the Company’s and the individual defendants’ demurrersto the case without leave to amend. After judgment was entered, plaintiff fileda notice of appeal. The parties subsequently agreed that the appeal would bedismissed, with each side to bear its own costs.  The stipulation to this effect has been filed with the SuperiorCourt.  Accordingly, the lawsuit hasconcluded.

 

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OnFebruary 18, 2004, a complaint was filed by BC-USA, Inc. a/k/a BongrainCheese USA against the Company, James M. Williams, its Chief Executive Officer,and CIBO Naturals, LLC in the King County Superior Court, State of Washington.  Mr. Williams was Chief Executive Officer ofBongrain Cheese USA prior to his employment by the Company.  The complaint pleads several causes ofaction based principally upon an allegation that Mr. Williams, by participatingin the acquisition of CIBO naturals, LLC by Monterey Pasta Company, breachedagreements between himself and Bongrain Cheese USA. The complaint seekspreliminary and permanent injunctive relief enjoining the defendants from usingor disclosing confidential, proprietary or trade secret information of BongrainCheese USA, plus unspecified damages. Management believes that plaintiffs’ allegations are without merit andintends to contest the case vigorously.

 

TheCompany will incur legal fees in defending these lawsuits. At this time, theCompany cannot estimate the amount of fees that will be incurred.  There are no other material legalproceedings pending to which the Company is a party or to which any of itsproperty is subject.  The Company is aparty to ordinary routine litigation incidental to the Company’s business.

 

**10**.                               **SignificantCustomers**

 

Costco and Sam’s Club(including Wal-Mart Supercenters) stores each accounted for portions of totalrevenues as follows:

 
|                    |   | **2001** |   | **2002** |   | **2003** |   |
|-------------------------|--------|----------|--------|----------|--------|----------|--------|
| Costco                  |   | 48       | %      | 43       | %      | 34       | %      |
| Sam’s  Club stores |   | 31       | %      | 31       | %      | 32       | %      |

 

At December 29,2002, and December 28, 2003, Costco and Sam’s Club stores accounted forthe following concentration of accounts receivable:

 
|                    |   | **2002** |   | **2003** |   |
|-------------------------|--------|----------|--------|----------|--------|
| Costco                  |   | 35       | %      | 33       | %      |
| Sam’s  Club stores |   | 33       | %      | 32       | %      |

 

The Company currentlysells its products to eight separate Costco regions which make purchasingdecisions independently of one another. On a regular basis, these regions re-evaluate the products carried intheir stores.  There can be no assurancethat these Costco regions will continue to offer Monterey Pasta’s products inthe future or continue to allocate Monterey Pasta the same amount of shelfspace.  Purchasing decisions for Sam’sClub stores (“Sam’s”) and Wal-Mart Supercenters, the Company’s second largestcustomer, are made at their respective head offices with input from thestores.  While the Company is in theseventh year of its relationship with Sam’s, it is in the second year of itsrelationship with Wal-Mart. On February 2, 2004 the Company announced thatWal-Mart Supercenters discontinued its private label program which could impactthe Company’s profitability. There can be no assurance that Sam’s Club willcontinue to carry the Company’s products. Currently, the loss of either Costco or Sam’s would materially adverselyaffect the Company’s business operations.

 

No other single customeraccounted for more than 10% of revenues or accounts receivable.

 

**11.****                               SupplementalCash Flow information**

 
|                                                |   | **2001** |   | **2002** |   | **2003** |   |
|-----------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| ***Cash payments:***                                |   |     |   |     |   |     |   |
| Interest                                            |   | $        | 4,719  |     | $      | 5,134    |   | $ | 750 |   |
| Income  Taxes                                       |   | 230,975  |   | (119,763 | )      | 166,181  |   |
|                                                |   |     |   |     |   |     |   |
| ***Non-cash Financing and Investing  Activities:*** |   |     |   |     |   |     |   |
| Purchase  of leased equipment                       |   | 10,954   |   | —   |   | —   |   |
|                                                     |        |          |        |          |        |          |        |  |  |  |

 

**12.****                               EmployeeBenefit Plan**

 

In 1996, the Companyinstituted a 401(k) Plan covering substantially all full-time employees withsix months of service.  Under the Plan,employees may elect to defer up to 15% of compensation (subject to certainlimitations).  Prior to 2003 the Companymatched one-half of employee contributions up to 6% of compensation.  Beginning in January 2003 the Companyadopted a Safe Harbor Plan and will match employee contributions up to 4% ofcompensation.  In addition, the Companymay make an annual discretionary profit-sharing contribution.   Employee contributions, Company matchingcontributions and related earnings are always 100% vested.  Company profit-sharing contributions andrelated earnings vest 20% a year, with 100% vesting

 

43

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after five years ofservice.  During 2001, 2002 and 2003,the Company’s expense for matching contributions was $109,619, $121,507, and$191,280, respectively; there were no profit-sharing contributions for 2001,2002, or 2003.

