NATROL INC - 10-K Annual Report

FOR ANNUAL AND TRANSITIONAL REPORTS
PURSUANT TO SECTIONS 13 AND 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

Delaware
(State of Incorporation)

95-3560780
(I.R.S. Employer Identification No.)

21411 Prairie Street
Chatsworth, California 91311
(Address of principal executive offices)

Securities registered pursuant to section 12(g) of the Act: Common Stock, par value $.01 per share

Indicate by a 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 ý No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Registration S-K is not contained herein, and will not be contained, to the best of the 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. o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 126-2). Yes o No ý

The aggregate market value of the shares of the registrant's Common Stock held by non-affiliates of the registrant on June 30, 2003 was approximately $29.9 million based upon the closing price per share of the registrant's Common Stock as reported on the NASDAQ National Market on such date. Calculations of holdings by non-affiliates is based upon the assumption, for these purposes only, that executive officers, directors, and persons holding 10% or more of the outstanding Common Stock are affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of March 15, 2004, the registrant had 13,166,686 shares of Common Stock outstanding.

Portions of the registrant's definitive proxy statement for its 2003 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K.

		Page
PART I	3
Item 1.	Business	3
Item 2.	Properties	24
Item 3.	Legal Matters	24
Item 4.	Submission of Matters to a Vote of Security Holders
PART II	25
Item 5.	Market for Registrant's Common Equity and Related Stockholder Matters	25
Item 6.	Selected Consolidated Financial Data	25
Item 7.	Management's Discussion and Analysis of Financial Condition and Results of Operations	27
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	37
Item 8.	Financial Statements and Supplementary Data	38
Item 9.	Changes and Disagreements with Accountants on Accounting and Financial Disclosure	62
PART III	Items 10, 11, 12, 13 and 14
PART IV	64
Item 15.	Exhibits, Financial Statements, Schedules, and Reports on Form 8-K

This report contains "forward looking statements." Natrol, Inc., a Delaware corporation organized in 1980, the "Company", is including this statement for the express purpose of availing itself of protections of the safe harbor provided by the Private Securities Litigation Reform Act of 1995 with respect to all such forward looking statements. Examples of forward looking statements include, but are not limited to, the use of forward-looking terminology such as "believes," "expects," "may," "will," "should," "intend," "estimate," "assume," "plan," or "anticipates" or the negative thereof, other variations thereon, or comparable terminology, or by discussions of strategy that predict or indicate future events or trends or that are not historical facts. The Company cannot assure the future results or outcome of the matters described in these statements; rather, these statements merely reflect its current expectations of the approximate outcome of the matter discussed. The Company does not undertake any obligation and does not currently intend to update any such statements at any time in the future.

The Company's ability to predict results or the effect of certain events on the Company's operating results is inherently uncertain. Forward-looking statements should not be unduly relied on since they involve known and unknown risks, uncertainties and other factors, some of which are beyond the Company's control. These risks, uncertainties and other factors may cause actual results, performance or achievements to differ materially from the anticipated future results, performance or achievements expressed or implied by such forward-looking statements. Therefore, the Company wishes to caution each reader of this report to carefully consider the following factors and certain other factors discussed herein, including the factors discussed under the caption "Business Risk Factors & Factors Affecting Forward Looking Statements," and factors discussed in other past reports. The factors discussed herein may not be exhaustive. Therefore, the factors contained herein should be read together with other reports and documents that are filed by the Company with the SEC from time to time, which may supplement, modify, supersede or update the factors listed in this document.

Factors that could cause or contribute to the Company's actual results differing materially from those discussed herein or for the Company's stock price to be affected adversely include, but are not limited to: (i) industry trends, including a general downturn or slowing of the growth of the dietary supplement industry; (ii) increased competition from current competitors and new market entrants including but not limited to increased competition from private label house brands supported by retailers seeking to increase the market share of their proprietary house brands. Private label brands control the largest share of the vitamin, mineral and supplement (VMS) sector; (iii) adverse publicity regarding the dietary supplement industry or the Company's products; (iv) exposure to product liability claims, in particular because the Company beginning in July, 2003 has chosen to self-insure against product liability claims due to the high price of product liability insurance, the inability to secure occurrence based coverage, as well as the limited amount of coverage provided by insurers willing to provide insurance at high prices; (v) exposure to and the expense of resolving and defending potential product liability claims that are left uncovered by insurance; (vi) the Company's dependence upon its ability to develop new products; (vii) returns of the Company's products which may be returned by customers at any time due to lack of sell through to consumers or because competitors have convinced the Company's customers that Natrol's products should be replaced with competitor products; (viii) the Company's ability to manage inventory or sell its inventory before such inventory becomes outdated, (xix) the Company's ability to gain or expand or maintain distribution within new or existing customers and new or existing channels of trade; (x) an increase in the cost of obtaining and maintaining shelf space with major national retailers who demand various forms of incentives from their suppliers such as slotting fees, coop advertising, or rebates; (xi) adverse changes in government regulation or changes in local or national laws; (xii) dependence on significant customers; (xiii) the Company's ability to keep and attract key management employees; (xiv) the Company's inability to manage growth and execute its business plan, or the Company's ability to modify its business plan in response to market conditions, including, but not limited to, its ability to enter into new businesses and capitalize upon new business

opportunities; (xv) the Company's ability to consummate future acquisitions and its ability to integrate acquired businesses; (xvi) the absence of conclusive clinical studies for many of the Company's products; (xvii) the Company's inability to obtain raw materials that are in short supply including its ability to obtain garlic powders or arabinogalactan for its EPI raw material sales division; (xviii) sales and earnings volatility, (xix) volatility of the stock market; (xx) the Company's ability to manufacture its products efficiently; (xxi) the Company's reliance on independent brokers to sell its products; (xxii) the inability of the Company to protect its intellectual property; (xxiii) control of the Company by principal shareholders, (xxiv) the possible sale of large amounts of stock by controlling stockholders; (xxv) a general downturn in the national economy as a whole; (xxvi) continued market acceptance of Natrol supplements, Laci Le Beau teas, Prolab's sports nutrition products, and EPI's raw material products, (xxvii) increases in the cost of borrowings; (xxviii) and, the unavailability of additional debt or equity capital; (xix) legal actions brought forth by federal, state and local governmental and private parties.

There are a number of other factors affecting the Company's business, including the following risk factors of which investors should be aware.

Natrol and its other brands, Laci LeBeau and Prolab have each sold ephedrine-based products in past years. The volume of such sales has not been large relative to the overall sales of the Company and as of March 31, 2003 the Company stopped selling or manufacturing ephedrine-based products. Even so, the Company cannot guarantee that all of the ephedrine-based products produced and sold to retailers are no longer on retailer shelves and unavailable for sale.

During 2002, product liability insurance for ephedrine-based products was generally unavailable. Occurrence-based product liability insurance became unavailable during the fourth quarter of 2002. "Claims-made insurance," that was available for these products, was offered to the Company only with substantially lower limits than the Company had carried in prior years and at rates that were many times higher than those paid in prior years. In July, 2003, the Company chose to self-insure against product liability claims due to the high price of product liability insurance, the inability to secure occurrence based coverage, as well as the limited amount of coverage provided by insurers willing to provide insurance at high prices. The Company cannot predict the state of the insurance market in future years, or for that matter, whether or not insurance will be available to the Company at any price.

The Company's executive offices are located at 21411 Prairie Street, Chatsworth, California 91311 and its telephone number is 818-739-6000. Company information may be accessed via the Company's web site at http://www.natrol.com. Unless the context otherwise requires the terms the "Company" and "Natrol" refer to Natrol, Inc. and, as applicable, its subsidiaries.

Natrol manufactures and markets branded, high-quality dietary supplements, herbal teas, nutraceutical ingredients and sports nutrition products under three labels: the Natrol brand, the Laci Le Beau brand of herbal teas, and the Prolab sports nutrition brand. The Company also markets high quality nutraceutical ingredients to other manufacturers of supplements or fortified foods through its Essentially Pure Ingredient (EPI) raw material supply division which also markets contract manufacturing services to companies within the nutraceutical industry.

The Company's core Natrol brand focuses on supplements that are in high demand as well as specialty niche and proprietary formulations that have potentially strong margins. The Company positions Natrol as a premium brand of supplements rather than as a value brand.

Dietary supplements are sold primarily under the Company's Natrol brand. These supplements include vitamins, minerals, hormonal supplements, herbal products and specialty combination formulas that contribute to an individual's physical well being. The Company sells its products through multiple distribution channels throughout the United States. These channels include domestic health food stores and mass-market drug, retail and grocery store chains. The Company also sells its products through independent catalogs, Internet shopping sites, and, to a limited degree, within select foreign countries through international distributors who purchase Natrol's products F.O.B. the United States. The Company's strategy emphasizes building strong recognition of the Natrol brand across multiple distribution channels through an advertising strategy that includes print advertising, television advertising, radio advertising and coop advertising with customers designed to build consumer awareness and increase the purchase of its products by consumers.

Herbal teas are sold under the Company's Laci Le Beau brand. Laci Le Beau teas are flavored herbal teas. The primary tea category is Laci Le Beau Dieter's tea. The Company uses the same sales people and brokers to sell teas as it does supplements. And, as with its supplement business, the Company's strategy emphasizes building strong recognition of the Laci Le Beau brand across multiple distribution channels.

The Prolab sports nutrition line of products is targeted to body builders and health minded individuals seeking a high degree of physical fitness. Prolab's products include supplements designed to help these individuals gain and lose weight as well as improve muscle mass and muscle definition. Prolab products are sold through fitness centers, health food stores, and internationally, through selected distributors. In past years, Prolab was operated as a separate operating segment with its own management and administration. This operating segment was managed in Bloomfield, Connecticut. During 2003, the Company integrated Prolab into the core Natrol business with Prolab becoming a brand within the Natrol company similar to Laci Le Beau. This consolidation was completed at the end of the third quarter of 2003 and as of the fourth quarter of 2003, the Company no longer reports Prolab as a separate operating entity. As of the completion of the consolidation, all management and administration for Prolab was consolidated into the Company's headquarters in Chatsworth, California and the only functions remaining in Bloomfield, Ct. are warehousing and distribution. While functioning as an independent operating unit, Prolab consistently suffered operating losses. Operating losses were $937,000 in 2002 and $22.0 million in 2001. Operating losses in 2001 include a $20 million

impairment charge taken against goodwill incurred in connection with the acquisition of Prolab. During the first nine months of 2003, operating losses were approximately $1.2 million.

The Company also sells nutraceutical grade ingredients, garlic, vegetable powders, kava kava, melatonin and arabinogalactan to other manufacturers through its EPI division. The Company's strategy is to establish exclusive relationships with primary manufacturers of raw materials and to sell these ingredients to other users of nutraceutical grade materials. EPI maintains an independent sales force. EPI, however, shares all of Natrol's other resources including Natrol's headquarters facility, its manufacturing and product development personnel and expertise, its financial resources, as well as accounting and management resources. The EPI sales force markets Natrol's manufacturing capabilities to other nutraceutical businesses that need contract manufacturing support.

Natrol's consumer products fall into the general definition of vitamin, minerals, herbs and dietary supplements ("VMS"). Each year, every segment of the Company strives to broaden its product offerings so as to increase revenue and gross profits while lessening dependence upon any one product. Corporately, the Company produces approximately 190 products for domestic consumption and 40 products are labeled for international consumption. These products are packages into more than 650 stocking units (SKUs).

No one product represented more than 10% of gross sales in 2003 or 2002. The Company's sales of one product comprised 10.1% of gross sales during the year ended December 31, 2001.

During March 2004, the Company settled its litigation with the former owners of Prolab Nutrition, Inc. The Company received $2 million in cash, which will be reflected on the financial statements for the quarter ending March 31, 2004 as a reduction in goodwill.

During 2002, the Company founded Annasa, Inc. as a wholly owned subsidiary of the Company and entered the multi-level marketing business to distribute a new proprietary line of nutritional products. Annasa had revenue of $44,000 in 2002 and $667,000 in 2003. Operating losses for Annasa in 2002 were approximately $1.1 million and, were approximately $1.8 million in 2003. These losses were higher than anticipated and the Company discontinued the operations of Annasa at year-end 2003, selling the trademarks and certain other assets to an investor group lead by former Annasa distributors. The Company received $35,000 for the intellectual property assets and received a commitment from the investor group to purchase Annasa's remaining inventory at cost. The investor group also agreed to pay Natrol a royalty of between one and two percent of net revenue for 20 years.

During 2002, Tamsol, Inc. was established as a wholly owned subsidiary of Natrol to generate direct-to-consumer sales. During 2002, Tamsol recorded $27,000 of net revenue and a loss before income taxes of $41,000. During 2003, Tamsol failed to meet revenue or profit goals and its operations were discontinued during the final quarter of 2003. For the year ended December 31, 2003, Tamsol generated net revenue of $30,000 and a loss before income taxes of $542,000.

The Company distributes its Natrol supplements and Laci Le Beau teas primarily to domestic, independent, health food stores and mass-market drug, retail and food stores. Although the Company sells the same Natrol or Laci Le Beau products to both the health food and mass-market channels of distribution, it has built different sales organizations to meet the differing requirements of each channel of trade.

The Company sells its branded Natrol and Laci Le Beau products to health food stores primarily through leading national distributors, including United Natural Foods and Tree of Life. Natrol and Laci Le Beau products are also sold by health food store chains such as Wild Oats Markets, Whole Foods Market, Hi-Health, Vitamin Cottage, Fred Meyer Nutrition Centers and Vitamin Shoppes, as well as by most independent health food stores.

Within the health food channel of trade, the Company maintains a sales staff of regional representatives across the country managed by a national manager who reports to the Company's Vice President of Sales. These sales representatives call on individual storeowners and distributors promoting the Natrol and Laci Le Beau lines.

The mass-market distribution channel is managed by the Company's Vice President of Sales, a Vice President of National Accounts and regional managers who work with a network of independent brokers. The Company's employees service certain of its larger mass-market accounts directly while independent brokers service others in conjunction with the Company's management. The Company sells its products to mass-market merchandisers either directly or through distributors of vitamins, minerals and other supplement products such as:

Some of the Company's major drug and mass-market retail and grocery customers include:


• Walgreens	Costco	CVS
• Albertson's	Rite Aid	Long's Drug
• Eckerd	Brooks Drug	Wal-Mart
• BJ's Wholesale Club	Sam's Clubs	Dominick's
• Ralphs	Von's	Cub Foods
• Food For Less	Gelsen's	Hi Vee
• Wegmans.

Sales of vitamins and supplements within the mass-market channel of trade are extremely competitive with all vendors competing vigorously to defend their positions within each mass-market account. Many mass-market retailers emphasize their own in-house private label brand which creates additional competition. Vendors to the mass-market class of trade continually analyze their own shelf space as well as that of their competitors in an effort to maximize profits for themselves and the mass-market retailer. The result is a natural cycle in which companies such as Natrol prune slower moving items from store shelves, replacing them with faster selling products. The Company's central strategy is to ensure that its most profitable and rapidly selling items remain on retailers' shelves while it seeks to obtain more shelf space for additional, potentially profitable, items. In addition, the Company is continually seeking to develop or acquire rights to new products able to capture a substantial consumer following.

Within the health food store channel of distribution, the Company believes that its product line is under-represented and its strategy within that channel of trade is to ensure that retail outlets carry a higher percentage of what the Company considers to be its core line of products.

The Company provides retailers in both the health food store and the mass-market distribution channels with a wide array of comprehensive services tailored to meet their individual needs. In the health food store channel, the Company's dedicated sales force maintains direct and regular contact with key store personnel, informing them of new product developments and industry trends, aiding them in the design of store sets and creating merchandising programs that promote brand and category awareness. The Company's regional managers and independent brokers in the mass-market distribution channel work with corporate buyers focusing on special promotional activities and brand and category awareness in order to improve the consumer purchases of Natrol products and increase the movement of items through each outlet. The objective of these activities is to build strong relationships with the Company's marketing partners, to increase the number of stores carrying its products and improve the profitability of the items sold within each of the Company's trading partners.

Prolab products are sold primarily through fitness centers, health food stores and internationally through designated distributors. Approximately 38.0% of Prolab's sales are to distributors who sell products to European, Canadian and other non-domestic accounts.

Prolab's domestic sales are primarily to wholesalers who in turn service retail accounts. Prolab's wholesaler network focuses on health food stores, health clubs and fitness facilities that cater to body builders and other individuals seeking a high level of fitness. With the integration of Prolab as a brand within the Natrol, Natrol's health food oriented sales professionals have become responsible for presenting appropriate Prolab products to health food retailers who in turn order from distributors who carry Prolab product.

No customer of the Company represented more than 10% of net sales for the year ended December 31, 2003. One customer represented 12.3% of net sales in the year ended December 31, 2002. No customers represented more than 10% of net sales in the years ended December 31, 2001.

The Company's contract manufacturing services are primarily marketed through the EPI sales force. The Company manufactures a number of products pursuant to contracts with customers who distribute the products under their own private labels. As a contract manufacturer, the Company will often assist its customers in the formulation of their products. Contract manufacturing accounted for approximately 3.7% of the Company's gross sales in 2003.

