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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(MARK ONE)


|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended March 31, 2003

OR


|_| 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: 0-16612

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


Delaware
(State or other jurisdiction
of incorporation or organization)
   41-1580270
(I.R.S. Employer
Identification No.)

7615 Smetana Lane
Eden Prairie, MN 55344

(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (952) 229-1500

Securities registered pursuant to section 12(b) of the Act:  None
Securities registered pursuant to section 12(g) of the Act:


              Title of each class
Common Stock, par value of $.01 per share
Preferred Stock purchase rights

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES |X| No |_|

Indicate by check mark if disclosure of delinquent filers pursuant to Rule 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. |X|

As of March 31, 2003, the aggregate market value of the Company’s Common Stock held by non-affiliates is $71,501,532, computed by reference to the closing sales price of the Company’s Common Stock of $5.74 on September 30, 2002, the last business day of the Company’s most recently completed second fiscal quarter.

Indicated by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2): Yes |_| No |X|

As of June 13, 2003, the Company had outstanding 13,305,792 shares of Common Stock of $.01 par value per share.

Documents Incorporated by Reference: Portions of the Company’s Proxy Statement for its Annual Meeting of Stockholders to be held on August 27, 2003, are incorporated by reference into Part III of this Form 10-K.




TABLE OF CONTENTS


Page
     
PART I  
  
Item 1          Business 3
Item 2   Properties 16
Item 3   Legal Proceedings 16
Item 4   Submission of Matters to a Vote of Security Holders 16
  
PART II  
  
Item 5   Market for Registrant’s Common Equity and Related Stockholder Matters    17
Item 6   Selected Financial Data 19
Item 7   Management’s Discussion and Analysis of Financial Condition
   and Results of Operations
20
Item 7A   Quantitative and Qualitative Disclosures about Market Risk 31
Item 8   Financial Statements and Supplementary Data 32
Item 9   Changes in and Disagreements with Accountants on Accounting and
   Financial Disclosure
32
  
PART III  
  
Item 10   Directors and Executive Officers of the Registrant 32
Item 11   Executive Compensation 33
Item 12   Security Ownership of Certain Beneficial Owners and Management 33
Item 13   Certain Relationships and Related Transactions 34
Item 14   Controls and Procedures 34
  
PART IV  
  
Item 15   [Reserved] 35
Item 16   Exhibits, Financial Statement Schedules, and
   Reports on Form 8-K
35
  
SIGNATURES   36
CERTIFICATIONS   38, 39
EXHIBIT INDEX   40
INDEX TO FINANCIAL STATEMENTS F-1

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Forward-Looking Statements

              Certain statements contained in this Annual Report on Form 10-K and other written and oral statements made from time to time by the Company do not relate strictly to historical or current facts but provide current expectations or forecasts of future events. As such, they are considered “forward-looking statements” under the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties that could cause actual results to differ materially from those presently anticipated or projected. Such forward-looking statements can be identified by the use of terminology such as “may,” “will,” “expect,” “plan,” “intend,” “anticipate,” “estimate,” or “continue” or similar words or expressions. It is not possible to foresee or identify all factors affecting the Company’s forward-looking statements and investors therefore should not consider any list of factors to be an exhaustive statement of all risks, uncertainties or potentially inaccurate assumptions. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to, the following factors: (i) the Company’s revenue and profitability is reliant on sales of Breathe Right® nasal strips; (ii) the Company currently has a seasonal pattern of sales that is typically higher in the third and fourth quarters of each fiscal year due to increased nasal strip usage during the cough/cold season and its revenues and earnings may be impacted by the severity of such season; (iii) the Company’s success and future growth will depend significantly on its ability to effectively market Breathe Right nasal strips and upon its ability to develop and achieve markets for additional products; (iv) the Company’s competitive position will, to some extent, be dependent on the enforceability and comprehensiveness of the patents on its Breathe Right nasal strip technology which have been, and in the future may be, the subject of litigation and could be narrowed as a result of the outcome of the reexamination of one such patent by the United States Patent and Trademark Office (see Item 1, “Patents, Trademarks and Proprietary Rights”); (v) the Company has faced and will continue to face challenges in successfully developing and introducing new products; (vi) the Company operates in competitive markets where recent and potential entrants into the nasal dilator segment pose competitive challenges (see Item 1, “Competition”); (vii) the Company is dependent upon contract manufacturers for the production of substantially all of its products; and (viii) the Company currently purchases its nasal strip products from different contract manufacturers that obtain the raw materials from a single supplier (see Item 1, “Manufacturing and Operations”).

PART I

Item 1. BUSINESS

General

              CNS, Inc. (the “Company”) is in the business of developing and marketing consumer health care products, including Breathe Right® nasal strips, Breath Right Snore Relief™ throat spray and FiberChoice® chewable fiber tablets. The Company focuses on products that address important consumer needs within the aging well/self care market, including better breathing and digestive health.

              The Company’s principal product, the Breathe Right nasal strip, improves breathing by reducing nasal airflow resistance. It can be effective in providing temporary relief for nasal congestion, reducing snoring and reducing breathing difficulties due to a deviated nasal septum. In 2000, the Company expanded its Breathe Right product line to include mentholated vapor strips for colds that are sized for the entire family, and nasal strips for children that are available in multiple colors. Breathe Right with mentholated vapor strips were introduced in selected overseas markets in 2001.

              The Company further extended the Breathe Right brand in fiscal 2003 by launching Breathe Right Snore Relief throat spray. Snore Relief spray lubricates and soothes dry throats, while a natural astringent firms loose tissue to reduce the vibrations that cause snoring. Breathe Right strips open nasal passages and reduce mouth breathing that leads to snoring. These two products provide a portfolio of solutions for snoring. In addition to expanding the Breathe Right® brand and introducing other new products, the Company is exploring possibilities for acquiring new consumer health care products that have established consumer brands, particularly those that complement the Company’s drug-free, better breathing platform. The Company is also considering opportunities for licensing new products and technologies.

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              The Company introduced its FiberChoice® chewable fiber tablets in March, 2000. The FiberChoice product is an orange-flavored, chewable fiber tablet that offers consumers an effective, convenient and good-tasting way to supplement their daily intake of dietary fiber.

              In 1999, the Company introduced its FLAIR™ equine nasal strip, a product that enables horses to breathe more easily during strenuous exercise. In March 2002, the Company established an exclusive, worldwide distribution relationship for its FLAIR equine nasal strip product with a joint venture entity comprised of Merial, LLC, an affiliate of Merck & Co., Inc. and Aventis. The Company has had limited sales of its FLAIR product to date.

              During June, 2001, the Company completed a restructuring and organizational realignment plan. The Company eliminated 20 positions across all areas for a 25% work force reduction. These actions enabled the Company to focus its resources on better leveraging the success of the Breathe Right brand, both in the United States and abroad, and operate the FiberChoice business more flexibly and efficiently.

              On January 23, 2002, the Company changed its fiscal year-end from December 31 of each year to March 31 of each year. The change in its fiscal year-end aligns the Company’s financial reporting period with its business and customer-planning cycle. The Company believes this change provides a clearer picture of the Company’s financial results by including an entire cough/cold season within the same fiscal year.

Management

              The Company’s management structure is organized into strategic business teams to expand the Breathe Right and Fiber-Choice brands and to develop and launch new products: Breathe Right Brand Team; FiberChoice Team; International Team and New Business Development Team. The Company believes that its team focus enables the Company to more effectively implement its business strategies.

              Breathe Right Brand Team. The Company’s Breathe Right Brand Team is responsible for the strategic development and management of the domestic Breathe Right nasal strip business and other products that carry the Breathe Right brand name. Breathe Right nasal strip products currently represent the cornerstone of the Company’s business. The Company intends to exploit new markets and opportunities that it believes exist for its current nasal strip products and plans to commercialize potential new Breathe Right branded products. This team is responsible for developing and launching additional Breathe Right products. The Company introduced two new products in the United States during the fall of 2000 to coincide with the cough/cold season: mentholated vapor strips for colds for the entire family and nasal strips with stars for children. During 2002, the Company launched Breathe Right Snore Relief™ throat spray. This product leverages the Company’s existing position in the better breathing/snoring product category and complements existing Breathe Right offerings. In the 2003 cough/cold season, the Company intends to launch Breathe Right VaporShot!™ personal vaporizer. This product builds on the existing line of Breathe Right mentholated vapor strips for colds. The VaporShot! product gives consumers a drug-free breathing solution that can be used in the daytime, complementing the Breathe Right nasal strips, which are generally used to relieve nighttime breathing conditions. VaporShot! works by dropping an effervescent tablet into hot water in the VaporShot! cup with a customized lid. The VaporShot! cup delivers an intense shot of mentholated vapors that instantly relieves congested noses.

              FiberChoice Team. The Company introduced FiberChoice® chewable fiber tablets in March, 2000. The FiberChoice Team is responsible for the strategic development and management of the FiberChoice chewable fiber supplement business.

              International Team. The Company began shipping Breathe Right® nasal strips to new distributor partners in Europe, Australia and Japan during 2000. Breathe Right mentholated vapor strips for colds were introduced in selected overseas markets in 2001. In 2003, the Company introduced Breathe Right nasal strips for kids in Japan and Italy and introduced Breathe Right Snore Relief™ throat spray in the UK. The Company intends to expand the distribution of Breathe Right Snore Relief throat spray into several more countries during fiscal 2004. The International Team is responsible for developing and managing the Company’s overseas business and its relationships with distributors and representatives in international markets. See Item 1, “International Distribution.”

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              New Business Development Team. The New Business Development Team is committed to the expansion of the Company’s product base through the development, acquisition or licensing of promising consumer health care products. The New Business Development Team is responsible for identifying and evaluating potential new products, inventions and other business prospects that will enable the Company to achieve its long-term growth and profit objectives, including opportunities for the acquisition of established product lines.

Products

              Breathe Right Nasal Strips. The Breathe Right nasal strip is a nonprescription, single-use disposable device that improves breathing by opening the nasal passages. The Company has 510(k) clearance from the United States Food and Drug Administration (“FDA”) to market the Breathe Right nasal strip for improvement of nasal breathing, temporary relief of nasal congestion, elimination or reduction of snoring and temporary relief of breathing difficulties due to a deviated nasal septum. See Item 1, “Government Regulation.” Breathe Right nasal strips come in tan, clear, mentholated and stars-for-kids varieties.

              The Breathe Right nasal strip includes two embedded plastic strips. When folded down onto the sides of the nose, the Breathe Right nasal strip lifts the side walls of the nose outward to open the nasal passages. The product improves nasal breathing upon application and does not include any drugs, thereby avoiding any medicinal side effects. The Breathe Right nasal strip is offered in three sizes (kids, small/medium and large) to accommodate the range of nose sizes. The Breathe Right nasal strip is packaged for the consumer market in various quantities ranging between 10 to 38 strips per box. The Company believes that Breathe Right nasal strips are priced less than medicinal decongestants on a daily or nightly basis at retail prices ranging between $3.99 and $11.99 per box.

              The Company expanded the Breathe Right nasal strip line with the introduction of Breathe Right nasal strips with mentholated vapors and Breathe Right nasal strip for kids in 2000. In March 2000, the Company licensed the Vicks® trademark from The Proctor & Gamble Company for use with the mentholated nasal strip product. Effective July, 2003 the Vicks trademark will no longer be used. The mentholated vapor strip uses traditional Breathe Right strip technology but contains a soothing mentholated aroma for additional relief. The mentholated vapors are released when the strip surface is rubbed. The Company believes that its mentholated vapor strip product has increased the Company’s customer base for nasal strip products by more clearly communicating that Breathe Right nasal strips can ease the congestion associated with the common cold. The kids’ strips are sized specifically to fit children and include a brightly-colored version and a mentholated version.

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              Breathe Right® Brand Products. Breathe Right saline nasal spray is a non-habit forming, drug-free product that restores moisture to comfort and soothe dry, irritated nasal passages due to colds, allergies, dry air (low humidity), air pollution and the overuse of nasal decongestants. Breathe Right Snore Relief™ throat spray is a drug-free product that addresses a different cause of snoring than nasal strips and lubricates and soothes dry throats while a natural astringent firms loose tissues to reduce the vibrations that produce snoring. This product leverages the Company’s existing position in the better breathing/snoring product category and complements existing Breathe Right product offerings. The Company intends to introduce additional non-nasal strip products in the future that carry the Breathe Right brand name to extend the product line. For example, the Company intends to launch a new product during the fall 2003 cough/cold season — Breathe Right
VaporShot!™ personal vaporizer. This product builds the Company’s existing line of Breathe Right mentholated vapor strips for colds. Breathe Right VaporShot! personal vaporizer works by dropping an effervescent tablet into hot water in the customized VaporShot! cup which delivers an intense shot of mentholated vapors that instantly relieves congested noses. This product leverages the Company’s existing position in the better breathing product category and complements existing Breathe Right product offerings.

              FiberChoice® Chewable Fiber Tablets. The Company introduced its FiberChoice chewable fiber tablets in March, 2000. FiberChoice is an orange-flavored, chewable tablet that offers consumers an effective, convenient, good-tasting way to supplement their daily intake of dietary fiber. The tablets contain four grams of fiber per dose and provide more than twice the amount of fiber per dose versus other convenient fiber supplements. The active ingredient in FiberChoice tablets is inulin, a natural fiber source. Inulin is also a prebiotic that helps promote the growth of healthy intestinal tract bacteria. FiberChoice tablets can be taken without water and have been clinically proven to be as effective as powder alternatives. The product is available in both regular and sugar-free varieties and is packaged in 90-count and 36-count bottles and 10-count tubes.

Markets

              Breathe Right Brand Product Line. The Breathe Right brand of products includes Breathe Right nasal strips, Breathe Right saline nasal spray and Breathe Right Snore Relief throat spray. The Company intends to expand the Breathe Right brand in 2003 during the fall cough/cold season with the introduction of its Breathe Right VaporShot! personal vaporizer.

              Air impedance in the nose accounts for approximately one-half of the total airway resistance involved in the respiratory system (i.e., one-half of the energy required for breathing). If the effort to breathe through the nose during sleep is excessive, the person will resort to mouth breathing, promoting snoring, dry mouth, sore throat and mini-awakenings which disrupt sleep. In addition, nasal breathing difficulties during sleep are often caused by nasal congestion found in people who have a common cold, allergies and sinusitis and by those who experience nasal obstruction due to a deviated nasal septum. The Company believes that people with chronic conditions such as snoring or allergies or with structural problems such as deviated septa may be more predisposed to use Breathe Right products on a regular or daily basis, while seasonal sufferers are likely to use Breathe Right products as needed. These chronic conditions are aggravated when people have nasal congestion, thus increasing the opportunity for usage and consumer trial during the cough/cold season. People suffering from these conditions are currently the primary users of the Company’s Breathe Right products and are the main targets of its advertising.

              In 1999, the Company began to emphasize the Breathe Right nasal strip position as a product that provides instant, drug-free relief for those suffering from nasal congestion and other symptoms due to the common cold, allergies and sinusitis. The Company’s advertising emphasizes the ability of Breathe Right nasal strips to provide immediate relief from nasal congestion due to colds, and in a separate campaign, it promotes both Breathe Right nasal strips and Breathe Right Snore Relief throat spray as solutions for snoring.

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              The Company’s marketing efforts capitalize on the benefits of Breathe Right® products to consumers in various, and often overlapping, consumer market segments:


Nasal Congestion Relief. Most Americans suffer some nasal congestion annually as a result of the common cold. Nasal congestion as a result of allergies affects approximately 35 million Americans. The Company believes that Breathe Right nasal strips are often used as either an alternative or as an adjunct to decongestant drugs (including nasal sprays and oral decongestants). This broad cough/cold/allergy market represents significant potential for the Breathe Right brand. In 1999, the Company commenced marketing efforts aimed at repositioning the Breathe Right nasal strip as a product that provides relief for the common cold. In the fall of 2000, this repositioning as a product for colds was reinforced by the introduction of Breathe Right mentholated vapor strips for colds. At the same time, the product line was extended into children’s sizes, with a brightly colored “stars” strip and a Kid Strip with mentholated vapors.

Snoring Relief. Based on results from clinical trials, Breathe Right products were effective in reducing snoring loudness in approximately 85% of the participants. This market remains very important to the Company since approximately 37 million people snore regularly, while another 50 million people snore occasionally. The Company believes that snorers can be targeted effectively and directly through relationship marketing efforts as well as through broad-based advertising.

