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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT

pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

FOR THE FISCAL YEAR ENDED JUNE 30, 2003

000-15701

(Commission file number)

NATURAL ALTERNATIVES INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.01 par value per share

Indicate by check mark whether Natural Alternatives International, Inc. (NAI) (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 NAI was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  Yes    ¨  No

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

Indicate by check mark whether NAI is an accelerated filer (as defined in Rule 12b-2 of the Act).    ¨  Yes    x  No

The aggregate market value of NAI’s common stock held by non-affiliates of NAI as of the last business day of NAI’s most recently completed second fiscal quarter (December 31, 2002) was approximately $17,578,361 (based on the closing sale price of $3.985 reported by Nasdaq on December 31, 2002). For this purpose, all of NAI’s officers and directors and their affiliates were assumed to be affiliates of NAI.

As of September 17, 2003, 5,821,973 shares of NAI’s common stock were outstanding, net of 272,400 treasury shares.

DOCUMENTS INCORPORATED BY REFERENCE

Part III (Items 10, 11, 12, 13 and 14) of this Form 10-K incorporates by reference portions of NAI’s definitive proxy statement for its 2004 Annual Meeting of Stockholders, to be filed on or before October 28, 2003.

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SPECIAL NOTE—FORWARD-LOOKING STATEMENTS

Certain statements in this report, including information incorporated by reference, are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934, and the Private Securities Litigation Reform Act of 1995. Forward-looking statements reflect current views about future events and financial performance based on certain assumptions. They include opinions, forecasts, projections, guidance, expectations, beliefs or other statements that are not statements of historical fact. Words such as “may,” “will,” “should,” “could,” “would,” “expects,” “plans,” “believes,” “anticipates,” “intends,” “estimates,” “approximates,” “predicts,” or “projects,” or the negative or other variation of such words, and similar expressions may identify a statement as a forward-looking statement. Forward-looking statements in this report may include statements about:

The forward-looking statements in this report speak only as of the date of this report. Forward-looking statements are subject to certain events, risks, and uncertainties that may be outside of our control. When considering forward-looking statements, you should carefully review the risks, uncertainties and other cautionary statements in this report as they identify certain important factors that could cause actual results to differ materially from those expressed in or implied by the forward-looking statements. These factors include, among others, the risks described under Item 7 and elsewhere in this report, as well as in other reports and documents we file with the SEC.

PART I

Overview

We provide private label contract manufacturing services to companies that market and distribute vitamins, minerals, herbs, and other nutritional supplements, as well as other health and personal care products, to consumers both within and outside the United States. We provide both product and market development services including:

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In fiscal 2000, we initiated our direct-to-consumer marketing program to develop, manufacture and market our own products. Under this program, we work with nationally recognized physicians and other personalities to develop brand name products that reflect their individual approaches to restoring, maintaining or improving health. In March 2000, we launched Basic Nutrient Support^TM, our first product developed in collaboration with Dr. Reginald B. Cherry, M.D. In fiscal 2001, we launched Dr. Cherry’s Pathway to Healing^TM product line.

While private label contract manufacturing remains our core business, we are actively pursuing new products and initiatives for our direct-to-consumer marketing program. In April 2003, we began marketing our Jennifer O’Neill line of vitamins and skin care products.

Our U.S.-based manufacturing facilities are located in San Marcos and Vista, California. Natural Alternatives International Europe S.A. (NAIE), our wholly-owned subsidiary existing under the laws of Switzerland, also operates a manufacturing, warehousing and distribution facility in Manno, Switzerland. This facility helps us provide improved service to our customers that sell their products in Europe. Among other benefits, our facility in Switzerland can help lower distribution and other costs of products sold outside the United States and can also help reduce lead times and lower inventory costs. NAIE operates under a five-year Swiss federal and cantonal income tax holiday that ends in fiscal 2005.

In addition to our operations in the United States and Switzerland, we have a full-time representative in Japan who provides a range of services to our customers seeking to expand into the Japanese market and other markets in the Pacific Rim. These services include regulatory and marketing assistance along with guidance and support in adapting products to these markets.

Originally founded in 1980, Natural Alternatives International, Inc. reorganized as a Delaware corporation in 1989. Our principal executive offices are located at 1185 Linda Vista Drive, San Marcos, California 92069. Unless the context requires otherwise, all references in this report to the “Company,” “NAI” “we,” “our,” and “us” refer to Natural Alternatives International, Inc. and, as applicable, NAIE, its wholly-owned subsidiary.

Business Strategy

Our goals are to increase and diversify our revenues and improve our overall financial results. To achieve these goals, we intend to:

We believe our comprehensive approach to customer service is unique within our industry. We believe this approach, together with our commitment to high-quality, innovative products and the leadership of our experienced management team, will provide the means to implement our strategy and achieve our goals. There can be no assurance, however, that we will successfully implement any of our business strategies or that we will increase our revenues or improve our overall financial results.

Products, Principal Markets and Methods of Distribution

We provide private label contract manufacturing services to companies that market and distribute vitamins, minerals, herbs, and other nutritional supplements, as well as other health and personal care products, to consumers both within and outside the United States. Our products are generally available in a variety of forms, including capsules, tablets, chewable wafers, powders and creams, to accommodate a variety of consumer preferences.

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Our private label contract manufacturing customers include direct selling organizations and other specialized corporate accounts. We have a worldwide manufacturing agreement with NSA International, Inc., located in Memphis, Tennessee. NSA International, Inc. is our largest customer and sells its nutritional products to consumers in over 30 countries.

Under our direct-to-consumer marketing program, we develop and manufacture our own products. We work with nationally recognized physicians and other personalities to develop brand name products that reflect their individual approaches to restoring, maintaining or improving health. The products in our direct-to-consumer marketing program are sold through a variety of distribution channels including television programs, personal appearances of brand name personalities, newsletters, direct mail solicitations, websites, radio, magazines and other marketing channels.

In October 1999, the Therapeutic Goods Administration (TGA) of Australia certified our operations. The TGA evaluates new therapeutic products, prepares standards, develops testing methods and conducts testing programs to ensure that products are high in quality, safe and effective. TGA certification enables us to manufacture products for export into countries that have signed the Pharmaceutical Inspection Convention, which include most European countries as well as several Pacific Rim countries. The TGA recertified our operations in March 2000.