In its bulk ingredient business, EPI sells nutraceutical grade garlic, vegetable powders, kava kava, melatonin and arabinogalactan to other manufacturers of nutritional products.

EPI obtains its bulk vegetable ingredients from ConAgra Foods, Inc. (ConAgra) pursuant to a multi-year supply agreement that gives the Company the exclusive right to sell ConAgra's nutraceutical grade vegetable powders in the dietary supplement industry. This agreement extends until December 31, 2007 and stipulates certain pricing and volume targets. Nutraceutical grade garlic is also available from international suppliers at competitive prices. Should Con Agra be unable to supply the Company or should the terms of the contract with ConAgra become uncompetitive, or should better sources of supply become available, the Company will purchase alternative supplies through these suppliers in the most efficient manner possible consistent with its sales and distribution obligations and duties.

In 2003, the Company secured exclusive distribution rights within the nutraceutical industry for an immune enhancing raw material named arabinogalactan. The contract requires the company to purchase minimum quantities of arabinogalactan in order to maintain the exclusive rights specified in

the contract. In January 2004, the Company also entered into a yearly endorsement contract for arabinogalactan with Earvin "Magic" Johnson, a well-known former National Basketball Association all-star. Mr. Johnson personally endorses the use of Natrol's My Defense formulation which includes arabinogalactan and he takes this immune enhancing product by regularly.

Acquiring the distribution rights to arabinogalactan within the nutraceutical industry is in line with the Company's strategy of establishing exclusive relationships with primary manufacturers of raw materials and to sell these ingredients to other users of nutraceutical grade materials and to broaden its product offerings as favorable distribution opportunities arise.

Management believes the Company's strategy of selling the Natrol and Laci Le Beau and Prolab brands through all appropriate channels of distribution including the health, mass-market, convenience store, fitness and health clubs and Internet channels distinguishes the Company from its competition. Most competitors sell products into each channel using different brand names within each channel.

The Company's core strategy is to continue to build the Natrol, Laci Le Beau and Prolab brand names within multiple channels of distribution in order to develop increased brand awareness and strong brand recognition among consumers seeking products with a reputation for quality. The Company believes it can leverage its reputation for high quality products developed within the health food distribution channel in the mass-market and other channels by positioning its products as a high quality brand rather than a value brand.

The Company utilizes print, radio and television advertising as well as cooperative and other incentive programs to build consumer awareness and generate sales revenue.

The Company regularly reviews its media mix for its effectiveness in creating consumer demand. As such, the Company's use of certain media in past operating periods is not necessarily an indicator of media choices to be made in future operating periods.

The Company's EPI division relies primarily on visibility developed through trade shows, advertising in trade publications and brochures to supplement the sales efforts of its sales people. An exception is the Company's immunue enhancing product, arabinogalactan. In January 2004, the Company entered into a celebrity endorsement agreement with Earvin "Magic" Johnson under which Mr. Johnson endorses both Natrol's My Defense formulation and EPI's raw material arabinogalactan as marketed by EPI.

The contract manufacturing business relies on trade shows, trade publications, and word-of-mouth as well as the delivery of information from its sales staff, primarily its Essentially Pure Ingredients sales people.

During 2003, the Company revamped its product development department. Prior to the third quarter of 2003, the Company's product development department reported to the Vice President of Marketing. During the third quarter of 2003, the Company recruited an experienced Vice President of Technology Product Development (TPD) who reports directly to the President of the Company. The Company effectively doubled its product development budget and in the last quarter of 2003, the Vice

President of TPD added key personnel to his department in order to amplify the Company's product development efforts.

It is the role of TPD to monitor product developments within the dietary supplement industry and facilitate the generation of new ideas for product introductions. The Company's product development staff constantly reviews periodicals, scientific research and relevant clinical studies within medical journals and on-line databases. The staff meets with vendors and evaluates new ingredients. The product development team also consults scientists and employs research consultants on a regular basis regarding new product concepts.

Before a product is introduced, the product development team reviews the safety and efficacy of ingredients, standards for production, and with assistance from counsel reviews labeling information, label claims and potential patent, trademark, legal or regulatory issues. The TPD department ensures that all Natrol products meet label claims and that all Natrol formulations are safe and efficacious if produced to the standards that have been developed.

The Company actively participates in and financially supports a number of scientific and educational industry organizations that promote consumer well being. These include the Citizens for Health, the National Nutritional Foods Association ("NNFA"), American Herbal Products Association, American Herbal Pharmacopoeia, and the American Botanical Council. The Company is also a founding member of the Dietary Supplement Education Alliance ("DSEA") of which Mr. Balbert serves as the CEO. The DSEA is a not-for-profit organization consisting of more than 60 companies whose role is to improve public health by communicating the benefits of dietary supplements.

The Company manufactures its branded Natrol and private label supplements as well as Prolab tablets and capsules at its 90,000 square foot manufacturing facility/headquarters located in Chatsworth, California. At this facility, the Company manufactures both tablets and two-piece capsules, which account for the vast majority of the Company's supplement sales. The Company uses third party vendors to produce its liquid products, bars, powders and softgels and tea.

The Company places a strong emphasis on quality control because it believes that quality standards play a critical factor in consumer purchasing decisions and in differentiating the Natrol brand. The Company's products are manufactured in accordance with current Good Manufacturing Practices ("GMPs").

The Company requires all raw materials or finished products produced by third party vendors to be placed in quarantine upon receipt before release by the Company's quality control laboratory. The Company conducts sample testing, weight testing, purity testing, dissolution testing and, where required, microbiological testing. When materials are released from quarantine, each lot is assigned a unique lot number which is tracked throughout the manufacturing process. Materials are blended, tested and then encapsulated or formed into pills which may or may not be coated. The Company routinely performs qualitative and quantitative quality control procedures on its finished products.

During 2002, the Company converted to SAP, one of the most sophisticated integrated computer systems in the world. Through SAP, the Company can efficiently monitor the details of its production and shipping systems giving managers step-by-step visibility into each of the Company's production processes.

The Company obtains its raw materials for the manufacture of its products from third-party suppliers. Many of the raw materials used in the Company's products are harvested internationally. With the exception of bulk garlic and arabinogalactan, the Company does not have contracts with any

suppliers committing such suppliers to provide the materials required for the production of its products. During the last decade, Coenzyme Q10, natural vitamin E, beta carotene, Melatonin, Kava, Sam-E, and St. John's Wort have had significant price fluctuations as a result of short supply and or increases in demand. The Company has experienced occasional shortages of raw materials for a limited number of its products, but to date has only encountered short-term production interruptions as a result of such shortages. One supplier, Century Foods accounted for more than 10% of the Company's material purchases in 2003.

ConAgra supplies the Company's EPI division nutraceutical grade vegetable powders including garlic, under an exclusive supply agreement. Because the Company does not control the actual production of these raw materials, it is also subject to delays caused by interruption in production of materials based on conditions not within its control. Such conditions include job actions or strikes by employees of suppliers, weather, crop conditions, transportation interruptions and natural disasters or other catastrophic events.

The Company also sells a limited number of products under the supplier's trademark. The most significant of these is the Company's Ester-C® line of products which accounts for approximately 9% of the Company's gross sales. When the Company markets products under the supplier's trademark, the Company is limited to that single supplier as a source of raw materials for that product. As a result, any shortage of raw materials from that supplier would adversely affect the Company's ability to manufacture that product. Price increases from these suppliers could severely impact the profitability of these items. The inability of the Company to obtain adequate supplies of raw materials for its products at favorable prices, or at all, could have a material adverse effect on the Company's business, financial condition and results of operations.

The Company's source of arabinogalactan is Larex, Inc. Should the endorsement of Earvin "Magic" Johnson and other marketing support by the Company lead to extremely high level of sales, it is possible that Larex may not be able to adequately meet short term demand. The Company does not believe that other sources of the nutraceutical grade of arabinogalactan are readily available from other suppliers.

The Company has current manufacturing capability to produce four million tablets and capsules per eight hour shift and 420,000 bottles per week per eight hour shift.

The Company operates flexible manufacturing lines which enable it to shift output efficiently among various pieces of equipment depending upon such factors as batch size, tablets or capsule count and labeling requirements. The Company strives to fulfill and ship all orders within 48 hours.

The Company also owns a 132,000 sq. ft. warehouse facility located less than one-quarter mile from its manufacturing facility. Approximately 52,000 sq. ft. of this warehouse facility is subleased. Rental income was approximately $473,000, $460,000, $414,000, for the years ended December 31, 2003, 2002, 2001, respectively. The remaining 80,000 sq. ft. is now being used by the Company to ship finished goods to the Company's customers. Finished goods are transferred from the Company's packaging lines to the distribution facility for storage prior to shipment to customers.

The Company primarily relies upon third parties for the milling and processing of its herbal teas. The Company directly provides a majority of the herbs and other raw materials used in the production of its teas to these third parties. Tea bags produced by these parties are packaged into boxes at the Company's manufacturing facility in Chatsworth, California.

The Company produces, at its headquarters/manufacturing facility, Prolab supplements that are sold in tablet or capsule form. However, the Company relies on third party vendors to process and package a majority of Prolab's products which consists of powders, nutrition bars and drinks.

The Company's EPI division provides raw material ingredients to the Company and other customers. The Company acquires nutraceutical grade garlic and other vegetable powders pursuant to a multi-year supply agreement with ConAgra which requires ConAgra to sell and the Company to purchase specified amounts of certain vegetable, fruit, herbal and botanical product. The agreement with ConAgra gives the Company the exclusive right to sell certain ConAgra products in the dietary supplement industry. This agreement may be terminated by either party upon a material breach of the obligations of the other party, or certain other specified conditions, if the breach is not cured within 60 days, or within 15 days in the case of non-payment by the Company. The agreement was originally signed with Basic Vegetable Products ("BVPs") in 1998 when the Company purchased BVPs' Pure Gar Division. In November 2000, BVP was acquired by ConAgra. As the successor to BVP, ConAgra was obligated to assume the terms and conditions of the original supply agreement. At that time, Natrol and ConAgra negotiated certain modifications to the original agreement including an extension to 2007 of the supply agreement.

Should Con Agra be unable to supply the Company or should the terms of the contract with ConAgra become uncompetitive, the Company believes it can secure alternative supply through these international suppliers without disturbing sales or distribution.

In 2003, the Company secured exclusive distribution rights within the nutraceutical industry for an immune enhancing raw material named arabinogalactan from Larex, Inc. In January 2004, the Company entered into an endorsement contract for arabinogalactan with Earvin "Magic" Johnson, a well-known former National Basketball Association all-star. Mr. Johnson personally uses this immune enhancing product by regularly taking Natrol's "My Defense" formulation which is based on arabinogalactan.

Acquiring the distribution rights to arabinogalactan within the nutraceutical industry is in line with the Company's strategy is to establish exclusive relationships with primary manufacturers of raw materials and to sell these ingredients to other users of nutraceutical grade materials and to broaden its product offerings as favorable distribution opportunities arise.

The Company regards its trademarks, patent applications and other proprietary rights as valuable assets. The Company believes that protecting its key trademarks is crucial to its business strategy of building strong brand name recognition and that such trademarks have significant value in the marketing of its products. The Company may in some cases seek to protect its research and development efforts by filing patent applications for proprietary products.

The Company's policy is to pursue registrations for all of the trademarks associated with its key products. The Company relies on common law trademark rights to protect its unregistered trademarks as well as its trade dress rights. Common law trademark rights generally are limited to the geographic area in which the trademark is actually used, while a United States federal registration of a trademark enables the registrant to stop the unauthorized use of the trademark by any third party anywhere in the United States. Furthermore, the protection available, if any, in foreign jurisdictions may not be as extensive as the protection available to the Company in the United States.

Currently, the Company has received one United States patent for its Kavatrol product and has received two United States patents on its amino acid products, SAF and SAF for Kids. To the extent the Company does not have patents on its products, another company may replicate one or more of the Company's products.

Although the Company seeks to ensure that it does not infringe on the intellectual property rights of others, there can be no assurance that third parties will not assert intellectual property infringement claims against the Company.

The dietary supplement industry is highly competitive. Numerous companies, many of which have greater size and financial, personnel, distribution and other resources than the Company, compete with the Company in the development, manufacture and marketing of dietary supplements. The Company's principal competition in the health food store distribution channel comes from a limited number of large nationally known manufacturers and many smaller manufacturers of dietary supplements. In the mass-market distribution channel, the Company's principal competition comes from broadline manufacturers, major private label manufacturers and other companies. In addition, several large pharmaceutical companies, compete with the nutritional supplement companies. Increased competition from such companies could have a material adverse effect on the Company because such companies have greater financial and other resources available to them and possess manufacturing, distribution and marketing capabilities far greater than those of the Company. The Company also faces competition in both the health food store and mass-market distribution channels from private label dietary supplements and multivitamins offered by health and natural food store chains, drugstore chains, mass merchandisers and supermarket chains.

The Company competes on the basis of product quality, pricing, customer service, product development and marketing support.

The manufacture, packaging, labeling, advertising, promotion, distribution and sale of the Company's products are subject to regulation by numerous governmental agencies which regulate the Company's products. The Company's products are subject to regulation by, among other regulatory entities, the Consumer Product Safety Commission ("CPSC"), the U.S. Department of Agriculture ("USDA"), the Environmental Protection Agency ("EPA") and the U.S. Food and Drug Administration ("FDA"). Advertising and other forms of promotion and methods of marketing of the Company's products are subject to regulation by the U.S. Federal Trade Commission ("FTC"), which regulates

these activities under the Federal Trade Commission Act ("FTCA"). The manufacture, labeling and advertising of the Company's products are also regulated by various state and local agencies as well as those of each foreign country to which the Company distributes its products.

The Dietary Supplement Health and Education Act of 1994 ("DSHEA") revised the provisions of the Federal Food, Drug, and Cosmetic Act ("FFDC Act") concerning the regulation of dietary supplements. The substantial majority of the products marketed by the Company are regulated as dietary supplements under the FFDC Act.

Under the current provisions of the FFDC Act there are four categories of claims that pertain to the regulation of dietary supplements. Health claims are claims that describe the relationship between a nutrient or dietary ingredient and a disease or health related condition and can be made on the labeling of dietary supplements if supported by significant scientific agreement and authorized by the FDA in advance via notice and comment rulemaking. Nutrient content claims describe the nutritional value of the product and may be made if defined by the FDA through notice and comment rulemaking and if one serving of the product meets the definition. Health claims may also be made if a scientific body of the U.S. government with official responsibility for the public health has made an authoritative statement regarding the claim, the claim accurately reflects that statement and the manufacturer, among other things, provides the FDA with notice of and the basis for the claim at least 120 days before the introduction of the supplement with a label containing the health claim into interstate commerce. For health claims that the FDA has approved, no prior notification is required. Statements of nutritional support or product performance, which are permitted on labeling of dietary supplements without FDA pre-approval, are defined to include statements that: (i) claim a benefit related to a classical nutrient deficiency disease and discloses the prevalence of such disease in the United States; (ii) describe the role of a nutrient or dietary ingredient intended to affect the structure or function in humans; (iii) characterize the documented mechanism by which a dietary ingredient acts to maintain such structure or function; or (iv) describe general well-being from consumption of a nutrient or dietary ingredient. In order to make a nutritional support claim the marketer must possess substantiation to demonstrate that the claim is not false or misleading and if the claim is for a dietary ingredient that does not provide traditional nutritional value, prominent disclosure of the lack of FDA review of the relevant statement and notification to the FDA of the claim is required. Drug claims are representations that a product is intended to diagnose, mitigate, treat, cure or prevent a disease. Drug claims are prohibited from use in the labeling of dietary supplements.

Claims made for the Company's dietary supplement products may include statements of nutritional support and health and nutrient content claims when authorized by the FDA or otherwise allowed by law. The FDA's interpretation of what constitutes an acceptable statement of nutritional support may change in the future thereby requiring that the Company revise its labeling. In addition, a dietary supplement that contains a new dietary ingredient (i.e., one not on the market before October 15, 1994) must have a history of use or other evidence of safety establishing that it is reasonably expected to be safe. The manufacturer must notify the FDA at least 75 days before marketing products containing new dietary ingredients and provide the FDA the information upon which the manufacturer based its conclusion that the product has a reasonable expectation of safety.

The FDA has proposed a ban on ephedrine products. The Company discontinued the sale of ephedrine products in the first quarter of 2003.

The FDA has also announced that it's intention to promulgate new GMPs specific to dietary supplements.

The failure of the Company to comply with applicable FDA regulatory requirements could result in, among other things, injunctions, product withdrawals, recalls, product seizures, fines and criminal prosecutions. The Company intends to comply with the new GMPs once they are adopted.

As a result of the Company's efforts to comply with applicable statutes and regulations, the Company has from time to time reformulated, eliminated or relabeled certain of its products and revised certain of its advertising claims. The Company cannot predict the nature of any future laws, regulations, interpretations or applications, nor can it determine what effect additional governmental regulations or administrative orders, when and if promulgated, would have on its business in the future. They could, however, require the reformulation of certain products to meet new standards, the recall or discontinuance of certain products not capable of reformulation, additional record keeping, expanded documentation of the properties of certain products, expanded or different labeling, and/or scientific substantiation. Any or all of such requirements could have a material adverse effect on the Company's business, financial condition and results of operations.