 

**13.****                               Goodwilland Other Intangible Assets**

 

Goodwill and otherintangible assets consist of:

 
|                                                        |   | **Year-end  2002** |      | **2003  Additions** |   | **Year-end  2003** |   |
|-------------------------------------------------------------|--------|--------------------|-----------|---------------------|--------|--------------------|--------|
| Trademark  and****Tradenames                                |   | $                  | 819,376   |                | $      | —             |   | $ | 819,376 |   |
| Customer  list                                              |   | 1,500,000          |      | —              |   | 1,500,000          |   |
| Other  intangibles                                          |   | 456,977            |      | —              |   | 456,977            |   |
| Goodwill  and other intangibles not separately quantifiable |   | 5,063,106          |      | 79,135              |   | 5,142,241          |   |
|                                                        |   | $                  | 7,839,459 |                | 79,135 |               | $      | 7,918,594 |   |
| Less  accumulated amortization                              |   | 931,092            |      | 243,353             |   | 1,174,445          |   |
| Net  intangible assets                                      |   | $                  | 6,908,367 |                | $      | (164,218           | )      | $ | 6,744,149 |   |

 

All of the Company’sbusiness combinations were accounted for using the purchase method.  As of December 28, 2003, the netcarrying amount of goodwill was $4,748,000 and other intangible assets was$1,996,000.  Amortization expense for2003 was $243,000.  The Companyperformed annual impairment testing as required by SFAS 142 at the beginning ofthe fourth quarter of 2003 to determine if any writedowns were necessary, withno impairment adjustments needed.

 

Thefollowing table reflects the components of trademarks and other intangibleassets as of December 28, 2003. Total amortization expense for the year-ended December 28, 2003 was$243,000.

 
|                                           |   | **Gross Carrying Amount** |      | **Accumulated Amortization** |   | **Net Carrying Amount** |   |
|------------------------------------------------|--------|---------------------------|-----------|------------------------------|--------|-------------------------|--------|
| Amortized intangible assets:                   |   |                      |      |                         |   |                    |   |
| License agreements, recipes, and customer list |   | $                         | 2,176,353 |                         | $      | 780,593                 |   | $ | 1,395,760 |   |
| Non-amortized intangible assets:               |   |                      |      |                         |   |                    |   |
| Trademark                                      |   | 600,000                   |      | —                       |   | 600,000                 |   |
| Total gross and net carrying amounts           |   | $                         | 2,776,353 |                         | $      | 780,593                 |   | $ | 1,995,760 |   |

 

Followingis table of estimated amortization expense for the next five years:

 
| **Year** |   | **Estimated  Amortization Expense** |    |
|----------|--------|-------------------------------------|---------|
| 2004     |   | $                                   | 205,000 |   |
| 2005     |   | 197,000                             |    |
| 2006     |   | 162,000                             |    |
| 2007     |   | 156,000                             |    |
| 2008     |   | 156,000                             |    |
|          |        |                                     |         |  |

 

**14.****                               Business Acquisitions**

 

***The Emerald Valley Purchase***

 

On August 23,2002 the Company purchased the operating assets and inventory of Emerald ValleyKitchen, Inc. (“Emerald Valley”), a Eugene, Oregon based producer of organicfresh salsas, dips, hummus, and sauces with over 90% retail chain distribution.The Company considered this purchase an opportunity to enter the rapidlygrowing organic food market.  Theconsideration to the sellers consisted of $5,744,000 in cash.  Additionally, the Emerald Valley owners areeligible to receive an earn-out based upon Emerald Valley Earnings beforeInterest, Taxes, Depreciation, and Amortization (“EBITDA”) above apredetermined level for the first five years after the acquisition date.  The earn-out will be calculated annually atthe end of successive twelve-month periods following acquisition and anyamounts due will be treated as additional purchase price.  A payment of $79,000 was made in 2003 underthis earn-out agreement.  Funding forthe transaction came from existing cash balances.

 

44

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The total considerationof $5,744,000, plus related acquisition costs of $188,000, was allocated asfollows: The trademark, which has been included in intangible assets, willcontinue to be used for an indefinite period. Therefore, this asset will not be amortized on a monthly basis, but willbe tested for impairment annually in keeping with SFAS 142.  Recipes will be amortized over a three-yearlife.  The customer list will beamortized over a ten-year life.

 
| Inventories             |   | $         | 299,000   |   |
|-------------------------|--------|-----------|-----------|--------|
| Fixed  assets           |   | 120,000   |      |
| Customer  List          |   | 1,500,000 |      |
| Trademark               |   | 600,000   |      |
| Recipes                 |   | 60,000    |      |
| Goodwill                |   | 3,353,000 |      |
| Total  acquisition cost |   | $         | 5,932,000 |   |

 

Also in 2002, the Companypurchased certain recipe information from Chet’s Fine Foods and certaintrademark rights and recipes from Isabella’s Kitchen, LLC.  The total amount paid for these assets was$150,000.  Therefore total expenditureson the acquisition of business operating assets equated to $6,082,000 in 2002.