In October 2002, we were awarded Good Manufacturing Practices (GMP) registration by NSF International (NSF) through the NSF Dietary Supplements Certification Program. GMP requirements are regulatory requirements that provide guidelines for necessary processes, procedures and documentation to assure the product produced has the identity, strength, composition, quality and purity it is represented to possess.

For the last three fiscal years, net sales from our private label contract manufacturing and direct-to-consumer marketing program were as follows:

Research and Development

We are committed to quality research and development. We focus on the development of new products and the improvement of existing products through continued testing. We continuously produce sample runs of products to help ensure their stability, potency, and safety, as well as to determine ingredient interaction and the potential for customer acceptance of the final product. We maintain quality control procedures to verify that our products comply with applicable specifications and standards established by the Food and Drug Administration and other regulatory agencies. We also direct and participate in clinical research studies, often in collaboration with other scientists and research institutions, to establish the benefits of a product, including its potency and efficacy, and to provide scientific support for product claims and marketing initiatives. We believe our research and development team of experienced personnel, as well as our facilities and strategic alliances with our suppliers and customers, allow us to effectively identify, develop and market high-quality and innovative products.

As part of the services we provide to our private label contract manufacturing customers, we may perform certain research and development activities related to the development or improvement of their products. While our customers typically do not pay directly for this service, the cost of this service is included as a component of the price we charge to manufacture and deliver their products. Research and development costs are expensed as incurred.

Our research and development expenses for the fiscal years ended June 30, 2003, 2002 and 2001 were $1.7 million, $821,000 and $718,000, respectively.

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Sources and Availability of Raw Materials

We use various raw materials in our operations including nutrient powders, excipients, empty gelatin capsules, and components for packaging and distributing our finished products. We typically buy raw materials in bulk from a limited number of qualified vendors located both within and outside the United States. During fiscal 2003, Carrington Laboratories Incorporated was our largest supplier, accounting for 35% of our total raw material purchases.

We test the materials we buy to ensure their quality, purity and potency before we use them in our products. During the fiscal year ended June 30, 2003, we did not experience any shortages or difficulties obtaining adequate supplies of raw materials and we do not anticipate any significant shortages or difficulties in the near term.

Major Customers

Most of our customers are marketing organizations that distribute a variety of nutritional and health related products throughout the United States, Europe and the Pacific Rim. NSA International, Inc. has been our largest customer over the past several years. During the fiscal year ended June 30, 2003, NSA International, Inc. accounted for approximately 43% of our net sales. Our second largest customer was Mannatech Incorporated, which accounted for approximately 27% of our net sales during fiscal 2003. No other customer accounted for 10% or more of our net sales during fiscal 2003.

Competition

We compete with other manufacturers and distributors of vitamins, minerals, herbs, and other nutritional supplements, as well as other health and personal care products, both within and outside the United States. The nutritional supplement industry is highly fragmented and competition for the sale of nutritional supplements and other health and personal care products comes from many sources. These products are sold primarily through mass market retailers (drug store chains, supermarkets, and large chain discount retailers), health and natural food stores, and direct sales channels (mail order, network marketing and internet distribution companies). The products we produce for our private label contract manufacturing customers may compete with our direct-to-consumer products, although we believe any competition will be limited.

We believe competition in our industry is based on, among other things, price, delivery, product quality and safety, innovation and customer service. We believe we compete favorably with other companies because of our comprehensive approach to customer service and our commitment to innovation, quality and safety through our research and development activities. Our future position in the industry will likely depend on, but not be limited to the following:

The nutritional supplement industry is highly competitive and we expect the level of competition to remain high over the near term. We do not believe it is possible to accurately estimate the number or size of our competitors. The industry has undergone consolidation in the recent past and we expect that trend to continue in the near term.

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Government Regulation

Our business is subject to varying degrees of regulation by a number of government authorities in the United States, including the United States Food and Drug Administration (FDA), the Federal Trade Commission (FTC), the Consumer Product Safety Commission, the United States Department of Agriculture, and the Environmental Protection Agency. Various agencies of the state and localities in which we operate and in which our products are sold also regulate our business, such as the California Department of Health Services, Food and Drug Branch. The areas of our business that these and other authorities regulate include, among others:

The FDA, in particular, regulates the formulation, manufacturing, packaging, storage, labeling, promotion, distribution and sale of vitamin and other nutritional supplements in the United States, while the FTC regulates marketing and advertising claims. The FDA issued a final rule called “Statements Made for Dietary Supplements Concerning the Effect of the Product on the Structure or Function of the Body,” which includes regulations requiring companies, their suppliers and manufacturers to meet Good Manufacturing Practices in the preparation, packaging, storage and shipment of their products. The FDA also published a Notice of Advance Rule Making for Good Manufacturing Practices that would require manufacturing of dietary supplements to follow Good Manufacturing Practices. While the final regulations are subject to revision, we are committed to meeting or exceeding the standards set by the FDA.

The FDA has also issued regulations governing the labeling and marketing of dietary and nutritional supplement products. They include:

The Dietary Supplement Health and Education Act of 1994 (DSHEA) revised the provisions of the Federal Food, Drug and Cosmetic Act concerning the composition and labeling of dietary supplements and defined dietary supplements to include vitamins, minerals, herbs, amino acids and other dietary substances used to supplement diets. DSHEA generally provides a regulatory framework to help ensure safe, quality dietary supplements and the dissemination of accurate information about such products. Under DSHEA, companies must provide evidence that a dietary supplement is reasonably safe. The FDA is generally prohibited from regulating active ingredients in dietary supplements as drugs unless product claims, such as claims that a product may heal, mitigate, cure or prevent an illness, disease or malady, trigger drug status.

We are also subject to a variety of other regulations in the United States, including those relating to taxes, labor and employment, import and export, the environment and intellectual property.

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Our operations outside the United States are similarly regulated by various agencies and entities in the countries in which we operate and in which our products are sold. The regulations of these countries may conflict with those in the United States and may vary from country to country. The sale of our products in Europe is subject to the rules and regulations of the European Union, which may be interpreted differently among the countries within the union. In markets outside the United States, we may be required to obtain approvals, licenses, or certifications from a country’s ministry of health or comparable agency before we begin operations or the marketing of products in that country. Approvals or licenses may be conditioned on reformulation of our products for a particular market or may be unavailable for certain products or product ingredients. These regulations may limit our ability to enter certain markets outside the United States.

