FORM 10-Q

 

(Mark one)

 

 

NATROL, INC.

(Exact name of registrant as specified in its charter)

 

DELAWARE		95-3560780
(State of Incorporation)		(I.R.S. Employer Identification No.)
21411 PRAIRIE STREET CHATSWORTH, CALIFORNIA 91311
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(818) 739-6000
(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

 

INDICATE BY A CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS.

YES  ý   NO  o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes o No ý

 

Indicate the number of shares outstanding of the issuer’s common stock, as of the latest practicable date:

 

 

 

PART 1. FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

 

Natrol, Inc. and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share and per share data)

(Unaudited)

 

		June 30, 2004			December 31, 2003
Assets
Current assets:
Cash and cash equivalents		$	3,314		$	2,599
Accounts receivable, net of allowances of $640 and $635 at June 30, 2004 and December 31, 2003, respectively		9,530			7,698
Inventory		10,123			9,053
Income taxes receivable		176			349
Deferred income taxes		1,110			1,110
Prepaid expenses and other current assets		773			914
Net assets of discontinued operations		60			35
Total current assets		25,086			21,758
Property and equipment:
Building and improvements		15,626			15,612
Machinery and equipment		5,164			5,215
Furniture and office equipment		2,964			3,158
		23,754			23,985
Accumulated depreciation		(7,547		)	(7,315		)
Property and equipment, net		16,207			16,670
Restricted cash		5,000			5,000
Deferred income taxes		3,902			3,902
Goodwill, net of accumulated amortization and impairment charge of $37,381		2,026			4,026
Other assets		244			83
Total assets		$	52,465		$	51,439
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable		$	3,915		$	5,601
Accrued expenses		2,058			1,732
Accrued payroll and related liabilities		1,875			772
Current portion of long-term debt		339			325
Total current liabilities		8,187			8,430
Long-term debt, less current portion		7,277			7,451
Commitments and contingencies
Stockholders’ equity:
Preferred stock, par value of $0.01 per share:
Authorized shares—2,000,000; Issued and outstanding shares-none
Common stock, par value of $0.01 per share:
Authorized shares—50,000,000
Issued and outstanding shares-14,225,959 and 14,054,309 at June 30, 2004 and December 31, 2003, respectively		142			141
Additional paid-in capital		62,600			62,377
Accumulated deficit		(22,860		)	(24,079		)
		39,882			38,439
Shares held in treasury, at cost-921,900 shares at June 30, 2004 and December 31, 2003		(2,881		)	(2,881		)
Total stockholders’ equity		37,001			35,558
Total liabilities and stockholders’ equity		$	52,465		$	51,439

 

See accompanying notes

 

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Natrol, Inc. and Subsidiaries

Consolidated Statements of Operations

(In thousands, except share and per share data)

(Unaudited)

 

		Three months ended June 30,						Six months ended June 30,
		2004			2003			2004			2003
Net sales		$	20,682		$	18,866		$	41,107		$	37,861
Cost of goods sold		11,338			12,262			23,933			23,128
Gross profit		9,344			6,604			17,174			14,733
Selling and marketing expenses		5,643			4,132			10,262			9,101
General and administrative expenses		2,274			2,727			4,599			5,366
Total operating expenses		7,917			6,859			14,861			14,467
Operating income (loss) from continuing operations		1,427			(255		)	2,313			266
Interest income		22			4			44			14
Interest expense		(156		)	(162		)	(314		)	(324		)
Income (loss) from continuing operations before income taxes		1,293			(413		)	2,043			(44		)
Income tax provision (benefit)		524			(167		)	824			(26		)
Income (loss) from continuing operations		769			(246		)	1,219			(18		)
Discontinued operations:
(Loss) from operations		—			(461		)	—			(1,035		)
Income tax benefit		—			157			—			379
Loss on discontinued operations		—			(304		)	—			(656		)
Net Income (loss)		$	769		$	(550	)	$	1,219		$	(674	)
Basic income (loss) per share:
Income (loss) per share from continuing operations		$	.06		$	(.02	)	$	.09		$	.00
Loss per share from discontinued operations		—			(.02		)	—			(.05		)
Income (loss) per share		$	.06		$	(.04	)	$	.09		$	(.05	)
Diluted income (loss) per share:
Income (loss) per share from continuing operations		$	.05		$	(.02	)	$	.09		$	.00
Loss per share from discontinued operations		—			(.02		)	—			(.05		)
Income (loss) per share		$	.05		$	(.04	)	$	.09		$	(.05	)
Weighted-average shares outstanding—basic and diluted
Basic		13,240,248			12,886,746			13,201,354			12,878,722
Diluted		14,093,944			12,886,746			14,085,885			12,878,722