The Company's advertising and sale of its dietary supplement products is subject to regulation by the FTC under the FTCA. Section 5 of the FTCA prohibits unfair methods of competition and unfair or deceptive acts or practices in or affecting commerce. Section 12 of the FTCA provides that the dissemination or the causing to be disseminated of any false advertisement pertaining to drugs or foods, which would include dietary supplements, is an unfair or deceptive act or practice. Under the FTC's Substantiation Doctrine, an advertiser is required to have a "reasonable basis" for all objective product claims before the claims are made. Failure to adequately substantiate claims may be considered either deceptive or unfair practices. Pursuant to this FTC requirement the Company is required to have adequate substantiation for all material advertising claims made for its products.

On November 18, 1998, the FTC issued "Dietary Supplements: An Advertising Guide for Industry." This guide provides marketers of dietary supplements with guidelines on applying FTC law to dietary supplement advertising. It includes examples of the principles that should be used when interpreting and substantiating dietary supplement advertising. Although the guide provides additional explanation, it does not substantively change the FTC's existing policy that all supplement marketers have an obligation to ensure that claims are presented truthfully and to verify the adequacy of the support behind such claims. The Company's internal staff, in conjunction with outside counsel, reviews its advertising claims for compliance with FTC requirements.

The FTC has a variety of processes and remedies available to it for enforcement, both administratively and judicially, including compulsory process, cease and desist orders and injunctions. FTC enforcement can result in orders requiring, among other things, limits on advertising, corrective advertising, consumer redress, divestiture of assets, rescission of contracts and such other relief as may be deemed necessary. A violation of such orders could have a material adverse effect on the Company's business, financial condition and results of operations.

Advertising and labeling for dietary supplements and conventional foods are also regulated by state, county and other local governmental authorities. Some states also permit these laws to be enforced by Private Attorneys General. These Private Attorneys Generals may seek relief for consumers, seek class action certifications, seek class-wide damages, seek class-wide refunds and product recalls of products sold by the Company. In the ordinary course of business, the Company is named as a defendant in these types of state governmental agency and Private Attorneys General Actions along with other vitamin and supplement companies. Until the courts rule that laws have been violated, that the actions can proceed by state governmental agencies or Private Attorneys General and or Class Actions and that cognizable injuries have occurred, the Company does not believe such actions will have any material impact on its operations. There can be no assurance that state and local authorities will not commence regulatory action which could restrict the permissible scope of the Company's product advertising claims or products that can be sold in the future.

regulations is generally the responsibility of the Company's distributors for those countries. These distributors are independent contractors over whom the Company has limited control.

The Company manufactures certain products pursuant to contracts with customers who distribute the products under their own or other trademarks. Such private label customers are subject to government regulations in connection with their purchase, marketing, distribution and sale of such products. The Company is subject to government regulations in connection with its manufacture, packaging and labeling of such products. However, the Company's private label customers are independent companies, and their labeling, marketing and distribution of such products is beyond the Company's control. The failure of these customers to comply with applicable laws or regulations could have a material adverse effect on the Company's business, financial condition and results of operations. The Company many be named in legal proceedings directed at the independent companies' sales and liability creating activities.

The Company may be subject to additional laws or regulations by the FDA or other federal, state, county, local or foreign regulatory authorities, the repeal of laws or regulations which the Company considers favorable, such as the Dietary Supplement Health and Education Act of 1994, or more stringent interpretations of current laws or regulations, from time to time in the future. The Company is unable to predict the nature of such future laws, regulations, interpretations or applications, nor can it predict what effect additional governmental regulations, legal proceedings or administrative orders, when and if promulgated or initiated would have on its business in the future. They could, however, require the reformulation of certain products to meet new standards, the recall or discontinuance of certain products not able to be reformulated, imposition of additional record keeping requirements, expanded documentation of the properties of certain products, expanded or different labeling and scientific substantiation. Any or all of such requirements could have a material adverse affect on the Company's business, financial condition and results of operations.

As of March 1, 2004, the Company had approximately 268 employees. Of such employees, approximately 54 were engaged in marketing and sales, 172 were devoted to production and distribution and 42 were responsible for management and administration. None of the Company's employees is covered by a collective bargaining agreement. The Company considers its relations with its employees to be good.

The Company's ability to predict results or the effect of certain events on the Company's operating results is inherently uncertain. Therefore, the Company wishes to caution each reader of this report to carefully consider the following factors and certain other factors discussed herein and in other past filings with the Securities and Exchange Commission.

Factors that could cause or contribute to the Company's actual results differing materially from those discussed herein and in any forward looking statement or for the price of the Company's Common Stock to be affected adversely include but are not limited to:

Industry trends. The total United States retail market for nutritional supplements is highly fragmented. Industry sources report that the VMHS sector grew substantially during most of the 1990s, in many years at a double digit pace. However, the data during the last several years shows the rate of growth in the industry is currently in the low single digit growth range.

Information Resources, Inc. ("IRI") tracks sales data within the food, drug, and mass-market channels of distribution. This tracking does not include Wal-mart sales which are a significant portion of this sector. For the year ending 2003, VMS sales as tracked by IRI increased 5%. For the 52 weeks ending March 3, 2003, vitamin, mineral and supplement sales in these channels of distribution rose 0.2% when compared to the same period a year earlier. However unit sales were down 1.2%.

Private label business has been a significant growth element within the VMHS industry. The growth of private label sales impacts the sales of branded products such as those distributed by Natrol. Private label sales are, to an ever greater degree, being emphasized by large mass-market retailers. As such, the growth of brands such as Natrol, Laci LeBeau, and Prolab within food, drug, and general mass-market merchants remains both highly competitive and uncertain.

In addition to the trends in the nutraceutical industry, the United States economy has experienced significant fluctuations over the last few years, in part due to uncertainty over foreign events, terrorist's activities, the war with Iraq, unemployment and job creation in the United States and swings in overall consumer confidence. A sluggish economy inevitably impacts Natrol as well as the entire vitamin, mineral and supplement sector.

Competition. The dietary supplement industry is highly competitive. Numerous companies, many of which have greater size and financial, personnel, distribution and other resources than the Company, compete with the Company in the development, manufacture and marketing of dietary supplements. The Company's principal competition in the health food store distribution channel comes from a limited number of large nationally known manufacturers and many smaller manufacturers of dietary supplements. In the mass-market distribution channel, the Company's principal competition comes from broadline manufacturers, major private label manufacturers and other companies. In addition, large pharmaceutical companies compete with the Company and others in the dietary supplement industry. Packaged food and beverage companies compete with the Company on a limited basis in the dietary supplement market. Increased competition from such companies could have a material adverse effect on the Company because such companies have greater financial and other resources available to them and possess manufacturing, distribution and marketing capabilities far greater than those of the Company. The Company also faces competition in both the health food store and mass-market distribution channels from private label dietary supplements and multivitamins offered by health and natural food store chains, drugstore chains, mass merchandisers and supermarket chains. Private label brands at mass-market chains represent substantial sources of income for these merchants and the mass-market merchants often support their own labels at the expense of other brands.

Effect of Unfavorable Publicity. The Company believes the dietary supplement market is significantly affected by national media attention regarding the consumption of dietary supplements.

Future scientific research or publicity may not be favorable to the dietary supplement industry or to any particular product or ingredient and may not be consistent with earlier favorable research or publicity. Because of the Company's dependence on consumers' perceptions, adverse publicity associated with illness or other adverse effects resulting from the consumption of the Company's products or ingredients or any similar products distributed by other companies and future reports of research that are perceived as less favorable or that question earlier research could have a material adverse effect on the Company's business, financial condition and results of operations. The Company is highly dependent upon consumers' perceptions of the safety and quality of its products as well as dietary supplements distributed by other companies. Thus, the mere publication of reports asserting that such products may be harmful or questioning their efficacy could have a material adverse effect on the Company's business, financial condition and results of operations, regardless of whether such reports are scientifically supported or whether the claimed harmful effects would be present at the dosages recommended for such products. For example, during 2002, ephedrine products were routinely criticized in the press due to high profile athlete deaths that the press assumed or reported were related to ephedrine. The result of the extremely negative publicity surrounding ephedrine was that even before the FDA or other regulatory agencies had made any decisions on the safety or efficacy of ephedrine, product liability insurance coverage for ephedrine based products disappeared and as a result companies were forced to either abandon the sale of ephedrine products or to sell such products with no liability coverage in force. As a practical matter, the lack of available insurance made selling ephedrine impossible for most manufacturers since larger retailers will not sell a product that is not insurable.

The National Advertising Division of the Better Business Bureau (NAD) is a nonprofit organization that investigates advertising claims. Its proceedings are non-binding. However, results of its investigations may be publicized in the media. The company and other vitamin and supplement companies from time to tome are the subject of such investigations. Currently, the company has been notified of suggested changes to advertising regarding one of company's diet products that neutralizes carbohydrates.

There is no guarantee that unfavorable publicity will not have a similar negative effect on other products in the future. This may be the case regardless of whether or not the negative publicity is warranted to any degree.

Reduced Product Liability Insurance Coverage and Exposure to Product Liability Claims. The Company, like other retailers, distributors and manufacturers of products designed for human consumption, faces an inherent risk of exposure to product liability claims in the event that the use of its products results in injury. The Company may be subjected to various product liability claims, including, among others, that its products include inadequate instructions for use or inadequate warnings concerning possible side effects and interactions with other substances. In addition, although the Company maintains strict quality controls and procedures, including the quarantine and testing of raw materials and qualitative and quantitative testing of selected finished products, there can be no assurance that the Company's products will not contain contaminated substances. In addition, in certain cases, the Company relies on third party manufacturers for its products. With respect to product liability claims, the Company self-insures. The company formerly maintained occurrence based insurance coverage. However, such coverage became unavailable during the Company's renewal period in 2002. The cost of limited claims made coverage with high deductibles rose to such an extent, that the Company chose to self-insure as of July 2003. The company deposited $5.0 million for a five-year policy term with an insurance carrier who provides certificates of insurance to the Company's vendors. The $5.0 million earns interest and is classified as an non-current asset entitled "Restricted Cash" on the accompanying December 31, 2003 consolidated balance sheet. The $5 million is fully refundable to the Company should it decide to end the self-insurance program at the end of the policy term.

There can be no assurance that insurance will, in future years, be available at a reasonable cost or available with limits that meet the requirements of the Company's current customer base, or, if available, will be adequate to cover liabilities or that any insurance carrier will be willing to continue assisting the Company with its self insurance program in future years.

In order to limit its exposure to lawsuits, the Company generally seeks to obtain contractual indemnification from parties supplying raw materials for its products or manufacturing or marketing its products, and to be added as an additional insured under such parties' insurance policies. Any such indemnification or insurance, however, is limited by its terms and any such indemnification, as a practical matter, is limited to the creditworthiness of the indemnifying party. In the event that the Company does not have adequate insurance or contractual indemnification, product liabilities relating to its products or contract manufacturing activities could have a material adverse effect on the Company's business, financial condition and results of operations.

Dependence on New Products. The Company believes growth of its net sales is substantially dependent upon its ability to introduce new products. The Company seeks to introduce additional products each year. The success of new products is dependent upon a number of factors, including the Company's ability to develop products that will appeal to consumers and respond to market trends in a timely manner. There can be no assurance that the Company's efforts to develop new products will be successful or that consumers will accept the Company's new products. New products can often take substantial periods of time to develop consumer awareness, consumer acceptance and sales volume. Some new products fail and as a result have to be discontinued. In addition, products currently experiencing strong popularity and rapid growth may not maintain their sales volumes over time.

Product Returns. Product returns are a part of the Company's business. Products may be returned for various reasons including expiration dates or lack of sufficient sales velocity. The Company accrues allowances for returns based on historical data and future expectations. During 2003, returns and charges for damages and outdated products amounted to approximately 4.7% of gross sales, less than the 8.7% figure for 2002. The Company continually works to lessen the impact of returns through better management of its SKU count at retail establishments and more effective use of sales and marketing programs. Even so, there is no guarantee that future returns will not equal or exceed the levels experienced in prior years when returns amounted to as much as 14.5% of gross shipments. Furthermore, the loss of a major account could result in a substantial amount of returns.

Inventory Risk. The Company's products are tested for stability and each product has associated with it an expiration date after which the product cannot be sold. Expiration dates can be as short as months or, in some cases as long as three years or four years. In order to provide the freshest product possible, the Company makes every attempt to produce a product on a just-in-time basis. However, as sales trends change it is possible for the Company to over-produce finished goods inventory or have excess raw materials which are not used before their expiration dates. The Company regularly disposes of overstocked finished goods and expired raw material inventory. Should sales trends change too rapidly or should manufacturing planning be poor, the Company could be subject to larger than normal expenses for writing off inventory which would effect the financial condition of the Company and results of operations during the period in which larger than expected write downs of inventory were to occur.

The Company closely monitors its inventory, performing daily cycle counts. In addition, the Company regularly reviews its inventory, the velocity of sales, and raw material and component usage relative to inventory, in an effort to ensure that on hand inventory is good and usable and that potentially unusable inventory is adequately reserved.

Distribution Gains. One of the Company's primary goals has been to gain additional distribution in the various channels of trade that sell vitamins and supplements to consumers. The Company

continues to seek additional avenues to sell its products as well as to gain additional distribution for profitable and rapidly selling products in its existing accounts. The Company's failure to make addition distribution gains or to maintain current distribution and expand sales of core products could have an adverse material effect on the Company's business, financial condition and results of operations.

Cost of Retail Relationships. Many large retailers require various forms of incentive programs in order to develop branded sales with them. These programs include slotting fees, coop advertising programs, rebate incentives, price off promotions, scandowns and other forms of support. The Company must continually evaluate specific programs to ascertain the profitability of potential business from each retailer. Because of such brand based programs, the Company may ascertain that it cannot profitably do business with a retailer. This may cause the Company to stop doing business with existing customers or not allow the Company to enter into a business relationship with a potential new customer, each of which in turn could dampen future revenue growth. In 2003, the Company approximately 10.5% of the revenue from gross shipments was allocated to such support programs.

Government Regulation. The manufacture, packaging, labeling, advertising, promotion, distribution and sale of the Company's products are subject to regulation by numerous governmental agencies which regulate the Company's products. The Company's products are also subject to regulation by, among other regulatory entities, the CPSC, the USDA, the EPA and the United States FDA. Advertising and other forms of promotion and methods of marketing of the Company's products are subject to regulation by the FTC which regulates these activities under the FTCA. The manufacture, labeling and advertising of the Company's products are also regulated by various state and local agencies as well as those of each foreign country to which the Company distributes its products.

The Company's products are generally regulated as dietary supplements under the FDCA, and are, therefore, not subject to pre-market approval by the FDA. However, these products are subject to extensive regulation by the FDA relating to adulteration and misbranding. For instance, the Company is responsible for ensuring that all dietary ingredients in a supplement are safe, and must notify the FDA in advance of putting a product containing a new dietary ingredient (i.e., an ingredient not marketed for use as a supplement before October 15, 1994) on the market and furnish adequate information to provide reasonable assurance of the ingredient's safety. Furthermore, if the Company makes statements about the supplement's effects on the structure or function of the body, the Company must, among other things, have substantiation that the statements are truthful and not misleading. In addition, the Company's product labels must bear proper ingredient and nutritional labeling and the Company's supplements must be manufactured in accordance with current GMPs for foods. The FDA has issued an advanced notice of its intention to promulgate new GMPs which, when finally adopted may be more expensive to follow than prior GMPs. A product can be removed from the market if it is shown to pose a significant or unreasonable risk of illness or injury. Moreover, if the FDA determines that the "intended use" of any of the Company's products is for the diagnosis, cure, mitigation, treatment or prevention of disease, the product would meet the definition of a drug and would require pre-market approval of safety and effectiveness prior to its manufacture and distribution. Failure of the Company to comply with applicable FDA regulatory requirements may result in, among other things, injunctions, product withdrawals, recalls, product seizures, fines and criminal prosecutions.

The Company's advertising of its dietary supplement products is subject to regulation by the FTC under the FTCA. Section 5 of the FTCA prohibits unfair methods of competition and unfair or deceptive acts or practices in or affecting commerce. Section 12 of the FTCA provides that the dissemination or the causing to be disseminated of any false advertisement pertaining to, among other things, drugs or foods, which includes dietary supplements, is an unfair or deceptive act or practice. Under the FTC's "substantiation doctrine," an advertiser is required to have a "reasonable basis" for all product claims at the time the claims are first used in advertising or other promotions. Failure to adequately substantiate claims may be considered either as a deceptive or unfair practice. Pursuant to this FTC requirement, the Company is required to have adequate substantiation for all advertising

claims made about its products. The type of substantiation will be dependent upon the product claims made. For example, a health claim normally would require competent and reliable scientific evidence, while a taste claim would require only survey evidence.