Improved Breathing for Consumers with Deviated Septum. Approximately 12 million people in the United States suffer from a deviated septum, a bend in the cartilage or bone that divides the nostrils. Breathe Right nasal strips were cleared by the Food and Drug Administration in 1996 to provide temporary relief from breathing difficulties associated with a deviated septum.

Athletic Market. The Company believes that Breathe Right nasal strips make nasal breathing more comfortable and may improve endurance during athletic activity, particularly when a mouth guard is used. An exercise physiology study published in peer-reviewed medical literature in 1997 concluded that Breathe Right nasal strips provided physiologic advantages in ventilation and heart rate during mid-level exercise. Other exercise physiology studies have been conducted and add to the substantiation of the positive effects of Breathe Right nasal strips during exercise. The Company continues to use athletes to endorse Breathe Right nasal strips to increase the visibility of the product, which leads to greater awareness of the product and the Breathe Right brand.

              FiberChoice® Chewable Fiber Tablets. Approximately 10 million U.S. households annually purchase bulk fiber products, primarily to promote regularity and improve digestive health. The bulk fiber category represents approximately $325 million in U.S. retail sales. The Company believes there is a significant opportunity to expand this category due to both the aging of the baby-boomer generation and the marketing of a better consumer solution to existing dietary fiber products–FiberChoice chewable fiber tablets. As people age, they frequently develop digestive problems. People over 55 years old are three times more likely to purchase a bulk fiber supplement than those younger than 55. The first year the baby-boom generation turned 55 was in 2001. This generation is generally more active and demanding than their parents. These consumers search for solutions that do not hamper their active lifestyles. Additionally, most Americans only get 10-15 grams of fiber a day, while experts recommend 25-30 grams daily. The Company believes that its FiberChoice chewable fiber tablet represents such a solution in that it provides an effective, convenient and good-tasting alternative for supplementing dietary fiber intake. The tablets provide four grams of fiber per dose and can be taken anytime and anywhere, with or without water.

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Business Strategies

              The Company’s business strategy includes attempting to increase sales of its Breathe Right® nasal strip and other Breathe Right brand products through advertising, expanding its Breathe Right product line with value added line extensions like Breathe Right mentholated vapor strips for colds and children’s nasal strips, maximizing the potential of recently introduced products and successfully introducing new products with an emphasis on drug-free, better breathing such as the Company’s Breathe Right Snore Relief™ throat spray and Breathe Right VaporShot!™ personal vaporizer.

              Increasing New Consumer Product Trial and Increasing Product Usage. The Company uses a combination of advertising, sampling, promotions, public relations and celebrity endorsements to increase consumer awareness and to encourage consumer trial of the Breathe Right nasal strip. In 1999, the Company began to increase its emphasis on positioning the Breathe Right nasal strip as a product that provides instant, drug-free relief for those suffering from nasal congestion and other breathing conditions such as the common cold, allergies and sinusitis. The Company’s advertising introduced Breathe Right mentholated vapor strips for colds, emphasizing the ability of Breathe Right nasal strips to provide instant, drug-free relief from nasal congestion. In 2001, the Company began separately advertising Breathe Right nasal strips as a product that provides drug-free relief from nasal congestion and for snoring.

              Marketing New Breathe Right Brand Products. The Company believes that the Breathe Right brand name is one of its most valuable assets. In 1998, the Company introduced Breathe Right saline nasal spray. The Company has also expanded the Breathe Right product line to include mentholated vapor strips for colds and nasal strips for children, both of which were introduced during the fall of 2000 in order to coincide with the cough/cold season. In the 2002 cough/cold season the Company launched Breathe Right Snore Relief throat spray. This product leverages the Company’s existing position in the better breathing/snoring product category and complements existing Breathe Right offerings. In the 2002 cough/cold season, the Company intends to launch Breathe Right VaporShot! personal vaporizer. This product also leverages the Company’s existing position in the better breathing product category and complements existing Breathe Right offerings.

              Expanding Company Presence in International Markets. The Company believes that there is significant market potential for its products outside the United States. The Company is devoting significant resources to the development of its international business. The Company entered into agreements with new distributors and representatives for the distribution of the Company’s nasal strip products in Japan, Australia and a number of major markets in Europe in 2000 and in Hong Kong in 2001. The Company is considering additional distributors and representatives for distribution of its nasal strip products in international markets. During 2001, the Company launched its Breathe Right mentholated vapor strips for colds in some international markets in conjunction with each market’s cough/cold season. During fiscal 2003, the Company test-marketed Breathe Right nasal strips in China. The Company intends to launch Breathe Right Snore Relief throat spray in Canada, Italy and Spain in fiscal 2004. The Company believes that the network that it has established for the international distribution of Breathe Right nasal strips will also enable the Company to build its international marketing and distribution capacity for other products. See Item 1, “International Distribution.”

              Acquiring, Developing and Marketing New Products. The Company plans to take advantage of its position as the drug-free, better breathing company and its marketing and distribution strengths by acquiring, developing or licensing the rights to new products that it believes have merit and bringing them to market. The FiberChoice® chewable fiber tablet was launched in March, 2000 and the FLAIR™ equine nasal strip was introduced in 1999. Breathe Right Snore Relief throat spray was launched during the fall of 2002 and Breathe Right VaporShot! personal vaporizer will be launched in the second quarter of fiscal 2004. See Item 1, “Marketing Strategies.” In addition, the Company is evaluating opportunities for licensing new products and acquiring product lines that have an established base of consumer acceptance.

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Marketing Strategies

              Breathe Right® Nasal Strips. The Company’s marketing efforts for Breathe Right products are directed to different consumer markets — the nasal congestion market and the snoring market. The Company has primarily used television advertising to market its products. The Company’s advertising focuses on the Breathe Right brand benefits of providing instant, drug-free relief from nasal congestion and snoring. The Company also uses product promotion programs, such as sampling, coupons and public relations activities to encourage product trial and repeat purchases. Introduction of the Breathe Right mentholated vapor strips for colds has aided in expanding the Company’s penetration into this significant market. Marketing communications are generally designed to promote trial of Breathe Right brand products by increasing consumer awareness of the benefits of each product. In January 2003, the Company concluded a highly successful promotion for Breathe Right nasal strips and Breathe Right Snore Relief™ throat spray by having NFL wide receiver Jerry Rice select the loudest snorer in the Company’s “NFL’s Loudest Snorer” contest.

              Marketing efforts for Breathe Right nasal strips as an aid in the prevention of snoring also included direct mail sampling and sampling through direct response television. In both programs, self-identified snorers were sent a sample of Breathe Right nasal strips along with a brochure explaining the causes of snoring and how the Company’s Breathe Right products can alleviate the condition.

              Because Breathe Right nasal strips are sold as a consumer product, sales of the product will depend in part upon the degree to which the consumer is aware of the product and is satisfied with its use, which also influences repeat usage and word of mouth referrals. The most recent research data collected by a nationally recognized consumer market research firm indicated that approximately 35% of those in the United States who had purchased Breathe Right nasal strips have purchased additional product in the same year.

              FiberChoice® Chewable Fiber Tablets. The Company’s marketing efforts for FiberChoice tablets are directed toward all consumers who don’t get enough fiber in their diet. In 2002, the Company tested a new advertisement in four focused markets that simply states how busy people usually don’t get the fiber they need from their diets and that FiberChoice tablets offer at least twice as much fiber per dose than any other convenient fiber supplement. During fiscal 2003, the Company expanded its successful four-market advertising test to thirteen markets. The Company intends to broaden the FiberChoice brand marketing efforts to 68% of the United States in fiscal 2004.

New Products Strategy

              The Company is committed to the future expansion of its product base through the acquisition and development of unique consumer health care products and technologies that have good market potential, particularly those that complement the Company’s drug-free, better breathing platform. The Company routinely evaluates the merit of product concepts and acquisition opportunities and, from time to time, may acquire or license the rights to products which it believes could successfully be sold through the Company’s established distribution channels. The Company also seeks to extend the Breathe Right brand awareness through licensing to other better breathing products in new categories. The Company intends to launch a new product during the fall 2003 cough/cold season–Breathe Right VaporShot!™ personal vaporizer. This product will leverage the Company’s existing position in the better breathing category and complement existing Breathe Right offerings.

              Most, if not all, of the Company’s current products are regulated to varying degrees by the FDA and other regulatory bodies. See Item 1, “Government Regulation.” Products that the Company may acquire or develop in the future could also be subject to a variety of regulatory requirements. Some products will require extensive clinical studies and regulatory approvals prior to marketing and sale. There can be no assurance that any required regulatory approvals will be obtained or that the Company will market or sell any of these products.

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Domestic Distribution

              Breathe Right® nasal strips, Breathe Right saline nasal spray, Breathe Right Snore Relief™ throat spray and FiberChoice® chewable fiber tablets are sold primarily as consumer products in mass merchant stores, drug stores, grocery stores, warehouse clubs and military base stores in the United States. The Company sells its products through a direct sales force that concentrates on serving certain key retail accounts as well as through a network of independent sales representatives referred to in the industry as brokers. The Company uses direct sales people and brokered sales forces who call on the mass merchant, chain drug, and grocery accounts and the wholesalers who serve primarily the independent drug stores and many of the grocery stores in the United States.

              Breathe Right nasal strips are typically positioned in the cough, cold and allergy sections of stores because they provide benefits similar to those obtained with other decongestant products. Breathe Right saline nasal spray is also usually positioned in the same section of the store as Breathe Right nasal strips since the products are typically used by those suffering from congestion, allergies and colds. Breathe Right Snore Relief throat spray is also usually positioned in the cough/cold section of stores, adjacent to Breathe Right nasal strips. FiberChoice chewable tablets are positioned in the bulk fiber and laxative sections of stores.

              The Company’s retail customers include national chains of mass merchants, drug stores and grocery stores such as Wal-Mart, Kmart, Target, Eckerd, Walgreens, RiteAid, CVS, Kroger and Albertson’s and warehouse clubs such as Sam’s Club and Costco, as well as regional and independent stores in the same store categories. In fiscal 2003, Wal-Mart accounted for approximately 25% of sales. The loss of this customer or any other large retailer would require the Company to replace the lost sales through other retail outlets and could disrupt distribution of the Company’s products.

International Distribution

              From August of 1995 through September of 1999, The 3M Company (“3M”) was the exclusive distributor of the Company’s Breathe Right nasal strip products outside the United States and Canada. The contractual relationship with 3M produced less than anticipated results in international markets. The Company believed that international markets required an increased level of focus, advertising and promotion to reach their potential. On September 30, 1999, the Company and 3M agreed to terminate the existing distribution agreement in a manner that enabled the Company to take a direct and immediate role in the sale, marketing and distribution of its nasal strip products in international markets. As part of the agreement, 3M also agreed not to sell any nasal dilator devices for a period of two years, which period ended on June 30, 2002.

              In 2000, the Company established a broad-ranging international distribution system for the Breathe Right nasal strip business that consists of both sales representatives and reselling distributors. The Company has established relationships with distributors in Canada, Australia, Japan, Hong Kong, China and most of the major markets in Europe. The Company is also pursuing additional distribution opportunities. Sales are supervised by the Company from its Minnesota headquarters and by CNS International, Inc., a wholly-owned domestic subsidiary with one business manager in Europe. The business manager supervises and coordinates the activities of the distributors and sales representatives in Europe. Distributors are appointed largely on an exclusive basis, with territories consisting of one or more countries, and it is expected that this pattern will continue. The Company retains control over the packaging and advertising in all territories. Most shipments are made in bulk, either to reselling distributors who package for the local market, or to warehouse facilities abroad, where final packaging is arranged by the Company directly before shipment to retailers.

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Manufacturing and Operations

              The Company currently subcontracts with multiple manufacturers to produce Breathe Right® nasal strips, Breathe Right saline nasal spray, Breathe Right Snore Relief™ throat spray and FiberChoice® chewable fiber tablets. The Company does no in-house product production. These contract manufacturers provide full turnkey service and ship product to the Company that is completely packaged ready to be sold to retailers or provide semi-finished goods to the Company that require final packaging.

              Each of the manufacturers makes Breathe Right nasal strips to the Company’s specifications using materials specified by the Company. The contract manufacturers have all entered into confidentiality agreements with the Company to protect the Company’s intellectual property rights. Company quality control and operations personnel regularly inspect the contract manufacturers to observe processes and procedures in an attempt to ensure compliance with FDA Good Manufacturing Practice Standards. Finished goods are also inspected to ensure that they meet quality requirements. The Company works closely with its material vendors and contract manufacturers to reduce scrap and waste, improve efficiency and improve yields to reduce the manufacturing costs of the product. The Company has received certification that it has established and maintains a quality system which meets the requirements of ISO 9001:2000/EN 46001.

              To ensure consistent quality and supply, the Company has multi-year contracts with manufacturers that purchase most of the major components for the Breathe Right nasal strips directly from 3M. In 2001, the Company entered into a multi-year contract with 3M that provides for consistent supply, adherence to specifications and pricing. Although similar materials are currently available from other suppliers, the Company has historically utilized 3M components in its products. Although the Company believes that this relationship will not be disrupted or terminated, the inability to obtain sufficient quantities of these components or the need to develop alternative sources in a timely and cost-effective manner could adversely affect the Company’s operations until new sources of these components become available, if at all.

Competition

              Breathe Right Nasal Strips. The market for decongestant products is highly competitive. The Company’s competition in the consumer market for decongestant products and other cold, allergy and sinus relief products consists primarily of pharmaceutical products sold over the counter, other nasal sprays and external nasal dilators, while competition in the snoring remedies market also consists primarily of nasal dilators, throat sprays, herbs, supplements and homeopathic remedies. Although the Company is currently the leading manufacturer of external nasal dilation products, Schering Plough Corp. entered the market in September, 1998 with an external nasal dilation device. Schering Plough Corp. recently sold its nasal strip business to Aso Corp., a subsidiary of Aso International of Japan. In May 2003, Aso Corp. announced it was acquiring the marketing, sales and distribution of Schering Plough’s nasal strip device effective June 3, 2003. Other companies have also entered the nasal dilation market with private label products. Many of the companies that compete with the Breathe Right nasal strip and other Breathe Right products have significantly greater financial and operating resources than the Company. The Company has developed and implemented marketing strategies aimed at minimizing the impact of competitive products. As a result of these strategies and other steps taken by the Company, the Breathe Right nasal strip has maintained approximately 90% of the nasal dilator market despite the entry of other competitors into the market place.

              The patents owned and licensed by the Company on the Breathe Right nasal strip will limit the ability of others to introduce competitive external nasal dilator products similar to the Breathe Right nasal strip in the United States and major international markets. The Company intends to aggressively enforce its patent rights covering the Breathe Right nasal strip and has engaged in litigation to protect its patent rights.

              There can be no assurance that potential competitors will not be able to develop nasal dilation products which circumvent the Company’s patents. In addition, external nasal dilator products compete in the consumer markets with decongestant and sinus relief products and snoring remedies in many international markets where the Company does not yet have, and may not in the future have, patent protection on the Breathe Right® nasal strip.

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              FiberChoice® Chewable Fiber Tablet. The market for dietary fiber supplements is highly competitive and dominated by large companies with resources greater than the Company’s and established brands, such as Metamucil®, Citrucel® and FiberCon®. The Company believes that its FiberChoice chewable fiber tablet is a unique product with significant market potential that offers consumers an effective, convenient and good-tasting alternative to existing products with more fiber per dose than any other convenient fiber supplement. The technology of the FiberChoice chewable fiber tablet is currently protected by one issued U.S. patent with other U.S. and international patents pending.

Government Regulation

              As a manufacturer and marketer of medical devices, the Company is subject to regulation by, among other governmental entities, the FDA and the corresponding agencies of the states and foreign countries in which the Company sells its products. The Company must comply with a variety of regulations, including the FDA’s Good Manufacturing Practice regulations, and is subject to periodic inspections by the FDA and applicable state and foreign agencies. If the FDA believes that its regulations have not been fulfilled, it may implement extensive enforcement powers, including the ability to ban products from the market, prohibit the operation of manufacturing facilities and effect recalls of products from customer locations. The Company believes that it is currently in compliance with applicable FDA regulations.

              FDA regulations classify medical devices into three categories that determine the degree of regulatory control to which the manufacturer of the device is subject. In general, Class I devices involve compliance with labeling and record keeping requirements and are subject to other general controls. Class II devices are subject to performance standards in addition to general controls. Class III devices are those devices, usually invasive, for which pre-market approval (as distinct from pre-market notification) is required before commercial marketing to assure product safety and effectiveness.