 

See accompanying notes

 

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Natrol, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(In thousands)

(Unaudited )

 

		Six Months Ended June,
		2004			2003
Operating activities
Net Income (loss)		$	1,219		$	(674	)
Loss from discontinued operations		—			656
Income (loss) from continuing operations		1,219			(18		)
Adjustments to reconcile income from continuing operations to net cash used in operating activities:
Loss from discontinued operations		—			(656		)
Change in net assets of discontinued operations		(25		)	(65		)
Depreciation and amortization		642			745
Loss on disposal of property and equipment		2			—
Provision for bad debts		105			112
Shares issued for services		—			15
Changes in operating assets and liabilities:
Accounts receivable		(1,937		)	(2,778		)
Inventory		(1,070		)	745
Income taxes receivable/payable		173			(613		)
Prepaid expenses and other current assets		141			778
Accounts payable		(1,686		)	1,753
Accrued expenses		326			(1,124		)
Accrued payroll and related liabilities		1,103			372
Net cash used in operating activities		(1,007		)	(734		)
Investing activities
Purchases of property and equipment		(181		)	(127		)
Reduction in goodwill		2,000			—
Other assets		(161		)	7
Net cash provided by (used in) investing activities		1,658			(120		)
Financing activities
Repayments on long-term debt		(160		)	(151		)
Proceeds from issuance of common stock		224			14
Net cash provided by (used in) financing activities		64			(137		)
Net increase (decrease)  in cash and cash equivalents		715			(991		)
Cash and cash equivalents, beginning of period		2,599			10,077
Cash and cash equivalents, end of period		$	3,314		$	9,086

 

See accompanying notes

 

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NATROL, INC.
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
(ALL AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

 

1. BASIS OF PRESENTATION

 

The accompanying consolidated financial statements have been prepared by the Company, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC).  This Report on Form 10-Q should be read in conjunction with the Company’s annual report on Form 10-K for the year ended December 31, 2003.  Certain information and footnote disclosures which are normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to SEC rules and regulations.  The information reflects all normal and recurring adjustments which, in the opinion of the Company’s management, are necessary for a fair presentation of the financial position of the Company and its results of operations for the interim periods set forth herein.  The results for the three months and six months ended June 30, 2004 are not necessarily indicative of the results to be expected for the full year or any other future period.

 

2. STOCK BASED COMPENSATION

 

The Company accounts for its employee stock option plan under the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations.  The Company has a stock-based compensation plan.  The Company’s operating results do not include a compensation charge related to this plan, as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant.  The following table illustrates the effect on the operating results and per share amounts if the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based compensation, had been applied to stock-based employee compensation:

 

		3 Months Ended June 30,						6 Months Ended June 30,
		2004			2003			2004			2003
Income (loss) from continuing operations		$	769		$	(246	)	$	1,219		$	(18	)
Total stock-based employee compensation expense determined under the fair value-based method for all awards, net of related tax benefits (“Stock Compensation”)		18			49			34			90
Income (loss) from continuing operations—pro forma		$	751		$	(295	)	$	1,185		$	(108	)
Loss from discontinued operations		—			(304		)	—			(656		)
Net Income (loss)—pro forma		$	751		$	(599	)	$	1,185		$	(764	)
Income per share from continuing operations:
Basic—as reported		$	.06		$	(.02	)	$	.09		$	.00
Diluted—as reported		$	.05		$	(.02	)	$	.09		$	.00
Basic—pro forma		$	.06		$	(.02	)	$	.09		$	.01
Diluted—pro forma		$	.05		$	(.02	)	$	.08		$	.01
Net loss per share:
Basic—as reported
Diluted—as reported		$	.06		$	(.04	)	$	.09		$	(.05	)
Basic—pro forma		$	.05		$	(.04	)	$	.09		$	(.05	)
Diluted—pro forma		$	.06		$	(.05	)	$	.09		$	(.06	)
		$	.05		$	(.05	)	$	.08		$	(.06	)

 

During the six months ended June 30, 2004, 60,000 stock options were granted with exercise prices ranging between $2.76 and $3.04 which equaled the fair value of the underlying common stock on the date of grant.