In recent years the FTC has initiated numerous investigations of dietary supplement and weight loss products and companies. On November 18, 1998, the FTC issued "Dietary Supplements: An Advertising Guide for Industry." This guide provides marketers of dietary supplements with guidelines on applying FTC law to dietary supplement advertising. It includes examples of the principles that should be used when interpreting and substantiating dietary supplement advertising. Although the guide provides additional explanation, it does not substantively change the FTC's existing policy that all supplement marketers have an obligation to ensure that claims are presented truthfully and to verify the adequacy of the support behind such claims. The Company's internal staff, in conjunction with outside counsel, reviews its advertising claims.

The Company is not currently a party to any investigation, consent order or other decree of the FTC. The Company may be subject to investigation by the FTC in the future. If the FTC has reason to believe the law is being violated (e.g., the Company does not possess adequate substantiation for product claims), it can initiate enforcement action. The FTC has a variety of processes and remedies available to it for enforcement, both administratively and judicially, including compulsory process authority, cease and desist orders and injunctions. FTC enforcement could result in orders requiring, among other things, limits on advertising, consumer redress, divestiture of assets, rescission of contracts and such other relief as may be deemed necessary. Violation of such orders could result in substantial financial or other penalties. Any such action by the FTC could materially adversely affect the Company's ability to successfully market its products.

The Company manufactures certain products pursuant to contracts with customers who distribute the products under their own or other trademarks. Such private label customers are subject to government regulations in connection with their purchase, marketing, distribution and sale of such products, and the Company is subject to government regulations in connection with its manufacture, packaging and labeling of such products. However, the Company's private label customers are independent companies, and their labeling, marketing and distribution of such products is beyond the Company's control. The failure of these customers to comply with applicable laws or regulations could have a material adverse effect on the Company's business, financial condition and results of operations.

Governmental regulations in foreign countries where the Company plans to commence or expand sales may prevent or delay entry into the market or prevent or delay the introduction, or require the reformulation, of certain of the Company's products. Compliance with such foreign governmental regulations is generally the responsibility of the Company's distributors in those countries. These distributors are independent contractors over whom the Company has limited control.

The Company may be subject to additional laws or regulations by the FDA or other federal, state or foreign regulatory authorities, the repeal of laws or regulations which the Company considers favorable, such as the DSHEA of 1994, or more stringent interpretations of current laws or regulations, from time to time in the future. The Company is unable to predict the nature of such future laws, regulations, interpretations or applications, nor can it predict what effect additional governmental regulations or administrative orders, when and if promulgated, would have on its business in the future. They could, however, require the reformulation of certain products to meet new standards, the recall or discontinuance of certain products that cannot be reformulated, imposition of additional record keeping requirements, expanded documentation of the properties of certain products, or expanded or different labeling or scientific substantiation. Any or all of these requirements could have a material adverse effect on the Company's business, financial condition and results of operations.

Dependence on Significant Customers. No major customer during 2003 represented 10% of net sales. The Company's top 10 customers accounted for approximately 47.3% of the Company's business.

There is no assurance that the Company's major customers will continue as major customers of the Company. The loss of a significant number of major customers, or a significant reduction in purchase volume by or financial difficulty of such customer, for any reason, could have a material adverse effect on the Company's business, financial condition and results of operations.

Dependence on Key Personnel. The Company believes that its continued success depends to a significant extent on the management and other skills of Elliott Balbert, the Company's Chairman, Chief Executive Officer and President, and its senior management team, as well as its ability to attract and retain other skilled personnel. All of the members of the Company's management team are employees-at-will and no executive is subject to an employment contract. The Company's employees are not covered by a non-competition agreement. The loss or unavailability of the services of Mr. Balbert or the other members of the Company's senior management team or the inability to attract other skilled personnel could have a material adverse effect on the Company's business, financial condition and results of operations.

Ability to Manage Business Fluctuations. In reaction to past industry trends and the Company's financial performance, the Company has worked to manage expenses such as payroll and advertising in order to ensure the profitability of the Company. Such restrictions on expenditures may have a long-term effect on revenue growth. Should industry and general economic trends for the nation as a whole be difficult, the Company may have to reduce payroll as well as other forms of overhead and fixed expenses. Such cutbacks could further affect, in a negative manner, the Company's ability to increase revenues and profits.

Additionally, should national economic trends deteriorate, the Company may not be able to reduce expenses as rapidly as is necessary to maintain profitability. If corporate or industry trends strengthen in a strong, positive way resulting in sudden growth of the Company's revenues, the Company's management, operations, sales and administrative personnel and other resources may be strained in the short term. Attracting, training, motivating, managing and retaining qualified employees may be difficult in the short term. No assurance can be given that the Company's business will grow in the future or that the Company will be able to effectively manage such growth. Nor can assurance be given that if the Company's core business erodes, the Company can stabilize its revenue and manage the Company profitably in the short term. The Company's inability to manage its growth or negative growth successfully could have a material adverse effect on the Company's business, financial condition and results of operations.

Furthermore, the Company may have to substantially alter its business strategy to grow the business. During 2002 and 2003, the Company invested approximately $3 million, including operating losses, in an effort to grow revenue and profits by entering new marketplaces, namely multi-level marketing through an investment in Annasa as well as direct marketing through an investment in personnel to manage a direct marketing business. Both efforts have ceased due to a lack of positive financial performance. The Company is constantly looking for opportunities to broaden distribution into additional markets. There is no guarantee that the Company's efforts will succeed.

Risks Associated with Acquisitions. The Company completed one acquisition in 1999, two acquisitions in 1998, and, although no acquisitions were completed since, the Company expects to pursue additional acquisitions and new business opportunities in the future as a part of its business strategy. The Company faces significant competition for acquisition opportunities from numerous companies, many of which have greater financial resources than the Company. Accordingly, there can be no assurance that attractive acquisition opportunities will be available to the Company. Should an acquisition opportunity arise, the Company would have to seek outside funding to support such an acquisition. There is no guarantee that the Company would be able to obtain financing for or otherwise consummate any future acquisitions even if management believes such an acquisition would be beneficial to the Company. Moreover, future acquisitions would likely require additional financing

which would likely result in an increase in the Company's indebtedness or the issuance of additional stock which may be dilutive to the Company's shareholders. Acquisitions involve numerous risks, including the risk that the acquired business will not perform in accordance with expectations, difficulties in the integration of the operations and products of the acquired businesses with those of the Company, the diversion of the management's attention from other aspects of the Company's business, the risks associated with entering geographic and product markets in which the Company has limited or no direct prior experience and the potential loss of key employees of the acquired business. The acquisition of another business can also subject the Company to liabilities and claims arising out of such business. As a general rule, the Company will publicly announce acquisitions only after a definitive agreement has been signed.

The Company has faced all of these challenges with its acquisitions, in particular its acquisition of Prolab in October 1999. In 2001, the Company recorded a charge of $20 million as a result of the impairment of the goodwill resulting from the purchase of Prolab.

In past years, Prolab operated as an independent operating unit with a headquarters facility located in Bloomfield, Ct. While functioning as an independent operating unit, Prolab consistently incurred operating losses. Operating losses were $937,000, and $22.0 million in 2002, respectively. Operating losses in 2001 included a $20 million impairment charge.

During 2003, the Company integrated Prolab into the core Natrol business with Prolab becoming a brand within Natrol similar to Laci Le Beau. This consolidation was completed at the end of the third quarter of 2003 and as of the fourth quarter of 2003, the Company no longer reports Prolab as a separate operating segment. As of the completion of the consolidation, all management and administration for Prolab was consolidated into the Company's Natrol headquarters in Chatsworth, California and the only functions remaining in Bloomfield, Ct. are warehousing and distribution.

The Company's expectation is that Prolab, operating as a brand rather than an as an operating, will contribute to operating income. While the Company continues to believe that Prolab's business is an important part of the Company's product mix, there can be no guarantee that Prolab sales will increase or increase at satisfactory rates.

Regardless of the potential problems surrounding a potential acquisition, the Company regularly evaluates potential acquisitions of other businesses, products and product lines and may hold discussions regarding such potential acquisitions.

Absence of Conclusive Clinical Studies. Although many of the ingredients in the Company's products are vitamins, minerals, herbs and other substances for which there is a long history of human consumption, some of the Company's products contain ingredients with more recent history of use and effects. Accordingly, the Company's products, even when used as directed, are evaluated to identify any harmful side effects. Any such unintended and unconnected effects may result in adverse publicity or product liability claims which could have a material adverse effect on the Company's business, financial condition and results of operations.

Risks Associated with Supply of Raw Materials. The Company obtains all of its raw materials for the manufacture of its products from third-party suppliers. Many of the raw materials used in the Company's products are harvested internationally. With the exception of bulk garlic and arabinogalactan, the Company does not have contracts with any suppliers committing such suppliers to provide the materials required for the production of its products. During the last decade, coenzyme Q10, natural vitamin E, beta carotene and melatonin have had significant price fluctuations as a result of short supply and/ or increases in demand. The Company has experienced occasional shortages of raw materials for a limited number of its products. There can be no assurance that suppliers, including suppliers of bulk garlic, arabinogalactan and Ester-C®, will provide the raw materials needed by the Company in the quantities requested or at a price the Company is willing pay.

Because the Company does not control the actual production of these raw materials, it is also subject to delays caused by interruption in production of materials based on conditions not within its control. Such conditions include job actions or strikes by employees of suppliers, weather, crop conditions, transportation interruptions and natural disasters or other catastrophic events.. As a result, any shortage of raw materials from that supplier would adversely affect the Company's ability to manufacture that product. Price increases from such suppliers would directly affect the Company's profitability should the Company be unable to pass such price increases on to its direct customers. The inability of the Company to obtain adequate supplies of raw materials for its products at favorable prices, or at all, could have a material adverse effect on the Company's business, financial condition and results of operations. The Company purchases goods from a variety of vendors. One vendor accounted for more than 10% of the Company's purchases of raw material in 2003. The loss of this vendor could have a material impact on the Company's ability to source raw material and manufacture finished product associated with the raw materials supplied by this vendor. The result could be a material and adverse effect on the Company's profitability.

Sales and Earnings Volatility. The Company's sales and earnings continue to be subject to volatility based upon, among other things: (i) trends and general conditions in the dietary supplement industry and the ability of the Company to recognize such trends and effectively introduce and market new products in response to such trends; (ii) the introduction of new products by the Company or its competitors; (iii) the loss of one or more significant customers; (iv) increased media attention on the use and efficacy of dietary supplements; (v) consumers' perceptions of the products and operations of the Company or its competitors; (vi) the availability of raw materials from suppliers; and, (vii) the Company's ability to accurately predict inventory needs so that it does not overstock items which eventually must be written off due to low demand, or, that it fails to stock enough of an item so that sales are not lost due to lack of supply. Sales and earnings volatility as a result of the foregoing factors may affect the Company's operating results from period to period which may adversely affect the market price of the Common Stock.

Possible Volatility of Stock Price. There can be no assurance that an active market in the Company's stock will be sustained. The trading price of the Common Stock has historically been subject to wide fluctuations and daily trading volume is currently relatively low.

The price of the Common Stock may fluctuate in the future in response to quarter-to-quarter variations in the Company's operating results, material announcements by the Company or its competitors, governmental regulatory action, conditions in the dietary supplement industry, or other events or factors, many of which are beyond the Company's control. In addition, the stock market has historically experienced significant price and volume fluctuations which have particularly affected the market prices of many dietary supplement companies and which have, in certain cases, not had a strong correlation to the operating performance of such companies. In addition, the Company's operating results in future quarters may be below the expectations of securities analysts and investors. In such event, the price of the Common Stock would likely decline, perhaps substantially.

Risks Associated with Manufacturing. The Company's results of operations are dependent upon the continued operation of its manufacturing facility in Chatsworth, California at its current levels. The operation of dietary supplement manufacturing plants involves many risks, including the breakdown, failure or substandard performance of equipment, natural and other disasters, and the need to comply

with the requirements of directives of government agencies, including the FDA. In particular, the Company's manufacturing facility is located in Southern California, a geographic area that has historically been prone to earthquakes, which in some cases have been catastrophic. Prior to the Company's build-out of the building in which its manufacturing facility is located, the building was severely damaged in a major earthquake on January 17, 1994, the epicenter of which was within five miles of the building. Although the building was rebuilt with an enhanced ability to withstand earthquakes and conforms to current local and state code requirements, the Company's manufacturing facility could be damaged or destroyed in the event of an earthquake. Any such damage or destruction would have a material adverse effect on the Company's business, financial condition and results of operations. The Company does not carry earthquake insurance on its facilities. In addition, the Company's softgel and liquid products, the Laci Le Beau tea products as well as all of Prolab's non-tablet and capsule products which make up a majority of Prolab's business are manufactured by third party contractors. The Company's profit margins on these products and its ability to deliver these products on a timely basis are dependent upon the ability of the outside manufacturers to continue to supply products that meet the Company's quality standards in a timely and cost-efficient manner. The occurrence of any of the foregoing or other material operational problems could have a material adverse effect on the Company's business, financial condition and results of operations during the period of such operational difficulties.

Reliance on Independent Brokers. The Company places significant reliance on a network of independent brokers to act as its first-line sales force to mass-market retailers. Although the Company employs management personnel, including regional sales managers, to closely monitor the brokers, such brokers are not employed or otherwise controlled by the Company and are generally free to conduct their business at their own discretion. Although these brokers enter into contracts with the Company, such contracts typically can be terminated upon 30 days notice by the Company or the independent broker.

Intellectual Property Protection. The Company's policy is to pursue registrations for all of the trademarks associated with its key products. The Company relies on common law trademark rights to protect its unregistered trademarks as well as its trade dress rights. Common law trademark rights generally are limited to the geographic area in which the trademark is actually used, while a United States federal registration of a trademark enables the registrant to stop the unauthorized use of the trademark by any third party anywhere in the United States. The Company intends to register its trademarks in certain foreign jurisdictions where the Company's products are sold. However, the protection available, if any, in such jurisdictions may not be as extensive as the protection available to the Company in the United States.

Currently, the Company has few patents on its products and no material business is derived from those items that are patented. To the extent the Company does not have patents on its products, another company may replicate one or more of the Company's products.

Although the Company seeks to ensure that it does not infringe the intellectual property rights of others, there can be no assurance that third parties will not assert intellectual property infringement claims against the Company.

Risk Associated with Large Controlling Shareholders. Natrol's public float is relatively small, consisting of less than 30% of the Company's issued shares. More than 70% of the Company's stock is owned by three large shareholders. The decision by any one of these shareholders to sell their interest in the Company could materially and adversely affect the Company's share price.

Risk Associated with National Trends. Natrol sells its products nationally in several channels of distribution. As such, the Company is not immune from trends in the national economy. Negative employment or other economic trends directly affects the average consumer's purchasing ability which

in turn can affect Natrol sales. Uncertainty due to the world events such as the war in the Middle East can affect the general willingness of consumers to spend on any item, including Natrol products, that the consumer may not feel is essential. National economic trends affect Natrol's customers. Should any one of Natrol's national customers fail due to national trends, their failure could have a direct impact on the success of the Natrol business.

Continued Acceptance of Natrol Products. The Company works assiduously to continually burnish the brand image of its products. Even so, negative events, negative publicity about supplements in particular or in general, and other factors could lead to a future lack of acceptance of the Company's products. Such events or publicity may not be related to the Company itself. Even so such events or other factors could reduce demand for Natrol products.

Availability of Capital. Natrol's debt is currently limited to mortgage debt associated with its property. Should the Company need to borrow, the cost of capital may be high. Traditional debt financing may be unavailable and the Company may have to seek alternative sources of financing, including the issuance of new shares of stock or preferential stock that could dilute current shareholders.

Risk of Litigation from Private Attorneys General. Advertising and labeling for dietary supplements and conventional foods are, in addition to the federal government, regulated by state, county and local authorities. Some states also permit these laws to be enforced by Private Attorneys General. These Private Attorneys Generals may seek relief for consumers, seek class action certifications, seek class wide damages and product recalls of products sold by the Company. In the ordinary course of business, the Company is named as a defendant in these types of State Attorneys and Private Attorneys General Actions along with other vitamin and supplement companies. Until the courts rule that laws have been violated, that the actions can proceed as Private Attorneys General Class Actions and that the cognizable injury has occurred, the Company does not believe such actions will have any material impact on its operations. There can be no assurance that State, County or Local Regulatory Authorities will not commence regulatory or legal proceedings which could restrict the permissible scope of the Company's product claims or the ability to sell its products in the future.

The Company owns its 90,000 square foot manufacturing, distribution and office facility in Chatsworth, California. The Company has occupied this facility since March 1997. The facility was designed and constructed to the Company's specifications and includes areas for receiving, quarantine of new materials, manufacture, quality control and laboratory activities, research and development, packaging, warehousing and administrative offices.

The Company owns its 132,000 square foot warehouse facility. This facility is located within one-quarter mile of the Company's headquarters facility. The Company leases 52,000 sq. ft. of this space to a third party.

The Company also owns a 25,000 sq. ft. light manufacturing and warehouse facility which houses its Prolab shipping operations in Bloomfield, Connecticut.

