** **

**UNITED STATES 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**                                                                                                                                                                                                                                                |
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|       |       |                                                                                                                                                                                                                                                                                                                                               |
|       |       | **For the  fiscal year ended December 26, 2004**                                                                                                                                                                                                                                                                                              |
|       |       |                                                                                                                                                                                                                                                                                                                                               |
| **OR**     |
|       |       |                                                                                                                                                                                                                                                                                                                                               |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                           |
|       |       |                                                                                                                                                                                                                                                                                                                                               |
|       |       | **FOR THE  TRANSITION PERIOD  FROM                         TO                         ** |

 

**Commission file number 0-22534-LA**

 

**MONTEREY GOURMET FOODS, INC.**

(Exact name of registrant 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**                     |

 

Indicateby check mark whether registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months, and (2) has been subject to such filingrequirements for the past 90 days.

Yes  ý                  No  o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof the registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.  ý

 

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

 

Yes  o                  No  ý

 

Theapproximate aggregate market value of the voting and non-voting common equityheld by non-affiliates of the issuer as of June 27, 2004****was $27,988,000.  Thenumber of shares outstanding of the issuer’s common stock as of March 25,2005 was 14,392,574.

 

 

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**PART I**

 

**ITEM 1.****                  BUSINESS**

 

**Introduction**

 

MontereyGourmet Foods, Inc. formerly****Monterey PastaCompany (“the Company”) began its business in 1989 as a producer anddistributor of refrigerated gourmet pasta and sauces to restaurants and grocerystores in the Monterey, California area. The Company has since expanded its operations to include a morediversified range of gourmet refrigerated food products, which it provides togrocery and club stores throughout the United States, as well as selectedregions in Canada, the Caribbean, Latin America, and Asia Pacific.  The Company’s overall strategy is to enhancethe value of the Monterey Gourmet Foods brand by distributing its gourmet foodproducts through multiple channels of distribution, while selectivelyparticipating in private label partnerships.

 

TheCompany currently produces and markets premium quality refrigerated gourmetpastas, gnocchi, pasta sauces, 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 Company offers over 250varieties of contemporary gourmet food products that are produced using theCompany’s proprietary recipes.   In 2004,the Company introduced new prepared food items such as the grilled wrappedsandwiches, expanded its line of “quick preparation” gourmet entrées, expandedits distribution of reduced-carbohydrate pastas and sauces and began the introductionof a line of whole wheat pastas.  In2003, the Company introduced new prepared food items such as lasagna and stuffedmanicotti along with a line of reduced-carbohydrate pasta products under the**CARB-SMARTTM Brand, and several extensions ofexisting lines.

###### ** **

On January 11,2005, as a subsequent event, Monterey Gourmet Foods, Inc., Casual GourmetFoods, Inc., and the shareholders of Casual entered into a definitiveagreement for the purchase by Monterey Gourmet Foods of 60% of Casual’soutstanding shares andfor the acquisition by Monterey Gourmet Foods of Casual’s remainingshares over the next three years.  Casual, which produces branded gourmetsausages, prepared soups and other food products, is a Florida corporation withheadquarters in Tampa, Florida.

 

In2004, the Company acquired an 80% interest in CIBO Naturals LLC (“CIBO”), aleading manufacturer of premium sauces and spreads located in Seattle,Washington.  CIBO produces a variety ofrefrigerated gourmet sauces and spreads including fresh pesto sauces, flavoredcheeses, bruschetta toppings and tapenade spreads.  Their products are sold nationally throughclub stores, supermarket delis and specialty food stores. The CIBO acquisitionmeets the Company’s strategy for growth in the premium refrigerated foodscategory.  CIBO, through its “CIBONaturals” brand, sells unique, high quality products and has developed a strongposition in its markets which has great growth potential in both expanded distributionand in new products.

 

###### **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. In 2004, the Company introduced new wrapped sandwiches, baked panninisand whole wheat pasta.**

###### ** **

TheCompany sells its products through leading grocery store chains includingAlbertson’s, King Soopers, Safeway,  FredMeyer, Kroger, Raley’s, Trader Joe’s, Wegmans, Dominick’s, Hannaford Brothers,Shop Rite, Jewel and QFC; and warehouse club stores including Costco Wholesale,Sam’s Club, a division of Wal-Mart, and BJ’s. As of December 26, 2004, approximately 9,600 grocery and clubstores offered Monterey Gourmet Foods’ products.

 

The Companyalso has a web site, www.montereygourmetfoods.com**,**tofurther support its brand by providing both consumer and investor information.  The site provides insight into the Company’sprofile, product offerings, financial strength, as well as consumer tips forthose interested in gourmet food.

 

The success of the Company’s sales efforts will dependin large part on four key factors: (1) whether grocery and club storechains will continue to increase the number of their stores offering theCompany’s products, (2) whether the Company can continue to increase thenumber of grocery and club store chains offering its products, 3) whether theCompany can continue to introduce new products that meet consumer acceptanceand 4) whether the Company can diversify into other complementary businessesand leverage its strengths to continue to grow revenues and profits at levels attractiveto its investors.  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.

 

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MontereyGourmet Foods was originally incorporated in California in June 1989 andwas reincorporated in Delaware in August 1996. The Company’s executiveoffices and principal facilities are located at 1528 Moffett Street, Salinas,California 93905.  The Company’stelephone number is (831) 753-6262. Investors can obtain copies of theCompany’s periodic reports and proxy material from the Company’s website freeof charge, as well as from the SEC’s website at www.sec.gov.

 

This Form 10-K contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, and Section 21E of the Securities Exchange Act of 1934, that involvesubstantial risks to the Company, including statements about the Company’s pastand present operating losses, the ability to attract and retain qualifiedmanagement, the impact of inflation, food production risks, dependence on majorcustomers, and marketing and sales risks. Also risks associated with processingand distributing refrigerated food products, changing customer preferences andintegration of acquired companies.  Inconnection therewith, please see the cautionary statements contained herein in “BusinessRisks” which identify important factors that could cause actual results todiffer materially from those in the forward-looking statements.

 

**IndustryOverview**

 

TheCompany believes that the U.S. retail market for refrigerated specialty foodsis fragmented and growing.  Although refrigerated pasta products are notnew, fresh pasta and pasta sauce were essentially created as a nationalspecialty food category in 1986.

 

Whilethe market for refrigerated gourmet food products is fragmented, with a largenumber of national, regional and local competitors, the Company believes thatit can be successful in this market by offering higher quality, upscaleproducts with superior flavor profiles. The Company also believes that it can leverage its existing presence inclub stores to gain distribution of its prepared food products.

 

Theorganic food business has been growing at a double-digit rate since the 1960sand has now reached over $10 billion in retail sales, according to OrganicTrade Associations 2004 Manufacturing Survey.  New Federal standards,under the auspices of the United States Department of Agriculture (“USDA”),were adopted for the industry in October 2002.  The purpose of thenew standards was to provide a framework for organic content of product withthe use of the USDA seal for those products meeting the “organic” definition(95% organic content), and set standards for product quality and food safety soas to improve the overall strength of the organic foods industry and protectthe consumer.  Emerald Valley and other credible producers who meet thestandards to be labeled USDA organic will be in an excellent position toparticipate in the future growth of the industry.  Currently all EmeraldValley products qualify for the USDA designation.  The Company’s futureorganic offerings will be produced and formulated with the objective ofqualifying for the USDA designation.

 

Noassurance can be given that the market for refrigerated gourmet food productswill expand further and that space will be made available at the store level tohouse refrigerated products.  Nor can there be any assurance that currenttrends in healthy gourmet eating, perception of many of the Company’s productsas healthy gourmet eating alternatives, consumer demand for quick mealsolutions, or consumer spending levels in the specialty food category willcontinue in the future.  Additionally, as the Company expands intodifferent geographic regions and new product categories, it may encounterdifferent consumer perceptions, diet trends, attitudes and behavior.  Thismay adversely impact the Company’s expansion strategy and cause it to incurgreater expenses in the promotion of its products.

 

**Strategy**

 

MontereyGourmet Foods’ overall objective is to become a leading national supplier ofrefrigerated gourmet food products through distribution of its products togrocery and club stores and through key acquisitions.  The key elements ofthe Company’s strategy include the following:

 

**•**      Expandmarket share through same-store revenue growth, addition of new grocery andclub stores, geographic and product line diversification, including creation ofadditional meal solutions using Monterey Gourmet Food products.

 

**•**      Introducenew products on a timely basis to maintain customer interest and to respond tochanging consumer tastes.  In order to maximize its margins, the Companywill focus most of its efforts on those new products that can be manufacturedand distributed out of its Salinas, California, Eugene, Oregon or Seattle,Washington facilities, and may supplement this effort by selected co-packingarrangements that compliment its existing product 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 Gourmet Foodsprovides a healthful and nutritious line of products, and therefore, promoterepeat business by reinforcing positive experiences with the Company’sproducts.

 

**•**      Considerthe acquisition of other compatible companies or product lines to expanddistribution, 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.

 

TheCompany will continue to direct its advertising and promotional activities tospecific programs customized to suit its grocery and club store accounts aswell as to reach target consumers.  These will include in-storedemonstrations, coupon programs, temporary price reduction promotions, and otherrelated activities. There can be no assurance that the Company will be able toincrease its net revenues from grocery and club stores.  Because theCompany will continue to make expenditures associated with the expansion of itsbusiness, the Company’s results of operations may be affected.

 

Thesuccess of the Company’s acquisition strategy is dependent upon its ability togenerate cash from current operations, attract new capital, find suitableacquisition candidates, and successfully integrate new businesses andoperations.  There is no assurance that acquisitions can be financed fromcurrent cash flow, and, if not, that outside sources of capital will beavailable to supplement internally-generated funds.  There is no assurancethat management can successfully select suitable acquisition candidates andthat these new businesses can be successfully integrated to create long termstockholder value.

 

**Products**

 

The Company produces and markets a variety of gourmetrefrigerated pasta; including borsellini, ravioli, tortelloni, tortellini;pasta sauces; panninis; salsas; dips; hummus; and polenta under the MontereyGourmet Foods, Monterey Pasta, Arthur’s, CIBO Naturals, La Frescala and EmeraldValley Kitchen brands, as well as private labels.  Arthur’s is a mid-priced pasta and saucelabel, which was acquired as part of the March 1999 acquisition of SanAntonio Texas-based Frescala Foods, Inc. (“Frescala”).  The Emerald Valley Kitchen brand was acquiredas part of the Emerald Valley acquisition in August 2002.  For further information, see “Liquidity,Capital Resources, and Business Acquisitions”.

 

The Company is committedto diversifying its offerings with innovative new product line extensions,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 are introduced,selected items will be discontinued to help ensure that the product line isfocused on consumer demand, to maximize the Company’s return on its shelf spacein grocery and club stores, and to respond to changing trends and consumerpreferences.

 

The Company’s refrigerated products are packagedpredominantly in clear lightweight containers, which reveal the freshappearance of its products.  Monterey GourmetFoods presents its products with a colorful logo, distinctive graphics,ingredient information and cooking instructions to communicate the gourmet,fresh and healthful qualities of its products. All of the Company’s products now feature newly redesigned packaging tomaximize shelf impact and generate increased consumer interest in the products,with increased emphasis on quickly informing the consumer about theproducts.  The Company will continue toemphasize innovative packaging techniques to maximize appeal on the shelf.

 

The goal of the Company is to introduce new productson a timely and regular basis to increase customer interest and to respond tochanging consumer tastes.  There can beno assurance that the Company’s efforts to achieve such a goal will result insuccessful new products or product lines or that new products can be developedand introduced on a timely and regular basis. If the Company’s new products are not successful, the Company’s groceryand club store sales may be adversely affected as customers seek new products.

 

**Production**

 

The Company currently produces pasta, pasta sauce andwrapped sandwiches in a 43,700 square foot Monterey County, Californiafacility.  The Company also leases 89,200square feet of space three miles from the main production facility.  Within this 89,200 square foot facility, theCompany has its refrigerated distribution center, a prepared foodsmanufacturing line and ambient storage  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. CIBONaturals LLC which operates out of a 17,500 square foot facility in Seattle, WAwas acquired in 2004. The California facilities are strategically located inone of the largest produce-growing regions in the United States and are nearseveral major vendors and food distributors. Both California facilities are certified by the USDA and utilize stateof the art thermal processing, chilling and packaging processes.  The Company employs a

 

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total of approximately 279 persons at all locations, including 63administrative personnel, eight sales personnel, five drivers, and 203distribution and production personnel. For additional information, see “Employees” on page 7.

 

Refrigerated pasta is manufactured at the Californiafacilities using high quality ingredients such as Extra Fancy Durham wheat,whole eggs or egg whites, fresh and dry herbs and Individually Quick Frozen (“IQF”)vegetables and spices, and cheeses and milk products.  The ingredients are mixed in accordance withthe Company’s proprietary recipes.  Afterfilling with fresh and unusual ingredients such as snow crab, spinach, fetacheese, lobster, and other types of specialty cheeses, the pasta productsreceive a prescribed thermal process, or pasteurization to insure productsafety and to preserve flavor, quality and shelf life.  The products are then chilled immediately andpackaged 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.  Thenew “quick preparation” baked products are baked in new rotary tray ovens.After preparation, processing, chilling and packaging, all pasta, bakedproducts, and sauces are kept in cold storage to preserve quality and shelflife. The new grilled wrapped sandwiches are produced with proprietary recipes,hand rolled in a special tortilla, grilled and quickly packaged to preserveflavor, quality and shelf life.

 

The Company regularly reviews a variety of potential capitalprojects for the production department and in the past three years has spentapproximately $8.6 million on capital improvements. These included significantupgrades and improvements to the pasta production lines, two packaging lines,capacity for chunky ravioli, a new jar sauce filling line, two clean rooms,increased sauce capacity and efficiency, a pizza/calzone line, and boiler andutility upgrades to accommodate capacity increases.  Capital resources were used to improve saucelabeling, borsellini pasta production capability, and upgrade the ingredientsblending area.  The new productionfacility, established during 2003, added approximately 30 percent of additionalpasta manufacturing capacity at a cost, including leasehold improvements, ofapproximately $2.1 million.  Also in2003, the Company added the ability to produce items in the rapidly growingprepared foods category, and corresponding plant improvement to accommodatethese new products. Also added were automated filling equipment that reducedoperating costs. Future additions of assets will be evaluated for increasedefficiency, flexibility and capacity needs. In 2004, only $.8 million was spenton capital spending.  Of this amount $.25million was spent at the newly acquired CIBO facility to upgrade its fillingand packaging equipment.  Projectscompleted in 2004 consisted of improved packaging equipment for the new “quickpreparation” baked line to improve product quality and consistency, productpouching equipment which allows the company to sell its products in a pouch andother smaller projects to ensure product safety.

 

###### **Raw Materials**

###### ** **

###### **The Companypurchases its raw materials from vendors throughout the United States and theworld, although over 90% by dollar volume comes from domestic sources, and themajority 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 which are one year or less in duration, as well asopen market purchases to minimize the pricing risks and uncertainty ofsupply.  The Company does have onelong-term contract with its liquid nitrogen provider**which expires November 30,2007.

###### ** **

###### **Themost important ingredients used are dairy-based ingredients, eggs, flour, cookedseafood, cooked chicken and other meats, spinach, basil, and spices.  Management is unaware of any currentrestrictions or other factors that would have a material adverse effect on theavailability of these raw materials.  TheCompany’s purchasing policies are designed to provide more than one crediblesource for all ingredients.  In 2004, theCompany experienced higher than normal raw material costs in protein and dairybased ingredients.  Higher raw materialcosts have impacted gross margin by approximately 3% when compared to 2003.**

###### ** **

###### **Distribution**

###### ** **

The Company’s success depends upon an effective system of distributionfor its products.  In NorthernCalifornia, the Company maintained three direct store delivery (“DSD”) routesto deliver its products to approximately 140 stores until February 2005when these routes were transferred to a more cost efficient outside distributor.The Company also delivers products directly to warehouses for several NorthernCalifornia chains.  To distribute itsproducts to other customers and other parts of the country which is over 90% ofits business, the Company uses common carriers. The dependence on other companies for delivery of its products poses arisk to the Company.  While the commoncarrier method of delivery has been reliable and available at acceptable ratesthus far, there can be no assurance that the Company will continue to be ableto negotiate acceptable freight rates in the future and that delivery will notbe disrupted for reasons including, but not limited to, adverse weather,natural disasters or labor disputes in the trucking industry.  During 2004, fuel costs increased compared to2003 and impacted the Company’s operating margin in 2004.

 

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**GroceryChain and Club Store Sales**

 

Monterey Gourmet Foods sells its products to chain grocery and clubstores with the approximate number of stores at each year-end listed below:

 
| ** **            | ** ** | **Number of Stores Carrying  Monterey Gourmet Foods Products** | ** ** |
|-----------------------|------------|----------------------------------------------------------------|------------|
| ** **            | ** ** | **2002**                                                       | ** ** | **2003** | ** ** | **2004** | ** ** |
| Retail Grocery Stores |       | 7,780                                                          |       | 7,940 |   | 8,500 |   |
| Club Stores           |       | 920                                                            |       | 1,060 |   | 1,100 |   |
| **Total**             |       | 8,700                                                          |       | 9,000 |   | 9,600 |   |

 

The Company hastwo customers that represent more than ten percent of net revenues.  Net revenues are detailed as follows:

 
| ** **                                        | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                              |       |     |       |     |       |     |       |
| Costco Wholesale                                  |       | 43       | %          | 34       | %          | 36       | %          |
| Sam’s Club (including Wal-Mart Supercenters) |       | 31       | %          | 32       | %     | 24       | %          |
| All other customers                               |       | 26       | %          | 34       | %     | 40       | %          |
|                                              |       |     |       |     |       |     |       |
| Total                                             |       | 100      | %          | 100      | %          | 100      | %          |

 

The Company currently sells its products to eightseparate US Costco regions, Mexico and Canada which make purchasing decisionsindependently of one another.  Theseregions re-evaluate, on a regular basis, the products carried in theirstores.  During 2003, Costco made adecision to reduce the number of items that it offers to its members, whichcaused a reduction in the number of items that the Company sold to Costcoduring 2003 and 2004. There can be no assurance that these Costco regions willcontinue to offer Monterey Gourmet Foods products in the future or continue toallocate Monterey Gourmet the same amount of shelf space. The Company currentlysupplies its products to approximately 458 Sam’s Club stores. Purchasingdecisions for these affiliates are made at the company headquarters with inputfrom the store level.  During the 4thquarter, 2004 Sam’s Club implemented an item reduction program which reducedthe number of items that the Company is currently selling to Sam’s Club andcorrespondingly has reduced the amount of shelf space for the Company’sproducts.  While the Company is in theseventh year of its relationship with Sam’s Club, there can be no assurancethat Sam’s Club stores will continue to carry its products.  On February 2, 2004 the Companyannounced that approximately 1,100 Wal-Mart Supercenters discontinued itsprivate label pasta and sauce program which the Company had been making since2002.  Wal-Mart Supercenter’s privatelabel business represented $2,823,000, $3,490,000 and $147,000 of Net Sales in2002, 2003 and 2004, respectively.  Theloss of either Costco or Sam’s could materially and adversely affect theCompany’s business operations.

 

During 2002, 2003 and 2004 net revenues to foreign customersrepresented 3.0%, 3.4% and 3.4% of total net revenues, with Canada and Mexicoaccounting for over 92% of those sales, and the remainder going to AsiaPacific.

 

**Marketing**

 

The Company’s marketing strategy is to create and sell innovativepremium quality products in the categories in which it competes and tocommunicate to consumers that Monterey Gourmet Foods provides a gourmet qualitynutritious line of products and to promote repeat business by reinforcingpositive experiences with the Company’s products.  The Company’s approach includes theintroduction of new products on a timely basis to increase customer interestand to respond to changing consumer tastes. Additionally, the Company will continue to expand its sales into thosegeographic regions that will best support the purchase of the Company’s upscalepremium grade products.

 

**Competition**

 

The Company’s business is subject to significant competition.  The fresh pasta and pasta sauce industry ishighly competitive and is dominated by two very large multinational companies,Nestle, with its Buitoniâ brand, and Kraft,with its DiGiornoâ brand.  Thereare also a number of regional competitors, such as Olivieriâowned by Maple Leaf Foods of Toronto, Ontario, Canada and Valley Fine Foods,Benicia CA.  Multinational competitorshave significantly more brand name recognition, marketing personnel, and cashresources than the Company.  Moreover,competition for shelf space in club and grocery stores is intense and posesgreat difficulty for smaller food companies.

 

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The Company has developed several products for which there is limitedcompetition currently in the refrigerated sector including borsellini, wholewheat pasta, low carbohydrate pasta, wrapped sandwiches and quick preparationgourmet entrees.  Management willcontinue to try to produce distinctive products, which fill specific nicheswhere there is little or no national competition.

 

Competitive factors in the refrigerated food market include brandawareness, product quality and taste, perceived healthfulness, price andavailability of grocery and club store shelf space. The Company’s prices areslightly higher than most of its competitors’ prices on most items due tohigher quality ingredients and the overall premium quality of its productline.  The Company believes the excellentquality, taste and perceived healthfulness of its products are superior to thatof most of its competitors.  The Companyalso believes that the quality of its products and the variety of its productlines provide a competitive advantage over many companies which market moretraditional products.

 

**Management**

 

Information relating to directors and executive officers of the Companyis set forth in Part III of this report.

 

**GovernmentRegulation**

 

The Company is subject to the regulations of the U.S. Food and DrugAdministration (“FDA”), USDA, state, local, and organic industry regulationsrelating to cleanliness, maintenance of food production equipment, foodstorage, cooking and cooling temperatures, food handling, and organicingredient content of products, and is subject to unannounced on-siteinspections of production facilities. Regulations in new markets, new regulations in existing markets, andfuture changes in existing regulations may adversely impact the Company byraising the cost of production and delivery of its products and/or by affectingthe perceived healthfulness of the Company’s products.  A failure to comply with one or moreregulatory requirements could result in a variety of sanctions, including finesand the withdrawal of the Company’s products from store shelves.  The Company is not aware of any currentlyexisting facts or circumstances that it is not addressing which would cause itto fail to comply with any of the regulations to which it is currently subject.

 

**Employees**

 

As of December 26, 2004, the Company employed a total of 279persons at all locations, including 63 administrative personnel, eight salespersonnel, 2 drivers, 3 driver/salesmen and 203 distribution and productionpersonnel.  None of the Company’semployees are represented by a labor union and the Company believes itsrelations with its employees are good.

 

**Trademarksand Service Marks**

 

The Company has registered the “Monterey Gourmet Foods”, “MontereyPasta Company”, “CIBO Naturals” names and corresponding logo design with theUnited 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,” page 13).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, theUnited States Patent and Trademark Office approved the “Homestyle-Fresh”trademark currently used in the Company’s soup line.  Also the Company acquired the rights to threeunregistered trademarks, “La Frescala”, “Isabella’s Kitchen”, and “EmeraldValley Organics”, as part of acquisitions of businesses.