 

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3. INVENTORY

 

Inventories consist of the following:

 

		June 30, 2004			December 31, 2003
Raw material and packaging supplies		$	4,627		$	3,736
Finished goods		5,496			5,317
Total Inventory		$	10,123		$	9,053

 

4. SHIPPING AND HANDLING COSTS

 

The Company records all amounts charged to customers for shipping and handling as revenue. All outbound shipping and fulfillment costs are classified as selling and marketing expenses and totaled $1,803 and $1,552 for six months ended June 30, 2004 and 2003 respectively.

 

5. EARNINGS PER SHARE

 

Basic earnings per share has been computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted earnings per share has been computed by dividing net income (loss) by the weighted average number of common shares and dilutive common stock equivalents (stock options), when dilutive.  Stock options to purchase 538,750  and 537,500 common shares for the three and six months ended June 30, 2004, and stock options to purchase 1,322,500 and 1,807,500 common shares for the three and six months ended June 30, 2003 were outstanding but considered to be anti-dilutive.

 

6. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

 

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

 

7. DISCONTINUED OPERATIONS

 

In December 2003, the Company discontinued its Annasa and Tamsol units.  Annasa, a subsidiary of Natrol and a multi-level marketer of proprietary nutritional products began operations in 2002.  Tamsol, was also formed in 2002, to generate direct-to-consumer sales via radio, television, direct mail and other non retail venues.  The Company has reclassified its financial statements to segregate the revenues, direct costs and expenses (excluding allocated costs), assets and liabilities and cash flows of the discontinued operations.  The net operating results, net assets and net cash flows of these businesses have been reported as “Discontinued Operations” in the accompanying consolidated financial statements.

 

 

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Summarized financial information for the discontinued operations is as follows:

 

		3 Months Ended June 30, 2003			Six Months Ended June 30, 2003
Annasa:
Revenue		$	116		$	266
Gross Margin		77			190
Selling and Marketing		200			454
General and Administrative		261			629
Loss From Operations		(384		)	(893		)
Income Tax Benefit		126			322
Net Loss		$	(258	)	$	(571	)
Tamsol:
Revenue		$	6		$	28
Gross Margin		6			28
Selling and Marketing		14			33
General and Administrative		69			137
Loss From Operations		(77		)	(142		)
Income Tax Benefit		31			57
Net Loss		$	(46	)	$	(85	)

 

		June 30, 2004			December 31, 2003
Net assets of discontinued operations:
Current assets		$	58		$	116
Total assets		60			151
Current liabilities		0			116
Net assets of discontinued operations		60			35

 

8. LITIGATION SETTLEMENT

 

During March 2004, the Company settled its litigation with the former owners of Prolab Nutrition, Inc.  The Company received $2 million in cash, which has been reflected as a reduction in goodwill in the accompanying June 30, 2004 balance sheet.

 

 

ITEM 2:

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

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

 

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

 

