GARDENBURGER INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2005

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number 0-20330

GARDENBURGER, INC.

(Exact name of registrant as specified in its charter)

Oregon		93-0886359
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

15615 Alton Parkway, Suite 350, Irvine, California		92618
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: 949-255-2000

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

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

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

Common stock without par value		9,002,101
(Class)		(Outstanding at May 9, 2005)

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

GARDENBURGER INC.

BALANCE SHEETS

(In thousands, except share amounts)

(Unaudited)

	March 31,			September 30,
	2005			2004
Assets
Current Assets:
Cash and cash equivalents	$	9		$	5
Restricted cash	54			166
Accounts receivable, net of allowances of $100 and $104 at March 31, 2005 and September 30, 2004	3,576			2,848
Inventories, net	7,110			8,964
Prepaid expenses	827			1,155
Total current assets	11,576			13,138

Machinery, equipment and leasehold improvements, net of accumulated depreciation of $14,580 and $13,303 at March 31, 2005 and September 30, 2004, respectively	9,574			10,650
Other assets, net of accumulated amortization of $1,834 and $1,725 at March 31, 2005 and September 30, 2004, respectively	611			696
Total assets	$	21,761		$	24,484

Liabilities and Shareholders’ Deficit
Current Liabilities:
Short-term note payable	$	4,666		$	4,791
Current portion of long-term debt	2,000			2,000
Accounts payable	3,703			2,905
Accrued payroll and employee benefits	680			475
Other current liabilities	798			3,583
Total current liabilities	11,847			13,754

Long-term debt, less current maturities	2,549			3,513
Convertible note payable	24,503			19,392
Total long-term debt	27,052			22,905

Convertible redeemable preferred stock, liquidation preference of $60,054 and $58,104 at March 31, 2005 and September 30, 2004, respectively, and 650,000 shares outstanding	58,101			55,851

Commitments and contingencies

Shareholders’ Deficit:
Preferred stock, no par value, 5,000,000 shares authorized	—			—
Common stock, no par value, 25,000,000 shares authorized; 9,002,101 shares issued and outstanding at March 31, 2005 and September 30, 2004	11,189			11,189
Additional paid-in capital	12,500			12,500
Accumulated deficit	(98,928		)	(91,715		)
Total shareholders’ deficit	(75,239		)	(68,026		)
Total liabilities and shareholders’ deficit	$	21,761		$	24,484

See accompanying notes to financial statements.

GARDENBURGER INC.

STATEMENTS OF OPERATIONS

(In thousands, except share amounts)

(Unaudited)

	Three months ended March 31,						Six months ended March 31,
	2005			2004			2005			2004
				(Restated)						(Restated)
Net sales	$	12,083		$	12,914		$	21,211		$	23,684
Cost of goods sold	8,769			8,122			14,396			14,686
Gross margin	3,314			4,792			6,815			8,998

Operating expenses:
Sales and marketing	3,134			3,527			6,432			6,634
General and administrative	1,356			909			2,555			2,510
Other operating income	—			—			—			(17		)
	4,490			4,436			8,987			9,127
Operating income (loss)	(1,176		)	356			(2,172		)	(129		)

Other income (expense):
Interest income	—			1			1			2
Interest expense	(1,740		)	(1,252		)	(2,792		)	(2,489		)
	(1,740		)	(1,251		)	(2,791		)	(2,487		)
Loss before cumulative effect of a change in accounting for slotting fees and preferred dividends	(2,916		)	(895		)	(4,963		)	(2,616		)
Cumulative effect of a change in accounting for slotting fees	—			—			—			(1,150		)
Net loss	(2,916		)	(895		)	(4,963		)	(3,766		)
Preferred dividends	1,125			1,294			2,250			2,588
Net loss applicable to common shareholders	$	(4,041	)	$	(2,189	)	$	(7,213	)	$	(6,354	)

Basic and diluted loss per share before cumulative effect of a change in accounting principle	$	(0.45	)	$	(0.24	)	$	(0.80	)	$	(0.58	)

Basic and diluted loss per share for cumulative effect of a change in accounting principle	—			—			—			(0.13		)

Basic and diluted loss per share	$	(0.45	)	$	(0.24	)	$	(0.80	)	$	(0.71	)

Weighted average shares used in basic and diluted per share calculations	9,002			9,002			9,002			9,002

See accompanying notes to financial statements.

GARDENBURGER INC.

STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Six Months Ended March 31,
	2005			2004
				(Restated)
Cash flows from operating activities:
Net loss	$	(4,963	)	$	(3,766	)
Adjustments to reconcile net loss to net cash flows provided by (used in) operating activities:
Depreciation and amortization	1,387			1,626
Cumulative effect of a change in accounting for slotting fees	—			1,150
Accrual of long-term debt and convertible note payable exit fees	327			652
Accrual of Annex amendment fee	250			—
Gain on sale of other assets	—			(17		)
(Increase) decrease in:
Restricted cash	112			37
Accounts receivable, net	(728		)	(286		)
Inventories, net	1,854			(1,486		)
Prepaid expenses	328			58
Increase (decrease) in:
Accounts payable	798			621
Accrued payroll and employee benefits	205			380
Other current liabilities	1,785			297
Net cash provided by (used in) operating activities	1,355			(734		)

Cash flows from investing activities:
Payments for purchase of machinery, equipment and leasehold improvements	(201		)	(908		)
Proceeds from sale of other assets	—			113
Net cash used in investing activities	(201		)	(795		)

Cash flows from financing activities:
Proceeds from (payments on) short-term note payable, net	(125		)	2,065
Payments on long-term debt	(1,000		)	(735		)
Capitalized financing fees	(25		)	(328		)
Net cash (used in) provided by financing activities	(1,150		)	1,002

Increase (decrease) in cash and cash equivalents	4			(527		)

Cash and cash equivalents:
Beginning of period	5			1,070
End of period	$	9		$	543

Supplemental Cash Flow Information
Cash paid during the period for income taxes	$	10		$	2
Cash paid during the period for interest	455			469
Non-cash preferred dividends	2,250			2,588

Supplemental Non-Cash Information
Reclassification of accrued interest from other current liabilities to convertible note payable	$	4,570		$	—

See accompanying notes to financial statements.

GARDENBURGER, INC.

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

Note 1. Basis of Presentation

The financial information included herein for the three and six month periods ended March 31, 2005 and 2004 and the financial information as of March 31, 2005 is unaudited; however, such information reflects all adjustments, consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods. The financial information as of September 30, 2004 is derived from our 2004 Annual Report on Form 10-K. The interim financial statements should be read in conjunction with the financial statements and the notes thereto included in our 2004 Annual Report on Form 10-K. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the full year.

Our financial statements have been presented on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. As shown in the 2004 financial statements, we incurred net losses applicable to common shareholders for fiscal years 2004, 2003 and 2002 and had a total shareholders’ deficit at September 30, 2004. These results continued in the first two quarters of fiscal 2005. We are highly leveraged and have significant annual interest and dividend accruals related to our convertible note payable and convertible redeemable preferred stock, which, although not payable until June 2007 and June 2008, respectively, contribute to our net losses and shareholders’ deficit.

During the fourth quarter of fiscal 2004, we experienced sales declines due to one of our major competitors initiating a program of price discounting at unprecedented levels. These sales declines resulted in operating performance that was lower than our plans. When combined with the significant cash outlays for capital expenditures, slotting fees and other product introduction costs associated with the launch of our new microwavable meals, these events caused a higher than expected use of our short-term note payable. We ended fiscal 2004 with $4.8 million outstanding on the short-term note payable, compared to $2.2 million at the end of fiscal 2003.

At March 31, 2005, we had $4.7 million outstanding on our short-term note payable and $2.1 million available, including $500,000 of additional availability provided until May 31, 2005 (as discussed below). Cash required to meet our required interest and principal payments on our debt outstanding at March 31, 2005 totals approximately $2.9 million in the next twelve months as follows (in thousands), exclusive of any contingent lender fees that may be required:

Principal payments due on long-term debt	$	2,000
Interest on long-term debt	333
Estimated interest on short-term note payable	496
Estimated unused line of credit fee related to short-term note payable	36
Total	$	2,865

These factors raise substantial doubt about our ability to continue as a going concern.

To improve our cash flow and liquidity, we have identified the following initiatives, among others for fiscal 2005:

• A full year reduction of $1.7 million in finished goods inventories which were built up over the 2002-2004 timeframe;

• A reduction in slotting fees from approximately $3.1 million in 2004 to a planned $737,000 in 2005;

• A reduction in capital expenditures from approximately $1.4 million in 2004 to a planned $325,000 in 2005;

• The completion, on October 1, 2004, of a reduction in force at our manufacturing facility;

• A ban on non-essential travel and other administrative costs;

• The negotiation of extended payment terms with several of our major vendors; and

• The institution of additional cash management and tracking procedures.