              Before a new medical device can be introduced into the market, the manufacturer generally must obtain FDA clearance through either a 510(k) pre-market notification or a pre-market approval application (“PMA”). A 510(k) clearance will be granted if the submitted data establish that the proposed device is “substantially equivalent” to a legally marketed Class I or II medical device, or to a Class III medical device for which the FDA has not called for PMAs. The PMA process can be expensive, uncertain and lengthy, frequently requiring from one to several years from the date the PMA is accepted. In addition to requiring clearance for new products, FDA rules may require a filing and waiting period prior to marketing modifications of existing products. The Company has received 510(k) approvals to market the Breathe Right nasal strip as a device that can (i) temporarily relieve the symptoms of nasal congestion and stuffy nose, (ii) eliminate or reduce snoring, (iii) improve nasal breathing by reducing nasal airflow resistance, and (iv) temporarily relieve breathing difficulties due to a deviated nasal septum. Nasal dilators have since been classified by the FDA as Class I devices and exempt from pre-market notification.

              The Company’s FiberChoice product is considered to be a dietary supplement and is regulated under the Federal Food, Drug, and Cosmetic Act as amended by the Dietary Supplement Health and Education Act “DSHEA” of 1994, and under the Fair Packaging and Labeling Act. There is generally no requirement that a company obtain a license or approval from FDA before marketing dietary supplements in the United States. The FDA is developing regulations for certain provisions of the DSHEA which will be published as final rules in the Federal Register.

              Sales of the Company’s products outside the United States are subject to regulatory requirements that vary widely from country to country. The Company has selected a third party to act as an “Authorized Representative” in the European Union. The Company believes that it has the necessary documentation to support affixing the “CE” mark, an international symbol of quality and compliance with applicable European medical device directives, to the Company’s Breathe Right® nasal strips in Europe. Regulatory approvals have also been obtained for the Breathe Right nasal strip in Australia and additional approvals in other jurisdictions will be sought by the Company as needed for all of its products.

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              No assurance can be given that the FDA or state or foreign regulatory agencies will give on a timely basis, if at all, the requisite approvals or clearances for additional applications for the Breathe Right nasal strip or for any of the Company’s other products. Moreover, after clearance is given, the Company is required to advise the FDA and these other regulatory agencies of modifications to its products. These agencies have the power to withdraw the clearance or require the Company to change the device or its manufacturing process or labeling, to supply additional proof of its safety and effectiveness or to recall, repair, replace or refund the cost of the medical device if it is shown to be hazardous or defective. The process of obtaining clearance to market products is costly and time-consuming and can delay the marketing and sale of the Company’s products. Furthermore, federal, state and foreign regulations regarding the manufacture and sale of medical devices and other products are subject to future change. The Company cannot predict what impact, if any, such changes might have on its business.

              The Company is also subject to substantial federal, state and local regulation regarding occupational health and safety, environmental protection, hazardous substance control, waste management and disposal, among others.

Patents, Trademarks and Proprietary Rights

              The Company has registered trademarks, owns several patents and pending patent applications, and has a number of patents through licenses which are used in connection with its business. Some of these patents and licenses cover significant product formulations, methods and designs for the Company’s current and possible future products. The Company believes its trademarks are important as protection for the Company’s image in the marketplace. The Company’s success is and will continue to be dependent upon the existence of and ability to protect its patents, trademarks and those under its licenses and the Company intends to take such steps as are necessary to protect its intellectual property rights.

              There can be no assurance that the Company’s technology and proprietary rights will not be challenged on the grounds that its products infringe on patents, copyrights or other proprietary information owned or claimed by others, or that others will not successfully utilize part or all of the Company’s technology without compensation to the Company. Nor can there be any assurance that others will not attempt to challenge the validity or enforceability of the Company’s patents and licensed patents on the basis of prior art or introduce competitive products. In addition to seeking patent protection for its products, the Company also intends to protect its proprietary technologies and proprietary information as trade secrets.

              The Company entered into license agreements pursuant to which the Company acquired from the licensors the exclusive worldwide rights to manufacture and sell the Breathe Right nasal strip in its various versions and the FiberChoice® chewable fiber tablet. Specifically, the Company has the exclusive right pursuant to those license agreements to manufacture, sell and otherwise practice any invention claimed in the licensors’ patents issued in any country, including those that issue on pending applications. The Company is obligated to pay royalties to the licensors based on sales of the products typically including certain minimum royalty amounts in order to maintain its exclusivity.

              The original licensor of the Breathe Right nasal strip has filed patent applications with the U.S. Patent and Trademark Office seeking patent protection for different aspects of the Breathe Right nasal strip technology. Seven of these patent applications have resulted in issued patents in the United States, including one with claims that cover the single-body construction of the Breathe Right® nasal strip. The licensor of the Breathe Right nasal strip also has one patent application which is currently pending. In addition, that licensor has obtained patent protection on the Breathe Right nasal strip in several foreign countries and has various applications pending which seek further patent protection in these and a number of additional countries. The later licensor of the Breathe Right mentholated vapor strip has filed several patent applications with the U.S. Patent and Trademark Office as well as international patent offices resulting in both issued and pending applications. The Company, in addition to the patents and patent applications pending in the U.S. mentioned above, has filed corresponding patent applications seeking protection in several foreign countries to protect certain rights to nasal dilation technology that it acquired.

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              The licensor of the FiberChoice® chewable fiber tablet has one issued U.S. Patent and other issued and pending international patents seeking patent protection for different aspects of this product.

              Although the Company believes that its owned and licensed patents on nasal strips will limit the ability of others to introduce competitive external nasal dilator products in the United States, there can be no assurance that the patents on the Breathe Right nasal strip, or any additional patents on this or other products that may be issued in the future, if any, will effectively foreclose the development of competitive products or that the Company will have sufficient resources to pursue enforcement of any patents issued. The Company does, however, intend to aggressively enforce the patents covering nasal strips and its other products. In order to enforce any patents issued covering nasal strips, including the Breathe Right nasal strip, or any of its other products, the Company may have to engage in litigation which may result in substantial cost to the Company and counterclaims against the Company. Any adverse outcome of such litigation could have a negative impact on the Company’s business.

              The Company has engaged in litigation to enforce its patent rights relating to the Breathe Right nasal strip. In 1999, the Company brought a suit in federal district court to enforce one of the licensed nasal strip patents containing the broadest claims and providing the most comprehensive protection. In the course of this suit, the defendant requested reexamination in the U.S. Patent and Trademark Office (the “Patent Office”) of the Company’s primary licensed patent. On September 29, 2000, the Patent Office issued an Office Action in Reexamination and rejected certain of the claims. Other claims that were not subject to reexamination remain in effect. The Company has joined the licensor in the exercise of its right to contest the action of the Patent Office and has provided reasons that it believes establish that the claims should not have been rejected. The Company and its licensor are also seeking to amend certain claims to provide the Company with additional protection under the patent. The final outcome of the reexamination by the Patent Office is therefore uncertain. Although an adverse ruling from the Patent Office would narrow the protection available for nasal dilators and limit the breadth of the Company’s patent protection, the Company believes that its current portfolio of both pending patent applications and newly issued patents will enable it to maintain significant patent protection for its nasal strip products.

              The Company has registered its Breathe Right and FiberChoice trademarks in the United States and in several foreign countries and is seeking further registration of those trademarks and other trademarks.

              The Company has one patent pending for Breathe Right Snore Relief™ throat spray and two patents pending for the Breathe Right VaporShot!™ vaporizer technology. Both Snore Relief and VaporShot! are trademarks of the Company and their registrations are pending.

Employees

              At June 13, 2003, the Company had 53 full-time employees and 4 part-time employees, of whom 15 were engaged in operations, 22 in general administration, and 20 in marketing and sales. There are no unions representing Company employees. Relations with its employees are believed to be positive and there are no pending or threatened labor employment disputes or work interruptions.

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EXECUTIVE OFFICERS OF THE COMPANY

              The following table sets forth the names and ages of the Company’s current Executive Officers together with all positions and offices held with the Company by such executive officers. Officers are appointed to serve until the meeting of the Board of Directors following the next Annual Meeting of Stockholders and until their successors have been elected and have qualified.


Name and Age Office

 
Daniel E. Cohen (50)                Chairman of the Board and Director
   
Marti Morfitt (45)   President, Chief Executive Officer and Director
   
Marcia O’Brien (47)   Interim Chief Financial Officer
   
Milton Anderson, Ph.D (52)   Vice President of Product Development
  and Regulatory
   
John J. Keppeler (41)   Vice President of Worldwide Sales
   
Linda Kollofski (50)   Vice President of New Business Development
   
John Kundtz (41)   Vice President of Marketing
   
Larry R. Muma (52)   Vice President of Operations
   
Carol J. Watzke (55)   Vice President of Consumer Strategy


              Daniel E. Cohen has served as the Company’s Chairman of the Board since 1993, its Chief Executive Officer from 1989 to June 2001 and a director since 1982. He also served as the Company’s Treasurer from 1982 to March of 1999. Mr. Cohen, a founder of the Company, is a medical doctor and board-certified neurologist.

              Marti Morfitt has served as the Company’s President and a director since March 1998 and its Chief Executive Officer since June 2001. She also served as the Company’s Chief Operating Officer from 1998 to June 2001. From September of 1982 through February of 1998, Ms. Morfitt served in a series of positions of increasing responsibility with The Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, most recently serving from May of 1997 to February of 1998 as Vice-President, Meals, and from February 1994 to May 1997 as Vice-President, Green Giant Brands. She also serves as a director of Graco, Inc., a Minneapolis-based manufacturer of fluid handling systems.

              Marcia O’Brien has served as the Company’s Interim Chief Financial Officer since March 31, 2003. From 1985 to 2002, Ms. O’Brien served as Executive Vice President and Chief Financial Officer of Signal Financial Corporation, a $1.1 billion bank holding company based in Minnesota that was acquired by Associated Bank in 2002. Prior to Signal, she served as a senior manager at accounting firm KPMG, as well as a senior auditor at Deloitte & Touche. Ms. O’Brien is a certified public accountant.

              Milton Anderson, Ph.D has served as the Company’s Vice President of Product Development and Regulatory since 1998, Vice President of Clinical and Regulatory Affairs from 1994 to 1998, and Vice President of Research and Development from 1990 to 1994. He has served in various other capacities since joining the Company in 1984, including Director of Applications Research and Director of Research and Development. Prior to joining the Company in 1984, Dr. Anderson was an Assistant Professor at the University of Minnesota’s College of Pharmacy.

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              John J. Keppeler has served as the Company’s Vice President of Worldwide Sales since August of 1999, and has served as the Company’s Vice President of Sales from 1998 to 1999. From November of 1986 to June of 1998, Mr. Keppeler served in a series of sales and marketing positions of increasing responsibility with The Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, most recently serving as Director of Category & Customer Development for the Green Giant and Progresso Business.

              Linda Kollofski has served as the Company’s Vice President of New Business Development since November of 2002. Prior to joining the Company in 2002, Ms. Kollofski was principal of Linda K. Consulting, Inc. from October of 1994 to October of 2002. Ms. Kollofski provided marketing expertise to various Pillsbury brands including Hagen-Daz, Totino’s and Green Giant as well as to Telex Communications, Hazeldon Foundation publishing business and the Company’s FiberChoice business. Previously, Ms. Kollofski served in senior marketing and new business development positions with the Hazeldon Foundation, Dow Brands, Pillsbury and Munsingwear.

              John Kundtz has served as the Company’s Vice President of Marketing since July of 2002. From 2001 to 2002, Mr. Kundtz served as Vice President, Strategic Marketing for Eagan, MN based West Group, a division of The Thompson Corporation, the nation’s leading legal information company. From 1987 to 2000, Mr. Kundtz served in a series of senior marketing and management positions with the Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, most recently serving as Vice President of Channel Development and Vice President of the Totinos brand. In addition, Mr. Kundtz co-founded Dogs Howling, Inc., which operates an upscale restaurant and entertainment venue.

              Larry R. Muma has served as the Company’s Vice President of Operations since January of 2001. From May of 2000 to December of 2000, Mr. Muma served as Director of Supply Chain for Novartis, Inc., a worldwide manufacturer and distributor of health care and pharmaceutical products. From February of 1992 to April of 2000, Mr. Muma served in various operations positions of increasing responsibility with The Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, serving from February 1994 to April of 1999 as Vice President of Operations for Pillsbury North America and most recently from April of 1999 to April of 2000 as Vice President of Operations Frozen Division.

              Carol J. Watzke has served as the Company’s Vice President of Consumer Strategy since July of 1998. Prior to joining the Company, Ms. Watzke served in a series of positions of increasing responsibility since 1974 with The Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, most recently serving as Consumer Insights Director from May of 1997 to July of 1998 and as Market Research Director, Green Giant Brands, from 1994 to 1997.

Item 2. PROPERTIES

              The Company leases approximately 73,000 square feet of office, manufacturing and warehouse space in Eden Prairie, Minnesota. The lease expires in November of 2010 and contains a renewal option. Monthly payments on the lease are $61,766.

Item 3. LEGAL PROCEEDINGS

              From time to time, the Company may be involved in litigation that arises through the normal course of its business. As of the date of this Annual Report on Form 10-K, the Company is not a party to any litigation the Company believes could reasonably be expected to have a material adverse effect on its business or results of operations.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

              None.

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PART II

Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Market Information

              The Company’s Common Stock has been traded on The Nasdaq Stock Market under the symbol “CNXS” since April 8, 1994. The following table sets forth the high and low last sale prices of the Company’s Common Stock for the period indicated which cover the Company’s fiscal years ending March 31, 2003 and December 31, 2001 and the transition period of January 1, 2002 to March 31, 2002.


               Fiscal Year Ended March 31, 2003 High                Low
   
 
Quarter Ended March 31, 2003 7.19   5.87
Quarter Ended December 31, 2002 6.79   5.08
Quarter Ended September 30, 2002 6.15   5.00
Quarter Ended June 30, 2002 7.11   5.54
     
Transition Period High   Low


Quarter Ended March 31, 2002 6.92   4.90
     
Fiscal Year Ended December 31, 2001 High   Low


Quarter Ended December 31, 2001 5.95   3.66
Quarter Ended September 30, 2001 5.13   3.15
Quarter Ended June 30, 2001 6.08   3.25
Quarter Ended March 31, 2001 5.13   3.50

              On June 13, 2003, the last sale price of the Common Stock was $8.40 per share.

Shareholders

              As of June 13, 2003, there were approximately 700 owners of record of Common Stock and an estimated 7,000 beneficial holders whose shares were registered in the names of nominees.

Dividends

              The Company has never paid any dividends on its Common Stock. The Company currently intends to retain any earnings for use in its operations and does not anticipate paying cash dividends in the foreseeable future. The payment of dividends, if any, in the future will be at the discretion of the Board of Directors and will depend upon, among other things, future earnings, capital requirements, restrictions in future financing agreements, the general financial condition of the Company and general business considerations.

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Information Regarding Equity Compensation Plans

              The following table sets forth information regarding the Company’s equity compensation plans in effect as of March 31, 2003. Each of the Company’s equity compensation plans is an “employee benefit plan” as defined by Rule 405 of Regulation C of the Securities Act of 1933.

Securities Authorized for Issuance under Equity Compensation Plans


Plan Category Number of shares
of common stock to
be issued upon
exercise of
outstanding options,
warrants and rights
Weighted-average
exercise price of
outstanding options,
warrants and rights
Number of shares of
common stock remaining
available for future
issuance under equity
compensation plans
 
      
Equity compensation plans                              
approved by stockholders 2,084,504   $4.58   86,710  
      
Equity compensation plans not        
approved by shareholders -0 -   -0 -0 -
      
Totals 2,084,504   $4.58   86,710  

              The equity compensation plans approved by CNS, Inc. shareholders are the 2000 Stock Option Plan, the 1994 Amended Stock Plan, the 1990 Stock Plan and the 1987 Employee Incentive Stock Option Plan. No shares remain available for future awards under any of the 1994, 1990 or 1987 Plans.

              The Company also maintains a 1989 Employee Stock Purchase Plan, participation in which is available to substantially all of the Company’s employees. Participating employees may purchase the Company’s common stock at the end of each participation period at a purchase price equal to 85% of the lower of the fair market value of the stock at the beginning or end of the period. The six-month participation period runs from January 1 to June 30 and from July 1 to December 31 each year. Employees may contribute up to 10% of their base compensation to the plan subject to certain IRS limits on stock purchases through the plan. This plan has been approved by the Company’s shareholders.