Intellectual Property

Trademarks. We have developed and use registered trademarks in our business, particularly relating to corporate and product names. We own 19 trademark registrations in the United States and 10 trademark applications pending with the United States Patent and Trademark Office. Federal registration of a trademark enables the registered owner of the mark to bar the unauthorized use of the registered mark in connection with a similar product in the same channels of trade by any third party anywhere in the United States, regardless of whether the registered owner has ever used the trademark in the area where the unauthorized use occurs.

We have filed applications and own trademark registrations and intend to register additional trademarks in foreign countries where products are or may be sold in the future. Currently, we have five trademark applications filed with the Japan Trademark Office.

We also claim ownership and protection of certain product names, unregistered trademarks and service marks under common law. Common law trademark rights do not provide the same level of protection afforded by registration of a trademark. In addition, common law trademark rights are limited to the geographic area in which the trademark is actually used. We believe these trademarks, whether registered or claimed under common law, constitute valuable assets, adding to our recognition and the marketing of our products and that these proprietary rights have been and will continue to be important in enabling us to compete.

Trade Secrets. We own certain intellectual property, including trade secrets, that we seek to protect, in part, through confidentiality agreements with employees and other parties, although some employees involved in research and development activities have not entered into these agreements. Although we regard our proprietary technology, trade secrets, trademarks and similar intellectual property as critical to our success, we rely on a combination of trade secrets, contract, patent, copyright and trademark law to establish and protect our rights in our products and technology. In addition, the laws of certain foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States.

Patent Licenses. We have licensed exclusive worldwide rights to three certain United States patents, and each patent’s corresponding foreign patent application, and are currently involved in research and development of products employing the licensed inventions.

Backlogs

Our backlog was approximately $10.1 million at September 2, 2003 and September 5, 2002, respectively. Our sales are made primarily pursuant to standard purchase orders for the delivery of products. Quantities of our products to be delivered and delivery schedules are frequently revised to reflect changes in our customers’ needs. Customer orders generally can be cancelled or rescheduled without significant penalty to the customer. For these reasons, our backlog as of any particular date is not representative of actual sales for any succeeding period, and therefore, we believe that backlog is not necessarily a good indicator of future revenue.

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Employees

As of June 30, 2003, we employed 175 full-time employees in the United States, 6 of whom held executive management positions. Of the remaining full-time employees, 23 were employed in research, laboratory and quality control, 9 in sales and marketing, and 137 in manufacturing and administration. From time to time we use temporary personnel to help us meet short-term operating requirements. These positions typically are in manufacturing and manufacturing support. As of June 30, 2003, we had approximately 12 temporary personnel.

In January 2003, Randell Weaver was promoted from Executive Vice President and Chief Operating Officer to President. John Reaves was promoted from Vice President of Finance to Chief Financial Officer.

As of June 30, 2003, NAIE employed 24 full-time employees. Most of these positions are in the areas of manufacturing and manufacturing support.

Our employees are not represented by a collective bargaining agreement and we have not experienced any work stoppages as a result of labor disputes. We believe our relationship with our employees is good.

Seasonality

We believe there is no material impact on our business or results of operations from seasonal factors.

Financial Information about Our Business Segment and Geographic Areas

Our business consists of one industry segment, the development, manufacturing, marketing and distribution of nutritional supplements and other health and personal care products. It is grouped into two geographic areas, the United States and all other markets outside the United States. Our primary market outside the United States is Europe.

For the last three fiscal years, the percentage of our net sales to customers in markets outside the United States and the percentage of our net sales from products manufactured by NAIE for customers within the European market were as follows:

For additional financial information about our business segment and geographic areas, please see the notes to the consolidated financial statements included under Item 8 of this report.

As we continue to expand into markets outside the United States, we will become increasingly subject to political, economic and other risks in the countries in which the products are sold and in which we operate. For more information about these and other risks, please see Items 7 and 7A in this report.

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This table summarizes our facilities as of June 30, 2003. We believe our facilities are adequate to meet our operating requirements for the foreseeable future.

We believe we have adequate capacity in our domestic and Swiss facilities for current and foreseeable business requirements.

From time to time, we become involved in various investigations, claims and legal proceedings that arise in the ordinary course of our business. These matters may relate to product liability, employment, intellectual property, tax, regulation, contract or other matters. The resolution of these matters as they arise will be subject to various uncertainties. While unfavorable outcomes are possible, we believe the resolution of these matters, individually or in the aggregate, will not result in a material adverse effect on our business, financial condition or results of operations.

As of September 17, 2003, neither NAI nor its subsidiaries were a party to any material pending legal proceedings nor was any of their property the subject of any material pending legal proceedings.

We did not submit any matters to our stockholders for a vote during the fourth quarter ended June 30, 2003.

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PART II

Market Information

Our common stock trades on the Nasdaq National Market under the symbol “NAII.” Below are the high and low closing prices of our common stock as reported on the Nasdaq National Market for each quarter of the fiscal years ended June 30, 2003 and 2002:

Holders

As of September 17, 2003, there were approximately 408 stockholders of record of our common stock.

Dividends

We have never paid a dividend on our common stock and we do not intend to pay a dividend in the foreseeable future. Our current policy is to retain all earnings to help provide funds for future growth.

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Securities Authorized for Issuance Under Equity Compensation Plans

Recent Sales of Unregistered Securities

During the fiscal year ended June 30, 2003, we did not sell any unregistered securities.

The following tables contain certain financial information about NAI, including its subsidiaries. When you review this information, you should keep in mind that it is historical. Our future financial condition and results of operations will vary based on a variety of factors. You should carefully review the following information together with the information on risks under Item 7 and elsewhere in this report, and our consolidated financial statements included in this report under Item 8.

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Annual Financial Data

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Quarterly Financial Data

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The following discussion and analysis is intended to help you understand our financial condition and results of operations for the last three fiscal years ended June 30, 2003. You should read the following discussion and analysis together with our audited consolidated financial statements and the notes to the consolidated financial statements included under Item 8 in this report. Our future financial condition and results of operations will vary from our historical financial condition and results of operations described below.