 

**ITEM 2.****                  PROPERTIES**

 

During 2003, the Companyleased an additional 41,300 square feet of space at its offsite distributioncomplex to accommodate plant expansion and to provide for future growth.  The added space has been only partially developedwith two new production lines brought on-line in the second quarter of2003.  The Company now leasesapproximately 133,000 square feet in Salinas, California, comprised of 43,700at its headquarters facility and 89,200 at its distribution facility threemiles from its headquarters. The headquarters facility is dedicated tomanufacturing operations, offices and its test kitchen.  The distribution complex is comprised of19,800 feet of refrigerated cold storage, 2,100 square feet of office space,26,000 square feet of ambient storage, and the new lease for 41,300 sq. ft.,which is dedicated to production space and storage, with approximately 8,000square feet currently used for production. The current productionfacilities/headquarters lease expired in October 2004.  The Company and the landlord have agreed to aten year extension of the current lease at current fair-market value.  The fair-market value is being determined bya real estate appraiser in the area.  Thefair

 

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market value is likely to create a significantincrease in rent for the Moffett Street facility. The lease for thedistribution center and adjacent production and storage facilities expires in June 2007with two five-year renewal options.

 

On January 2, 2003the Company entered into a three-year lease for an additional 1,200 square feetof office space next door to its headquarters facility in Salinas,California.  The lease commenced March 1,2003 and expires February 28, 2006. In 2004, the Company announced thepurchase of an 80% interest in CIBO Naturals LLC which operates out of a 17,500square foot leased facility in Seattle, WA which expires in May 2005 whichis in the process of being extended for an additional three years.

 

The Company acquired alease for the 19,000 square foot production facility and offices as part of itsacquisition of Emerald Valley.  The leaseexpires December 31, 2007, with three five-year renewal options.

 

Management feels that itsfacilities are adequate to support sales growth for at least 24 months unlessan acquisition is made.  Most of itsfacilities are only operating one shift per day and only running five days perweek.

 

**ITEM 3.****                  LEGALPROCEEDINGS**

 

There are no material legal proceedings pending to whichthe Company is a party or to which any of its property is subject.  The Company is a party to ordinary routinelitigation incidental to the Company’s business.

 

On February 18, 2004, a complaint was filed byBC-USA, Inc. dba Bongrain Cheese USA against the Company, James M.Williams, its Chief Executive Officer, and CIBO Naturals, LLC in the KingCounty Superior Court, State of Washington. Mr. Williams was Chief Executive Officer of Bongrain Cheese USAprior to his employment by the Company. The complaint pled several causes of action based principally upon anallegation that Mr. Williams, by participating in the acquisition of CIBOby the Company, breached agreements between himself and Bongrain Cheese USA.The complaint asked for preliminary and permanent injunctive relief enjoiningthe defendants from using or disclosing confidential, proprietary or tradesecret information of Bongrain Cheese USA, plus unspecified damages.  In July 2004, the Company entered into aconfidential settlement to avoid future litigation and legal costs.  For 2004, the Company expensed $248,000 ofcosts associated with this litigation.

 

The Company incurred legal fees in defending past lawsuits.During 2004, the Company paid $497,000 net of insurance reimbursement to settleall lawsuits and to pay for legal defense and legal advice.

 

**ITEM 4.****                  SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

No matters were submitted to vote of the security holders during thefourth quarter of 2004.

 

**PART II**

 
| **ITEM 5.** | **MARKET FOR THE REGISTRANT’S COMMON EQUITY AND  RELATED STOCKHOLDER MATTERS** |
|-------------|-------------------------------------------------------------------------------------|

 

**PriceRange of Common Stock**

 

The Company went public on December 7, 1993.  Since that date, the Company’s Common Stockhas traded on the NASDAQ National Market System under the symbol “PSTA.”  The following table sets forth for the periodsindicated the high and low sales prices of shares of the Common Stock on theNASDAQ National Market System.

 
| **Fiscal  year 2003:** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------|------------|----------|------------|---------|------------|
| First quarter          |       | $        | 4.99       |    | $          | 2.93 |   |
| Second quarter         |       | 4.90     |       | 2.99    |       |
| Third quarter          |       | 5.05     |       | 3.55    |       |
| Fourth quarter         |       | 4.13     |       | 3.31    |       |
|                        |            |          |            |         |            |  |  |

 

8

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| **Fiscal year 2004:** | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------|------------|----------|------------|---------|------------|
| First quarter         |       | $        | 4.11       |    | $          | 3.33 |   |
| Second quarter        |       | 3.81     |       | 3.32    |       |
| Third quarter         |       | 3.64     |       | 2.90    |       |
| Fourth quarter        |       | 3.61     |       | 3.08    |       |
|                       |            |          |            |         |            |  |  |

 

As of February 6, 2005, there were 227 stockholders of record ofthe Common Stock and approximately 4,600****investors withshares in street name.

 

**DividendPolicy**

 

The Company has not paid any cash dividends to Common stockholderssince 1997.  The Company’s line of creditcurrently prohibits the payment of dividends. In addition, the Company intends to retain future earnings in itsbusiness and does not anticipate paying cash dividends on the outstandingCommon stock in the near future.

 

**EquityCompensation Plan**

 

The information regarding stock plans approved by Shareholders and notapproved by Shareholders required by this Item is incorporated by reference andis found in the “Notes to Financial Statements” attached to the FinancialStatements within this document.

 

**ITEM 6.****                  SELECTEDFINANCIAL DATA**

 

The following table sets forth consolidated financial data for theCompany.  These data should be read inconjunction with the consolidated financial statements and related notesincluded elsewhere in Form 10-K.

 
| ** **                                      | ** ** | **Years Ended**                                                    | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                      | ** ** | **2000**                                                           | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                      | ** ** | **(dollar amounts in thousands  except share and per share data)** | ** ** |
| ** **                                      |       |                                                               |       |   |   |   |   |   |   |   |   |
| **Consolidated Statements of Operations Data:** |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net revenues                                    |       | $                                                                  | 46,090     |   | $ | 56,987 |   | $ | 61,679 |   | $ | 60,490 |   | $ | 62,491 |   |
| Gross profit                                    |       | 16,615                                                             |       | 20,518 |   | 22,262 |   | 18,569 |   | 16,468 |   |
| SG&A                                        |       | 10,494                                                             |       | 13,282 |   | 15,654 |   | 17,161 |   | 18,224 |   |
| Operating income (loss)                         |       | 6,121                                                              |       | 7,236 |   | 6,540 |   | 1,408 |   | (1,761 | ) |
| Net income (loss)                               |       | 6,141                                                              |       | 4,429 |   | 9,491 |   | 1,035 |   | (1,344 | ) |
|                                            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic net income per common share               |       | $                                                                  | 0.46       |   | $ | 0.33 |   | $ | 0.68 |   | $ | 0.07 |   | $ | (0.09 | ) |
| Diluted income per common share                 |       | $                                                                  | 0.44       |   | $ | 0.31 |   | $ | 0.65 |   | $ | 0.07 |   | $ | (0.09 | ) |
|                                            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Weighted average basic shares outstanding       |       | 13,222,062                                                         |       | 13,491,177 |   | 14,039,902 |   | 14,206,627 |   | 14,343,386 |   |
| Weighted average diluted shares outstanding     |       | 13,835,384                                                         |       | 14,254,248 |   | 14,664,762 |   | 14,414,931 |   | 14,343,386 |   |

 

9

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| ** **                                                             | ** ** | **Years Ended**                                      | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2000**                                             | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                             | ** ** | **(dollar amounts in thousands  except share data)** | ** ** |
| ** **                                                             |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Consolidated Statements of Income Data as  Percent of Net Revenues** |       |                                                 |       |   |   |   |   |   |   |   |   |
| Net revenues                                                           |       | 100.0                                                | %          | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |
| Gross profit                                                           |       | 36.0                                                 | %          | 36.0 | % | 36.1 | % | 30.7 | % | 26.4 | % |
| SG&A                                                               |       | 22.8                                                 | %          | 23.3 | % | 25.4 | % | 28.4 | % | 29.2 | % |
| Operating income (loss)                                                |       | 13.3                                                 | %          | 12.7 | % | 10.6 | % | 2.3 | % | (2.8 | )% |
| Net income (loss)                                                      |       | 13.3                                                 | %          | 7.8 | % | 15.4 | % | 1.7 | % | (2.2 | )% |
|                                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Consolidated Balance Sheet Data:**                                   |       |                                                 |       |   |   |   |   |   |   |   |   |
| Working capital                                                        |       | $                                                    | 9,799      |   | $ | 14,934 |   | $ | 16,880 |   | $ | 16,704 |   | $ | 7,753 |   |
| Total assets                                                           |       | $                                                    | 25,189     |   | $ | 31,596 |   | $ | 43,799 |   | $ | 44,204 |   | $ | 46,873 |   |
| Total debt and capital lease obligations                               |       | $                                                    | 73         |   | $ | 49 |   | $ | 17 |   | $ | 3 |   | $ | 2,390 |   |
| Stockholders’ equity                                              |       | $                                                    | 21,663     |   | $ | 27,981 |   | $ | 38,941 |   | $ | 40,035 |   | $ | 39,216 |   |

 
| **ITEM 7.** | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATION** |
|-------------|------------------------------------------------------------------------------------------------|

 

The following discussion should be read in conjunction with thefinancial statements and related notes and other information included in thisreport.  The financial results reportedherein do not indicate the financial results that may be achieved by theCompany in any future period.

 

**Background**

 

Monterey Gourmet Foods was incorporated in June 1989 as a producerand wholesaler of refrigerated gourmet pasta and sauces to restaurants andgrocery stores in the Monterey, California area.  The Company has since expanded its operationsto provide a variety of gourmet refrigerated food products to grocery and clubstores throughout the United States, selected regions in Canada, the Caribbean,Latin America and Asia Pacific.  TheCompany’s overall strategic plan is to enhance the value of the MontereyGourmet Foods brands by distributing its gourmet products through multiplechannels of distribution.

 

TheCompany’s product distribution to grocery and club stores increased fromapproximately 25 stores as of December 1989, to approximately 9,600 storesby December 26, 2004.  During recentyears the Company added retail and club distribution through internal growthand through the Frescala Foods, Nate’s, Emerald Valley and CIBO acquisitions. Alsoin 2004, the Board of Directors unanimously approved a resolution to change thename of the Company to Monterey Gourmet Foods, Inc.  The name change was made to define theCompany’s strategic direction more accurately. The name change also announcesto the investor community, our customers and consumers, our strategic directionto become more than just a pasta company.

 

In2004 the Company launched two new product lines outside its core pasta/saucebusiness, including Gourmet Refrigerated Entrees, such as Seafood Lasagna andPasta Primavera, and Grilled Wrap Sandwiches, featuring a Garlic Chicken Wrapand a Chicken Ranchero Burrito. Over the past two years, the Company alsocompleted two acquisitions outside its pasta business: Emerald Valley Kitchen(September, 2002), a Eugene, Oregon based manufacturer of organic dips andsalsas, and CIBO Naturals (January, 2004), a maker of sauces, dips and spreads.  The Company believes that the gourmet foodsegment is growing rapidly as time-starved consumers seek high qualityquick-meal solutions and Monterey Gourmet Foods, with its staff of senior chefsand its flexible manufacturing facilities, is well positioned to bring newproducts to these consumers.

 

Thesuccess of the Company’s efforts to increase revenue will depend on four keyfactors: (1) whether grocery and club store chains will continue toincrease the number of their stores offering the Company’s products, (2) whetherthe Company can continue to increase the number of grocery and club storechains offering its products, (3) continued introduction of new productsthat meet consumer acceptance and (4) whether the Company, by diversifyinginto other complementary businesses through new product offerings oracquisitions can leverage its strengths and continue to grow revenues at levelsattractive to its investors.  Grocery andclub store chains continually re-evaluate the products carried in their stores,and no assurances 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

 

10

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products.  During 2003, Costco chose to reduce thenumber of items it carries, which caused a reduction of sales from the Companyto Costco. In late 2004, Sam’s Club has also begun an SKU (Stock Keeping Unit)reduction project which may impact the Company’s sales in 2005.

 

TheCompany believes that access to substantially greater capital resources,increased sales to offset higher fixed overhead, coupled with continuedreduction of its administrative and production costs as a percent of salesrevenue, will be key requirements in the Company’s efforts to enhance itscompetitive position and increase its market penetration.  In order to support its expansion program,the Company continues to develop new products for consumers and revisedadvertising and promotional activities for its retail grocery and club storeaccounts. There can be no assurance that the Company will be able to increaseits net revenues from grocery and club stores. Because the Company will continue to make expenditures associated withthe expansion of its business, the Company’s results of operations may be affected.

 

**Operationsfor 2002, 2003 and 2004**

 

Net revenues were as follows:

 
| ** **                                     | ** ** | **Years Ended** | ** ** |
|------------------------------------------------|------------|-----------------|------------|
| ** **                                     | ** ** | **2002**        | ** ** | **2003** | ** ** | **2004** | ** ** |
|                                           |       |            |       |   |   |   |   |   |   |   |
| Net Revenues                                   |       | $               | 61,679     |   | $ | 60,490 |   | $ | 62,491 |   |
| Percent Change in Net Revenues from prior year |       | 8               | %          | (2 | )% | 3 | % |

 

The change in net revenues is mostly a result of changesin shipping product and only a small portion is a result of price changes forthe Company’s products. In 2004, the Company announced that approximately 1,100Wal-Mart Supercenters discontinued its private label refrigerated pasta andpasta sauce program which the Company was making since 2002.  The Company does not sell any other productsto Wal-Mart Supercenters.  Wal-MartSupercenter’s private label business represented $2,823,000, $3,490,000 and$147,000 of Net Sales in 2002, 2003 and 2004, respectively.  Additionally, popular diet trends in theUnited States impacted the overall consumption of pasta which negativelyimpacted sales.  Sales to Costco’scontinued to be impacted by Costco’s SKU reduction and also from competitorinroads.  Sales to Costco were $22.8million in 2004.  During 2004, MontereyPasta branded retail sales of pasta items grew by 1% inspite of a decline inthe overall pasta category, reflecting on the Company’s focus on thisdistribution channel.

 

The 2003 sales decline of 2% is a result of a salesdecline at Costco of 23.9% for the year.  At the beginning of 2003, Costcomade a decision to reduce the number of items that it offers to its members,which caused a reduction in the number of items that the Company sold to Costcoduring 2003. Costco’s decision to reduce the number of items purchased from theCompany by approximately 50% resulted in a reduction of sales to Costco of$6,521,000 when comparing 2003 sales to 2002. The Company has embarked upon a diversification strategy which includedthe acquisition in 2002 of Emerald Valley Kitchens and in 2004 of CIBO Naturals,LLC. The table below represents the percent of net revenues these twoacquisitions represent:

 
| ** **                                        | ** ** | **Years Ended** | ** ** |
|---------------------------------------------------|------------|-----------------|------------|
| ** **                                        | ** ** | **2002**        | ** ** | **2003** | ** ** | **2004** | ** ** |
| Percent of net  revenues from recent acquisitions |       | 2.3             | %          | 7.0 | % | 24.9 | % |
| All other net revenues                            |       | 97.7            | %          | 93.0 | % | 75.1 | % |
|                                              |       |            |       |   |   |   |   |
| Total                                             |       | 100.0           | %          | 100.0 | % | 100.0 | % |

 

Grossprofit and gross margin were as follows:

 
| ** **           | ** ** | **Years Ended** | ** ** |
|----------------------|------------|-----------------|------------|
| ** **           | ** ** | **2002**        | ** ** | **2003** | ** ** | **2004** | ** ** |
| Gross profit         |       | $               | 22,262     |   | $ | 18,569 |   | $ | 16,468 |   |
| Gross margin percent |       | 36.1            | %          | 30.7 | % | 26.4 | % |
|                      |            |                 |            |  |  |  |  |  |  |  |

 

11

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In2004, the gross margin declined compared to 2003.  The decline is a result of higher rawmaterial costs which the Company was not fully able to pass along to itscustomers, a decline in pasta sales of 22% which increased fixed costs as apercent of sales, higher workers compensation costs, and new productintroductions start up costs, including label development, USDA approvals, andproduct development costs.  As aconsequence of lower pasta sales and raw material higher costs, in 2004,management reorganized its production and plant overhead workforce whichreduced the number of employees at the Company by approximately 15%. Since thattime additional reduction in workforce both in the plant and in generaloverhead has taken place.  Currently, theCompany has reduced its California work force by 33% compared to the same timein 2003.  Other initiatives that havebeen implemented have reduced the Company’s packaging costs, offset increasedfreight costs, lowered general and administrative costs, and minimized theimpact of higher raw material costs. These projects were done in an effort to reduce processing costs and increasemargins.  The impact of these changes onthe Company’s gross profit is difficult to quantify because of its sensitivityto volume through the plant.

 

Thegross profit decline in 2003 compared to 2002 was a function of increased fixedcosts in anticipation of increased sales which have not grown at the levelexpected, increased costs involving the development and design of newpackaging, and higher costs associated with the new packaging concept. TheCompany charged to costs or expense $510,000 and $550,000 in 2003 and 2004respectively, 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 in productionfollowed by rapid production causing high expenditures all of which contributedto the decline in gross margin.

 

Selling,General and Administrative expenses (“SG&A”) were as follows:

 
| ** **                                    | ** ** | **Years Ended** | ** ** |
|-----------------------------------------------|------------|-----------------|------------|
| ** **                                    | ** ** | **2002**        | ** ** | **2003** | ** ** | **2004** | ** ** |
| SG&A Expense                              |       | $               | 15,654     |   | $ | 17,161 |   | $ | 18,224 |   |
| SG&A Expense as a percent of net revenues |       | 25.4            | %          | 28.4 | % | 29.2 | % |
|                                               |            |                 |            |  |  |  |  |  |  |  |

 

Theincreases in 2004 compared to 2003 were related to increased marketing costsrelated to the introduction of new products, increased freight costs due tofuel surcharges and reduced volume on each truck due to reduced club salesandthe addition of expenses associated with operating the CIBO business.  These increases were offset by reduction instaffing during the year of approximately 100 employees.  The 2003 increase over 2002 is a result of  additional staffing in the sales and marketingarea, increased freight cost due to fuel surcharges and less efficient loadsrelated to increased retail sales, and increased marketing and selling costsattributable to spending levels geared to higher sales growth expectation thanwas achieved during the year. Demonstration costs, paid to outside vendors as apercent of Net Sales are 8.3%, 9.1%  and8.1% for the years 2002, 2003, and 2004, respectively.

 

Depreciationand amortization expense, included in cost of sales and SG&A increased to $2,510,000or 4.0% of net revenues in 2004 compared to $2,082,000, or 3.4% of net revenuesin 2003, and  $1,720,000 or 2.8% of netrevenues in 2002.  The increases over thepast two years relate primarily to capacity expansion and equipment upgrades inthe Salinas, California production facilities that occurred in 2002 and 2003, theaddition of Emerald Valley Kitchen and CIBO Naturals businesses. Amortizationof intangible assets as a result of acquisitions was $482,000 in 2004, $243,000in 2003 and $127,000 in 2002. See “Liquidity, Capital Resources and BusinessAcquisitions”, page 13.

 

Net interest expense for 2004 was $130,000, compared to net interestincome of $71,000 in 2003 and income of $110,000 in 2002.  The interest expense in 2004 is attributableto the bank loans needed for the CIBO Naturals acquisition and the subordinateddebt remaining on the CIBO Naturals balance sheet.  The 2003 and 2002 interest income wasgenerated from investment in short-term money funds from operating cash flow inthe absence of bank debt.

 

Incometax benefit (expense) for 2004, 2003 and 2002 was $505,000, $(444,000), and$2,838,000, respectively.  Income taxesfor 2004 reflect a deferred tax credit of $505,000 or 27% of pretax loss.  The 2003 tax expense was $444,000, or 30.0%of pre-tax income.  During 2002,  $5,196,000 of net operating loss carryforwards(“NOLs”) not previously reserved were released and offset against income taxsince, after a comprehensive study of the nature of the NOLs and theirlikelihood of being utilized, management concluded that it was more likely thannot that they would be utilized.  Thisbenefit, together with permanent differences and other current tax effectsresulted in a net income tax benefit of $2,838,000 for 2002.  Utilization of these NOLs and other deferredtax assets offset substantially all of the cash federal income taxes otherwisepayable for 2002 and 2003.

 

12

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Additionally,the Company realized additional tax benefits as a result of the exercise ofnon-qualified stock options and the exercise and subsequent sale of certainincentive stock options or disqualifying dispositions in 2004, 2003, and 2002.For financial reporting purposes, any resulting reduction in actual income taxobligations as a result of these disqualifying dispositions is credited toadditional paid-in capital.  See “Liquidity,Capital Resources and Business Acquisition: Deferred Tax Assets” on page 13,and Note 10 to the consolidated financial statements****onpage 45.

 

###### **Liquidity, CapitalResources, and Business Acquisitions**

###### ** **

During the twelve months ended December 26, 2004,$1,898,000 of cash was provided by the Company’s operations, compared to $1,511,000provided in 2003 and $9,494,000 in 2002. The 2004 net loss of $1,344,000 plus depreciation and amortization of$2,510,000, reduced accounts receivable, inventory and prepaid expense balancestotaling $1,543,000 were offset by a decrease in current liabilities of $314,000and an increase in deferred income taxes of $557,000 all combined to generatecash for the year. The 2004 increase in cash provided by operations compared to2003 is a result of additional depreciation and amortization and improvedbalance sheet management.

 

As of December 26, 2004, the Company has a creditfacility, which was renegotiated in August 2001 and has been renewed eachyear for $10.0 million in aggregate borrowings which had been unused until January 2004when the Company purchased an 80% interest in CIBO Naturals LLC.  The facility consists of $1.5 working capitalline of credit and an $8.5 million non-revolving term loan.  The $1.5 million working capital portion ofthe facility is priced at LIBOR, plus 200 basis points.  The working capital commitment expires October 31,2005.  As of December 26, 2004, theCompany was using approximately $1.5 million of the non-revolving term facilityand has a total of $8.5 million remaining in the combined facilities for itsuse. The $8.5 million non-revolving term portion of the facility pricing is ateither prime rate or LIBOR plus premiums 225 basis points over LIBOR.  The term loan facility is subject to annualreview and bank approvals must be obtained before funding.  The Company is required to pay $62,500principal payment per month plus interest on the non-revolving term loan.

 

Subsequent to the year end, on January 11, 2005,the Company borrowed an extra $5 million from Comerica Bank in order to fundthe acquisition of Casual Gourmet Foods. See Notes 15 to the Financial Statements.  As part of the new financing, the entirecredit facility was revised.  The Companynow has a $2.0 million dollar working capital line of credit against which aletter of Credit in the amount of $1,000,000 is issued in favor of an insurancecompany to support a deductible worker’s compensation program initiated by theCompany on January 1, 2003 and continuing into 2005.  The loan covenants have been changed toreflect the additional borrowing.