In February 2005, we also negotiated waivers with CapitalSource Finance LLC (“CapitalSource”) and Annex Holdings I LP (“Annex”) for our non-compliance with certain of our financial covenants as of December 31, 2004 and set new financial covenants going forward. In addition, CapitalSource agreed to provide a $500,000 over advance facility from February 18, 2005 to May 31, 2005 as part of the loan amendments. We agreed to pay CapitalSource a fee of $110,000 in connection with the amendment and a fee of $25,000 for the additional availability under the revolving credit facility. In addition, we are required to pay a $500,000 fee to CapitalSource if our ratio of total debt under the Loan Agreement plus the Convertible Note with Annex to earnings (as defined) exceeds 1.25:1.00 as of September 30, 2005 and a $250,000 fee if such ratio exceeds 1.25:1.00 as of the end of each quarterly period thereafter. We are considering alternatives that could preclude payment of these fees. See also Note 6.

As a result of the various initiatives, during the first two quarters of fiscal 2005, we were able to reduce our short-term note payable by $125,000, make scheduled principal payments of $1.0 million on our long-term debt and fund all interest payments on our CapitalSource debt. Net cash provided by operating activities for the six months ended March 31, 2005 improved by $2.1 million from the same period of last year.

We anticipate funding our cash commitments for the next twelve month period out of operating cash flows and short-term note payable borrowings, bolstered by the impact of the cash initiatives and over advance facility discussed above. There can be no assurance that our various sources of cash will be sufficient to sustain operations.

Our financial statements have been prepared assuming that we will continue as a going concern and do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern. Our continuation as a going concern is dependent on our ability to generate sufficient cash flow to meet our obligations on a timely basis, to comply with the terms of our financing agreements and ultimately to attain profitable operations.

Note 2. Change in Accounting Principle

Slotting fees refer to oral arrangements pursuant to which the retail grocer allows our products to be placed on the store’s shelves in exchange for a slotting fee. As reported in previous filings, slotting fees were initially recorded as a prepaid asset and the related expense was recognized ratably over a 12-month period beginning two months following product shipment as an offset to sales. Typically, twelve months is the estimated minimum period during which a retailer agrees to allocate shelf space. However, given that there are no written contractual commitments requiring the retail grocers to allocate shelf space for twelve months, in fiscal 2004, we determined that it was a preferable accounting method to expense the slotting fees as a reduction of sales in determining net sales in the period the related revenue is recognized for the first shipment of the related product. In accordance with Accounting Principles Board Opinion (“APB”) 20, “Accounting Changes,” the cumulative effect of the change in accounting for slotting fees was reflected in the first quarter of fiscal 2004.

The unaudited results for the three and six-month periods ended March 31, 2004 are restated for this change in accounting policy as indicated below (in thousands, except per share data):

	Three Months Ended March 31, 2004			Six Months Ended March 31, 2004
	(Restated)			(Restated)
Loss before cumulative effect of a change in accounting principle and preferred dividends, as reported	$	(1,225	)	$	(2,955	)
Adjustment to record actual slotting fees incurred	330			339
Loss before cumulative effect of a change in accounting principle and preferred dividends, as adjusted	(895		)	(2,616		)
Cumulative effect of a change in accounting for slotting fees	—			(1,150		)
Preferred dividends	1,294			2,588
Net loss applicable to common shareholders, as adjusted	$	(2,189	)	$	(6,354	)

Basic and diluted net loss per share applicable to common shareholders, as reported	$	(0.28	)	$	(0.62	)
Adjustment for reversal of period slotting fee additions and amortization and cumulative effect of a change in accounting principle	$	0.04		$	(0.09	)
Basic and diluted net loss per share applicable to common shareholders, as adjusted	$	(0.24	)	$	(0.71	)

Note 3. Inventories

Inventories are valued at the lower of cost (based on standard costs, which approximate the first-in, first-out (FIFO) method) or market, and include materials, labor and manufacturing overhead. Inventories consisted of the following (in thousands):

	March 31, 2005		September 30, 2004
Raw materials	$	1,056	$	967
Packaging and supplies	398		426
Finished goods	5,656		7,571
	$	7,110	$	8,964