 

No acquisitions occurredin 2003, however, the Company announced on January 28, 2004 theacquisition of an 80% interest in CIBO Naturals LLC (“CIBO”), a leadingmanufacturer of premium sauces and spreads located in Seattle, Washington.  Monterey Pasta paid CIBO and its members$6.0 million cash for 80% interest in CIBO and loaned CIBO $1.0 million.  Additionally, the acquisition agreementprovides for the purchase of the remaining 20% ownership after four years at apredetermined calculation based on earnings before taxes.  The cash came partly from the Company’s cashbalances and from its credit facilities

 

CIBO produces a varietyof refrigerated gourmet sauces and spreads including fresh pesto sauces,flavored cheeses, bruschetta toppings and tapenade spreads.  Their products are sold nationally throughclub stores, supermarket delis and specialty food stores. CIBO fits well withthe Company’s growth strategy in premium refrigerated foods.  CIBO through its “CIBO Naturals” brand sellsunique, high quality products and has developed a strong position in itsmarkets which has great growth potential in both expanded distribution and innew products.

 

**15.****                               SubsequentEvents**

 

The Company announced onJanuary 28, 2004 the acquisition of an 80% interest in CIBO Naturals LLC,a leading manufacturer of premium sauces and spreads located in Seattle, Washington.  Monterey Pasta paid CIBO and its members$6.0 million cash for 80% in CIBO and loaned CIBO $1.0 million.  Additionally, the acquisition agreementprovides for the purchase of the remaining 20% ownership after four years at apredetermined calculation based on earnings before taxes.  The cash came partly from the Company’s cashbalances and from its credit facilities

 

The Company announced onFebruary 2, 2004 that Wal-Mart Supercenters had discontinued its privatelabel pasta and sauce program.  TheCompany had been the supplier of both the pastas and the sauces for thisprogram.  This private label businessrepresented $3,490,000 in Net Revenues in 2003.

 

OnFebruary 18, 2004, a complaint was filed by BC-USA, Inc. a/k/a BongrainCheese USA against the Company, James M. Williams, its Chief Executive Officer,and CIBO Naturals, LLC in the King County Superior Court, State ofWashington.  Mr. Williams was ChiefExecutive Officer of Bongrain Cheese USA prior to his employment by theCompany.  The complaint pleads severalcauses of action based principally upon an allegation that Mr. Williams, byparticipating in the acquisition of CIBO naturals, LLC by Monterey PastaCompany, breached agreements between himself and Bongrain Cheese USA. Thecomplaint seeks preliminary and permanent injunctive relief enjoining thedefendants from using or disclosing confidential, proprietary or trade secretinformation of Bongrain Cheese USA, plus unspecified damages.  Management believes that plaintiffs’allegations are without merit and intends to contest the case vigorously.

 

45

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**16.****                               QuarterlyInformation (unaudited)**

 

The summarized quarterlyfinancial data presented on the following page reflect all adjustments which,in the opinion of management, are of a normal and recurring nature necessary topresent fairly the results of operations for the periods presented.

 
|                               |   | **First  Quarter** |       | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |       | **2002**   |   |
|------------------------------------|--------|--------------------|------------|---------------------|--------|--------------------|--------|---------------------|------------|------------|--------|
| **Year  Ended 2002**               |   |               |       |                |   |               |   |                |       |       |   |
|                               |   |               |       |                |   |               |   |                |       |       |   |
| Net  revenue                       |   | $                  | 16,062,000 |                | $      | 13,794,000         |   | $                   | 16,569,000 |       | $      | 15,253,000 |   | $ | 61,678,000 |   |
|                               |   |               |       |                |   |               |   |                |       |       |   |
| Gross  profit                      |   | 6,087,000          |       | 4,919,000           |   | 6,183,000          |   | 5,073,000           |       | 22,262,000 |   |
| Operating  income                  |   | 2,275,000          |       | 1,144,000           |   | 1,989,000          |   | 1,132,000           |       | 6,540,000  |   |
|                               |   |               |       |                |   |               |   |                |       |       |   |
| Net  income                        |   | 1,986,000          |       | 1,100,000           |   | 5,544,000          |   | 861,000             |       | 9,491,000  |   |
|                               |   |               |       |                |   |               |   |                |       |       |   |
| Primary  earnings per common share |   | $                  | 0.14       |                | $      | 0.08               |   | $                   | 0.39       |       | $      | 0.06 |   | $ | 0.68 |   |
|                               |   |               |       |                |   |               |   |                |       |       |   |
| Diluted  earnings per common share |   | $                  | 0.14       |                | $      | 0.07               |   | $                   | 0.38       |       | $      | 0.06 |   | $ | 0.65 |   |