Critical Accounting Policies and Estimates

Our consolidated financial statements included under Item 8 in this report have been prepared in accordance with accounting principles generally accepted in the United States (GAAP). Our significant accounting policies are described in the consolidated financial statements. The preparation of financial statements in accordance with GAAP requires that we make estimates and assumptions that affect the amounts reported in our financial statements and their accompanying notes. We have identified certain policies that we believe are important to the portrayal of our financial condition and results of operations. These policies require the application of significant judgment by our management. We base our estimates on our historical experience, industry standards, and various other assumptions that we believe are reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. An adverse effect on our financial condition, changes in financial condition, and results of operations could occur if circumstances change that alter the various assumptions or conditions used in such estimates or assumptions. Our critical accounting policies include those listed below.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses resulting from any inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowance may be required.

Revenue Recognition

We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 101 “Revenue Recognition in Financial Statements,” or SAB 101. SAB 101 requires that four basic criteria be met before revenue can be recognized: 1) there is evidence that an arrangement exists; 2) delivery has occurred; 3) the fee is fixed or determinable; and 4) collectibility is reasonably assured. We recognize revenue upon determination that all criteria for revenue recognition have been met. The criteria are usually met at the time title passes to the customer, which usually occurs upon shipment. Revenue from shipments where title passes upon delivery are deferred until the shipment has been delivered. In addition, we record reductions to revenue for estimated returns. If actual returns exceed our estimates, additional reductions to revenue would result.

Inventory Reserve

We record valuation reserves on our inventory for estimated excess and obsolete inventory equal to the difference between the cost of inventory and the estimated market value based on assumptions about future product demand and market conditions. If demand and/or market conditions are less favorable than we estimated, additional inventory reserves may be required.

Depreciation of Long-Lived Assets

We assign useful lives for long-lived assets based on periodic studies of actual asset lives and the intended use for those assets. Any change in the asset lives would be reported in the statement of operations as soon as practicable after we determine any change in the estimate.

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Accounting for Income Taxes

We estimate income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure, together with assessing temporary differences resulting from differing treatment of items, such as property and equipment depreciation, for tax and financial reporting purposes. Actual income taxes could vary from these estimates due to future changes in income tax law or results from final tax examination reviews. At June 30, 2003, we assessed the need for a valuation allowance on our deferred tax assets. A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based on the historical operating losses and the uncertainty about sufficient near term taxable income, we believe that this evidence creates sufficient uncertainty about the realizability of the net deferred tax assets. Therefore, a full valuation allowance of $1.6 million is recorded at June 30, 2003. Should we determine that we would be able to realize all or part of our net deferred tax assets in the future, we would record an adjustment to the deferred tax assets to operations in the period for which such determination was made.

Results of Operations—Fiscal 2003 Compared to Fiscal 2002

Net Sales

Our total net sales increased 12% in fiscal 2003. Net sales from our direct-to-consumer marketing program increased 22%. This increase in fiscal 2003 was due primarily to the introduction of five new direct-to-consumer products. Total net sales for all private label contract manufacturing customers with individual volumes of at least $1.0 million was $42.9 million (three customers) in fiscal 2003 and $39.2 million (four customers) in fiscal 2002. This represents an increase of $3.7 million, which was primarily due to new product sales together with an increase in the volume of established products for our two largest customers.

Gross Profit

The improvement in gross profit margin to 24% from 22% was due to fixed cost leverage from higher net sales and improved efficiency from investments in our packaging operations. Our direct and indirect manufacturing expenses were 23% of net sales in fiscal 2003 and 24% of net sales in fiscal 2002. Our material and packaging costs as a percentage of net sales was 53% in fiscal 2003 ($29.6 million) and 53.7% in fiscal 2002 ($26.9 million).

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $12.0 million (21.5% of net sales) in fiscal 2003 and $10.7 million (21.4% of net sales) in fiscal 2002. The increase in absolute dollars in fiscal 2003 was primarily due to increases in direct-to-consumer fulfillment and recurring media costs of $573,000 associated with incremental sales, new direct-to-consumer media and production costs of $603,000 for introducing Dr. Cherry’s Pathway to Healing^TM brand in several new television markets, sales and executive personnel costs of $325,000, research and development personnel costs of $459,000, insurance premiums of $352,000, information system costs of $204,000 and clinical study costs of $197,000. These increases were partially offset by a $350,000 reduction in legal costs, $300,000 reduction in employee separation expenses, and $767,000 reduction of direct-to-consumer costs incurred in the prior year for improving customer service, processing and reporting.

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Income from Operations

Our income from operations was $1.2 million in fiscal 2003 and $285,000 in fiscal 2002. The improvement in our income from operations was due to the increase in gross profit of $2.2 million from improved gross margin on higher net sales, partially offset by incremental selling, general and administrative expenses of $1.3 million.

Other income

We received proceeds from the settlement of claims associated with the vitamin antitrust litigation of $225,000 in fiscal 2003 and $3.4 million in fiscal 2002.

Income Taxes

In fiscal 2002, federal tax legislation was passed allowing companies to carryback net operating losses for five years. This resulted in recognition of a $701,000 income tax refund receivable, which was included as an income tax benefit in our consolidated statement of operations for the year ended June 30, 2002. At June 30, 2003, we assessed the need for a valuation allowance on our deferred tax assets. Based on the historical operating losses and the uncertainty about sufficient near term taxable income, we believe that this evidence creates sufficient uncertainty about the realizability of the net deferred tax assets. Therefore, a full valuation allowance of $1.6 million was recorded at June 30, 2003.

Net Income

Our net income was $1.1 million ($0.18 per diluted share) in fiscal 2003 and $3.9 million ($0.67 per diluted share) in fiscal 2002. Excluding the effect of the litigation settlement proceeds and income tax refund receivable of $701,000 in the prior year, net income increased $1.1 million to $880,000 ($0.15 per diluted share) compared to a net loss of $232,000 ($0.04 per diluted share.)

Results of Operations—Fiscal 2002 Compared to Fiscal 2001

Net Sales

Our total net sales increased 19% in fiscal 2002. Net sales from our direct-to-consumer marketing program increased 46%. This increase was due primarily to the introduction of eight new direct-to-consumer products in fiscal 2002. Total net sales for all private label contract manufacturing customers with individual volumes of at least $1.0 million was $39.2 million (four customers) in fiscal 2002 and $34.4 million (six customers) in fiscal 2001. This represents an increase of $4.8 million, which was primarily due to new product sales together with an increase in the volume of established products to our two largest customers.

Gross Profit

Sales increases in both our private label contract manufacturing business and our direct-to consumer marketing program favorably impacted our gross profit in fiscal 2002. Our direct and indirect manufacturing expenses were 24% of net sales in fiscal 2002 and 28% of net sales in fiscal 2001. This reduction was due to improved internal process controls and increased efficiency.