 

The Company finances its operations and growthprimarily with cash flows generated from operations. Access to capital providesthe Company with flexible working capital, which occasionally may be needed inthe normal course of business, and the opportunity to grow the business throughacquisitions or develop the existing infrastructure through capital investment

 

In addition to operating cash flows, the Company alsoreceived cash proceeds of $990,000, $58,000 and $470,000 from the exercise ofemployee stock options and sales of stock under the Company’s stock purchasePlan during 2002, 2003, and 2004, respectively.

 

Cash balance at the end of 2004 was $569,000 comparedwith $5,285,000 in 2003.  The cash fromoperations in 2004, cash balances on hand and part of the non-revolving bank loanwas used to purchase an 80% interest in CIBO Naturals LLC. Purchases ofequipment were kept to a minimum during the year.  Over half of the equipment spending was tofinish projects started in 2003.

 

The cash from operations in 2003 and cash balancesfrom the prior year were 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 operations in 2002, combined with thecash proceeds from stock sales and option exercises and accumulated cashbalances, was used principally to fund $4.8 million of plant expansion andimprovement projects, and to fund the $5,744,000 in cash paid for theacquisition of the operating assets and inventory of Emerald Valley, and acquisitionrelated costs of $188,000.  The capitalprojects funded in 2002 included approximately $2.1 million for a plantexpansion at the Company’s Salinas distribution center.  Other significant projects included a new jarline for sauce packing, a new chunky ravioli line, a new pasta packing line andlabeler, a spiral chiller, and an electrical upgrade improved packagingequipment.

 

13

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TheCompany anticipates capital expenditures in 2005 to be approximately $1.0million which is slightly more than that spent in 2004.  All future capital expenditures are expectedto be funded with a combination of cash flow from operations or the use of theCompany’s line of credit.

 

Management believes that cash on hand of $569,000 at December 26,2004, projected 2005 cash flows from operations, and availability under the bankcredit facility,  less the funds used topurchase 60% interest in Casual Gourmet Foods, is sufficient to fund workingcapital needs, expected Company growth, and anticipated capital expendituresduring 2005. Additional financing arrangements will need to be found if theCompany makes further acquisitions.

 

**ContractualObligations**

 

The Company has no raw material contracts exceedingone year in duration.  However, it doeshave one long-term contract with its liquid nitrogen provider, which expires November 30,2007. In addition, the Company leases production, warehouse and corporateoffice space as well as certain equipment under both a month-to-month andnon-cancelable operating lease agreement. Most building leases have renewal options and all include cost of livingadjustments.  The Company’s President andChief Executive Officer accepted employment with the Company commencing October 1,2002 pursuant to terms set forth in a letter from the Company, a copy of whichis filed as Exhibit 10. The following table summarizes the estimatedannual obligations.

 
| ** **                                  | ** ** | **Payments due by period** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|
| **Contractual Obligations  (in Thousands)** | ** ** | **Total**                  | ** ** | **Less than 1 year** | ** ** | **1 - 3 years** | ** ** | **3 - 5 years** | ** ** | **More than 5  years** | ** ** |
| Long-term debt                              |       | $                          | 2,390      |   | $ | 750 |   | $ | 640 |   | $ | 175 |   | $ | 825 |   |
| Capital lease obligations                   |       | 18                         |       | 7 |   | 11 |   | — |   | — |   |
| Operating leases                            |       | 7,639                      |       | 1,182 |   | 2,112 |   | 1,151 |   | 3,194 |   |
| Purchase obligations                        |       | 2,302                      |       | 695 |   | 1,607 |   | — |   | — |   |
| Total                                       |       | $                          | 12,349     |   | $ | 2,634 |   | $ | 4,370 |   | $ | 1,326 |   | $ | 4,019 |   |

 

The Company has commitments for leased manufacturing,warehouse and office space that range from three years to 10 years.  See discussion in item 2 titled “Properties”.

 

Inaddition, the Company has a $1,000,000 standby letter of credit in favor of aninsurance company for the Company’s self-funded workers compensation programwhich will expire on December 31, 2005.

 

**Off-BalanceSheet Arrangements**

 

TheCompany does not have any off-balance sheet arrangements that are material toits financial position or results of operations.  See Notes to the Consolidated FinancialStatements for information regarding capitalized leases and operating leases.

 

**BusinessAcquisitions**

 

On August 23, 2002, the Company purchased theoperating assets and inventory of Emerald Valley Kitchen, Inc. a Eugene,Oregon based producer of organic fresh salsas, dips, hummus, and sauces withover 90% retail chain distribution. The Company considered this purchase anopportunity to enter the rapidly growing organic food market.  The consideration to the sellers consisted of$5,744,000 in cash.  Additionally, theEmerald Valley Kitchen owners are eligible to receive an earn-out based uponEmerald Valley Kitchen Earnings before Interest, Taxes, Depreciation, andAmortization (“EBITDA”) above predetermined levels, calculated annually at theend of the first five years after the acquisition date.  The Company paid $79,000 and $59,000 in 2003and 2004, respectively, as a result of the earn-out.  Funding for the transaction came fromexisting cash balances.

 

The Company announced on January 28, 2004 theacquisition of controlling 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 acquisition agreementprovides for the purchase of the remaining 20% ownership after four years at apredetermined calculation based on earnings before taxes.  The cash to fund the acquisition came partlyfrom the Company’s cash balances and from its credit facilities.  On May 12, 2004, the Company purchasedfor

 

14

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$316,500 (but without any earn-out provision) theentire remaining holdings of one of the minority members of CIBO.  This additional acquisition increased theCompany’s interest in CIBO to 84.5%.

 

CIBO produces a variety of refrigerated gourmet saucesand spreads including fresh pesto sauces, flavored cheeses, bruschetta toppingsand tapenade spreads.  CIBO’s productsare sold nationally through club stores, specialty food stores, and regionallyin supermarket delis. CIBO fits well with the Company’s growth strategy inpremium refrigerated foods.  CIBO throughits “CIBO Naturals” brand sells unique, high quality products and has developeda strong market position which the Company believes has growth potential inboth expanded distribution and new products.

 

On January 11,2005, the Company closed an agreement to purchase for $6,000,000 in cash, 60%of the outstanding shares of Casual Gourmet Foods, Inc., a Tampa, Floridacorporation (“Casual”), with a commitment to acquire Casual’s remaining shares over thenext three years. Casual produces branded gourmet sausages, prepared soups andother food products.

 

This acquisition pursues the Company’s growth strategyin the specialty premium refrigerated food category. Casual’s flavorful, lowerfat, low-calorie sausages and burgers fit well with today’s consumer interestin unique and healthy food choices. Casual’s sausage products are positioned inthe fast growing “healthy gourmet” segment of the large cooked sausagecategory, and its refrigerated, fully cooked soups cater to the time conscious consumerswho desire premium gourmet meal options. Like the Company, Casual competes inthe refrigerated sections in club and retail food store channels. The Companyenvisions expanding the existing Casual brand, developing new products, andincreasing distribution in club, retail, and potentially other channels.

 

**Quantitativeand Qualitative Disclosure About Market Risks**

 

Certain characteristics and dynamics of the Company’sbusiness and of financial markets generally create risks to the Company’slong-term success and to predictable quarterly results.  These risks include:

 

**•**      NoAssurance of Continued Profitability. In the second quarter of 1994, the Company reported its first operatingloss from continuing operations.  Subsequentto that quarter the Company incurred losses through the first quarter of 1997,after which it regained profitability, which continued through twenty-fiveconsecutive quarters until losses were recorded in the third, fourth quartersof 2003 and the first and second quarters of 2004.  The Company is reporting a loss for theentire year of 2004.  At December 26,2004 the Company had an accumulated deficit of $5,901,000.  There can be no assurance that the Companywill 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 2005 calendar year.  See Notes to the financial statements for adescription of the credit facility.  Ifthe Company’s operations do not provide cash sufficient to fund its operations,and the Company seeks outside financing, there can be no assurance that theCompany will be able to obtain such financing when needed, on acceptable terms,or at all.  In addition, any futureequity financing or convertible debt financing could cause the Company’sstockholders to incur dilution in net tangible book value per share of theCompany’s 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. CEO James Williams joinedthe Company in October 2002 and Mr. Scott Wheeler became CFO in October 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 that keymanagement will remain stable; significant management turnover could disruptthe Company’s operations with consequent adverse effect on the business.

 

**•**      Impactof Inflation.  The increased cost ofdairy ingredients had a material inflationary impact on the Company’soperations during 2004.  Protein itemssuch as chicken also increased over 30% over previous year’s costs.  Freight rate increases related to fuelsurcharges impacted 2004 and 2003.  Medicalbenefits continued to increase at rates higher than the consumer price index.Potential increases in labor, employee benefits, freight, ingredients andpackaging, rents and other operating expenses, as well as increases in dairyingredients could adversely affect the Company’s profitability in futureperiods.  The Company cannot predictwhether such increases will occur in the future or their magnitude if they do.

 

**•**      RisksInherent in Food Production.  TheCompany faces all of the risks inherent in the production and distribution ofrefrigerated food products, including contamination, adulteration, spoilage,and the associated risks of product liability litigation, which may occur evenwith an isolated event.  Although theCompany has modern production facilities, and has obtained USDA approval forthem, and employs what it believes are the necessary processes and equipment inorder to insure food safety, there can be no

 

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assurancethat the Company’s procedures will be adequate to prevent the occurrence ofsuch events. On January 31, 2005, Monterey Gourmet Foods has issued avoluntary recall for CIBO Naturals Portabella Mushroom Grande Ravioli due tothe undeclared presence of lobster meat, a known allergen. Some units of CIBONatural’s Atlantic Lobster Ravioli were inadvertently labeled as PortabellaMushroom Ravioli.  Persons who have anallergy to lobster meat are at risk of a serious and possibly life threateningreaction if they consume this product.

 

**•**      Dependenceon Major Customers.  During 2004, twoof the Company’s customers, Costco and Wal-Mart, Inc including its subsidiary,Sam’s Club, accounted for 36% and 24%, respectively, of the Company’s totalrevenues.  The Company currently sellsits products to eight separate US Costco regions and its international regions whichcurrently make 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 the Company’s products in thefuture or continue to allocate Monterey Pasta the same amount of shelfspace.  On February 2, 2004 theCompany announced that Wal-Mart Supercenters discontinued its private labelrefrigerated pasta and pasta sauce program. The Company does not sell any otherproducts to Wal-Mart Supercenters. During 2003 the Company sold $3,490,000 to Wal-Mart Supercenters andonly $147,000 in 2004.  There can be noassurance that Sam’s Club will continue to carry the Company’s products.  Loss of either of these customers, Costco orSam’s Club, or a significant further reduction in sales to either, would have amaterial adverse effect on the Company. Additionally, liberalized pricing or allowance terms would createdownward pressure on gross margins.

 

**•**      ChangingConsumer Preferences.  Consumerpreferences change, sometimes quickly, and the success of the company’s foodproducts depends on the company’s ability to identify the tastes and dietaryhabits of consumers 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 diets bycertain segments of the U.S. population has affected the consumption of pasta,and pasta sales have decline as a percentage of grocery sales in the U.S.  As American consumers seek new ways to reducetheir intake of carbohydrates, Monterey Gourmet Foods has developed products toaddress these changing preferences.  Towardsthe end of 2004, the low-carbohydrate diet trend decreased and the trend has beentowards whole grains and less refined products. The Company has spent resources to develop whole wheat pasta productsthat meet this new trend.  However, therecan be no assurance that these new products will meet the changing demands ofthe consumer.

 

**•**      Seasonalityand Quarterly Results.  The Company’sgrocery and club store accounts are expected to experience seasonalfluctuations to some extent.  The Company’sbusiness in general may also be affected by a variety of other factors,including but not limited to general economic trends, competition, marketingprograms, 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 dependent oncommon 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.  Because mostof the Company’s operations are in California, its operating costs are affectedby increases in electricity and natural gas prices. As a result, the Company’soperating results have been affected in some measure by the increased cost of energy.  Management cannot predict the level of futureenergy 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, be attributableto the Company’s operating results or to changes in the direction of theCompany’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 volatility hashad 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. Moreover, any announced shortfall in the Company’s net sales or earningsfrom levels expected by securities analysts or the market could have animmediate and significant adverse effect on the trading price of the Company’scommon stock in any given period. Additionally, the Company may not learn of such shortfalls until late inthe fiscal quarter, shortly before operating results are due to beannounced.  The announcement, together orin succession, of such a shortfall and of lower than expected quarterlyoperating results, could result in an even more immediate and significantadverse impact on the trading price of the Company’s common stock uponannouncement of the shortfall or quarterly operating results.

 

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**•**      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 riskof significant product returns resulting from the Company’s supply of slowerselling items to its customers.  Inaddition, grocery and club store chains continually re-evaluate the productscarried in their stores and no assurances can be given that the chainscurrently offering the Company’s products will continue to do so in the future,either in the same measure or at all. Should these channels choose to reduce or eliminate products, theCompany could experience a significant reduction in its product sales.  The Company remains dependent on the use ofslotting allowances and other incentives to expand retail distribution.

 

**•**      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 2005. This program, which features a fixed annual payment, a deductible of $300,000per occurrence, and a $1,000,000 letter of credit in favor of the insurancecompany, creates a maximum exposure of approximately $2.1 million for claimsreported.  A competitive “guaranteed cost”program would have cost the Company approximately $2.0 million.  Management believes that its current safetyprogram and its safety record will provide the foundation to enable the Companyto realize the premium savings deductible programs are designed toachieve.  During 2003 the Companyrecorded total workers compensation expense of $579,000 resulting fromapproximately 49 claims and for 2004 the Company recorded total workerscompensation expense of $1,179,000 resulting from approximately 20 claims.  There can be no assurances that the Companywill save money through this program.

 

**CriticalAccounting Policies and Management Judgments**

 

The discussion and analysisof the financial condition and results of operations are based on theconsolidated financial statements. The preparation of these financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make a number of estimates andassumptions relating to the reporting of assets and liabilities, revenues andexpenses, and the disclosure of contingent assets and liabilities. On anongoing basis, management evaluates these estimates and assumptions, includingthose related to accounts receivable and allowances, goodwill and intangibleassets, income taxes, inventory valuation, workers compensation reserves andrevenue recognition. Management bases its estimates on historical experience andon various other assumptions believed to be reasonable under the circumstances,which form the basis for making judgments about the carrying values of assetsand liabilities that are not readily apparent from other sources. Actualresults could differ from those estimates under different assumptions orconditions.

 

Management believes thefollowing critical accounting policies affect the more significant judgmentsand estimates used in the preparation of the consolidated financial statements

 

***Accounts Receivable and Allowances***

 

The Company provides allowances for estimated creditlosses, product returns, spoilage, and adjustments at a level deemedappropriate to adequately provide for known and inherent risks related to suchamounts.  The allowances are based onreviews of the history of losses, returns, spoilag, contractual relationshipswith customers, current economic conditions, and other factors warrantconsideration in estimating potential losses. While management uses the best information available in making itsdetermination, the ultimate recovery of recorded accounts, notes, and otherreceivables is also dependent on future economic and other conditions that maybe beyond management’s control.

 

***Income Taxes***

 

The Company accounts for corporate income taxes inaccordance with SFAS 109, “Accounting for Income Taxes*”*,which requires 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

 

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of assets and liabilities. Future tax benefits are subject to a valuation allowance to the extentof the likelihood that the deferred tax assets may not be realized. The Company’s deferred tax assets includesignificant amounts of NOLs. During 2004, the valuation allowance was increasedslightly due to consideration of the impact of the 2004 losses and the Company’sassessment of the realization of such NOLs. The amount of the valuationallowance is significantly dependent on management’s assumptions regardingfuture taxable income and the availability of these NOLs to offset futuretaxable income. The effect on the Company’s net income is significant wheneverthe estimate of realizability changes,. The Company expects to utilize most ofthe remaining NOLs in future years.

 

***Inventory Valuation***

 

Inventoriesare stated at the lower of cost (using the first-in, first-out method) ormarket and consist principally of component ingredients to the Company’srefrigerated pasta and sauces, finished goods, and packaging materials.  Many of the ingredients used in the Company’sproducts are short shelf-lived products and if not used in a certain amount oftime may spoil.  Management estimatesthat the raw material will be used in a timely manner; however, management hasestablished certain reserves for the potential of inventory obsolescence,especially for slow moving inventory.  Inaddition, the Company purchased certain packaging materials for its productsthat are intended to be used in the future. As of December 26, 2004, the Company reduced the carrying value ofits inventory by $213,000.  This write-downwas made to cover certain refrigerated raw material inventory that is nearingits shelf-life, certain packaging labels for products that may be rotated outof the Club Store accounts and for products that have already been rotated outof the Club Store accounts that may or may not be rotated back into the ClubStore accounts. The allowance is established based on managements estimate ofalternative usage or salvage value of obsolete inventory.  Management believes its estimates for spoilsand obsolete inventory is adequate given the current volume of business to itscurrent customers.

 

***Workers Compensation Reserve***

 

TheCompany entered into a partially self-insured worker’s compensation program forfiscal year 2003 and will continue the program into 2005.  This program, which features a fixed annualpayment, with a deductible on a per occurrence basis. The annual expenseconsist of a base fee paid to an insurance company to administer the program,direct cash expenses to pay for injuries, an estimate for potential injuriesthat may have occurred but have not been reported, an estimate by the insurancecompany of costs to close out each injury and an estimate for injurydevelopment.  The Company has been onthis partially self-insured program for only two years and therefore has limitedhistory of claim resolution available to support the Company’s specificactuarial projections.  Therefore theCompany is using published industry actuarial data from an insurance carrierand reviewing each claim individually to determine the amount of reserves thatshould be established.  Managementbelieves that its current safety program and its safety record will provide thefoundation to enable the Company to realize the premium savings partiallyself-insured programs are designed to achieve, however, estimated reserves mayvary from future cash outlays.

 

***Revenue Recognition***

 

The Company recognizes revenues through sales of itsproducts primarily to grocery and club store chains.  Revenues are recognized once there isevidence of an arrangement (such as a customer purchase order), product has eithershipped to the customer or has been delivered to the customer, the price andterms are finalized, and collectibility is reasonably assured.  Accordingly, sales are recorded when goodsare shipped or for one customer, when the product is delivered, at which timetitle and risk of loss have passed to the customer, consistent with the freightterms for most customers.  Title and riskof loss pass upon delivery to retail locations for the Direct Store Deliveryprogram, as that 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 records shipping cost for productdelivered to customers in selling expense. Any amounts charged to customers for freight and deliveries are includedin revenues.  Certain incentives grantedto customers such as promotions, trade ads, slotting fees, and coupons arerecorded as offsets to revenues.

 

***Goodwill/Intangible Assets***

 

Effective January 1,2002 under SFAS 142, “Goodwill and Other Intangible Assets.” goodwill andintangible assets with indefinite useful lives are to be tested for impairmentat least annually. Intangible assets with definite useful lives continue to beamortized over their respective estimated useful lives. The primaryidentifiable intangible assets of the Company’s reporting units  are trademarks, tradenames and customerrelationships acquired in business acquisition. Identifiable intangibles withfinite lives are amortized and those with indefinite lives are not amortized.The estimated useful life of an identifiable intangible asset to the reportingunit  is based upon a number of factors,including the effects of demand, competition, and future cash flows. As of December 26,2004, the net book value of trademarks and other identifiable intangible assetswas $6.1 million.

 

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Identifiable intangibleassets that are subject to amortization are evaluated for impairment using aprocess similar to that used to evaluate elements of property. Identifiableintangible assets not subject to amortization are assessed for impairment atleast as often as annually and as triggering events may occur. The impairmenttest for identifiable intangible assets not subject to amortization consists ofa comparison of the fair value of the intangible asset with its carryingamount. An impairment loss is recognized for the amount by which the carryingvalue exceeds the fair value of the asset. In making this assessment,management relies on a number of factors to discount anticipated future cashflows including operating results, business plans and present value techniques.Rates used to discount cash flows are dependent upon interest rates and thecost of capital at a point in time. There are inherent uncertainties related tothese factors and management’s judgment in applying them to the analysis ofintangible asset impairment. It is possible that assumptions underlying theimpairment analysis will change in such a manner that impairment in value mayoccur in the future.

 

Goodwill is notamortized but is subject to periodic assessments of impairment. At December 26,2004, the Company had $8.7 million of goodwill on its books. Goodwill isassessed for impairment at least as often as annually and as triggering eventsmay occur. The corporation performs its annual review in the fourth quarter ofeach year. Recoverability of goodwill is evaluated using a comparison of thefair value of a reporting unit with its carrying value. If the carrying valueof the goodwill of a reporting unit exceeds the fair value of that goodwill, animpairment loss is recognized in an amount equal to the excess. Reporting unitsare business components one level below the operating segment level for whichdiscrete financial information is available and reviewed by segment management.

 

In evaluating therecoverability of goodwill, it is necessary to estimate the fair value of thereporting units. In making this assessment, management relies on a number offactors to discount anticipated future cash flows including operating results,business plans and present value techniques. Rates used to discount cash flowsare dependent upon interest rates and the cost of capital at a point in time.There are inherent uncertainties related to these factors and management’sjudgment in applying them to the analysis of goodwill impairment. It ispossible that assumptions underlying the impairment analysis will change insuch a manner that impairment in value may occur in the future.  The Company completed an analysis of futurecash flows at December 26, 2004 and determed that no impairement chargeswere required.

 

**RecentlyIssued Accounting Standards**

 

In December 2004,the FASB issued SFAS No. 123R, “Share-Based Payment”. SFAS No. 123Ris a revision of SFAS No. 123, “Accounting for Stock Based Compensation”,and supersedes APB 25. Among other items, SFAS 123R eliminates the use of APB25 and the intrinsic value method of accounting, and requires companies torecognize the cost of employee services received in exchange for awards ofequity instruments, based on the grant date fair value of those awards, in thefinancial statements.

 

The effective date ofSFAS 123R is the first reporting period beginning after June 15, 2005,which is third quarter 2005 for calendar year companies, although earlyadoption is allowed. SFAS 123R permits companies to adopt its requirementsusing either a “modified prospective” method, or a “modified retrospective”method. Under the “modified prospective” method, compensation cost isrecognized in the financial statements beginning with the effective date, basedon the requirements of SFAS 123R for all share-based payments granted after thatdate, and based on the requirements of SFAS 123 for all unvested awards grantedprior to the effective date of SFAS 123R. Under the “modified retrospective”method, the requirements are the same as under the “modified prospective”method, but also permits entities to restate financial statements of previousperiods based on proforma disclosures made in accordance with SFAS 123.