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Item 6. SELECTED FINANCIAL DATA

              The following selected financial data should be read in conjunction with the Company’s Consolidated Financial Statements and Notes thereto together with the “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” all of which are included elsewhere in this Report. The Consolidated Statements of Operations and Balance Sheet data presented below as of and for the years ended December 31, 1998 through March 31, 2003 have been derived from the Company’s Consolidated Financial Statements included elsewhere in this Report, which have been audited by KPMG LLP, independent certified public accountants.

FINANCIAL HIGHLIGHTS
(In thousands, except per share amounts)


Years ended
Mar 31
Dec 31
Dec 31
Dec 31
Dec 31
 
2003
2001
2000
1999
1998
 
Net sales 79,075           76,242            61,777            38,409            49,037
Operating income (loss)   9,639     (1,225 )   (17,843 )   (18,696 )   701
Net income (loss)   6,516     81     (15,660 )   (13,756 )   2,982
Diluted net income (loss) per share 0.46   0.01   (1.09 ) (0.89 ) 0.16
  
Working capital 45,266   32,712   32,507   50,183   72,025
Total assets   65,375     50,618     56,344     65,337     84,963
Stockholders’ equity   49,054     36,612     36,937     53,584     75,866

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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
             RESULTS OF OPERATIONS

              The following discussion of the financial condition and results of operations should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto appearing elsewhere in this Annual Report. Fiscal 2001 and 2000 amounts have been restated to give effect to the adoption on January 1, 2002 of the provisions of EITF Issue No. 01-9. These new accounting standards had no impact on the Company’s net income; however, they did require reclassification of certain promotional costs. In this discussion, our fiscal years ended March 31, 2003; December 31, 2001 and 2000 are referred to as fiscal year 2003, 2001 and 2000, respectively. In the opinion of the Company’s management, the quarterly unaudited information set forth below has been prepared on the same basis as the audited financial information, and includes all adjustments (consisting only of normal, recurring adjustments) necessary to present this information fairly when read in conjunction with the Company’s consolidated financial statements and notes thereto.

Overview

              The Company was founded in 1982. From 1987 until 1995, the Company designed, manufactured and marketed computer-based diagnostic devices for sleep disorders. In 1995, the Company divested itself of the assets related to its sleep disorders business to focus on the Breathe Right® nasal strip.

              The Company obtained the exclusive license to manufacture and sell the Breathe Right nasal strip in 1992 and received FDA clearance in October 1993 to market the Breathe Right nasal strip as a product that improves nasal breathing. The Company has also received FDA clearance to market the Breathe Right nasal strip for the reduction or elimination of snoring, for the temporary relief of nasal congestion and for the temporary relief of breathing difficulties due to a deviated nasal septum.

              In August 1995, the Company signed an exclusive international distribution agreement with the 3M Company (“3M”) to market Breathe Right nasal strips outside the U.S. and Canada. On September 30, 1999, the Company and 3M amended the distribution agreement in a manner that enabled the Company to regain control of the marketing, sales and distribution of Breathe Right nasal strips in international markets. In exchange for the one-time contract termination fee, the international distribution agreement with 3M terminated on June 30, 2000. During 2000, the Company established an international distribution network that consists of both sales representatives and reselling distributors and reintroduced nasal strips in Europe, Japan and Australia.

              In July 1996, U.S. Utility Patents were issued covering the basic invention of the Breathe Right nasal strip and additional elements incorporated in the product. During 1997, the Company became aware of a foreign reference to a nasal dilator, not commercially available. During 2000, the U.S. Patent and Trademark Office (“Patent Office”) reexamined the Company’s primary licensed patent and rejected certain claims. The Company has joined its licensor in the exercise of its right to contest the action of the Patent Office. The Company and its licensor have amended and are also seeking to further amend certain claims to provide the Company with additional protection under the patent. The final outcome of the reexamination is uncertain. Although an adverse ruling could narrow the range of protection available for nasal dilators and limit the breadth of the Company’s patent protection, the Company believes that its current portfolio of both pending patent applications and issued patents will enable it to maintain significant patent protection for its nasal strip products.

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              Beginning in 1998, the Company strengthened its management team to add consumer packaged goods and new products experience. The Company also formed teams to focus on individual product lines. The Company completed positioning research work to expand the Breathe Right® brand and developed a road map for new product development. During 1999 and 2000, the Company invested aggressively in marketing, selling and product development expenses to build the Breathe Right brand and launch additional products.

              In 2000, the Company expanded its domestic Breathe Right product line to include nasal strips for colds with mentholated vapors that are sized for the entire family and nasal strips for children that are available in multiple colors. Breathe Right nasal strips for colds with mentholated vapors were introduced in selected overseas markets in 2001.

              During 2000, the Company launched FiberChoice® chewable fiber tablets. The tablets are positioned in the bulk fiber supplement market and give the Company an entry into the digestive health products market. FiberChoice chewable fiber tablets can be taken without water and have been clinically proven to be as effective as powder alternatives.

              In 2001, the Company streamlined and realigned the Company’s resources to better match its strategic goals and to focus on building the core businesses. The Company recorded a special charge related to costs associated with this plan. Approximately 25% of the workforce, from throughout the organization, was eliminated. These cost-cutting actions were expected to result in annual savings of approximately $2 to $2.5 million. The cost savings relating to this plan were realized beginning in July of 2001.

              In 2002, the Company changed its fiscal year-end from December 31 to March 31. The change in its fiscal year end aligns the Company’s financial reporting with its business and customer planning cycle. The Company believes this change provides a clearer picture of the Company’s financial results by including an entire cough/cold season within the same fiscal year. The first period to be reported in 2002 was a three-month stub period ending March 31, 2002. Fiscal 2003 is from April 1, 2002 through March 31, 2003.

              In fiscal 2003, the Company continued to expand its Breathe Right product line by launching Breathe Right Snore Relief™ throat spray. Snore Relief spray lubricates and soothes dry throats, while a natural astringent firms loose tissue to reduce the vibrations that cause snoring. Breathe Right strips open nasal passages and reduce the mouth breathing that leads to snoring. These two products provide a portfolio of solutions for snoring.

Accounting Policies

              In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management must make decisions which impact the reported amounts and the related disclosures. Such decisions include the selection of the appropriate accounting principles to be applied and the assumptions on which to base accounting estimates. In reaching such decisions, management applies judgment based on its understanding and analysis of the relevant circumstances. Note 1 to the consolidated financial statements provides a summary of the significant accounting policies followed in the preparation of the financial statements.

              The Company’s critical accounting policies include the following:

              Sales Returns and Other Allowances, and Allowance for Doubtful Accounts. Revenue from sales is recognized at the time products are shipped less estimated sales returns, certain promotional costs and other allowances. Management must make estimates of potential future product returns and other allowances related to current period revenue. Management analyzes historical returns, current trends, and changes in customer and consumer demand when evaluating the adequacy of the sales returns and other allowances. The Company has established a reserve of $1.4 million for future sales returns and other allowances as of March 31, 2003. Similarly, management must make estimates of the uncollectability of accounts receivables. Management specifically analyzes customer account balances, historical bad debts, current economic trends and changes in the timing of customer payments. The balance of accounts receivable was $11.0 million, net of the allowance for doubtful accounts of $330,000 as of March 31, 2003.

21




              Inventory Valuation. Inventory is valued at the lower of cost, determined on a first-in, first-out basis (FIFO), or market. The Company analyzes the cost and the market value of inventory items and establishes the appropriate valuation reserves. The Company has established a reserve of $667,000 as of March 31, 2003. Management believes that the inventory valuation results in carrying inventory at the lower of cost or market.

              Accounting for Income Taxes. As part of the process of preparing financial statements, the Company is required to estimate income taxes, both state and federal. This process involves management estimating the actual current tax exposure together with assessing temporary differences resulting from different treatment for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the consolidated balance sheet. Management must then assess the likelihood that deferred tax assets will be utilized to offset future taxable income during the periods in which these temporary differences are deductible. Based on the level of historical taxable income and projections of future taxable income for the periods, in which the deferred tax assets are deductible, management believes that it is more likely than not the Company will realize the benefits of these deductible differences. Accordingly, the Company has eliminated the valuation allowance of $9.1 million against the net deferred tax assets as of March 31, 2002.

              Valuation of Product Rights. Management assesses the impairment of product rights whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors that are considered important for the assessment include significant underperformance of a product line relative to projected or historical results, significant change in the market in relation to competitive products and significant negative industry or economic trends. Management currently does not believe that it is necessary to record an impairment charge at this time and that the carrying value of these assets will be recoverable.

Operating Results

              On January 23, 2002, the Company changed its fiscal year-end from December 31 to March 31. The first period to be reported in 2002 was a three-month stub period ended March 31, 2002. The change in fiscal year-end aligns the Company’s financial reporting period with its business and customer-planning cycle. The Company believes this change provides a clearer picture of the Company’s financial results by including an entire cough/cold season within the same fiscal year.

              The following discussion of historical operating results compares the fiscal year ended March 31, 2003 to the previous fiscal year ended December 31, 2001 and compares the fiscal year ended December 31, 2001 to the fiscal year ended December 31, 2000. Additionally, the three-month transition period ended March 31, 2002 is compared to the same unaudited period in the prior year.

              The tables below set forth certain selected financial information of the Company and the percentage of net sales represented by certain items included in the Company’s statements of operations for the periods indicated.

22




              Certain prior period amounts have been reclassified to conform to the current period’s presentation. These reclassifications had no impact on the operating net income (loss) or net income (loss) for 2001 and 2000.


Three Months Ended Year
Ended
Mar 31,
Jun 30,
Sep 30,
Dec 31,
Mar 31,
Mar 31,

2002
2002
2002
2002
2003
  2003

(In thousands)
Domestic net sales 15,195         12,711         15,346          19,088          18,117         65,262
International net sales   3,940     1,812     2,040     6,826     3,135     13,813






    Net sales   19,135     14,523     17,386     25,914     21,252     79,075
Cost of goods sold   6,390     5,319     5,912     8,119     6,642     25,992






       Gross profit   12,745     9,204     11,474     17,795     14,610     53,083






Operating expenses:                      
    Advertising and promotion   8,796     4,115     2,881     13,407     10,527     30,930
    Selling, general and                      
    administrative   3,213     2,763     3,015     3,204     3,532     12,514






       Total operating expenses   12,009     6,878     5,896     16,611     14,059     43,444






       Operating income   736     2,326     5,578     1,184     551     9,639
Investment income   272     229     240     240     130     839






       Income before income                      
       taxes   1,008     2,555     5,818     1,424     681     10,478
Income tax expense (benefit)   (9,126 )   1,000     2,300     550     112     3,962






       Net income 10,134   1,555   3,518   874   569   6,516







23




Three Months Ended Year
Ended
Mar 31,
Jun 30,
Sep 30,
Dec 31,
Dec 31,

2001
2001
2001
2001
2001

(In thousands)
Domestic net sales 18,727        11,448         13,709          16,344         60,228  
International net sales   4,741     2,922     3,340     5,011     16,014  





    Net sales   23,468     14,370     17,049     21,355     76,242  
Cost of goods sold   8,706     5,557     6,059     7,376     27,698  





       Gross profit   14,762     8,813     10,990     13,979     48,544  





Operating expenses:                    
    Advertising and promotion   13,935     7,529     3,175     9,617     34,256  
    Selling, general and administrative   4,766     3,519     3,247     3,051     14,583  
    Special charges   0     1,100     0     (170 )   930  





       Total operating expenses   18,701     12,148     6,422     12,498     49,769  





       Operating income (loss)   (3,939 )   (3,335 )   4,568     1,481     (1,225 )
Investment income   362     345     269     330     1,306  





       Income (loss) before income taxes   (3,577 )   (2,990 )   4,837     1,811     81  
Income taxes   0     0     0     0     0  





       Net income (loss) (3,577 ) (2,990 ) 4,837   1,811   81  





            
Three Months Ended Year
Ended
Mar 31, Jun 30, Sep 30, Dec 31, Dec 31,

2000
2000
2000
2000
2000

(In thousands)
Domestic net sales 13,210   11,210   14,899   16,408   55,727  
International net sales   286     598     2,588     2,578     6,050  





    Net sales   13,496     11,808     17,487     18,986     61,777  
Cost of goods sold   4,846     5,110     6,875     8,076     24,907  





       Gross profit   8,650     6,698     10,612     10,910     36,870  





Operating expenses:                    
    Advertising and promotion   10,920     4,503     7,756     16,400     39,579  
    Selling, general and administrative   3,915     3,470     3,756     3,993     15,134  





       Total operating expenses   14,835     7,973     11,512     20,393     54,713  





       Operating loss   (6,185 )   (1,275 )   (900 )   (9,483 )   (17,843 )
Investment income   498     566     507     612     2,183  





       Loss before income taxes   (5,687 )   (709 )   (393 )   (8,871 )   (15,660 )
Income taxes   0     0     0     0     0  





       Net loss (5,687 ) (709 ) (393 ) (8,871 ) (15,660 )






24




Three Months Ended Year
Ended
Mar 31, Jun 30, Sep 30, Dec 31, Mar 31, Mar 31,

2002
2002
2002
2002
2003
2003

Net sales 100.0 %       100.0 %       100.0 %       100.0 %       100.0 %       100.0 %
Cost of goods sold 33.4   36.6   34.0   31.3   31.2   32.9  






       Gross profit 66.6   63.4   66.0   68.7   68.8   67.1  






Operating expenses:            
    Advertising and promotion 46.0   28.3   16.6   51.7   49.5   39.1  
    Selling, general and            
    administrative 16.8   19.0   17.3   12.4   16.6   15.8  






       Total operating expenses 62.8   47.3   33.9   64.1   66.1   54.9  






       Operating income 3.8   16.1   32.1   4.6   2.7   12.2  
Investment income 1.4   1.6   1.4   0.9   0.6   1.1  






       Income before income            
       taxes 5.2   17.7   33.5   5.5   2.7   13.3  
Income tax expense (benefit) (47.7 ) 6.9   13.2   2.1   0.5   5.0  






       Net income 52.9 % 10.8 % 20.3 % 3.4 % 2.8 % 8.3 %







Three Months Ended Year
Ended
Mar 31, Jun 30, Sep 30, Dec 31, Dec 31,

2001
2001
2001
2001
2001

Net sales 100.0 %       100.0 %       100.0 %       100.0 %       100.0 %
Cost of goods sold 37.1   38.7   35.5   34.5   36.3  





       Gross profit 62.9   61.3   64.5   65.5   63.7  





Operating expenses:          
    Advertising and promotion 59.4   52.4   18.6   45.0   44.9  
    Selling, general and administrative 20.3   24.5   19.0   14.3   19.1  
    Special charges 0.0   7.7   0.0   (0.8 ) 1.2  





       Total operating expenses 79.7   84.6   37.6   58.5   65.2  





       Operating income (loss) (16.8 ) (23.3 ) 26.9   7.0   (1.5 )
Investment income 1.5   2.4   1.6   1.5   1.7  





       Income (loss) before income taxes 15.3   20.9   28.5   8.5   0.2  
Income taxes 0.0   0.0   0.0   0.0   0.0  





       Net income (loss) (15.3 )% (20.9 )% 28.5 % 8.5 % 0.2 %






25




Three Months Ended Year
Ended
Mar 31, Jun 30, Sep 30, Dec 31, Dec 31,

2000
2000
2000
2000
2000

Domestic net sales          
International net sales          
    Net sales 100.0 %       100.0 %       100.0 %       100.0 %       100.0 %
Cost of goods sold 35.9   43.3   39.3   42.5   40.3  





       Gross profit 64.1   56.7   60.7   57.5   59.7  





Operating expenses:          
    Advertising and promotion 80.9   38.1   44.4   86.4   64.1  
    Selling, general and administrative 29.0   29.4   21.5   21.0   24.5  





       Total operating expenses 109.9   67.5   65.9   107.4   88.6  





       Operating loss (45.8 ) (10.8 ) (5.2 ) (49.9 ) (28.9 )
Investment income 3.7   4.8   2.9   3.2   3.5  





       Loss before income taxes (42.1 ) (6.0 ) (2.3 ) (46.7 ) (25.4 )
Income taxes 0.0   0.0   0.0   0.0   0.0  





       Net loss (42.1 )% (6.0 )% (2.3 )% (46.7 )% (25.4 )%






2003 Compared to 2001

              Net Sales. Net sales for 2003 of $79.1 million increased 3.8% over 2001 sales of $76.2 million. Domestic sales of Breathe Right® products grew to $57.9 million, representing an increase of 7.6% over 2001 sales of $53.8 million. FiberChoice® tablet sales for 2003 grew to $7.1 million from $6.4 million for the previous year, representing an increase of 10.9%, primarily as the result of expanding the advertising support to thirteen U.S. markets.

