Natrol Inc - Quarterly Report (10-Q)

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

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FORM 10-Q

 

(Mark one)

 

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007
OR
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 NO: 0-24567

 

NATROL, INC.

(Exact name of registrant as specified in its charter)

 

Delaware		95-3560780
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

 

21411 Prairie Street
Chatsworth, California 91311

(Address of principal executive offices)

 

[phone]

(Registrant’s telephone number, including area code)

 

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12-B2 of the Exchange Act. (check one)

 

Large accelerated filer o

Accelerated filer o

or Non-accelerated filer x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o   No  x

 

As of November 5, 2007, 14,261,544 shares of the registrant’s common stock were outstanding.

 

 

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TABLE OF CONTENTS

 

PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements
		Consolidated Balance Sheets
		Consolidated Statements of Operations
		Consolidated Statements of Cash Flows
		Notes to Consolidated Unaudited Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
Item 1A.	Risk Factors
Item 5.	Other Information
Item 6.	Exhibits
Signature
Exhibit Index

 

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PART 1—FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

Natrol, Inc. and Subsidiaries

Consolidated Condensed Balance Sheets

(In thousands, except share and per share data)

 

		September 30 2007			December 31 2006
		(unaudited)
Assets
Current assets:
Cash and cash equivalents		$	5,891		$	1,003
Accounts receivable, net of allowances of $244 and $181 at September 30, 2007 and December 31, 2006, respectively		7,494			6,485
Inventory		18,593			11,788
Income taxes receivable		2,345			375
Deferred income taxes		1,636			1,630
Prepaid expenses and other current assets		603			1,743
Total current assets		36,562			23,024
Property and equipment:
Building and improvements		—			14,953
Machinery and equipment		6,142			5,757
Furniture and office equipment		3,042			3,013
		9,184			23,723
Accumulated depreciation and amortization		(7,576		)	(9,912		)
Property and equipment, net		1,608			13,811
Restricted cash		5,337			5,000
Deferred income taxes		4,265			4,265
Goodwill, net of accumulated amortization and impairment charge		2,026			2,026
Trademarks		5,730			5,730
Other assets		984			744
Total assets		$	56,512		$	54,600
Liabilities and stockholders’ equity
Current liabilities:
Line of credit		$	—		$	3,694
Accounts payable		5,608			3,058
Accrued expenses		4,888			2,558
Accrued payroll and related liabilities		1,608			1,185
Current portion of long-term debt		11			414
Total current liabilities		12,115			10,909
Long-term debt, less current portion		30			6,301
Deferred benefit from sale leaseback		5,003			—
Commitments and contingencies		—			—
Stockholders’ equity:
Preferred stock, par value of $0.01 per share: Authorized shares—2,000,000; Issued and outstanding shares—none		—			—
Common stock, par value of $0.01 per share: Authorized shares—50,000,000, Issued and outstanding shares—14,155,544 and 14,116,148 at September 30, 2007 and December 31, 2006, respectively		143			141
Additional paid-in capital		62,219			61,638
Accumulated deficit		(23,061		)	(24,409		)
Accumulated other comprehensive income		63			20
Total stockholders’ equity		39,364			37,390
Total liabilities and stockholders’ equity		$	56,512		$	54,600

 

See accompanying notes

 

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Natrol, Inc. and Subsidiaries

Consolidated Condensed Statements of Operations

(In thousands, except share and per share data)

(unaudited)

 

		Three months ended September 30,						Nine months ended September 30,
		2007			2006			2007			2006
Net sales		$	19,206		$	15,660		$	57,460		$	49,171
Cost of goods sold		13,156			8,972			33,340			28,395
Gross profit		6,050			6,688			24,120			20,776
Selling and marketing expenses		5,951			3,848			16,527			12,031
General and administrative expenses		5,050			2,688			11,064			8,337
Total operating expenses		11,001			6,536			27,591			20,368
Operating income (loss)		(4,951		)	152			(3,471		)	408
Interest income		113			70			296			186
Interest expense		(18		)	(149		)	(309		)	(456		)
Other		(26		)	—			(60		)	—
Gain on sale of property		—			—			6,062			230
Income (loss) before taxes		(4,882		)	73			2,518			368
Income tax provision (benefit)		(1,717		)	33			1,171			155
Net income (loss)		$	(3,165	)	$	40		$	1,347		$	213
Net income (loss) per share:
Basic		$	(.22	)	$	.00		$	.10		$	.02
Diluted		$	(.22	)	$	.00		$	.08		$	.02
Weighted-average shares outstanding—basic and diluted
Basic		14,160,244			13,604,572			14,171,714			13,573,108
Diluted		14,160,244			13,711,047			16,598,985			13,931,927