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Our material and packaging costs as a percentage of net sales were relatively steady at 53.7% ($26.9 million) in fiscal 2002 and 52.7% ($22.2 million) in fiscal 2001. Material contribution margins decreased in fiscal 2002 due to material costs for our packaged powder products. Excluding the packaged powder products, material costs as a percentage of net sales would have improved 4% due to our cost reduction efforts.

Selling, General, and Administrative Expenses

Selling, general and administrative expenses were $10.7 million (21% of net sales) in fiscal 2002 and $8.8 million (21% of net sales) in fiscal 2001. The increase in absolute dollar terms in fiscal 2002 was primarily due to incremental spending for our direct-to-consumer marketing program of $1.7 million, and spending of $350,000 to reorganize our manufacturing and sales organizations. In addition, lower than expected performance by our former third party provider of direct-to-consumer call and fulfillment services resulted in significantly higher processing and customer service costs. We replaced the third party provider in December 2001 and began an aggressive campaign to improve customer service. This resulted in additional charges of approximately $500,000. The start-up costs of our direct-to-consumer call and fulfillment center were approximately $267,000.

Total operating expenses were comparable in absolute dollar terms at approximately $10.7 million in fiscal 2002 and $10.4 million in fiscal 2001. Operating expenses in fiscal 2001 included a charge of $1.5 million. This charge reflected a write down for intangible assets and additional expenses associated with our attempt to commercialize the software we obtained from our FitnessAge and Custom Nutrition ventures.

Income (Loss) from Operations

Our income from operations was $285,000 in fiscal 2002. In fiscal 2001, we suffered a loss of $2.2 million. The improvement in our income from operations was primarily due to the increase in gross profit of $2.8 million in fiscal 2002 and the intangible asset impairment charge of $1.5 million recorded in 2001.

Other income

We received proceeds from the settlement of claims associated with the vitamin antitrust litigation of $3.4 million in fiscal 2002 and $298,000 in fiscal 2001.

Income Taxes

Our income tax expense for fiscal 2001 was $2.4 million, resulting from the establishment of a valuation allowance on our net deferred tax assets. In fiscal 2002, federal tax legislation was passed allowing companies to carryback net operating losses for five years. This resulted in recognition of a $701,000 income tax refund receivable, which was included as an income tax benefit in our consolidated statement of operations for the year ended June 30, 2002.

Net Income (Loss)

Our net income was $3.9 million ($0.67 per share) in fiscal 2002. In fiscal 2001, we suffered a net loss of $4.9 million ($0.85 per share). The improvement in our net income was due to improved operating results, the vitamin antitrust litigation settlement, and the income tax benefit described above.

Liquidity and Capital Resources

Our working capital increased substantially in fiscal 2003 to $12.3 million at June 30, 2003 versus $8.7 million at June 30, 2002. Cash and cash equivalents increased $4.8 million as a result of the new credit facility, as discussed below, collection of the income tax refund of $701,000 and cash generated from operations. The new credit facility provided a $1.3 million increase in our cash position and freed up $1.5 million of cash previously restricted as collateral for the prior line of credit. Accounts receivable increased $2.1 million due to higher net sales in the fourth quarter of fiscal 2003 as compared with the same period in the prior fiscal year and an increase in days sales outstanding. Accounts payable as a percentage of inventory was 64% at June 30, 2003 versus 52% at June 30, 2002 due to timing of payments.

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Approximately 47% of our operating cash flow was generated by NAIE in fiscal 2003. There are currently no material restrictions on the transfer of these funds within the Company.

Capital expenditures for fiscal 2003 were approximately $977,000. These expenditures were for investments in our continuing development of the Swiss manufacturing facility of approximately $222,000 and domestic manufacturing and information system improvements of approximately $755,000. The domestic capital expenditures were primarily for improving our finished goods packaging operation. We plan on increasing capital expenditures in fiscal 2004 by greater than 50% to expand capacity in encapsulation and packaging operations.

Our consolidated debt increased to $3.0 million at June 30, 2003 from $2.2 million at June 30, 2002. Our consolidated debt of $3.0 million was comprised of a $748,000 term loan secured by a building and $2.2 million outstanding on the term loan included in our new credit facility. On October 25, 2002, we entered into a $6.5 million two-year credit facility. The facility includes a $4 million working capital line of credit and a $2.5 million term loan and is secured by all of our assets. The working capital line of credit is subject to eligibility requirements for current accounts receivable and inventory balances. As of June 30, 2003, we had $4.0 million available under the line of credit. The interest rate on the line of credit and the term loan is prime plus 0.5%. This new facility replaced our previous $2.5 million line of credit that expired on October 31, 2002 and refinanced a $1.2 million outstanding term note.

In fiscal 2004 we plan on funding normal working capital needs, capital expenditures and debt payments using cash flow from operations.

On June 24, 2003 we purchased option contracts designated as cash flow hedges to protect against the foreign currency exchange risk inherent in our forecasted transactions denominated in Euros. The option contracts had a notional amount of $1.5 million and a purchase price of $16,100. The premium associated with each option contract is amortized on a straight-line basis over the term of the option, and mark-to-market amounts and realized gains or losses are recognized on the settlement date in cost of good sold. The risk of loss associated with purchased options is limited to premium amounts paid for the option contracts. At June 30, 2003, the value of the purchased options of $16,100 was included in other current assets in the consolidated financial statements. There are no other derivative financial instruments at June 30, 2003.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet debt nor do we have any transactions, arrangements or relationships with any special purposes entities.

Contractual Obligations

This table summarizes our known contractual obligations and commercial commitments at June 30, 2003 (dollars in thousands).

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Inflation

We do not believe that inflation or changing prices have had a material impact on our historical operations or profitability.

Recent Accounting Pronouncements

In November 2002, the Financial Accounting Standards Board (FASB) issued Interpretation No. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 is applicable to guarantees issued or modified after December 31, 2002. FIN 45 expands the existing disclosure required for most guarantees, including loan guarantees such as standby letters of credit. FIN 45 also requires a company to recognize an initial liability for the fair market value of the obligations it assumes under that guarantee upon issuance and disclosure of certain information about the guarantee in its interim and annual financial statements. We do not expect this interpretation to have a significant impact on our financial condition or results of operations.

