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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
FOR ANNUAL AND TRANSITIONAL REPORTS
PURSUANT TO SECTIONS 13 AND 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
(Mark One)
/X/ FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _____ TO ______
COMMISSION FILE NO: 000-24567
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NATROL, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 95-3560780
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(State of Incorporation) (I.R.S. Employer Identification No.)
21411 PRAIRIE STREET
CHATSWORTH, CALIFORNIA 91311
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(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(818) 739-6000
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(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
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Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to section 12(g) of the Act:
Common Stock, par value $.01 per share
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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 X NO
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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. [ ]
The aggregate market value of the shares of the registrant's Common Stock
held by non-affiliates of the registrant on March 24, 1999 was approximately
$27.8 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 24, 1999, the registrant has 13,301,990 shares of Common Stock
outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive proxy statement for its 1999 Annual
Meeting of Stockholders on Form 10-K are incorporated by reference into Part
III of this report.
NATROL, INC.
1998 ANNUAL REPORT ON Form 10-K
TABLE OF CONTENTS
Page
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PART I
Item 1. Business................................................................ 4
Item 2. Properties.............................................................. 33
Item 3. Legal Matters........................................................... 34
Item 4. Submission of Matters to a Vote of the Securities Holders............... 34
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. 35
Item 6. Selected Consolidated Financial Data.................................. 37
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations................................................. 38
Item 7A. Quantitative and Qualatative Disclosures About Market Risk............ 49
Item 8. Financial Statements and Supplementary Data........................... 49
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.................................................. 49
PART III ...................................................................... 50
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K....... 50
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This report contains "forward looking statements." 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" or "anticipates" or the negative thereof, other variations thereon,
or comparable terminology, or by discussions of strategy.
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 reports, including but not limited to, the Company's Prospectus dated
July 22, 1998 filed with the Securities and Exchange Commission.
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 potential general downturn or slowing of the
growth of the dietary supplement industry, (ii) increased competition from
current competitors and new market entrants, (iii) adverse publicity
regarding the dietary supplement industry or the Company's products, (iv) the
Company's dependence upon its ability to develop new products, (v) government
regulation, (vi) exposure to product liability claims,(vii) dependence on
significant customers, (viii) the Company's ability to keep and attract key
management employees, (ix) the Company's inability to manage growth and
execute its business plan, (x) the Company's ability to consummate future
acquisitions and its ability to integrate acquired businesses and to retain
key personnel associated with any acquisition, (xi) the absence of clinical
trials for many of the Company's products, (xii) the Company's inability to
obtain raw materials that are in short supply, (xiii) sales and earnings
volatility, (xiv) the Company's ability to manufacture its products
efficiently, (xv) the Company's reliance on independent brokers to sell its
products, (xvi) the inability of the Company to protect its intellectual
property, (xvii) control by principal shareholders, (xviii) the possible sale
of large amounts of stock by controlling shareholders, (xiv)
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volatility in the stock markets, (xx) a failure of the Company to properly
address the year 2000 issue and (xxi) a general downturn in the national
economy as a whole. These and other such factors are discussed in more
detail under the caption "Risk Factors" and elsewhere in this report.
PART I
ITEM 1. BUSINESS
The Company's executive offices are located at 21411 Prairie Street,
Chatsworth, California 91311 and its telephone number is 818-739-6000. Unless
the context otherwise requires the terms the "Company" and "Natrol" refer to
Natrol, Inc. and, as applicable, its direct and indirect subsidiaries.
GENERAL
Natrol manufactures and markets branded, high-quality dietary supplements.
These supplements include vitamins, minerals, hormonal supplements, herbal
products, and specialty combination formulas that contribute to an
individual's mental or physical well being. The Company sells its products,
primarily under the Natrol brand name, 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. The
Company's strategy emphasizes building strong recognition of the Natrol brand
across multiple distribution channels through a widespread multi-media
marketing and advertising strategy.
Since its inception, the Company has emphasized the ongoing development and
marketing of new products in order to capitalize on and create market
opportunities. As a part of its product development efforts, the Company
introduced 34 new products in 1997 and approximately 70 new items in 1998.
Today, the Natrol brand product line includes approximately 190 items which
are packaged in various sizes (e.g., 30 count, 60 count, etc.), strengths
(e.g., 50 mg, 100 mg, etc.) and combinations (e.g., multiple vitamins with or
without iron). These sizes, strengths and combinations create approximately
500 stockkeeping units (SKUs).
RECENT ACQUISITIONS
In February 1998, the Company acquired Pure-Gar, L.P., ("Pure-Gar") then a
wholly owned subsidiary of Basic
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Vegetable Products, L.P., ("BVP"). Pure-Gar mainly sells nutraceutical grade
vegetable powders and ingredients to manufacturers of nutritional supplements
of which garlic represents approximately 90% of such sales. At the time of
the acquisition, Pure-Gar also sold garlic supplements to consumers in health
store and mass-market outlets under two proprietary labels. These brands
have since been replaced with the Natrol brand "Garlipure." Since acquiring
the Pure-Gar ingredient business, the Company has expanded the base of
products sold to include Kava Kava and the Company is seeking to expand the
number of ingredients it can offer its customers.
In October 1998, the Company broadened its product line by acquiring the tea
business and certain related assets of the Laci Le Beau Corporation and other
affiliated entities ("Laci Le Beau"). Laci Le Beau manufactures and
distributes approximately 20 herbal teas under the Laci Le Beau brand name.
The Company's strategy has been to aggressively promote the Natrol brand name
through as many channels of distribution as possible. The Company expects to
utilize this strategy on the promotion of the Laci Le Beau tea line. Laci Le
Beau had previously been selling its teas to both mass market and health food
accounts on a more limited basis due to the relatively small size of its
sales force. Natrol expects to broaden the Laci Le Beau selling effort by
capitalizing upon the Natrol team of sales people, managers, brand managers,
and brokers.
SALES
BRANDED PRODUCTS
The Company distributes its branded products primarily to domestic 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 health food channel of distribution accounted for approximately 31% of
the Company's revenues for the year ended December 31, 1998. The Company
sells its branded Natrol and Laci Le Beau products to health food stores
through leading national distributors, including UNITED NATURAL FOODS and
TREE OF LIFE, as well as directly to GNC (General Nutrition Company). Natrol
products are sold by health food store chains such as WILD OATS MARKETS,
WHOLE FOODS MARKET,
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HI-HEALTH, VITAMIN COTTAGE, FRED MEYER NUTRITION CENTERS and VITAMIN SHOPPES,
as well as most independent health food stores.
A majority of these outlets buy their product from distributors rather than
directly from Natrol. The Company maintains a sales staff of more than 20
representatives across the country who are managed by regional supervisors
and a national health food sales manager who reports to the Company's Vice
President of Sales. These sales representatives call on individual store
owners and distributors promoting the Natrol and Laci Le Beau lines.
The mass market distribution channel, which accounted for approximately 54%
of the Company's revenues for the year ended December 31, 1998, is managed by
the Company's Vice President of Sales 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 BERGEN BRUNSWICK,
MCKESSON and CARDINAL. Some of the Company's major mass market retail
customers are WALGREENS, CVS, AMERICAN DRUG STORES, RITE AID, LONG'S DRUG,
DRUG EMPORIUM, ECKERD, SNYDERS, BROOKS DRUG, WAL-MART, KMART, TARGET, SHOPKO
and BJ'S WHOLESALE CLUB. The Company also sells its products in grocery
stores and supermarkets, including DOMINICK'S, RALPHS, VON'S, SCHNUCKS, CUB
FOODS, FOOD FOR LESS and WEGMANS.
Within each channel of trade, the Company believes that there is opportunity
for growth in that a majority of outlets that carry the Natrol or Laci Le
Beau lines stock only a small percentage of the products the Company offers.
A prime objective of the Natrol selling effort is to increase the amount of
shelf space devoted to Company products at each location. During 1998, the
average number of SKUs carried by the mass market retailers that buy products
directly from the Company increased by approximately 40%.
The Company provides retailers in both the health food store and the mass
market distribution channel 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
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sales 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 gain more shelf space. The
objective of these activities is to build strong relationships with the
Company's marketing partners and to increase the number of stores carrying
its products and the amount of space allocated to, and the overall number of,
the Company's products and SKUs within each store.
The Company had only one customer whose sales amounted to more than 10% of
the Company's business during 1998. Sales to Walgreens in 1998 amounted to
$10.9 million, or 15.9% of Natrol's total revenue. Walgreens is one of the
largest chains of drug stores in the country with more that 2,700 stores
nationally. An average Walgreens drug store carries approximately 45 Natrol
products.
PRIVATE LABEL AND INGREDIENT SUPPLY SALES
The Company manufactures certain products pursuant to contracts with
customers who distribute the products under their own private labels. Sales
to private label customers accounted for 3% of the Company's revenues for
1998. The Company generally does not actively solicit private label business.
In its bulk ingredient business, the Company primarily sells nutraceutical
grade dehydrated vegetable products, primarily garlic, to other
manufacturers, distributors and marketers of dietary supplements. The Company
obtains its bulk ingredients from BVP pursuant to a multi-year supply
agreement that gives the Company the exclusive right to sell BVP's vegetable
powders in the dietary supplement industry.
Bulk ingredient sales are the responsibility of the Pure-Gar division
president as well as two sales persons who report to the president. These
sales persons call on customers directly and work with brokers to enhance the
sale of Pure-Gar products.
The Company currently offers nutraceutical grade Kava Kava to its customers
and expects to offer other bulk raw materials as opportunities arise.
MARKETING
BRANDED PRODUCTS
Management believes the Company's strategy of selling the Natrol or Laci Le
Beau brand through both the health food store and mass market channels of
distribution distinguishes
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the Company from its competition. Most competitors sell products into each
channel using different brand names within each channel. Oftentimes, in the
case of the Company's competitors, the brand sold in the health channel is
positioned as the quality brand while the mass market line is positioned as
the value brand.
The Company's core strategy is to continue to build the Natrol and Laci Le
Beau 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 channel by positioning its
products as a premium, high quality brand rather than a value brand. By
maintaining a single brand identity, the Company believes it can also
leverage its advertising budget across multiple distribution channels.
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 spent approximately $11 million or nearly
16% of total sales in 1998 on various marketing and sales incentive programs.
The Company generally uses targeted, health-oriented magazines, such as
BETTER NUTRITION, DELICIOUS and GREAT LIFE, to support the health food store
distribution channel and uses mainstream publications such as PREVENTION,
HEALTH, USA TODAY, TV GUIDE, MCCALLS, FAMILY CIRCLE, WOMEN'S DAY and major
airline in-flight publications to support the mass market distribution
channel.
Throughout 1998, the Company's television commercials were featured on the
CNN/Turner Network, including such programs as CNN HEADLINE NEWS, CNN MORNING
NEWS and BURDEN OF PROOF. In addition, the Natrol logo appeared on HEADLINE
WEATHER and HEADLINE SPORTS TICKER.
During 1998, the Company utilized radio advertising including regular radio
spots that were featured on the DR. LAURA SCHLESSINGER and RUSH LIMBAUGH
radio shows.
The Company expects to focus on television and print advertising in 1999.
Natrol launched its 1999 TV season by unveiling a new corporate brand
commercial featuring founder and CEO, Elliott Balbert.
The Company's television commercials are scheduled to be shown on CNN's LARRY
KING LIVE and CNN HEADLINE NEWS along
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with TNT and TBS programs as well as several game show programs including
WHEEL OF FORTUNE, JEOPARDY and HOLLYWOOD SQUARES.
In print, Natrol expects to continue with periodic advertisements in
in-flight airline magazines, popular health magazines like PREVENTION,
HEALTH, LET'S LIVE and others, as well as main stream publications such as
READER'S DIGEST, USA WEEKEND and FAMILY CIRCLE.
The Company also actively works to keep the news media aware of product
developments. During 1998, Company's products have appeared in periodicals
such as TIME and THE WALL STREET JOURNAL as well as in television footage
produced by programs such as NBC's DATELINE.
PRIVATE LABEL AND INGREDIENT SUPPLY SALES
The Company does not actively market its private label business and relies on
word-of-mouth as well as the delivery of information from it sales staff,
primarily its Pure-Gar sales people.
The Company's Pure-Gar division relies primarily on visibility developed
through trade shows, advertising in trade publications and brochures to
supplement the sales efforts of its sales people.
RESEARCH & PRODUCT DEVELOPMENT
The Company believes it has an excellent reputation among retailers for
introducing items at the front end of the consumer demand curve and then
working to develop brand loyalty after product introduction. For example, in
recent years, the Company was one of the first major supplement manufacturers
to introduce Melatonin, DHEA, St. John's Wort, 5-HTP, Alpha Lipoic Acid and
Yohimbe. The Company has also introduced a number of proprietary formulations
including Kavatrol, Mood Support, Thera-C and a line of women's specialty
products. The Company's Kava based proprietary product (Kavatrol) was one of
the first heavily promoted Kava products in the United States and during 1998
it was featured on NBC's DATELINE when the program produced a segment on the
effects of Kava as an herb. As a result of its product development efforts,
the Company introduced 34 new products in 1997 and approximately 70 new
products in 1998.
The Company's Vice President of Marketing and others keep abreast of product
trends and work to develop and introduce products in response to those
emerging trends. Management continually evaluates product categories and SKUs
for trends
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in sales and profitability, de-emphasizing or dropping products when
profitability or SKU velocity lags. New products are introduced to replace
slower moving products, capitalize on market trends and diversify the
Company's product offerings. In addition, new products often have higher
gross margins than mature items.
The Company has established a focused process to anticipate consumer demand,
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
searches on-line databases. The staff meets with vendors and evaluates new
ingredients. The product development team also consults with a panel of
scientific advisors. These advisors include: Dr. Terry Willard, a recognized
herbal expert, an author and president of the Canadian Association of Herbal
Practitioners; Dr. Alexander Schauss, Director of the Life Sciences Division,
Natural and Medicinal Products Research of the American Institute for
Biosocial Research, Inc.; Dr. Ronald R. Watson, a scientist who has published
more than 150 articles relating to nutrition and immunology; Dr. Bruce
Hensel, a physician and journalist; and Dr. Anthony Verlangieri, Associate
Professor of Pharmacology and Toxicology at the University of Mississippi
School of Pharmacy and an expert in Toxicology. As appropriate, the Company
also communicates with other scientists on a regular basis regarding new
product concepts.