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Factors that could cause or contribute to the Company’s actual results differing materially from those discussed herein or for the Company’s stock price to be affected adversely include, but are not limited to: (i) industry trends, including a general downturn or slowing of the growth of the dietary supplement industry; (ii) increased competition from current competitors and new market entrants including but not limited to increased competition from private label house brands supported by retailers seeking to increase the market share of their proprietary house brands because private label brands control the largest share of the vitamin, mineral and supplement (VMS) sector; (iii) adverse publicity regarding the dietary supplement industry or the Company’s products; (iv) exposure to product liability claims, in particular because the Company beginning in July, 2003 has chosen to self-insure against product liability claims due to the high price of product liability insurance, the inability to secure occurrence based coverage, as well as the limited amount of coverage provided by insurers willing to provide insurance at high prices; (v) exposure to and the expense of resolving and defending potential product liability claims that are left uncovered by insurance including potential claims involving ephedrine based products which the company sold prior to April, 2003; (vi) the Company’s dependence upon its ability to develop new products; (vii)  returns of the Company’s products which may be returned by customers at any time due to lack of sell through to consumers or because competitors have convinced the Company’s customers that Natrol’s products should be replaced with competitor products; (viii) the Company’s ability to manage inventory or sell its inventory before such inventory becomes outdated, (xix) the Company’s ability to gain or expand or maintain distribution within new or existing customers and new or existing channels of trade; (x) an increase in the cost of obtaining and maintaining shelf space with major national retailers who demand various forms of incentives from their suppliers such as slotting fees, coop advertising, or rebates; (xi) adverse changes in government regulation or changes in local or national laws; (xii) dependence on significant customers; (xiii) the Company’s ability to keep and attract key management employees; (xiv) the Company’s inability to manage growth and execute its business plan, or the Company’s ability to modify its business plan in response to market conditions, including, but not limited to, its ability to enter into new businesses and capitalize upon new business opportunities; (xv) the Company’s ability to consummate future acquisitions and its ability to integrate acquired businesses; (xvi) the absence of conclusive clinical studies for many of the Company’s products; (xvii) the Company’s inability to obtain raw materials that are in short supply including its ability to obtain garlic powders or arabinogalactan for its EPI raw material sales division; (xviii) sales and earnings volatility, (xix) volatility of the stock market; (xx) the Company’s ability to manufacture its products efficiently; (xxi) the Company’s reliance on independent brokers to sell its products; (xxii) the inability of the Company to protect its intellectual property; (xxiii) control of the Company by principal shareholders, (xxiv) the possible sale of large amounts of stock by controlling stockholders; (xxv) a general downturn in the national economy as a whole; (xxvi) continued market acceptance of Natrol supplements, Laci Le Beau teas, Prolab’s sports nutrition products, and EPI’s raw material products, (xxvii) increases in the cost of borrowings; (xxviii) and, the unavailability of additional debt or equity capital; (xix) legal actions brought forth by federal, state and local governmental and private parties.

 

OVERVIEW

 

Since divesting itself of its unprofitable multi-level marketing and direct marketing units in 2003 (see discontinued operations), the Company’s business plan has been to focus on its core Natrol, Prolab sports nutrition and Laci Le Beau tea brands.  The Natrol and Laci Le Beau brands are sold in health food stores, in mass-market drug, food and retail chains as well as club stores.   Prolab products are sold through distributors who in turn service retail accounts.  Prolab’s distributor network focuses on health food stores, health clubs and fitness facilities that cater to body builders and other individuals seeking a high level of fitness.   With the integration of Prolab as a brand within Natrol, Natrol’s health food oriented sales professionals have become responsible for presenting appropriate Prolab products to health food retailers, who in turn, order from distributors who carry Prolab product. In addition, more than 40% of Prolab sales are to distributors who sell Prolab products outside the United States.  The Company is continually seeking to expand the distribution of its best selling items to additional retail outlets and to create promotional opportunities for its products within its existing customer base.

 

The Company also provides contract manufacturing services to other supplement companies.

 

Key issues for Company’s management include product development, product introductions, inventory management, and controlling the cost of doing business in its various channels of trade.

 

The nutritional supplement business is dependent upon new product introductions for both growth and to replace volume lost by products reaching the end of their product life cycles.  As such, the Company is continually researching potential new products for placement into the marketplace. Developing a single new product can be a multi-year effort depending upon the complexity of the product and the amount of testing that must be completed to validate the product concept.

 

Product introductions do not come without risk.  Most customers maintain a right of return,  so that if a new product is not successful, product returns can be high.  A broad product launch, one in which a new product is introduced into thousands of retail outlets, can cause a strain on corporate resources since inventories must be built and delivered with a corresponding increase in accounts receivable.  In addition, product introductions generally require advertising and public relations efforts.  Oftentimes retailers demand slotting fees or other up front expenditures.  A failure in a product launch can be very expensive.

 

Nutritional supplements must maintain potency levels during their selling life.  As a result, products must be stamped with an expiration date and retailers will not accept product with limited shelf life into their warehouses.  Shelf life issues require a high

 

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degree of inventory management of raw materials and finished goods to ensure that shelf life is maximized and that the out-of-date inventory is minimized.