 

 

 
|                               |   | **First  Quarter** |       | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |       | **2003**   |   |
|------------------------------------|--------|--------------------|------------|---------------------|--------|--------------------|--------|---------------------|------------|------------|--------|
| **Year  Ended 2003**               |   |               |       |                |   |               |   |                |       |       |   |
|                               |   |               |       |                |   |               |   |                |       |       |   |
| Net  revenue                       |   | $                  | 16,077,000 |                | $      | 15,311,000         |   | $                   | 14,876,000 |       | $      | 14,226,000 |   | $ | 60,490,000 |   |
|                               |   |               |       |                |   |               |   |                |       |       |   |
| Gross  profit                      |   | 5,585,000          |       | 4,950,000           |   | 3,986,000          |   | 4,048,000           |       | 18,569,000 |   |
| Operating  income                  |   | 1,460,000          |       | 569,000             |   | (408,000           | )      | (213,000            | )          | 1,408,000  |   |
|                               |   |               |       |                |   |               |   |                |       |       |   |
| Net  income                        |   | 912,000            |       | 490,000             |   | (259,000           | )      | (109,000            | )          | 1,034,000  |   |
|                               |   |               |       |                |   |               |   |                |       |       |   |
| Basic  earnings per common share   |   | $                  | 0.06       |                | $      | 0.03               |   | $                   | (0.02      | )          | $      | (0.01 | ) | $ | 0.07 |   |
|                               |   |               |       |                |   |               |   |                |       |       |   |
| Diluted  earnings per common share |   | $                  | 0.06       |                | $      | 0.03               |   | $                   | (0.02      | )          | $      | (0.01 | ) | $ | 0.07 |   |

 

46

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**SCHEDULE II**

**MONTEREYPASTA COMPANY**

**VALUATIONAND QUALIFYING ACCOUNTS**

 
|                                        |   | **Balance, Beginning of 2001** |    | **Additions - Charged to Costs and  Expense** |   | **Deductions - Write-offs Charged to  Reserves** |   | **Balance, End of 2001** |      |
|---------------------------------------------|--------|--------------------------------|---------|-----------------------------------------------|--------|--------------------------------------------------|--------|--------------------------|-----------|
|                                        |   |                           |    |                                          |   |                                             |   |                     |      |
| Allowances  against Receivables —      |   |                           |    |                                          |   |                                             |   |                     |      |
| Spoils,  Returns, Adjustments And Bad Debts |   | $                              | 242,301 |                                          | $      | 1,331,337                                        |   | $                        | 1,268,155 |   | $ | 305,483 |   |
|                                        |   |                           |    |                                          |   |                                             |   |                     |      |
|                                        |   |                           |    |                                          |   |                                             |   |                     |      |
| Inventory  Reserves —                  |   |                           |    |                                          |   |                                             |   |                     |      |
| Spoils  and Obsolescence                    |   | $                              | 27,500  |                                          | $      | 111,000                                          |   | $                        | 111,000   |   | $ | 27,500 |   |

 

 
|                                        |   | **Balance, Beginning of 2002** |    | **Additions - Charged to Costs and  Expense** |   | **Deductions - Write-offs Charged to  Reserves** |   | **Balance, End of 2002** |      |
|---------------------------------------------|--------|--------------------------------|---------|-----------------------------------------------|--------|--------------------------------------------------|--------|--------------------------|-----------|
|                                        |   |                           |    |                                          |   |                                             |   |                     |      |
| Allowances  against Receivables —      |   |                           |    |                                          |   |                                             |   |                     |      |
| Spoils,  Returns, Adjustments and Bad Debts |   | $                              | 305,483 |                                          | $      | 2,564,897                                        |   | $                        | 2,343,031 |   | $ | 527,349 |   |
|                                        |   |                           |    |                                          |   |                                             |   |                     |      |
|                                        |   |                           |    |                                          |   |                                             |   |                     |      |
| Inventory  Reserves —                  |   |                           |    |                                          |   |                                             |   |                     |      |
| Spoils  and Obsolescence                    |   | $                              | 27,500  |                                          | $      | 42,000                                           |   |                     |      | $ | 69,500 |   |
|                                             |        |                                |         |                                               |        |                                                  |        |                          |           |  |  |  |  |