The Company sponsors scientific research by independent researchers as a part
of its product development efforts. In 1998, the Company sponsored a
randomized, double-blind, placebo-controlled study at the University of
Virginia regarding the efficacy of the Company's proprietary Kavatrol
product, which produced favorable results. The Company has commissioned
further independent research by the same researchers at the University of
Virginia on its proprietary Kavatrol product regarding dosage levels.
Before a product is introduced, the product development team reviews the
safety and efficacy of ingredients, standards for production, labeling
information, label claims and potential patent, trademark, legal or
regulatory issues.
The Company actively participates in and supports a number of scientific and
educational industry organizations that promote consumer well being. These
include the Citizens for Health and the National Nutritional Foods
Association. The Company is also a founding member of the Corporate Alliance
for Integrative Medicine, a not-for-profit organization
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funding research at Harvard University that was created to increase knowledge
and awareness of the efficacy and safety of vitamins, herbs and other dietary
supplements.
Although the Company spends less than 1% of its revenue on clinical and other
scientific research, it expects the total amount spent on research and
development to increase as it seeks to develop more proprietary products.
PRODUCTS
The Company sells premium dietary supplements and herbal tea products under
the respective Natrol and Laci Le Beau brand names. The Company focuses on
supplements that are in high demand as well as specialty niche and
proprietary formulations that have potentially strong margins. The Company's
supplement products include vitamins, minerals, herbs, specialty
formulations, weight control products, hormones and various nutrients. The
Company positions Natrol as a premium brand of vitamins, minerals and other
supplements rather than a value brand. The Company manufactures and sells
more than 190 products packaged into approximately 500 SKUs. The Laci Le Beau
teas are flavored herbal teas.
The Company's consumer products fall into the general definition of vitamin,
minerals, and supplements. Each year the Company strives to broaden its
product offering so as to increase revenue and gross profits while lessening
the Company's dependence upon any one product.
Only two branded products, Ester C and Melatonin, accounted for more than 10%
of the Company's net revenue in 1998.
ESTER-C-Registered Trademark-. The Company introduced Ester-C-Registered
Trademark- in 1986 and in 1998 this product accounted for approximately 14%
of the Company's net sales revenue. A buffered form of pH-neutral Vitamin C,
Ester-C-Registered Trademark- is considered a Natrol cornerstone product.
Although many Natrol competitors sell Ester-C-Registered Trademark-,
according to Spence Information Services, Natrol's Ester-C-Registered
Trademark- held approximately 25% of the Vitamin C market in health food
stores in 1997. The Company has built its market share through heavy
promotion, associating Ester-C-Registered Trademark- with the Natrol brand.
The Company sells approximately 45 SKUs of Ester-C-Registered Trademark-,
each offering a special potency, pill count, delivery system or specialty
combination, such as Ester-C-Registered Trademark-with zinc.
MELATONIN. Melatonin helped establish the Company's reputation within the
mass market channel of distribution. In 1996, the Company received the Rex
Award for Market Maker of the Year and the Rex Award for Best Nutritional
Supplement, each from Drug Store News, for its introduction of Melatonin into
the chain drugstore distribution channel. In 1998,
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Melatonin accounted for approximately 10% of the Company's net sales revenue.
During the 10 months the Company owned the Pure-Gar ingredients business,
ingredient sales, consisting of nearly all garlic sales, accounted for
approximately 10% of the Company's revenue in 1998 and on a pro-forma basis
sales would have amounted to slightly more than 10% of sales in 1998.
The Laci Le Beau tea business accounted for $1.6 million in revenue during
the 3 months it was owned by the Company and on a pro-forma basis sales from
Laci Le Beau for all of 1998 would have amounted to approximately 10% of the
Company's business.
MANUFACTURING AND PRODUCT QUALITY
DIETARY SUPPLEMENTS
The Company manufactures its branded Natrol and private label supplements at
its 90,000 square foot manufacturing facility/headquarters located in
Chatsworth, California. In December 1998, the Company purchased its
manufacturing facility/headquarters for $5.25 million (see "Properties"). At
this facility, the Company manufactures both tablets and two piece capsules
which account for more than 90% of the Company's supplement sales in 1998.
The Company uses third party vendors to produce its liquid products and
softgels.
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 GMPs (Good Manufacturing Practices)
of the FDA for foods and the applicable regulations of other agencies.
The Company's manufacturing facility includes an on-site laboratory which is
staffed by the director of quality assurance, bench chemists and other
quality control personnel. The Company's laboratory contains equipment for
performing testing procedures, including high performance liquid
chromatography, ultra-violet and infra-red spectrophotometer and thin layer
chromatography. The Company requires all raw materials or finished product
produced by third party vendors to be placed in quarantine upon receipt and
tested by the Company's quality control laboratory. The Company conducts
sample testing, weight testing, purity testing, dissolution testing and,
where required, microbiological testing. When raw materials are released from
quarantine, each lot is assigned a unique lot number which is
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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.
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
Ester-C-Registered Trademark-, the Company does not have contracts with any
suppliers committing such suppliers to provide the materials required for the
production of its products. In the last few years, natural vitamin E, beta
carotene, Melatonin, Kava 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. No single supplier
accounted for more than approximately 10% of the Company's total purchases in
1998 and only one, Inter-Cal Corporation (Inter-Cal), the Company's source
for Ester-C-Registered Trademark- accounted for more than 5% of purchases.
There can be no assurance that suppliers, including suppliers of bulk garlic
and Ester-C-Registered Trademark-, will provide the raw materials needed by
the Company in the quantities requested or at a price the Company is willing
to 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. With respect to products that are sold by the Company
under the supplier's trademark, such as Ester-C-Registered Trademark- and
Tonalin, 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. 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 is a party to a multi-year Distributorship/Packager/Supply
Agreement (the Inter-Cal Agreement) with Inter-Cal under which Inter-Cal is
required to supply the Company with its requirements of bulk
Ester-C-Registered Trademark-. Ester-C-Registered Trademark- products
accounted for nearly 15% of the Company's business in 1998. The Inter-Cal
Agreement requires the Company to use
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its best efforts to promote and sell Ester-C-Registered Trademark- vitamin
products worldwide with the exception of certain specified countries,
including Australia, New Zealand and certain European countries. The
Inter-Cal Agreement may be terminated by Inter-Cal immediately if the Company
violates the terms of certain provisions relating to distribution and
packaging and may be terminated by either party upon a default of the
obligations of the other party if the default has not been cured within 60
days.
The Company has the 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 believes it can triple current sales volumes
without the necessity of expanding the current manufacturing facility. Such a
tripling of production would require additional space for the warehousing of
raw material as well as the addition of some manufacturing and packaging
equipment.
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.
During 1998, the Company shipped finished product from its
manufacturing/headquarters facility. As of March 1999, the Company began
leasing 26,000 sq. ft. of space less than one-quarter mile from the
manufacturing facility for the purpose of storing and shipping finished
product. Finished goods are transferred from the Company's packaging lines to
the shipping facility for storage prior to shipment to customers.
TEAS
The Company primarily relies upon third parties for the milling, processing
and packaging of its herbal teas. The Company directly provides a majority
of the herbs and other raw materials used in the production of its teas.
INGREDIENT SUPPLY
The Company's Pure-Gar division provides raw material ingredients to the
Company and approximately 120 other customers. The Company acquires
nutraceutical grade garlic and other vegetable powders pursuant to a
multi-year Supply Agreement (the "BVP Agreement") with BVP, which requires
Basic Vegetable Products to sell and the Company to purchase specified
amounts of certain vegetable, fruit, herbal and botanical products (the "BVP
Products"). The BVP Agreement gives the Company the exclusive right to sell
certain BVP
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Products in the dietary supplement industry. The BVP 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.
During 1998, the Company's Pure-Gar division also sourced raw Kava root from
foreign sources and then engaged processors to process the root into powders
useable to the Company and other supplement manufacturers. The Pure-Gar
division may source other raw ingredients and contract for the processing of
these ingredients when management feels market conditions are such that the
purchasing and processing of these materials would be beneficial to the
Company and its customers.
TRADEMARKS AND PATENTS
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, has a second United States patent application pending for a method
of using 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
15
can be no assurance that third parties will not assert intellectual property
infringement claims against the Company. Natrol was contacted in June 1997 by
a third party that claimed Natrol's marketing of Melatonin infringed on the
third party's patents relating to a method of using Melatonin and sought to
license such patents to Natrol. Since Natrol does not believe its marketing
of Melatonin infringes on the third party's patent claims, Natrol has
declined to enter into a license agreement with the third party. Any
infringement claims by third parties against the Company may have a material
adverse effect on the Company's business, financial condition and results of
operations.
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
recent years, a number of the Company's competitors have begun to market and
sell their products under different labels in both the health food store and
the mass market distribution channels. In addition, during 1998 several large
pharmaceutical companies, including Warner Lambert, Bayer and American Home
Products, began to compete within the nutritional supplement companies,
especially the herbal market. The pharmaceutical companies have launched
aggressive advertising campaigns to support newly launched lines of herbal
products. Celestial Seasonings, a large supplier of herbal teas, also
launched a line of herbal supplements during 1998. 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
and marketing support. The Company
16
believes that it competes favorably with its competitors on the strength of
the Company's brand recognition across multiple distribution channels, an
ability to quickly develop new products with market potential, sophisticated
marketing, advertising and promotional support, product quality and an
effective sales force and distribution network.
REGULATORY MATTERS
The manufacture, packaging, labeling, advertising, promotion, distribution
and sale of the Company's products are subject to regulation by numerous
governmental agencies, the most active of which is the U.S. Food and Drug
Administration (the "FDA"), which regulates the Company's products under the
Federal Food, Drug and Cosmetic Act (the "FDCA") and regulations promulgated
thereunder. The Company's products are also subject to regulation by, among
other regulatory agencies, the Consumer Product Safety Commission, the U.S.
Department of Agriculture (the "USDA") and the Environmental Protection
Agency (the "EPA"). Advertising of the Company's products is subject to
regulation by the U.S. Federal Trade Commission (the "FTC"), which regulates
the Company's advertising under the Federal Trade Commission Act (the
"FTCA"). The manufacture, labeling and advertising of the Company's products
are also regulated by various state and local agencies as well as 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 FDCA concerning the regulation of dietary supplements. In
the judgment of the Company, the DSHEA is favorable to the dietary supplement
industry. The legislation for the first time defined "dietary supplement."
The term "dietary supplement" is defined as a product intended to supplement
the diet that contains one or more of certain dietary ingredients, such as a
vitamin, a mineral, an herb or botanical, an amino acid, a dietary substance
for use by man to supplement the diet by increasing the total dietary intake,
or a concentrate, metabolite, constituent, extract, or combination of the
preceding ingredients. The substantial majority of the products marketed by
the Company are regulated as dietary supplements under the FDCA.
Under the current provisions of the FDCA 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
17
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 and nutrient content 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 claim into interstate commerce. 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 using 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. The
FDA recently issued a proposed rule on what constitutes permitted
structure/function claims as distinguished from prohibited disease claims.
Although the Company believes its product claims comply with the law,
depending on the content of the final regulation, it may need to 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
18
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 issued final dietary supplement labeling regulations in 1997 that
require a new format for product labels and will necessitate revising dietary
supplement product labels by March 23, 1999. All companies in the dietary
supplement industry are required to comply with these labeling regulations.
The FDA has also announced that it is considering promulgating new GMPs
specific to dietary supplements. Such GMPs, if promulgated, may be
significantly more rigorous than currently applicable GMP requirements and
contain quality assurance requirements similar to GMP requirements for drug
products. Therefore, the Company may be required to expend additional capital
and resources on manufacturing in the future in order to comply with the law.
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.
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 recordkeeping, 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 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
19
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 uses counsel to review its advertising claims and
believes its current advertising is in substantial compliance with the Guide,
although no assurance can be given in this regard.
In recent years the FTC has initiated numerous investigations of dietary
supplement and weight loss products and companies. The FTC is reexamining its
regulation of advertising for dietary supplements and has announced that it
will issue a guidance document to assist supplement marketers in
understanding and complying with the substantiation requirement. Upon release
of this guidance document Natrol will be required to evaluate its compliance
with the guideline and may be required to change its advertising and
promotional practices.
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 and local authorities. 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 claims.
20
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 for
those countries. These distributors are independent contractors over whom the
Company has limited control.
In addition, the Company has in the past, from time to time, been the subject
of investigation by the FTC, however, the Company is not currently a party to
any consent order or other decree of the FTC. The Company may be the subject
of investigation in the future. The FTC may impose limitations on the
Company's advertising of its products. Any such limitations 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. 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 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 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 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 able to be reformulated,
imposition of additional recordkeeping requirements, expanded
21
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.
EMPLOYEES
As of March 1, 1999, the Company had approximately 291 employees. Of such
employees, 25 were engaged in marketing and sales, 193 were devoted to
production and distribution and 73 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.
RISK FACTORS
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 reports including, but not limited to, the Company's Prospectus dated
July 22, 1998 and filed with the Securities and Exchange Commission.
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:
INDUSTRY TRENDS.
Based on estimates in THE U.S. MARKET FOR VITAMINS, SUPPLEMENTS, AND
MINERALS, a 1997 market report prepared by Packaged Facts (the "Packaged
Facts Report"), an independent consumer marketing research firm, the retail
market for vitamins, minerals and other supplements (excluding sports
nutrition and diet products) has grown at a compound annual rate of 15% from
$3.7 billion in 1992 to $6.5 billion in 1996 and other industry sources
estimate the market grew 20% in 1997 to $7.8 billion.
More recent Information Resources, Inc. ("IRI") data show evidence that this
rapid growth pace is slowing. Dollar sales for vitamins in the food, drug and
mass market channel of distribution for the 4 weeks ended January 3, 1999
were down slightly (.73%) when compared to the same four week period in 1998.
In addition, when comparing the 12 weeks ending January 3, 1999 against the
same 12 weeks ending January 3, 1998, dollar sales were up only 1.8%. Dollar
sales for mineral
22
supplements, which includes herbal products, were up 3.4% in the four week
period and climbed 5.34 % in the 12 week period. Both rates are
substantially less than the growth rates reported in prior years.