Note 4. Stock-Based Compensation

We account for stock options using the intrinsic value method as prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” as amended, we have computed, for pro forma disclosure purposes, the impact on net loss and net loss per share as if we had accounted for our stock-based compensation plans in accordance with the fair value method prescribed by SFAS No. 123 as follows (in thousands, except per share amounts):

	Three Months Ended March 31,						Six Months Ended March 31,
	2005			2004			2005			2004
				(Restated)						(Restated)
Net loss applicable to common shareholders, as reported	$	(4,041	)	$	(2,189	)	$	(7,213	)	$	(6,354	)
Deduct - total stock-based employee compensation expense determined under the fair value based method for all awards	(41		)	(50		)	(82		)	(100		)
Net loss applicable to common shareholders, pro forma	$	(4,082	)	$	(2,239	)	$	(7,295	)	$	(6,454	)
Basic and diluted net loss per share:
As reported	$	(0.45	)	$	(0.24	)	$	(0.80	)	$	(0.71	)
Pro forma	$	(0.45	)	$	(0.25	)	$	(0.81	)	$	(0.72	)

There were no options granted during the three or six-month periods ended March 31, 2005 and 2004.

SFAS No. 123R, “Share-Based Payment,” requires companies to recognize in their income statement the grant-date fair value of stock options and other equity-based compensation issued to employees. SFAS No. 123R is effective for annual periods beginning after June 15, 2005. Accordingly, we will adopt SFAS No. 123R in our first quarter of fiscal 2006. Unamortized stock-based compensation expense, on a pro forma basis, as of March 31, 2005 totaled $273,000, with $83,000 to be amortized in the remainder of fiscal 2005, $144,000 to be amortized in fiscal 2006 and $46,000 to be amortized in fiscal 2007.

Note 5. Earnings Per Share

Basic earnings per share (“EPS”) and diluted EPS are the same for the three and six-month periods ended March 31, 2005 and 2004 since we were in a loss position.

Potentially dilutive securities that are not included in the diluted EPS calculations because they would be antidilutive are as follows (in thousands):

	March 31,
	2005	2004
Stock options	2,776	3,360
Stock warrants	1,116	1,116
Convertible Note	1,753	1,730
Convertible preferred stock	4,062	4,062
Total	9,707	10,268

Note 6. Amendments to Debt Agreements

In order to address issues relating to our ability to meet our financial obligations and to address non-compliance with certain of our financial covenants, we entered into amendments to our Loan Agreement with CapitalSource and our Note Purchase Agreement and Convertible Note with Annex on February 18, 2005.

Pursuant to the amendment to our Loan Agreement, CapitalSource agreed to waive our non-compliance with certain financial covenants as of September 30, 2004 and December 31, 2004 and to provide additional availability of up to $500,000 under the revolving credit facility from February 18, 2005 to May 31, 2005. Interest on outstanding advances under the revolving notes shall continue to be payable monthly in arrears at an annual rate of prime rate plus 2.50%, except that from February 18, 2005 to May 31, 2005, interest shall be payable at an annual rate of prime rate plus 4.50%. After May 31, 2005, the interest rate will revert back to the annual rate of prime rate plus 2.50% unless any of the additional $500,000 amount is outstanding, in which case interest shall be payable at an annual rate of prime rate plus 4.50%. In any event, interest on outstanding advances under the revolving notes shall not be less than 8.00%. We paid CapitalSource a fee of $110,000 in connection with the amendment, which was recorded as additional interest expense in the second quarter of fiscal 2005 since it was related to the waiver of our non-compliance with certain financial covenants, and a fee of $25,000 for the additional availability under the revolving credit facility, which was recorded as deferred financing fees and is being amortized over the life of the additional availability. In addition, we are required to pay a $500,000 fee to CapitalSource if our ratio of total debt under the Loan Agreement plus the Convertible Note with Annex to earnings (as defined below) exceeds 1.25:1.00 as of September 30, 2005 and a $250,000 fee if such ratio exceeds 1.25:1.00 as of the end of each quarterly period thereafter. This fee will be expensed when incurred or when payment is considered probable. We are considering alternatives that could preclude payment of these fees.