 

The competition for shelf space at retailers is intense. We have ongoing discussions with our retail customers with regards to the allocation of shelf space and promotional support for our products.  Retailers look to their vendors for promotional support for the products on their shelves in order to maximize sales.  Vendors such as Natrol look to retailers for advantageous placement of their products and promotion of their products within stores and within a retailer’s promotional media such as newspaper advertisements placed by retailers.  The cost of promotions and support to the retailer on the part of vendors such as Natrol can be very high and Management must continually review its promotional efforts with retailers to ensure that sales remain profitable.

 

During the first half of 2004, the Company’s overall strategy of concentrating on its core business has been successful and results for the first and second quarters of 2004 have been positive when measured against performance in 2003.  However, across product lines, results have been mixed.

 

Future challenges include maintaining the current positive trends for the Company across all product lines as as well as developing new innovative products and delivery systems that will capture the support of consumers.

 

The Company continues to believe that additional opportunities for growth exist as it seeks to improve its position with retailers and consumers. Management seeks to capitalize on these opportunities in what remains a very competitive marketplace.

 

RESULTS OF OPERATIONS

 

The following discussion of the results of operations and the financial condition of the Company should be read in conjunction with the response to Part 1 Item 1 of this report.

 

THREE MONTHS ENDED JUNE 30, 2004 AND JUNE 30, 2003

 

NET SALES. The Company recognizes revenue from sales only after product is shipped and title is transferred. Net sales represent product shipped less actual and estimated future returns, spoilage allowances, allowances for product deemed to be unsaleable by customers, free goods shipped to customers for promotional or other purposes and slotting fees. Estimates and allowances are based upon known claims and an estimate of additional returns when the amount of future returns from customers can be reasonably estimated.

 

Net sales increased 9.6%, or $1.8 million, to $20.7 million for the second quarter of 2004 from $18.9 million in the second quarter of 2003.  The growth came from the Company’s Natrol brand.  Net sales of the Natrol brand increased approximately 13.8% over the comparable three month period in 2003.  The increase was due to many factors including broader distribution of certain products, promotional efforts made by the Company, and strong consumer demand for Natrol products.  Net sales of Prolab brand products decreased 5.2% and net sales of the Company’s EPI division, which along with manufacturing Natrol products, sells raw materials and contract manufacturing services, decreased 23.5%.  The majority of the decrease in EPI sales was due to a reduction in the sale of garlic powders. The reduction in the sale of garlic powders was partially offset by a higher level of contract manufacturing.  Contract manufacturing sales, however, have, in general, lower gross margins than does the sale of garlic powders. The Company estimates that the weakness in the sale of garlic powders may continue through the end of 2004 and perhaps longer due to negative industry trends and strong competition amongst suppliers.

 

GROSS PROFIT.  Gross profit increased 41.6%, or $2.7 million, to $9.3 million for the three months ended June 30, 2004 from $6.6 million for the three months ended June 30, 2003. Gross margin increased to 45.2% for the three months ended June 30, 2004 from 35.0% for the three months ended June 30, 2003.  The increase in gross margin and gross profit was due, in part, to overall favorable product mix which resulted in a lower cost of products, and an approximately 26.4% reduction in the amount of deductions given to customers that reduce revenue from approximately $3.2 million in the second quarter of 2003 to approximately $2.3 million in the second quarter of 2004. These deductions include returns, allowances for damages and outdates, slotting fees, rebates, and other promotional expenses.  Additionally, during the second quarter of 2003, the Company had an unusually large, $1.3 million write-down of inventory as opposed to a $254,000 write-down in the second quarter of 2004.  Expenses related to inventory write-downs are included in costs of goods sold and, as such, have an impact on gross margins.

 

SELLING AND MARKETING EXPENSES.  Selling and marketing expenses consist primarily of advertising and promotional expenses, cost of distribution, and related payroll expenses and commissions. Selling and marketing expenses increased 36.6%, or $1.5 million, to $5.6 million for the three months ended June 30, 2004 from $4.1 million for the three months ended June 30, 2003. Approximately 75% of the increase was due to increased spending on coop advertising, and various forms of media including brochures, public relations, celebrity endorsements, radio, television and advertising in publications.  Approximately 12% of the increase was due to increased shipping costs.  These expenditures rose due to the higher level of sales as well as higher costs of freight caused, in part, by higher fuel prices.  The remainder of the increase was due to personnel costs as well a general increase in

 

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expenditures necessary to support the selling and marketing efforts of the Company.