There can be no assurance that the higher industry growth rates of prior
years can be sustained, or, if not sustained, will return. Such a failure to
sustain growth in the industry may have a material adverse effect on the
Company's ability to sustain its historic rates of growth and its results of
operations.
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
recent years, a number of the Company's competitors have begun to market and
sell their products under different labels in both the health food store and
the mass market distribution channels. In addition, large pharmaceutical
companies have begun to compete with the Company and others in the dietary
supplement industry, in particular in the more rapidly growing herbal sector
of the business. 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.
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, 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 any similar products
distributed by other companies and future reports of
23
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. See "Absence of Conclusive Clinical Studies."
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. In addition, products
currently experiencing strong popularity and rapid growth may not maintain
their sales over time. For example, the Company's net sales of DHEA, a
specialty dietary supplement introduced by the Company in March 1996, peaked
at $4.6 million for the three months ended December 31, 1996 and accounted
for 39.5% of the Company's net sales in such period. In comparison, the
Company's net sales of DHEA were only $257,000, or 1.3% of the Company's net
sales, for the three months ended December 31, 1998.
GOVERNMENT REGULATION. The manufacture, packaging, labeling, advertising,
promotion, distribution and sale of the Company's products are subject to
regulation by numerous governmental agencies, the most active of which is the
U.S. Food and Drug Administration (the "FDA"), which regulates the Company's
products under the Federal Food, Drug and Cosmetic Act (the "FDCA") and
regulations promulgated thereunder. The Company's products are also subject
to regulation by, among other regulatory entities, the Consumer Product
Safety Commission (the "CPSC"), the U.S. Department of Agriculture (the
"USDA") and the Environmental Protection Agency (the "EPA"). 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 (the "FTC"),
which regulates these activities under the Federal Trade Commission Act (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.
24
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.
Further, 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 Good Manufacturing Practice regulations ("GMPs") for
foods. The FDA has issued an advanced notice of proposed rulemaking to
consider whether to develop specific GMP regulations for dietary supplements
and dietary supplement ingredients. Such regulations, if promulgated, may be
significantly more rigorous than current requirements and contain quality
assurance requirements similar to GMPs for drug products. 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 withrawals, 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
25
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. The FTC is reexamining its
regulation of advertising for dietary supplements and has announced that it
will issue a guidance document to assist dietary supplement marketers in
understanding and complying with the substantiation requirement. Upon release
of this guidance document, Natrol will be required to evaluate its compliance
with the guideline and may be required to change its advertising and
promotional practices.
On two occasions, claims made by the Company have been the subject of
investigation by the FTC. In both matters, the FTC terminated its
investigation without further action or any formal findings. 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
26
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 Dietary
Supplement Health and Education Act of 1994 ("DSHEA"), 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.
PRODUCT LIABILITY. 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 has $2.0
million in aggregate liability insurance. If such claims should exceed $2.0
million, the Company has excess umbrella liability insurance of up to $25.0
million. However, there can be no assurance that such insurance will continue
to be available at a reasonable cost, or, if available, will be adequate to
cover liabilities. 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
27
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 could have a
material adverse effect on the Company's business, financial condition and
results of operations.
DEPENDENCE ON SIGNIFICANT CUSTOMERS. Net sales to Walgreens accounted for
15.9% of the Company's net sales for the year ended December 31, 1998 and
17.8% and 12.6% of the Company's net sales in 1997 and 1996, respectively.
Net sales to Tree of Life accounted for 6.8% of the Company's net sales for
the year ended December 31, 1998 and 11.6% and 10.2% of the Company's net
sales in 1997 and 1996, respectively. The Company does not have long-term
contracts with any of its customers. There can be no assurance that Walgreens
or the Company's other major customers will continue as major customers of
the Company. The loss of Walgreens or the loss of a significant number of
other major customers, or a significant reduction in purchase volume by or
financial difficulty of such customers, 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 other skilled
personnel. Many of the Company's employees are not covered by a
non-competition agreement, and the ability of the Company to enforce such an
agreement in California, the state in which the Company's operations are
principally located, is limited and uncertain. 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 GROWTH. The Company believes that continued growth may
strain the Company's management, operations, sales and administrative
personnel and other resources. In order to serve the needs of its existing
and future customers, the Company has increased and intends to continue to
increase its workforce, which requires the Company to attract, train,
motivate, manage and retain qualified employees. The Company's ability to
manage further growth depends in part upon the Company's ability to expand
its operating, management, information and financial systems, and production
capacity, which may significantly increase its future operating expenses. No
assurance can be given that the
28
Company's business will grow in the future or that the Company will be able
to effectively manage such growth. The Company's inability to manage its
growth successfully could have a material adverse effect on the Company's
business, financial condition and results of operations.
RISKS ASSOCIATED WITH ACQUISITIONS. The Company completed two acquisitions
in 1998 and expects to pursue additional acquisitions 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.
There can be no assurance that the Company will be able to obtain financing
for or otherwise consummate any future acquisitions. Moreover, 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. Future acquisitions
would likely require additional financing, which would likely result in an
increase in the Company's indebtedness or the issuance of additional capital
stock, which may be dilutive to the Company's stockholders, including
purchasers of shares offered hereby.
The Pure-Gar and Laci Le Beau acquisitions resulted in a significant increase
in the Company's goodwill and any future acquisitions may result in
additional goodwill and related amortization expense. At December 31, 1998,
goodwill on the Company's balance sheet was $13.8 million, representing 20.1%
of the Company's total assets at that date. In the event of any sale or
liquidation of the Company or a portion of its assets, there can be no
assurance that the value of the Company's intangible assets will be realized.
In addition, the Company continually evaluates whether events and
circumstances have occurred indicating that any portion of the remaining
balance of the amount allocable to the Company's intangible assets may not be
recoverable. When factors indicate that the amount allocable to the Company's
intangible assets should be evaluated for possible impairment, the Company
may be required to reduce the carrying value of such assets. Any future
determination requiring the write-off of a significant portion of unamortized
intangible assets could have a material adverse effect on the Company's
business, financial condition and operating results.
29
The Company regularly evaluates potential acquisitions of other businesses,
products and product lines and may hold discussions regarding such potential
acquisitions. As a general rule, the Company will publicly announce such
acquisitions only after a definitive agreement has been signed.
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 for which no such history exists. In addition,
although the Company believes all of its products are safe when taken as
directed by the Company, there is little long-term experience with human
consumption of certain of these product ingredients in concentrated form.
Accordingly, there can be no assurance that the Company's products, even when
used as directed, will have the effects intended or will not have harmful
side effects. Any such unintended 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
Ester-C-Registered Trademark-, the Company does not have contracts with any
suppliers committing such suppliers to provide the materials required for the
production of its products. In the last few years, 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
and Ester-C-Registered Trademark-, 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. With respect to products that are sold by the Company
under the supplier's trademark, such as Ester-C-Registered Trademark- and
Tonalin-Registered Trademark-, the Company is limited to that single supplier
as a source of raw material 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. The inability of the Company to obtain adequate
supplies of raw materials for its
30
products at favorable prices, or at all, could have a material adverse effect
on the Company's business, financial condition and results of operations.
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; and (vi) the availability of raw materials from
suppliers. 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 been subject to wide fluctuations.
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. 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 lease and
31
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 because such
insurance is unobtainable on commercially reasonable terms in the Company's
geographic location. In addition, the Company's softgel and liquid products
are manufactured by outside contractors. The Company's profit margins on
these products and its ability to deliver these products on a timely basis
are dependent on 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 primary 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. The simultaneous loss of the services of a number of these
independent brokers could have a material adverse effect on the Company's
business, financial condition and results of operations
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.
32
Currently, the Company has received one United States patent for its Kavatrol
product, has a second United States patent application pending for a method
of using 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 the
intellectual property rights of others, there can be no assurance that third
parties will not assert intellectual property infringement claims against the
Company. Natrol was contacted in June 1997 by a third party that claimed
Natrol's marketing of Melatonin infringed the third party's patents relating
to a method of using Melatonin and sought to license such patents to Natrol.
Since Natrol does not believe its marketing of Melatonin infringes the third
party's patent claims, Natrol has declined to enter into a license agreement
with the third party. Any infringement claims by third parties against the
Company may have a material adverse effect on the Company's business,
financial condition and results of operations.
ITEM 2. PROPERTIES
In December 1998, the Company purchased, for $5.25 million, the 90,000 square
foot manufacturing, distribution and office facility in Chatsworth,
California it had been leasing pursuant to a 10 year lease. The Company has
occupied this facility since March 1997. The facility was designed and
constructed to the Company's specifications and includes areas for shipping
and receiving, quarantine of new materials, manufacture, quality control and
laboratory activities, research and development, packaging, warehousing and
administrative offices.
On March 1, 1999 the Company commenced leasing a 26,640 square foot shipping
facility located within one quarter mile of its headquarters facility in
Chatsworth, California. The Company stores raw materials and ships finished
products from this warehouse.
The Company also leases 6,800 square feet of space in Chatsworth, California
that it periodically subleases to others. As of the end of December, the
lease on this property had 2.5 years remaining. The Company attempts to keep
this space fully leased but, on occasion, this space remains unoccupied. The
Company does not intend to renew this lease once the lease obligation is
fulfilled.
33
ITEM 3. LEGAL MATTERS
From time to time the Company is subject to litigation incidental to its
business, including possible product liability claims. Such claims, if
successful, could exceed applicable insurance coverage.
The Company is not currently a party to any material legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of the calendar year 1998, no matters were submitted
to a vote of the security holders of the Company.
34
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
PRICE RANGE OF COMMON STOCK
The Common Stock of the Company has traded on the Nasdaq National Market
under the symbol "NTOL" since the Company's initial public offering ("IPO")
in July 1998, in which 3,200,000 shares of Common Stock were issued and sold
by the Company. The Company sold an additional 295,500 shares in connection
with the underwriter's exercise of their over-allotment option in the IPO.
Prior to the IPO, there was no market for the Common Stock. On March 24,
1999, the last reported sales price of the Company's Common Stock as reported
on the Nasdaq National Market was $6.00. As of March 24, 1999 there were 21
holders of record of the Company's Common Stock. The high and low sales
prices for the Common Stock as reported by the Nasdaq National Market for the
periods since the IPO are summarized below.
Fiscal Year Ended December 31, 1998 High Low
- ----------------------------------- ---- ---
Quarter ended September 30, 1998
(from July 27, 1998) $17.875 $7.438
Quarter ended December 31, 1998 15.625 6.125
DIVIDEND POLICY
In 1996, the Company was taxed under Subchapter S of the Internal Revenue
Code of 1986, as amended (the "Code") for the period from July 1, 1996
through September 29, 1996. During this period, the Company declared and
paid dividends to its stockholders, including amounts sufficient for its
stockholders to pay their income taxes on the earnings of the Company that
were treated as having been earned by the Company's stockholders. The Company
terminated its "S" corporation status on September 30, 1996.
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 Company currently has no debt obligations whose
covenants restrict the payment of dividends. However, in the past, the
Company has entered into agreements with lenders that have restricted the
Company's ability to issue dividends and at some future date the Company may
enter into similar loan agreements limiting
35
the ability of the Company to pay dividends.
RECENT SALES OF UNREGISTERED SECURITIES
The Company has not sold any securities since the IPO that were not
registered under the Securities Act of 1933, as amended.
USE OF PROCEEDS
The Company completed the IPO in July 1998. The IPO was made pursuant to a
Registration Statement on Form S-1, originally filed with the Securities and
Exchange Commission on May 7, 1998, as amended (Commission File No.
333-52109), which was declared effective on July 21, 1998. The IPO commenced
on July 22, 1998 and terminated shortly thereafter after the sale into the
public market of all of the registered shares of Common Stock.
The shares of Common Stock sold in the IPO were offered for sale by a
syndicate of underwriters represented by Adams, Harkness & Hill, Inc.,
NationsBanc Montgomery Securities LLC and Piper Jaffray Inc.
The Company registered an aggregate of 4,531,000 shares of Common Stock
(including 591,000 shares issuable upon the exercise of the underwriters'
overallotment option) for sale in the IPO at a per share price of $15.00, for
an aggregate offering price of approximately $68.0 million. Of the 4,531,000
shares sold in the IPO, 3,495,500 shares were registered for the Company's
account.
The Company incurred the following expenses in connection with the IPO:
Underwriting discounts and commissions $3.67 million
Other expenses $1.05 million
-------------
Total expenses $4.72 million
After deducting the expenses set forth above, the Company received
approximately $47.7 million in net proceeds from the IPO. The Company used
approximately (a) $8.4 million of the proceeds to repay in July 1998
borrowings under the Company's then existing senior credit facility with
Wells Fargo Bank, N.A., including fees and accrued and unpaid interest, (b)
$6.0 million to redeem all of the outstanding shares of the Company's
Redeemable Preferred Stock in July 1998, (c) $7.5 million to complete the
acquisition of the Laci Le Beau tea business in October 1998, and (d) $5.25
million to purchase its headquarters/ manufacturing facility in December
1998.
36
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following selected financial data for the four years ended December 31,
1998 is derived from consolidated financial statements of Natrol, Inc. and
subsidiaries, which have been audited by Ernst & Young LLP, independent
auditors. The selected financial data for the year ended December 31, 1994 is
derived from unaudited financial statements. The unaudited consolidated
financial statements have been prepared by the Company on a basis consistent
with the Company's audited financial statements and, in the opinion of
management, include all adjustments, consisting only of normal recurring
accruals, necessary for a fair presentation of the Company's consolidated
financial position and results of operations for the year ended 1994. 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.