 

 
|                                        |   | **Balance, Beginning of 2003** |    | **Additions - Charged to Costs and  Expense** |   | **Deductions - Write-offs Charged to  Reserves** |   | **Balance, End of 2003** |      |
|---------------------------------------------|--------|--------------------------------|---------|-----------------------------------------------|--------|--------------------------------------------------|--------|--------------------------|-----------|
|                                        |   |                           |    |                                          |   |                                             |   |                     |      |
| Allowances  against Receivables —      |   |                           |    |                                          |   |                                             |   |                     |      |
| Spoils,  Returns, Adjustments And Bad Debts |   | $                              | 527,349 |                                          | $      | 3,281,796                                        |   | $                        | 3,297,653 |   | $ | 511,492 |   |
|                                        |   |                           |    |                                          |   |                                             |   |                     |      |
|                                        |   |                           |    |                                          |   |                                             |   |                     |      |
| Inventory  Reserves —                  |   |                           |    |                                          |   |                                             |   |                     |      |
| Spoils  and Obsolescence                    |   | $                              | 69,500  |                                          | $      | 509,541                                          |   | $                        | 527,595   |   | $ | 51,446 |   |

 

47

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 of the Securities Exchange Act of 1934, theRegistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized, in the city of San Francisco, State ofCalifornia, on the 3rd day of March,****2004

 
|   | MONTEREY PASTA COMPANY |
|--------|------------------------|
|   |                   |   |
|   |                   |   |
|   | By:                    | /s/JAMES M. WILLIAMS |   |
|   |                   | James M. Williams |
|   |                   | President and Chief  Executive Officer |
|   |                   |   |
|   | By:                    | /s/SCOTT WHEELER |   |
|   |                   | Scott Wheeler |
|   |                   | Chief Financial Officer |
|        |                        |  |  |  |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons in the capacities indicated and on thedates indicated.

 
| **Name**                   |   | **Title**                                |   | **Date**           |   |
|----------------------------|--------|------------------------------------------|--------|--------------------|--------|
|                       |   |                                     |   |               |   |
| /s/JAMES  M. WILLIAMS |   | Chief Executive  Officer, President, and |   | March 5, 2004 |   |
| James M. Williams          |   | Director                                 |   |               |   |
|                       |   |                                     |   |               |   |
| /s/CHARLES B. BONNER       |   | Director                                 |   | March 5, 2004 |   |
| Charles B. Bonner          |   |                                     |   |               |   |
|                       |   |                                     |   |               |   |
| /s/F. CHRISTOPHER  CRUGER  |   | Director                                 |   | March 5, 2004 |   |
| F. Christopher Cruger      |   |                                     |   |               |   |
|                       |   |                                     |   |               |   |
| /s/MICHAEL P. SCHALL       |   | Director                                 |   | March 5, 2004 |   |
| Michael P. Schall          |   |                                     |   |               |   |
|                       |   |                                     |   |               |   |
| /s/VAN TUNSTALL            |   | Director                                 |   | March 5, 2004 |   |
| Van Tunstall               |   |                                     |   |               |   |
|                       |   |                                     |   |               |   |
| /s/JAMES WONG              |   | Director                                 |   | March 5, 2004 |   |
| James Wong                 |   |                                     |   |               |   |
|                       |   |                                     |   |               |   |
| /s/WALTER L. HENNING       |   | Director                                 |   | March 5, 2004 |   |
| Walter L. Henning          |   |                                     |   |               |   |
|                       |   |                                     |   |               |   |
| /s/R. LANCE HEWITT         |   | Chairman of the Board                    |   | March 5, 2004 |   |
| R. Lance Hewitt            |   |                                     |   |               |   |

 