From time to time, the Company is subject to litigation incidental to its business, including product liability claims, state agency actions, Private Attorneys General Actions and Class actions. Such claims, if successful, could exceed the $5 million retention under the Company's self-insurance program.

See Part III, Item 12, for a description of securities authorized for issuance under the Company's equity compensation plans.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Common Stock of the Company is traded on the NASDAQ National Market under the symbol "NTOL." On March 15, 2004, the last reported sales price of the Company's Common Stock as reported on the NASDAQ National Market was $3.45. As of March 15, 2004 there were 25 holders of record of the Company's Common Stock.

The high and low sales closing prices for the Common Stock as reported by the NASDAQ National Market for the years ended December 31, 2003 and 2002 are set below:

	Fiscal year ended December 31, 2003
	High		Low
Quarter ended March 31, 2003	$	1.49	$	1.05
Quarter ended June 30, 2003		2.37		1.40
Quarter ended September 30, 2003		3.49		2.18
Quarter ended December 31, 2003		3.18		2.40

	Fiscal year ended December 31, 2002
	High		Low
Quarter ended March 31, 2002	$	2.70	$	1.58
Quarter ended June 30, 2002		1.75		1.26
Quarter ended September 30, 2002		1.80		1.07
Quarter ended December 31, 2002		1.65		.96

The Company currently intends to retain earnings to finance its operations and future growth and does not anticipate paying dividends on its Common Stock in the foreseeable future. Under Delaware law, the Company is permitted to pay dividends only out of its surplus, or, if there is no surplus, out of its net profits.

The following selected financial data is derived from the audited consolidated financial statements of Natrol and its subsidiaries. The data set forth below should be read in conjunction with

"Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements of the Company and Notes thereto included herein.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of the results of operations and financial condition of the Company should be read in conjunction with the "Selected Consolidated Financial Data" and the audited Consolidated Financial Statements of the Company and the notes thereto included elsewhere in this document.

Natrol, Inc. and subsidiaries (collectively, the "Company") manufactures and markets branded, high-quality dietary supplement products, including vitamins, minerals, hormonal supplements, herbal products, specialty combination formulations and sports nutrition supplements. Prior to the fourth quarter of 2003, the Company operated three operating segments. The segments included: the Natrol operating segment, which manufactures and markets Natrol and Laci Le Beau branded products, and which, under the EPI name, contract manufactures products and sells raw material ingredients, and which under the Tamsol, Inc. subsidiary which was established in 2002 and discontinued in 2003 attempted to market Natrol products directly to consumers; Prolab Nutrition, Inc. ("Prolab"), which developed and marketed sports nutrition products; and Annasa, Inc. ("Annasa"), which was established in 2002 to develop a direct-to-consumer multi-level marketing business and which was discontinued in December 2003. Beginning in the fourth quarter of 2003, the Prolab operating segment was consolidated into the Natrol operating segment. With the Annasa segment discontinued, the Company currently has one operating segment. The Company also ceased reporting Prolab as an independent operating segment, beginning with the fourth quarter of 2003 (see discussion in Footnote 10 to the Consolidated Financial Statements).

In 2003, the Company had income before income taxes from continuing operations of $53,000. However during the nine months ended September 30, 2003 the Company's Prolab segment had net a loss before income taxes of $1.2 million. The Company consolidated its Prolab subsidiary into Natrol in order to reduce costs thereby improving the Prolab brand's contribution to the results of operations. Operating as a separate segment, Prolab consistently reported net losses. With Prolab operating as a brand similar to Laci Le Beau, Prolab's accounting, sales, marketing, and product development is managed by personnel within the Natrol headquarters organization thereby eliminating the need for independent Prolab departments in each of these areas.

The Company sells its core products under the Natrol brand name through multiple distribution channels throughout the United States, including domestic health food stores and mass-market drug, retail and grocery store chains. In addition to the core brand, Natrol sells herbal teas under the Laci Le Beau brand name within the same channels of trade as the Natrol core brand. The Company markets sports nutrition products under the Prolab brand name. Prolab products are sold primarily in health clubs and heath and fitness centers as well as the health food store channel of trade and internationally in select countries through international distributors.

During 2002, the Company launched a multi-level marketing company using the Annasa brand name. Annasa, had limited operations in 2002, with approximately $44,000 in revenue. The full launch of Annasa commenced in January 2003. The Company expected to continue to invest in Annasa during 2003. However, revenue, profit and cash flow projections failed to meet expectations and the Company discontinued Annasa's operations at the end of 2003, selling Annasa's intellectual property, formulations, and miscellaneous assets to an investment group made up primarily of former distributors. The Company received $35,000 for the intellectual property assets and received a commitment from the investor group to purchase Annasa's remaining inventory at cost.

Also in 2002, the Company established Tamsol, Inc. as a wholly owned subsidiary whose purpose was to market Natrol products directly to consumers. The Tamsol unit generated only $27,000 of revenue in 2002 and $30,000 in 2003 and was discontinued at year end 2003.

Natrol products are sold in most mass-market chain drug retail outlets such as Walgreens, Rite Aid, Walmart, Eckerd, CVS, most health food stores including Whole Foods Markets, Vitamin Cottage, Hi Health and Wild Oats and, to a more limited degree, grocery stores such as Kroger and Ralphs.

The Company is faced with substantial competition from other vendors and private label "house" brands which are strongly supported by the Company's largest mass-market customers. Private label business has been a significant growth element within the VMS industry. The growth of private label sales impacts the sales of branded products such as those distributed by Natrol. As noted above, private label sales are, to an ever greater degree, being emphasized by large mass-market retailers. As such, the growth of brands such as Natrol, Laci Le Beau, and Prolab within food, drug, and general mass-market merchants remains both highly competitive and uncertain.

In 2001 and 2002, the Company focused a large part of its efforts on analyzing the movement of its products within its key customers. A key goal was to reduce the high level of returns the Company was experiencing. Product returns are a recurring part of the Company's business. Products may be returned for various reasons including expiration dates or lack of sufficient sales velocity. During 2002, returns and reimbursements for damages and outdated products amounted to 8.7% of gross sales, a significant decrease from 2001, when returns represented approximately 14.5% of gross sales. The Company worked with its customers to eliminate slow moving and unprofitable items and to replace them with products that are in greater demand. In 2003, the comparable percentage improved to 4.7%.

In 2003, the Company also focused on strengthening its position within key retail accounts as well as in securing additional distribution for its core items at accounts that carried little or no Natrol, Laci Le Beau or Prolab items.

The consolidated financial statements of the Company are prepared in accordance with accounting principles generally accepted in the United States of America, which requires the Company to make certain estimates and assumptions affecting the reported amounts in the consolidated financial statements and accompanying notes. The Company bases its estimates on historical experience and on various other assumptions believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily

apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Management believes the following critical accounting policies, among others, affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.

Revenue Recognition. The Company sells its products to retail outlets through a direct sales force and a national distributor network. The Company recognizes revenue from sales only after product is shipped and title is transferred. Net sales represent product shipped less actual and estimated future returns, spoilage allowances, allowances for product deemed to be unsaleable by customers, free goods shipped to customers for promotional or other purposes and slotting fees. Estimates and allowances are based upon known claims and an estimate of additional returns, however, the amount of future returns can be reasonably estimated.

The Company's recognition of revenue from sales to distributors and retailers is impacted by agreements giving them rights to return damaged and outdated products as well as the fact that as a practical business matter, the Company and its customers are constantly working to ensure the profitability of its products within retailers by rotating slow moving items out of stores and replacing those products with what the Company and the retailer expect will be more profitable, faster selling items. The Company's obligation to accept returns of slow moving items may or may not be contractually bound.

The Company regularly monitors its historical patterns of returns from customers as well as current and ongoing sales to customers and, when information is available, consumer purchases of the Company's products from the Company's customers. When historical trends with respect to customer returns are quantifiable, the Company will create an allowance for future returns at the time sales are made. Should the Company determine that a particular product is slow moving and will eventually result in significant returns, it will provide for those returns at the time such an assessment is made.

In recent years, as a result of a combination of the factors described above, gross sales have been materially reduced to reflect the estimated amount of returns. It is also possible that returns could increase rapidly and significantly in the future. Accordingly, estimating product returns requires significant management judgment. In addition, different return estimates that we reasonably could have used would have had a material impact on our reported sales and thus have had a material impact on the presentation of our results of operations. For those reasons, we believe that the accounting estimate related to product returns is a "critical accounting estimate."

In preparing our financial statements, the total amount charged against sales for returns and damages and outdates in 2003, 2002 and 2001 respectively, was $4.0 million, $6.7 million, and $12.5 million. Our estimate for returns at December 31, 2003 was $0.4 million less than at December 31, 2002. Our estimate at December 31, 2002 was $0.6 million greater than our estimate at December 31, 2001. The decrease in the estimate of returns at December 31, 2003 is due in part to the $2.7 million decrease in actual returns in 2003.

Impairment of Goodwill. The determination as to whether goodwill is impaired requires a great deal of judgment. Prior to January 1, 2002, the Company evaluated goodwill for impairment whenever events or changes in circumstances indicated that the carrying value may not be recoverable. In 2001, the Company determined that it was appropriate to write down $20 million of goodwill associated with its Prolab reporting unit. The Company focused on Prolab's declining sales volume, issues surrounding Prolab's ephedrine-based products, the sports nutrition market as a whole, and cash flows. Based on all of these considerations, the Company deemed that in accordance with the then current accounting rules, a $20 million write down of goodwill was appropriate.

On January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 requires that goodwill not be amortized. In accordance with such adoption, the

Company identified all reporting units in conjunction with the provisions of SFAS No. 142 and allocated all goodwill accordingly. Beginning in 2002, goodwill is evaluated for impairment annually, or whenever events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. The Company tested goodwill for impairment using the two-step process prescribed in SFAS No.142. The first step is a screen for potential impairment, while the second step measures the amount of the impairment, if any. The Company performed the first step of the impairment test, and determined that the there was no impairment of the Prolab segment, but that there was potential impairment of the Natrol segment. The Company performed the second step as of January 1, 2002 for the Natrol segment and determined that its goodwill balance of $10,958,000 was impaired. The impairment loss was recorded as a cumulative effect of a change in accounting principle, net of income tax benefit of approximately $4.1 million, in the accompanying consolidated statement of operations for the year ended December 31, 2002.

The remaining goodwill balance at December 31, 2002 and 2003 was approximately $4.0 million. In the fourth quarter of 2003, the Company completed its annual goodwill impairment testing and does not believe that goodwill has been impaired. Additionally, during March 2004, the Company settled its litigation with the former owners of Prolab Nutrition, Inc. The Company received $2 million in cash, which will be reflected in the financial statements for the quarter ending March 31, 2004 as a reduction of goodwill. In accordance with the provisions of SFAS No. 142, the Company will, at a minimum, perform an annual impairment review of the goodwill.

Income Taxes. Deferred income tax assets have been established for future tax benefits related to deductible goodwill for which the Company has recorded an impairment charge and for certain other temporary items. The aggregate benefit of which is approximately $5.0 million. Realization of this benefit is dependent on generating sufficient taxable income in future periods. Although it is not assured, management believes it is more likely than not that the carrying value of this benefit will be realized. The amount of the benefit that is considered realizable, however, could change if estimates of future taxable income are adjusted in future periods.

Inventory. The Company monitors its inventory and analyzes it on a regular basis. Cycle counts are taken daily to verify inventory levels. In addition, the Company analyzes the movement of items within its inventory in an effort to determine the likelihood that inventory will be sold or used before expiration dates are reached. The Company provides an allowance against that portion of its inventory that it believes is unlikely to be sold or used before expiration dates are reached. At December 31, 2003, inventory allowances were approximately $1.3 million.

Net Sales. Net sales in 2003 increased 3.4%, or $2.4 million, to $72.7 million from $70.3 million in 2002. Net sales in 2003 were positively affected by a lower level of returns than in 2002. The level of returns was approximately 4.7% of gross shipments in 2003 and as compared to 8.7% of gross shipments in 2002. During 2002, the Company worked to "rationalize" its product offerings in the mass-market channel of trade where returns are most likely to occur. During 2001 it became apparent to the Company that sales of secondary and tertiary items in this channel of trade were not sufficient to prevent significant product returns. This rationalization process directly resulted in lower net revenue since the Company stopped selling many secondary and tertiary items within mass-market accounts. The Company limited the sale of these items to specialty stores where the volume of sales was sufficient to prevent a large volume of returns. As a result of this rationalization process, the level of returns was reduced substantially in both 2002 and 2003. The reduction in returns helped increase net revenue since returns reduce gross sales revenue when calculating net sales.

The Company did not have any products that represented 10% or more of its gross sales in either 2003 or 2002. No customer accounted for 10% or more of net sales in 2003. One customer, Walmart, accounted for 12.3% of the Company's net sales in 2002. The Company's top 10 customers accounted for approximately 47% and 44% of the Company's net sales in 2003 and 2002, respectively.

Gross Profit. Gross profit decreased $133,000, to $28.4 million, in 2003 as compared to $28.5 million in 2002. Gross margin decreased to 39.1% in 2003 from 40.6% in 2002. Product mix, increase in cost of materials, labor rates and an increase in quality assurance expenditures resulted in the decrease in gross margin.

Selling and Marketing Expenses. Selling and marketing expenses increased by 0.3% to 24.4% in 2003 from 24.1% of net sales in 2002. The dollar amount spent for sales and marketing expenses increased 4.6% or $786,000 in 2003, from $16.9 million in 2002 to $17.7 million in 2003. Of the $786,000 net increase in selling and marketing expenses, approximately $670,000 was due to the increased cost of shipping product and approximately $420,000 of payroll increases. These increases were partially offset by decreases in media spending and other forms of promotional support and well as decreases in other expenses.

General and Administrative Expenses. General and administrative expenses increased 15.1% or $1.3 million in 2003 from $8.7 million in 2002 to $10.1 million in 2003. Of this increase $179,000 was due to the establishment of a product development department in the fourth quarter of 2003. General insurance expenses increased $711,000 relative to 2002. In order to reduce these expenditures, the Company began to self-insure its product liability exposure in July of 2003 and it is expected that insurance expenses will be less in 2004 than in 2003. Depreciation expense was $131,000 higher in 2003 than in 2002, primarily because of the implementation of the Company's SAP software system in November 2002. The Company also accrued $226,000 more for bad debt expenses in 2003 than it did in 2002. The Company increased its allowances for bad debts due to the larger amount of receivables carried at year end 2003 than at year end 2002. The remainder of the increase in general and administrative expenses was due to increases in payroll partially offset by miscellaneous decreases in other expenditures.

Interest Income (Expense), net. Interest expense was $649,000 in 2003 versus interest expense of $731,000 in 2002. Interest income in 2003 was $54,000 versus $87,000 in 2002. Interest expense decreased in 2003 as the Company had less debt outstanding. Interest income decreased due to the level of interest rates as well as the average level of cash on hand earning interest.

Income Tax Provision (Benefit). Income taxes were $34,000 in 2003 as compared to $861,000 in 2002. The difference in income tax expense was primarily due to the differences in taxable income earned in 2003 versus 2002. The Company's tax rate in 2003 was 64.2% in 2003 versus 38.4% in 2002. The difference was due primarily to the fact that the some of the Company's expenses cannot be expensed for tax purposes. When earnings are at a low level, these permanent adjustments to taxable income have a proportionately greater effect on the company's tax rate than when total earnings are at a higher level.

In December 2003, the Company discontinued its Annasa and Tamsol units. Annasa, a subsidiary of Natrol, a multi-level marketer of proprietary nutritional products began operations in 2002. Tamsol, was also formed in 2002, to generate direct-to-consumer sales via radio, television, direct mail and other non retail venues. Annasa had revenue of $44,000 in 2002 and $667,000 in 2003. Operating losses for Annasa in 2002 were approximately $1.1 million and, were approximately $1.8 million in 2003. These losses were higher than anticipated and the Company discontinued the operations of Annasa at year-end 2003. During 2002, Tamsol had $27,000 of net revenue and a loss before income taxes of $41,000. During 2003, Tamsol failed to meet revenue or profit goals and its operations were discontinued during the fourth quarter of 2003. For the year ended December 31, 2003, Tamsol had net revenue of $30,000 and a loss before income taxes of $542,000. The Company has reclassified its financial statements to segregate the revenues, direct costs and expenses (excluding allocated costs), assets and liabilities and cash flows of the discontinued operations. The net operating results, net assets and net cash flows of these businesses have been reported as "Discontinued Operations" in the accompanying consolidated financial statements.

Net Sales. Net sales in 2002 decreased 2.2%, or $1.5 million, to $70.3 million from $71.8 million in 2001. Net sales in both years were adversely affected by a high level of product returns. The level of returns was approximately 8.7% of gross sales in 2002 and 14.5% of gross sales in 2001. During 2002, the Company worked to "rationalize" its product offerings in the mass-market channel of trade where returns are most likely to occur. During 2001 it became apparent to the Company that sales of secondary and tertiary items were not sufficient to prevent significant product returns. This rationalization process directly resulted in lower net revenue since the Company stopped selling many secondary and tertiary items within mass-market accounts, instead limiting the sale of these items to specialty stores where the volume of sales was sufficient to prevent a large volume of returns. As a result of this rationalization process, the level of returns was reduced substantially from that experienced in 2001.