YEAR ENDED DECEMBER 31,
----------------------------------------------
1994 1995 1996 1997 1998
------- ------- -------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENT OF
INCOME DATA:
Net sales $12,214 $23,566 $40,802 $42,875 $68,207
Cost of goods sold 7,106 12,214 18,497 19,800 32,012
------- ------- -------- ------- -------
Gross profit 5,108 11,352 22,305 23,075 36,195
------- ------- -------- ------- -------
Selling and marketing expenses 2,552 4,458 8,736 11,398 17,757
General and administrative
expenses 1,739 3,378 5,431 4,450 6,513
------- ------- -------- ------- -------
Total operating expenses 4,291 7,836 14,167 15,848 24,270
------- ------- -------- ------- -------
Operating income 817 3,516 8,138 7,227 11,925
------- ------- -------- ------- -------
Interest income (expense), net (25) (19) 54 (220) (197)
------- ------- -------- ------- -------
Income before income tax
provision 792 3,497 8,192 7,007 12,122
Income tax provision 301 1,453 2,299(1) 2,816 4,606
------- ------- -------- ------- -------
Net income $491 $2,044 $5,893 $4,191 $7,516
------- ------- -------- ------- -------
Basic earnings per share $0.08 $0.34 $0.94 $0.59 $0.76
Diluted earnings per share $0.08 $0.34 $0.83 $0.41 $0.63
Weighted average shares
outstanding-basic 6,000 6,000 6,275 7,100 9,854
Weighted average shares
outstanding-diluted 6,000 6,000 7,065 10,273 11,891
37
DECEMBER 31,
----------------------------------------------
1994 1995 1996 1997 1998
------- ------- -------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents $560 $515 $285 $1,800 $559
Marketable securities - - - - 19,010
Working capital 926 2,741 4,496 8,424 35,673
Total assets 3,972 7,608 11,345 19,716 68,708
Long-term debt, less current
maturities 84 67 405 2,606 -
Convertible participating
preferred stock - - 12,000 12,000 -
Total stockholders' equity
(deficit) 1,259 3,303 (5,755) (1,564) 59,641
Cash dividend declared per
common share $0.00 $0.00 $0.55 $0.00 $0.00
- --------------
(1) In 1996, the Company was taxed under Subchapter S of the Code for the
period from July 1, 1996 through September 29, 1996, and was taxed under
Subchapter C of the Code for the period from January 1, 1996 through
June 30, 1996 and for the period from September 30, 1996 through
December 31, 1996. Accordingly, the provision for income taxes for the
period in which the Company was taxed as a Subchapter S corporation
reflects primarily state income tax, if any. If the Company had been
subject to taxation under Subchapter C of the Code for the entire year
ended December 31, 1996, the pro forma provision for income taxes would
have been $3.2 million and pro forma basic earnings per share and pro forma
diluted earnings per share would have been $0.80 and $0.71, respectively.
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.
OVERVIEW
Natrol's core business is the manufacturing and marketing of branded,
high-quality dietary supplements.
38
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.
The growth in Natrol brand sales historically has been a result of the
introduction of new products on an ongoing basis and the expansion of sales
through additional channels of distribution. During the last three years, the
Company's net sales have been affected by the success of certain products,
including Melatonin, DHEA and St. John's Wort, which were introduced in 1995,
1996 and 1997, respectively. Melatonin was introduced in the third quarter of
1995 and generated $6.7 million in revenue that year. In 1996, Melatonin and
DHEA gained substantial popularity with the general public and accounted for
$22.9 in million revenues, more than 50% of the Company's net sales in that
year. However, during 1997 the net sales volume of these two products
declined by an aggregate of $9.8 million, or 42.9%. When consumer products
experience heightened public popularity, it is not uncommon for them to enjoy
peaks of pipeline sales followed by declines. Accordingly, the Company
anticipated a decline in net sales of Melatonin and DHEA and introduced 34
new products in 1997, which accounted for $8.9 million, or 20.7%, of net
sales in 1997. One major item in this product introduction mix was St.
John's Wort, which was launched in the third quarter of 1997 and generated
$3.8 million in sales. Growth in existing product lines in 1997 added an
additional $6.8 million to 1997 net sales.
During 1998, the Company introduced approximately 70 new items. The Natrol
brand product line currently includes approximately 190 items which are
packaged in various sizes (e.g., 30 count, 60 count, etc.), strengths (e.g.,
50 mg, 100 mg, etc.), and combinations (e.g., multiple vitamins with or
without iron). These sizes, strengths and combinations create approximately
500 stockkeeping units (SKUs).
During 1998 approximately 14% of the Company's revenues were generated by
these new Natrol brand items. Ester-C-Registered Trademark- and Melatonin
generated 14% and 10% of revenues, respectively. The Company continues to
believe that introducing new products is important to the Company's growth
and to maintaining what it believes to be an excellent reputation for being
an innovative Company within the nutritional supplement industry and as such
the Company expects to introduce more new products in 1999.
Prior to 1995, most of the Company's distribution was within the health food
channel of trade. Today, the health food
39
channel of trade accounts for approximately 31% of the Company's branded
Natrol business. A majority of the remaining sales are to mass market
accounts. Net sales to Walgreens accounted for 15.9% of the Company's net
sales for 1998 and 17.8% and 12.6% of the Company's net sales in 1997 and
1996, respectively. No other customer accounted for more than 10% in 1998.
ACQUISITIONS DURING 1998
During 1998, the Company completed two acquisitions.
On February 27, 1998, the Company acquired substantially all of the assets
and certain liabilities of Pure-Gar, L.P. The acquisition involved the
purchase of two brands of garlic supplements, Quintessence and Highgar Farms,
as well as a bulk ingredient business. In connection with the acquisition,
the Company recorded a purchase price of $11.0 million with $9.0 million of
goodwill which is being amortized on a straight line basis over 15 years,
amounting to $600,000 of annual amortization expense. Upon completing the
acquisition, the Company began the process of developing its own Garlipure
line of Natrol garlic supplements and then filling shelf space formerly
allocated by retailers to the acquired Highgar Farms and Quintessence lines
with its Garlipure line. The Company also began to aggressively promote its
ingredient supply business. Sales of garlic supplements prior to the
acquisition were nominal. In 1998, the Company sold approximately $2.2
million in garlic supplements.
Many of the Company's ingredient customers are direct competitors to the
Company's core branded Natrol business and as such the Company maintains a
"Chinese Wall" between its Pure-Gar division and the rest of the Company. The
purpose is to ensure that Pure-Gar customer sales information is not
transferred to the rest of the Company. The Company's Pure-Gar ingredient
supply business contributed approximately $6.5 million to revenues and $3.4
million to the Company's gross margin during the period from when the Company
acquired Pure-Gar through December 31, 1998.
On October 1, 1998, the Company acquired certain of the assets of Laci Le
Beau which consisted of Laci Le Beau Corporation as well as certain related
companies. The total purchase price for the acquisition was $7.5 million in
cash. Laci Le Beau is a formulator, packager and distributor of specialty
teas sold through the health channel of distribution as well as in food
stores, drug stores and mass market merchandisers. These channels of
distribution are essentially the same as those used by the Company's Natrol
branded products. Under the terms of the acquisition agreement, the Company
acquired no accounts receivable, nor did it assume any liabilities of Laci Le
Beau. The acquisition is being accounted for using the purchase
40
method, and, accordingly, the assets acquired are recorded at their estimated
fair values. The excess of the cost of the acquisition over the fair value
of the assets purchased was approximately $5.0 million and is being amortized
over 15 years.
The Laci Le Beau tea business contributed $1.6 million in revenue for the
quarter and year ended December 31, 1998.
CAPITAL ADDITIONS
During 1997 the Company invested heavily in corporate infrastructure and the
building out and equipping of a 90,000 square foot manufacturing and
headquarters facility. The facility has improved manufacturing efficiency,
and management believes the facility provides the flexibility to service
customers more effectively and respond rapidly to increases in demand for
particular products.
The Company purchased the headquarters facility on December 24, 1998 for
$5.25 million in cash. The Company is now in the process of financing 75% of
the purchase price via a non-recourse fixed rate, fixed payment loan to be
amortized over 15 years. The estimated rate for the loan is between 7.25% and
7.75%. The Company's depreciation expense will increase as a result of the
purchase. Other capital additions in fiscal 1998 amounted to $861,000.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
NET REVENUE. Net Revenue in 1998 increased 58.9% to $68.2 million from $42.9
million in 1997. Of the $25.3 million increase, $6.5 million was due to the
sale of raw material ingredients, primarily nutraceutical grade garlic,
attributable to the acquisition of Pure-Gar. Another $1.6 million in sales
were generated through the sale of Laci Le Beau teas. The remaining $17.2
million represents a 40% increase in sales of Natrol branded products. The
increase was achieved through distribution gains at the retail level as well
as additional sales from existing and new products.
Two product groupings represented 10% or more of sales in 1998;
Ester-C-Registered Trademark- with approximately 14% of revenue and Melatonin
with approximately 10% of revenue.
Sales to Walgreens equaled 15.9% of the Company's revenue. No other customer
accounted for more than 10% of the Company's revenues in 1998.
41
GROSS PROFIT. Gross profit increased 56.8% to $36.2 million, or $13.1
million, in 1998 versus $23.1 million in 1997. The gross margin decreased
slightly to 53.1% in 1998 from 53.8% in 1997. The decrease was due primarily
to shifts in product mix, including the addition of the Pure-Gar ingredient
supply business and the Laci Le Beau tea business.
SELLING AND MARKETING EXPENSES. Selling and marketing expenses increased
56.1%, or $6.4 million, to $17.8 million in 1998 from $11.4 million in 1997.
As a percentage of net sales, selling and marketing expenses decreased to
26.0% in 1998 from 26.6% in 1997. The decrease was due to sales growth being
more rapid in percentage terms than the growth in corresponding payroll or
consumer marketing expenses.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased 44.4%, or $2.0 million, to $6.5 million in 1998 from $4.5 million
in 1997. As a percentage of net sales, general and administrative expenses
decreased to 9.6% in 1998 from 10.4% in 1997. Of the absolute dollar
increase, 30%, or $600,000, was due to the amortization of goodwill recorded
as a result of the acquisition of Pure-Gar and Laci Le Beau. The remainder
was due to increased general and administrative expenses incurred because of
the two acquisitions as well as additional personnel and overhead that were
added to support the Company's growth during the year.
INTEREST INCOME (EXPENSE), NET. Net interest income for 1998 was $197,000
versus a net expense of $220,000 in 1997. Immediately after the Company's
IPO, which was completed in July, 1998, the Company retired all of its debt
and began investing its surplus cash in interest bearing investments. Total
interest expense for 1998 amounted to $407,000. Interest earned amounted to
$604,000. A portion of the interest earned was taxable as income to the
corporation and a portion was non-taxable.
INCOME TAX PROVISION. Provision for income taxes increased 64.2%, or $1.8
million, to $4.6 million in 1998 from $2.8 million in 1997. The effective tax
rate for 1998 was 38.0% compared to 40.2% for 1997.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
NET SALES. Net sales increased 5.1%, or $2.1 million, to $42.9 million in
1997 from $40.8 million in 1996. The increase was due to net sales of $8.9
million attributable to products introduced in 1997 and a $3.0 million
overall increase in net sales of existing products, which more than offset a
$9.8 million decrease in net sales of two products, Melatonin and DHEA, whose
sales peaked in 1996. The net increase in net sales of new and existing
products (other
42
than Melatonin and DHEA ) was primarily due to increased penetration and
expanded presence in both the health food store and mass market distribution
channels.
GROSS PROFIT. Gross profit increased 3.5%, or $771,000, to $23.1 million in
1997 from $22.3 million in 1996. Gross margin decreased to 53.8% for 1997
from 54.7% for 1996. The decrease was primarily due to a shift in product mix
as a result of a decrease in sales in the Company's higher gross margin
specialty dietary supplements category, principally Melatonin and DHEA.
SELLING AND MARKETING EXPENSES. Selling and marketing expenses increased
30.5%, or $2.7 million, to $11.4 million in 1997 from $8.7 million in 1996.
As a percentage of net sales, selling and marketing expenses increased to
26.6% in 1997 from 21.4% in 1996. The increase was primarily due to increases
in spending to support increased net sales, in particular increases in print,
radio and television advertising, and other promotional expenses and payroll
expenses.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased 18.2%, or $981,000, to $4.5 million in 1997 from $5.4 million in
1996. As a percentage of net sales, general and administrative expenses
decreased to 10.4% in 1997 from 13.3% in 1996. This decrease was primarily
attributable to increased payroll expenses as a result of significantly
higher management performance-based incentive bonuses in 1996.
INTEREST INCOME (EXPENSE), NET. Interest expense increased $274,000 to
$220,000 in 1997 from interest income of $54,000 in 1996. The increase net
was primarily due to increased borrowings to fund capital expenditures.
INCOME TAX PROVISION. Provision for income taxes increased 22.5%, or
$518,000, to $2.8 million in 1997 from $2.3 million in 1996. The effective
tax rate for 1997 was 40.2%, compared to 28.0% for 1996. The Company was
taxed under Subchapter S of the Code for the period from July 1, 1996 through
September 30, 1996, at which time the Company ceased to qualify as an S
corporation. As a result, the Company paid no federal income taxes for the
third calendar quarter of 1996. If the Company had been required to pay
federal income taxes during such quarter, the provision for income taxes
would have been $3.2 million and the effective tax rate would have been
38.6%. The increase in the effective tax rate in 1997 from the pro forma tax
rate in 1996 was primarily due to the differences in the various income tax
rates in the states in which the Company did business.
43
LIQUIDITY AND CAPITAL RESOURCES
Prior to its IPO, the Company had financed its operations and capital
requirements primarily through funds from operations and, to a lesser extent,
borrowings. At December 31, 1998, the Company had working capital of $35.7
million, as compared to $8.4 million in working capital at December 31, 1997.
The increase was primarily due to net proceeds from the IPO, after paying
down long-term debt and the redemption of preferred stock.
On July 27, 1998, the Company completed the IPO of 3,940,000 shares of Common
Stock priced at $15.00 per share. Of the total shares offered, 3,200,000
shares were sold by the Company. The Company sold an additional 295,500
shares of Common Stock on August 6, 1998, pursuant to the underwriters'
exercise of the overallotment option granted in the IPO. The net proceeds to
the Company from the IPO were $47.7 million, including the shares sold
pursuant to the underwriters' exercise of the overallotment option. Of the
net proceeds to the Company, $8.4 million was used to repay in full long-term
debt. As more fully described in Natrol's prospectus dated July 22, 1998,
all of the 27,000 shares of convertible participating preferred stock
purchased by certain investors in September 1996 were converted into
2,700,000 shares of Common Stock of the Company and shares of redeemable
preferred stock, which were immediately redeemed for a total of $6.0 million.
The redemption price of the redeemable preferred stock was funded from the
proceeds of the IPO.