In December 2002, FASB issued Statement of Financial Accounting Standards No. 148 (SFAS 148), “Accounting for Stock-Based Compensation—Transition and Disclosure and amendment of FASB Statement No. 123.” SFAS 148 is effective for fiscal years ending after December 15, 2002. SFAS 148 provides an alternative method of transition for an entity that voluntarily changes accounting for its stock-based employee compensation to the fair value method. In addition, SFAS 148 changes the disclosure provisions to provide more prominent disclosures about the effects on reported net income with respect to stock-based employee compensation and adds additional disclosures relating to stock-based employee compensation for interim financial information. We have made the required disclosures in the notes to our consolidated financial statements. However, we do not plan to change the accounting for our employee stock-based compensation at this time.

In January 2003, FASB issued Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities.” FIN 46 is effective for variable interest entities created after January 31, 2003. FIN 46 is an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. We do not expect this interpretation to have a significant impact on our financial condition or results of operations.

In April 2003, FASB issued Statement of Financial Accounting Standards No. 149 (SFAS 149), “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under Statement 133. SFAS 149 requires that contracts with comparable characteristics be accounted for similarly. In particular, SFAS 149 (1) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, (2) clarifies when a derivative contains a financing component, and (3) amends the definition of underlying to conform it to language used in FIN 45. SFAS 149 is effective for contracts entered into or modified after June 30, 2003. We do not expect this interpretation to have a significant impact on our financial condition or results of operations.

In May 2003, FASB issued Statement of Financial Accounting Standards No. 150 (SFAS 150), “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS 150 establishes standards for how to classify and measure certain financial instruments with characteristics of both liabilities and equity. It is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. We do not expect this interpretation to have a significant impact on our financial condition or results of operations.

Risks

You should carefully consider the risks described below, as well as the other information in this report, when evaluating our business and future prospects. If any of the following risks actually occur, our business, financial condition and results of operations could be seriously harmed. In that event, the market price of our common stock could decline and you could lose all or a portion of the value of your investment in our common stock.

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Because we derive a significant portion of our revenues from a limited number of customers, our revenues would be adversely affected by the loss of a major customer.

We have in the past, and expect to continue in the near future, to derive a significant portion of our revenues from a relatively limited number of customers. During the fiscal year ended June 30, 2003, sales to one customer, NSA International, Inc., were approximately 43% of our total net sales. Our second largest customer was Mannatech Incorporated, which accounted for approximately 27% of our net sales. The loss of either of these customers or other major customers, or a significant decrease in sales to these customers, would materially affect our financial condition and results of operations.

Our operating results will vary and there is no guarantee that we will earn a profit. Fluctuations in our operating results may adversely affect the share price of our common stock.

While our net sales and income from operations have both improved during the past two fiscal years, there can be no assurance that they will continue to improve, or that we will earn a profit in any given year. We have experienced losses in the recent past and may incur losses in the future. Our operating results may fluctuate from year to year due to various factors including differences related to the timing of revenues and expenses for financial reporting purposes and other factors described in this report. At times, these fluctuations may be significant. Fluctuations in our operating results may adversely affect the share price of our common stock.

A significant or prolonged economic downturn could have a material adverse effect on our results of operations.

Our results of operations are affected by the level of business activity of our customers, which in turn is affected by the level of consumer demand for their products. A significant or prolonged economic downturn may adversely affect the disposable income of many consumers and may lower demand for the products we produce for our private label contract manufacturing customers, as well as for our direct-to-consumer products. A decline in consumer demand and the level of business activity of our customers due to economic conditions could have a material adverse effect on our revenues and profit margins.

Because our direct-to-consumer sales rely on the marketability of key personalities, the inability of a key personality to perform his or her role or the existence of negative publicity surrounding a key personality may adversely affect our revenues.

Our direct-to-consumer products have been a growing part of our business. For the fiscal year ended June 30, 2003, our direct-to-consumer products accounted for 18% of our net sales. These products are marketed with a key personality through a variety of distribution channels. The inability or failure of a key personality to fulfill his or her role as a spokesperson for a product, a reduction in the exposure of a key personality or negative publicity about a key personality may adversely affect the sales of our product associated with that personality and could affect the sale of other products. A decline in sales would negatively affect our results of operations and financial condition.

Our industry is highly competitive and we may be unable to compete effectively. Increased competition could adversely affect our financial condition.

The market for our products is highly competitive. Many of our competitors are substantially larger and have greater financial resources and broader name recognition than we do. Our larger competitors may be able to devote greater resources to research and development, marketing and other activities that could provide them with a competitive advantage. Our market has relatively low entry barriers and is highly sensitive to the introduction of new products that may rapidly capture a significant market share. Increased competition could result in price reductions, reduced gross profit margins or loss of market share, any of which could have a material adverse effect on our financial condition and results of operations. There can be no assurance that we will be able to compete in this intensely competitive environment.

We may not be able to raise additional capital or obtain additional financing if needed.

Our cash from operations may not be sufficient to meet our working capital needs and/or to implement our business strategies. Although we obtained a new $6.5 million two-year line of credit in October 2002, there can be no

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assurance that this line of credit will be sufficient to meet our needs. Furthermore, if we fail to maintain certain loan covenants we will no longer have access to the credit line. As a result, we may need to raise additional capital or obtain additional financing.

In recent years, it has been difficult for companies to raise capital due to a variety of factors including the overall poor performance of the stock markets and the economic slowdown in the United States and other countries. Thus, there is no assurance we would be able to raise additional capital if needed. To the extent we do raise additional capital, the ownership position of existing shareholders could be diluted. Similarly, there can be no assurance that additional financing will be available if needed or that it will be available on favorable terms. Our inability to raise additional capital or to obtain additional financing if needed would negatively affect our ability to implement our business strategies and meet our goals. This, in turn, would adversely affect our financial condition and results of operations.

The failure of our suppliers to supply materials in sufficient quantities, at a favorable price, and in a timely fashion could adversely affect the results of our operations.

We buy our raw materials from a limited number of suppliers. During fiscal 2003, Carrington Laboratories Incorporated was our largest supplier, accounting for 35% of our total raw material purchases. The loss of Carrington Laboratories Incorporated or other major supplier could adversely affect our business operations. Although we believe that we could establish alternate sources for most of our raw materials, any delay in locating and establishing relationships with other sources could result in product shortages and back orders for our products, with a resulting loss of sales and customers. In certain situations we may be required to alter our products or to substitute different materials from alternative sources.