 

GENERAL AND ADMINISTRATIVE EXPENSES.  General and administrative expenses consist primarily of personnel costs related to general management functions, finance, accounting and information systems, as well as professional fees related to legal, audit and tax matters and depreciation. General and administrative expenses decreased 16.5%, or approximately $451,000 to $2.3 million for the three months ended June 30, 2004 from $2.7 million for the three months ended June 30, 2003.  The cost of general and product liability insurance was approximately $257,000 less in the second quarter 2004 than in the second quarter 2003 due to the implementation of the Company’s self insurance program in July of 2003. Legal expenditures were $182,000 less in the second quarter 2004 than in the second quarter 2003.  The decrease was due to a number of factors including a greater proportional use of in-house counsel as opposed to outside counsel.  Approximately $200,000 of savings generated by the consolidation of Prolab’s administrative functions into Natrol were offset by the establishment of an independent Product Development department and other increases in payroll.

 

INTEREST EXPENSE.  Interest expense was $156,000 for the three months ended June 30, 2004 as compared to $162,000 for the three months ended June 30, 2003. The Company pays interest on approximately $7.6 million of long-term mortgage debt.

 

INCOME TAX PROVISION. For the three months ended June 30, 2004 and June 30, 2003 the Company’s effective tax rate was approximately 40.5%.

 

DISCONTINUED OPERATIONS. In December 2003, the Company discontinued its Annasa and Tamsol units.  Annasa, a subsidiary of Natrol, a multi-level marketer of proprietary nutritional products began operations in 2002.  Tamsol, was also formed in 2002, to generate direct-to-consumer sales via radio, television, direct mail and other non retail venues.  The Company has reclassified its financial statements to segregate the revenues, direct costs and expenses (excluding allocated costs), assets and liabilities and cash flows of the discontinued operations.  The net operating results, net assets and net cash flows of these businesses have been reported as “Discontinued Operations” in the accompanying consolidated financial statements. As the operations were shut down as of the end of calendar 2003, the Company had no revenue or expenses from discontinued operations in the second quarter of 2004.  During the second quarter of 2003, the Company had a net loss of approximately $304,000 from discontinued operations.

 

SIX MONTHS ENDED JUNE 30, 2004 AND JUNE 30, 2003

 

NET SALES. Net sales increased 8.6%, or $3.2 million, to $41.1 million for the six months ended June 30, 2004 from $37.9 million for the six months ended June 30, 2003.  The growth came from the Company’s Natrol brand.  Net sales of the Natrol brand increased 13.7% when comparing the first six months of 2004 to the first six months of 2003.  The increase was due to many factors including broader distribution of certain products, promotional efforts made by the Company, and strong consumer demand for Natrol products. Net sales of Prolab brand products decreased .9% during the same comparison period and net sales of the Company’s EPI division, which along with manufacturing Natrol products, sells raw materials and contract manufacturing services increased 1.0% during the same time frame.  The increase was due to a higher level of contract manufacturing business which offset a 44.8% decrease in the sale of garlic due to negative industry trends and strong competition amongst suppliers.  The Company estimates that the weakness in the sale of garlic powders may continue through the end of 2004 and perhaps longer.

 

GROSS PROFIT.  Gross profit increased 16.6%, or $2.4 million, to $17.1 million for the six months ended June 30, 2004 from $14.7 million for the six months ended June 30, 2003. Gross margin increased to 41.8% for the six months ended June 30, 2004 from 38.9% for the six months ended June 30, 2003.  The increase in gross margin and gross profit was due, in part, to overall favorable product mix which resulted in a lower cost of products as well as an approximately 7.7% reduction in the amount of deductions given to customers that reduce revenue.  These deductions include returns, allowances for damages and outdates, slotting fees, rebates, and other promotional expenses.  Additionally, during the second quarter of 2003, the Company had an unusually large, $1.3 million write-down of inventory which had a significant impact on gross margins in the comparable 2003 period. Ongoing gross margins can be impacted by product mix. Additionally, periodic short-term changes in demand for certain raw materials can result in fluctuating prices which can also have an impact on gross margins.  Currently, prices for whey, an important raw material included in many Prolab products have risen rapidly,  which will in turn affect the margin on whey products sold under the Prolab brand name.