              International sales decreased by 13.8% to $13.8 million dollars compared to 2001 sales of $16.0 million. This decrease resulted from some international partners decreasing their inventory levels.

              The Company has experienced in the past, and expects that it will continue to experience in the future, quarterly fluctuations in both domestic and international sales and earnings. These fluctuations are due in part to advertising levels and seasonality of sales as described below, as well as increases and decreases in purchases by distributors and retailers in anticipation of future demand by consumers.

              Gross Profit. Gross profit was $53.1 million for 2003 compared to $48.5 million for 2001. Gross profit as a percentage of net sales increased to 67.1% for 2003 compared to 63.7% for 2001. The improvement in gross profit is due to lower product costs on products sold.

              Advertising and Promotion. Advertising and promotion expenses were $30.9 million for 2003 compared to $34.3 million for 2001. Advertising and promotion expenses as a percentage of net sales decreased to 39.1% in 2003 from 44.9% in 2001. This decrease in spending rate was the result of a planned lower support level for FiberChoice tablets.

              Selling, General and Administrative. Selling, general and administrative expenses were $12.5 million for 2003 compared to $14.6 million for 2001. Selling, general and administrative expenses as a percentage of net sales decreased to 15.8% for 2003 compared to 19.1% for 2001. This decrease was primarily the result of the corporate restructure that included a workforce reduction and that enabled the Company to streamline its resources to focus on building the core businesses.

              Investment Income. Investment income was $.8 million for 2003 compared to $1.3 million for 2001. The decrease in investment income was primarily due to a decrease in market interest rates. The Company also incurred $100,000 of interest expense relating to an IRS audit in 2003.

26




              Income Tax Expense (Benefit).Income tax expense was $4.0 million for 2003 compared to $0 for 2001. The Company did not recognize an income tax benefit in 2001 due to the increase in net income before tax, offset by changes in deferred tax assets, including utilization of net operating loss carryforwards for which a full valuation allowance had been established.

2001 Compared to 2000

              Net Sales. Net sales for 2001 of $76.2 million showed a 23.3% increase over 2000 sales of $61.8 million. Domestic sales of Breathe Right® products grew to $53.8 million, representing an increase of 8.9% over 2000 sales of $49.4 million. FiberChoice® tablet sales for 2001 of $6.4 million remained flat from sales of $6.4 million in 2000.

              International sales increased by 162.3% to $16.0 million compared to 2000 sales of $6.1 million. This increase was the result of a full year of distribution in Japan, Europe, and Australia as well as the launch of Breathe Right nasal strips for colds with mentholated vapors in selected countries.

              Gross Profit. Gross profit was $48.5 million for 2001 compared to $36.9 million for 2000. Gross profit as a percentage of net sales increased to 63.7% for 2001 compared to 59.7% for 2000. Gross profit in 2000 was unfavorably impacted by the lower gross profit on 10-count FiberChoice chewable tablets, disposal of an excess inventory of pillow covers and higher costs associated with expediting inventory purchases and deliveries.

              Advertising and Promotion. Advertising and promotion expenses were $34.3 million for 2001 compared to $39.6 million for 2000. Advertising and promotion expenses as a percentage of net sales decreased to 44.9% in 2001 from 64.1% in 2000. This decrease in spending rate was the result of a planned lower support level for FiberChoice tablets in the year following its introduction and the elimination of less effective expenditures for the Breathe Right brand.

              Selling, General and Administrative. Selling, general and administrative expenses were $14.6 million for 2001 compared to $15.1 million for 2000. Selling, general and administrative expenses as a percentage of net sales decreased to 19.1% compared to 24.5% for 2000. This decrease was primarily the result of the corporate restructure that included a workforce reduction that enabled the Company to streamline its resources to focus on building the core businesses.

              Special Charges. The Company recorded a special charge of $930,000 in 2001 for the costs of implementing the Company’s corporate restructuring plan to streamline and realign the Company’s resources. The charge was primarily for severance benefits.

              Investment Income. Investment income was $1.3 million for 2001 compared to $2.2 million for 2000. The decrease in investment income was the result of a decrease in funds invested and lower market interest rates.

              Income Tax Expense (Benefit). There was no income tax benefit for 2001 and 2000 due to fully reserving for tax loss carryforwards for which a full valuation allowance had been established.

27




Three Months ended March 31, 2002 Compared to the Three Months ended March 31, 2001 (unaudited)

              Net Sales. Net sales for the March 2002 quarter were $19.1 million compared to $23.5 million (unaudited) for the 2001 quarter, representing a decrease of 18.7%. Domestic sales for the March 2002 quarter were $15.2 million compared to $18.7 million (unaudited) for the same quarter of 2001. As anticipated, sales for the 2002 March quarter were comparably lower due to the significant sales boost generated by the introduction of mentholated strips in 2001, as well as industry-wide slower sales of cough/cold products during the 2001/2002 cough/cold season.

              International sales were $3.9 million for the March 2002 quarter compared to $4.7 million (unaudited) for the same quarter of 2001. Sales for the 2002 March quarter were lower due to the timing of purchases by international distributors.

              Gross Profit. Gross profit was $12.7 million for the March 2002 quarter compared to $14.8 million (unaudited) for the same quarter of 2001. Gross profit as a percentage of net sales increased to 66.6% for the March 2002 quarter compared to 62.9% (unaudited) for the same quarter of 2001. The lower gross profit percentage in 2001 resulted primarily from higher deductions from sales for promotional expenditures in conjunction with the launch of new products.

              Advertising and Promotion. Advertising and promotion expenses were $8.8 million for the March 2002 quarter compared to $13.9 million (unaudited) for the same quarter in 2001. The decrease resulted primarily from elimination of less effective advertising expenditures and the planned reduction in spending for FiberChoice® tablets in the year following the launch.

              Selling, General and Administrative. Selling, general and administrative expenses were $3.2 million for the March 2002 quarter compared to $4.8 million (unaudited) for the same quarter of 2001. This decrease was primarily the result of the June 2001 corporate restructuring that included a workforce reduction and that has enabled the Company to streamline its resources to focus on building the core businesses.

              Investment Income. Investment income was $272,000 for the March 2002 quarter compared to $362,000 (unaudited) for the same quarter of 2001. This decrease was primarily the result of a decrease in market interest rates.

              Income Tax Expense (Benefit). Income tax benefit was $9.1 million for the March 2002 quarter compared to $0 (unaudited) taxes for the same quarter of 2001. The Company recognized a tax benefit of $9.1 million during the March quarter of 2002 as a result of reinstating net deferred tax assets, including the benefit of net operating loss carryforwards. Management believes, based on the level of historical taxable income and projections of future taxable income for the periods in which the deferred tax assets are deductible, that it is more likely than not the Company will realize the benefits of the deductible differences. There were no income taxes recognized for the March quarter of 2001 as the Company was in a net operating loss carryforward position.

Seasonality

              The Company believes that a portion of Breathe Right® nasal strip use is for the temporary relief of nasal congestion and congestion-related snoring. Sales of nasal congestion remedies are higher during the fall and winter seasons because of increased use during the cough/cold season.

28




Liquidity and Capital Resources

              At March 31, 2003, the Company had cash, cash equivalents and marketable securities of $41.6 million and working capital of $45.3 million.

              Operating Activities. The Company had cash provided by operations of $19.2 million in 2003 primarily due to net income for the year, an increase in operating liabilities and a decrease in deferred income taxes. The Company used cash in operations of $2.8 million in 2001 primarily due to a decrease in operating liabilities. The Company used cash in operations of $4.4 million in 2000 primarily due to the net loss for the year, partially offset by an increase in operating liabilities. The Company used cash in operations of $53,000 for the three months ended March 31, 2002 compared to $11.4 million (unaudited) for the same quarter in 2001. The use of cash in 2002 was the result of net income offset primarily by the non-cash deferred income tax benefit and a decrease in operating liabilities. The use of cash in the March quarter of 2001 was due to the net loss for the quarter along with a decrease in operating liabilities.

              Investing Activities. Purchases of marketable securities exceeded sales and maturities by $5.9 million in 2003. Marketable securities purchased consisted primarily of U.S. Government obligations. Sales and maturities of marketable securities exceeded purchases by $10.6 million in 2001. Net proceeds were used primarily to fund the cash used in operations and to purchase treasury shares. Sales and maturities of marketable securities exceeded purchases by $8.8 million in 2000. Net proceeds were used to fund the cash used in operations, purchase property and equipment and purchase treasury shares. Purchases of marketable securities exceeded sales and maturities by $372,000 for the three months ended March 31, 2002. Sales and maturities of marketable securities exceeded purchases by $10.5 million (unaudited) for the March 31, 2001 quarter. Net proceeds were used primarily to fund the cash used in operations.

              The Company purchased $60,000 and $394,000 of property and equipment in 2003 and 2001, respectively, primarily associated with upgrading personal computers and software. The Company purchased $2.0 million of property and equipment in 2000 primarily associated with the Company’s move to different facilities. The Company purchased $8,000 and $255,000 (unaudited) of property and equipment in the March 2002 and March 2001 quarter, respectively.

              The Company purchased $510,000; $357,000 and $141,000 of product rights during the years ended March 31, 2003; December 31, 2001 and 2000, respectively. The Company purchased $148,000 (unaudited) of product rights during the quarter ended March 31, 2001.

              Financing Activities. The Company purchased 458,000 shares of its common stock for $2.8 million in 2003 and purchased 202,000 shares for $1.0 million in 2001. The Company purchased 482,000 shares of its common stock for $2.4 million during the quarter ended March 31, 2002. These treasury shares will be used to meet the Company’s obligations under its employee stock purchase plan and stock option plans, and for possible future acquisitions. The Company received $949,000 in 2003 and $288,000 in 2001 from the exercise of stock options and issuance of stock under the employee stock purchase plan. The Company received $72,000 from the exercise of stock options during the quarter ended March 31, 2002.

29




              Significant Agreements and Lease Obligations. The Company has entered into certain agreements and leases in order to secure product rights and office space. The following is a summary of significant agreements and lease obligations:


Year ending March 31, Minimum
Royalties
Operating
Leases
Total

              2004                $ 795            $ 766            $ 1,561
  2005     795     741     1,536
  2006     795     741     1,536
  2007     795     741     1,536
  2008     795     741     1,536
  Later years         1,977    

  Total       $ 5,707    


              The Company has agreements that exclusively license intellectual property rights for certain products. Royalties due under these agreements are based on various percentages of net sales. The licensing agreements are valid for the lives of the related patents, however, they may be terminated earlier under certain conditions. Total minimum royalties are not determinable since royalties continue for the life of current and potential future patents related to the licensed intellectual property. The Company has entered into operating leases for office space and office equipment. Leases expire at various dates beginning in 2003 through 2010. Management is not aware of any significant agreements or obligations that would have a material negative impact upon the Company’s short-term or long-term liquidity.

              The Company believes that its existing funds will be sufficient to support its planned operations for the foreseeable future.

Recent Accounting Pronouncements

              In June 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” This statement provides guidance on accounting for restructuring activities. This statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The provisions of the statement are effective for exit or disposal activities initiated after December 31, 2002, with early adoption encouraged. The Company will apply the provisions of SFAS No. 146 for exit or disposal activities initiated after December 31, 2002, as required.

              In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock Based Compensation.” This statement supercedes SFAS No. 123, “Accounting for Stock Based Compensation”. This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. In addition, the statement amends disclosure requirements to require prominent disclosures in annual and interim financial statements about the method of accounting used for stock-based employee compensation and the effect of the method used on reported results. The interim disclosure provisions became effective for the Company for the interim period beginning January 1, 2003. The annual disclosure provisions became effective for the Company for the year ended March 31, 2003.

              In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” which requires certain guarantees to be recorded at fair value. This Interpretation also requires a guarantor to make certain disclosures about guarantees, including product warranties, even when the likelihood of making any payments under the guarantee is remote. The Company has adopted the disclosure requirements in this Interpretation as of January 1, 2003, as required.

30




              In May 2003, the FASB issued SFAS No.150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” which requires that certain types of financial instruments with characteristics of a liability be presented as a liability. The Company is required to implement SFAS No. 150 beginning with the quarter ending June 30, 2003. Management does not expect this statement to have a material impact on the Company’s consolidated financial position.

Forward Looking Statements

              Certain statements contained in this Annual Report and other written and oral statements made from time to time by the Company do not relate strictly to historical or current facts but provide current expectations or forecasts of future events. As such, they are considered “forward-looking statements” under the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties that could cause actual results to differ materially from those presently anticipated or projected. Such forward-looking statements can be identified by the use of terminology such as “may,” “will,” “expect,” “plan,” “intend,” “anticipate,” “estimate,” or “continue” or similar words or expressions. It is not possible to foresee or identify all factors affecting the Company’s forward-looking statements and investors therefore should not consider any list of factors to be an exhaustive statement of all risks, uncertainties or potentially inaccurate assumptions. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to, the following factors: (i) the Company’s revenue and profitability is reliant on sales of Breathe Right® nasal strips; (ii) the Company currently has a seasonal pattern of sales that is typically higher in the third and fourth quarters of each fiscal year due to increased nasal strip usage during the cough/cold season and its revenues and earnings may be impacted by the severity of such season; (iii) the Company’s success and future growth will depend significantly on its ability to effectively market Breathe Right nasal strips and upon its ability to develop and achieve markets for additional products; (iv) the Company’s competitive position will, to some extent, be dependent on the enforceability and comprehensiveness of the patents on its Breathe Right nasal strip technology which have been, and in the future may be, the subject of litigation and could be narrowed as a result of the outcome of the reexamination of one such patent by the United States Patent and Trademark Office; (v) the Company has faced and will continue to face challenges in successfully developing and introducing new products; (vi) the Company operates in competitive markets where recent and potential entrants into the nasal dilator segment pose competitive challenges; (vii) the Company is dependent upon contract manufacturers for the production of all of its products; and (viii) the Company currently purchases its nasal strip products from different contract manufacturers that obtain the raw materials from a single supplier.

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

              The Company’s market risk exposure is primarily interest rate risk related to its cash and cash equivalents and investments in marketable securities. The Company has investment guidelines which limit the types of securities in which it may invest as well as the length of maturities. No investment may exceed 36 months in maturity and the weighted average life of the portfolio may not exceed 18 months.

              The table below provides information about the Company’s cash and cash equivalents and marketable securities as of March 31, 2003:


(In Thousands)
Cost Fair Value

Due within one year 27,056             27,112
Due after one year through three years   14,237     14,503


41,293   41,615



31




Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

              The Consolidated Balance Sheets of the Company as of March 31, 2003 and 2002, and the related Consolidated Statements of Operations, Stockholders’ Equity and Comprehensive Income (Loss), and Cash Flows for each of the years ended March 31, 2003, December 31, 2001 and December 31, 2000 and for the three months ended March 31, 2002 and 2001 (unaudited), the Notes to the Consolidated Financial Statements and the Report of KPMG LLP, independent certified public accountants, are listed under Item 16 of this Report.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
             FINANCIAL DISCLOSURE

              None.

PART III

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Directors

              The following sets forth certain information with respect to the Company’s directors:

              Daniel E. Cohen, 50, has served as the Company’s Chairman of the Board since 1993 and has served as a director of the Company since its formation in 1982. Mr. Cohen also served as the Company’s Chief Executive Officer from 1989 to June 2001 and as Treasurer from 1982 to March 1999. Mr. Cohen, a founder of the Company, is a medical doctor and board-certified neurologist.

              Patrick Delaney, 60, has served as a director of the Company since 1983 and as the Company’s Secretary since 1995. In December 2002, Mr. Delaney retired as a partner in the Minneapolis-based law firm of Lindquist & Vennum P.L.L.P., counsel to the Company. He was in the private practice of law since 1967. He is also a director of Community First Bankshares, Inc., a multi-bank holding company.