Under the amendment, we are now required to comply with the following financial covenants:

• Ratio of aggregate indebtedness under the Loan Agreement to earnings (as defined below) shall not exceed a ratio of 1.50:1.00 as of September 30, 2005 and a ratio of 1.25:1.00 as of December 31, 2005 and each quarterly period thereafter;

• Minimum earnings (losses) (as defined below), as adjusted to exclude certain expenses and non-cash charges, for the following periods: ($1.0) million for the quarterly period ended

March 31, 2005, $1.6 million for the quarterly period ending June 30, 2005, and $3.5 million for the fiscal year ending September 30, 2005 and each rolling twelve-month period on a quarterly basis thereafter;

• Capital expenditures must not exceed $150,000 for the quarterly period ended March 31, 2005, $100,000 for the quarterly period ending June 30, 2005, $100,000 for the quarterly period ending September 30, 2005, and $600,000 for each fiscal year thereafter; and

• The fixed charge coverage ratio shall not be less than a ratio of 1.10:1.00 as of September 30, 2005 and a ratio of 1.15:1.00 as of December 31, 2005 and each quarterly period thereafter.

Earnings (losses) for the purpose of calculating financial covenants is calculated as follows: net income or loss determined in accordance with GAAP, plus (a) interest expense, (b) taxes on income, whether paid, payable or accrued, (c) depreciation expense, (d) amortization expense, (e) non-cash dividends on preferred stock, and (f) all other non-cash, non-recurring charges and expenses, excluding accruals for cash expenses made in the ordinary course of business, all of the foregoing determined in accordance with GAAP, less all non-cash income.

Pursuant to the amendment to our Note Purchase Agreement and Convertible Note, Annex agreed to waive our non-compliance with certain financial covenants, and to consent to the amendment to the Loan Agreement. Under the terms of the amendment, interest on all outstanding amounts under the Convertible Note will accrue at the rate of 15% per annum. We paid Annex a fee of $250,000 in connection with the amendment, which was recorded as additional interest expense added to the principal balance of the Convertible Note. In addition, we are required to pay a $1.0 million fee to Annex if our ratio of total debt under the Loan Agreement plus the Convertible Note with Annex to earnings (as defined above) exceeds 1.25:1.00 as of September 30, 2005 and a $500,000 fee if such ratio exceeds 1.25:1.00 as of the end of each quarterly period thereafter. These fees will be added to the principal amount due under the Convertible Note. We reviewed the changes to the Convertible Note with Annex in relation to the provisions of EITF 96-19, “Debtor’s Accounting for a Modification or Exchange of Debt Instruments,” and determined that no debt extinguishment had occurred. Accordingly, the changes to the terms of the Convertible Note with Annex will be treated as modifications on a prospective basis. The financial covenants applicable to the Convertible Note are similar, but in each case slightly less restrictive than those in the Loan Agreement. The amendment also provides that we may not make, and Annex may not receive, any payment or distribution until the earlier of (i) the date that CapitalSource has been paid in full under the Loan Agreement and (ii) if the maturity date of the term loan or the revolving facility under the Loan Agreement is extended beyond the maturity date under the Convertible Note, the date of maturity under the Convertible Note. In addition, prior to August 16, 2005, Annex may not exercise any collection or enforcement rights and remedies they may have, if any, under the Convertible Note.

Since we are not allowed to make any payments of principal or interest to Annex as discussed above, we transferred all accrued interest, totaling $4.6 million as of March 31, 2005, to the Convertible Note balance. In addition, we began accruing the 20% exit premium on the accrued interest, which totaled $108,000 during the quarter ended March 31, 2005. As of March 31, 2005, the quarterly accretion of the exit fee related to the accrued interest was $216,000. This amount will increase as additional interest is accrued.

We were in compliance with all covenants as of March 31, 2005.

Note 7. Retention Agreements

We entered into Retention Agreements with each of our three executive officers and with two key employees (the “Executives”) on January 27, 2005. The Executives are Scott C. Wallace, Chief Executive Officer, President and Chairman of the Board, James W. Linford, Senior Vice President and Chief Operating Officer, Robert T. Trebing, Jr., Senior Vice President and Chief Financial Officer, Robert Dixon, Vice President of Sales and Lori Luke, Vice President of Marketing. On March 24, 2005, we entered into amendments to these Retention Agreements in order to, among other things,