 

SELLING AND MARKETING EXPENSES.  Selling and marketing expenses increased 12.8%, or $1.2 million, to $10.3 million for the six months ended June 30, 2004 from $9.1 million for the six months ended June 30, 2003. Approximately 46% of the increase was due to increased spending on coop advertising, and various forms of media including brochures, public relations, celebrity endorsements, radio, television and advertising in publications.  Approximately 21% of the increase was due to increased shipping costs.  These expenditures rose due to the higher level of sales as well as higher costs of freight caused in part by higher fuel prices.  Approximately 27% of the increase was due to personnel costs.  The remainder was due to a general increase in expenditures necessary to support the selling and marketing efforts of the Company.

 

GENERAL AND ADMINISTRATIVE EXPENSES.  General and administrative expenses consist primarily of personnel costs related to general management functions, finance, accounting and information systems, as well as professional fees related to legal, audit and tax matters and depreciation. General and administrative expenses decreased 14.3%, or $766,000 to $4.6 million for the six months

 

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ended June 30, 2004 from $5.4 million for the six months ended June 30, 2003.  The cost of general and product liability insurance was approximately $596,000 less in six months ended June 30, 2004 than in six months ended June 30, 2003 due to the implementation of the Company’s self insurance program in July of 2003. Legal expenditures were $492,000 less in the first half of 2004 than in the first half of 2003.  These savings were offset by the establishment of a product development department whose expenses are included within general and administrative expenses.  These expenses amounted to $421,000. Approximately $575,000 of savings generated by the consolidation of Prolab’s administrative functions into Natrol were offset by the establishment of an independent Product Development department and other increases in payroll.

 

INTEREST EXPENSE.  Interest expense was $314,000 for the six months ended June 30, 2004 as compared to $324,000 for the six months ended June 30, 2003. The Company pays interest on approximately $7.6 million of long-term mortgage debt.

 

INCOME TAX PROVISION. For the six months ended June 30, 2004 the Company’s effective tax rate was approximately 40.3%.  For the six months ended June 30, 2003 the Company’s effective tax rate was 59.6%.  The difference is due to the Company’s loss from continuing operations during the six months ended June 30, 2003 and the disproportionate effect of items that are not deductible for tax purposes on the tax calculations had during 2003.

 

DISCONTINUED OPERATIONS. In December 2003, the Company discontinued its Annasa and Tamsol units.  Annasa, a subsidiary of Natrol, a multi-level marketer of proprietary nutritional products began operations in 2002.  Tamsol, was also formed in 2002, to generate direct-to-consumer sales via radio, television, direct mail and other non retail venues.  The Company has reclassified its financial statements to segregate the revenues, direct costs and expenses (excluding allocated costs), assets and liabilities and cash flows of the discontinued operations.  The net operating results, net assets and net cash flows of these businesses have been reported as “Discontinued Operations” in the accompanying consolidated financial statements. As the operations were shut down as of the end of calendar 2003, the Company had no revenue or expenses from discontinued operations in the second quarter of 2004.  During the six months ended June 30, 2003, the Company had a net loss of $656,000 from discontinued operations.

 

LIQUIDITY AND CAPITAL RESOURCES

 

As of June 30, 2004, the Company had working capital of $16.9 million as compared to $13.3 million in working capital at December 31, 2003. The Company’s cash balance at June 30, 2004 was approximately $3.3 million.  The increase in working capital was due to income earned during the 2004 period and the $2.0 million cash received from settling litigation with the former owners of Prolab Nutrition, Inc. The cash received in the settlement was recorded as a reduction of goodwill.

 

Net cash used by operating activities was $1.0 million for the six months ended June 30, 2004 versus net cash used of $ 0.7 million for the six months ended June 30, 2003. Cash used by operating activities during the six months ended June 30, 2004 consisted primarily of cash used by changes in operating assets and liabilities of $2.9 million partially offset by $1.9 million of cash provided by net income and non-cash charges.  The increases in cash used by operating assets and liabilities consisted principally of an increase in accounts receivable of $1.9 million, an increase in inventory of $1.1 million and a decrease in accounts payable and accrued expenses of $1.4 million offset by an increase in accrued payroll of $1.1 million. The increase in accounts receivable is due to the higher level of sales and the timing of those sales.  The increase in inventory levels is also due to the higher level of sales.  The increase in accrued payroll is due to the timing of payroll and accruals for bonus payments to support the Company’s bonus plan which was filed as an exhibit to the Company’s 10-K for the year ending period after December 31, 2003.  Cash provided by net income and non-cash charges consisted principally of $1.2 million of net income and depreciation of $642,000.