Net cash provided by operating activities was $4.5 million for the year ended
December 31, 1998 versus cash provided of $2.1 million and $3.8 million in
1997 and 1996, respectively. The increase in net cash provided by operating
activities in 1998 compared to 1997 was primarily due to higher levels of
depreciation and amortization, an increase in provisions to reserves for
doubtful accounts and other reserves and an increase in accounts payable and
other accruals which were partially offset by higher levels of inventory
balances and accounts receivable. The increase in inventory balances, from
$6.9 million to $13.4 million, was primarily due to the purchase of larger
quantities of raw materials to obtain favorable volume discounts and the
necessity to carry additional inventory to support the Company's broader
product offerings with its introduction of several new products during the
year. The increase in accounts receivable was the result of increased sales
by the Company. At December 31, 1998, the Company's average trade receivable
aging was approximately 54 days versus 1997 when the average receivable aging
was 46 days. The lengthening of the average accounts receivable aging is due
in part to changes in the Company's customer mix, which includes ingredient
supply customers and a high proportion of mass market business where, in each
44
case, payment terms are typically longer than in the rest of the Company's
business.
The decrease in net cash provided by operating activities in 1997 compared to
1996 was primarily due to a decrease in net income and reflects higher levels
of accounts receivable and inventory balances, partially offset by higher
levels of depreciation and amortization, provision for reserves for doubtful
accounts and other reserves and accounts payable. The increase in inventory
balances was primarily due to the purchase of larger quantities of raw
materials to obtain favorable volume discounts and the purchase of raw
materials for new products in anticipation of new product introductions
scheduled for 1998. The increase in accounts receivable was the result of
increased sales by the Company during such period to mass market retailers
from whom accounts receivable are on average outstanding for a longer period
of time.
Net cash used in investing activities was $43.8 million for the year ended
1998 and $3.2 million and $1.9 in 1997 and 1996, respectively. Of the net
cash used in investing activities in 1998, the Company used $11.1 million to
consummate the Pure-Gar acquisition, $7.6 million to complete the Laci Le
Beau acquisition, $5.3 million to purchase its corporate headquarters
facility and invested $861,000 in plant and equipment. The remainder of cash
used in investing activities, or $19.0 million net, was used to purchase
marketable securities. Substantially all net cash used in investing
activities in 1997 and 1996 constituted capital expenditures made in
connection with the build-out of the Company's manufacturing
facility/headquarters, which the Company began in 1996.
Net cash provided by financing activities was $38.1 million for the year
ended December 31, 1998 and $2.6 million and ($2.1 million) in 1997 and 1996,
respectively. Net cash provided by financing activities in the year ended
December 31, 1998 consisted of net proceeds of $47.7 million from the
Company's IPO, which was completed on July 27, 1998, as well as $9.0 million
of borrowings to finance the acquisition of Pure-Gar in late February 1998.
This inflow of funds was offset by the repayment of $4.2 million of debt
prior to the IPO as well as the repayment of all of the Company's outstanding
debt of $8.4 million in July 1998 and the redemption of $6.0 million of
redeemable preferred stock as described above.
Net cash provided by financing activities in 1997 was comprised of net
borrowings of $3.0 million to finance capital expenditures made in connection
with the build-out and equipping of the Company's manufacturing facility,
which was partially offset by $400,000 used to pay dividends to stockholders
declared in 1996.
45
Net cash used in financing activities in 1996 was comprised of net borrowings
of $415,000 used for capital expenditures and proceeds of $854,000 from the
sale by the Company of 1,921.9 shares of convertible participating preferred
stock. These amounts were more than offset by $503,000 (net of $349,000 of
compensation expense) used to redeem shares of Common Stock from a
stockholder and $2.9 million used to pay dividends to stockholders.
As of the end of 1998, the Company had no outstanding debt, nor did it have
any credit facilities in place. The Company is currently negotiating with its
prime bank, Wells Fargo, to refinance the acquisition of its headquarters
building which was completed on December 24, 1998. The Company expects to
have this financing in place during the second quarter of 1999.
The Company's cash and marketable securities balances combined at the close
of 1998 was approximately $19.6 million. The Company believes that this
amount, together with cash generated from operations and the cash it will
receive from financing its headquarters facility, will be sufficient to fund
its anticipated working capital needs and capital expenditures (other than
financing necessary to complete future acquisitions, if any) for at least the
next 12 months. Future acquisitions, if any, could be funded with cash from
operations as well as future borrowings. Future borrowings may include
covenants restricting the Company's ability to issue dividends or to make
additional acquisitions. There can be no assurance that attractive
acquisition opportunities will be available to the Company or will be
available at prices and upon such other terms that are attractive to the
Company. The Company regularly evaluates the potential acquisition of other
businesses, products and product lines and may hold discussions regarding
such potential acquisitions. As a general rule, the Company will publicly
announce such acquisitions only after a definitive agreement has been signed.
The Company currently has no commitments or agreements with respect to any
acquisition. In addition, in order to meet its long-term liquidity needs or
consummate future acquisitions, 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 its strategy and could negatively affect its
operations in future periods.
IMPACT OF INFLATION
Generally, inflation has not had a material impact on the Company's
historical operations or profitability.
46
YEAR 2000 READINESS DISCLOSURE
The statements in the following section include "Year 2000 readiness
disclosure" within the meaning of the Year 2000 Information and Readiness
Disclosure Act.
Many existing computer programs and databases use two digits to identify a
year in the date field (i.e., 98 would represent 1998). These programs and
databases were designed and developed without considering the impact of the
upcoming millennium. If not corrected, many computer systems could fail or
create erroneous results relating to the year 2000. If the Company, its
significant customers, or suppliers fail to make necessary modifications and
conversions on a timely basis, the year 2000 issue could have a material
adverse effect on Company operations. However, the impact cannot be
quantified at this time. The Company believes that its competitors face a
similar risk.
The Company has developed plans to address the possible exposures related to
the impact on its computer systems of the year 2000 issue. Key financial,
information and operational systems, including equipment with embedded
microprocessors, have been or are currently being inventoried and assessed,
and detailed plans have been or are currently being developed for the
required systems modifications or replacements. Progress against these plans
is monitored and reported to management on a regular basis. Implementation of
required changes to critical systems is expected to be completed during the
first half of 1999. The Company is also focusing on major customers and
suppliers to assess their compliance. The Company has received assurances
from customers that such customers expect to be Year 2000 compliant and is
seeking such assurances from its other material customers and suppliers.
Nevertheless, there can be no assurance that there will not be a material
adverse effect on the Company if third party, governmental or business
entities do not convert or replace their systems in a timely manner and in a
way that is compatible with the Company's systems. In the event a material
customer or supplier is not Year 2000 compliant, the Company's business,
financial condition and results of operations could be materially and
adversely affected.
The costs incurred to date related to these programs have not been material
and the Company does not expect its future costs related to these programs to
be material. Such costs have been and will continue to be funded through
operating cash flows. The Company presently believes that the total cost of
achieving year 2000 compliant systems is not expected to be material to its
financial condition, liquidity, or results of operations.
Time and cost estimates are based on currently available information.
Developments that could affect estimates
47
include, but are not limited to, the availability and cost of trained
personnel; the ability to locate and correct all relevant computer code and
systems; and remediation success of the Company's customers and suppliers.
The preceding "Year 2000 Readiness Disclosure" contains various
forward-looking statements within the meaning of Section 21E of the
Securities Exchange Act of 1934 and the Section 27A of the Securities Act of
1933. These forward-looking statements represent the Company's beliefs or
expectations regarding future events. When used in the "Year 2000 Readiness
Disclosure", the words "believes," "expects," "estimates" and similar
expressions are intended to identify forward-looking statements.
Forward-looking statements include, without limitation, the Company's
expectations as to when it will complete the modification and testing phases
of its Year 2000 project plan as well as its Year 2000 contingency plans; its
estimated cost of achieving Year 2000 readiness; and the Company's belief
that its internal systems will be Year 2000 compliant in a timely manner. All
forward-looking statements involve a number of risks and uncertainties that
could cause the actual results to differ materially from the projected
results. Factors that may cause these differences include, but are not
limited to, the availability of qualified personnel and other information
technology resources; the ability to identify and remediate all date
sensitive lines of computer code or to replace embedded computer chips in
affected systems or equipment; and the actions of governmental agencies or
other third parties with respect to Year 2000 problems.
RISK FACTORS
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 reports including but not limited to the Company's Prospectus dated July
22, 1998 and filed with the Securities and Exchange Commission.
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 potential general downturn or slowing of the growth of
the dietary supplement industry, (ii) increased competition from current
competitors and new market entrants, (iii) adverse publicity regarding the
dietary supplement industry or the Company's products, (iv) the Company's
dependence upon its ability to develop new
48
products, (v) government regulation, (vi) exposure to product liability
claims,(vii) dependence on significant customers, (viii) the Company's
ability to keep and attract key management employees, (ix) the Company's
inability to manage growth and execute its business plan, (x) the Company's
ability to consummate future acquisitions and its ability to integrate
acquired businesses and to retain key personnel associated with any
acquisition, (xi) the absence of clinical trials for many of the Company's
products, (xii) the Company's inability to obtain raw materials that are in
short supply, (xiii) sales and earnings volatility, (xiv) the Company's
ability to manufacture its products efficiently, (xv) the Company's reliance
on independent brokers to sell its products, (xvi) the inability of the
Company to protect its intellectual property, (xvii) control by principal
shareholders, (xviii) the possible sale of large amounts of stock by
controlling shareholders, (xiv) volatility in the stock markets, (xx) a
failure of the Company to properly address the year 2000 issue, and (xxi) a
general downturn in the national economy as a whole. These and other such
factors are discussed in more under the caption "Risk Factors" and elsewhere
in this report.
ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The following discussion about the Company's market risk disclosures involves
forward-looking statements. Actual results could differ materially from
those projected in the forward-looking statements. The Company is exposed to
market risk related to changes in interest rates.
The Company maintains a portfolio of highly liquid cash equivalents and
marketable securities. Marketable securities consist primarily of
certificates of deposits, commercial paper and corporate and municipal bonds.
Given the short-term nature and liquidity of these investments, and that the
Company has no borrowings outstanding, the Company is not subject to
significant interest rate risk.
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Report of Independent Accountants and the Consolidated Financial
Statements and notes thereto are presented under Item 14 of this Report.
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not Applicable
49
PART III
Information required under Part III (Items 10, 11, 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 beheld on June 2, 1999.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) INDEX TO CONSOLIDATED FINANCIAL STATEMENTS: PAGE(S)
Report of Independent Auditors 55
Consolidated Balance Sheets as of December 31, 1998
and 1997 56
Consolidated Statements of Income for the years
ended December 31, 1998, 1997 and 1996 57
Consolidated Statements of Stockholders' Equity
(Deficit) for the years ended December 31,
1998, 1997 and 1996 58
Consolidated Statements of Cash Flows for the years
ended December 31, 1998, 1997 and 1996 59
Notes to Consolidated Financial Statements 60
(a)(2) Index to Consolidated Financial Statement Schedules:
All 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:
(2) Plan of Acquisition, Reorganization, Arrangement, Liquidation or
Succession:
2.1 Asset Purchase Agreement by and among Natrol
Acquisition Corp., the Company, Laci Le Beau
Corporation, Shay Lee Corporation, and the
Nutrition Products Trust of 1995 dated as of
September 18, 1998 (incorporated herein by reference
to Item 7(c) of the Company's Current Report on
Form 8-K report filed October 9, 1998)
(3) Articles of Incorporation and By-Laws:
3.1 The Third Amended and Restated
50
Certificate of Incorporation of the Company is
filed herewith as exhibit 3.1
3.2 The Amended and Restated By-Laws of
the Company (incorporated herein by
reference to Exhibit 3.6 to the
Company's Registration Statement on
Form S-1, as amended, File No. 333-52109).
(4) 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).
(10) Material Contracts
10.1 Natrol, Inc. Amended and Restated 1996 Stock
Option Plan (incorporated herein by reference
to Exhibit 10.2 to the Company's Registration
Statement on Form S-1, as amended, File No.
333-52109);
10.2 Natrol, Inc. 1998 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 Restricted Stock Agreement, dated November
14, 1996, by and between Natrol, Inc. and
Dennis R. Jolicoeur (incorporated herein by
reference to Exhibit 10.5 to the Company's
Registration Statement on Form S-1, as
amended, File No. 333-52109);
10.5 Promissory Note of Dennis R. Jolicoeur,
51
dated November 14, 1996 (incorporated herein by
reference to Exhibit 10.6 to the Company's
Registration Statement on Form S-1, as
amended, File No. 333-52109);
10.6 Pledge Agreement, dated November 14, 1996, by
and between Natrol, Inc. and Dennis R.
Jolicoeur (incorporated herein by reference
to Exhibit 10.7 to the Company's Registration
Statement on Form S-1, as amended, File No.
333-52109);
10.7 Form of Stock Option Agreement (incorporated
herein by reference to Exhibit 10.9 to the
Company's Registration Statement on Form S-1,
as amended, File No. 333-52109);
10.8 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 Distributorship/Packager/Supply Agreement,
dated as of January 1, 1995, by and between
the Company and Inter-Cal Corporation
(incorporated herein by reference to Exhibit
10.11 to the Company's Registration Statement
on Form S-1, as amended, File No. 333-52109);
10.10 Letter Agreement dated July 18, 1997 between
the Company and Jon J. Denis (incorporated
herein by reference to Exhibit 10.12 to the
Company's Registration Statement on Form S-1,
as amended, File No. 333-52109);
10.11 Description of Salary and Incentive Bonus
Arrangements for Dennis R. Jolicoeur, Cheryl R.
Richitt and Gary P. DeMello (incorporated herein by
reference to Exhibit 10.13 to the Company's
Registration Statement on Form S-1, as amended, File
No. 333-52109);
10.12 Purchase and Sale Agreement between WHLW Real
Estate Limited Partnership,
52
Natrol Real Estate, Inc. and Natrol, Inc. is filed
herewith as Exhibit 10.12.
(21) Subsidiaries of Natrol, Inc.: A list of Subsidiaries of the
Company is filed herewith as Exhibit 21.1.
(23) Consent of Experts and Counsel: Consent of Ernst & Young
LLP is filed herewith as Exhibit 23.1.
(27) Financial Data Schedule: The Financial Data Schedule is
filed herewith as Exhibit 27.1.