revise the definition of “Change in Control” and delete Section 4.3 “Bankruptcy Limitation” in each of the agreements. On May 4, 2005, we entered into Amended and Restated Retention Agreements (the “Agreements”) with each of the Executives. The Agreements provide incentive for each of the Executives to continue to be employed by us through and following the execution of a definitive agreement relating to a change in control or going private transaction. The Agreements provide for payment of 75% of a retention bonus on the date of our execution of a definitive agreement (“Definitive Agreement”), the consummation of which would result in either: (1) a Change in Control or (2) a Going Private Transaction (each as defined in the Agreements). The remaining 25% of the retention bonus is payable following the date of the consummation of the transactions contemplated by the Definitive Agreement (“Closing”). If the signing of a Definitive Agreement occurs on or before July 27, 2006, the Executive receives a lump sum payment equal to 75% of twelve months of base salary at the time of signing of a Definitive Agreement, with the remaining 25% payable upon the Closing. If the signing of a Definitive Agreement occurs after July 27, 2006, the Executive receives a lump sum payment equal to 75% of sixteen months of base salary at the time of signing of a Definitive Agreement, with the remaining 25% payable upon the Closing. If the signing of a Definitive Agreement and/or a Closing does not occur by January 27, 2007, the full 100% of the retention bonus is payable to the Executive. The Agreements also provide for payment of a retention bonus if the Executive’s employment by us is terminated by us without Cause (as defined in the Agreements) other than in connection with the Executive’s death or Disability (as defined in the Agreements). These retention bonuses are subject to certain conditions set forth in the Agreements. The Agreements are filed as exhibits to our Current Report on Form 8 K, filed May 9, 2005.

Note 8. Reclassifications

Certain prior period amounts have been reclassified to conform to the current period presentation.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

General

Approximately 68% of our gross sales were attributable to the Gardenburger® veggie burger and soy burger products, with the remaining 32% attributable to our newer meat alternative products in the six months ended March 31, 2005. For the three months ended March 31, 2005, the split was 71% and 29%, respectively. Consumers have been moving to the wider range of meat alternative products becoming available in the marketplace. In response to this development in consumer tastes, in fiscal 2003, we added five new products, including BBQ Chik’n and Meatless Meatloaf. In the third quarter of fiscal 2004, we introduced a new line of six microwaveable meatless entrees to capitalize on the consumers’ need for convenience. Sales of this new line of Gardenburger Meals added $1.1 million and $2.4 million of net sales, respectively, in the three and six month periods ended March 31, 2005. We further expanded our convenience focus with the early 2005 launch of Gardenburger Wraps, which added $0.4 million of net sales in the three and six month periods ended March 31, 2005.

Our results have been, and continue to be, adversely affected by consumer trends favoring a low-carbohydrate diet. In addition, the low-carbohydrate shift has led to increased meat consumption. This shift in consumer demand contributed to an 1.2% and a 5.6% decrease, respectively, in sales of our veggie burger products in the three and six month periods ended March 31, 2005 compared to the same periods of fiscal 2004. This comes after drops of 8.7% and 11.0% in fiscal 2004 and 2003, respectively. In fiscal 2004, we reformulated our veggie burgers to reduce carbohydrates while increasing protein and improving taste. Demand for meatless products may continue to decrease in the future. In addition, effective the second quarter of fiscal 2004, the Costco club stores ceased to require system-wide distribution of The Original Gardenburger® product, which resulted in a $118,000, or 1.1%, decrease and a $710,000, or 31.4% decrease, respectively, in sales to Costco in the three and six month periods ended March 31, 2005 compared to same periods of fiscal 2004. We believe our new packaging, which started shipping at the end of the first quarter of fiscal 2004, has increased consumers’ awareness of how our products can fit into their diet choices and lifestyles, including low carbohydrate choices.

Results of Operations

	Three Months Ended March 31, 2005					Three Months Ended March 31, 2004 (Restated)
(Dollars in thousands)	Dollars			% of net sales(1)		Dollars			% of net sales(1)
Net sales	$	12,083		100.0	%	$	12,914		100.0	%
Cost of goods sold	8,769			72.6		8,122			62.9
Gross margin	3,314			27.4		4,792			37.1

Sales and marketing expense	3,134			25.9		3,527			27.3
General and administrative expense	1,356			11.2		909			7.0
	4,490			37.2		4,436			34.4
Operating income (loss)	(1,176		)	(9.7	)%	356			2.8	%
Other expense, net	(1,740		)			(1,251		)
Net loss	(2,916		)			(895		)
Preferred dividends	1,125					1,294
Net loss applicable to common shareholders	$	(4,041	)			$	(2,189	)

	Six Months Ended March 31, 2005					Six Months Ended March 31, 2004 (Restated)
	Dollars			% of net sales(1)		Dollars			% of net sales(1)
Net sales	$	21,211		100.0	%	$	23,684		100.0	%
Cost of goods sold	14,396			67.9		14,686			62.0
Gross margin	6,815			32.1		8,998			38.0