 

See accompanying notes

 

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Natrol, Inc. and Subsidiaries

Consolidated Condensed Statements of Cash Flows

(In thousands)

(unaudited)

 

 

		Nine Months Ended September 30,
		2007			2006
Operating activities
Net income		$	1,347		$	213
Adjustments to reconcile income to net cash provided by (used in) operating activities:
Depreciation and amortization		879			1,048
Foreign currency translation		43			5
Provision for bad debts		63			(50		)
Deferred income taxes		(6		)	(167		)
Shares issued for services		—			32
Option expense		386			460
Gain on sale of property		(6,062		)	—
Changes in operating assets and liabilities:
Accounts receivable		(1,072		)	90
Inventory		(6,807		)	1,750
Income taxes receivable/payable		(1,970		)	243
Prepaid expenses and other current assets		1,140			(434		)
Accounts payable		2,548			(2,135		)
Accrued expenses		2,329			797
Accrued payroll and related liabilities		423			526
Net cash provided by (used in) operating activities		(6,759		)	2,378
Investing activities
Purchases of property and equipment		(258		)	(272		)
Proceeds from sale of property		26,000			759
Net cash outlay for acquisition of MRI		(3,232		)	—
Other assets		(692		)	(103		)
Net cash provided by investing activities		21,818			384
Financing activities
Repayment of line of credit		(3,694		)	—
Repayments on long-term debt		(6,674		)	(884		)
Proceeds from issuance of common stock		197			126
Net cash used in financing activities		(10,171		)	(758		)
Net increase (decrease) in cash and cash equivalents		4,888			2,004
Cash and cash equivalents, beginning of period		1,003			3,097
Cash and cash equivalents, end of period		$	5,891		$	5,101
Supplemental cash flow information
Cash paid during the year for:
Interest **		$	3,683		$	457
Income taxes		$	149		$	79

 

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** Includes defeasance paid to retire real estate loans

 

See accompanying notes

 

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Natrol, Inc. and Subsidiaries

Notes to Consolidated Unaudited Financial Statements

(In thousands, except share and per share data)

 

1. BASIS OF PRESENTATION

 

The accompanying consolidated condensed financial statements have been prepared by Natrol, Inc. (the “Company”), pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). This quarterly report on Form 10-Q should be read in conjunction with the Company’s annual report on Form 10-K for the year ended December 31, 2006. The balance sheet as of December 31, 2006 is derived from audited financial statements. The balance sheet as of September 30, 2007 as well as the income statements and cash flow statements for the periods presented are unaudited. Certain information and footnote disclosures which are normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to SEC rules and regulations. The information reflects all normal and recurring adjustments which, in the opinion of the Company’s management, are necessary for a fair presentation of the financial position of the Company and its results of operations for the interim periods set forth herein. The results for the three and nine months ended September 30, 2007 are not necessarily indicative of the results to be expected for the full year or any other period.

 

2. STOCK BASED COMPENSATION

 

During the three and nine month periods ended September 30, 2007, the Company granted options to purchase 60,000 shares and 137,500 shares of common stock, respectively. During the three and nine month periods ended September 30, 2006 the Company granted options to purchase 610,000 and 7,399,999 shares of common stock, respectively. Of these shares, 6,029,500 options were granted to Wayne M. Bos upon his appointment as the Company’s CEO and President. This option award was approved by the stockholders of the Company at its 2006 annual meeting of stockholders. The remaining options were granted to other employees and directors. The options granted to Mr. Bos have certain service and performance conditions which have been discussed in the Company’s prior SEC filings. These options were fully vested upon grant, and we recognized a related expense of $0.3 million during the first quarter of 2006.

 

The Company used a Monte Carlo method to simulate stock price paths over the term of the 6,029,500 options awarded to Mr. Bos. All other options were valued using a Black-Scholes model. The Monte Carlo method, which is one acceptable valuation method per Statement of Financial Accounting Standard 123R, was used due to many factors which make utilizing a Black-Scholes model inappropriate for a block of options of this magnitude. These factors include but are not limited to the size of the grant in relation to the total shares outstanding, the trading volume of the Company’s stock and the holder’s ability to resell the shares, and the control factor, which the size of the grant implies. The Company used the services of a well-credentialed group of valuation experts to perform the valuation of Mr. Bos’ options. This group developed multiple scenarios, including continuing operation and sale scenarios, to assess the potential to create shareholder value over the term of the options. The resulting Monte Carlo analysis gave rise to a range of fair values for which the mean amount was utilized in valuing the options for Mr. Bos.