48

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**Index to Exhibits**

 
| 3.1   |   | Certificate  of Incorporation dated August 1, 1996 (incorporated by reference from  Exhibit B to the Company’s 1996 Proxy)                                                                                                                                                                                                                                                                                 |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2   |   | Bylaws  of the Company (incorporated by reference from Exhibit C to the 1996 Proxy)                                                                                                                                                                                                                                                                                                                                  |
| 4.1   |   | Form  of Warrant for purchase of the Company’s Common Stock, dated as of  July 1, 1996 (incorporated by reference from Exhibit 4.5 filed with the  Company’s 1996 Form S-3)                                                                                                                                                                                                                           |
| 4.2   |   | Form  of Registration Rights Agreement dated April 1996, among the Company,  Spelman & Co., Inc. and investor (incorporated by reference from Exhibit  10.42 filed with the Company’s Original March 31, 1996 Quarterly Report  on Form 10-Q on May 1, 1996 (“1996 Q1 10-Q”))                                                                                                           |
| 4.3   |   | Stockholder  Rights Agreement dated as of May 15, 1996 between the Company and Corporate  Stock Transfer, as rights agent (incorporated by reference from Item 2 of  Form 8-A filed with the Securities and Exchange Commission on May 28, 1996)                                                                                                                                                                     |
| 4.4   |   | Amendment  to Registration Rights Agreement dated as of April 20, 1997 among the  Company, Spelman & Co., Inc. and investor, amending the Registration  Rights Agreement entered into as of April, 1996 (incorporated by reference  from Exhibit 4.9 filed with the Company’s 1996 Form 10-KA)                                                                                                         |
| 4.5   |   | Registration  Rights Agreement dated as of December 31, 1996 among the Company, Sentra  Securities Corporation and investor (incorporated by reference from Exhibit  4.12 filed with the Company’s 1996 Form 10-K/A)                                                                                                                                                                                       |
| 4.6   |   | Form  of Warrant (“Sentra Warrant”) for purchase of Company’s Common stock dated  March 1997 issued in connection with the Company’s March 1997  Private Placement (incorporated by reference from Exhibit 4.13 filed with the  Company’s Pre-Effective Amendment No. 1 to the Registration Statement on Form  S-3 filed on May 6, 1997 (“1997 Amendment No. 1 to Form S-3)) |
| 4.7*  |   | Stock  Purchase Agreement between the Company and Kenneth A. Steel, Jr. dated  April 29, 1997 (incorporated by reference from Exhibit 4.14 filed with  the 1997 Amendment No. 1 to Form S-3)                                                                                                                                                                                                                    |
| 10.1* |   | Second  Amended and Restated 1993 Stock Option Plan (as amended on August 1,  1996) (incorporated by reference to Exhibit 10.1 filed with the Company’s  1996 Form 10-K)                                                                                                                                                                                                                                   |
| 10.2* |   | 1995  Employee Stock Purchase Plan (incorporated by reference from Exhibit 10.15 to  the Company’s 1994 Form 10-K)                                                                                                                                                                                                                                                                                              |
| 10.3  |   | Monterey  County Production Facility Lease of the Company, as amended (incorporated by  reference from Exhibit 10.03 to the SB-2)                                                                                                                                                                                                                                                                                    |
| 10.4  |   | Amendment  No. 1 dated February 1, 1995 and Amendment No. 2 dated March 1,  1995 to Monterey County Production Facility Lease of the Company  (incorporated by reference from Exhibit 10.6 filed with the 1995 Form 10-K)                                                                                                                                                                                  |
| 10.5  |   | Amendment  No. 3 dated September 12, 1997, and Amendment No. 4 dated  February 6, 1999 to Monterey County Production Facility Lease of the  Company (incorporated by reference from Exhibit 10.5 filed with the Company’s  September 27, 1999 Quarterly Report on Form 10-Q dated November 4,  1999 (“1999 Q3 10-Q”))                                                             |
| 10.6  |   | Trademark  Registration – MONTEREY PASTA COMPANY, under Registration No. 1,664,278,  registered on November 12, 1991 with the U.S. Patent and Trademark  Office (incorporated by reference from Exhibit 10.09 to the SB-2)                                                                                                                                                                                 |
| 10.7  |   | Trademark  Registration – MONTEREY PASTA COMPANY, under Registration No. 1,943,602,  registered on December 26, 1995 with the U.S. Patent and trademark  Office (incorporated by reference from Exhibit 10.24 to the 1995 Form 10-K)                                                                                                                                                                       |
| 10.8  |   | Trademark  Registration – MONTEREY PASTA COMPANY and Design, under Registration No.  1,945,131, registered on January 2, 1996 with the U.S. Patent and  trademark Office (incorporated by reference from Exhibit 10.25 to the 1995  Form 10-K)                                                                                                                                                             |
| 10.9  |   | Trademark  Registration—MONTEREY PASTA COMPANY and Design, under Registration No.  1,951,624, registered on January 23, 1996 with the U.S. Patent and  Trademark Office (incorporated by reference from Exhibit 10.26 to the 1995  Form 10-K)                                                                                                                                                              |
| 10.10 |   | Trademark  Registration—MONTEREY PASTA COMPANY and Design, under Registration No.  1,953,489, registered on January 30, 1996 with the U.S. Patent and  Trademark Office (incorporated by reference from Exhibit 10.27 to the 1995  Form 10-K)                                                                                                                                                              |

 