              R. Hunt Greene, 52, has served as a director of the Company since 1985. Mr. Greene has been an investment banker for over twenty years. He is presently Managing Director and Member of Greene Holcomb & Fisher LLC (“GH&F”), a Minneapolis investment banking firm that was formed in 1995. GH&F has provided the Company with certain financial advisory and investment banking services from time to time since 1996.

              Andrew J. Greenshields, 65, has served as a director of the Company since 1986. Mr. Greenshields has been President of Pathfinder Ventures, Inc., Minneapolis, Minnesota, since 1980. He is also a general partner of Pathfinder Venture Capital Fund III and a general partner of Spell Capital Partners, LP, both of which are Minneapolis-based financial limited partnerships. Mr. Greenshields is also a director of Aetrium, Inc., a manufacturer of semi-conductor handling equipment.

              H. Robert Hawthorne, 58, has served as a director of the Company since 1999. Mr. Hawthorne served as Chief Executive Officer of Ocean Spray Cranberries, Inc., a Boston-based food and beverage company, from February 2000 to November 2002. From 1997 to 1999, Mr. Hawthorne served as a director, President and Chief Executive Officer of Select Comfort Corporation, a Minneapolis-based company that manufactures air beds and sleep related products. From 1986 to 1997, Mr. Hawthorne served in a series of positions of increasing responsibility with The Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, most recently serving from February 1992 to December 1997 as President of The Pillsbury Brands Group, a subsidiary of The Pillsbury Company.

32




              Marti Morfitt, 45, has served as the Company’s President and Chief Executive Officer since June 2001, its President and Chief Operating Officer from March 1998 to June 2001. Ms. Morfitt has served as a director of the Company since 1998. From September 1982 to February 1998, Ms. Morfitt served in a series of positions of increasing responsibility with The Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, most recently serving from May 1997 to February 1998 as Vice-President, Meals, and from February 1994 to May 1997 as Vice-President, Green Giant Brands. She also serves as a director of Graco, Inc., a Minneapolis-based manufacturer of fluid handling systems.

              Richard W. Perkins, 72, has been a director of the Company since 1993. Mr. Perkins has been President, Chief Executive Officer and a director of Perkins Capital Management, Inc., a Minneapolis-based investment management company, since 1985. He is also a general partner of Spell Capital Partners, LP, a Minneapolis-based venture capital limited partnership. He is also a director of the following publicly-held companies: Synovis Life Technologies, Inc., a manufacturer of medical products; Intellefilm Corp., a producer of television and internet commercials; PW Eagle, Inc., a manufacturer of plastic pipe; Lifecore Biomedical, Inc., a medical device company; Nortech Systems, Inc., a contract manufacturer for the electronics industry; Vital Images, Inc., a medical diagnostic software company; and Paper Warehouse, Inc., a retailer specializing in party supplies and paper products.

              Morris J. Siegel, 53, has served as a director of the Company since April 18, 2003. Mr. Siegel is the founder and retired chairman of Celestial Seasonings, Inc., a manufacturer and marketer of specialty herb teas. In 2000, Celestial Seasonings merged with The Hain Food Group, a natural, specialty, organic and snack food company. Mr. Siegel then served as vice chairman of the merged company, The Hain Celestial Group, Inc. and was Chief Executive Officer of Celestial Seasonings until September 2002. In 1987, Mr. Siegel founded Earth Wise, Inc., a marketer of environmentally friendly cleaning products and recycled trash bags. Mr. Siegel also currently serves as a director of Annie’s Homegrown Foods, Inc., which manufactures, markets and sells premium all natural and organic macaroni and cheese dinners, all natural pasta meals and other all natural and organic food products, and is a subsidiary of Solera Capital LLC.


              Certain other information required under this Item with respect to directors is contained in the Section “Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s Proxy Statement for the Annual Meeting of Stockholders to be held on August 27, 2003 (the "2003 Proxy Statement”), a definitive copy of which will be filed with the Commission within 120 days of the close of the last fiscal year, and is incorporated herein by reference.

Executive Officers

              Information concerning executive officers is set forth in the Section entitled “Executive Officers of the Company” in Part I of this Form 10-K pursuant to Instruction 3 to paragraph (b) of Item 401 of Regulation S-K.

Item 11. EXECUTIVE COMPENSATION

              Information required under this item is contained in the section entitled “Executive Compensation” in the Company’s 2003 Proxy Statement and is incorporated herein by reference.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

              Information required under this item is contained in the section entitled “Security Ownership of Principal Stockholders and Management” in the Company’s 2003 Proxy Statement and is incorporated herein by reference.

33




Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

              Information required under this item is contained in the section entitled “Certain Relationships and Related Transactions” in the Company’s 2003 Proxy Statement and is incorporated herein by reference.

Item 14. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures.

              The Company’s Chief Executive Officer, Marti Morfitt, and interim Chief Financial Officer, Marcia O’Brien, have reviewed the Company’s disclosure controls and procedures within 90 days prior to the filing of this report. Based upon this review, each such officer believes that the Company’s disclosure controls and procedures are effective in ensuring that material information related to the Company is made known to her by others within the Company.

(b) Changes in Internal Controls.

              There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls during the quarter covered by this report or from the end of the reporting period to the date of this Form 10-K.

34




PART IV

Item 15. [RESERVED]

Item 16. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K


(a) Documents filed as part of this Report:

Form 10-K
Page Reference
       
               1.        Financial Statements.  
  
  Independent Auditors’ Report F-1
  
  Consolidated Statements of Operations for the Years Ended
     March 31, 2003, December 31, 2001 and December 31, 2000 and
     for the three months ended March 31, 2002 and March 31, 2001 (unaudited) F-2
  
  Consolidated Balance Sheets as of March 31, 2003 and 2002 F-3
  
  Consolidated Statements of Stockholders’ Equity and Comprehensive
     Income (Loss) for the Years Ended March 31, 2003, December 31, 2001
     and December 31, 2000 and for the three months ended
     March 31, 2002 and March 31, 2001 (unaudited) F-4
  
  Consolidated Statements of Cash Flows for the Years Ended
     March 31, 2003, December 31, 2001 and December 31, 2000 and
     for the three months ended March 31, 2002 and March 31, 2001 (unaudited) F-5
  
  Notes to Consolidated Financial Statements F-6
  
2.   Financial Statement Schedules.
  
  None.
  
3.   Exhibits.
  
  See “Exhibit Index” on the page following the Signature Page.

(b) Reports on Form 8-K.

  None.

35




SIGNATURES

              Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.






Dated: June 26, 2003
CNS, INC.
(“Registrant”)


By /s/ Marti Morfitt
      ————————————————
      Marti Morfitt
      Chief Executive Officer and Director


              Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons on June 26, 2003 on behalf of the Registrant in the capacities indicated.

(Power of Attorney and Signatures)

              Each person whose signature appears below constitutes and appoints DANIEL E. COHEN and MARTI MORFITT as his or her true and lawful attorneys-in-fact and agents, each acting alone, with the full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any or all amendments to this Annual Report on Form 10-K and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, each acting alone, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all said attorneys-in-fact and agents, each acting alone, or his or her substitute or substitutes, may lawfully do or cause to be done by virtue thereof.

/s/ Marti Morfitt
————————————————
Marti Morfitt
Chief Executive Officer and Director
(Principal Executive Officer)

/s/ Marcia O’Brien
————————————————
Marcia O’Brien
Interim Chief Financial Officer
(Principal Financial and Accounting Officer)

/s/ Daniel E. Cohen
————————————————
Daniel E. Cohen
Chairman of the Board and Director

/s/ Patrick Delaney
————————————————
Patrick Delaney
Director

36




/s/ H. Robert Hawthorne
————————————————
H. Robert Hawthorne
Director

/s/ R. Hunt Greene
————————————————
R. Hunt Greene
Director

/s/ Andrew J. Greenshields
————————————————
Andrew J. Greenshields
Director

/s/ Richard W. Perkins
————————————————
Richard W. Perkins
Director

/s/ Morris J. Siegel
————————————————
Morris J. Siegel
Director

37




CERTIFICATIONS

I, Marti Morfitt, certify that:


1. I have reviewed this annual report on Form 10-K of CNS, Inc.;

2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

4. I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and I have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to me by others within those entities, particularly during the period in which this annual report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and

c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.


Date June 26, 2003

/s/ Marti Morfitt
——————————————
Chief Executive Officer

38




CERTIFICATIONS

I, Marcia O’Brien, certify that:


1. I have reviewed this annual report on Form 10-K of CNS, Inc.;

2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

4. I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and I have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to me by others within those entities, particularly during the period in which this annual report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and

c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.


Date June 26, 2003

/s/ Marcia O’Brien
——————————————
Interim Chief Financial Officer

39




CNS, INC.
EXHIBIT INDEX


Exhibit No. Description

3.1 Company’s Certificate of Incorporation as amended to date (incorporated by reference to Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1995 (the "1995 Form 10-K”)).

3.2 Company’s Amended and Restated By-Laws (incorporated by reference to Exhibit 3.1 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2001).

4.1 Form of Amended and Restated Rights Agreement dated as of December 20, 2002 by and between CNS, Inc. and Wells Fargo Bank Minnesota, N.A., as Rights Agent (incorporated by reference to Exhibit 4.1 to the Company’s Amendment No. 1 to Registration Statement on Form 8-A/A, Commission File No. 0-16612).

10.1* CNS, Inc. 1987 Employee Incentive Stock Option Plan (incorporated by reference to Exhibit 10.1 to the Company’s Registration Statement on Form S-18, Commission File No. 33-14052C).

10.2* CNS, Inc. 1989 Employee Stock Purchase Plan, as amended (incorporated by reference to Exhibits 4.1 and 4.2 to the Company’s Registration Statement on Form S-8, Commission File No. 333-68310).

10.3* CNS, Inc. 1990 Stock Plan (incorporated by reference to Exhibit 10.11 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1990).

10.4* CNS, Inc. 1994 Amended Stock Plan (incorporated by reference to Exhibit 10.5 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1997).

10.5* CNS, Inc. 2000 Stock Option Plan (incorporated by reference to Exhibit 4.1 of the Company’s Registration Statement on Form S-8 (File No. 333-42108)).

10.6** License Agreement dated January 30, 1992 between the Company and Creative Integration and Design, Inc. (incorporated by reference to Exhibit 10.11 to the Company’s Registration Statement on Form S-2, Commission File No. 33-46120).

10.7** License Agreement dated November 10, 1997 between the Company and Onesta Nutrition, Inc. (incorporated by reference to Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the year ending December 31, 1999 (the “1999 Form 10-K”)).

10.8** License Agreement dated March 12, 1999 between the Company and WinEase LLC (incorporated by reference to Exhibit 10.10 to the Company’s 1999 Form 10-K).

10.9** Addendum to License Agreement between the Company and WinEase LLC dated March 21, 2002 (incorporated by reference to Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001).

10.10** License Agreement dated June 21, 1999 between the Company and Peter Cronk and Kristen Cronk (incorporated by reference to Exhibit 10.11 of the 1999 Form 10-K).

40




10.11** License Agreement dated March 1, 2000 between the Company and Proctor and Gamble (incorporated by reference to Exhibit 10.10 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000 (the "2000 Form 10-K”)).

10.12 Amendment to Trademark License Agreement effective as of March 20, 2001 by and between the Company and the Procter & Gamble Company (incorporated by reference to Exhibit 10.11 to the Company’s Quarterly Report on Form 10-Q for the period ended March 31, 2001).

10.13** Second Amendment to Trademark License Agreement effective as of April 27, 2001 by and between the Company and the Procter & Gamble Company (incorporated by reference to Exhibit 10.12 to the Company’s Quarterly Report on Form 10-Q for the period ended March 31, 2001).

10.14** Distributor Agreement between the Company and Eisai Co., Ltd. dated August 1, 2000 (incorporated by reference to Exhibit 10.11 to the Company’s 1999 Form 10-K).

10.15** Repackaging Agreement between the Company and Herusu, Co., Ltd. dated August 1, 2000 (incorporated by reference to Exhibit 10.12 to the Company’s 2000 Form 10-K).

10.16** Supply Agreement between the Company and Tapemark, Inc. dated October 15, 2001 (incorporated by reference to Exhibit 10.15 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2001 (the “September 30, 2001 Quarterly Report”)).

10.17** Supply Agreement between the Company and WebTec Converting, LLC dated October 5, 2001 (incorporated by reference to Exhibit 10.16 to the September 30, 2001 Quarterly Report).

10.18** Medical Specialties Material Purchase Agreement between the Company and Minnesota Mining and Manufacturing Company dated August 1, 2001 (incorporated by reference to Exhibit 10.17 to the September 30, 2001 Quarterly Report).

10.19* Employment Agreement between the Company and Daniel E. Cohen dated February 12, 1999 (incorporated by referenced to Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1998 (the “1998 Form 10-K”)).

10.20* First Amendment to Executive Employment Agreement between the Company and Daniel E. Cohen dated June 29, 2001 (incorporated by reference to Exhibit 10.19 to the September 30, 2001 Quarterly Report).

10.21* Employment Agreement between the Company and Marti Morfitt dated February 12, 1999 (incorporated by referenced to Exhibit 10.10 to the 1998 Form 10-K).

10.22* Employment Agreement between the Company and John J. Keppeler dated February 12, 1999 (incorporated by referenced to Exhibit 10.13 to the 1998 Form 10-K).

10.23* Employment Agreement between the Company and Carol J. Watzke dated February 12, 1999 (incorporated by referenced to Exhibit 10.15 to the 1998 Form 10-K).

10.24* Employment Agreement between the Company and M. W. Anderson dated February 12, 1999 (incorporated by referenced to Exhibit 10.17 to the 1998 Form 10-K).

41




10.25* Employment Agreement between the Company and Larry R. Muma dated January 2, 2001 (incorporated by reference to Exhibit 10.21 to the 2000 Form 10-K).

10.26* Agreement between the Company and Teri P. Osgood dated February 14, 2002.

10.27* Employment Agreement between the Company and Linda Kollofski dated October 29, 2002.

10.28* Employment Agreement between the Company and John Kundtz dated July 22, 2002.

21.1 Subsidiaries of the Company (incorporated by reference to Exhibit 21.1 to the 1999 Form 10-K).

23.1 Consent of KPMG LLP.

24.1 Powers of Attorney (included on signature page hereof).

99.1 Certification Pursuant to 18 U.S.C. Section 1350.



* Indicates Compensatory Agreement

** Certain portions of this Exhibit have been deleted and filed separately with the Commission pursuant to a request for confidential treatment under Rule 24b-2. Spaces corresponding to the deleted portions are represented by brackets with asterisks.

42




Independent Auditors’ Report

The Board of Directors and Stockholders
CNS, Inc.:

We have audited the accompanying consolidated balance sheets of CNS, Inc. and subsidiaries as of March 31, 2003 and 2002 and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for the years ended March 31, 2003, December 31, 2001 and 2000 and the three months ended March 31, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CNS, Inc. and subsidiaries as of March 31, 2003 and 2002 and the results of their operations and their cash flows for the years ended March 31, 2003, December 31, 2001 and 2000 and the three months ended March 31, 2002 in conformity with accounting principles generally accepted in the United States of America.

Minneapolis, Minnesota
April 23, 2003




CNS, INC.
Consolidated Statements of Operations
(in thousands, except per share amounts)


For the Years Ended For the Three
Months Ended
March 31, December 31, March 31,

 
2003 2001 2000 2002 2001

 
(unaudited)  
Net sales 79,075         76,242         61,777         19,135         23,468  
Cost of goods sold   25,992     27,698     24,907     6,390     8,706  

 
  
               Gross profit   53,083     48,544     36,870     12,745     14,762  

 
  
Operating expenses:                    
     Advertising and promotion   30,930     34,256     39,579     8,796     13,935  
     Selling, general and administrative   12,514     14,583     15,134     3,213     4,766  
     Special charges   0     930     0     0     0  

 
  
               Total operating expenses   43,444     49,769     54,713     12,009     18,701  

 
  
               Operating income (loss)   9,639     (1,225 )   (17,843 )   736     (3,939 )
  
Investment income   821     1,242     2,234     236     345  
Gain (loss) on sales of marketable securities   18     64     (51 )   36     17  

 
  
               Income (loss) before income taxes   10,478     81     (15,660 )   1,008     (3,577 )
  
Income tax expense (benefit)   3,962     0     0     (9,126 )   0  

 
  
               Net income (loss) 6,516   81   (15,660 ) 10,134   (3,577 )

 
  
Basic net income (loss) per share 0.48   .01   (1.09 ) .74   (.25 )

 
  
Weighted average number of common shares
    outstanding
  13,467     14,131     14,372     13,711     14,123  

 
  
Diluted net income (loss) per share 0.46   .01   (1.09 ) .71   (.25 )

 
Weighted average number of common                    
     and assumed conversion shares outstanding   14,044     14,431     14,372     14,198     14,123  

 

The accompanying notes are an integral part of the consolidated financial statements.