 

Net cash provided by investing activities was $1.7 million for the six months ended June 30, 2004 versus net cash used of approximately $120,000 during the six months ended June 30, 2003. The settlement of the litigation with the former owners of Prolab Nutrition, Inc., which was recorded as a reduction of goodwill, provided $2.0 million of cash which was offset by an increase in investment in property and equipment and other assets. All of the investment in the six months ended June 30, 2003 was in property and equipment and increase in other assets.

 

Net cash provided by financing activities was approximately $64,000 for the six months ended June 30, 2004 as opposed to approximately $137,000 used in financing activities during the six months ended June 30, 2003. During the six months ended June 30, 2004, the Company made principal payments of approximately $160,000 on its long-term mortgage debt and received approximately $224,000 from the exercise of stock options and the purchase of stock through the Company’s Employee Stock Purchase Plan.  During the six months ended June 30, 2003 the Company made principal payments of $151,000 on its long-term mortgage debt.

 

As of June 30, 2004, the Company had $7.6 million of outstanding debt all of which is the result of long-term mortgage debt on the Company’s manufacturing/headquarters facility and on the Company’s shipping facility. The Company has no line of credit in place.

 

The Company believes that its cash balance together with cash generated from operations should be sufficient to fund its anticipated working capital needs and planned capital expenditures for the next twelve months. However, if the Company does not meet its operating plan it may also need additional borrowings to fund working capital needs. The Company currently has no outstanding debt

 

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

 

CRITICAL ACCOUNTING POLICIES

 

Management’s beliefs regarding significant accounting policies have not changed significantly from those discussed in Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

 

CONTRACTUAL OBLIGATIONS

 

Contractual obligations have not changed significantly from those discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

There has been no material change during the six months ended June 30, 2004 from the disclosures about market risk provided in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

 

ITEM 4. CONTROLS AND PROCEDURES

 

An evaluation was conducted under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of June 30, 2004.  Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are, to the best of their knowledge, effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. There were no significant changes in the Company’s internal control over financial reporting that occurred during the fiscal quarter covered by this report that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.

 

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PART II

 

OTHER INFORMATION

 

ITEM 1.  LEGAL PROCEEDINGS

 

None

 

ITEM 2.  CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

None

 

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

 

None

 

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

 

a)                                      The 2003 Annual Meeting of Stockholders of Natrol, Inc. (the “Annual Meeting”) was held on June 10, 2004.

b)                                     At the Annual Meeting, the following were re-elected to the Company’s Board of Directors:

 

		Votes For		Votes Withheld
Elliott Balbert		13,005,807		66,863
Dennis De Concini		13,007,187		65,483

 

The following individuals are members of the Company’s Board of Directors whose terms of office as directors continued after the Annual Meeting.

 

Elliott Balbert

Vernon Brunner

Gordon F. Bruner

Dennis De Concini

Dennis R. Jolicoeur

Ronald J. Consiglio

 

ITEM 5.  OTHER INFORMATION

 

None

 

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

 

On May 14, 2004, the Company furnished a Current Report, dated the same date, on form 8-K regarding its earnings press release for the first quarter ended March 31 2004.

 

On June 9, 2004, the Company furnished a Current Report, dated the same date, on Form 8-K regarding the adoption of a Code of Ethics.

 

Exhibit 31.1		Certification of Chief Financial Officer
Exhibit 31.2		Certification of President/CEO/Chairman
Exhibit 32.1		Certification of Chief Financial Officer
Exhibit 32.2		Certification of President/CEO/Chairman

 

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SIGNATURES

 

Pursuant to the requirements 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.

 

	NATROL, INC.
Date:  8/16/04	By:	/s/ Elliott Balbert
		Chairman, President and Chief Executive Officer
Date:  8/16/04	By:	/s/ Dennis R. Jolicoeur
		Chief Financial Officer and Executive Vice President

 

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