49

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| 10.11  |   | Registration  Rights Agreement dated as of June 15, 1995 with GFL Advantage Fund  Limited, as amended on October 13 and 19, 1995, respectively (incorporated  by reference from Exhibit 10.2 to the 1995 Q2 10-Q, and Exhibits 10.6 and  10.7 to the Company’s S-3 Registration Statement No. 33-96684, filed on  December 12, 1995 (“1995 S-3”)) |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.12* |   | The  Company’s 401(k) Plan, established to be effective as of January 1,  1996, adopted by the Board of Directors on June 7, 1996 (incorporated by  reference from Exhibit 10.44 to the Company’s Quarterly Report on Form 10-Q  on August 13, 1996 (“1996 Q2 10-Q”))                                                                        |
| 10.13* |   | Directed  Employee Benefit Trust Agreement dated June 17, 1996 between the Company  and The Charles Schwab Trust Company, as Trustee of the Company’s 401(k) Plan  (incorporated by reference from Exhibit 10.45 to the 1996 Q2 10-Q)                                                                                                                                 |
| 10.14  |   | Security  and Loan Agreement (Accounts Receivable and/or Inventory) dated July 24,  1997 between the Company and Imperial Bank (incorporated by reference from  Exhibit 10.47 of the Company’s Pre-Effective Amendment No. 3 to Form S-3  filed on October 14, 1997 (“1997 Amendment No. 3 to Form S-3”))                                              |
| 10.15* |   | Agreement  Regarding Employment, Trade Secrets, Inventions, and Competition dated May  26, 1997 with Mr. R. Lance Hewitt (incorporated by reference from Exhibit  10.48 of the 1997 Amendment No. 3 to Form S-3)                                                                                                                                                                |
| 10.16* |   | Employment  Agreement dated August 25, 1997 with Mr. Stephen L. Brinkman  (incorporated by reference to Exhibit 10.49, in the Company’s  September 28, 1997 Quarterly Report on Form 10-Q filed on  November 10, 1997)                                                                                                                                      |
| 10.17  |   | First  Amendment to Security and Loan Agreement dated July 24, 1997 between the  Company and Imperial Bank (incorporated by reference from Exhibit 10.50 in  the Company’s 1997 Form 10-K)                                                                                                                                                                            |
| 10.18  |   | Second  Amendment to Security and Loan Agreement dated July 24, 1997 between the  Company and Imperial Bank (incorporated by reference from Exhibit 10.18 filed  with the Company’s 1998 Q3 10-Q)                                                                                                                                                                     |
| 10.19  |   | Security  and Loan Agreement dated July 23, 1998 between the Company and Imperial  Bank (incorporated by reference from Exhibit 10.19 filed with the Company’s  1998 Q3 10-Q)                                                                                                                                                                                         |
| 10.20  |   | Addendum  to Security and Loan Agreement dated July 23, 1998 between the Company  and Imperial Bank (incorporated by reference from Exhibit 10.20 filed with  the Company’s 1998 Q3 10-Q)                                                                                                                                                                             |
| 10.21  |   | Agreement  for Handling and Storage Services between the Company and CS Integrated LLC  dated February 5, 1999 (incorporated by reference to Exhibit 10.21 filed  with the Company’s 1998 Form 10-K on March 17, 1999 (“1998 Form 10-K”))                                                                                                              |
| 10.22  |   | Defined  Contribution Administrative Service Agreement between the Company and First  Mercantile Trust dated December 15, 1999 (incorporated by reference to  Exhibit 10.22 filed with the Company’s 1998 Form 10-K)                                                                                                                                                  |
| 10.23  |   | First  Amendment to Security and Loan Agreement and Addendum thereto between the  Company and Imperial Bank dated July 23, 1999 (incorporated by reference  to Exhibit 10.23 filed with the Company’s April 1, 2001 Quarterly Report  on Form 10-Q filed on April 28, 1999)                                                                                 |
| 10.24  |   | Agreement  for Purchase and Sale of Assets dated as of March 12, 1999, by and among  the Company and the shareholders of Frescala Foods, Inc. (incorporated by  reference from Exhibit 2.1 filed with the Company’s 8-K on March 17,  1999)                                                                                                                      |
| 10.25  |   | Royalty  agreement dated July 12, 1999 between Company and Chet’s Gourmet Foods,  Inc. for soups (incorporated by reference to Exhibit 10.25, in the Company’s  September 26, 1999 Quarterly Report on Form 10-Q filed on  November 9, 1999 (“1999 Q3 10-Q”))                                                                                |
| 10.26  |   | Storage  Agreement Manufactured Products dated August 3, 1999 between the Company  and Salinas Valley Public Warehouse for storage and handling of Company’s  product in Monterey County, California storage facility (incorporated by  reference to Exhibit 10.26, filed with the Company’s 1999 Q3 10-Q)                                                       |
| 10.27  |   | Commercial  Lease dated August 10, 1999 between Company and Salinas Valley Public  Warehouse for storage space in Monterey County, California (incorporated by  reference to Exhibit 10.27, filed with the Company’s 1999 Q3 10-Q)                                                                                                                                    |
| 10.28  |   | Rental  Agreement dated September 6, 1999 between Company and Porter Family  Trust for storage space in Monterey County, California (incorporated by  reference to Exhibit 10.28 filed with the Company’s 1999 Q3 10-Q)                                                                                                                                               |
| 10.29  |   | Royalty  agreement dated September 15, 1999 between Company and Chet’s Gourmet  Foods, Inc. for meatball and sauce item (incorporated by reference to Exhibit  10.29, filed with the Company’s 1999 Q3 10-Q)                                                                                                                                                     |
| 10.30  |   | Credit  Agreement between the Company and Imperial Bank dated August 2, 1999  (incorporated by reference to Exhibit 10.30 filed with the Company’s 1999  Form 10-K on February 18, 2000 (“1999 Form 10-K”))                                                                                                                                            |

 