F-2




CNS, INC.
Consolidated Balance Sheets
(in thousands, except per share amounts)


  March 31,
 
Assets  2003    2002  

 
Current assets:        
     Cash and cash equivalents $ 16,554                 $ 5,633  
     Marketable securities   25,061     19,029  
     Accounts receivable, net of allowance for doubtful accounts
              of $330 in 2003 and $500 in 2002
  11,011     11,682  
     Inventories   3,266     4,465  
     Deferred income taxes   4,660     5,879  
     Prepaid expenses and other current assets   1,035     999  

 
  
                                           Total current assets   61,587     47,687  
  
Property and equipment, net   1,605     2,400  
Product rights, net   1,293     1,179  
Deferred income taxes   890     3,220  

 
  
  $ 65,375   $ 54,486  

 
  
Liabilities and Stockholders’ Equity        

 
  
Current liabilities:        
     Accounts payable $ 7,615   $ 3,413  
     Accrued expenses   7,948     6,330  
     Accrued income taxes   758     521  

 
  
                                           Total current liabilities   16,321     10,264  
  
Stockholders’ equity:        
     Preferred stock - authorized 8,484 shares;        
              none issued or outstanding   0     0  
     Common stock - $.01 par value; authorized 50,000 shares;        
              issued 19,295 shares in 2003 and 2002   193     193  
     Additional paid-in capital   59,879     60,796  
     Treasury shares - at cost; 5,989 shares in 2003 and 5,756 shares in 2002   (26,694 )   (25,821 )
     Retained earnings   15,472     8,956  
     Accumulated other comprehensive income   204     98  

 
  
                                           Total stockholders’ equity   49,054     44,222  
  
Commitments (notes 10 and 11)        

 
  
$ 65,375   $ 54,486  

 

The accompanying notes are an integral part of the consolidated financial statements.

F-3




CNS, INC.
Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss)
(in thousands)


Common stock Additional
paid-in
capital
Treasury shares Retained
earnings
(deficit)
Accumulated
other
comprehensive
income (loss)
Total
stockholders’
equity
 


Number
of shares
Par
value
Number
of shares
Cost

 
Balance at December 31, 1999 19,295        $ 193        $ 61,531        4,838         $   (22,221 )       $ 14,401         $ (320 )       $ 53,584  
   
     Stock issued in connection with                            
        Employee Stock Purchase Plan 0     0     (131 ) (26 )   214     0     0     83  
     Stock options exercised 0     0     (218 ) (29 )   238     0     0     20  
     Treasury shares purchased 0     0     0   396     (1,510 )   0     0     (1,510 )
     Comprehensive loss:                            
        Net loss for the year 0     0     0   0     0     (15,660 )   0     (15,660 )
        Unrealized gains on marketable securities                            
           net of income tax effect of $0 0     0     0   0     0     0     420     420  

              Total comprehensive loss                           (15,240 )

   
Balance at December 31, 2000 19,295     193     61,182   5,179     (23,279 )   (1,259 )   100     36,937  
   
     Stock issued in connection with                            
        Employee Stock Purchase Plan 0     0     (189 ) (36 )   303     0     0     114  
     Stock options exercised 0     0     (262 ) (51 )   436     0     0     174  
     Other 0     0     54   0     0     0     0     54  
     Treasury shares purchased 0     0     0   202     (1,010 )   0     0     (1,010 )
     Comprehensive income:                            
        Net income for the year 0     0     0   0     0     81     0     81  
        Unrealized gains on marketable securities                            
           net of income tax effect of $0 0     0     0   0     0     0     262     262  

              Total comprehensive income                           343  

   
Balance at December 31, 2001 19,295     193     60,785   5,294     (23,550 )   (1,178 )   362     36,612  
   
     Stock options exercised 0     0     (95 ) (20 )   167     0     0     72  
     Other 0     0     106   0     0     0     0     106  
     Treasury shares purchased 0     0     0   482     (2,438 )   0     0     (2,438 )
     Comprehensive income:                            
        Net income for the period 0     0     0   0     0     10,134     0     10,134  
        Unrealized losses on marketable securities                            
           net of income tax effect of $58 0     0     0   0     0     0     (264 )   (264 )

              Total comprehensive income                           9,870  

   
Balance at March 31, 2002 19,295     193     60,796   5,756     (25,821 )   8,956     98     44,222  
   
     Stock issued in connection with                            
        Employee Stock Purchase Plan 0     0     (69 ) (19 )   163     0     0     94  
     Stock options exercised 0     0     (862 ) (206 )   1,717     0     0     855  
     Other 0     0     14   0     2     0     0     16  
     Treasury shares purchased 0     0     0   458     (2,755 )   0     0     (2,755 )
     Comprehensive income:                            
        Net income for the year 0     0     0   0     0     6,516     0     6,516  
        Unrealized gains on marketable securities                            
           net of income tax effect of $60 0     0     0   0     0     0     106     106  

              Total comprehensive income                           6,622  

   
Balance at March 31, 2003 19,295   $ 193   $ 59,879   5,989   (26,694 ) $ 15,472   $ 204   49,054  


The accompanying notes are an integral part of the consolidated financial statements.

F-4




CNS, INC.
Consolidated Statements of Cash Flows
(in thousands)


For the Years Ended For the Three Months Ended
March 31, December 31, March 31,

 
2003 2001 2000 2002 2001

 
(unaudited)  
Operating activities:                    
     Net income (loss) $ 6,516         $ 81        $   (15,660 )       $ 10,134         $ (3,577 )
     Adjustments to reconcile net income (loss) to net                    
        cash provided by (used in) operating activities:                    
            Depreciation and amortization   1,251     1,244     1,051     330     271  
            Deferred income taxes   3,489     0     0     (9,126 )   0  
            Other   16     90     81     74     0  
            Changes in operating assets and liabilities:                    
               Accounts receivable   671     275     (1,212 )   626     (1,182 )
               Inventories   1,199     (1,070 )   153     1,357     (1,767 )
               Prepaid expenses and other current assets   (36 )   1,964     3,546     294     362  
               Accounts payable and accrued expenses   6,057     (5,401 )   7,654     (3,742 )   (5,544 )

 
                                  
                      Net cash provided by (used in) operating
                         activities
  19,163     (2,817 )   (4,387 )   (53 )   (11,437 )

 
                                  
Investing activities:                    
     Purchases of marketable securities   (36,255 )   (44,911 )   (63,151 )   (11,218 )   (6,970 )
     Sales and maturities of marketable securities   30,389     55,550     71,967     10,846     17,425  
     Payments for purchases of property and equipment   (60 )   (394 )   (2,019 )   (8 )   (255 )
     Payments for product rights   (510 )   (357 )   (141 )   0     (148 )

 
                                  
                      Net cash provided by (used in) investing
                         activities
  (6,436 )   9,888     6,656     (380 )   10,052  

 
                                  
Financing activities:                    
     Proceeds from the issuance of common stock                    
        under Employee Stock Purchase Plan   94     114     83     0     0  
     Proceeds from the exercise of stock options   855     174     20     72     88  
     Purchase of treasury shares   (2,755 )   (1,010 )   (1,510 )   (2,438 )   (51 )

 
                                  
                      Net cash provided by (used in) financing
                         activities
  (1,806 )   (722 )   (1,407 )   (2,366 )   37  

 
                                  
                      Net increase (decrease) in cash and cash
                         equivalents
  10,921     6,349     862     (2,799 )   (1,348 )
                                  
Cash and cash equivalents:                    
     Beginning of period   5,633     2,083     1,221     8,432     2,083  

 
                                  
     End of period $ 16,554   $ 8,432   $ 2,083   $ 5,633   $ 735  

 
                                  
Supplemental disclosure of cash flow information:                    
     Cash paid during the year for interest $ 0   $ 0   $ 0   $ 0   $ 0  
     Cash paid during the year for income taxes   237     0     0     35     0  

 

The accompanying notes are an integral part of the consolidated financial statements.

F-5




CNS, INC.
Notes to Consolidated Financial Statements
March 31, 2003, December 31, 2001 and 2000


(1) Summary of Significant Accounting Policies

  Principles of Consolidation The accompanying consolidated financial statements include the accounts of CNS, Inc. and its subsidiaries (“the Company”). All material intercompany accounts and transactions have been eliminated in consolidation.

  Business The Company designs, manufactures and markets consumer products, including Breathe Right® nasal strips, Breathe Right Snore Relief™ throat spray and FiberChoice® tablets. The Company’s products are sold over-the-counter in retail outlets, including mass merchant, drug, grocery and club stores. The Company primarily uses international distributors to market Breathe Right nasal strips outside the U.S.

  Fiscal Year Change In 2002, the Company changed its fiscal year-end from December 31 to March 31. The three-month transition period ended March 31, 2002 bridges the gap between the Company’s old and new fiscal year-ends.

  Principles of Consolidation The accompanying consolidated financial statements include the accounts of CNS, Inc. and its subsidiaries (“the Company”). All material intercompany accounts and transactions have been eliminated in consolidation.

  Accounting Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company’s estimates and assumptions primarily arise from risks and uncertainties associated with potential future product returns, the uncollectibility of accounts receivable and inventory obsolescence.

  Basis of Presentation Certain amounts from prior years’ financial statements have been reclassified to conform to the current year presentation.

  Change in Method of Accounting for Sales Incentives and Consideration Paid to a Reseller Effective January 1, 2002, the Company implemented Emerging Issues Task Force bulletins Number 00-14 “Accounting for Certain Sales Incentives”, Number 00-25 “Vendor Income Statement Characterization of Consideration Paid to a Reseller” and Number 01-9 “Accounting for Consideration Given by a Vendor to a Customer”. These new accounting standards had no impact on the Company’s net income; however, they did require reclassification of certain promotional costs such as sales incentives, promotional funds, and consumer coupon redemptions that were previously reported as a component of advertising and promotion expense as a reduction of net sales.

F-6




  The following table presents the impact of the adoption of the provisions of EITF Issue Nos. 00-14, 00-25 and 01-9 discussed above, on the consolidated statements of operations for the years ended December 31, 2001 and 2000, respectively:

For the Years Ended
December 31,

   2001 2000
 
 
               Net sales - previous reporting basis 83,934             68,892  
Impact of adopting accounting changes   (7,692 )   (7,115 )

Net sales - current reporting basis 76,242   61,777  

  
Advertising and promotion expense -        
   previous reporting basis 41,948   46,694  
Impact of adopting accounting changes   (7,692 )   (7,115 )

Advertising and promotion expense -        
   current reporting basis 34,256   39,579  


  The Company’s results of operations for the years disclosed above were not affected by the adoption of the provisions of these three announcements.

  Change in Method of Accounting for Long-Lived Assets Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” This statement superceded SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.” SFAS No. 144 retains the previously existing accounting requirements related to the recognition and measurement of the impairment of long-lived assets to be held and used while expanding the measurement requirements of long-lived assets to be disposed of by sale. It also expands the previously existing reporting requirements for discontinued operations to include a component of an entity that either has been disposed of or is classified as held for sale.

  Revenue Recognition Revenue from sales is recognized at the time products are shipped less estimated sales returns, certain promotional costs and other allowances.

  Fair Value of Financial Instruments All financial instruments are carried at amounts that approximate fair value.

  Cash Equivalents Cash equivalents consist primarily of money market funds.

  Marketable Securities The Company classifies its marketable debt securities as available-for-sale and records these securities at fair market value. Net realized and unrealized gains and losses are determined on the specific identification cost basis. Any unrealized gains and losses, net of deferred income taxes, are included in stockholders’ equity as a separate component of other comprehensive income. A decline in the market value of any available-for-sale security below cost that is deemed other than temporary, results in a charge to operations resulting in the establishment of a new cost basis for the security. Realized securities gains or losses are included in gain (loss) on sales of marketable securities in the consolidated statements of operations.

F-7




  Inventories Inventories are valued at the lower of cost (determined on a first-in, first-out basis) or market. Inventory reserves have been established for potential product obsolescence.

  Property and Equipment Property and equipment are stated at cost. Equipment is depreciated using the straight-line method over three to five years. Leasehold improvements are amortized over the lesser of the estimated useful life of the improvement or the term of the lease.

  Product Rights Product rights, consisting of patents, trademarks and other product rights, are stated at cost and are amortized over three to seven years using the straight-line method.

  Stock-Based Compensation The Company accounts for stock-based compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and complies with the disclosure provisions of SFAS No. 148, “Accounting for Stock-Based Compensation”. Under APB No. 25, compensation cost is determined based on the difference, if any, on the grant date between the fair value of the Company’s stock and the amount an employee must pay to acquire the stock. Accordingly, no compensation expense associated with the fair market value of stock option grants or shares sold to employees under the Employee Stock Purchase Plan has been recognized in the Company’s financial statements.

  The fair value of each stock option grant issued and shares sold to employees under the Employee Stock Purchase Plan are estimated on the date of grant or purchase using the Black-Scholes option-pricing model. The following assumptions were made in estimating fair value:

For the Years Ended For the Three Months
Ended
March 31, December 31, March 31,

2003 2001 2000 2002 2001

(unaudited)
             Expected lives (Years)   6     6     6     6     6  
Dividend Yield   0.00 %           0.00 %           0.00 %           0.00 %           0.00  
Expected volatility   60.00 %   60.00 %   65.00 %   60.00 %   60.00 %
Risk-Free Interest Rate   5.00 %   5.00 %   6.50 %   5.00 %   5.00 %

F-8




  Had compensation cost for the Company’s stock option plan been determined pursuant to SFAS No. 148, net earnings and earnings per share would have been as follows:

For the Years Ended For the Three Months
Ended
March 31, December 31, March 31,

2003 2001 2000 2002 2001

(unaudited)
              Net income (loss),                                                     
    as reported $ 6,516   $ 81   $ (15,660 ) $ 10,134   $ (3,577 )
Deduct: Total stock-based                    
   compensation expense                    
   determined under the fair                    
   value based method for all                    
   awards, net of related tax                    
   effects   456     523     325     124     89  

  
Proforma net income (loss) $ 6,060   $ (442 ) $ (15,985 ) $ 10,010   $ (3,666 )

  
Earnings (loss) per share:                    
     Basic - as reported $ 0.48   $ 0.01   $ (1.09 ) $ .74   $ (.25 )
  
     Basic - proforma $ 0.45   $ (0.03 ) $ (1.11 ) $ .73   $ (.26 )
  
     Diluted - as reported $ 0.46   $ 0.01   $ (1.09 ) $ .71   $ (.25 )
  
     Diluted - proforma $ 0.43   $ (0.03 ) $ (1.11 ) $ .71   $ (.26 )

  Foreign Currency Transactions Most foreign transactions are in U.S. dollars, although some are conducted in functional local currencies. The functional currency is translated into U.S. dollars for the balance sheet accounts using current exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate during the fiscal year. Gains and losses resulting from transactions denominated in foreign currencies are included in the consolidated statements of operations.

  Advertising The Company capitalizes the production costs of advertising and expenses these costs the first time the advertising runs.

  Income Taxes Deferred tax assets and liabilities and the resultant provision for income taxes are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Deferred tax assets are recognized when management determines that it is more likely than not that the asset will be realized.

  Net Income (Loss) Per Share Basic net income (loss) per share and diluted net income (loss) per share have been computed based upon the weighted average number of common shares outstanding during the year. Assumed conversion shares were excluded from the net loss per share computation as their effect is antidilutive. Common stock options could potentially dilute basic earnings per share in future periods if the Company generates net income. Diluted net income per share has been computed based upon the weighted average number of common and assumed conversion shares outstanding during the year.

F-9




  Comprehensive Income (Loss) Comprehensive income (loss) consists of the Company’s net income (loss) and unrealized gains (losses) on marketable securities and is presented in the consolidated statements of stockholders’ equity and comprehensive income (loss).

  Recent Accounting Pronouncements In June 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” This statement provides guidance on accounting for restructuring activities. This statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The provisions of the statement are effective for exit or disposal activities initiated after December 31, 2002, with early adoption encouraged. The Company will apply the provisions of SFAS No. 146 for exit or disposal activities initiated after December 31, 2002, as required.