(b) REPORTS ON FORM 8-K:
The registrant filed the following Current Reports
on Form 8-K during the three month period ended
December 31, 1998:
1. On October 9, 1998, the Company filed a
Current Report on Form 8-K announcing that on
September 30, 1998, the Company, through its
wholly-owned subsidiary Natrol Acquisition
Corp., acquired substantially all of the
assets and properties of Laci Le Beau
Corporation, Shay Lee Corporation and the
Nutrition Products Trust of 1995 pursuant to
an Asset Purchase Agreement dated as of
September 18, 1998.
2. On December 14, 1998, the Company filed an
amendment to a Current Report on Form 8-K/A
filing the Combined Financial Statements of
Laci Le Beau Corporation and Related Entities
as of September 30, 1998 and for the nine
months then ended as Exhibit 99.1 and the
Unaudited Pro Forma Consolidated Financial
statements of Natrol, Inc. as of and for the
nine months ended September 30, 1998 and
Consolidated Statement of Income for the year
ended December 31, 1997 as Exhibit 99.2.
53
SIGNATURE
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 __ day of March,
1999.
Natrol, Inc.
By: /s/ ELLIOTT BALBERT
-----------------------------
Elliott Balbert
President and Chief
Executive Officer
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.
SIGNATURES TITLE DATE SIGNED
- ---------- ----- -----------
/s/ Elliott Balbert
- ------------------------ Chairman of the Board, March 30, 1998
Elliott Balbert Chief Executive Officer,
President and Director
(Principal Executive Officer)
/s/ Dennis R. Jolicoeur
- ------------------------ Chief Financial Officer, March 30, 1998
Dennis R. Jolicoeur Executive Vice President
and Director (Principal
Financial Officer and
Principal Accounting
Officer)
/s/ Norman Kahn
- ------------------------ Director March 30, 1998
Norman Kahn
/s/ David Laufer
- ------------------------ Director March 30, 1998
David Laufer
/s/ P. Andrews McLane
- ------------------------ Director March 30, 1998
P. Andrews McLane
54
REPORT OF INDEPENDENT AUDITORS
The Board of Directors
Natrol, Inc.
We have audited the accompanying consolidated balance sheets of Natrol, Inc.
and subsidiaries as of December 31, 1998 and 1997, and the related
consolidated statements of income, stockholders' equity (deficit) and cash
flows for each of the years in the three year period ended December 31, 1998.
These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Natrol, Inc.
and subsidiaries at December 31, 1998 and 1997 and the consolidated results
of its operations and its cash flows for each of the years in the three year
period ended December 31, 1998, in conformity with generally accepted
accounting principles.
Woodland Hills, California
February 16, 1999
55
Natrol, Inc.
Consolidated Balance Sheets
DECEMBER 31
1998 1997
-------------------------
ASSETS
Current assets:
Cash and cash equivalents $559,424 $1,800,202
Marketable securities 19,010,826 -
Accounts receivable, net of allowances of $332,000
and $262,000 at December 31, 1998 and 1997,
respectively 9,987,002 5,396,625
Inventories 13,437,455 6,934,181
Deferred taxes 1,214,076 553,890
Prepaid expenses and other current assets 499,366 340,649
-------------------------
Total current assets 44,708,149 15,025,547
Property and equipment:
Building and improvements 6,881,707 1,875,625
Machinery and equipment 3,826,351 2,804,346
Furniture and office equipment 1,238,749 871,048
-------------------------
11,946,807 5,551,019
Accumulated depreciation and amortization (1,756,182) (922,839)
-------------------------
10,190,625 4,628,180
Goodwill, net of accumulated amortization of $588,168 13,774,701 -
Other assets 34,365 62,373
-------------------------
Total assets $68,707,840 $19,716,100
-------------------------
-------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable $5,943,224 $3,867,846
Accrued expenses 2,066,935 899,311
Accrued payroll and related liabilities 804,623 413,687
Income taxes payable 220,135 422,083
Current portion of long-term debt - 998,611
-------------------------
Total current liabilities 9,034,917 6,601,538
Deferred income taxes, noncurrent 32,013 72,774
Long-term debt, less current portion - 2,606,250
Convertible participating preferred stock, $0.01 par
value per share, none and 27,000 shares authorized,
issued and outstanding as of December 31, 1998 and - 12,000,000
1997, respectively
Commitments
Stockholders' equity (deficit):
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 - 13,301,990 and
7,100,000 at December 31, 1998 and 1997,
respectively 133,020 71,000
Additional paid-in capital 60,187,301 559,500
Retained earnings (deficit) (116,911) (1,632,462)
-------------------------
60,203,410 (1,001,962)
Receivable from stockholder (562,500) (562,500)
-------------------------
Total stockholders' equity (deficit) 59,640,910 (1,564,462)
-------------------------
Total liabilities and stockholders' equity (deficit) $68,707,840 $19,716,100
-------------------------
-------------------------
SEE ACCOMPANYING NOTES.
56
Natrol, Inc.
Consolidated Statements of Income
YEAR ENDED DECEMBER 31
1998 1997 1996
----------------------------------------
Net sales $ 68,206,585 $ 42,874,759 $ 40,802,352
Cost of goods sold 32,011,641 19,799,712 18,497,818
----------------------------------------
Gross profit 36,194,944 23,075,047 22,304,534
Selling and marketing expenses 17,757,395 11,398,390 8,735,815
General and administrative expenses 6,513,094 4,450,244 5,431,368
----------------------------------------
Total operating expenses 24,270,489 15,848,634 14,167,183
----------------------------------------
Operating income 11,924,455 7,226,413 8,137,351
Interest income 604,871 20,695 109,102
Interest expense (407,452) (240,250) (55,472)
----------------------------------------
Income before income tax provision 12,121,874 7,006,858 8,190,981
Income tax provision 4,606,323 2,816,158 2,298,593
----------------------------------------
Net income $ 7,515,551 $ 4,190,700 $ 5,892,388
----------------------------------------
----------------------------------------
Pro forma net income data (NOTE 5):
Income before provision for
income taxes $ 12,121,874 $ 7,006,858 $ 8,190,981
Pro forma income tax provision
(actual for the years
ended 1998 and 1997) 4,606,323 2,816,158 3,159,793
----------------------------------------
Pro forma net income $ 7,515,551 $ 4,190,700 $ 5,031,188
----------------------------------------
----------------------------------------
Basic earnings per share $0.76 $0.59 $0.94
----------------------------------------
----------------------------------------
Diluted earnings per share $0.63 $0.41 $0.83
----------------------------------------
----------------------------------------
Weighted average shares outstanding
basic 9,854,411 7,100,000 6,275,000
----------------------------------------
----------------------------------------
Weighted average shares outstanding
diluted 11,890,513 10,272,859 7,065,385
----------------------------------------
----------------------------------------
SEE ACCOMPANYING NOTES.
57
Natrol, Inc.
Consolidated Statements of Stockholders' Equity (Deficit)
REDEEMABLE PREFERRED ORIGINALLY ISSUED
STOCK COMMON STOCK COMMON STOCK ADDITIONAL
---------------------- ---------------------- ---------------------- PAID-IN
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT CAPITAL
----------- --------- --------- ----------- --------- ----------- -----------
Balance at January 1, 1996 -- $ -- 6,000,000 $ 10,000 -- $ -- $ 50,000
Dividends, $0.55 per share -- -- -- -- -- -- --
Exchanged shares in exchange for new
shares -- -- (6,000,000) (10,000) 7,027,780 70,278 (50,000)
Repurchase from stockholder -- -- -- -- (227,780) (2,278) --
Restricted stock issued -- -- -- -- 300,000 3,000 559,500
Adjustment for redemption value of
convertible participating preferred
stock -- -- -- -- -- -- --
Net income -- -- -- -- -- -- --
----------- --------- --------- ---------- ---------- ----------- ----------
Balance at December 31, 1996 -- -- -- -- 7,100,000 71,000 559,500
Net income -- -- -- -- -- -- --
----------- --------- --------- ---------- ---------- ----------- ----------
Balance at December 31, 1997 -- -- -- -- 7,100,000 71,000 559,500
Issuance of Common Stock at $15 per share
(net of approximately $4,720,000 of
offering costs) -- -- -- -- 3,495,500 34,955 47,605,218
Conversion of convertible participating
preferred stock to Common Stock -- -- -- -- 2,700,000 27,000 11,973,000
Conversion of convertible participating
stock to redeemable preferred stock 13,500 6,000,000 -- -- -- -- --
Redemption of redeemable preferred stock (13,500) (6,000,000) -- -- -- -- --
Issuance of Common Stock under employee
stock purchase plan -- -- -- -- 6,490 65 49,583
Net income -- -- -- -- -- -- --
----------- --------- --------- ---------- ---------- ----------- ----------
Balance at December 31, 1998 -- $ -- -- $ -- 13,301,990 $ 133,020 60,187,301
----------- --------- --------- ---------- ---------- ----------- ----------
----------- --------- --------- ---------- ---------- ----------- ----------
RETAINED RECIVABLE
EARNINGS FROM
(DEFICIT) STOCKHOLDER TOTAL
--------- ------------- ---------
Balance at January 1, 1996 $3,243,45 $ -- $3,303,450
Dividends, $0.55 per share (3,300,000) -- (3,300,000)
Exchanged shares in exchange for new
shares (13,250) -- (2,972)
Repurchase from stockholder (502,900) -- (505,178
Restricted stock issued -- (562,500) --
Adjustment for redemption value of
convertible participating preferred
stock (11,142,850) -- (11,142,850)
Net income 5,892,388 -- 5,892,388
--------- --------- -----------
Balance at December 31, 1996 (5,823,162) (562,500) (5,755,162)
Net income 4,190,700 -- 4,190,700
--------- --------- -----------
Balance at December 31, 1997 (1,632,462) (562,500) (1,564,462)
Issuance of Common Stock at $15 per share
(net of approximately $4,720,000 of
offering costs) -- -- 47,640,173
Conversion of convertible participating
preferred stock to Common Stock -- -- 12,000,000
Conversion of convertible participating
stock to redeemable preferred stock (6,000,000) -- --
Redemption of redeemable preferred stock -- -- (6,000,000)
Issuance of Common Stock under employee
stock purchase plan -- -- 49,648
Net income 7,515,551 -- 7,515,551
--------- --------- -----------
Balance at December 31, 1998 $(116,911) $(562,500) $59,640,910
--------- --------- -----------
--------- --------- -----------
SEE ACCOMPANYING NOTES.
58
Natrol, Inc.
Consolidated Statements of Cash Flows
YEAR ENDED DECEMBER 31
1998 1997 1996
----------------------------------------
OPERATING ACTIVITIES
Net income $ 7,515,551 $ 4,190,700 $ 5,892,388
Adjustments to reconcile net income to
net cash provided by operating
activities:
Depreciation and amortization 837,014 690,335 364,158
Amortization of goodwill 588,168 - -
Provision for bad debts 69,230 1,002,683 314,820
Deferred taxes (700,947) 138,163 (397,461)
Changes in operating assets and
liabilities:
Accounts receivable (3,387,913) (1,440,220) (88,178)
Inventories (3,335,621) (3,059,881) (1,770,548)
Income taxes receivable/payable (201,948) 600,944 (1,031,246)
Prepaid expenses and other current
assets (158,717) (140,126) (52,632)
Other assets 24,337 9,570 (40,757)
Accounts payable 1,686,466 878,849 549,052
Accrued expenses 1,167,624 (899,368) (3,475)
Accrued payroll and related liabilities 390,936 167,183 35,201
---------- ---------- ----------
Net cash provided by operating 4,494,180 2,138,832 3,771,322
activities
INVESTING ACTIVITIES
Assets purchased, net of liabilities
assumed in connection with acquisitions (18,697,869) - -
Purchases of marketable securities (99,153,298) - -
Sales of marketable securities 80,142,472 - -
Purchases of property and equipment (6,111,223) (3,219,650) (1,865,099)
---------- ---------- ----------
Net cash used in investing activities (43,819,918) (3,219,650) (1,865,099)
FINANCING ACTIVITIES
Proceeds from long-term debt 9,000,000 4,000,000 750,000
Repayments on long-term debt (12,604,861) (1,004,167) (207,639)
Proceeds from issuance of Common Stock,
net of issuance costs 47,689,821 - -
Redemption of redeemable preferred stock (6,000,000) - -
Repayments on line of credit, net - - (127,778)
Convertible participating preferred - -
stock sold 854,178
Repurchase of Common Stock - - (505,178)
Dividends paid to stockholders - (400,000) (2,900,000)
---------- ---------- ----------
Net cash provided by (used in) financing
activities 38,084,960 2,595,833 (2,136,417)
---------- ---------- ----------
Net increase (decrease) in cash and cash
equivalents (1,240,778) 1,515,015 (230,194)
Cash and cash equivalents, beginning of
year 1,800,202 285,187 515,381
---------- ---------- ----------
Cash and cash equivalents, end of year $ 559,424 $ 1,800,202 $ 285,187
---------- ---------- ----------
---------- ---------- ----------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:
Cash paid during the year for:
Interest $ 407,452 $ 240,250 $ 55,472
Income taxes $ 5,509,261 $ 2,215,000 $ 3,770,000
SUPPLEMENTAL NONCASH TRANSACTION:
During the year ended December 31, 1996, the Company adjusted retained earnings
(deficit) for $11,142,850, which increases the convertible participating
preferred stock to its redemption value.
In July 1998, upon completion of the Company's initial public offering, all of
the convertible participating preferred stock converted into 2,700,000 shares of
Common Stock and 13,500 shares of redeemable preferred stock.
SEE ACCOMPANYING NOTES.
59
Natrol, Inc.
Notes to Consolidated Financial Statements
December 31, 1998
1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF THE BUSINESS
Natrol, Inc. (collectively with its subsidiaries, referred to as the Company)
manufactures and markets branded, high-quality dietary supplement products,
including vitamins, minerals, hormonal supplements, herbal products and
specialty combination formulations. The Company primarily sells its 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.
On July 1, 1996, the Company elected to be treated as an S Corporation for
federal income and California franchise tax purposes under Subchapter S of
the Internal Revenue Code and the corresponding provisions of the California
statute. Accordingly, the stockholders reported their equity in the earnings
or losses of the Company on their individual tax returns. In connection with
this election, the Company changed its year end from June 30 to a calendar
year end.