50

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| 10.31  |   | First  Amendment to Credit Agreement between the Company and Imperial Bank dated  August 2, 1999 (incorporated by reference to Exhibit 10.21 filed with  the Company’s 1999 Form 10-K)                                                                                                                                                   |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                               |
| 10.32  |   | Commercial  lease dated January 1, 2000 between the Company and PTF for Operating  Engineers, LLC for storage space in Monterey County, California (incorporated  by reference to Exhibit 10.32, in the Company’s June 25, 2000 Quarterly  Report on Form 10-Q filed on August 4, 2000)                                        |
| 10.33  |   | Second  Amendment to Credit Agreement between the Company and Imperial Bank dated  August 2, 1999 (incorporated by reference to Exhibit 10.33 in the  Company’s September 25, 2000 Quarterly Report on Form 10-Q filed on  November 6, 2000 (“2000 Q3 10-Q”))                                                        |
| 10.34  |   | Third  Amendment to Credit Agreement between the Company and Imperial Bank dated  August 2, 1999 (incorporated by reference to Exhibit 10.34 in the  Company’s 2000 Q3 10-Q)                                                                                                                                                             |
| 10.35  |   | Royalty  agreement dated February 11, 2000 between Company and William Naim for  development of pizza and calzone recipes and process (incorporated by  reference to Exhibit 10.35 filed with the Company’s 2000 Form 10-K on  February 7, 2001 (“2000 Form 10-K”))                                                       |
| 10.36  |   | Fourth  Amendment to Credit Agreement between the Company and Imperial Bank dated  August 2, 1999 (incorporated by reference to Exhibit 10.36 filed with  the Company’s 2000 Form 10-K)                                                                                                                                                  |
| 10.37  |   | Asset  Purchase Agreement dated as of December 8, 2000, by and among the  Company and the shareholders of Elena’s Food Specialties, Inc. (incorporated  by reference to Exhibit 10.37 filed with the Company’s 2000 Form 10-K)                                                                                                      |
| 10.38  |   | Limited  License for use of Nate’s brand dated as of December 8, 2000, by and  among the Company and the shareholders of Elena’s Food Specialties, Inc.  (incorporated by reference to Exhibit 10.38 filed with the Company’s 2000  Form 10-K on February 7, 2000)                                                        |
| 10.39  |   | Fifth  Amendment to Credit Agreement between the Company and Imperial Bank dated  August 2, 1999 (incorporated by reference to Exhibit 10.39 in the Company’s  April 1, 2001 Quarterly Report on Form 10-Q filed on May 7, 2001)                                                                                                    |
| 10.40  |   | Lease  Extension and Modification Agreement between the Company and Marco Warehouse  d.b.a. Salinas Valley Public Warehouse dated September 1, 2001  (incorporated by reference to Exhibit 10.40 in the Company’s  September 30, 2001 Quarterly Report on Form 10-Q filed on  November 7, 2001)                                |
| 10.41  |   | Royalty  Agreement dated January 18, 2002 between Company and Toscana Foods, LLC  for ravioli with unique rough chopped filling (incorporated by reference to  Exhibit 10.41 in the Company’s June 30, 2002 Quarterly Report on Form  10-Q filed on August 9, 2002)                                                            |
| 10.42  |   | Asset  Purchase Agreement dated August 23, 2002 by and among the Company and  the shareholders of Emerald Valley Kitchen, Inc. (incorporated by reference  from Exhibit 10.42 filed with the Company’s 8-K on August 30, 2002)                                                                                                      |
| 10.43  |   | Commercial  lease dated August 23, 2002 between the Company and Mel Bankoff for  plant, warehouse and office space in Eugene, Oregon (incorporated by  reference from Exhibit 10.43 filed with the Company’s 8-K on August 30,  2002)                                                                                               |
| 10.44  |   | Commercial  lease dated January 3, 2003 between the Company and Conrad Family Trust  for office space in Salinas, Monterey County, California (incorporated by  reference from Exhibit 10.44 filed with the Company’s 2002 Form 10-K filed on  February 14, 2003)                                                                   |
| 10.45  |   | Second  Lease modification to Commercial lease dated January 1, 2000 between the  Company and PTF for Operating Engineers, LLC for storage space in Monterey  County, California (incorporated by reference from Exhibit 10.45 filed with  the Company’s June 29, 2003 Quarterly Report of Form 10-Q filed on  August 7, 2003) |
| 23.1** |   | Consent  of BDO Seidman, LLP                                                                                                                                                                                                                                                                                                                       |
| 31.1** |   | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                                                                                          |
| 31.2** |   | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                                                                                          |
| 32.1** |   | Certification  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                      |
| 32.2** |   | Certification  of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                      |

 

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*                 Managementcontract or compensatory plan or arrangement covering executive officers ordirectors of the Company and its former subsidiary, Upscale Food Outlets, Inc.

 

**          filed herewith

 

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