  In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation”. This statement supercedes SFAS No. 123, “Accounting for Stock-Based Compensation”. This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. In addition, the statement amends disclosure requirements to require prominent disclosures in annual and interim financial statements about the method of accounting used for stock-based employee compensation and the effect of the method used on reported results. The interim disclosure provisions became effective for the Company for the interim period beginning January 1, 2003. The annual disclosure provisions became effective for the Company for the year ended March 31, 2003.

  In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” which requires certain guarantees to be recorded at fair value. This Interpretation also requires a guarantor to make certain disclosures about guarantees, including product warranties, even when the likelihood of making any payments under the guarantee is remote. The Company has adopted the disclosure requirements in this Interpretation as of January 1, 2003, as required.

  In May 2003, the FASB issued SFAS No.150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” which requires that certain types of financial instruments with characteristics of a liability be presented as a liability. The Company is required to implement SFAS No. 150 beginning with the quarter ending June 30, 2003. Management does not expect this statement to have a material impact on the Company’s consolidated financial position.

F-10




(2) Marketable Securities

  Marketable securities, including estimated fair value based on quoted market prices or valuation models, are summarized as follows (in thousands):

March 31,

2003 2002

Cost Fair Value Cost Fair Value
 
             Commercial paper $ 5,415          $ 5,415         $ 3,148         $ 3,148
Certificate of deposit   0     0     1,000     997
Corporate bonds   7,225     7,361     9,075     9,240
U.S. Government obligations   12,099     12,285     5,650     5,644

    
        Total marketable securities $ 24,739   $ 25,061   $ 18,873   $ 19,029


  Maturities of marketable securities at March 31, 2003 are as follows (in thousands):

Cost Fair Value
 
                         Due within one year $ 10,502             $ 10,558
Due after one year through three years   14,237     14,503

 
            Total marketable securities $ 24,739   $ 25,061


  Gross unrealized gains on marketable securities available for sale totaled $324,000 and $195,000 at March 31, 2003 and 2002, respectively. Gross unrealized losses on marketable securities available for sale totaled $2,000 and $39,000 at March 31, 2003 and 2002, respectively.

  Realized gains on sales of marketable securities were $18,000; $64,000 and $0 for the years ended March 31, 2003; December 31, 2001 and 2000, respectively. Realized gains on sales of marketable securities were $36,000 and $17,000 (unaudited) for the three months ended March 31, 2002 and 2001, respectively. Realized losses on sales of marketable securities were $51,000 for the year ended December 31, 2000.

(3) Advertising

  At March 31, 2003 and 2002, $668,000 and $686,000, respectively, of advertising costs were reported as assets. Advertising expense was $22,657,000, $19,486,000 and $26,027,000 for the years ended March 31, 2003, December 31, 2001 and 2000, respectively. Advertising expense was $6,708,000 and $9,081,000 (unaudited) for the three months ended March 31, 2002 and 2001, respectively.

F-11




(4) Details of Selected Balance Sheet Accounts

  Details of selected balance sheet accounts are as follows (in thousands):

March 31, December 31,
   
 
2003 2002 2001 2000
 
 
              Allowance for doubtful accounts:                                        
    Balance beginning of period $ 500   $ 500   $ 300   $ 280  
    Plus provision for doubtful accounts   55     31     316     26  
    Less charge offs   225     31     116     6  

  
            Balance end of period 330   500   500   300  

  
  March 31,
 
 
2003 2002
 
 
Inventories:                
    Finished goods         $ 2,225   $ 2,602  
    Raw materials and component parts           1,041     1,863  

  
            Total inventories         $ 3,266   $ 4,465  

  
Property and equipment:                
    Warehouse and production equipment         $ 760   $ 760  
    Office equipment and information systems           3,680     3,650  
    Leasehold improvements           1,050     1,050  

  
    Less accumulated depreciation           (3,885 )   (3,060 )

  
               Property and equipment, net         $ 1,605   $ 2,400  

  
Product rights:                
    Product rights         $ 3,416   $ 2,906  
    Less accumulated amortization           (2,123 )   (1,727 )

  
               Product rights, net         $ 1,293   $ 1,179  

  
Accrued expenses:                
    Promotions and allowances         $ 4,703   $ 3,347  
    Royalties and commissions           778     951  
    Salaries, incentives and paid time off           1,829     1,638  
           Restructuring costs           26     206  
    Other           612     188  

  
                     Total accrued expenses         $ 7,948   $ 6,330  


(5) Stockholders’ Equity

  Stock Options The Company’s stock option plans allow for the grant of options to officers, directors, and employees to purchase up to 3,650,000 shares of common stock at exercise prices not less than 100% of fair market value on the dates of grant. The term of the options may not exceed ten years and options vest in increments over 1 to 5 years from the grant date. The plans allow for the grant of shares of restricted common stock. No shares of restricted common stock have been granted under these plans as of March 31, 2003.

F-12




  Stock option activity under these plans is summarized as follows:

Weighted-average
Exercise Price
Per Share
Shares
Outstanding
Shares
Available
For Grant
 
 
              Balance at December 31, 1999 $ 4.47             1,771,390             64,750  
    New 2000 Plan     0   700,000  
    Granted   4.01   358,400   (358,400 )
    Exercised   4.18   (69,690 ) 0  
    Canceled   5.18   (168,100 ) 168,100  

  
Balance at December 31, 2000   4.33   1,892,000   574,450  
    Granted   4.26   345,960   (345,960 )
    Exercised   3.36   (51,800 ) 0  
    Canceled   4.47   (102,970 ) 102,970  
    Expired     0   (7,280 )

  
Balance at December 31, 2001   4.33   2,083,190   324,180  
    Granted   5.98   117,100   (117,100 )
    Exercised   3.63   (19,696 ) 0  
    Canceled   4.09   (4,560 ) 4,560  
    Expired     0   (3,000 )

  
Balance at March 31, 2002 $ 4.43   2,176,034   208,640  
    Granted   6.01   175,460   (175,460 )
    Exercised   4.15   (205,900 ) 0  
    Canceled   4.68   (61,090 ) 61,090  
    Expired     0   (7,560 )

  
Balance at March 31, 2003 $ 4.58   2,084,504   86,710  


  Information on outstanding and currently exercisable options by price range as of March 31, 2003, is summarized as follows:

Price Range
Per Share
Total
Number of
Shares
Weighted-
average
Remaining
Life (Years)
Weighted-
average
Exercise
Price
Exercisable
Number of
Shares
Weighted-
average
Exercise
Price
 
             $ 2.31 - 2.81           192,303           5.6           $ 2.77           192,303           $ 2.77
3.10 - 3.94   379,000   2.8     3.26   337,200     3.21
4.00 - 4.50   608,381   7.2     4.23   443,613     4.25
5.00 - 5.94   640,600   4.6     5.37   532,600     5.38
6.05 - 6.85   174,220   9.0     6.40   34,740     6.05
7.25   90,000   4.3     7.25   90,000     7.25


  2,084,504         1,630,456    



F-13




  At March 31, 2003, the weighted-average remaining contractual life of outstanding options was 5.5 years. At March 31, 2003; December 31, 2001 and 2000, currently exercisable options aggregated 1,630,456; 1,409,570 and 1,207,232 shares of common stock, respectively and the weighted-average exercise price of those options was $4.43; $4.46 and $4.55, respectively.

  The per share weighted-average fair value of stock options granted during the year ended March 31, 2003; December 31, 2001 and 2000 is estimated as $3.54; $2.55 and $2.60, respectively on the date of grant using the Black-Scholes option pricing model with the following assumptions: volatility of 60% in 2003 and 2001 and 65% in 2000; risk-free interest rate of 5.00% in 2003 and 2001 and 6.50% in 2000, and an expected life of 6 years.

  Employee Stock Purchase Plan The Employee Stock Purchase Plan allows eligible employees to purchase shares of the Company’s common stock through payroll deductions. The purchase price is the lower of 85% of the fair market value of the stock on the first or last day of each six-month period during which an employee participated in the plan. The Company has reserved 400,000 shares under the plan of which employees as of March 31, 2003 have purchased 243,884 shares. Common shares sold to employees under the Purchase Plan in fiscal 2003, 2001 and 2000 were 19,517, 35,860 and 25,857, respectively. There was no common stock sold to employees during the periods ended March 31, 2002 and 2001.

  The weighted-average fair value of each purchase right granted in fiscal 2002, 2001 and 2000 was $2.26, $2.25 and $1.44, respectively.

  Warrants In connection with agreements to license certain intellectual property rights to potential products, licensors were issued warrants. During 1999, warrants were issued to purchase 50,000 shares of the Company’s common stock exercisable at a price of $3.44 per share exercisable evenly over three years and for a period of 10 years. The issuance of the warrants resulted in an expense of $110,000. Warrants were issued during 1997 to purchase 25,000 shares at a price of $8.00 per share exercisable in 2000 and for a period of five years. Of these warrants, 65,000 shares are currently exercisable.

  Preferred Stock At March 31, 2003, the Company is authorized to issue 1,000,000 shares of Series A Junior Participating Preferred Stock upon a triggering event under the Company’s stockholders’ rights plan and is authorized to issue up to an additional 7,483,589 shares of undesignated preferred stock.

F-14




(6) Income Taxes

  Income tax expense (benefit) for the years ended March 31, 2003; December 31, 2001 and 2000 and for the three months ended March 31, 2002 and 2001 is as follows (in thousands):

For the Years Ended For the Three Months Ended
March 31, December 31, March 31,

2003 2001 2000 2002 2001

(unaudited)
             Current income tax                                                  
   expense (benefit)                    
   Federal $ 224   $ 0   $ 0   $ 0   $ 0  
   State   115     0     0     0     0  

 
    339     0     0     0     0  

Deferred income tax                    
   expense (benefit)                    
   Federal   3,366     0     0     (8,388 )   0  
   State   257     0     0     (738 )   0  

    3,623     0     0     (9,126 )   0  

Total income tax                    
   expense (benefit) $ 3,962   $ 0   $ 0   $ (9,126 ) $ 0  


  The following table is a reconciliation of the statutory federal income tax expense (benefit) to the effective income tax expense (benefit) for the years ended March 31, 2003; December 31, 2001 and 2000 and for the three months ended March 31, 2002 and 2001 (in thousands):

For the Years Ended For the Three Months Ended
March 31, December 31, March 31,

2003 2001 2000 2002 2001

(unaudited)
             Computed tax                                                
   expense (benefit) $ 3,667   $ 28   $ (5,481 ) $ 353   $ (1,252 )
State taxes, net of                    
   federal benefit   242     0     (554 )   (480 )   0  
Change in deferred tax                    
   valuation allowance   0     (46 )   6,018     (9,126 )   1,252  
Other   53     18     17     127     0  

Actual tax                    
   expense (benefit) $ 3,962   $ 0   $ 0   $ (9,126 ) $ 0  


  The Company recognized a tax benefit of $9.1 million during the March quarter of 2002 as a result of reinstating net deferred tax assets, including the benefit of net operating loss carryforwards.

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  The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities for 2003 and 2002 are presented below (in thousands):

March 31,

2003 2002
 
 
              Deferred tax assets:                 
    Inventory items $ 383   $ 324  
    Accounts receivable allowance   122     185  
    Product rights   304     304  
    Accrued expenses   2,108     2,128  
    Contract termination   770     0  
    Net operating loss and credit carryforwards   2,166     6,400  

  
Less valuation allowance   0     0  

    5,853     9,341  

  
Deferred tax liabilities:        
    Unrealized gains on marketable securities   (119 )   (58 )
    Property and equipment   (184 )   (184 )

    (303 )   (242 )

  
            Net deferred tax assets $   5,550   $   9,099  


  In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based on the level of historical taxable income and projections of future taxable income over the periods in which the deferred tax assets are deductible, management believes that it is more likely than not the Company will realize the benefits of these deductible differences.

  As of March 31, 2003, the Company has reported federal net operating loss carryforwards of approximately $3,900,000. The federal net operating loss carryforwards begin to expire in 2019. Additionally, the Company has a federal credit carryforward for alternative minimum tax of approximately $730,000 that has no expiration date.

(7) Sales

  The Company had one significant customer who accounted for 25%, 22% and 20% of net sales in the years ended March 31, 2003; December 31, 2001 and 2000, respectively. The Company had one significant customer who accounted for approximately 22% and 21% (unaudited) of net sales for the three months ended March 31, 2002 and 2001, respectively. Accounts receivable from this customer as of March 31, 2003 and 2002 were $2,611,000 and $2,223,000, respectively.

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  Net sales by geographic area are as follows (in thousands):

For the Years Ended For the Three Months Ended
March 31, December 31, March 31,

2003 2001 2000 2002 2001

(unaudited)
              Domestic $   65,262           $   60,228           $   55,727            15,195           18,727  
International                    
      Japan   5,360     8,055     2,083     1,996     2,644  
      UK   2,275     2,378     767     426     665  
      Italy   2,020     2,312     808     260     621  
      Netherlands   1,632     1,178     750     522     333  
      Canada   1,161     1,102     928     346     296  
      Other   1,365     989     714     390     182  

Total                    
international   13,813     16,014     6,050     3,940     4,741  

  
   Net sales 79,075   76,242   61,777   19,135   23,468  


(8) Employee Benefit Plan

  The Company provides a defined contribution plan which covers all eligible employees. Generally, employees may contribute up to 50% of base compensation to the plan, not to exceed annual limits. The Company matches 25% of employee contributions up to 5% each year, with certain limitations. The Company may also make additional discretionary contributions. Employee benefit plan expense was $204,000; $269,000 and $166,000 for the years ended March 31, 2003; December 31, 2001 and 2000, respectively. Employee benefit plan expense was $46,000 and $120,000 (unaudited) for the three months ended March 31, 2002 and 2001, respectively.

(9) Special Charges

  On June 26, 2001, the Company announced a plan to streamline and realign the Company’s resources to better match its strategic goals. The Company recorded a special charge of $930,000 for costs associated with this restructure plan. Approximately 20 jobs, or 25% of the workforce from throughout the Company, were eliminated. These cost-cutting actions were expected to result in annualized savings of approximately $2 to $2.5 million. Cost savings relating to this plan were realized beginning in July of 2001. During 2001, the Company utilized $608,000 of the $930,000 accrual, primarily for severance benefits. During the three months ended March 31, 2002, the Company utilized $116,000 for severance payments and during the year ended March 31, 2003, the Company utilized $180,000 for severance payments.

(10) License Agreements

  The Company has agreements to exclusively license intellectual property rights to certain products. Royalties due under these agreements are based on various percentages of net sales. To maintain the Company’s licenses, it must make minimum royalty payments of $795,000 each year until patents for the products expire. Royalties are classified as a component of cost of goods sold. Royalty expense was approximately $2,652,000, $3,524,000 and $2,692,000 for the years ended March 31, 2003; December 31, 2001 and 2000, respectively. Royalty expense was approximately $724,000 and $1,040,000 (unaudited) for the three months ended March 31, 2002 and 2001, respectively.

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(11) Operating Leases

       The Company leases equipment and office space under noncancelable operating leases that have initial or noncancelable lease terms in excess of one year. Future minimum lease payments due in accordance with these leases as of March 31, 2003 are as follows (in thousands):

Year ending March 31, Amount
 
              2004 $ 766,000
2005   741,000
2006   741,000
2007   741,000
2008   741,000
Later years   1,977,000

 
Future minimum lease payments $ 5,707,000


  Total rental expense for operating leases was $781,000, $789,000 and $559,000 for the years ended March 31, 2003; December 31, 2001 and 2000, respectively. Total rental expense for operating leases was $195,000 and $195,000 (unaudited) for the three months ended March 31, 2002 and 2001, respectively.

(12) Net Income (Loss) Per Share

  A reconciliation of basic and diluted weighted average common shares outstanding is as follows (in thousands):

For the Years Ended For the Three Months
March 31, December 31, Ended March 31,

2003 2001 2000 2002 2001

(unaudited)
              Weighted average common                                                    
   shares outstanding   13,467     14,131     14,372     13,711     14,123  
Assumed conversion of                    
   stock options   577     300     0     487     0  

 
Average common and                    
   assumed conversion shares   14,044     14,431     14,372     14,198     14,123  


  As of March 31, 2003, a total of 191,000 options and warrants to purchase shares of common stock with a range of exercise prices from $6.79 to $8.00 per share were outstanding but were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of the common shares. The options expire from 2003 to 2011.

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