On September 30, 1996, the Company filed an amendment to its charter whereby
all outstanding shares of Common Stock were split-up and converted to shares
of Common Stock and 25,078.1 shares of convertible participating preferred
stock. The original stockholders subsequently sold all of their convertible
participating preferred stock to unrelated third parties (the new
stockholders). The Company also sold an additional 1,921.9 shares of the
convertible participating preferred stock to the new stockholders. Upon
completion of the transactions, the new stockholders held 27,000 shares of
convertible participating preferred stock which were convertible into
approximately 27% of the then outstanding shares of Common Stock and 13,500
shares of redeemable preferred stock.
Upon the creation and issuance of the convertible participating preferred
stock on September 30, 1996, the Company was required to change its status
for income tax purposes back to a C Corporation.
PRESENTATION
For purposes of comparability to the year ended December 31, 1998 and 1997,
the consolidated financial information for 1996 has been restated to include
the twelve month period ended December 31, 1996. This twelve month period is
referred to in the consolidated financial statements and the following notes
60
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
to the consolidated financial statements as the year ended December 31, 1996.
On January 15, 1998, the Company reincorporated itself in the State of
Delaware. Effective with the reincorporation, a ten-for-one reverse stock
split occurred affecting all classes of stock then outstanding. The
Company's Board of Directors approved a one hundred-for-one stock split of
the Company's Common Stock which became effective on June 19, 1998. All
references in the accompanying consolidated financial statements to the
number of shares of Common Stock and per common share amounts have been
retroactively adjusted to reflect the stock splits. In addition, the
Company's capital structure was changed effective June 19, 1998 to reflect
50,000,000 shares of Common Stock and was further changed to authorize an
additional 2,000,000 shares of preferred stock. The Board of Directors has
authority to fix the rights, preferences, privileges and restrictions,
including voting rights, of these shares of preferred stock without any
future vote or action by the shareholders.
PRINCIPLES OF CONSOLIDATION
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.
ESTIMATES AND ASSUMPTIONS
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts in the consolidated financial
statements and accompanying notes. Actual results could differ from those
estimates, although management does not believe that any differences would
materially affect the Company's consolidated financial position or results of
operations.
61
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
CASH EQUIVALENTS
The Company considers all highly liquid instruments with a maturity of three
months or less when purchased to be cash equivalents.
MARKETABLE SECURITIES
Marketable securities consist of certificates of deposits, commercial paper
and corporate and municipal bonds in the amounts of $4,086,958, $2,458,846
and $12,465,022, respectively.
In accordance with Statement on Financial Accounting Standards (SFAS) No.
115, "Accounting for Certain Investments in Debt and Equity Securities," the
Company determines the appropriate classification of debt and equity
securities at the time of purchase and re-evaluates such designation as of
each balance sheet date. All marketable securities were classified as
"available-for-sale" securities at December 31, 1998. Available-for-sale
securities are carried at fair value with unrealized gains and losses
reported as other comprehensive income. Net unrealized gains and losses were
not material to the consolidated financial statements as of December 31,
1998, and therefore no amounts are recorded in other comprehensive income.
Realized gains and losses on investment transactions are recognized when
realized based on settlement dates and recorded as interest income. Interest
and dividends on securities are recognized when earned.
INVENTORIES
Inventories are carried at the lower of cost (first-in, first-out method) or
market.
PROPERTY AND EQUIPMENT
Property and equipment are stated on the basis of cost. Depreciation is
computed using the straight-line method over the estimated useful lives of
the assets ranging from five to ten years for furniture, machinery and
equipment. Buildings and improvements are depreciated using straight-line
methods over five to forty years. Amortization of leasehold improvements is
computed using the straight-line method over the shorter of the estimated
lives of the assets or the lease terms.
62
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
TRADEMARKS AND PATENTS
Costs of obtaining trademarks and patents are capitalized and amortized using
the straight-line method over the estimated useful life of eleven years.
Trademarks and patents are included in other assets at $40,499 at December 31,
1998 and 1997, respectively, net of accumulated amortization of $25,295 and
$21,624 at December 31, 1998 and 1997, respectively. The costs of servicing the
Company's patents and trademarks are expensed as incurred.
LONG-LIVED ASSETS
The Company reviews for the impairment of long-lived assets and certain
identifiable intangibles whenever events or changes in circumstances indicate
that the carrying amount of any asset may not be recoverable. An impairment
loss would be recognized when the estimated undiscounted future cash flows
expected to result from the use of the asset and its eventual disposition is
less than the carrying amount. If an impairment is indicated, the amount of
the loss to be recorded is based upon an estimate of the difference between
the carrying amount and the fair value of the asset. Fair value is based upon
discounted estimated cash flows expected to result from the use of the asset
and its eventual disposition and other valuation methods. No such impairment
losses have been identified by the Company.
INCOME TAXES
The Company accounts for income taxes under the liability method. Under this
method, deferred tax assets and liabilities are determined based on
differences between enacted rates and laws that will be in effect when the
differences are expected to reverse. Deferred taxes arising from temporary
differences that are not related to an asset or liability are classified as
current or noncurrent depending on the periods in which the temporary
differences are expected to reverse.
REVENUE RECOGNITION
The Company sells its products to retail outlets through a direct sales force
and a national broker network. Sales are recorded when products are shipped
to customers by the Company. Net sales represent products shipped, less
estimated returns and allowances for which provisions are made at the time of
sale. Generally the returns and allowances are limited to damaged goods and
the estimates recorded are based upon known claims and an estimate of
additional returns.
63
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ADVERTISING COSTS
Advertising and promotional costs are expensed at first showing. In addition,
the Company advertises on a cooperative basis by accruing an obligation to
reimburse retailers for qualified advertising of Company products. The
Company provides for cooperative advertising obligations in the same period
as the related revenue is recognized. Advertising and promotional costs
amounted to $10,942,024, $6,944,454 and $5,638,500 for the years ended
December 31, 1998, 1997 and 1996, respectively.
RESEARCH AND DEVELOPMENT COSTS
The Company incurs research and development costs relating to the development
of its dietary supplement products. Research and development costs are
expensed as incurred and amounted to $433,549, $357,064 and $117,184 for the
years ended December 31, 1998, 1997 and 1996, respectively. Research and
development costs are included in general and administrative expenses on the
consolidated statements of income.
STOCK-BASED COMPENSATION
SFAS No. 123, "Accounting for Stock-Based Compensation" encourages, but does
not require, companies to record compensation cost for stock-based employee
compensation plans at fair value. The Company has chosen to continue to
account for stock-based compensation using the intrinsic value method
prescribed in Accounting Principles Board Opinion (APB) No. 25, "Accounting
for Stock Issued to Employees."
EARNINGS PER SHARE
The Company calculates earnings per share in accordance with SFAS No. 128
"Earnings per Share." Basic earnings per share have been computed by dividing
net income by the weighted average number of common shares outstanding.
Diluted earnings per share have been computed by dividing net income by
securities or other contracts to issue Common Stock as if these securities
were exercised or converted to Common Stock.
The following table sets forth the calculation for basic and diluted earnings
per share for the periods indicated:
64
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
EARNINGS PER SHARE (CONTINUED)
YEAR ENDED DECEMBER 31
1998 1997 1996
------------------------------------
Earnings:
Net income $7,515,551 $4,190,700 $5,892,388
------------------------------------
------------------------------------
Shares:
Weighted average shares for basic
earnings per share 9,854,411 7,100,000 6,275,000
Conversion of convertible
participating preferred stock 1,494,247 2,700,000 675,000
Share equivalent for redeemable
preferred stock 255,247 461,538 115,385
Stock options 286,429 11,321 -
------------------------------------
Weighted average shares for diluted
earnings per share 11,890,513 10,272,859 7,065,385
------------------------------------
------------------------------------
Shares issuable under stock options of 445,000 in fiscal 1998 have been
excluded from the computation of diluted earnings per share because the
effect would be antidilutive.
As discussed further in Notes 1 and 5, the Company elected to be taxed as an
S Corporation for federal income and California franchise tax purposes for
the period from July 1, 1996 through September 29, 1996, and was taxed as a C
Corporation for all the other periods in the year ended December 31, 1996.
Accordingly, the provision for income taxes for the period in which the
Company was taxed as an S Corporation reflects primarily state income tax, if
any. If the Company had been subject to tax as a C Corporation for the entire
year ended December 31, 1996, pro forma basic and diluted earnings per share
would have been $0.80 and $0.71, respectively.
COMPREHENSIVE INCOME
In June 1997, SFAS 130 "Reporting Comprehensive Income" was issued. The
provisions of SFAS 130 require companies to classify items of comprehensive
income by their nature in financial statements and display the accumulated
balance of other comprehensive income separately from retained earnings in
the financial statements. The Company's comprehensive income items are not
material at December 31, 1998, 1997 or 1996 and therefore no disclosures have
been made.
65
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
MAJOR CUSTOMERS
The Company had net sales to one customer which individually represented
15.9% of net sales during the year ended December 31, 1998. The Company had
net sales to two customers which individually represented 17.8% and 11.6%,
respectively, of total Company net sales during the year ended December 31,
1997. The Company had net sales to three customers which individually
represented 14.5%, 12.6% and 10.2%, respectively, of total Company net sales
during the year ended December 31, 1996.
MAJOR PRODUCTS
The Company's sales of two products each comprised approximately 14.0% and
10.0%, respectively, of net sales during the year ended December 31, 1998.
The Company's sales of two products each comprised approximately 17.1% and
17.7%, respectively, of net sales during the year ended December 31, 1997.
The Company's sales of three products each comprised approximately 36.0%,
18.8% and 18.1%, respectively, of net sales during the year ended December
31, 1996.
CONCENTRATIONS OF CREDIT RISK
Concentrations of credit risk with respect to trade receivables, other than
significant customers previously discussed, are limited, due to the
distribution of sales over a large customer base. The Company performs
periodic credit evaluations of its customers' financial conditions and
generally does not require collateral. Credit losses have been within
management's expectations.
SEGMENT REPORTING
Effective January 1, 1998, the Company adopted SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information." SFAS No.131
establishes standards for the way that public business enterprises report
information about operating segments in annual financial statements and
requires that those enterprises report selected information about operating
segments in interim financial reports. SFAS No. 131 also establishes
standards for related disclosures about products and services, geographic
areas and major customers. The adoption of SFAS No. 131 did not affect the
reported results of operations or financial position. In addition, the
adoption of the new statements did not affect disclosures of segment
information as the Company is engaged principally in one line of business,
the manufacturing and marketing of branded, high-quality dietary supplement
66
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
SEGMENT REPORTING (CONTINUED)
products, including vitamins, minerals, herbs and specialty formulations,
weight control products and hormones, which represents more than 85% of
consolidated sales.
RECLASSIFICATIONS
Certain reclassifications have been made to the prior years consolidated
financial statements to conform to the presentation in 1998.
2. ACQUISITIONS
On October 31, 1998, the Company completed the acquisition of certain of the
assets of Laci Le Beau Tea Company of Fresno, California, which consists of
Laci Le Beau, Inc., a California corporation, as well as certain related
companies (Laci Le Beau). The total purchase price for the acquisition was
$7,500,000 in cash. Laci Le Beau is a formulator, packager and distributor of
specialty teas sold through the health channel of distribution as well as in
food stores, drug stores and mass market merchandisers. These channels of
distribution are essentially the same as the Company's channels of
distribution. Assets purchased consisted primarily of inventories of
$2,146,526, as well as fixed assets of $153,474 and intangible assets of the
business of $5,200,000. No liabilities were assumed. The acquisition was
accounted for using the purchase method, and accordingly, the acquired assets
are recorded at their estimated fair values with revenues and expenses from
the date of acquisition included in the consolidated statement of income. The
excess of cost over the fair value of assets acquired will be amortized over
fifteen years. Amortization expense for the year ended December 31, 1998 was
$88,168 and is included in general and administrative expenses.
On February 27, 1998, the Company purchased substantially all of the assets
and assumed certain liabilities of Pure-Gar L.P. (Pure-Gar), a distributor of
bulk dehydrated vegetable products and dietary supplements, for a total
purchase price of $11,085,736, which included $85,736 of deferred acquisition
costs. Assets purchased include accounts receivable of $1,271,694 and
inventories of $1,021,127, as adjusted for purchase price accounting
adjustments through December 31, 1998, as well as fixed assets of $131,091
and intangible assets of the business of $8,965,000. Liabilities assumed
consisted primarily of trade payables of $388,912. In addition, the Company
entered into long-term supply and royalty agreements with the
67
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
2. ACQUISITIONS (CONTINUED)
seller. The supply agreement requires the seller to sell and the Company to
purchase specified amounts of certain vegetable, fruit, herbal and botanical
products (the "Products") manufactured by the seller. The supply agreement
gives the Company the exclusive right to sell certain Products in the dietary
supplement industry. The supply 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 15
days in the case of nonpayment by the Company. The acquisition was accounted
for using the purchase method, and accordingly, the acquired assets and
liabilities are recorded at their estimated fair values with revenues and
expenses from the date of acquisition included in the consolidated statement
of income. The excess of cost over the fair value of assets acquired will be
amortized over fifteen years. Amortization expense for the year ended
December 31, 1998 was $500,000 and is included in general and administrative
expenses.
The following pro forma information presents a summary of consolidated
results of operations of the Company as if the acquisitions described above
had occurred at the beginning of the years ended December 31, 1998 and 1997,
with pro forma adjustments for the amortization of goodwill, interest expense
for the acquisition of Pure-Gar and certain income tax adjustments. The pro
forma financial information is not necessarily indicative of the results of
operations as they would have been had the acquisitions been effected on the
assumed dates or of future results of the combined entities.