 

The Company currentlyutilizes a standard option pricing model (i.e., Black-Scholes) to measure thefair value of stock options granted to Employees. While SFAS 123R permitsentities to continue to use such a model, the standard also permits the use ofa “lattice” model. The Company has not yet determined which model it will useto measure the fair value of employee stock options upon the adoption of SFAS123R. See Note entitled “Stock Based Compensation” for furtherinformation.  SFAS 123R also requiresthat the benefits associated with the tax deductions in excess of recognizedcompensation cost be reported as a financing cash flow, rather than as anoperating cash flow as required under current literature. This requirement willreduce net operating cash flows and increase net financing cash flows inperiods after the effective date. These future amounts cannot be estimated, becausethey depend on, among other things, when employees exercise stock options.

 

The Company currentlyexpects to adopt SFAS 123R effective July 1, 2005; however, the Companyhas not yet determined which of the aforementioned adoption methods it willuse.

 

In November 2004,the FASB issued SFAS No. 151, “Inventory Costs: an amendment of ARB No. 43,Chapter 4” to clarify the accounting of abnormal amounts of idle facilityexpense, freight, handling costs and wasted material.  SFAS No. 151 is effective for inventorycosts incurred during fiscal years beginning after June 15, 2005.  At this time, management is in the process ofreviewing this

 

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statement for its impacton the Company’s cost of goods sold and inventory valuation.  Management has not determined if thisstatement will impact its statement of operations in the future.

 

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

 

*Market Risk Disclosure*

 

The Company does not hold market risk-sensitivetrading instruments, nor does it use financial instruments for tradingpurposes.  All sales, operating items andbalance sheet data are denominated in U.S. dollars; therefore, the Company hasno foreign currency exchange rate risk.

 

In the ordinary course of its business the Companyenters into commitments to purchase raw materials over a period of time,generally six months to one year, at contracted prices.  At December 26, 2004 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 Rate Risk*

 

The Company invests excess cashin variable income investments consisting of cash equivalents.  The magnitude of the interest incomegenerated by these cash equivalents is affected by market interest rates.  Management does not use marketable securitiesor derivative financial instruments in its investment portfolio.

 

The interest payable on theCompany’s bank line of credit is based on variable interest rates and thereforeaffected by changes in market interest rates. The Company does not believe that changes in interest rates will have amaterial impact to the Company’s results of operation.

 

*CurrencyRisk*

 

During 2004, the Company sold $168,000 of product incurrency other than US dollars.  Thesesales have terms of net 30 days from shipment. The Company believes that its currency exposure is not material and has chosennot to hedge these sales.

 

**ITEM 8.****                  FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 

Thefinancial statements and supplementary data of the Company required by thisitem are set forth at the pages indicated at Item 15(a) and areincorporated here by reference.

 
| **ITEM 9.** | **CHANGES  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE** |
|-------------|-------------------------------------------------------------------------------------------|

 

None

 

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

 
| *(a)*  | *Disclosure  Controls and Procedures.* Under the supervision and with the  participation of our management, including our chief executive officer and  chief financial officer, we evaluated the effectiveness of our disclosure  controls and procedures, as such term is defined in Rule 13a-15(e) promulgated  under the Securities Exchange Act of 1934, as amended. Based on this evaluation,  made in accordance with Rule 13a-15b under the Securities Exchange  act, our chief executive officer and chief financial officer concluded that  our disclosure controls and procedures were effective as of the end of the  period covered by this annual report in providing reasonable assurance that  information required to be disclosed by Monterey Gourmet Foods in reports  that it files under the Exchange Act is recorded, processed, summarized and  reported within the time periods specified in Securities and Exchange  Commission rules and forms. |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| *(b)*  | *Internal Controls*. During the  last quarter of fiscal year 2004, there has been no change in the Company’s  internal control over financial reporting (as defined in Rule 13a-15(f) under  the Exchange Act) that has materially affected, or is reasonably likely to  materially affect, the Company’s internal control over financial reporting.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |

 

**ITEM  9B.****              OTHERINFORMATION**

 

None

 

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##### **PART III**

##### ** **

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

 

As of March 25,2005, the directors, executive officers, and other significant employees of theCompany are as follows:

 

**Directorsand Executive Officers:**

 
| **Name**                           | ** ** | **Age** | ** ** | **Position**                                                       |
|------------------------------------|------------|---------|------------|--------------------------------------------------------------------|
| Charles B. Bonner (1)              |       | 62      |       | Director                                                           |
|                               |       |    |       |                                                               |
| F. Christopher Cruger (2) (3) |       | 69      |       | Director                                                           |
|                               |       |    |       |                                                               |
| James M. Williams                  |       | 55      |       | Chief Executive  Officer, President officer President and Director |
|                               |       |    |       |                                                               |
| R. Lance Hewitt                    |       | 65      |       | Chairman of the  Board and Director                                |
|                               |       |    |       |                                                               |
| Michael P. Schall (1)              |       | 51      |       | Director                                                           |
|                               |       |    |       |                                                               |
| Van Tunstall (2) (3)          |       | 58      |       | Director                                                           |
|                               |       |    |       |                                                               |
| James Wong (2) (3)            |       | 57      |       | Director                                                           |
|                               |       |    |       |                                                               |
| Walter L Henning (1)               |       | 60      |       | Director                                                           |
|                               |       |    |       |                                                               |
| Scott Wheeler                      |       | 50      |       | Chief Financial  Officer and Corporate Secretary                   |

 

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(1)          Memberof Audit Committee

(2)          Memberof Compensation Committee

(3)          Memberof Nominating Committee

 

**Othersignificant employees:**

 
| **Name**          | ** ** | **Age** | ** ** | **Position**                     |
|-------------------|------------|---------|------------|----------------------------------|
|              |       |    |       |                             |
| Dan Brown         |       | 45      |       | Vice President -  Operations     |
|              |       |    |       |                             |
| Carl Anderson PhD |       | 53      |       | Director-Quality  Assurance      |
|              |       |    |       |                             |
| Joseph Stirlacci  |       | 44      |       | General Manager  - Club Division |

 

Normally each director is elected for a period of oneyear and serves until the stockholders duly elect his or her successor.  Directors may be elected by the Board to filla vacancy between annual stockholder meeting elections.  The principal occupations of each directorand executive officer of the Company, for at least the past five years, are asfollows:

 

***Charles B. Bonner.***  Mr. Bonner served as a Director of theCompany from 1993 through January 1995, and was reappointed as a Directoreffective September 1995.  Mr. Bonneris Principal and Founder of Pacific Resources, Inc., a mergers andacquisitions advisory firm, a position he has held since September 1989.  From 1975 to 1988 he was president of BonnerPacking Co., an $80MM dried fruit processing and marketing company which wassold to Dole Food Company in 1988.  Mr. Bonneralso serves as a director for Everything Metal Imaginable, Inc., and ScripAdvantage, Inc.

 

***F. Christopher Cruger*.**  Mr. Cruger waselected to the Board of Directors in December of 2001.  He is a retired investor and former seniormanager or executive of several consumer product companies.  Mr. Cruger joined McCormick and Company,a maker of

 

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spices and seasonings, 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.  Mr. Cruger was president and CEO of ToneBrothers, Inc., a spice producer, from 1985 to 1995. He is a Director ofKemin Industries, Inc

 

***James M. Williams.* ** Mr. Williamsjoined the Company as President on October 1, 2002 and was elected to theBoard of Directors on October 29, 2002. On January 3, 2003 Mr. Williams was promoted to ChiefExecutive Officer. Prior to his employment with the Company, Mr. Williamsserved as President and CEO of Bongrain Cheese-USA, a division of the Frenchcompany Bongrain SA, a world-wide public company focusing on specialty cheeses,from 1990 to 2002.  Previously he heldexecutive, sales and marketing positions with the Hillshire Farm division ofSara Lee Corporation, a global consumer products company.

 

***R. Lance Hewitt*.**  Mr. Hewitt joined the Company in June 1997as President and Director and was named Chief Executive Officer in August 1997.  Mr. Hewitt served in this capacity untilhe retired from day-to-day activities and assumed the position of Chairman ofthe Board of Directors effective January 2003.  Mr. Hewitt was President of CarriageHouse Fruit Company, a food manufacturing company, from 1995 to 1997.  He was Chief Operating Officer of IngroMexican Foods from 1988 to 1995.  Hewittalso served as Vice President of Marketing and Sales for the Lawry’s Foodsdivision of Thomas J. Lipton, Inc., a subsidiary of Unilever, aninternational food manufacturer, and spent fifteen years with McCormickSchilling, Inc., a spice company, in various executive capacities.

 

***Michael P. Schall.* **Mr. Schallwas elected to the Board of Directors in December of 2001.   Mr. Schallis currently President of Strategic Marketing Methods, a consulting andadvisory firm providing sales and marketing, business development advisory andnew product expertise to the food and foodservice industries.   Mr. Schall served as SeniorVice President of Sales, Marketing, and Direct Store Delivery for Wise Foods, asnack food company, from January 2002 until March 2003.  From 2000 until January of 2002 he was President and CEO of The B.Manischewitz Company, LLC, one of the nation’s largest kosher foodcompanies.  Prior to that Mr. Schall was President and CEOof Guiltless Gourmet, a food manufacturing company, from 1994 until it’sacquisition by Manischewitz.  Mr. Schall held executive orsenior management positions with Carnation Company, now Nestle S.A.and Lawry’s Foods Inc., a division of Unilever U.S., and Prepared Products Co.

 

***Van Tunstall*. **Mr. Tunstall was elected to theBoard of Directors****in February 1997.  Since 1997, he has served as President of theCentral Coast Group, a strategic consulting and business services firm.  Mr. Tunstall has been an independentconsultant with a variety of companies since 1997.  Mr. Tunstall was a senior executive withGilroy Foods, Inc., an international manufacturer of various food productingredients, from 1977 to 1995.  Heserved as President and Chairman of the Board of Gilroy Foods, Inc. from1991 through 1995.  Previously, Mr. Tunstallheld several executive positions with McCormick & Company, Inc.  Mr. Tunstall also serves on the Board ofother food companies, including Rudi’s Organic Bakery, Inc. and CascadeSpecialties, Inc.

 

***James Wong.***  Mr. Wong was elected to the Board ofDirectors in March 1997.  Since1988, he has worked on five continents as an entrepreneur and managementconsultant facilitating strategic alliances and technology transferprojects.  Mr. Wong is currentlyChairman and a Director of Restaurant Connections International, Inc. a companyhe co-founded in September 1998, which owns and operates a chain ofrestaurants in Brazil.  Until September 2001,Mr. Wong was also President and CEO of Restaurant ConnectionsInternational.  From 2000 to 2002, Mr. Wongserved as CEO and a Director of Service Interactive, Inc., a serviceturnaround manager for PepsiCo and General Motors.

 

***Walter L. Henning.* **Mr. Henning was elected to the Boardof Directors in December 1999.  Heis currently Plant Manager of the Salinas Plant, McCormick & Company, Inc.,a position he has held since early 1999. Mr. Henning began his career with McCormick and Company in 1971 asManager, Technical Services.  Hesubsequently was promoted several times to other positions in technical andplant management before leaving the company in 1983 to accept the position ofVice President of Operations with Tone Spices. Following the sale of Tone Spices, Mr. Henning returned to asubsidiary of McCormick and Company, Gilroy Foods, Inc. in 1995 as VicePresident of Operations.  Mr. Henningremained with Gilroy Foods, Inc. in the same capacity after it waspurchased by ConAgra Foods Inc., a packaged food company, in 1996, beforeultimately returning to McCormick & Company in 1999.

 

***ScottWheeler, Chief Financial Officer and Corporate Secretary***.  Mr. Wheeler joined the company in April 2003as Corporate Controller, and was promoted to Chief Financial Officer, effectiveOctober 27, 2003.  His most recentposition was Vice President and Financial Officer of KBC Edible Beans Divisionof ConAgra Foods, Inc. a public company, where he worked for three years.  Prior to that he worked for Mallard’s FoodProducts both when it was an independent company and after it was sold to TysonFoods, Inc, a public company.  He beganhis career at Mallard’s Food Products in 1994 as Chief Financial Officer until1999 when he was promoted to General Manager until joining KBC in April of2000.  Prior to joining Mallard’s, Mr. Wheelerheld a 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.

 

22

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Below are principal occupations of certain other significant employeesof 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 he served in a variety of technical andoperations positions, ultimately being promoted to Manager of Plant Operationsin 1997.  He also served as a LogisticsSupervisor with Frito Lay, a public company, from 1984-86.

 

***Carl Anderson,Ph.D Director,Quality Assurance****.*  Dr. Anderson joined Monterey GourmetFoods in August, 2003.  Prior to joiningMonterey Pasta, Carl was Director Quality Assurance for ConAgra FoodIngredients a division of ConAgra Foods, a public company, with operations inCalifornia, Nevada, Oregon, New Mexico, Illinois and New Jersey.  Responsibilities included quality assurance,regulatory affairs and quality systems management for the primary companieswithin ConAgra Food Ingredients, Gilroy Foods and Spice Tec.  From 1991 to 1999, Carl held positions asSenior Microbiologist, Principal Scientist and Director of Quality Assurancefor Gilroy Foods a division of McCormick a public company.  From 1983 to 1991, Carl worked at DelMonte/Nabisco, a public company,  asPrincipal 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, —GeneralManager — Club Division.*** Mr. Stirlacci joined the Company in 1995 and served as Western ZoneManager until December 1999 when he was promoted to Senior SalesManager-West.  In January 2001 hewas promoted to Vice President, Sales. His primary responsibility is to manage, and develop the Company’sbusiness with club stores.  Mr. Stirlaccihas been in the food and beverage industry since 1981, serving seven years withYoung’s Market managing wholesale liquor and wine from 1988 to 1995, after sixyears as the account executive for four large grocery chains.

 

**Compliancewith Section 16(a) of the Securities Exchange Act of 1934**

 

Section 16(a) of the Securities Exchange Actof 1934, as amended, requires the Company’s directors and executive officers,and persons who own more than 10% of a registered class of the Company’s equitysecurities, to file with the SEC initial reports of ownership and reports ofchanges in ownership of Common Stock and other equity securities of theCompany.  Officers, directors and greaterthan 10% beneficial owners are required by SEC regulations to furnish theCompany with copies of all reports they file under Section 16(a).  To the Company’s knowledge, based solely onits review of the copies of such reports furnished to the Company and writtenrepresentations that no other reports were required, all Section 16(a) filingrequirements applicable to its officers, directors and greater than 10%beneficial owners were complied with during the fiscal year ended December 28,2003, except that Messrs. Bonner, Cruger, Schall, Henning, Hewitt andWheeler each filed one late report covering one transaction.

 

**AuditCommittee Composition**

 

Among the committees identified above, the Company hasa separately designated standing audit committee established in accordance withSection 3(a)(58)(A) of the Securities Exchanges Act of 1934, asamended.  Charles B. Bonner, Michael P.Schall and Walter L. Henning are members of the audit committee.  The Company’s Board of Directors hasdetermined that all members of the Company’s Audit Committee are “independent”as defined in NASD Marketplace Rule 4200(a)(15).

 

**Audit CommitteeExpert**

 

TheCompany’s Board of Directors has determined that Mr. Charles B. Bonner,because of his experience in mergers and acquisitions, extensive experience infinancial transactions and knowledge of business operations, is the Board’sdesignated financial expert.  The Company’sBoard of Directors has also determined that Mr. Bonner is independent.

 

**Code ofEthics**

 

TheCompany has adopted a Code of Ethics as defined in Item 406 of Regulation S-Kthat applies to its principal executive and financial officers and the personsperforming similar functions.  MontereyGourmet Foods will provide a copy of its Code of Ethics, without charge, to anyinvestor that requests it.  Requestsshould be addressed in writing to Mr. Scott Wheeler, Corporate Secretary,1528 Moffett Street, Salinas, CA 93905.

 

23

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

 

**SUMMARYCOMPENSATION TABLE**

 
| ** **                       | ** ** | **Annual Compensation** | ** ** | **Long Term Compensation** | ** ** |
|----------------------------------|------------|-------------------------|------------|----------------------------|------------|
| **Name and  Principal Position** | ** ** | **Year**                | ** ** | **Salary $ (1)**      | ** ** | **Bonus $** | ** ** | **Other  Annnual  Compensation** | ** ** | **Securities  Underlying  Options (#)** | ** ** | **All  Other  Compensation** | ** ** |
| ** **                       | ** ** | ** **              | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **James M. Williams (2)**        |       | 2004                    |       | $                          | 317,681    |   | $ | 16,000 | (3) | $ | 9,000 | (4) | 50,000 | (1) | $ | 20,000 | (5) |
| President and CEO                |       | 2003                    |       | $                          | 292,453    |   | $ | 69,500 | (3) | $ | 9,000 | (4) | 50,000 | (1) | $ | 27,708 | (5) |
|                             |       | 2002                    |       | $                          | 60,231     |   | $ | — |   | $ | 2,250 | (4) | 50,000 | (1) | $ | 67,030 | (5) |
|                             |       |                    |       |                       |       |   |   |   |   |   |   |   |   |
| **Scott S. Wheeler**             |       | 2004                    |       | $                          | 146,779    |   | $ | 20,000 | (3) | $ | — |   | 15,000 | (2) | $ | — |   |
| Chief Financial Officer          |       | 2003                    |       | $                          | 66,635     |   | $ | — |   | $ | — |   | 25,000 | (2) | $ | 50,000 | (5) |
|                             |       | 2002                    |       | $                          | —     |   | $ | — |   | $ | — |   | — |   | $ | — |   |
|                                  |            |                         |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

Note:  (“options” in all casesrefer to an option to purchase one share of common stock for each optiongranted)

 

(1)                                  Includes amounts (if any) deferred at thenamed executive officer’s option under Monterey Pasta’s 401(k) plan.

 

(2)                                  Mr. Williamsjoined Monterey Pasta in October 2002 as President.   On December 28, 2002, Mr. Williamswas promoted to President and Chief Executive Officer.

 

(3)                                  Bonuseswere based on the Company’s performance and other objectives obtained.

 

(4)                                  Representsthe sum of monthly automobile allowances.

 

(5)                                  Representsrelocation expenses and housing allowances paid by the Company

 

**StockOptions Granted in Fiscal 2004**

** **

The following table provides the specified informationconcerning grants of options to purchase our Common Stock made during thefiscal year ended December 26, 2004 to the persons named in the SummaryCompensation Table:

 

**OPTION GRANTS IN LAST FISCAL YEAR**

 
| ** **        | ** ** | **Individual Grants**                                  | ** ** | ** **                                                      | ** ** |
|-------------------|------------|--------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **Name**          | ** ** | **Number of  Shares  Underlying  Options  Granted(1)** | ** ** | **% of Total  Options  Granted to  Employees  in Fiscal  Year** | ** ** | **Exercise  Price  Per Share(2)** | ** ** | **Expiration  Date** | ** ** | **Potential Realizable  Value on 12/26/04 (3)** | ** ** |
|              |       |                                                   |       |                                                            |       |   |   |   |   |   |   |
| James M. Williams |       | 50,000                                                 |       | 14.53                                                           | %          | $3.44 |   | 11/11/2014 |   | $77,097 |   |
|              |       |                                                   |       |                                                            |       |   |   |   |   |   |   |
| Scott S. Wheeler  |       | 15,000                                                 |       | 4.36                                                            | %          | $3.44 |   | 11/11/2014 |   | $23,129 |   |

 

24

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----

(1)                                  Theoption to purchase shares was granted on November 11, 2004 and will vestin 50% on November 11, 2005 and will vest 50%  on November 11, 2006 conditioned uponcontinued service with the Company.

 

(2)                                  Alloptions were granted at market value on the date of grant.

 

(3)                                  ThePotential Realizable Value of the options was calculated using a Black-Scholesoption pricing model assuming no dividends, a weighted average risk-freeinterest rate of 3.69% and a weighted-average volatility of 54.9%.

 

**OptionExercises and Fiscal 2004 Year-End Values**

** **

Therewere no exercises of options by any of the officers named in the SummaryCompensation Table during the fiscal year ended December 26, 2004.  The following table specifies the number andvalue of unexercised options held as of December 26, 2004, by the personsnamed in the Summary Compensation Table above.

 

**AGGREGATED OPTION EXERCISES INLAST FISCAL YEARAND FISCAL YEAR-END VALUES**

** **
| ** **        | ** ** | **Number of Shares  Underlying Unexercised Options at  Fiscal Year End** | ** ** | **Value of Unexercised  In-the-Money Options at Fiscal Year End(1)** | ** ** |
|-------------------|------------|--------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| **Name**          | ** ** | **Exercisable**                                                          | ** ** | **Unexercisable**                                                    | ** ** | **Exercisable** | ** ** | **Unexercisable** | ** ** |
| James M. Williams |       | 100,000                                                                  |       | 50,000                                                               |       | -0- |   | -0- |   |
|              |       |                                                                     |       |                                                                 |       |   |   |   |   |
| Scott S. Wheeler  |       | 12,500                                                                   |       | 27,500                                                               |       | -0- |   | -0- |   |

 

----

(1)                                  Basedon a market value of $3.22 per share, the closing price of our Common Stock on December 26,2004, the last trading day of our fiscal year, as reported by the NASDAQ National Market.

 

**EmploymentContracts and Termination of Employment and Change-in-Control Arrangements**

** **

The Company’s President and Chief Executive Officeraccepted employment with the Company commencing October 1, 2002 pursuantto terms set forth in a letter from the Company, a copy of which is filed as Exhibit 10.11.  Pursuant to this letter, Mr. Williams isan “at will” employee with (1) salary payable at the rate of $290,000 perannum and eligibility for an annual bonus up to a maximum of 50% of grosssalary based upon achievement of mutually agreed performance standards, (2) optionsfor 200,000 shares of Company common stock vesting over a period of fouryears, (3) a car allowance of $750 per month, (4) the right toparticipate in group medical insurance and similar benefits available to allemployees, and (5) a severance benefit equal to one year’s salary in theevent his employment is terminated without cause. Pursuant to the letter also,the Company provided Mr. Williams with relocation assistance, including a$20,000 per year housing assistance bonus during the first three years ofemployment, reimbursement for moving costs, reimbursement for certain costs inconnection with sale of a previous home and purchase of a new one, and gross upto alleviate the income tax impact of the additional consideration.

 

**Compensation ofDirectors**

** **

DuringFebruary 2004, the Compensation Committee reviewed director compensationand compared current compensation with that of 19 peer companies.  As a result of the study, effective with theJuly, 2004 Board meeting, non-employee directors received and  will receive in future years, an optionpursuant to the Company’s Third Amended and Restated 1993 Stock Option Plan(the “Plan”) to purchase 10,000 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 and the grantdate will be the stockholder annual meeting date.  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. In addition, outside directors are also reimbursed forout-of-pocket travel expenses related to Board meetings and receive a stipendof $3,000 for each Board meeting attended. Also, the Audit Committeechairperson will receive a stipend of $700 for each Audit Committee meetingchaired and the Compensation Committee chairperson will receive a stipend of$500 for each committee meeting chaired. Total payments made to all directors in 2004 were $50,400, plus travelexpenses.