A shortage of raw materials or an unexpected interruption of supply could also result in higher prices for those materials. Although we may be able to raise our prices in response to significant increases in the cost of raw materials, we may not be able to raise prices sufficiently or quickly enough to offset the negative effects of the cost increases on our results of operations.

There can be no assurance that suppliers will provide the raw materials needed by us in the quantities requested or at a price we are willing to pay. Because we do not control the actual production of these raw materials, we are also subject to delays caused by interruption in production of materials based on conditions outside of our control, including weather, transportation interruptions, strikes by supplier employees, and natural disasters or other catastrophic events.

We rely solely on one supplier to process certain raw materials that we use in the product line of our largest customer. The loss of or unexpected interruption in this service would materially adversely affect our results of operations and financial condition.

Our business is subject to the effects of adverse publicity, which could negatively affect our sales and revenues.

Our business can be affected by adverse publicity or negative public perception about our industry, our competitors, or our business generally. This adverse publicity may include publicity about the nutritional supplements industry generally, the safety and quality of nutritional supplements and personal care products or ingredients in general or our products or ingredients specifically, and regulatory investigations, regardless of whether these investigations involve us or the business practices or products of our competitors. There can be no assurance that we will be able to avoid any adverse publicity or negative public perception in the future. Any adverse publicity or negative public perception will likely have a material adverse effect on our business, financial condition and results of operations. Our business, financial condition and results of operations also could be adversely affected if any of our products or any similar products distributed by other companies are alleged to be or are proved to be harmful to consumers or to have unanticipated health consequences.

We could be exposed to product liability claims or other litigation, which may be costly and could materially adversely affect our operations.

We could face financial liability due to product liability claims if the use of our products results in significant loss or injury. Additionally, the manufacture and sale of our products involves the risk of injury to consumers from

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tampering by unauthorized third parties or product contamination. We could be exposed to future product liability claims that, among others: our products contain contaminants; we provide consumers with inadequate instructions about product use; or we provide inadequate warning about side effects or interactions of our products with other substances.

We maintain product liability insurance coverage, including primary product liability and excess liability coverage. The cost of this coverage has increased dramatically in recent years, while the availability of adequate insurance coverage has decreased. There can be no assurance that product liability insurance will continue to be available at an economically reasonable cost or that our insurance will be adequate to cover any liability we may incur. Additionally, it is possible that one or more of our insurers could exclude from our coverage certain ingredients used in our products. In such event, we may have to stop using those ingredients or rely on indemnification or similar arrangements with our customers who wish to continue to include those ingredients in their products. A substantial increase in our product liability risk or the loss of customers or product lines could have a material adverse effect on our results of operations and financial condition.

As we continue to expand into markets outside the United States our business becomes increasingly subject to political and economic risks in those markets, which could adversely affect our business.

Our future growth may depend, in part, on our ability to continue to expand into markets outside the United States. There can be no assurance that we will be able to expand our presence in our existing markets outside the United States, enter new markets on a timely basis, or that new markets outside the United States will be profitable. There are significant regulatory and legal barriers in markets outside the United States that we must overcome. We will be subject to the burden of complying with a wide variety of national and local laws, including multiple and possibly overlapping and conflicting laws. We also may experience difficulties adapting to new cultures, business customs and legal systems. Our sales and operations outside the United States are subject to political, economic and social uncertainties including, among others:

Any changes related to these and other factors could adversely affect our business, profitability and growth prospects. As we continue to expand into markets outside the United States, these and other risks associated with operations outside the United States are likely to increase.

Our products and manufacturing activities are subject to extensive government regulation, which could limit or prevent the sale of our products in some markets and could increase our costs.

The manufacturing, packaging, labeling, advertising, promotion, distribution, and sale of our products are subject to regulation by numerous national and local governmental agencies in the United States and in other countries. Failure to comply with FDA regulations may result in, among other things, injunctions, product withdrawals, recalls, product seizures, fines, and criminal prosecutions. Any action of this type by the FDA could materially adversely affect our ability to successfully market our products. In addition, if the FTC has reason to believe the law is being violated (for example, if it believes we do not possess adequate substantiation for product claims), it can initiate an enforcement action. 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 these orders could result in substantial financial or other penalties. Any action by the FTC could materially adversely affect our ability to successfully market our products.

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In markets outside the United States, before commencing operations or marketing our products, we may be required to obtain approvals, licenses, or certifications from a country’s ministry of health or comparable agency. Approvals or licensing may be conditioned on reformulation of products or may be unavailable with respect to certain products or product ingredients. We must also comply with product labeling and packaging regulations that vary from country to country. Furthermore, the regulations of these countries may conflict with those in the United States and with each other. The sale of our products in Europe is subject to the rules and regulations of the European Union, which may be interpreted differently among the countries within the union. The cost of complying with these various and potentially conflicting regulations can be substantial and can adversely affect our results of operations.

We cannot predict the nature of any future laws, regulations, interpretations, or applications, nor can we determine what effect additional governmental regulations or administrative orders, when and if adopted, would have on our business. They could include requirements for the reformulation of certain products to meet new standards, the recall or discontinuance of certain products, additional record keeping, expanded or different labeling, and additional scientific substantiation. Any or all of these requirements could have a material adverse effect on our operations.

If we are unable to attract and retain qualified management personnel, our business will suffer.

Our executive officers and other management personnel are primarily responsible for our day-to-day operations. We believe our success depends largely on our ability to attract, maintain and motivate highly qualified management personnel. Competition for qualified individuals can be intense, and we may not be able to hire additional qualified personnel in a timely manner and on reasonable terms. We employed the majority of our current executive officers in fiscal 2002 and 2001. Our inability to retain a skilled professional management team could adversely affect our ability to successfully execute our business strategy and achieve our goals.

Our manufacturing activity is subject to certain risks.

We currently manufacture the vast majority of our products at our manufacturing facilities in California. As a result, we are dependent on the uninterrupted and efficient operation of that facility. Our manufacturing operations are subject to power failures, the breakdown, failure or substandard performance of equipment, the improper installation or operation of equipment, natural or other disasters, and the need to comply with the requirements or directives of governmental agencies, including the FDA. While we maintain business interruption insurance, there can be no assurance that the occurrence of these or any other operational problems at our facilities in California or at NAIE’s facility in Switzerland would not have a material adverse effect on our business, financial condition and results of operations. Furthermore, there can be no assurance that our insurance will continue to be available at a reasonable cost or, if available, will be adequate to cover any losses that we may incur from an interruption in our manufacturing and distribution operations.