Sales and marketing expense	6,432			30.3		6,634			28.0
General and administrative expense	2,555			12.0		2,510			10.6
Other operating income	—			—		(17		)	(0.1	)
	8,987			42.4		9,127			38.5
Operating loss	(2,172		)	(10.2	)%	(129		)	(0.5	)%
Other expense, net	(2,791		)			(2,487		)
Loss before cumulative effect of a change in accounting for slotting fees and preferred dividends	(4,963		)			(2,616		)
Cumulative effect of a change in accounting for slotting fees	—					(1,150		)
Net loss	(4,963		)			(3,766		)
Preferred dividends	2,250					2,588
Net loss applicable to common shareholders	$	(7,213	)			$	(6,354	)

(1) Percentages may not add due to rounding.

Net Sales

The $0.8 million, or 6.4%, decrease in net sales in the three months ended March 31, 2005, as well as the $2.5 million, or 10.4%, decrease in the six-month period ended March 31, 2005 compared to the same periods of fiscal 2004 were the result of overall sales reductions in the meatless category and decreases in sales to Costco, offset in part by decreases in trade spending and growth in products introduced since March 31, 2004, especially our new entrees. Sales of products launched after March 31, 2004 contributed $1.5 million and $2.9 million, respectively, to our net sales in the three and six months ended March 31, 2005.

Net sales to Costco decreased by $118,000, or 1.1%, and $710,000, or 31.4%, respectively, in the three and six month periods ended March 31, 2005 compared to the same periods of fiscal 2004 as a result of Costco’s decision to remove the Kirkland Signature co-branding label from our Gardenburger original packaging, effective the second quarter of fiscal 2004, which means that our product is no longer required to be carried by all Costco stores. After numerous regional presentations, approximately 48% of the Costco stores continue to carry our Gardenburger product.

Trade spending totaled $1.9 million and $4.1 million, respectively, in the three and six-month periods ended March 31, 2005, compared to $2.5 million and $4.4 million, respectively, in the comparable periods of fiscal 2004, and includes promotions, discounts, contract origination fees and slotting fees. Pursuant to EITF No. 01-9 “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Products,” these costs are recorded at the later of when revenue is recognized or when the sales incentive is offered and are generally classified as a reduction of sales. The decreases in trade spending are a result of our efforts to improve our cash flow and liquidity position in fiscal 2005.

Gross Margin

The $1.5 million, or 30.8%, decrease in gross margin and the decrease in gross margin as a percentage of net sales in the three months ended March 31, 2005, as well as the $2.2 million, or 24.3%, decrease and the decrease in gross margin as a percentage of net sales in the six-month period ended March 31, 2005 compared to the same periods of fiscal 2004 were due to continuing decreases in veggie burger sales, which have lower production costs than our other meatless products, and the impact of lower production volume as we reduce our inventory levels in fiscal 2005, therefore lowering the base over which to spread fixed costs. There were no material changes to raw material costs or selling prices in the first six months of fiscal 2005 compared to the first six months of fiscal 2004 and, at the current time, we do not anticipate any material selling price changes in fiscal 2005.

Sales and Marketing Expense

The $393,000, or 11.1%, decrease in sales and marketing expense in the three months ended March 31, 2005, as well as the $202,000, or 3.0%, decrease in the six month period ended March 31, 2005, compared to the same periods of fiscal 2004 were primarily due to planned reductions in travel and other non-essential expenditures as we focus on improving our cash flow and liquidity position. The three and six-month periods ended March 31, 2004 include approximately $7,000 and $57,000, respectively, of costs related to our move to Irvine, California from Portland, Oregon. The decrease in the six month period of fiscal 2005 was partially offset by $141,000 in severance.

General and Administrative Expense

The $447,000, or 49.2%, increase in general and administrative expense in the three months ended March 31, 2005 was primarily due to an $86,000 increase in consulting costs related to Sarbanes-Oxley compliance, $146,000 in additional audit costs and $105,000 in additional legal costs, as well as $120,000 of accruals for the new management retention program. These increases were partially offset by $32,000 of costs related to our move to Irvine, California from Portland, Oregon in fiscal 2004 and a decrease of $67,000 in depreciation expense in the fiscal 2005 period due to certain assets being fully depreciated as of the end of the second quarter of fiscal 2004. The $550,000 increase in general and administrative expense for consulting costs related to Sarbanes-Oxley compliance and audit and legal costs for the six-month period ended March 31, 2005 compared to the same period of fiscal 2004 was offset by $587,000 of costs in the fiscal 2004 period related to our move to Irvine, California from Portland, Oregon and a $170,000 decrease in depreciation, leaving general and administrative expense relatively flat in the six month comparable periods.