The Company had no products greater than 10% of gross sales in 2002. The Company's gross sales of the MSM-line of joint care products comprised 10.1% in 2001. One customer, Walmart, accounted for 12.3% of the Company's net sales in 2002. No one customer accounted for more than 10% of net sales in 2001. The Company's top 10 customers accounted for approximately 44% of the Company's net sales in 2002 and 42% of net sales in 2001.

Gross Profit. Gross profit decreased 1.0% or $287,000, to $28.5 million, in 2002 as compared to $28.8 million in 2001. Gross margin increased to 40.6% in 2002 from 40.1% in 2001. The increase was mainly due to a change in the product mix.

Selling and Marketing Expenses. Selling and marketing expenses decreased 6.6% or approximately $1.2 million to $16.9 million in 2002 from $18.1 million in 2001. As a percentage of net sales, selling and marketing expenses decreased to 24.1% in 2002 from 25.2% of net sales in 2001. This reduction was primarily due to a decrease in the number of promotions and advertisements run during the year. The Company's selling and marketing expenses consist primarily of payroll and advertising in

traditional media as well as the promotion of its products through targeted and sampling programs created with individual retailers.

General and Administrative Expenses. General and administrative expenses decreased 10.3% or approximately $1.0 million in 2002 from $9.7 million in 2001 to $8.7 million in 2002. However, consistent with the adoption of SFAS No. 142, "Goodwill and Other Intangible Assets," the Company did not amortize goodwill in 2002. In 2001, the Company incurred $2.3 million of amortization expense related to goodwill, which was included as a component of general and administrative expenses ("G&A expenses"). Taking this factor into consideration, G&A expenses rose $1.3 million when compared to 2001. A majority, or $800,000 of the increase was due to legal expenses which increased largely due to the successful defense of label claims and a California Proposition 65 matter which the Company is resolving and believes will ultimately be resolved in its favor. Depreciation increased approximately $96,000 when compared to 2001. During 2002, the Company invested approximately $1.4 million in a new SAP software system as well as new servers and other peripheral equipment to run the software. SAP is an integrated manufacturing, accounting, and management system. The SAP system was put into service in November 2002. General business and product liability insurance expenses also rose $115,000 in 2002. The Company experienced an increase in the price of insurance in November 2002 as it sought to renew its policies. The price of certain types of insurance rose nearly five-fold while the amount of coverage offered within the policies was reduced sharply The remaining increase in G&A expenses in 2002 over 2001 was due to general increases in payroll and the other expenses of maintaining the Company's business.

Impairment of Goodwill. In 2001, the Company determined that it was appropriate to write down $20 million of goodwill associated with its Prolab reporting unit. The Company focused on Prolab's declining sales volume, issues surrounding Prolab's ephedrine-based products, the sports nutrition market as a whole, and undiscounted cash flows. Based on all of these considerations, the Company deemed that in accordance with the then current accounting rules, a $20 million write down of goodwill was appropriate.

On January 1, 2002, the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 requires that goodwill not be amortized. In accordance with such adoption, the Company identified all reporting units in conjunction with the provisions of SFAS No. 142 and allocated all goodwill accordingly. Beginning in 2002, goodwill is evaluated for impairment annually, or whenever events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. The Company tested goodwill for impairment using the two-step process prescribed in SFAS No.142. The first step is a screen for potential impairment, while the second step measures the amount of the impairment, if any. The Company performed the first step of the impairment test, and determined that the there was no impairment of the Prolab segment, but that there was potential impairment of the Natrol segment. The Company performed the second step as of January 1, 2002 for the Natrol segment and determined that its goodwill balance of $10,958,000 was impaired. The impairment loss was recorded as a cumulative effect of a change in accounting principle, net of income tax benefit of approximately $4.1 million, in the accompanying consolidated statement of operations for the year ended December 31, 2002.

Interest Income (Expense), net. Interest expense in 2002 was $731,000 versus interest expense of $885,000 in 2001. Interest income in 2002 was $87,000 versus $149,000 in 2001. Interest expense decreased in 2002 as the Company had less debt outstanding. In addition to the debt on its property, during part of 2001, the Company also paid interest on outstanding borrowings related to its line of credit.

Income Tax Provision (Benefit). Income tax expense was $861,000 in 2002, and the effective income tax rate was approximately 38.4%. In addition, the Company recorded an income tax benefit of $4,139,000 related to the cumulative effect of the change in an accounting principle (adoption of SFAS

No. 142, "Goodwill and Other Intangible Assets"). The Company also received an income tax benefit of $421,000 from discontinued operations in 2002. Although the Company had a pretax loss of $19,753,000 in 2001, income tax expense was $587,000, as the loss included a charge of $20 million related to non-deductible goodwill.

At December 31, 2003, the Company had working capital of $13.3 million, as compared to $18.7 million in working capital at December 31, 2002. During 2003, the Company deposited $5.0 million with an insurance company as part of the Company's self-insurance program. This restricted cash, is classified as a non-current asset in the accompanying consolidated balance sheet. The restricted cash earns interest a current rate of 1.65% per annum, and will be returned to the Company should the Company terminate the policy. The policy, which is cancelable by the Company, is effective through 2008.

Net cash used in operating activities was $2.2 million for the year ended December 31, 2003 versus net cash provided of $6.2 million in 2002 and $10.3 million in 2001. The use of cash in 2003, consisted of $1.5 million from discontinued operations, $1.9 million from changes in operating assets and liabilities, net of $1.2 million provided by non-cash charges. The primary uses from operating assets and liabilities were increases of $1.1 million in accounts receivable, $445,000 in inventory, a decrease of $1.6 million in accrued expenses offset by an increase in accounts payable of $1.2 The non-cash charges consisted primarily of 1.4 million of depreciation, an increase in bad debt allowance, net of an increase in net deferred income tax assets.

At December 31, 2003, the Company's days sales outstanding in its trade receivable was approximately 38 days versus 35 days in 2002 and 33 days in 2001.

Net cash used in investing activities was $5.4 million in 2003, $1.5 million in 2002 and $368,000 in 2001. In July 2003, the Company deposited $5 million with an insurance company as part of a self-insurance program. The Company earns 1.65% on the $5 million of restricted cash The policy period of the self-insurance program is five years. The Company elected to self insure upon completion of a retrospective review and analysis of cost, coverage, litigation asserted by insurers issuing standard general and product liability coverage, litigation expense and claims resolution history. The Company concluded that the use of traditional insurance did not limit the Company's exposure to advertising and regulatory claims which traditional coverage refused to cover, and that self-insurance would not increase the risk of claims arising out of the normal course of business. This program has reduced insurance premiums, based on actual payments made in 2002, by approximately $1.2 million on an annualized basis..

Nearly all of the cash used for investing activities in 2003, 2002 and 2001, with the exception of the insurance deposit made in 2003, was for the acquisition of property, plant and equipment. Substantially all of the investment in 2002 related to the installation of a new integrated SAP software system and related computer equipment to manage the Company's business.

Net cash provided by financing activities was $56,000 in 2003 versus net cash used of $161,000 in 2002 and $8.5 million for the year ended December 31, 2001.

During 2003, the company reduced its debt by $303,000. This use of cash was offset by $359,000 raised through the exercise of employee stock option or the sale of stock to employees through the Company's Employee Stock Purchase Program.

As of December 31, 2003, the Company had $7.8 million in outstanding debt versus $8.1 at the end of 2002. The outstanding debt in both periodsis related to a mortgage on the Company's manufacturing/headquarters facility and a mortgage on the Company's shipping facility.

The Company's cash balance at the close of 2003 was approximately $2.6 as opposed to $10.1 million at the end of 2002 and $5.5 million at the end of 2001.

During March 2004, the Company agreed to settle its litigation with the former owners of Prolab Nutrition, Inc. The Company received $2 million in cash which will be recorded as a reduction in goodwill.

The Company believes that its cash balance together with cash generated from operations and the $2 million Prolab settlement should be sufficient to fund its anticipated working capital needs and planned capital expenditures for the next 12 months. However, if the Company does not meet its operating plan it may also need additional borrowings to fund working capital needs.

The Company currently has no outstanding debt on its books other than the mortgage debt on its properties. Because the Company's debt is limited, the Company believes that financing for its fixed asset needs will be available at reasonable rates with reasonable terms. However, there is no guarantee that, should the Company need additional capital for capital expansion or for working capital, that financial institutions will be willing to provide capital to the Company. Also, in providing the Company with additional funds, potential lenders may seek to institute covenants restricting the Company from certain activities and if the Company deems it necessary to borrow funds with these restrictions in place, it may find that its ability to compete effectively in its market sector is hindered.

In order to meet its long-term liquidity needs, the Company may be required to incur additional indebtedness or issue additional equity and debt securities, subject to market and other conditions. There can be no assurance that such additional financing will be available on terms acceptable to the Company or at all. The failure to raise the funds necessary to finance its future cash requirements or consummate future acquisitions could adversely affect the Company's ability to pursue new acquisitions and could negatively affect its operations in future periods.

In 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 143, "Accounting for Asset Retirement Obligations." The impact of SFAS No. 143 is effective for years that began after June 15, 2002 The Company adopted SFAS No. 143 on January 1, 2003. The adoption of this standard did not have a material impact on the Company's consolidated financial position or results of operations.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activities be initially measured at fair value and recognized when the liability is incurred. The adoption of SFAS No. 146 did not have a material impact to the Company's financial position or results of operations.

During November 2002, the Financial Accounting Standards Board issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," which is an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34. The initial recognition and measurement provisions of this Interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, and the disclosure requirements are effective for financial statements of periods ending after December 15, 2002. This Interpretation addresses the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees, and also clarifies the requirements related to the recognition of a liability by a guarantor at the inception of a guarantee for the obligations the guarantor has undertaken in issuing that guarantee. The adoption of FASB Interpretation No. 45 did not any material impact on the Company's consolidated financial position or results of operations. The Company does not currently provide any third party guarantees.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation—Transition and Disclosure." This statement amends SFAS No. 123, to provide alternative methods of voluntary transition to change to the fair value based method of accounting for stock-based employee compensation. Additionally, this statement amends disclosure requirements of accounting for stock-based employee compensation and the effect of the method used on reporting results. As of December 31, 2002, the Company has adopted the disclosure requirements of SFAS No. 148, but has elected to continue to account for stock-based compensation to its employees and directors using the intrinsic value method proscribed by APB No. 25 and related interpretations.

In January 2003, the FASB issued FASB Interpretation No. ("FIN") 46, "Consolidation of Variable Interest Entities" ("FIN 46"). In December 2003, FIN 46 was replaced by FASB interpretation No. 46(R) "Consolidation of Variable Interest Entities." FIN 46(R) clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements," to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46(R) requires an enterprise to consolidate a variable interest entity if that enterprise will absorb a majority of the entity's expected losses, is entitled to receive a majority of the entity's expected residual returns, or both. FIN 46(R) is effective for entities being evaluated under FIN 46(R) for consolidation no later than the end of the first reporting period that ends after March 15, 2004. The Company does not currently have any variable interest entities that will be impacted by adoption of FIN 46(R).

On April 30, 2003, the Financial Accounting Standards Board issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. The new guidance amends SFAS No. 133 for decisions made as part of the Derivatives Implementation Group ("DIG") process that effectively required amendments to SFAS No. 133, and decisions made in connection with other FASB projects dealing with financial instruments and in connection with implementation issues raised in relation to the application of the definition of a derivative and characteristics of a derivative that contains financing components. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. Adoption of this standard did not have an impact on the Company's consolidated financial statements.

In May 2003, the FASB issued SFAS No. 150 Accounting for Financial Instruments with the Characteristics of Both Liabilities and Equities. SFAS No. 150 establishes standards regarding the manner in which an issuer classifies and measures certain types of financial instruments having characteristics of both liabilities and equity. Pursuant to SFAS No. 150, such freestanding financial instruments (i.e., those entered into separately from an entity's other financial instruments or equity transactions or that are legally detachable and separately exercisable) must be classified as liabilities or, in some cases, assets. In addition, SFAS No. 150 requires that financial instruments containing obligations to repurchase the issuing entity's equity shares and, under certain circumstances, obligations that are settled by delivery of the issuer's shares be classified as liabilities. Certain aspects of SFAS No. 150 have been deferred; however, the Statement is effective for financial instruments entered into or modified after May 31, 2003 and for other instruments at the beginning of the first interim period beginning after June 15, 2003. The Company does not currently have any financial instruments that have been impacted by SFAS No. 150. The adoption of SFAS No. 150 did not have a material impact on the Company's financial position or results of operations.

The following table discloses the Company's obligations and commitments to make future payments under contractual obligations at December 31, 2003 (Amounts in thousands).

Generally, inflation has not had a material impact on the Company's historical operations or profitability.

The Company's exposure to market risks is limited to interest rate risks. The risks related to foreign currency exchange rates are immaterial and the Company does not use derivative financial instruments.

If the Company seeks financing or borrows other funds, it may be subject to interest rate market risk associated with a variable rate line of credit or fixed rate long-term debt. Even so, the Company does not believe the risk associated with such borrowing is significant. Additionally, the Company does not believe that the risk is significant for its long-term debt due to the low fixed rates and relative insignificance of the fixed long-term debt to the Company's consolidated balance sheet. The Company's long-term debt is comprised of fixed rate notes collateralized by the Company's facilities. The table below presents principal cash flows and related interest rates by fiscal year of maturity.

		Expected Year of Maturity
		2004		2005		2006		2007		2008		Thereafter		Total		Fair Value December 31, 2003(1)
Notes payable(2)		$	325		$	353		$	382		$	414		$	448		$	5,854		$	7,776		$	8,438

We have audited the accompanying consolidated balance sheets of Natrol, Inc. and its subsidiaries (the "Company") as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders' equity, and cash flows for the years then ended. Our audits also included the financial statement schedule listed at the index in Item 15(a) as of and for the years ended December 31, 2003 and 2002. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule 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, such consolidated financial statements present fairly, in all material respects, the financial position of Natrol, Inc. and its subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for the years then ended. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein as of and for the years ended December 31, 2003 and 2002.

As discussed in Note 1 to the consolidated financial statements, effective January 1, 2002, the Company changed its method of accounting for goodwill and other intangible assets to conform to Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets."

We have audited the accompanying consolidated statements of operations, stockholders' equity and cash flows of Natrol, Inc. and subsidiaries for the year ended December 31, 2001. Our audit also included the financial statement schedule listed at the index in Item 15(a) as of and for the year ended December 31, 2001. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audit.

We conducted our audit in accordance with auditing standards generally accepted in the United States. 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 audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of operations, changes in stockholders' equity and cash flows of Natrol Inc. and subsidiaries for the year ended December 31, 2001, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein as of and for the year ended December 31, 2001.'

Natrol, Inc. and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share and per share data)

Natrol, Inc. and Subsidiaries

Consolidated Statements of Operations

(In thousands, except share and per share data)

Natrol, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity
(In thousands, except share data)

Natrol, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(In thousands)

In February 2001, the Company repurchased 296,000 shares of common stock for $554,000 from an officer of the Company in exchange for an outstanding note receivable due from the officer.

Natrol, Inc. and subsidiaries (collectively, the "Company") manufactures and markets branded, high-quality dietary supplement products under three branded labels, Natrol, Laci LeBeau and Prolab. The Company's core Natrol brand markets vitamins, minerals, hormonal supplements, herbal products, and specialty combination formulations. The Laci Le Beau brand sells specialty teas and the Prolab brand markets sports nutrition products to athletes and other health minded individuals. The Company sells its products through multiple channels of distribution that reach consumers through mass market retailers, health food stores, fitness centers, the internet, catalogues and other points of distribution.

The Company also sells raw materials and markets limited contract manufacturing through its Essentially Pure Ingredients division which operates within the Company's core operating unit.

The consolidated financial statements include the accounts and operations of Natrol, Inc. and its wholly owned subsidiaries. All significant intercompany accounts have been eliminated in consolidation.

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions affecting the reported amounts in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates, although management does not believe any differences would materially affect the Company's consolidated financial position or results of operations.

Certain reclassifications have been made to the prior years' financial statements to conform to the current year's presentation.

Product returns are a recurring part of the Company's business. Estimating product returns requires significant management judgment. Products may be returned for various reasons including expiration dates or lack of sufficient sales. During 2003, returns and reimbursements for damages and outdated products were 4.7% of gross sales, a significant decrease from 2002 when returns represented approximately 8.7% of gross sales and from 2001 when returns were 14.5% of gross sales. There is no guarantee that future returns will not increase to, or exceed, the levels experienced in 2002 or 2001. Furthermore, the possibility exists that should the Company lose a major account, the Company may agree to accept a substantial amount of returns.