 

25

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Optionsgranted to a director who is also an employee of the Company (or to any otheremployee eligible under the Plan) are subject to different terms under the Planthan those of the non-employee director options.  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. A director who becomes an employee of the Company is nolonger eligible for non-employee director’s options. Under the Plan, the Boarddetermines for each employee option, among other things, the number of sharesof stock underlying the option, the timing and terms of and vesting of suchoption, in its sole discretion.  Theexercise price may not be less than the fair market value of a share of CommonStock on the date of grant.

 

**CompensationCommittee Interlocks and Insider Participation**

** **

During the fiscal year ended December 26, 2004,executive compensation was administered by the Compensation Committee comprisedof three outside directors of the Board of Directors, Van Tunstall, James Wongand F. Christopher Cruger.

 

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

 

The****table below sets forth (except as noted in the footnotes tothe table), certain information with respect to the beneficial ownership of theCompany’s Common Stock by  (i) allpersons known by the Company to be the beneficial owners of more than 5% of theoutstanding Common Stock of the Company as of December 31, 2004,  (ii) each director and director-nomineeof the Company,  (iii) the ChiefExecutive Officer and Chief Financial Officer as of December 31, 2004,and  (iv) all executive officers anddirectors of the Company for fiscal year 2004 through****December 31,2004,  as a group.

 
| ** **                                                                                      | ** ** | **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 |       | 2,341,935            |       | 16.3 | % |
| Fidelity  Investments (3)  82 Devonshire Street  Boston, MA 02109                               |       | 1,408,700            |       | 9.8 | % |
| T Rowe Price  Associates, Inc. (4)  100 East Pratt Street  Baltimore, MD 21202             |       | 1,118,100            |       | 7.8 | % |
| Dimensional Fund  Advisors (5)  1299 Ocean Ave  Santa Monica, CA 90401                          |       | 1,303,705            |       | 9.1 | % |
| Fifth Third  Asset Management (6)  600 Superior Avenue East  Cleveland, OH 44144                |       | 816,500              |       | 5.7 | % |
| AWM Investment  Co., Inc. (7)  153 East 53rd Street  New York, NY 10022                    |       | 735,299              |       | 5.1 | % |
| F. Christopher Cruger (8)                                                                       |       | 42,567               |       |   | * |
| Van Tunstall (9)                                                                                |       | 103,740              |       |   | * |
| Michael P. Schall (10)                                                                          |       | 43,750               |       |   | * |
| James Wong (11)                                                                                 |       | 58,500               |       |   | * |
| R. Lance Hewitt (12)                                                                            |       | 253,985              |       | 1.5 | % |
| Charles B. Bonner (13)                                                                          |       | 161,227              |       |   | * |
| Scott Wheeler (14)                                                                              |       | 13,500               |       |   | * |
| Walter L. Henning (15)                                                                          |       | 91,200               |       |   | * |
| James M. Williams (16)                                                                          |       | 105,500              |       |   | * |
| All Officers and  Directors as a group (9 persons) (17)                                         |       | 873,969              |       | 5.8 | % |

 

26

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----

* Represents less than 1%

 
| (1)    | Beneficial  ownership is determined in accordance with the rules of the Securities  and Exchange Commission. In computing the number of shares beneficially owned  by a person and the percentage ownership of that person, shares of Common  Stock subject to options or warrants held by that person that are currently  exercisable or will become exercisable within sixty (60) days after December 31,  2004 are deemed outstanding, while such shares are not deemed outstanding for  purposes of computing percentage ownership of any other person. Options  granted under the Company’s Third Amended and Restated 1993 Stock Option Plan  (the “1993 Stock Option Plan”) generally becomes exercisable as the  underlying shares vest. Unless otherwise indicated in the footnotes below,  the persons and entities named in the table have sole voting and investment  power with respect to all shares beneficially owned, subject to community  property laws where applicable. Unless otherwise indicated, the address of  each of the individuals listed in the table is: c/o Monterey Gourmet Foods, Inc.,  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 Lagunitas Partners,  L.P. (“Lag”), a California investment limited partnership. As of December 31,  2004, GMCM had shared voting and investment power over 2,073,685 shares; Mr. Gruber  has sole voting and investment power over 268,250 shares and shared voting  and investment power over 2,073,685 shares; Mr. McBaine has sole voting  and investment power over 293,950 shares and shared voting and investment  power over 2,073,685 shares; Lag has sole voting and investment power over  1,023,085 shares; Mr. Eric Swergold, an investment manager, has shared  voting and investment power over 2,073,685 shares, Mr. Lynn Rose, an  investment manager, has shared voting and investment power over 2,073,685  shares. Neither Mr. Gruber nor the Mr. McBaine participate in the  Management of the Company, direct the policies of the company, or serve on  the Board of Directors of the Company. In addition, one individual at GMCM  serves as an executive officer of the Company. |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |   |   |
| (3)    | As of December 31, 2004, FMR Corp. on behalf of certain of its  direct and indirect subsidiaries, and Fidelity International Limited on  behalf of certain of its direct and indirect subsidiaries (collectively “Fidelity”),  indirectly held 1,420,700 shares of Company stock. The beneficial ownership  of PSTA shares arises in the context of passive investment activities only by  the various investment accounts managed by Fidelity on a discretionary basis  (the “Fidelity Accounts”). Neither Fidelity nor the Fidelity Accounts  participate in the Management of the Company, direct the policies of the  company, or serve on the Board of Directors of the Company. In addition, no  Fidelity officer serves as an executive officer of the Company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |   |   |
| (4)    | As of December 31, 2004, T. Rowe Price Associates, Inc (“Price  Associates”) has sole dispositive power for an entire holding of 1,118,100  shares and sole voting power over 283,100 shares. These securities are owned  by various individual and institutional investors for which Price Associates  serves as investment advisor with power to direct investments and/or sole  power to vote the securities. For purposes of the reporting requirements of  the Securities Exchange Act of 1934, Price Associates expressly disclaims  that it is, in fact, the beneficial owner of such securities.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |   |   |
| (5)    | As of December 31,  2004, Dimensional Fund Advisors Inc (“Dimensional”) an investment advisor  registered under Section 203 of the Investment Advisors Act of 1940  which furnishes investment advice to four investment companies registered  under the Investment Company Act of 1940 and serves as investment manager to  certain other commingled groups trusts and separate accounts directly or  indirectly held 1,303,705 shares of Company stock. In its role as investment  advisor or manager, Dimensional possesses investment and/or voting power over  1,303,705 shares. However, Dimensional disclaims beneficial ownership of  these securities. In addition, no Dimensional officer serves as an executive  officer or director of the Company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |   |   |
| (6)    | As of December 31, 2004, Fifth Third Asset Management. (“Fifth  Third”), in its capacity of investment advisor, may be deemed to have  beneficial ownership of 816,500 shares of the common stock of the Company.  Fifth Third had voting power and/or dispositive power over 816,500 shares.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |   |   |
| (7)    | As of December 31, 2004, AWM Investment Co., Inc. (“AWM”),  in its capacity of investment advisor, may be deemed to have beneficial  ownership of 735,299 shares of the common stock of the Company. Mr. Austin  W. Marxe and Mr. David M. Greenhouse are the controlling principals of  AWM Investment Company, Inc. AWM had voting power and/or dispositive  power over 735,299 shares.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |   |   |
| (8)    | Includes 37,500 shares subject to options granted under the 1993  Stock Option Plan which are exercisable within sixty (60) days of December 31,  2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |

 

27

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| (9)    | Includes 82,500 shares subject to options granted under the 1993  Stock Option Plan which are exercisable within sixty (60) days of December 31,  2004.                                                                                                                                  |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                          |   |   |
| (10)   | Includes 37,500 shares subject to options granted under the 1993  Stock Option Plan which are exercisable within sixty (60) days of December 31,  2004.                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                          |
| (11)   | Includes 52,500 shares subject to options granted under the 1993  Stock Option Plan which are exercisable within sixty (60) days of December 31,  2004.                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                          |   |   |
| (12)   | Includes 238,985 shares subject to options granted under the 1993  Stock Option Plan which are exercisable within sixty (60) days of December 31,  2004.                                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                          |   |   |
| (13)   | Includes 102,500 shares subject to options granted under the 1993  Stock Option Plan which are exercisable within sixty (60) days of December 31,  2004.                                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                          |   |   |
| (14)   | Includes 12,500 shares subject to options granted under the 1993  Stock Option Plan which are exercisable within sixty (60) days of December 31,  2004.                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                          |   |   |
| (15)   | Includes 6,200 shares held in an IRA account in the name of Teresa A.  Henning to which Mr. Henning claims beneficial ownership, and 62,500  shares subject to options granted under the 1993 Stock Option Plan which are  exercisable within sixty (60) days of December 31, 2004. |
|   |                                                                                                                                                                                                                                                                                          |   |   |
| (16)   | Includes 100,000 shares subject to options granted under the 1993  Stock Option Plan which are exercisable within sixty (60) days of December 31,  2004.                                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                          |   |   |
| (17)   | Includes 726,485 shares subject to options granted under the 1993  Stock Option Plan which are exercisable within sixty (60) days of December 31,  2004.                                                                                                                                 |

 

 

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

 

None

 

**ITEM 14.****                                              PRINCIPALACCOUNTING FEES AND SERVICES**

 

The Audit Committee of the Board of Directors ofMonterey Gourmet Foods has selected BDO Seidman, LLP as independent registeredpublic accounting firm to audit the consolidated financial statements of Monterey Gourmet Foods for the fiscalyear ending December 26, 2004.  BDOSeidman, LLP has acted in such capacity since its appointment in fiscal year1997.  The following table sets forth theaggregate fees billed to Monterey Gourmet Foods for the fiscal years ended December 26,2004 and December 28, 2003 by BDO Seidman, LLP:

 
| ** **             | ** ** | **Fiscal 2004** | ** ** | **Fiscal 2003** | ** ** |
|------------------------|------------|-----------------|------------|-----------------|------------|
| Audit Fees (1)         |       | $               | 149,100    |            | $          | 131,000 |   |
| Audit-Related Fees (2) |       | $               | 6,900      |            | $          | 13,000 |   |
| Tax Fees (3)           |       | $               | 38,000     |            | $          | 30,000 |   |
| All Other Fees         |       | —          |       | —          |       |

 

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(1)                                  AuditFees consist of fees billed for professional services rendered for the audit ofthe Company’s consolidated annual financial statements and review of theinterim consolidated financial statements included in quarterly reports andservices that are normally provided by BDO Seidman, LLP in connection withstatutory and regulatory filings or engagements.

 

(2)                                  Audit-RelatedFees consist of fees billed for assurance and related services that arereasonably related to the performance of the audit or review of the Company’sconsolidated financial statements and are not reported under “Audit Fees.” Thiscategory includes fees related to consultationsregarding the proper accounting and reporting considerations for varioustransactions such as equity awards, business acquisitions and income taxes.

 

28

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(3)                                  TaxFees consist of fees billed for professional services rendered for annual compliance filings, ongoing tax planning,consultation regarding the tax implication of proposed or pending transactions.

 

The Audit Committee mustpre-approve audit and non-audit services provided to the Company by theindependent registered public accounting firm (or subsequently approvenon-audit services in those circumstances where a subsequent approval isnecessary and permissible); in this regard, the Audit Committee shall have thesole authority to approve the hiring and firing of the independent registeredpublic accounting firm, all audit engagement fees, terms and all non-auditengagements, as may be permissible, with the independent registered publicaccounting firm.

 

##### **PART IV**

##### ** **

**ITEM 15.****                                              EXHIBITS,FINANCIAL STATEMENT SCHEDULES**

 
| (a)(1) – (2)   Consolidated  Financial Statements of Monterey Gourmet Foods: |   |
|-------------------------------------------------------------------------------------------------------|--------|
|                                                                                                  |   |   |   |
| Report  of Independent Registered Public Accounting Firm                                              |   |
| Consolidated Balance Sheets:  Year-End 2003 and 2004                                                  |   |
| Consolidated  Statements of Operations: Years Ended 2002, 2003 and 2004                               |   |
| Consolidated  Statements of Stockholders’ Equity: Years Ended 2002, 2003 and 2004                |   |
| Consolidated  Statements of Cash Flows: Years Ended 2002, 2003 and 2004                               |   |
| 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 56.  The Exhibits listed in the accompanying Indexof Exhibits are filed or incorporated by reference as part of this report.  Exhibit Nos. 10.1, 10.2, and 10.11, aremanagement contracts or compensatory plans or arrangements.

 

29

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**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

 

 

To the Stockholders andBoard of Directors of

Monterey Gourmet Foods, Inc.

 

 

We have audited theaccompanying consolidated balance sheets of Monterey Gourmet Foods as of December 28,2003 and December 26, 2004 and the related consolidated statements of operations,stockholders’ equity and cash flows for each of the three years in the periodended December 26, 2004. We have also audited the schedule listed inthe accompanying index at Item 15(a). These financial statements and the schedule are the responsibilityof the Company’s management.  Ourresponsibility is to express an opinion on these financial statements and the schedule basedon our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements and schedule are free of material misstatement.  The Company is not required to have, nor werewe engaged to perform, an audit of its internal control over financialreporting.  Our audit includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements and schedule, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall presentation of the financial statements andschedule.  We believe that our auditsprovide 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 Gourmet Foods at December 28,2003 and December 26, 2004, and the results of its operations and its cashflows for each of the three years in the period ended December 26, 2004,in conformity with accounting principles generally accepted in the UnitedStates of America.

 

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

 

 

BDO Seidman, LLP

San Francisco, California

February 4, 2005

 

30

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**MONTEREY GOURMET FOODS, INC.**

**CONSOLIDATED BALANCE SHEET**

(inthousands, except share amounts)

 
| ** **                                                                                                                                                                     | ** ** | **December 28, 2003** | ** ** | **December 26, 2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
|                                                                                                                                                                           |       |                       |       |                       |       |
| ASSETS                                                                                                                                                                         |       |                       |       |                       |       |
| Current assets:                                                                                                                                                                |       |                       |       |                       |       |
| Cash and cash equivalents                                                                                                                                                      |       | $                          | 5,285      |                       | $          | 569 |   |
| Accounts receivable less allowances of $441 and $240                                                                                                                           |       | 6,313                      |       | 6,212                      |       |
| Inventories                                                                                                                                                                    |       | 4,323                      |       | 4,325                      |       |
| Deferred tax assets-current                                                                                                                                                    |       | 3,485                      |       | 1,126                      |       |
| Prepaid expenses and other                                                                                                                                                     |       | 1,466                      |       | 957                        |       |
|                                                                                                                                                                           |       |                       |       |                       |       |
| Total current assets                                                                                                                                                           |       | 20,872                     |       | 13,189                     |       |
|                                                                                                                                                                           |       |                       |       |                       |       |
| Propertyand equipment, net                                                                                                                                                     |       | 15,445                     |       | 14,768                     |       |
| Deferred tax assets-longterm                                                                                                                                                   |       | 1,036                      |       | 3,952                      |       |
| Deposits and other                                                                                                                                                             |       | 107                        |       | 126                        |       |
| Intangible assets, net                                                                                                                                                         |       | 1,996                      |       | 6,114                      |       |
| Goodwill                                                                                                                                                                       |       | 4,748                      |       | 8,724                      |       |
|                                                                                                                                                                           |       |                       |       |                       |       |
| Total assets                                                                                                                                                                   |       | $                          | 44,204     |                       | $          | 46,873 |   |
|                                                                                                                                                                           |       |                       |       |                       |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                      |       |                       |       |                       |       |
| Current liabilities:                                                                                                                                                           |       |                       |       |                       |       |
| Accounts payable                                                                                                                                                               |       | $                          | 2,850      |                       | $          | 2,298 |   |
| Accrued payroll and related benefits                                                                                                                                           |       | 875                        |       | 1,042                      |       |
| Accrued and other current liabilities                                                                                                                                          |       | 441                        |       | 1,328                      |       |
| Current portion of notes, loans, and capital leases  payable                                                                                                                   |       | 2                          |       | 757                        |       |
|                                                                                                                                                                           |       |                       |       |                       |       |
| Total current liabilities                                                                                                                                                      |       | 4,168                      |       | 5,425                      |       |
|                                                                                                                                                                           |       |                       |       |                       |       |
| Notes, loans, and capital leases payable, less  current portion                                                                                                                |       | 1                          |       | 1,651                      |       |
|                                                                                                                                                                           |       |                       |       |                       |       |
| Commitments and contingencies                                                                                                                                                  |       |                       |       |                       |       |
|                                                                                                                                                                           |       |                       |       |                       |       |
| Minorityinterest                                                                                                                                                               |       | —                     |       | 581                        |       |
|                                                                                                                                                                           |       |                       |       |                       |       |
| Stockholders’ equity:                                                                                                                                                     |       |                       |       |                       |       |
| Preferred stock, $.001 par value, 1,000,000 shares  authorized, non outstanding Common stock, $.001 par value, 50,000,000 shares  authorized, 14,213,682 and 14,392,574 issued |       | 14                         |       | 14                         |       |
| Additional paid-in capital                                                                                                                                                     |       | 44,578                     |       | 45,103                     |       |
| Accumulated deficit                                                                                                                                                            |       | (4,557                     | )          | (5,901                     | )          |
| Total stockholders’ equity                                                                                                                                                |       | 40,035                     |       | 39,216                     |       |
|                                                                                                                                                                           |       |                       |       |                       |       |
| Total liabilities and stockholders’ equity                                                                                                                                |       | $                          | 44,204     |                       | $          | 46,873 |   |

 

Seeaccompanying summary of significant accounting policies and notes toconsolidated financial statements

 

31

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**MONTEREY GOURMET FOODS, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(in thousands, except share and per share amounts)

 
| ** **                                     | ** ** | **Years Ended** | ** ** |
|------------------------------------------------|------------|-----------------|------------|
| ** **                                     | ** ** | **2002**        | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net revenues                                   |       | $               | 61,679     |   | $ | 60,490 |   | $ | 62,491 |   |
|                                           |       |            |       |   |   |   |   |
| Cost of sales                                  |       | 39,417          |       | 41,921 |   | 46,023 |   |
|                                           |       |            |       |   |   |   |   |
| Gross profit                                   |       | 22,262          |       | 18,569 |   | 16,468 |   |
|                                           |       |            |       |   |   |   |   |
| Selling, general and administrative expenses   |       | 15,654          |       | 17,161 |   | 18,224 |   |
| Gain (loss)on disposition of assets            |       | (68             | )          | — |   | (5 | ) |
|                                           |       |            |       |   |   |   |   |
| Operating income (loss)                        |       | 6,540           |       | 1,408 |   | (1,761 | ) |
|                                           |       |            |       |   |   |   |   |
| Other income (expense), net                    |       | 3               |       | (1 | ) | 42 |   |
| Interest income (expense), net                 |       | 110             |       | 72 |   | (130 | ) |
|                                           |       |            |       |   |   |   |   |
| Income (loss)before provision for income taxes |       | 6,653           |       | 1,479 |   | (1,849 | ) |
|                                           |       |            |       |   |   |   |   |
| Income tax benefit (provision)                 |       | 2,838           |       | (444 | ) | 505 |   |
|                                           |       |            |       |   |   |   |   |
| Net income (loss)                              |       | $               | 9,491      |   | $ | 1,035 |   | $ | (1,344 | ) |
|                                           |       |            |       |   |   |   |   |
| Net income per common share                    |       |            |       |   |   |   |   |
| Basic income per common share                  |       | $               | 0.68       |   | $ | 0.07 |   | $ | (0.09 | ) |
|                                           |       |            |       |   |   |   |   |
| Diluted income per common share                |       | $               | 0.65       |   | $ | 0.07 |   | $ | (0.09 | ) |
|                                           |       |            |       |   |   |   |   |
| Basic shares outstanding                       |       | 14,039,902      |       | 14,206,627 |   | 14,343,386 |   |
| Diluted shares outstanding                     |       | 14,664,762      |       | 14,414,931 |   | 14,343,386 |   |

 

See accompanying summaryof significant accounting policies and notes to consolidated financialstatements

 

32

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**MONTEREY GOURMET FOODS, INC.**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

**FOR THE YEARS ENDED 2002, 2003, and 2004**

(in thousands, except share amounts)

 
| ** **                                                   | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | **Accumulated** | ** ** | ** **  | ** ** |
|--------------------------------------------------------------|------------|------------------|------------|----------------|------------|-----------------|------------|-------------|------------|
| ** **                                                   | ** ** | **Shares**       | ** ** | **Amount**     | ** ** | **Capital**     | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| Balance, end of 2001                                         |       | 13,766,692       |       | $              | 14         |            | $          | 43,050      |       | $ | (15,083 | ) | $ | 27,981 |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Issuance of common stock under Employee Stock  Purchase Plan |       | 7,670            |       | —         |       | 36              |       | —      |       | 36 |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Issuance of common stock in net warrant exercise             |       | 47,414           |       | —         |       | —          |       | —      |       | — |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Exercise of stock options for cash                           |       | 374,615          |       | —         |       | 953             |       | —      |       | 953 |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Net settlement from investor 16(b) violation            |       | —           |       | —         |       | (4              | )          | —      |       | (4 | ) |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Tax benefit of disqualifying dispositions                    |       | —           |       | —         |       | 484             |       | —      |       | 484 |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Net income for the year                                      |       | —           |       | —         |       | —          |       | 9,491       |       | 9,491 |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Balance, end of 2002                                         |       | 14,196,391       |       | 14             |       | 44,519          |       | (5,592      | )          | 38,941 |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Issuance of common stock under Employee Stock  Purchase Plan |       | 15,695           |       | —         |       | 54              |       | —      |       | 54 |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Exercise of stock options for cash                           |       | 1,596            |       | —         |       | 4               |       | —      |       | 4 |   |
| Tax benefit of disqualifying dispositions                    |       | —           |       | —         |       | 1               |       | —      |       | 1 |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Net income for the year                                      |       | —           |       | —         |       | —          |       | 1,035       |       | 1,035 |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Balance, end of 2003                                         |       | 14,213,682       |       | 14             |       | 44,578          |       | (4,557      | )          | 40,035 |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Issuance of common stock under Employee Stock  Purchase Plan |       | 14,964           |       | —         |       | 43              |       | —      |       | 43 |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Exercise of stock options for cash                           |       | 163,928          |       | —         |       | 427             |       | —      |       | 427 |   |
| Tax benefit of disqualifying dispositions                    |       | —           |       | —         |       | 55              |       | —      |       | 55 |   |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Net income (loss) for the year                               |       | —           |       | —         |       | —          |       | (1,344      | )          | (1,344 | ) |
|                                                         |       |             |       |           |       |            |       |        |       |   |   |
| Balance, end of 2004                                         |       | 14,392,574       |       | $              | 14         |            | $          | 45,103      |       | $ | (5,901 | ) | $ | 39,216 |   |

 

See accompanyingsummary of significant accounting policies and noted to consolidated financialstatements

 