We may be unable to protect our intellectual property rights or may inadvertently infringe on the intellectual property rights of others.

We possess and may possess in the future certain proprietary technology, trade secrets, trademarks, tradenames and similar intellectual property. There can be no assurance that we will be able to protect our intellectual property adequately. In addition, the laws of certain foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States. Litigation in the United States or abroad may be necessary to enforce our intellectual property rights, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement. This litigation, even if successful, could result in substantial costs and diversion of resources and could have a material adverse effect on our business, results of operation and financial condition. If any such claims are asserted against us, we may seek to obtain a license under the third party’s intellectual property rights. There can be no assurance, however, that a license would be available on terms acceptable or favorable to us, if at all.

Collectively, our officers and directors own a significant amount of our common stock, giving them influence over corporate transactions and other matters and potentially limiting the influence of other shareholders on important policy and management issues.

Our officers and directors, together with their families and affiliates, beneficially owned approximately 24.2% of our outstanding shares of common stock as of June 30, 2003. As a result, our officers and directors could influence such

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business matters as the election of directors and approval of significant corporate transactions. Various transactions could be delayed, deferred or prevented without the approval of shareholders, including:

There can be no assurance that conflicts of interest will not arise with respect to the officers and directors who own shares of our common stock or that conflicts will be resolved in a manner favorable to us or our other shareholders.

If certain provisions of our Certificate of Incorporation, Bylaws and Delaware law are triggered, the future price investors might be willing to pay for our common stock could be limited.

Certain provisions in our Certificate of Incorporation, Bylaws and Delaware corporate law help discourage unsolicited proposals to acquire our business, even if the proposal benefits our shareholders. Our Board of Directors is authorized, without shareholder approval, to issue up to 500,000 shares of preferred stock having such rights, preferences, and privileges, including voting rights, as the board designates. The rights of our common stockholders will be subject to, and may be adversely affected by, the rights of holders of any preferred stock that may be issued in the future. Any or all of these provisions could delay, deter or prevent a takeover of our company and could limit the price investors are willing to pay for our common stock.

Our stock price could fluctuate significantly.

Our stock price has been volatile in recent years. The trading price of our stock could be subject to fluctuations in response to:

The stock market has historically experienced significant price and volume fluctuations. There can be no assurance that an active market in our stock will continue to exist or that the price of our common stock will not decline. Our future operating results may be below the expectations of securities analysts and investors. If this were to occur, the price of our common stock would likely decline, perhaps substantially.

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We generally do not engage in trading market risk sensitive instruments and do not buy investments as hedges or for purposes other than trading that are likely to expose us to certain types of market risk, including interest rate, commodity price, or equity price risk. We may, however, buy certain investments to hedge our foreign currency exchange rate exposures.

We are exposed to interest rate risk in connection with our credit facility established on October 25, 2002. As of June 30, 2003 the credit facility was $2.2 million of our total outstanding debt. The interest rate on the credit facility is equal to prime plus 0.5%, and was 4.5% as of June 30, 2003. The remaining outstanding debt of $748,000 at June 30, 2003 has a fixed interest rate. An immediate adverse change of one hundred basis points in interest rates would increase our annual interest expense by $13,000. Interest rates have been at or near historic lows in recent years. There can be no guarantee that interest rates will not rise. Any increase in interest rates may adversely affect our results of operations and financial condition.

We are also exposed to changes in currency exchange rates as measured against the United States dollar. To the extent our business continues to expand outside the United States, an increasing share of our net sales and cost of sales will be transacted in currencies other than the United States dollar. Accounting practices require that our non-United States dollar denominated transactions be converted to United States dollars for reporting purposes. Consequently, our reported net earnings may be significantly effected by fluctuations in currency exchange rates. When the United States dollar strengthens against currencies in which products are sold or weakens against currencies in which we incur costs, net sales and costs could be adversely effected.

We are exposed to the risk of fluctuation in the exchange rate between the Swiss Franc and the United States dollar given NAIE’s operations in Switzerland, and between the Euro and the United States dollar as NSA International, Inc., our largest customer, pays NAIE in Euros. On June 30, 2003, the Swiss Franc closed at 1.35 to 1 United States dollar and the Euro closed at 0.87 to 1 U.S. Dollar. A 10% adverse change to the exchange rate between both the Swiss Franc and the United States dollar and the Euro and the United States dollar would have decreased our earnings by $489,000.

Our goal in managing foreign currency risk is to help provide reasonable certainty to the functional currency value of foreign currency cash flows and to help stabilize the value of non-United States dollar denominated earnings. To hedge our foreign currency risk, we may enter into forward exchange contracts, foreign currency borrowing, and option contracts.

On June 24, 2003 we purchased option contracts designated as cash flow hedges to protect against the foreign currency exchange risk inherent in our forecasted transactions denominated in Euros. The option contracts had a notional amount of $1.5 million and a purchase price of $16,100. The options allow us to sell $227,273 Euros a month for a period of six months at an exchange rate of 1.10 to 1 United Sates dollar. The premium associated with each option contract is amortized on a straight-line basis over the term of the option, and mark-to-market amounts and realized gains or losses are recognized on the settlement date in cost of goods sold. The risk of loss associated with purchased options is limited to premium amounts paid for the option contracts.

We have not entered into any forward or futures contracts or any swaps and we do not use any financial instruments to manage our exposure to markets risks, other than foreign currency exchange rate risks as described above.

We cannot predict with any certainty our future exposure to fluctuations in interest rates, foreign currency exchange rates or other market risks or the impact, if any, such fluctuations may have on our future business, product pricing, consolidated financial condition, results of operations or cash flows.

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Report of Ernst & Young LLP, Independent Auditors

The Board of Directors and Stockholders

Natural Alternatives International, Inc.

We have audited the accompanying consolidated balance sheets of Natural Alternatives International, Inc. as of June 30, 2003 and 2002, and the related consolidated statements of operations and comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended June 30, 2003. Our audits also included the financial statement schedule listed under Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. 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 Natural Alternatives International, Inc. at June 30, 2003 and 2002, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 30, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

Ernst & Young LLP

San Diego, California

August 1, 2003

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Natural Alternatives International, Inc.

Consolidated Balance Sheets

As of June 30

(Dollars in thousands, except share and per share data)