The Company monitors its inventory and analyzes it on a regular basis. Cycle counts are taken daily to verify inventory levels. In addition, the Company analyzes the movement of items within its inventory in an effort to determine the likelihood that inventory will be sold or used before expiration dates are reached. The Company provides an allowance against that portion of its inventory that it believes is unlikely to be sold or used before expiration dates are reached. At December 31, 2003, inventory allowances were approximately $1.3 million.

The Company considers all highly liquid debt instruments with original maturity dates of three months or less when purchased to be cash equivalents. At December 31, 2003 and 2002, there were no cash equivalents.

Restricted cash represents cash that has been deposited with an insurance company as part of the Company's self-insurance program. The cash earns interest at a current rate of 1.65% per annum, and will be returned to the Company should the Company terminate the policy. The policy, which is cancelable by the Company, is effective through 2008.

Inventory is stated at the lower of cost (determined by the first-in, first-out method) or market.

Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets ranging from three-to-ten years for furniture, machinery and equipment. Buildings are depreciated over 40 years, and improvements are depreciated over periods ranging from five-to-forty years, using the straight-line method. Amortization of leasehold improvements is computed using the straight-line method over the shorter of the estimated useful lives of the assets or the lease terms.

The Company evaluates long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value.

Goodwill represents the excess of the purchase price over the estimated fair value of the net assets acquired and was being amortized, through December 31, 2001, on a straight-line basis over periods ranging from 15-to-20 years. In addition, prior to December 31, 2001, the Company evaluated goodwill for impairment whenever events or changes in circumstances indicated that the carrying value may not be recoverable. In 2001, the Company recorded a charge of $20 million to reduce goodwill during the fourth quarter of 2001, based on the amount by which the carrying amount of these assets exceeded their estimated fair value (see note 8).

In June 2001, the Financial Accounting Standards Board ("FASB") approved two new statements: Statement of Financial Accounting Standards ("SFAS") No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires business combinations entered into after June 30, 2001 to be accounted for using the purchase method of accounting. SFAS No. 142

requires that goodwill not be amortized, but be tested for impairment at least annually. The Company adopted SFAS No. 142 on January 1, 2002. In accordance with such adoption, the Company identified all reporting units in conjunction with the provisions of SFAS No. 142 and allocated all goodwill accordingly. Beginning in 2002, goodwill is evaluated for impairment annually as of December 31. The Company tested goodwill for impairment using the two-step process prescribed in SFAS No. 142. The first step is a screen for potential impairment, while the second step measures the amount of the impairment, if any. In 2002, the Company performed the first step of the impairment test and determined that the there was no impairment of the Prolab segment, but that there was potential impairment of the Natrol segment. The Company performed the second step as of December 31, 2002 for the Natrol segment and determined that its goodwill balance of $10,958,000 was impaired. The impairment loss was recorded as a cumulative effect of accounting change in the accompanying consolidated statement of operations for the year ended December 31, 2002. The changes in the carrying value of goodwill for the years ended December 31, 2002 and 2001 are as follows:

In accordance with the adoption of SFAS No. 142, beginning on January 1, 2002, the Company no longer amortizes goodwill. Pro forma net loss for the year ended December 31, 2001, had the non-amortization provisions of SFAS No. 142 been applied to that period, would have been $18,920,000 or $1.48 per share (basic and diluted), versus the $20,340,000 or $1.59 per share (basic and diluted) actually reported.

During 2003, the Prolab segment was consolidated into the Natrol segment (see Note 10) and the test for goodwill was performed on the Company as a whole. The Company performed its annual impairment test as of December 31, 2003 and concluded that goodwill was not impaired.

Deferred income taxes are provided for temporary differences between the financial statement and income tax bases of assets and liabilities, based on enacted tax rates. Management provides a valuation allowance when it believes, it is more likely than not that some portion or all of the deferred income tax assets will not be realized.

The Company sells its products to retail outlets through a direct sales force and a national broker network. The Company recognizes revenue from sales when product is shipped and title is transferred. Net sales represent product shipped less actual and estimated returns, spoilage allowances, allowances for product deemed to be unsaleable by customers, free goods shipped to customers for promotional or

other purposes and slotting fees. Estimates and allowances are based upon known claims and an estimate of additional returns, however, the amount of future returns can be reasonably estimated.

Advertising and promotional costs are expensed as incurred. Advertising and promotional costs were (in thousands) $5,427, $6,778, and $7,345 for the years ended December 31, 2003, 2002 and 2001, respectively. These amounts are exclusive of promotional and other costs that are netted against sales revenue.

The Company incurs costs in support of its dietary research and development. These costs are expensed as incurred and were (in thousands) $608, $504, and $551 for the years ended December 31, 2003, 2002 and 2001, respectively.

The Company records all amounts charged to customers for shipping and handling as revenue. All shipping and fulfillment costs are classified as selling and marketing expenses and were (in thousands) $3,172, $2,504, and $2,959 for the years ended December 31, 2003, 2002 and 2001, respectively.

The Company accounts for its employee stock option plan under the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations.

The Company has a stock-based compensation plan, which is described more fully in Note 5. The Company's operating results do not include a compensation charge related to this plan, as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on the operating results and per share amounts, if the

fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, had been applied to stock-based employee compensation.

		Years Ended December 31,
		2003		2002		2001
		(In thousands)
Income (loss) from continuing operations before cumulative effect of accounting change		$	19		$	1,381		$	(20,340	)
Total stock-based employee compensation expense determined under the fair value-based method for all awards, net of related tax benefits ("Stock Compensation")			(222	)		(294	)		(843	)

Income (loss) from continuing operations—pro forma			(203	)		1,087			(21,183	)
Loss from discontinued operations			(1,487	)		(688	)
Cumulative effect of change in accounting principle—net of tax			(6,819	)

Net loss—pro forma		$	(1,690	)	$	(6,420	)	$	(21,183	)
Income (loss) per share from continuing operations:
	Basic and diluted—as reported		$	0.00		$	0.11		$	(1.59	)
	Basic and diluted—pro forma		$	(0.02	)	$	0.09		$	(1.66	)
Net loss per share:
	Basic and diluted—as reported		$	(0.11	)	$	(0.48	)	$	(1.59	)
	Basic and diluted—pro forma		$	(0.13	)	$	(0.50	)	$	(1.66	)

The fair value of the options is estimated using a Black-Scholes option-pricing model with the following weighted-average assumptions for grants:

	Years Ended December 31,
	2003		2002		2001
Expected dividend yield	0.0	%	0.0	%	0.0	%
Expected stock price volatility	68.7		73.3		75.6
Risk free interest rate	3.0	%	4.2	%	5.5	%
Expected life of options	5 years		5 years		5 years

These assumptions resulted in weighted-average fair values of $0.87, $0.87 and $1.05 for each stock option granted in 2003, 2002 and 2001, respectively.

The Company calculates income (loss) per share in accordance with SFAS No. 128, Earnings per Share. Basic income (loss) per share has been computed by dividing net income (loss) by the weighted-average number of common shares outstanding during the period. Diluted income (loss) per share has been computed by dividing net income (loss) by the weighted average number of common shares and dilutive common stock equivalents (stock options), when dilutive.

Stock options to purchase 2,950,000, 2,916,000, and 2,696,000 shares of common stock in 2003, 2002 and 2001, respectively, were outstanding but considered to be anti-dilutive.

The carrying value of certain financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximates fair market value based on their short-term nature. The fair value of the Company's long-term notes payable is estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. The estimated fair value of long-term notes payable exceeded the carrying value by approximately $662,000 at December 31, 2003.

Financial instruments which potentially subject the Company to concentration of credit risk consist principally of cash and cash equivalents, and accounts receivable. Cash and cash equivalents are placed with high credit-quality institutions and the amount of credit exposure to any one institution is limited. Significant portions of the Company's sales are made directly to mass merchandisers and national retailers. Due to the increased volume of sales to these channels, the Company has experienced an increased concentration of credit risk, and as a result, may at anytime have individually significant receivable balances with such mass merchandisers and national retailers. While the Company monitors and manages this risk, financial difficulties on the part of one or more major customers may have a material adverse effect on the Company. The Company performs ongoing credit evaluations of customers and maintains an allowance for potential credit losses.

No one customer represented 10% or more of the Company's net sales in 2003. Accounts receivable from one customer represented approximately 16.0% of net accounts receivable at December 31, 2003. One customer represented 12.3% of net sales in the year ended December 31, 2002. This customer accounted for 13.4% of accounts receivable at December 31, 2002. No other customers represented more than 10% of net sales in 2002. No customers represented more than 10% of net sales in 2001.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activities be initially measured at fair value and recognized when the liability is incurred. The adoption of SFAS No. 146 did not have any impact to the Company's financial position or results of operations.

ending after December 15, 2002. This Interpretation addresses the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees, and also clarifies the requirements related to the recognition of a liability by a guarantor at the inception of a guarantee for the obligations the guarantor has undertaken in issuing that guarantee. The adoption of FASB Interpretation No. 45 did not have a material impact on the Company's consolidated financial position or results of operations. The Company does not currently provide any third party guarantees.

those entered into separately from an entity's other financial instruments or equity transactions or that are legally detachable and separately exercisable) must be classified as liabilities or, in some cases, assets. In addition, SFAS No. 150 requires that financial instruments containing obligations to repurchase the issuing entity's equity shares and, under certain circumstances, obligations that are settled by delivery of the issuer's shares be classified as liabilities. Certain aspects of SFAS No. 150 have been deferred; however, the Statement is effective for financial instruments entered into or modified after May 31, 2003 and for other instruments at the beginning of the first interim period beginning after June 15, 2003. The Company does not currently have any financial instruments that have been impacted by SFAS No. 150. The adoption of SFAS No. 150 did not have any impact on the Company's financial position or results of operations.

During 1999, the Company entered into two mortgage notes payable in the aggregate amount of $8,900, collateralized by the Company's facilities. These notes are payable in monthly installments of approximately $74 in the aggregate, including interest ranging from 7.75% to 8.32%, maturing in 2014 and 2019.

2004	$	325
2005		353
2007		382
2007		414
2008		448
Thereafter		5,854

Total	$	7,776

The difference between actual income tax provision (benefit) and the amount computed using the U.S. federal statutory income tax rate is as follows:

The significant components of the Company's deferred income tax assets and liabilities are as follows:

The Company has state net operating loss carryforwards of approximately $1,500 expiring beginning in fiscal 2007

In 2000, the Board of Directors of the Company authorized a stock repurchase program for the Company's common stock. Under the stock repurchase program, the Company can effect common stock repurchases from time to time up to an aggregate of $10,000,000. The stock repurchase program does not have an expiration date. During the year ended December 31, 2001, the Company repurchased 296,000 shares of its common stock, respectively, at a cost of $554,000. No such repurchases were made in 2002 or 2003.

Under the Company's 1996 Stock Option and Grant Plan, as amended (the "Plan"), the Board of Directors of the Company is authorized to grant incentive stock options or non-qualified stock options. Incentive stock options may be granted only to employees of the Company. Non-qualified stock options may be granted to officers and employees of the Company as well as to non-employees. The maximum number of shares to be issued under the Plan is 3,408,071 shares, as amended. All options granted under the Plan have been made at prices not less than the estimated fair market value of the stock at the date of grant. Generally, the options granted under the Plan vest over three-to-five years. Options granted under the Plan have a term of not more than 10 years.

A summary of the Company's stock option activity and related information is as follows (in thousands, except per share data):

At December 31, 2003, 459,000 shares were available for future grant. The weighted-average remaining contractual life for the outstanding options in years was 6.91, 7.71, and 8.37 at December 31, 2003, 2002 and 2001, respectively.

The Company leases certain equipment and facilities under noncancelable operating leases that expire in various years through 2006. Rent expense under operating leases totaled approximately $155,000, $117,000, and $108,000 for the years ended December 31, 2003, 2002 and 2001, respectively.

Future minimum lease payments under noncancelable operating leases with initial terms of one year or more consisted of the following at December 31, 2003 (in thousands):

2004	$	155
2005		62
2006		32
2007		1

Total minimum lease payments	$	250

The Company is a party to certain legal actions arising in the normal course of business. In the opinion of management, the ultimate outcome of such litigation will not have a material adverse effect on the financial position or results of operations of the Company.

The Company has a profit sharing 401(k) plan that covers substantially all of its employees. Eligible employees may contribute up to 10% of their compensation. Contributions are discretionary; however, the Company generally matches 10% of the employees' contributions up to the maximum of 1% of eligible compensation. Amounts recognized as expense were approximately $26,000, $14,000, and $20,000 for the years ended December 31, 2003, 2002 and 2001, respectively.

In 1998, the Board of Directors approved the Natrol, Inc. Employee Stock Purchase Plan ("ESPP"), which allows substantially all employees to purchase shares of common stock of the Company, through payroll deductions, at 85% of the fair market value of the shares at the beginning or end of the offering period, whichever is lower. The ESPP provides for employees to authorize payroll deductions of up to 10% of their compensation for each pay period. In conjunction with the ESPP, the Company registered with the Securities and Exchange Commission 225,000 shares of the Company's common stock reserved for purchase under the ESPP. As of December 31, 2003 and 2002, 96,402 and 138,356 shares are available for issuance under this plan. For the year ended December 31, 2003, 38,267 shares were issued at $0.98 per share under the plan. For the year ended December 31, 2002, 14,720 shares were issued at prices ranging from $1.68 to $1.85 per share under the plan. For the year ended December 31, 2001, 17,043 shares were issued at prices ranging from $1.28 to $2.00 per share under the plan.

The Company, as part of its review of financial results for 2001, performed an assessment of the carrying value of the Company's long-lived assets to be held and used, including significant amounts of goodwill recorded in connection with its various acquisitions. The assessment was performed pursuant to SFAS No. 121 because of the significant negative industry and economic trends affecting both the Company's operations and expected future sales as well as the general decline in market valuations. As a result, the Company recorded a charge of $20 million to reduce goodwill during the fourth quarter of 2001, based on the amount by which the carrying amount of these assets exceeded their estimated fair value.

The write-down was related to the goodwill recorded in connection with the Company's acquisition of Prolab. The charge is included in the caption impairment of goodwill on the statements of operations. Fair value was determined based on discounted future cash flows for the operating entity.

The Company sold Annasa's trademarks and certain other assets to an investor group led by former Annasa distributors. The Company received $35,000 for the intellectual property assets and received a commitment from the investor group to purchase Annasa's remaining inventory at cost. The investor group has agreed to also pay the Company a royalty of between one and two percent of net revenue for 20 years.

Prior to the fourth quarter of 2003, the Company reported its revenue and income through three operating segments; Natrol, Annasa and Prolab. As discussed in Note 9, Annasa was discontinued in the fourth quarter of 2003. Additionally, the Company consolidated its Prolab operating unit into the core Natrol operating unit, and Prolab now operates as a brand within the core operating unit similar to the Company's other brands. The consolidation of the related accounting, finance, marketing, sales and other functions was completed at the end of the third quarter of 2003 and as of October 1, 2003, the Company no longer considers Prolab a separate operating segment. As a result, segment operating results are no longer being reported.

During March 2004, the Company settled its litigation with the former owners of Prolab Nutrition, Inc. The Company received $2 million in cash, which will be reflected in the financial statements for the quarter ending March 31, 2004 as a reduction of goodwill.

Natrol, Inc. and Subsidiaries Schedule II—Valuation and Qualifying Accounts Years Ended December 31, 2003, 2002 and 2001

Description			Charged to Cost and Expense	Additions Charged to Acquisitions			Balance at End of Year
Allowance for Doubtful Accounts:
	Year ended December 31, 2001	$	479	$	438	$	—	$	554		$	363
	Year ended December 31, 2002	$	363	$	233	$	—	$	187		$	409
	Year ended December 31, 2003	$	409	$	397	$	—	$	171		$	635
Allowance for Sales Returns:
	Year ended December 31, 2001	$	1,460	$	12,490	$	—	$	12,910	(1)	$	1,020
	Year ended December 31, 2002	$	1,020	$	6,700	$	—	$	6,127	(1)	$	1,593
	Year ended December 31, 2003	$	1,593	$	4,014	$	—	$	4,372	(1)	$	1,235

ITEM 9: CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

On December 10, 2002, the Audit Committee of the Board of Directors of Natrol informed Ernst & Young, LLP, the Company's independent public accountants for the fiscal year ended December 31, 2001, of its decision to no longer engage Ernst & Young as the Company's independent public accountants. On December 10, 2002, the Company engaged Deloitte & Touche, LLP to serve as the Company's independent public accountants for the fiscal year ended December 31, 2002. On December 11, 2002, Natrol filed a Form 8-K announcing this change in independent public accountants. A subsequent form 8k-A was filed on January 7, 2003.

Ernst & Young's reports on the Company's consolidated financial statements for each of the fiscal years ended December 31, 2001, 2000, and 1999 did not contain an adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles.

During the fiscal years ended December, 31, 2001 and 2000, there were no disagreements with Ernst & Young on any matter of accounting principle or practice, financial statement disclosure, or auditing scope or procedure which, if not resolved to Ernst & Young's satisfaction, would have caused them to make reference to the subject matter in connection with their report on the Company's consolidated financial statements for such years; and there were no reportable events as defined in v 304(a)(1)(v) of Regulation S-K.