Other Operating Expense (Income)

Other operating income in the six-month period ended March 31, 2004 represents a gain on the sale of other assets.

Interest Expense

In March 2004, we amended our Articles of Incorporation to extend the earliest mandatory redemption date of our Series C and Series D convertible preferred stock to as late as June 30, 2008. As a result, we also extended the maturity dates under our CapitalSource Loan Agreement and our Convertible Note to January 31, 2007 and June 15, 2007, respectively. The extended maturity dates, which resulted in longer amortization periods, decreased our interest expense related to exit fees by approximately $186,000 per quarter to approximately $112,000 per quarter.

In connection with our debt amendments in February 2005, interest on outstanding advances under the revolving notes from February 18, 2005 to May 31, 2005 is at an annual rate of prime rate plus 4.50%. After May 31, 2005, the interest rate will revert back to the annual rate of prime rate plus 2.50% unless any of the additional $500,000 available through May 31, 2005 remains outstanding, in which case interest will remain at an annual rate of prime rate plus 4.50%. In addition, as of February 18, 2005, interest on all outstanding amounts under the Convertible Note accrues at the rate of 15% per annum. Also, as a condition to the February 2005 amendments to our CapitalSource Loan Agreement, we are prohibited from making any cash payments to Annex until CapitalSource has been paid in full. Accordingly all accrued interest, totaling $4.6 million as of March 31, 2005, and future interest on the Convertible Note, including the $250,000 fee for the February 2005 amendments, will be assessed the 20% exit fee, which will increase our interest expense in future periods.

Interest expense in the three and six-month periods ended March 31, 2005 includes $110,000 and $250,000 for the amendment fees paid to CapitalSource and Annex, respectively, related to the February 2005 amendments, as well as $181,000 of legal and other expenses related to the amendments and $108,000 for accretion of the 20% exit premium on the Convertible Note related to accrued interest. The amendment fees and related legal and other expenses were expensed in the second quarter of fiscal 2005 since they were related to the waivers of our non-compliance with certain financial covenants.

Income Taxes

A valuation allowance has been recorded for the full amount of deferred tax assets due to the uncertainty regarding the realization of the net deferred tax assets consisting primarily of net operating loss and credit carryforwards. Accordingly, no benefit has been recorded related to our losses in the three and six month periods ended March 31, 2005 or 2004.

Cumulative Effect of Change in Accounting for Slotting Fees

Preferred Dividends

As approved by our shareholders at our 2004 Annual Shareholder Meeting in March 2004, the terms of our Series C and Series D convertible preferred stock were amended to defer the earliest date on which holders may require redemption of their shares of Series C and Series D convertible preferred stock to as late as June 30, 2008 instead of March 31, 2006. Accordingly, the amount of the 10% redemption premium not previously accreted is being accreted over a longer period of time, which reduced our quarterly preferred dividend charge from $1.3 million to approximately $1.1 million beginning in the third quarter of fiscal 2004.

Detail of our preferred dividends is as follows (in thousands):

	Three Months Ended March 31,				Six Months Ended March 31,
	2005		2004		2005		2004
12% cumulative dividends	$	975	$	975	$	1,950	$	1,950
Accretion of 10% redemption premium	120		255		240		510
Accretion of original issue discount	30		64		60		128
	$	1,125	$	1,294	$	2,250	$	2,588

Liquidity and Capital Resources

Our financial statements have been presented on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. As shown in the 2004 financial statements, we incurred net losses applicable to common shareholders for fiscal years 2004, 2003 and 2002 and had a total shareholders’ deficit at September 30, 2004. These results continued in the first two quarters of fiscal 2005. We are highly leveraged and have significant annual interest and dividend accruals related to our Convertible Note and convertible redeemable preferred stock, which, although not payable until June 2007 and June 2008, respectively, contribute to our net losses and shareholders’ deficit.

Principal payments due on long-term debt	$	2,000
Interest on long-term debt	333
Estimated interest on short-term note payable	496
Estimated unused line of credit fee related to short-term note payable	36
Total	$	2,865