FOR THE YEAR ENDED
DECEMBER 31
-----------------------------
1998 1997
-----------------------------
(Unaudited)
Revenues $73,007,000 $58,477,000
Income from operations 12,607,000 7,537,000
Net income 7,834,000 3,831,000
Basic earnings per share $0.80 $0.54
Diluted earnings per share $0.66 $0.37
68
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
3. INVENTORIES
Inventories consist of the following:
DECEMBER 31
1998 1997
------------------------
Raw materials and packaging supplies $ 7,549,122 $3,837,856
Finished goods 5,888,333 3,096,325
------------------------
$13,437,455 $6,934,181
------------------------
------------------------
4. FINANCING
Long-term debt consists of the following:
DECEMBER 31
1998 1997
----------------------
Note payable to a bank, payable in monthly
installments of $41,667, beginning October 31, 1997,
plus interest at the prime rate plus 0.25%, paid in
full in July 1998 $ - $1,875,000
Note payable to a bank, payable in monthly
installments of $25,000, beginning June 30, 1997,
plus interest at the prime rate plus 0.25%, paid in
full in July 1998 - 1,325,000
Note payable to a bank, payable in monthly
installments of $11,458, beginning July 1, 1996,
plus interest at the prime rate plus 0.75%, paid in
full in July 1998 - 343,750
Other notes payable, due November 1, 1998, paid in
full in July 1998 - 61,111
----------------------
- 3,604,861
Less current portion - 998,611
----------------------
$ - $2,606,250
----------------------
----------------------
On February 27, 1998, the Company entered into an amended credit facility
(Loan Agreement) with a bank that provides for a revolving line of credit for
borrowings up to $8,000,000, based on a formula, through April 30, 2001. The
Loan Agreement amends and restates a previous revolving line of credit
agreement with the bank. Advances under the Loan Agreement bear interest at
the bank's adjusted LIBOR rate plus 1.25% or the bank's prime rate at the
option of the Company. Proceeds from the initial funding under the Loan
Agreement were used to assist in the funding of the Pure-Gar acquisition.
69
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
4. FINANCING (CONTINUED)
The credit facility was subsequently repaid in full in July, 1998 and
terminated in August 1998. Interest expense related to the Loan Agreement
was $161,306 for the year ended December 31, 1998.
In addition to providing for the revolving loans, the Loan Agreement provided
for a term loan of $9,000,000 to be used for financing the acquisition of
Pure-Gar. The term loan calls for monthly installments of $125,000 during the
period March 1, 1998 through February 28, 2004 and bears interest at the
bank's adjusted LIBOR rate plus 1.25% or the bank's prime rate at the option
of the Company. Mandatory prepayments are required on the term loan based on
excess cash flows, as defined. The term loan was repaid in full in July
1998. Interest expense related to the term loan was $246,146 for the year
ended December 31, 1998.
In 1997 and through the date of the Loan Agreement, the Company had an
agreement with a bank in addition to the notes payable, which provided for
maximum borrowings on a revolving line of credit up to $2,500,000, based on a
formula, with interest at the prime rate plus 0.5%. No amounts were
outstanding under this agreement at December 31, 1997. The agreement provided
for a letter of credit up to a maximum of $250,000, of which no amounts were
outstanding at December 31, 1997. Interest expense related to the revolving
line of credit and notes payable was $240,250 for the year ended December 31,
1997.
5. INCOME TAXES
The income tax provision consists of the following:
YEAR ENDED DECEMBER 31
1998 1997 1996
---------------------------------------
Current:
Federal $4,468,728 $2,161,400 $2,078,292
State 838,542 516,595 617,762
---------------------------------------
5,307,270 2,677,995 2,696,054
Deferred:
Federal (608,481) 72,202 (303,734)
State (92,466) 65,961 (93,727)
---------------------------------------
(700,947) 138,163 (397,461)
---------------------------------------
Total income tax provision $4,606,323 $2,816,158 $2,298,593
---------------------------------------
---------------------------------------
70
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
5. INCOME TAXES (CONTINUED)
As described in Note 1 to the consolidated financial statements, in 1996, the
Company elected to be treated as an S Corporation for federal income and
California franchise tax purposes under Subchapter S of the Internal Revenue
Code and the corresponding provisions of the California statute. Upon the
creation and issuance of the convertible participating preferred stock as
discussed in Notes 1 and 6 to the consolidated financial statements, the
Company was required to change its status for income tax purposes back to a C
corporation. The following unaudited pro forma income tax information has
been determined as if the Company operated as a C corporation for the entire
year ended December 31, 1996. The pro forma information presented below
represents actual amounts for the years ended December 31, 1998 and 1997 as
the Company was operating as a C corporation during those periods.
YEAR ENDED DECEMBER 31
1998 1997 1996
---------------------------------------
Federal tax provision $3,860,247 $2,233,602 $2,599,860
State income taxes net of federal
benefit 746,076 582,556 559,933
---------------------------------------
Total pro forma income tax provision $4,606,323 $2,816,158 $3,159,793
---------------------------------------
---------------------------------------
The difference between actual income tax expense and the U.S. Federal statutory
income tax rate is as follows:
YEAR ENDED DECEMBER 31
1998 1997 1996
------------------------------
Statutory rate 34.0% 34.0% 34.0%
State tax provision 4.0 6.2 4.0
S Corporation status - - (10.0)
------------------------------
Effective tax rate 38.0% 40.2% 28.0%
------------------------------
------------------------------
The significant components of the Company's deferred tax assets and liabilities
are as follows:
71
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
5. INCOME TAXES (CONTINUED)
DECEMBER 31
1998 1997
---------------------
Deferred tax assets:
Accounts receivable reserves $ 139,279 $ 69,455
Inventory reserves 98,105 46,486
Various accrued liabilities 695,762 315,297
State taxes 280,930 122,652
---------------------
1,214,076 553,890
Deferred tax liability:
Depreciation (32,013) (72,774)
---------------------
$1,182,063 $481,116
---------------------
---------------------
6. STOCKHOLDERS' EQUITY
In July 1998, the Company completed its initial public offering in which it
sold 3,495,500 shares of Common Stock at a price of $15.00 per share, with
aggregate net proceeds to the Company of $47,640,174. At the time of the
initial public offering, all of the convertible participating preferred stock
converted into 2,700,000 shares of Common Stock and 13,500 shares of
redeemable preferred stock. The shares of redeemable preferred stock were
then immediately redeemed by the Company for $6,000,000 in cash.
In September 1996, the shares of Common Stock held by the original
stockholders were split up and converted into 7,027,780 shares of Common
Stock and 25,078.1 shares of convertible participating preferred stock. In
addition, the Company sold an additional 1,921.9 shares of its convertible
participating preferred stock to third party investors. The total of 27,000
shares of convertible participating preferred stock purchased by the
investors are convertible into (i) approximately 27% of the then outstanding
shares of Common Stock of the Company on a fully diluted basis and (ii)
shares of redeemable preferred stock which are redeemable for a total of $6.0
million. The total consideration paid by the investors for the convertible
participating preferred stock was $12.0 million.
Each share of convertible participating preferred stock is convertible based
on a formula upon the written election of not less than 66 2/3% of the
outstanding shares of convertible participating preferred stock such that
each outstanding share of convertible participating preferred stocks will
convert into one share of Common Stock (prior to giving effect the 100-for-1
stock split) and one-half of one share of redeemable preferred stock, subject
to adjustment for stock splits, stock dividends, recapitalizations
72
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
6. STOCKHOLDERS' EQUITY (CONTINUED)
and similar transactions. The convertible participating preferred stock has
an automatic conversion feature which provides for each share of convertible
participating preferred stock to be automatically converted into shares of
Common Stock and redeemable preferred stock based on the then effective
conversion price immediately upon the closing of the Company's first firm
commitment public offering pursuant to an effective registration statement
under the Securities Act of 1933, as amended, provided that such registration
statement covers the offer and sale of Common Stock of which the aggregate
net proceeds exceeds $15 million at a price per share reflecting a valuation
of the Company's equity of at least $50 million.
The convertible participating preferred stock contains a liquidation
preference of $444.445 per share, adjusted for any stock splits, stock
dividends, recapitalizations, plus any declared but unpaid dividends. The
convertible participating preferred stock contains voting rights equal to the
number of full shares of Common Stock they are convertible into.
Upon the occurrence of certain events on or after September 26, 2002, the
Company is required to redeem all of the outstanding shares of convertible
participating preferred stock at the liquidation preference value. Therefore,
at the time of the issuance of the convertible participating preferred stock,
the Company adjusted retained earnings (deficit) by $11,142,850, which
represents the difference between the proceeds received for the convertible
participating preferred stock by the Company and its redemption value. Thus,
the convertible participating preferred stock is recorded at its redemption
value at December 31, 1997.
RECEIVABLE FROM STOCKHOLDER
The receivable from stockholder represents an interest bearing note from a
stockholder in the amount of $562,500 issued by the stockholder to finance in
part the purchase of 300,000 shares of the Company's Common Stock. The note
bears interest at 6.60% per year with interest payments due annually. The
note is due within ten days of the receipt by the stockholder of proceeds
from the sale of the Company's Common Stock or November 14, 2006, whichever
occurs first. Included in interest income is $37,125 for the years ended
December 31, 1998 and 1997, for interest from this stockholder.
73
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
6. STOCKHOLDERS' EQUITY (CONTINUED)
STOCK OPTIONS
The Company has adopted the 1996 Stock Option and Grant Plan, as amended (the
Plan), which authorizes the Board of Directors of the Company 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 of Common Stock to be issued
under the Plan is 2,294,325 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 ten years.
A summary of the Company's stock option activity, and related information is
as follows:
WEIGHTED
AVERAGE
NUMBER EXERCISE PRICE EXERCISE PRICE
OF OPTIONS PER SHARE PER SHARE
-------------------------------------------
Outstanding at January 1, 1996 - $ - $ -
Granted 200,000 1.88 1.88
-------------------------------------------
Outstanding at December 31, 1996 200,000 1.88 1.88
Granted 200,000 2.10 2.10
-------------------------------------------
Outstanding at December 31, 1997 400,000 1.99 1.88 - 2.10
Granted 445,000 10.87 10.40 - 13.00
-------------------------------------------
Outstanding at December 31, 1998 845,000 $ 6.67 $ 1.88 - 13.00
-------------------------------------------
-------------------------------------------
Exerciseable at:
December 31, 1996 70,000 $ 1.88 $ 1.88
December 31, 1997 116,250 $ 1.88 $ 1.88 - $ 2.10
December 31, 1998 304,663 $ 4.78 $ 1.88 - $13.00
-------------------------------------------
-------------------------------------------
At December 31, 1998, 1,449,325 shares were available for future grant. The
weighted average remaining contractual life for the outstanding options in
years was 8.91, 9.38 and 10.00 at December 31, 1998, 1997 and 1996,
respectively.
If the Company had elected to recognize compensation expense based on the fair
value of the options granted at grant date for its stock-based compensation
plans consistent with the method prescribed by SFAS No. 123,
74
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
6. STOCKHOLDERS' EQUITY (CONTINUED)
the Company's net income would have been reduced to the pro forma amounts
indicated below:
YEAR ENDED DECEMBER 31
1998 1997 1996
-------------------------------------
Net income:
As reported $7,515,551 $4,190,700 $5,892,388
Pro forma $7,367,551 $4,185,800 $5,892,288
Earnings per share:
As reported - basic $ 0.76 $ 0.59 $ 0.94
Pro forma - basic $ 0.75 $ 0.59 $ 0.94
As reported - diluted $ 0.63 $ 0.41 $ 0.83
Pro forma - diluted $ 0.62 $ 0.41 $ 0.83
The fair value of the options is estimated using a Black-Scholes option-pricing
model with the following weighted average assumptions for grants:
1998 1997 1996
----------------------------------
Expected dividend yield 0.0% 3.0% 6.0%
Expected stock price volatility 37.5% - -
Risk free interest rate 6.0% 6.0% 6.3%
Expected life of options 5 Years 5 Years 6 Years
These assumptions resulted in weighted average fair values of $3.35, $0.27
and $0.03 for each stock option granted in 1998, 1997 and 1996, respectively.
7. COMMITMENTS
The Company leases certain equipment and facilities under noncancelable
operating leases that expire in various years through 2002. Rent expense
under operating leases totaled $570,325, $641,731 and $406,446, for the years
ended December 31, 1998, 1997 and 1996, respectively. In August 1996, the
Company entered into a 120-month lease for an operating facility with an
option to extend the term of the lease for 60 months at 95% of the then
market value for similar space. This facility was purchased by the Company in
December, 1998.
Future minimum lease payments under noncancelable operating leases with initial
terms of one year or more consisted of the following at December 31, 1998:
75
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
7. COMMITMENTS (CONTINUED)
1999 $85,710
2000 80,175
2001 54,062
2002 3,566
--------
Total minimum lease payments $223,513
--------
--------
8. EMPLOYEE BENEFIT PLANS
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 $10,409, $0 and
$12,764 for the years ended December 31, 1998, 1997 and 1996, respectively.
In May, 1998, the Board of Directors approved the Natrol, Inc. Employee Stock
Purchase Plan (the 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, 1998, 218,510 shares are
available for issuance under this plan. For the year ended December 31,
1998, 6,490 shares were issued at $7.65 per share under the plan.
9. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in estimating its
fair value disclosures for financial instruments:
CASH AND CASH EQUIVALENTS: the carrying amount approximates fair value.
MARKETABLE SECURITIES: the carrying amount approximates fair value based upon
quoted market prices.
ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE: the carrying amount approximates fair
value.
76
Natrol, Inc.
Notes to Consolidated Financial Statements (Continued)
9. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
LONG-TERM DEBT: the fair values of the Company's long-term notes payable are
estimated using discounted cash flow analyses, based on the Company's current
incremental borrowing rates for similar types of borrowing arrangements. The
carrying amount of long-term notes payable approximate their fair value at
December 31, 1997.
10. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Three Months Ended
----------------------------------------------
March 31 June 30 September 30 December 31
----------------------------------------------
(in thousands, except per share data)
1998
Net sales $13,169 $16,344 $19,501 $19,193
Gross profit 7,017 8,788 10,174 10,217
Net income 1,175 1,578 2,517 2,245
Basic earnings per share $ 0.17 $ 0.22 $ 0.21 $ 0.17
Diluted earnings per share $ 0.11 $ 0.15 $ 0.20 $ 0.16
1997
Net sales $ 9,909 $ 8,191 $11,392 $13,382
Gross profit 5,434 4,376 6,024 7,240
Net income 810 277 1,324 1,779
Basic earnings per share $ 0.11 $ 0.04 $ 0.19 $ 0.25
Diluted earnings per share $ 0.08 $ 0.03 $ 0.13 $ 0.17
Certain reclassifications have been made to the quarterly information as
previously reported by the Company in the table above to conform to the
presentation for the year ended December 31, 1998.
77