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**MONTEREY GOURMET FOODS, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(in thousands, except share amounts)

 
| ** **                                                                                                   | ** ** | **Years Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|
| ** **                                                                                                   | ** ** | **2002**        | ** ** | **2003** | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                                                                        |       |            |       |   |   |   |   |
| Net income (loss)                                                                                            |       | $               | 9,491      |   | $ | 1,035 |   | $ | (1,344 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities net of acquisition: |       |            |       |   |   |   |   |
| Deferred income taxes                                                                                        |       | (3,258          | )          | 313 |   | (557 | ) |
| Depreciation and amortization                                                                                |       | 1,720           |       | 2,082 |   | 2,510 |   |
| Provisions for allowances for bad debts, returns, adjustments  and spoils                                    |       | 2,565           |       | 3,211 |   | 3,646 |   |
| Provisions for inventory allowances                                                                          |       | 42              |       | 510 |   | 550 |   |
| Tax benefit of disqualifying dispositions                                                                    |       | 484             |       | 1 |   | 55 |   |
| Loss on disposition of assets                                                                                |       | 68              |       | — |   | 5 |   |
| Changes in assets and liabilities:                                                                           |       |            |       |   |   |   |   |
| Accounts receivable                                                                                          |       | (2,598          | )          | (3,429 | ) | (2,924 | ) |
| Inventories                                                                                                  |       | (352            | )          | (1,146 | ) | (267 | ) |
| Prepaid expenses and other                                                                                   |       | 57              |       | (389 | ) | 538 |   |
| Accounts payable                                                                                             |       | 1,588           |       | (353 | ) | (3 | ) |
| Accrued and other current liabilities                                                                        |       | (313            | )          | (324 | ) | (311 | ) |
| Net cash provided by operating activities                                                                    |       | 9,494           |       | 1,511 |   | 1,898 |   |
|                                                                                                         |       |            |       |   |   |   |   |
| Cash flows from investing activities:                                                                        |       |            |       |   |   |   |   |
| Purchase of property and equipment                                                                           |       | (4,760          | )          | (3,029 | ) | (777 | ) |
| Acquisition of business net of cash and minority  interest                                                   |       | (6,082          | )          | (79 | ) | (7,689 | ) |
| Net cash used in investing activities                                                                        |       | (10,842         | )          | (3,108 | ) | (8,466 | ) |
|                                                                                                         |       |            |       |   |   |   |   |
| Cash flows from financing activities:                                                                        |       |            |       |   |   |   |   |
| Proceeds from bank borrowing                                                                                 |       | —          |       | — |   | 2,000 |   |
| Repayment of bank borrowing                                                                                  |       | —          |       | — |   | (610 | ) |
| Other miscellaneous activities                                                                               |       | (4              | )          | — |   | — |   |
| Repayment of capital lease obligations                                                                       |       | (32             | )          | (14 | ) | (8 | ) |
| Proceeds from issuance of common stock                                                                       |       | 990             |       | 58 |   | 470 |   |
| Net cash provided by financing activities                                                                    |       | 954             |       | 44 |   | 1,852 |   |
|                                                                                                         |       |            |       |   |   |   |   |
| Net decrease in cash and cash equivalents                                                                    |       | (394            | )          | (1,553 | ) | (4,716 | ) |
|                                                                                                         |       |            |       |   |   |   |   |
| Cash and cash equivalents, beginning of period                                                               |       | 7,232           |       | 6,838 |   | 5,285 |   |
| Cash and cash equivalents, end of period                                                                     |       | $               | 6,838      |   | $ | 5,285 |   | $ | 569 |   |
|                                                                                                         |       |            |       |   |   |   |   |
| ***Cash payments:***                                                                                         |       |            |       |   |   |   |   |
| Interest                                                                                                     |       | $               | 5          |   | $ | 1 |   | $ | 131 |   |
| Income taxes                                                                                                 |       | (120            | )          | 166 |   | 89 |   |
|                                                                                                         |       |            |       |   |   |   |   |
| ***Non-cash investing and  financing activities:***                                                          |       |            |       |   |   |   |   |
| Note issued to seller in acquisition of business                                                             |       | $               | —     |   | $ | — |   | $ | 1,000 |   |
| Capital lease obligations assumed in acquisition of  business                                                |       | —          |       | — |   | 5 |   |

 

See accompanying summary of significant accounting policiesand notes to consolidated financial statements

 

34

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**MONTEREY GOURMET FOODS, INC**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**1.**              Summary of Significant AccountingPolicies

 

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

 

The consolidated financial statements include the accountsof Monterey Gourmet Foods, Inc. (a producer, distributor, and marketer ofrefrigerated gourmet food products), together with its wholly owned subsidiary,Monterey Pasta Development Company (a franchiser of restaurants - inactive) and84.5% owned CIBO Naturals, LLC.  Allsignificant intercompany accounts and transactions have been eliminated inconsolidation.  Collectively, MontereyGourmet Foods, CIBO Naturals, LLC and Monterey Pasta Development Company arereferred to as the “Company.”

 

The Company’s production facilities and distributioncenter are located in Salinas (Monterey County), California, Seattle,Washington, 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 reporting purposes the Company employs a4-week, 4-week, 5-week reporting period.  The fiscal year ends on the last Sunday ofeach calendar year (52/53-week year). The 2002 fiscal year contained 52weeks and ended on December 29, the 2003 fiscal year contained 52 weeksand ended on December 28 and the 2004 fiscal year contained 52 weeks andended on December 26.

 

***Cash and Cash Equivalents***

 

The Company considers all highly liquid investmentspurchased with an original maturity of three months or less to be cashequivalents.  The Company’s cash consistsprimarily of cash in the Company’s bank account.

 

***Accounts Receivable and Allowances***

 

The Company provides allowances for estimated creditlosses, product returns, spoilage, and adjustments at a level deemedappropriate to adequately provide for known and inherent risks related to suchamounts.  The allowances are based onreviews of history of losses, returns, spoilages, adjustments, contractualrelationships with customers, current economic conditions, and other factorsthat warrant consideration in estimating potential losses.  While management uses the best informationavailable 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.

 

***Inventory Valuation***

 

Inventoriesare stated at the lower of cost (using the first-in, first-out method) ormarket and consist principally of component ingredients to the Company’srefrigerated pasta and sauces, finished goods, and packaging materials.  Many of the ingredients used in the Company’sproducts are short shelf-lived products and if not used in a certain amount oftime may spoil. Management estimates that the raw material will be used in atimely manner; however, management has established certain allowances for thepotential of inventory obsolescence, especially for slow moving inventory. Inaddition, the Company purchased certain packaging materials for its productsthat are intended to be used in the future. As of December 26, 2004, the Company has established an inventoryallowance of $213,000.

 

***Advertising Costs***

 

The Company expenses advertising costs as incurred orwhen the related campaign commences.  TheCompany spent $210,000, $145,000 and 149,000 on advertising during 2002, 2003,and 2004 respectively.

 

35

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***Property and Equipment***

 

Propertyand equipment are recorded at cost. Depreciation is provided for on the straight-line method over theestimated useful lives of the assets (or lease term for leasehold improvementsif 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, including plant and equipment, areassessed for possible impairment whenever events or changes in circumstancesindicate that the carrying amounts may not be recoverable, or whenevermanagement has committed to a plan to dispose of the assets.  Assets to be held and used affected by suchan impairment loss are depreciated or amortized at their new carrying amount overthe remaining estimated life; assets to be sold or otherwise disposed of arenot subject to further depreciation or amortization.

 

***Goodwill and Intangible Assets***

 

Intangibleassets other than goodwill consist of tradenames, customer lists, andnon-competes and other intangibles and are recorded at cost, net of accumulatedamortization.  Intangibles are amortizedover their respective useful lives, if determinate, ranging from 3 to 10 years

 

Effective January 1,2002 under SFAS 142, “Goodwill and Other Intangible Assets.” goodwill andintangible assets with indefinite useful lives are to be tested for impairmentat least annually. Intangible assets with definite useful lives continue to beamortized over their respective estimated useful lives. The primaryidentifiable intangible assets of the Company’s reporting units  are trademarks, tradenames and customerrelationships acquired in business acquisition. Identifiable intangibles withfinite lives are amortized and those with indefinite lives are not amortized. Theestimated useful life of an identifiable intangible asset to the reportingunit  is based upon a number of factors,including the effects of demand, competition, and future cash flows. As of December 26,2004, the net book value of trademarks and other identifiable intangible assetswas $6.1 million.

 

Identifiable intangibleassets that are subject to amortization are evaluated for impairment using aprocess similar to that used to evaluate elements of property. Identifiableintangible assets not subject to amortization are assessed for impairment atleast as often as annually and as triggering events may occur. The impairmenttest for identifiable intangible assets not subject to amortization consists ofa comparison of the fair value of the intangible asset with its carryingamount. An impairment loss is recognized for the amount by which the carryingvalue exceeds the fair value of the asset. In making this assessment,management relies on a number of factors to discount anticipated future cashflows including operating results, business plans and present value techniques.Rates used to discount cash flows are dependent upon interest rates and thecost of capital at a point in time. There are inherent uncertainties related tothese factors and management’s judgment in applying them to the analysis ofintangible asset impairment. It is possible that assumptions underlying theimpairment analysis will change in such a manner that impairment in value mayoccur in the future.

 

Goodwill is notamortized but is subject to periodic assessments of impairment. At December 26,2004, the Company had $8.7 million of goodwill on its books. Goodwill isassessed for impairment at least as often as annually and as triggering eventsmay occur. The corporation performs its annual review in the fourth quarter ofeach year. Recoverability of goodwill is evaluated using a comparison of thefair value of a reporting unit with its carrying value. If the carrying valueof the goodwill of a reporting unit exceeds the fair value of that goodwill, animpairment loss is recognized in an amount equal to the excess. Reporting unitsare business components one level below the operating segment level for whichdiscrete financial information is available and reviewed by segment management.

 

In evaluating therecoverability of goodwill, it is necessary to estimate the fair value of thereporting units. In making this assessment, management relies on a number offactors to discount anticipated future cash flows including operating results,business plans and present value techniques. Rates used to discount cash flowsare dependent upon interest rates and the cost of capital at a point in time.There are inherent uncertainties related to these factors and management’sjudgment in applying them to the analysis of goodwill impairment. It ispossible that assumptions underlying the impairment analysis will change insuch a manner that impairment in value may occur in the future.

 

36

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

 

TheCompany accounts for corporate income taxes in accordance with SFAS 109, “Accountingfor Income Taxes*”*, which requires an asset andliability approach.  This approachresults in the recognition of deferred tax assets (future tax benefits) and liabilitiesfor the expected future tax consequences of temporary timing differencesbetween the book carrying amounts and the tax basis of assets andliabilities.  Future tax benefits aresubject to a valuation allowance to the extent of the likelihood that thedeferred tax assets may not be realized. TheCompany’s deferred tax assets include significant amounts of NOLs. During 2004,the valuation allowance was increased slightly due to consideration of theimpact of the 2004 losses and the Company’s assessment of the realization ofsuch NOLs. The amount of the valuation allowance is significantly dependent onmanagement’s assumptions regarding future taxable income and the availabilityof these NOLs to offset future taxable income.

 

***Revenue Recognition***

 

The Company recognizes revenues through sales of itsproducts primarily to grocery and club store chains.  Revenues are recognized once there isevidence of an arrangement (such as a customer purchase order), product hasshipped and in some instances, not until the product has been delivered, theprice and terms are finalized, and collectibility is reasonably assured.  Accordingly, sales are recorded when goodsare shipped or for one customer, when the product is delivered, at which timetitle and risk of loss have passed to the customer, consistent with the freightterms for most customers.  Title and riskof loss pass upon delivery to retail locations for the Direct Store Deliveryprogram, as that 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 records shipping cost for productdelivered to customers in selling expense. These costs were approximately $2,609,000, $3,158,000 and $3,201,000 for 2002, 2003 and 2004respectively.  Any amounts charged tocustomers for freight and deliveries are included in revenues.  Certain incentives granted to customers suchas promotions, trade ads, slotting fees, and coupons are recorded as offsets torevenues.

 

***Stock-based Compensation***

 

As permitted under the provisions of SFAS 123, *Accounting for Stock-Based Compensation*, the Companycontinues to account for employee stock-based transactions under AccountingPrinciples Board Opinion (“APB”) No. 25, *Accountingfor Stock Issued to Employees*. However, SFAS 123 requires the Company to disclose pro forma net incomeand earnings per share as if the fair value method had been adopted.  Under the fair value method, compensationcost is measured at the grant date based on the fair value of the award and isrecognized over the service period, which is usually the vesting period.  For non-employees, cost is also measured atthe grant date, using the fair value method, but is actually recognized in the financialstatements over the vesting period, or immediately if no further services arerequired.

 

If theCompany had elected the fair value method of accounting for stock-basedcompensation, compensation cost would be accrued at the estimated fair value ofstock option grants over the service period, regardless of later changes instock prices and price volatility.  Thefair value at date of grant for options granted in 2002, 2003, and 2004 havebeen estimated based on a modified Black-Scholes pricing model with theassumptions identified in the following table.

 
| ** **               | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
|                     |       |     |       |     |       |     |       |
| Dividend Yield           |       | —   |       | —   |       | —   |       |
|                     |       |     |       |     |       |     |       |
| Volatility               |       | 75.0     | %          | 66.0     | %          | 54.9     | %          |
|                     |       |     |       |     |       |     |       |
| Risk-Free Interest Rates |       | 3.81     | %          | 4.60     | %          | 3.69     | %          |
|                     |       |     |       |     |       |     |       |
| Expected Lives in Years  |       | 5        |       | 5        |       | 4        |       |

 

Thetable below shows net income per share for 2002, 2003, and 2004 as if theCompany had elected the fair value method of accounting for stock options(dollars except per share data stated in thousands).

 

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| ** **                                                                                                                     | ** ** | **2002**   | ** ** | **2003**   | ** ** | **2004**   | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Net income (loss) as reported                                                                                                  |       | $          | 9,491      |       | $          | 1,035      |       | $ | (1,344 | ) |
|                                                                                                                           |       |       |       |       |       |       |       |
| Deduct: total stock-based employee compensation  determined under fair value method for all awards, net of related tax effects |       | (830       | )          | (1,393     | )          | (715       | )          |
|                                                                                                                           |       |       |       |       |       |       |       |
| Proforma net income (loss), as adjusted                                                                                        |       | 8,661      |       | (358       | )          | (2,059     | )          |
|                                                                                                                           |       |       |       |       |       |       |       |
| Earnings per share:                                                                                                            |       |       |       |       |       |       |       |
| Basic, as reported                                                                                                             |       | $          | 0.68       |       | $          | 0.07       |       | $ | (0.09 | ) |
| Basic, as adjusted                                                                                                             |       | $          | 0.62       |       | $          | (0.03      | )          | $ | (0.14 | ) |
|                                                                                                                           |       |       |       |       |       |       |       |
| Diluted, as reported                                                                                                           |       | $          | 0.65       |       | $          | 0.07       |       | $ | (0.09 | ) |
| Diluted, as adjusted                                                                                                           |       | $          | 0.59       |       | $          | (0.02      | )          | $ | (0.14 | ) |
|                                                                                                                           |       |       |       |       |       |       |       |
| Basic shares                                                                                                                   |       | 14,039,902 |       | 14,206,627 |       | 14,343,386 |       |
| Diluted Shares                                                                                                                 |       | 14,664,762 |       | 14,414,931 |       | 14,343,386 |       |

 

Beginningwith the fourth quarter of fiscal 2004, the Company decreased the estimate ofthe expected life of new options granted to employees from five years to fouryears. This change in expected life assumption is based on historicalexperience as well as the terms and vesting periods of the options granted. Thereduction in the estimated expected life was a result of an analysis of theCompany’s historical experience.

 

***Use of Estimates***

 

The preparation of financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities, disclosure of contingent assets and liabilities at the date of thefinancial statements, and the reported amounts of revenues and expenses duringthe period.  Actual results could differfrom those estimates.  The mostsignificant estimates made by the Company are those related to accountsreceivable and deferred tax allowances, allocation of purchase price ofacquired businesses, depreciation of fixed assets, amortization of acquiredintangible assets, and impairment assessments made for intangibles.

 

***Indemnifications***

 

The Company follows FASB Interpretation (“FIN”) No. 45,*Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*. FIN 45 requires a guarantor to recognize, at the inception of aqualified guarantee, a liability for the fair value of the obligationundertaken in issuing the guarantee.

 

Pursuantto its bylaws, the Company has agreed to indemnify its officers and directorsfor certain events or occurrences arising as a result of the officer ordirector serving in such capacity. The term of the indemnification period isfor the officer’s or director’s lifetime., The Company has no liabilities recordedfor these agreements as of December 26, 2004.

 

TheCompany enters into indemnification provisions under (i) its agreementswith other companies both in extraordinary transactions (such as acquisitionsof a material amount of assets or other investment in other companies) and inits ordinary course of business, typically with business partners, contractorsand customers, its sublandlord and (ii) its agreements with investors.Under these provisions the Company has agreed to generally indemnify and holdharmless the indemnified party for losses suffered or incurred by theindemnified party as a result of the Company’s activities or, in some cases, asa result of the indemnified party’s activities under the agreement. Theseindemnification provisions often include indemnifications relating torepresentations made by the Company with regard to intellectual property andother rights. These indemnification provisions generally survive termination ofthe underlying agreement. The maximum potential amount of future payments theCompany could be required to make under these indemnification provisions isunlimited. To date, the Company has not incurred any costs as there have beenno lawsuits or claims related to these indemnification agreements. Accordingly,the Company has no liabilities recorded for these agreements as of December 26,2004.

 

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***New Accounting Pronouncements***

 

In December 2004,the FASB issued SFAS No. 123R, “Share-Based Payment”. SFAS No. 123R isa revision of SFAS No. 123, “Accounting for Stock Based Compensation”, andsupersedes APB 25. Among other items, SFAS 123R eliminates the use of APB 25and the intrinsic value method of accounting, and requires companies torecognize the cost of employee services received in exchange for awards ofequity instruments, based on the grant date fair value of those awards, in thefinancial statements.

 

The effective date ofSFAS 123R is the first reporting period beginning after June 15, 2005,which is third quarter 2005 for calendar year companies, although earlyadoption is allowed. SFAS 123R permits companies to adopt its requirementsusing either a “modified prospective” method, or a “modified retrospective”method. Under the “modified prospective” method, compensation cost isrecognized in the financial statements beginning with the effective date, basedon the requirements of SFAS 123R for all share-based payments granted afterthat date, and based on the requirements of SFAS 123 for all unvested awards grantedprior to the effective date of SFAS 123R. Under the “modified retrospective”method, the requirements are the same as under the “modified prospective”method, but also permits entities to restate financial statements of previousperiods based on proforma disclosures made in accordance with SFAS 123.

 

The Company currentlyutilizes a standard option pricing model (i.e., Black-Scholes) to measure thefair value of stock options granted to Employees. While SFAS 123R permitsentities to continue to use such a model, the standard also permits the use ofa “lattice” model. The Company has not yet determined which model it will useto measure the fair value of employee stock options upon the adoption of SFAS123R. See Note entitled “Stock Based Compensation” for furtherinformation.  SFAS 123R also requiresthat the benefits associated with the tax deductions in excess of recognizedcompensation cost be reported as a financing cash flow, rather than as anoperating cash flow as required under current literature. This requirement willreduce net operating cash flows and increase net financing cash flows inperiods after the effective date. These future amounts cannot be estimated,because they depend on, among other things, when employees exercise stockoptions.

 

The Company currentlyexpects to adopt SFAS 123R effective July 1, 2005; however, the Companyhas not yet determined which of the aforementioned adoption methods it willuse.

 

In November 2004,the FASB issued SFAS No. 151, “Inventory Costs: an amendment of ARB No. 43,Chapter 4” to clarify the accounting of abnormal amounts of idle facilityexpense, freight, handling costs and wasted material.  SFAS No. 151 is effective for inventorycosts incurred during fiscal years beginning after June 15, 2005.  At this time, management is in the process ofreviewing this statement for its impact on the Company’s cost of goods sold andinventory valuation.  Management has notdetermined if this statement will impact its statement of operations in thefuture.

 

***Reclassification****s*

 

Certainof the prior year financial statement amounts have been reclassified to conformto the current year presentation.  Thesereclassifications had no impact on previously reported income or accumulateddeficit.

 

**2.**                                      **Concentration of Credit Risk**

 

Financialinstruments, which potentially subject the Company to concentration of creditrisk, include cash, cash equivalents, and accounts receivable.   The Company maintains its cash accounts inComerica Bank in Fresno, California.  Thebank cash balances are insured by the Federal Deposit Insurance Corporation upto $100,000.   At December 26, 2004uninsured cash balances totaled $469,000. As of December 26, 2004, approximately 67% of the Company’saccounts receivable are concentrated with two major customers (See Note 11).

 

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**3.****              Inventories**

 
| ** **                               | ** ** | **2003**           | ** ** | **2004** | ** ** |
|------------------------------------------|------------|--------------------|------------|----------|------------|
| ** **                               | ** ** | **(in thousands)** | ** ** |
| Inventories  consisted of the following: |       |               |       |     |       |
|                                     |       |               |       |     |       |
| Production – Ingredients            |       | $                  | 1,912      |     | $          | 1,971 |   |
| Production – Finished goods         |       | 1,219              |       | 1,341    |       |
| Paper goods and packaging materials      |       | 1,199              |       | 1,190    |       |
| Operating supplies                       |       | 44                 |       | 36       |       |
|                                     |       | 4,374              |       | 4,538    |       |
| Allowances for spoils and obsolescence   |       | (51                | )          | (213     | )          |
|                                     |       | $                  | 4,323      |     | $          | 4,325 |   |

 

**4.****              Propertyand Equipment**

 
| ** **                                         | ** ** | **2003**           | ** ** | **2004** | ** ** |
|----------------------------------------------------|------------|--------------------|------------|----------|------------|
| ** **                                         | ** ** | **(in thousands)** | ** ** |
| Property and equipment consisted of the following: |       |               |       |     |       |
|                                               |       |               |       |     |       |
| Leasehold improvements                             |       | $                  | 5,025      |     | $          | 5,084 |   |
| Machinery and equipment                            |       | 18,606             |       | 19,317   |       |
| Computers, office furniture and equipment          |       | 846                |       | 1,195    |       |
| Vehicles                                           |       | 364                |       | 298      |       |
|                                               |       | 24,841             |       | 25,894   |       |
| Less accumulated depreciation and amortization     |       | (9,828             | )          | (11,163  | )          |
|                                               |       | 15,013             |       | 14,731   |       |
| Construction in progress                           |       | 432                |       | 37       |       |
|                                               |       | $                  | 15,445     |     | $          | 14,768 |   |

 

Constructionin progress at December 26, 2004 includes deposits for equipment on orderor yet to be installed.  Depreciationexpense for 2002, 2003, and 2004 was $1,443,000, $1,593,000 and $2,029,000,respectively.