During the years ended December 31, 2001 and 2000 and through December 31, 2002, the Company did not consult Deloitte & Touche, LLP with respect to the application of accounting principles to a specific transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Company's consolidated financial statements, or any other matters or reportable events as set forth in Items 304(a) (2) (i) and (ii) of Regulation S-K.

As required by new Rule 13a-15 under the Securities Exchange Act of 1934, within the 90 days prior to this report, we carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. In designing and evaluating our disclosure controls and procedures, we and our management recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating and implementing possible controls and procedures. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that they believe that, as of the date of completion of the evaluation, our disclosure controls and procedures were reasonably effective to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. In connection with the new rules, we will continue to review and document our disclosure controls and procedures, including our internal controls and procedures for financial reporting, on an ongoing basis, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that our systems evolve with out business.

The Company has not, as of the filing of this document, adopted a Code of Ethics. The Company intends to adopt such a plan prior to the annual shareholders' meeting in June 2004.

Information required under Part III (Items 10, 11, 12, and 14 other than the information required by Item 201(d) of Regulation S-K for Item 12, and 13) is incorporated herein by reference to the Company's definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days after the year covered by this Form 10-K with respect to its Annual Meeting of Stockholders to be held in June 2004.

The flowing table provides information as of December 31, 2002 regarding shares of common stock of the Company that may be used under our existing equity compensation plans, including the Company's 1996 Stock Option and Grant Plan (the "1996 Plan") and the Company's 1998 Employee Stock Purchase Plan (the "ESPP").

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, this 14th day of April, 2004..

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated and on the dates indicated.

(Mark One)
ý	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For The Fiscal Year Ended December 31, 2003
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		Year Ended December 31,
		2003			2002			2001			2000			1999
		(in thousands except per share data)
Consolidated Statements of Operations Data:
Net sales		$	72,658		$	70,260		$	71,821		$	77,561		$	79,994
Cost of goods sold			44,246			41,715			42,989			50,334			39,841

Gross profit			28,412			28,545			28,832			27,227			40,153

Selling and marketing expenses			17,701			16,915			18,103			23,263			17,372
General and administrative expenses			10,063			8,744			9,746			10,318			8,499
Impairment of goodwill									20,000

Total operating expenses			27,764			25,659			47,849			33,581			25,871

Operating income (loss)			648			2,886			(19,017	)		(6,354	)		14,282
Interest income (expense), net			(595	)		(644	)		(736	)		(1,231	)		538

Income (loss) from continuing operations before income taxes			53			2,242			(19,753	)		(7,585	)		14,820
Income tax provision (benefit)			34			861			587			(2,369	)		5,632

Income (loss) from continuing operations before cumulative change in accounting principles			19			1,381			(20,340	)		(5,216	)		9,188

Discontinued operations (1):
(Loss) from operations of Annasa component			(1,766	)		(1,068	)
(Loss) from operations of Tamsol component			(542	)		(41	)
Income tax benefit			821			421

Loss on discontinued operations			(1,487	)		(688	)

Income (loss) before cumulative effect of accounting change			(1,468	)		693			(20,340	)		(5,216	)		9,188
Cumulative effect of change in accounting principle (2)						(6,819	)

Net income (loss)		$	(1,468	)	$	(6,126	)	$	(20,340	)	$	(5,216	)	$	9,188

Income (loss) per share:
	Basic income (loss) from continuing operations	$	0.00		$	0.11		$	(1.59	)	$	(0.39	)	$	0.69
	Diluted income (loss) from continuing operations	$	0.00		$	0.11		$	(1.59	)	$	(0.39	)	$	0.67
	Basic and diluted income (loss) from discontinued operations	$	(0.11	)	$	(0.06	)
	Basic and Diluted income (loss) from cumulative effect of change in accounting principle				$	(0.53	)
	Basic earnings (loss) per share	$	(0.11	)	$	(0.48	)	$	(1.59	)	$	(0.39	)	$	0.69
	Diluted earnings (loss) per share	$	(0.11	)	$	(0.48	)	$	(1.59	)	$	(0.39	)	$	0.67
	Weighted average shares outstanding—basic		12,946			12,852			12,783			13,237			13,325
	Weighted average shares outstanding—diluted		13,452			12,992			12,783			13,237			13,638

	December 31,
	2003		2002		2001		2000		1999
	(in thousands except per share data)
Consolidated Balance Sheet Data:
Cash and cash equivalents	$	2,599	$	10,077	$	5,485	$	4,004	$	485
Working capital		13,328		18,722		18,190		15,399		19,627
Total assets		51,439		53,357		59,357		87,921		92,596
Long-term debt, less current maturities		7,451		7,778		8,083		8,369		8,700
Total stockholders' equity		35,558		36,651		42,640		62,892		69,986

	Payment Due by Period
	Total		Less than 1 Year		2-3 Years		4-5 Years		Thereafter
Note Payable	$	7,776	$	325	$	735	$	862	$	5,854
Leases		250		155		94		1		—

Total	$	8,026	$	480	$	829	$	863	$	5,854

Index to Consolidated Financial Statements:
	Report of Independent Auditors—Deloitte & Touche, LLP	39
	Report of Independent Auditors—Ernst & Young, LLP	40
	Consolidated Balance Sheets as of December 31, 2003 and 2002	41
	Consolidated Statements of Operations for the years ended December 31, 2003, 2002 and 2001	42
	Consolidated Statements of Stockholders' Equity for the years ended December 31, 2003, 2002 and 2001	43
	Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001	44
	Notes to Consolidated Financial Statements	46

			December 31
			2003			2002
Assets
Current assets:
	Cash and cash equivalents		$	2,599		$	10,077
	Accounts receivable, net of allowances of $635 and $409 at December 31, 2003 and 2002, respectively			7,698			6,780
	Inventory			9,053			8,608
	Income taxes receivable			349
	Deferred income taxes			1,110			665
	Prepaid expenses and other current assets			914			1,452
	Net assets of discontinued operations			35			68

Total current assets				21,758			27,650

Property and equipment:
	Building and improvements			15,612			15,607
	Machinery and equipment			5,215			5,067
	Furniture and office equipment			3,158			2,981

				23,985			23,655
Accumulated depreciation and amortization				(7,315	)		(5,866	)

Property and equipment, net				16,670			17,789
Restricted cash				5,000
Deferred income taxes				3,902			3,853
Goodwill, net of accumulated amortization and impairment charge of $37,381				4,026			4,026
Other assets				83			39

Total assets			$	51,439		$	53,357

Liabilities and stockholders' equity
Current liabilities:
	Accounts payable		$	5,601		$	4,395
	Accrued expenses			1,732			3,347
	Accrued payroll and related liabilities			772			680
	Income taxes payable						205
	Current portion of long-term debt			325			301

Total current liabilities				8,430			8,928

Long-term debt, less current portion				7,451			7,778
Commitments and contingencies
Stockholders' equity:
	Preferred stock, par value of $0.01 per share:
		Authorized shares—2,000,000; Issued and outstanding shares—none
	Common stock, par value of $0.01 per share:
		Authorized shares—50,000,000
		Issued and outstanding shares—14,054,309 and 13,788,720 at December 31, 2003 and 2002, respectively		141			138
	Additional paid-in capital			62,377			62,005
	Accumulated deficit			(24,079	)		(22,611	)

				38,439			39,532
	Shares held in treasury, at cost—921,900 shares at December 31, 2003 and 2002			(2,881	)		(2,881	)

Total stockholders' equity				35,558			36,651

Total liabilities and stockholders' equity			$	51,439		$	53,357

		Common Stock					Retained Earnings (Accumulated Deficit)
		Common Stock			Additional Paid-In Capital					Shares Held in Treasury			Receivable from Stockholder
		Shares	Amount		Additional Paid-In Capital					Shares Held in Treasury			Receivable from Stockholder			Total
Balance, January 1, 2001		13,658,820	$	137	$	61,782	$	3,855		$	(2,327	)	$	(554	)	$	62,893
	Exercise of stock options	32,000				58											58
	Shares issued in exchange for services										(554	)		554
	Shares issued in exchange for services	4,491				8											8
	Issuance of common stock under employee stock purchase plan	17,043				21											21
	Net loss							(20,340	)								(20,340	)

Balance, December 31, 2001		13,712,354		137		61,869		(16,485	)		(2,881	)	$	0			42,640

	Exercise of stock options	49,166		1		92											93
	Shares issued in exchange for services	12,480				17											17
	Issuance of common stock under employee stock purchase plan	14,720				27											27
	Net loss							(6,126	)								(6,126	)

Balance, December 31, 2002		13,788,720		138		62,005		(22,611	)		(2,881	)					36,651
	Exercise of stock options	216,885		2		319											321
	Shares issued in exchange for services	10,437				16											16
	Issuance of common stock under employee stock purchase plan	38,267		1		37											38
	Net loss							(1,468	)								(1,468	)

Balance, December 31, 2003		14,054,309	$	141	$	62,377	$	(24,079	)	$	(2,881	)				$	35,558

Supplemental disclosures of cash flow information
Cash paid during the year for:
Interest	$	650	$	675	$	885
Income taxes	$	337	$	55	$	927

	Natrol			Prolab			Total
	(In thousands)
Balance, January 1, 2001	$	11,898		$	25,366		$	37,264
Impairment losses					(20,000	)		(20,000	)
Amortization expense		(940	)		(1,340	)		(2,280	)

Balance, December 31, 2001		10,958			4,026			14,984
Cumulative effect of change in accounting principle		(10,958	)					(10,958	)

Balance, December 31, 2002	$	—		$	4,026		$	4,026

		Number of Options		Weighted-Average Exercise Price Per Share		Exercise Price Per Share
Outstanding at December 31, 2000		1,987		$	4.59	$1.88—$13.00
	Granted	1,000			1.63	1.32—$3.60
	Forfeited	(259	)		1.81	1.50—$10.63
	Exercised	(32	)		3.01	1.32—$1.94

Outstanding at December 31, 2001		2,696			3.58	1.32—$13.00
	Granted	700			1.37	1.10—$1.75
	Forfeited	(431	)		3.41	1.13—$13.00
	Exercised	(49	)		1.88	1.50—$1.94

Outstanding at December 31, 2002		2,916			3.10	1.10—$13.00
	Granted	361			1.31	1.10—$2.04
	Forfeited	(111	)		2.23	1.45—$6.03
	Exercised	(217	)		1.48	1.15—$1.50

Outstanding at December 31, 2003		2,949		$	2.89	$1.10—$13.00

	Options Outstanding				Options Exercisable
Range of Exercise Prices	Number Outstanding	Weighted Average Remaining Contractual Life	Weighted Average Exercise Price		Shares Exercisable	Weighted Average Exercise Price
$1.10—$2.35	2,294	7.4	$	1.60	1,657	$	1.69
$2.76—$6.03	270	6.0		4.66	266		4.67
$7.00—$13.00	385	4.9		10.19	383		10.20

Total	2,949	6.91	$	3.44	2,306	$	2.96

	Fiscal Year ended:
	December 31, 2003			December 31, 2002
Annasa:
Revenue	$	667		$	44

Gross Margin		452			32
Selling and Marketing expenses		1,224			501
General and administrative		994			599

Loss from operations		(1,766	)		(1,068	)
Income tax benefit		616			404

Net loss	$	(1,150	)	$	(664	)

Tamsol:
Revenue	$	30		$	27

Gross Margin		30			27
Selling and Marketing expenses		152			2
General and administrative		420			66

Loss from operations		(542	)		(41	)
Income tax benefit		205			17

Net loss	$	(337	)	$	(24	)

Net assets of discontinued operations:
Current assets	$	115		$	71
Total assets		150			92
Current liabilities		115			24
Net assets of discontinued operations		35			68

		2003 Quarters Ended
		March 31,			June 30,			September 30,			December 31,
		(In thousands, except per share amounts)
Net sales		$	18,995		$	18,866		$	17,398		$	17,399
Gross profit			8,129			6,604			6,810			6,869
Income (loss) from continuing operations			228			(246	)		25			12
Loss from discontinued operations			(352	)		(304	)		(417	)		(414	)
Net loss			(124	)		(550	)		(392	)		(402	)
Basic and diluted net Income (loss) per share:
	Income from continuing operations	$	0.02		$	(0.02	)	$	(0.00	)	$	(0.00	)
	Loss from discontinued operations		(0.03	)		(0.02	)		(0.03	)		(0.03	)

	Net loss	$	(0.01	)	$	(0.04	)	$	(0.03	)	$	(0.03	)

	Equity Compensation Plan Information
Plan category	Number of securities To be issued Upon exercise of Outstanding options, Warrants and rights(1) (a)	Weighted-Average exercise price of outstanding options, warrants and rights (b)		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) (c)
Equity compensation plans approved by security holders(2)	2,949,447	$	2.89	458,624	(3)
Equity compensation Plans not approved by security holders

Total	2,949,447	$	2.89	458,624	(3)

(a)(1)	Consolidated Financial Statements
	The financial statements included in this Annual Report on Form 10-K are provided under Item 8.
(a)(2)	Index to Consolidated Financial Statement Schedules:
	Schedule II—Valuation and Qualifying Accounts	S-1
	All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are not material, and therefore have been omitted.
(a)(3)	Index to Exhibits:

		NATROL, INC.
		By:	/s/ ELLIOTT BALBERT Elliott Balbert President and Chief Executive Officer

Signatures Signed	Title	Date
Elliott Balbert	Chairman of the Board, Chief Executive Officer, President and Director (Principal Executive Officer)	April 14, 2004
Dennis Jolicoeur	Chief Financial Officer, Executive Vice President and Director (Principal Financial Officer and Principal Accounting Officer)	April 14, 2004
Vernon Brunner	Director	April 14, 2004
Gordon Brunner	Director	April 14, 2004
Dennis De Concini	Director	April 14, 2004
Ronald Consiglio	Director	April 14, 2004

3.1		The Third Amended and Restated Certificate of Incorporation of the Company incorporated herein by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K, as amended, filed on March 31, 1999.
3.2		The Amended and Restated By-Laws of the Company (incorporated herein by reference to Exhibit 3.6 to the Company's Amendment No. 2 to Registration Statement on Form S-1, as amended, File No. 333-52109).
Instruments Defining the Rights of Security Holders, Including Indentures:
4.1		Specimen Stock Certificate for shares of Common Stock, $.01 par value, of the Company (incorporated herein by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-1, as amended, File No. 333-52109).
Material Contracts
10.1		Natrol, Inc. Amended and Restated 1996 Stock Option Plan (incorporated herein by reference to Appendix A filed on May 2, 2000 Proxy Statement);
10.2		Natrol, Inc. Employee Stock Purchase Plan (incorporated herein by reference to Exhibit 10.3 to the Company's Registration Statement on Form S-1, as amended, File No. 333-52109);
10.3		Form of Indemnification Agreement between Natrol, Inc. and each of its directors (incorporated herein by reference to Exhibit 10.4 to the Company's Registration Statement on Form S-1, as amended, File No. 333-52109);
10.4		Form of Incentive Stock Option Agreement of the Natrol, Inc. Stock Option and Grant Plan (incorporated herein by reference to Exhibit 10.9 to the Company's Registration Statement on Form S-1, as amended, File No. 333-52109);
10.5		Amended and Restated Credit Agreement with Wells Fargo Bank, N. A (incorporated herein by reference to Exhibit 10.9 to the Company's Registration Statement on Form S-1, as amended, File No. 333-52109);
10.6		Credit Agreement with Wells Fargo Bank, N.A., dated as of March 1, 2001; (incorporated herein by reference to Exhibit 10.6 to the Company's Form 10-K) filed on March 30, 2001.

10.7		Revolving Line of Credit Agreement with Wells Fargo Bank, N.A., dated as of March 1, 2001, (incorporated herein by reference to Exhibit 10.7 to the Company's Form 10-K filed March 30, 2001.
10.8		Supply Agreement, dated as of February 8, 1998, by and between the Company and Basic Vegetable Products, L.P. (incorporated herein by reference to Exhibit 10.10 to the Company's Registration Statement on Form S-1, as amended, File No. 333-52109) ;
10.9		Assignment and Amendment to Supply and Royalty Supply Agreement, dated as of November 7, 2000 by and between the Company and ConAgra Foods, Inc., (incorporated by reference to Exhibit 10.9 to the Company's Form 10-K filed on March 30, 2001.
10.10		Bonus Compensation Plan
21.1		Subsidiaries of Natrol, Inc.
23.1		Consent of Experts and Counsel: Consent of Deloitte & Touche, LLP is filed herewith as Exhibit 23.1.
23.2		Consent of Experts and Counsel: Consent of Ernst & Young, LLP is filed herewith as Exhibit 23.2
31.1		Certification of Chief Executive Officer pursuant to section 302 of the Sarbanes Oxley Act of 2002
31.2		Certification of Chief Financial Officer pursuant to section 302 of the Sarbanes Oxley Act of 2002
32.1		Certification of Chief Executive Officer pursuant to section 901 of the Sarbanes Oxley Act of 2002
32.2		Certification of Chief Financial Officer pursuant to section 901 of the Sarbanes Oxley Act of 2002