 

**5.****              Goodwilland Other Intangible Assets**

 

Goodwilland other intangible assets consist of (in thousands of dollars):

 
| ** **                            | ** ** | **Year-end  2003** | ** ** | **2004  Additions** | ** ** | **Year-end  2004** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
|---------------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|-------------------------------|------------|--------------------------|------------|
| Trademarks and tradenames             |       | $                  | 820        |                | $          | 220                |       | $                             | 1,040      |                     | $          | 187 |   | $ | 853 |   |
| Customer lists                        |       | 1,500              |       | 3,240               |       | 4,740              |       | 632                           |       | 4,108                    |       |
| Other intangibles                     |       | 455                |       | 1,140               |       | 1,595              |       | 442                           |       | 1,153                    |       |
|                                  |       |               |       |                |       |               |       |                          |       |                     |       |
| Total intangilble assets              |       | 2,775              |       | 4,600               |       | 7,375              |       | 1,261                         |       | 6,114                    |       |
|                                  |       |               |       |                |       |               |       |                          |       |                     |       |
| Goodwill                              |       | 5,143              |       | 3,975               |       | 9,118              |       | 394                           |       | 8,724                    |       |
|                                  |       |               |       |                |       |               |       |                          |       |                     |       |
| Total goodwill and intangilble assets |       | $                  | 7,918      |                | $          | 8,575              |       | $                             | 16,493     |                     | $          | 1,655 |   | $ | 14,838 |   |

 

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All of the Company’s business combinations wereaccounted for using the purchase method. Amortization expense for 2004 was $481,000.  The Company performed annual impairmenttesting as required by SFAS 142 at the beginning of the fourth quarter of 2004to determine if any writedowns were necessary, with no impairment adjustmentsneeded.

 

Following is table of estimatedamortization expense for the next five years:

 
| **Year**   | ** ** | **Estimated Amortization Expense** | ** ** |
|------------|------------|------------------------------------|------------|
| ** ** | ** ** | **(in thousands)**                 | ** ** |
| 2005       |       | $                                  | 496        |   |
| 2006       |       | 461                                |       |
| 2007       |       | 455                                |       |
| 2008       |       | 455                                |       |
| 2009       |       | 455                                |       |
|            |            |                                    |            |  |

 

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

 

**Notes,leases and capital leases payable consist of (in thousands):**

 
| ** **                                                        | ** ** | **2003** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                              |       |     |       |     |       |
| Subordinated note payable to OBIC Inc.                            |       | $        | —     |     | $          | 1,000 |   |
| 6% interest only until March 31, 2006                        |       |     |       |     |       |
| Monthly principal payments of $8 starting April 1,  2006     |       |     |       |     |       |
| Marturity on March 31, 2016                                  |       |     |       |     |       |
| Note payable to Comerica Bank                                     |       | —   |       | 1,390    |       |
| Variable rate interest at LIBOR plus 225 basis  points            |       |     |       |     |       |
| Monthly principal payments of $62 plus interest                   |       |     |       |     |       |
| Maturity on October 31, 2006                                 |       |     |       |     |       |
| Capital lease payable                                             |       | 3        |       | 18       |       |
| Total notes, loans, and capital leases payable                    |       | $        | 3          |     | $          | 2,408 |   |
| Less current portion of notes, loans, and capital  leases payable |       | (2       | )          | (757     | )          |
| Notes, loans, and capital leases payable, less  current portion   |       | $        | 1          |     | $          | 1,651 |   |

 

***Notes and loans***

 

Thenote payable to OBIC, Inc. was a note on the balance sheet of CIBONaturals at the time the Company acquired CIBO. This note was not retired at the time of the acquisition. No principalpayments have been made on this note.

 

***Credit Facility***

 

As of December 26, 2004, the Company had a creditfacility extended by Comerica Bank, which was renegotiated in August 2001and has been renewed each year for $10.0 million in aggregate borrowings.  This facility was unused until January 2004when the Company purchased an 80% interest in CIBO Naturals LLC.  The facility consists of $1.5 million workingcapital line of credit and an $8.5 million non-revolving term loan.  The $1.5 million working capital portion ofthe facility is priced at LIBOR, plus 200 basis points and expires October 31,2005.  As of December 26, 2004, theCompany was using $900,000 of the working capital line in the form of a letterof credit for the partially self-insured workers compensation program and wasusing approximately $1.39 million of the non-revolving term facility, whichleft a total of $7,71 million remaining in the combined facilities for its use.The non-revolving term portion of the facility pricing is at either prime rateor LIBOR plus 225 basis points over LIBOR and is subject to annual review.  At December 26, 2004, the Company waspaying 5.25% interest on this loan.  TheCompany is required to pay $62,500 per month plus interest on the non-revolvingterm loan.

 

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Theterms of the Credit Facility prohibit the payment of cash dividends (exceptwith written approval) on the Company’s capital stock and restrict paymentsfor, among other things, repurchasing shares of Company’s capital stock.  Other terms of the Credit Facility limit theCompany with respect to, among other things, (i) incurring additionalindebtedness,  (ii) adverselychanging the capital structure, and (iii) acquiring assets other than inthe normal course of business including specific limits on annual capitalexpenditures.  As of December 26,2004, there were no violations of any loan covenants.

 

EffectiveJanuary 1, 2004, the Company initiated a $900,000 Letter of Credit infavor of Sentry Insurance as required collateral for a deductible worker’scompensation program.   On January 1,2005, the Letter of Credit was increased to $1,000,000 in favor of the sameinsurance company.  The new letter of creditexpires December 31, 2005.

 

Futureprincipal payments due under notes, loans, and capital leases payable are asfollows (in thousands):

 
| **Year**   | ** ** | **Principal Amount** | ** ** |
|------------|------------|----------------------|------------|
| 2005       |       | $                    | 757        |   |
| 2006       |       | 651                  |       |
| 2007       |       | 75,                  |       |
| 2008       |       | 100                  |       |
| Thereafter |       | 825                  |       |
|       |       | $                    | 2,408      |   |

 

***Capitalized Leases***

 

TheCompany leases certain equipment under capitalized leases, including officeequipment, and forklift, with a liability of $3,000 and $18,000 in 2003 and2004, respectively.

 

**7**.                                      **Operating Leases**

 

TheCompany currently leases production, warehouse and corporate office space aswell as certain equipment in Monterey County, California under bothmonth-to-month and non-cancelable operating lease agreements, expiring atvarious times through 2007.  The terms ofthe leases generally require the Company to pay common area maintenance, taxes,insurance, and certain other costs.  Allbuilding leases have renewal options (see Item 2 “Properties” on page 10)and all include cost of living adjustments. The Company records rent expense on a straigt-line basis over the leaseterm.

 

Futureminimum annual lease payments due under non-cancelable operating leases withterms of more than one year are as follows (in thousands):

 
| **Year**     | ** ** | **Lease Amount** | ** ** |
|--------------|------------|------------------|------------|
| 2005         |       | $                | 1,182      |   |
| 2006         |       | 1,176            |       |
| 2007         |       | 936              |       |
| 2008         |       | 567              |       |
| Thereafter 6 |       | 3,778            |       |
|         |       | $                | 7,639      |   |

 

Gross rent expense underthe leases for 2002, 2003, and 2004 was $711,000, $805,000, and 1,080,000  respectively.  Each of the Company’s four facilities areleased.  The Company leases approximately133,000 square feet in Salinas, California, comprised of 43,700 at its headquartersfacility and 89,200 at its distribution facility three miles from itsheadquarters. The current production facilities/headquarters lease expired in October 2004.  The Company and the landlord have agreed to aten year extension of the current lease at current fair-market value.  The fair-market value is being determined bya real estate appraiser in the area.  Thefair market value has yet to be determined, but will most likely be higher thanwhat the Company is currently paying.. The lease for the distribution centerand adjacent production and storage facilities expires in June 2007 withtwo five-year renewal options.

 

The Company acquired alease for the 19,000 square foot production facility and offices as part of itsacquisition of Emerald Valley.  The leaseexpires December 31, 2007, with three five-year renewal options. In 2004,the Company announced the purchase of

 

42

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an 80% interest in CIBO Naturals LLC which operatesout of a 17,500 square foot leased facility in Seattle, WA which expires in May 2005which is in the process of being extended for an additional three years.

 

**8**.                                      **Stockholders’ Equity**

 

***Preferred Stock***

 

TheCompany has 1,000,000 Preferred Shares at $.001 par value authorized, howevernone are issued.

 

***Common Stock***

 

During 2002, employee and director optionsrepresenting 224,204 shares of common stock were exercised for proceeds of$603,000.  Non-plan options representing150,411 shares of common stock granted to the shareholders and plant manager ofFrescala Foods, Inc. as part of the March 1999 acquisition were alsoexercised, resulting in proceeds of $350,456. In addition, warrants with an exercise price of $6.50 and an expirationdate of May 1, 2003, representing 47,414 shares of Company common stockwere exercised as parts of net exercises, with no cash proceeds to theCompany.  These warrants were originallyissued in connection with a July 1996 private placement in which theCompany issued warrants to purchase up to 400,750 shares of common stock.  Additionally, 7,670 employee stock purchaseplan shares were issued with proceeds of $36,000 in 2002.

 

Warrants representing up to 242,171 shares of commonstock issued in connection with the July 1996 private placement expiredunexercised in 2003 and at December 28, 2003 and December 26, 2004,there were no warrants outstanding.

 

During 2003 employee and director options representing1,596 shares of common stock were exercised for proceeds of $4,000 and 15,695employee stock purchase plan shares were issued for proceeds of $54,000.

 

During 2004 employee and director options representing163,928 shares of common stock were exercised for proceeds of $427,000 and14,964 employee stock purchase plan shares were issued for proceeds of $43,000.

 

***Employee Stock Purchase Plan***

 

In October 1994,the Company’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 offeringdate of such offering period or (b) the fair market value of the shares onthe given purchase date.  There were7,670, 15,696 and 14,964 shares of common stock issued under the plan in 2002,2003 and 2004, respectively.  At December 26,2004, there were 146,732 available shares remaining under the plan.

 

***Income per Share***

 

Basicearnings per share are based on earnings available to common stockholdersdivided by the weighted-average number of common shares actually outstandingduring the period.  Diluted earnings pershare also include the incremental effect of any dilutive common stockequivalents assumed to be outstanding during the period.  Because of equivalent shares includable indifferent periods or at different amounts, per-share amounts for the fourquarters do not necessarily equal per-share amounts for the entire year.

 

Options to purchase 1,528,385, 1,872,739 and 1,763,810shares of common stock were outstanding at year-end 2002, 2003, and 2004,respectively.  At 2002 year-end a totalof 1,423,885 options were included in the computation of diluted income pershare, with 104,500 excluded, because of anti-dilutive exercise prices. At 2003year-end a total of 649,739 options were included in the computation of dilutedincome per share, with 1,223,000 excluded, because of exercise prices.  At 2004 year-end a total of 1,763,810 optionswere excluded from the computation of diluted earnings per share because theywere anti-dilutive due to the Company’s net loss for the year.

 

Warrants to purchase 242,171, shares were outstandingat year-end 2002.  No warrants wereoutstanding at year end 2003 and 2004. At year-end 2002 no warrantsrepresenting shares of common stock were included in the computation of incomeper share, with

 

43

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warrants representing 242,171 shares of common stock excluded, becauseof exercise prices.  At year-end 2003 and2004 no warrants representing shares of common stock were included because theyexpired.

 

**9.****                                      StockOptions**

 

Effective August 31, 1993, the Company’s Board ofDirectors adopted a stock option plan (the “Plan”), subsequently several times amendedand restated, which provides for the granting of incentive stock options ornon-qualified stock options to eligible employees, consultants and outsidedirectors.  The Company initiallyreserved 1,200,000 shares of its common stock for issuance under the Plan andin subsequent years increased the total shares reserved to 3,240,000.  The Plan provides that the option price shallnot be less than the fair market value of the shares on the date of grant;therefore, no compensation expense is recorded for employees, unless the marketprice exceeds the strike price on the day of grant.  Compensation or other expense is recorded forany 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 additionaloptions to purchase up to 155,200 shares outside of the Plan (the “NonstatutoryPlan”).  As amended, the Plan expires April 30,2012.  As of December 26, 2004, theCompany had 1,244,879 shares available under the Plan, and 33,800 available aspart of the Nonstatutory Plan.

 

The following table showsactivity in outstanding options during 2002, 2003, and 2004:

 
| ** **                                                      | ** ** | **2002**      | ** ** | **2003**                              | ** ** | **2004**   | ** **    |
|-----------------------------------------------------------------|------------|---------------|------------|---------------------------------------|------------|------------|---------------|
| ** **                                                      | ** ** | **Shares**    | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Shares** | ** **    | **Weighted  Average  Exercise Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                                                            |       |          |       |                                  |       |       |          |   |   |   |   |   |   |
| Outstanding at beginning of year                                |       | 1,527,250     |       | $                                     | 3.91       |       | 1,528,385     |   | $ | 4.90 |   | 1,872,739 |   | $ | 4.63 |   |
| Granted                                                         |       | 400,800       |       | 6.47                                  |       | 391,200    |          | 3.82 |   | 344,000 |   | 3.46 |   |
| Exercised                                                       |       | (374,615      | )          | 2 54                                  |       | (1,596     | )             | 2.55 |   | (163,928 | ) | 2.61 |   |
| Canceled or expired                                             |       | (25,050       | )          | 5.30                                  |       | (45,250    | )             | 6.69 |   | (289,001 | ) | 5.59 |   |
| Outstanding at end of year                                      | ** ** | **1,528,385** | ** ** | **$**                                 | **4.90**   | ** ** | **1,872,739** | ** ** | **$** | **4.63** | ** ** | **1,763,810** | ** ** | **$** | **4.44** | ** ** |
|                                                            | ** ** | ** **    | ** ** | ** **                            | ** ** | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Options exercisable at year end                                 |       | 951,485       |       | $                                     | 3.96       |       | 1,338,639     |   | $ | 4.65 |   | 1,281,210 |   | $ | 4.76 |   |
|                                                            | ** ** | ** **    | ** ** | ** **                            | ** ** | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted average fair value of options granted  during the year |       |          |       | $                                     | 4.26       |       |          |   | $ | 3.82 |   |   |   | $ | 3.46 |   |

 

Thefollowing table shows information for options outstanding or exercisable as of December 26,2004:

 
| ** **                    | ** ** | ** **                                | ** ** | **OPTIONS OUTSTANDING**                            | ** ** | **OPTIONS EXERCISABLE**               | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number  Outstanding  As of 12/26/2004** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Exercisable  As of 12/26/2004** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                          |       |                                      |       |                                               |       |                                  |       |   |   |   |   |   |   |
| $                             | 1.12500    |                                      | $          | 2.25000                                            |       | 188,325                               |       | 2.33 Years |   | $ | 1.78604 |   | 188,325 |   | $ | 1.78604 |   |
| $                             | 2.40625    |                                      | $          | 3.34375                                            |       | 245,235                               |       | 5.96 Years |   | $ | 3.06051 |   | 188,235 |   | $ | 3.00608 |   |
| $                             | 3.35000    |                                      | $          | 3.44000                                            |       | 256,500                               |       | 9.71 Years |   | $ | 3.43361 |   | 12,500 |   | $ | 3.39600 |   |
| $                             | 3.45000    |                                      | $          | 3.76000                                            |       | 245,700                               |       | 8.63 Years |   | $ | 3.71020 |   | 149,350 |   | $ | 3.71844 |   |
| $                             | 3.77000    |                                      | $          | 5.00000                                            |       | 179,300                               |       | 7.44 Years |   | $ | 4.16841 |   | 94,050 |   | $ | 4.25542 |   |
| $                             | 5.20000    |                                      | $          | 6.03000                                            |       | 190,250                               |       | 6.98 Years |   | $ | 5.67308 |   | 190,250 |   | $ | 5.67308 |   |
| $                             | 6.05000    |                                      | $          | 6.55000                                            |       | 271,500                               |       | 7.15 Years |   | $ | 6.38116 |   | 271,500 |   | $ | 6.38116 |   |
| $                             | 6.62500    |                                      | $          | 8.08000                                            |       | 183,500                               |       | 6.90 Years |   | $ | 7.38341 |   | 183,500 |   | $ | 7.38341 |   |
| $                             | 8.37000    |                                      | $          | 9.20000                                            |       | 2,500                                 |       | 7.33 Years |   | $ | 8.71400 |   | 2,500 |   | $ | 8.71400 |   |
| $                             | 9.25000    |                                      | $          | 9.25000                                            |       | 1,000                                 |       | 7.30 Years |   | $ | 9.25000 |   | 1,000 |   | $ | 9.25000 |   |
|                          |       |                                      |       |                                               |       |                                  |       |   |   |   |   |   |   |
| Total                         |       | 1,763,810                                 |       | 7.03 Years                                         |       | $                                     | 4.43602    |   | 1,281,210 |   | $ | 4.75949 |   |
|                               |            |                                           |            |                                                    |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

44

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The following table provides information about ourcommon stock that may be issued upon the exercise of options, warrants andrights under all of our existing equity compensation plans as of December 26,2004, including the Monterey Gourmet Foods  Third Amended and Restated 1993 Stock OptionPlan, the Monterey Gourmet Foods 1995 Employee Stock Purchase Plan (See Note 6)and the Monterey Gourmet Foods 2001 Nonstatutory Stock Option Plan.

 
| **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     |       | 1,629,860                                                                                               | (1)        | $                                                                                       | 4.44       |                                                                                                                                                      | 1,244,879 |
| Equity compensation plans not approved by security  holders |       | 133,950                                                                                                 | (2)        | $                                                                                       | 6.55       |                                                                                                                                                      | 33,800 |
| Total                                                       |       | 1,763,810                                                                                               |       | $                                                                                       | 4.44       |                                                                                                                                                      | 1,278,679 |

 

----

(1)          Issued under the Monterey Gourmet Foods1993 Stock Option Plan and the Monterey Gourmet Foods 1995 employee StockPurchase Plan

 

(2)          Issued to Company employees under the MontereyGourmet Foods 2001 Nonstatutory Stock Option Plan (154,200 at $6.55)

 

**10.**                               **Income Taxes**

 

The Company’s income tax benefit (provision) consistsof (in thousands):

 
| ** **                | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:                  |       |     |       |     |       |     |       |
|                      |       |     |       |     |       |     |       |
| Federal                   |       | $        | (263       | )        | $          | (1       | )          | $ | 916 |   |
| State                     |       | (157     | )          | (130     | )          | 146      |       |
| Total                     |       | (420     | )          | (131     | )          | 1,062    |       |
|                      |       |     |       |     |       |     |       |
| Deferred:                 |       |     |       |     |       |     |       |
|                      |       |     |       |     |       |     |       |
| Federal                   |       | 3,366    |       | (373     | )          | (404     | )          |
| State                     |       | (108     | )          | 60       |       | (153     | )          |
| Total                     |       | 3,258    |       | (313     | )          | (557     | )          |
|                      |       |     |       |     |       |     |       |
| Net tax benefit (expense) |       | $        | 2,838      |     | $          | (444     | )          | $ | 505 |   |

 

A reconciliation between the Company’s effective taxrate and U.S. Federal income tax rate on loss from continuing operationsfollows:

 

45

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| ** **                                          | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                |       |     |       |     |       |     |       |
| Federal statutory rate                              |       | 34.0     | %          | 34.0     | %          | 34.0     | %          |
|                                                |       |     |       |     |       |     |       |
| State income taxes, net of effect on Federal income |       | 1.5      | %          | (3.7     | )%         | 5.6      | %          |
|                                                |       |     |       |     |       |     |       |
| Federal and State valuation allowances              |       | (78.6    | )%         | 0.0      | %          | (10.7    | )%         |
|                                                |       |     |       |     |       |     |       |
| Other                                               |       | 0.4      | %          | (0.3     | )%         | (1.6     | )%         |
|                                                |       |     |       |     |       |     |       |
| Effective income tax rate                           |       | (42.7    | )%         | 30.0     | %          | 27.3     | %          |

 

Thevaluation allowance for 2002, 2003, and 2004 was increased (reduced) by,($5,196,000), $0, and 197,000 respectively. During 2002, the valuation allowance was reduced due to its assessmentof the likelihood of realizing net operating loss carryforwards  (NOLs) associated with a business that hadpreviously been sold in the past.  During2004, the valuation allowance increased due to the Company’s assessment of itsutilization of such NOLs. This assessment is largely based upon the Company’sability to project future income, which was impacted negatively by the taxableloss generated in 2004.  As of December 26,2004, remaining net deferred tax assets available to offset future cash taxliabilities are $1,126,000 short-term and $3,952,000 long-term.

 

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. Significant components of the Company’s deferred tax assets are asfollows:

 
| ** **                                                               | ** ** | **2003**           | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------|------------|----------|------------|
| ** **                                                               | ** ** | **(in thousands)** | ** ** |
| Federal NOLs                                                             |       | $                  | 3,615      |     | $          | 5,861 |   |
| Accumulated depreciation and amortization                                |       | 342                |       | (567     | )          |
|                                                                     |       |               |       |     |       |
| Alternative minimum tax credit carryovers                                |       | 274                |       | 190      |       |
| State income and franchise taxes, net of effect on  Federal income taxes |       | 403                |       | (146     | )          |
| Allowances against receivables                                           |       | 150                |       | 94       |       |
| Other                                                                    |       | 480                |       | 585      |       |
|                                                                     |       | 5,264              |       | 6,017    |       |
| Less valuation allowance                                                 |       | (742               | )          | (939     | )          |
|                                                                     |       |               |       |     |       |
| Net deferred tax assets                                                  |       | $                  | 4,522      |     | $          | 5,078 |   |

 

As of December 26,2004, the Company has Federal NOLs totaling $14.5 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 $190,000 in CaliforniaManufacturer’s Tax Credits available to offset future California income taxes,expiring in varying amounts through 2012.

 

TheCompany realizes tax benefits as a result of the exercise of non-qualifiedstock options and the exercise and subsequent sale of certain incentive stockoptions (disqualifying dispositions). For financial reporting purposes, anyreduction in income tax obligations as a result of these tax benefits iscredited to additional paid-in capital. In the years 2002, 2003, and 2004 taxbenefits of disqualifying dispositions totaling $494,000, $1,000 and $55,000respectively have been credited to stockholders’ equity.

 

46

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**11**.                               **SignificantCustomers**

 

Costcoand Sam’s Club (including Wal-Mart Supercenters) stores each accounted forpercentages of total net revenues as follows:

 
| ** **             | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|------------------------|------------|----------|------------|----------|------------|----------|------------|
| Costco                 |       | 43       | %          | 34       | %          | 36       | %          |
| Sam’s Club stores |       | 31       | %          | 32       | %          | 24       | %          |

 

At December 28,2003, and December 26, 2004, Costco and Sam’s Club stores accounted for thefollowing concentration of accounts receivable:

 
| ** **             | ** ** | **2003** | ** ** | **2004** | ** ** |
|------------------------|------------|----------|------------|----------|------------|
| Costco                 |       | 33       | %          | 53       | %          |
| Sam’s Club stores |       | 32       | %          | 14       | %          |

 

The Company currently sells its products to eightseparate US Costco regions, Mexico and Canada which make purchasing decisionsindependently of one another.  On aregular basis, these regions re-evaluate the products carried in theirstores.  There can be no assurance thatthese Costco regions will continue to offer the Company’s products in thefuture or continue to allocate the Company the same amount of shelf space.  Purchasing decisions for Sam’s Club stores (“Sam’s”)and Wal-Mart Supercenters, the Company’s second largest customer, are made attheir respective head offices with input from the stores.  The Company is in the seventh year of itsrelationship with Sam’s. On February 2, 2004 the Company announced thatWal-Mart Supercenters discontinued its private label program which has impactedthe 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 or the significantreduction in sales to either of these customers would materially adverselyaffect the Company’s business operations.

 

Noother single customer accounted for more than 10% of revenues or accountsreceivable during 2003 and 2004.

 

The Company operates in the refrigerated specialty foods segment.  During 2002, 2003 and 2004 net revenues toforeign customers represented 3.0%, 3.4% and 3.4% of total net revenues, withCanada and Mexico accounting for over 92% of those sales, and the remaindergoing to Asia Pacific.  Most of theforeign sales are invoiced in US dollars.

 

**12**.                               **Litigationand Contingencies**

 

There are no material legal proceedings pending to whichthe Company is a party or to which any of its property is subject.  The Company is a party to ordinary routinelitigation incidental to the Company’s business.

 

On February 18, 2004, a complaint was filed byBC-USA, Inc. dba Bongrain Cheese USA against the Company, James M. Williams,its Chief Executive Officer, and CIBO Naturals, LLC in the King County SuperiorCourt, State of Washington.  Mr. Williamswas Chief Executive Officer of Bongrain Cheese USA prior to his employment bythe Company.  The complaint pled severalcauses of action based principally upon an allegation that Mr. Williams,by participating in the acquisition of CIBO by the Company, breached agreementsbetween himself and Bongrain Cheese USA. The complaint asked for preliminaryand permanent injunctive relief enjoining the defendants from using ordisclosing confidential, proprietary or trade secret information of BongrainCheese USA, plus unspecified damages.  InJuly 2004, the Company entered into a confidential settlement to avoidfuture litigation and legal costs.  For theyear ended December 26, 2004 the Company expensed $248,000 of costsassociated with this litigation.

 

The Company incurred legal fees in defending pastlawsuits. During 2004, the Company paid $497,000 net of insurance reimbursementto settle all lawsuits and to pay for legal defense and legal advice.

 

**13.****                               EmployeeBenefit Plan**

 

In1996, the Company instituted a 401(k) Plan covering substantially all full-timeemployees with six months of service. Under the Plan, employees may elect to defer up to 15% of compensation(subject to certain limitations).  Priorto 2003 the Company matched one-half of employee contributions up to 6% ofcompensation.  Beginning in January 2003the Company adopted a Safe Harbor Plan and will match employee contributions upto 4% of compensation.  In addition, theCompany may 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 after five years ofservice.  During 2002,

 

47

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2003 and 2004, theCompany’s expense for matching contributions was $122,000, $191,000, and$201,000 respectively; there were no discretionary profit-sharing contributionsfor 2002, 2003, or 2004.

 

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

 

***The Emerald Valley Purchase***

 

On August 23, 2002 the Company purchased the operating assets andinventory of Emerald Valley Kitchen, Inc. (“Emerald Valley”), a Eugene,Oregon based producer of organic fresh salsas, dips, hummus, and sauces withover 90% retail chain distribution. The Company considered this purchase anopportunity to enter the rapidly growing organic food market.  The consideration to the sellers consisted of$5,744,000 in cash.  Additionally, theEmerald Valley owners are eligible to receive an earn-out based upon EmeraldValley Kitchen Earnings before Interest, Taxes, Depreciation, and Amortization(“EBITDA”) above a predetermined level calculated annually at the end of thefirst five years after the acquisition date. The Company incurred $79,000 in2003 and $59,000 in 2004 respectively under this earn-out agreement.  Funding for the transaction came fromexisting cash balances.

 

Thetotal initial consideration of $5,744,000, plus related acquisition costs of$188,000, was allocated as follows: The trademark, which has been included inintangible assets, will continue to be used for an indefinite period.  Therefore, this asset will not be amortizedon a monthly basis, but will be tested for impairment annually in keeping withSFAS 142.  Recipes will be amortized overa three-year life.  The customer listwill be amortized over a ten-year life.

 

 
| ** **             | ** ** | **(in thousands)** | ** ** |
|------------------------|------------|--------------------|------------|
| Inventories            |       | $                  | 299        |   |
| Fixed assets           |       | 120                |       |
| Customer list          |       | 1,500              |       |
| Trademark              |       | 600                |       |
| Recipes                |       | 60                 |       |
| Goodwill               |       | 3,353              |       |
| Total acquisition cost |       | $                  | 5,932      |   |

 

Also in 2002, the Company purchased certain recipeinformation from Chet’s Fine Foods and certain trademark rights and recipesfrom Isabella’s Kitchen, LLC.  The totalamount paid for these assets was $150,000. Therefore total expenditures on the acquisition of business operatingassets equated to $6,082,000 in 2002.

 

***The CIBO Naturals Purchase***

 

In2004,  the Company acquired an 80%interest in CIBO Naturals LLC (“CIBO”), a leading manufacturer of premiumsauces and spreads located in Seattle, Washington. The Company paid CIBO andits members $7.0 million cash for 80% interest in CIBO.  $3,000,000 went to the owners of CIBO and$4,000,000 went to pay down debt on the books of CIBO.  The acquisition agreement provided for thepurchase of the remaining 20% ownership after four years at a predeterminedcalculation based on earnings before taxes. The cash came partly from the Company’s cash balances and from itscredit facilities

 

CIBOproduces a variety of refrigerated gourmet sauces and spreads including freshpesto sauces, flavored cheeses, bruschetta toppings and tapenade spreads.  CIBO’s 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 market position which theCompany believes has great growth potential in both expanded distribution andin new products.

 

Aspart of the acquisition, Management determined the components that representthe intangible assets such as customer and distributor relationships,non-competition agreements, recipes and tradements and goodwill purchased aspart of the purchase price.  Under thepurchase method of accounting, the total estimated purchase price is allocatedto CIBO’s tangible and intangible assets based upon their estimated fair valueas of the date of completion of the acquisition.  Based upon the purchase price and valuation,and based on financial information at the time of the acquisition thepreliminary purchase price allocation was as follows (in thousands of dollars):

 

48

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| Cash acquired at acquisition         |   | $      | 31     |   |
|--------------------------------------|--------|--------|--------|--------|
| Tangible assets acquired             |   | 1,528  |   |
| Goodwill acquired                    |   | 3,396  |   |
| Intangible assets acquired           |   | 4,600  |   |
| Total assets acquired                |   | 9,555  |   |
| Less assumed liabilities             |   | (5,805 | )      |
| Net assets acquired                  |   | 3,750  |   |
| Less minority interest               |   | (750   | )      |
| Cash paid directly to owners of CIBO |   | $      | 3,000  |   |

 

On May 12,2004, the Company purchased an additional 4.5% ownership in CIBO from OBIC, Inc.for $316,500 plus expenses associated with the purchase. No earnout wasinvolved with this purchase.  Thispurchase increased the Company’s investment in CIBO to 84.5% which reduced theamount of the minority interest to $581,000.

 

Thefollowing unaudited pro forma financial information presents a summary of theCompany’s consolidated results of operations for the year ended December 28,2003 and December 26, 2004, assuming the CIBO acquisition had taken placeas of January 1, 2003 and January 1, 2004 respectively (in thousandsexcept per share data).

 
| ** **                             | ** ** | **December 28, 2003** | ** ** | **December 26, 2004** | ** ** |
|----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
|                                   |       |                       |       |                       |       |
| Net revenues                           |       | $                          | 71,006     |                       | $          | 63,195 |   |
|                                   |       |                       |       |                       |       |
| Net income (loss)                      |       | $                          | 1,363      |                       | $          | (1,352 | ) |
|                                   |       |                       |       |                       |       |
| Net income (loss) per common share:    |       |                       |       |                       |       |
| Basic income (loss) per common share   |       | $                          | 0.10       |                       | $          | (0.09 | ) |
|                                   |       |                       |       |                       |       |
| Diluted income (loss) per common share |       | $                          | 0.09       |                       | $          | (0.09 | ) |
|                                   |       |                       |       |                       |       |
| Basic shares outstanding               |       | 14,206,627                 |       | 14,343,386                 |       |
| Diluted shares outstanding             |       | 14,414,931                 |       | 14,343,386                 |       |

 

Theunaudited condensed pro forma financial information has been prepared forcomparative purposes only and reflects the historical audited results of CIBONaturals LLC.  The pro forma financialinformation includes adjustments to reflect interest expense generated from cashthat was used for the acquisition and related income tax adjustments.  The pro forma information also includes anestimation of amortization of identifiable intangible assets.  The pro forma information does not purport tobe indicative of operating results that would have been achieved had theacquisition taken place on the dates indicated or the results that may beobtained in the future.

 

Thetable below details the expenditures the Company made with regards to allacquisition activity during 2004 (in thousands of dollars).

 

49

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Reconciliationof cash payments for acquistions (in thousands)

 
| Cash paid directly to owners of CIBO Naturals                    |   | $     | 3,000  |   |
|------------------------------------------------------------------|--------|-------|--------|--------|
| Cash payments on CIBO’s loans at time of closing            |   | 4,000 |   |
| Costs associated with closing CIBO acquisition                   |   | 344   |   |
| Purchase of 4.5% ownership in CIBO from OBIC, Inc.          |   | 317   |   |
| Cash payment on earn-out for Emerald Valley Kitchen  acquisition |   | 59    |   |
| Less cash acquired in CIBO acquisition                           |   | (31   | )      |
| Net cash expenditures for acquisitions in 2004                   |   | $     | 7,689  |   |

 

**15.****                               SubsequentEvents**

 

Subsequent toyear-end, on January 11, 2005, Monterey Gourmet Foods, Inc., CasualGourmet Foods, Inc.(“Casual”), and the shareholders of Casual entered intoa definitive agreement for the purchase by Monterey Gourmet Foods, Inc. of60% of Casual’s outstanding shares for $6,000,000 in cash and for the acquisition by Monterey GourmetFoods of Casual’s remaining shares over the next three years based on amultiple of EBITDA. Casual, which produces branded gourmet sausages, preparedsoups and other food products, is a Florida corporation with headquarters inTampa, Florida.

 

This acquisition supports the Company’s growthstrategy in the specialty premium refrigerated food category. Casual’sgreat-tasting lower fat, low-calorie sausages and burgers fit well with today’sconsumer interested in unique and healthy food choices. Casual’s sausageproducts are positioned in the fast growing healthy gourmet segment of thelarge cooked sausage category. Their refrigerated, fully cooked soups cater tothe time-starved consumer looking for premium gourmet meal options. LikeMonterey Gourmet Foods, Casual competes in the refrigerated sections in cluband retail food store channels, so there are several synergies availablebetween our two companies. The Company envisions expanding the existing Casualbrand, developing new products, and increasing distribution in club, retail,and potentially other channels.

 

The Company borrowed an additional $5 million fromComerica Bank in order to fund the acquisition of Casual Gourmet Foods.  As part of the new financing, the entirecredit facility was revised.  The Companynow has a $2.0 million dollar working capital line of credit against which aletter of credit in the amount of $1,000,000 is issued in favor of an insurancecompany to support a partially self-insured worker’s compensation programinitiated by the Company on January 1, 2003 and continuing into 2005.  The loan covenants also have been changed toreflect the additional borrowing.

 

50

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

 

Thesummarized quarterly financial data presented on the following page reflectall adjustments which, in the opinion of management, are of a normal andrecurring nature necessary to present fairly the results of operations for theperiods presented (in thousands of dollars).

 
| **Year Ended 2003**               | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **2003** | ** ** |
|-----------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|----------|------------|
|                              |       |               |       |                |       |               |       |                |       |     |       |
| Net revenue                       |       | $                  | 16,077     |                | $          | 15,311             |       | $                   | 14,876     |     | $          | 14,226 |   | $ | 60,490 |   |
|                              |       |               |       |                |       |               |       |                |       |     |       |
| Gross profit                      |       | 5,585              |       | 4,950               |       | 3,986              |       | 4,048               |       | 18,569   |       |
|                              |       |               |       |                |       |               |       |                |       |     |       |
| Operating income (loss)           |       | 1,460              |       | 569                 |       | (408               | )          | (213                | )          | 1,408    |       |
|                              |       |               |       |                |       |               |       |                |       |     |       |
| Net income (loss)                 |       | 912                |       | 490                 |       | (259               | )          | (108                | )          | 1,035    |       |
|                              |       |               |       |                |       |               |       |                |       |     |       |
| Primary 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 |   |
|                                   |            |                    |            |                     |            |                    |            |                     |            |          |            |  |  |  |  |  |  |  |

 
| **Year Ended 2004**               | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **2004** | ** ** |
|-----------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|----------|------------|
|                              |       |               |       |                |       |               |       |                |       |     |       |
| Net revenue                       |       | $                  | 16,385     |                | $          | 14,988             |       | $                   | 16,032     |     | $          | 15,086 |   | $ | 62,491 |   |
|                              |       |               |       |                |       |               |       |                |       |     |       |
| Gross profit                      |       | 4,375              |       | 3,580               |       | 4,367              |       | 4,146               |       | 16,468   |       |
|                              |       |               |       |                |       |               |       |                |       |     |       |
| Operating income (loss)           |       | (699               | )          | (900                | )          | 129                |       | (291                | )          | (1,761   | )          |
|                              |       |               |       |                |       |               |       |                |       |     |       |
| Net income (loss)                 |       | (481               | )          | (543                | )          | 75                 |       | (395                | )          | (1,344   | )          |
|                              |       |               |       |                |       |               |       |                |       |     |       |
| Primary earnings per common share |       | $                  | (0.03      | )                   | $          | (0.04              | )          | $                   | 0.01       |     | $          | (0.03 | ) | $ | (0.09 | ) |
|                              |       |               |       |                |       |               |       |                |       |     |       |
| Diluted earnings per common share |       | $                  | (0.03      | )                   | $          | (0.04              | )          | $                   | 0.01       |     | $          | (0.03 | ) | $ | (0.09 | ) |
|                                   |            |                    |            |                     |            |                    |            |                     |            |          |            |  |  |  |  |  |  |  |

 

51

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**SCHEDULE II**

**MONTEREY PASTA COMPANY**

**VALUATION AND QUALIFYING ACCOUNTS**

 
| ** **                                                                        | ** ** | **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        |                                            | $          | 2,565                                              |       | $                          | 2,343      |   | $ | 527 |   |
|                                                                              |       |                             |       |                                            |       |                                               |       |                       |       |
| Inventory reserves —  Spoils and obsolescence                                |       | $                                | 28         |                                            | $          | 42                                                 |       |                       |       | $ | 70 |   |
|                                                                                   |            |                                  |            |                                                 |            |                                                    |            |                            |            |  |  |  |  |

 
| ** **                                                                        | ** ** | ** **    | ** ** | **Additions -** | ** ** | **Deductions -** | ** ** | ** **   | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------|------------|-----------------|------------|------------------|------------|--------------|------------|
| ** **                                                                        | ** ** | **Balance,**  | ** ** | **Charged to**  | ** ** | **Write-offs**   | ** ** | **Balance,** | ** ** |
| ** **                                                                        | ** ** | **Beginning** | ** ** | **Costs and**   | ** ** | **Charged to**   | ** ** | **End of**   | ** ** |
| ** **                                                                        | ** ** | **of 2003**   | ** ** | **Expense**     | ** ** | **Reserves**     | ** ** | **2003**     | ** ** |
|                                                                              |       |          |       |            |       |             |       |         |       |
| Allowances against receivables —  Spoils, returns, adjustments and bad debts |       | $             | 527        |            | $          | 3,211            |       | $            | 3,298      |   | $ | 441 |   |
|                                                                              |       |          |       |            |       |             |       |         |       |
| Inventory reserves —  Spoils and obsolescence                                |       | $             | 70         |            | $          | 510              |       | $            | 528        |   | $ | 51 |   |

 
| ** **                                                                        | ** ** | ** **    | ** ** | **Additions -** | ** ** | **Deductions -** | ** ** | ** **   | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------|------------|-----------------|------------|------------------|------------|--------------|------------|
| ** **                                                                        | ** ** | **Balance,**  | ** ** | **Charged to**  | ** ** | **Write-offs**   | ** ** | **Balance,** | ** ** |
| ** **                                                                        | ** ** | **Beginning** | ** ** | **Costs and**   | ** ** | **Charged to**   | ** ** | **End of**   | ** ** |
| ** **                                                                        | ** ** | **of 2004**   | ** ** | **Expense**     | ** ** | **Reserves**     | ** ** | **2004**     | ** ** |
|                                                                              |       |          |       |            |       |             |       |         |       |
| Allowances against receivables —  Spoils, returns, adjustments and bad debts |       | $             | 441        |            | $          | 3,646            |       | $            | 3,847      |   | $ | 240 |   |
|                                                                              |       |          |       |            |       |             |       |         |       |
| Inventory reserves —  Spoils and obsolescence                                |       | $             | 51         |            | $          | 550              |       | $            | 388        |   | $ | 213 |   |

 

52

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**SIGNATURES**

 

Pursuantto the requirements of Section 13 of the Securities Exchange Act of 1934,the Registrant 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 25th day of March,****2005

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

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons in the capacities indicated and onthe dates indicated.

 
| **Name**                  | ** ** | **Title** | ** **                | **Date** |
|---------------------------|------------|-----------|---------------------------|----------|
|                      |       |      |                      |     |   |
| /s/JAMES M.  WILLIAMS     |       |      | Chief Executive  Officer, |     | March 25,  2005 |
| James M.  Williams        |       |      | President, and  Director  |     |   |
|                      |       |      |                      |     |   |
| /s/CHARLES B.  BONNER     |       |      | Director                  |     | March 25,  2005 |
| Charles B.  Bonner        |       |      |                      |     |   |
|                      |       |      |                      |     |   |
| /s/F.  CHRISTOPHER CRUGER |       |      | Director                  |     | March 25,  2005 |
| F. Christopher  Cruger    |       |      |                      |     |   |
|                      |       |      |                      |     |   |
| /s/MICHAEL P.  SCHALL     |       |      | Director                  |     | March 25,  2005 |
| Michael P.  Schall        |       |      |                      |     |   |
|                      |       |      |                      |     |   |
| /s/VAN TUNSTALL           |       |      | Director                  |     | March 25,  2005 |
| Van Tunstall              |       |      |                      |     |   |
|                      |       |      |                      |     |   |
| /s/JAMES WONG             |       |      | Director                  |     | March 25,  2005 |
| James Wong                |       |      |                      |     |   |
|                      |       |      |                      |     |   |
| /s/WALTER L.  HENNING     |       |      | Director                  |     | March 25,  2005 |
| Walter L.  Henning        |       |      |                      |     |   |
|                      |       |      |                      |     |   |
| /s/R. LANCE  HEWITT       |       |      | Chairman of the  Board    |     | March 25,  2005 |
| R. Lance Hewitt           |       |      |                      |     |   |

 

53

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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 Definitive Proxy Statement for its 1996 Annual Meeting of  Shareholders (the “1996 Proxy”).)                                                                                                                                                                |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2    | Delaware Certificate of  Amendment filed August 2004                                                                                                                                                                                                                                                                                                                                           |
| 3.3    | Bylaws of the Company  (incorporated by reference from Exhibit C to the 1996 Proxy)                                                                                                                                                                                                                                                                                                            |
| 4.1    | 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”))                                                            |
| 4.2    | 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)                                                                                                                                                 |
| 4.3    | 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)                                                                    |
| 4.4    | Registration Rights  Agreement dated as of June 15,1995 with GLF Advantage Fund Limited, as  amended on October 13 and 19, 1995, respectively (incorporated by  reference from Exhibit 10.2 to the 1995 second quarter 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”). |
| 10.1*  | Third Amended and  Restated 1993 Stock Option Plan (as amended on August 1, 1996 and April 30,  2002) (incorporated by reference to Exhibit 10.1 filed with the Company’s  1996 Form 10-K and Proposal No. 3 in the Company’s Definitive  Proxy Statement for its 2002 Annual Meeting of Shareholders)                                                           |
| 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 Company’s Registration Statement on Form SB-2  filed with the Commission (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,  1998 to Monterey County Production Facility Lease of the Company  (incorporated by reference from Exhibit 10.5 filed with the Company’s September 27,  1998 Quarterly Report on Form 10-Q dated November 4, 1998  (“1998 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)                                                                                                                               |
| 10.11* | Offer letter regarding  Employment as Chief Executive Officer dated August 20, 2002 with Mr. James  M. Williams                                                                                                                                                                                                                                                                           |
| 10.12  | 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”))                                                                                                                   |
| 10.13  | 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)                                                                                                                                |

 

54

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| 10.14   | 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”))                                              |
|---------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.15   | 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)                               |
| 10.16   | 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)                                                                                                            |
| 10.17   | 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)                                                                                                                       |
| 10.18   | 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)                                                                                                                        |
| 10.19   | 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”))                                                                                                          |
| 10.20   | 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)                                        |
| 10.21   | 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”))                                                        |
| 10.22   | 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)                                                                                                                                                  |
| 10.23   | 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)                                                                                               |
| 10.24   | 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)                                 |
| 10.25   | 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)                                                            |
| 10.26   | 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)                                                                                                     |
| 10.27   | 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)                                                                                                     |
| 10.28   | 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)                                                                   |
| 10.29   | 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) |
| 10.30   | Agreement for Purchase  and Sale of Limited Liability Company Units dated January 28, 2004 by  and among the Company and the Unitholders of CIBO Naturals, LLC.  (incorporated by reference from Exhibit 2.6 filed with the Company’s 8-K  on February 5, 2004 and amended on April 10, 2004)                                       |
| 10.31   | Agreement for Purchase  and Sale of OBIC, Inc.’s Limited Liability Company Units dated May 12,  2004 by and among the Company and the Unitholders of CIBO Naturals, LLC.                                                                                                                                                                      |
| 10.32   | Stock Purchase  Agreement by and among Monterey Gourmet Foods, Inc., Casual Gourmet  Foods, Inc., and Certain Shareholders dated January 11, 2005. .  (incorporated by reference from Exhibit 2.01 filed with the Company’s 8-K  on January 18, 2005)                                                                          |
| 10.33** | Third Modification to  Business Loan Agreement between the Company and Comerica Bank dated January 5,  2005.                                                                                                                                                                                                                                            |

 

55

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| 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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*Management contract orcompensatory plan or arrangement covering executive officers or directors ofthe Company and its former subsidiary, Upscale Food Outlets, Inc.

 

** filed herewith

 

56

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