 

All other stock options were valued using a Black-Scholes model. Under SFAS 123R, the Company will continue to utilize the Black-Scholes model to estimate the fair market value related to employee stock options granted, modified, cancelled or repurchased after January 1, 2006, unless such method is clearly inappropriate for a significant block of stock options, such as were granted to Mr. Bos. The Company’s assessment of the estimated compensation charges for these other stock options is affected by its stock price as well as assumptions regarding a number of complex and subjective variables and the related tax impact. These variables include, but are not limited to, the Company’s stock price volatility and expected employee stock option behavior. The Company recorded option expenses of $122,622 and $387,403 for the three and nine month periods ended September 30, 2007 and $101,614 and $460,409 for the three and nine month periods ended September 30, 2006, respectively.

 

The following summarizes the Company’s stock option activity for the nine months ended September 30, 2007:

 

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							Weighted
				Weighted			Average
				Average			Remaining		Aggregate
				Exercise			Contractual		Intrinsic
		Shares		Price			Term		Value
Number of option shares:
Outstanding at January 1, 2007		8,618,256		$	2.32
Granted		137,500		3.72
Exercised		127,817		1.28
Canceled or expired		69,000		2.15
Outstanding at September 30, 2007		8,558,939		$	2.36		3.96		$	0.0
Exercisable at September 30, 2007		7,671,023		$	2.34		3.70		$	0.0

 

The total fair value of unvested options as of September 30, 2007 was $753,947. The aggregate intrinsic value of unvested options as of September 30, 2007 was $0.0.

 

The following summarizes the fair value of the Company’s unvested stock options that vested during the nine months ended September 30, 2007.

 

		Shares		Weighted Average Fair Value
Unvested at January 1, 2007		1,231,574		$	0.91
Granted		137,500		1.30
Canceled or expired		53,500		1.21
Vested		427,658		0.89
Unvested at September 30, 2007		887,916		$	0.85

 

The Black-Scholes option-pricing model is used by the Company to determine the weighted average fair value of options, except for the options granted to Wayne Bos. The fair value of options at date of grant and the assumptions utilized to determine such values are indicated in the following table:

 

		Nine months ended September 30,
		2007			2006
Weighted average fair value at date of grant for options granted during the period using Black-Sholes		$	1.30		$	0.89
Risk-free interest rates		4.47		%	5.03		%
Expected stock price volatility		59.42			59.73
Expected dividend yield		0.0		%	0.0		%

 

These assumptions resulted in a weighted-average fair value of $1.30 and $0.89 respectively, for each stock option valued using the Black-Scholes method and granted in each of the nine month periods ended September 30, 2007 and 2006.

 

3. INVENTORY

 

Inventories consist of the following:

 

		(In thousands)
		September 30, 2007			December 31, 2006
Raw material and packaging supplies		$	9,765		$	6,778
Finished goods		8,828			5,010
Total inventory		$	18,593		$	11,788

 

The value of inventory in the quarter was affected by a write down of the value of hoodia material of approximately $800,000.

 

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4. SHIPPING AND HANDLING COSTS

 

The Company records all amounts charged to customers for shipping and handling as revenue. All outbound shipping and fulfillment costs are classified as selling and marketing expenses and totaled approximately $0.8 and $2.4 million for the three and nine month periods ending September 30, 2007 and approximately $0.9 and $2.5 million in the three and nine month periods ended September 30, 2006.

 

5. EARNINGS PER SHARE

 

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

 

As of the three and nine month periods ending September 30, 2007 and 2006, the following options were outstanding and considered anti-dilutive.

 

		Three months ended September 30,				Nine months ended September 30,
		2007		2006		2007		2006
Options outstanding		9,430,256		9,430,256		8,558,939		9,430,256
Anti-dilutive options		9,234,205		9,323,781		6,131,668		9,234,205

 

For the three months ended September 30, 2007, all outstanding options were considered anti-dilutive because of the Company’s net loss for the period.

 

6. SENIOR CREDIT FACILITY

 

The Company is party to a loan and security agreement with Wachovia Capital Finance (Western), as agent, the lenders party thereto, Prolab Nutrition, the Company’s wholly owned subsidiary, and certain of its other subsidiaries, as guarantors. The loan agreement provides for a three-year secured revolving credit facility of up to $10.0 million. Borrowings under the credit facility may be used for ongoing working capital purposes and certain future acquisitions. At September 30, 2007, the Company had no borrowings outstanding under the credit facility.

 

Under the credit facility, the Company may borrow up to the lesser of $10.0 million or the borrowing base (calculated based upon eligible inventory and eligible accounts). The interest rate on borrowings under the credit facility is equal to: (1) agent’s publicly announced prime rate for prime rate loans or (2) 2.25% plus the applicable Eurodollar rate for any Eurodollar rate loans. Interest is payable monthly in arrears not later than the first day of each calendar month. The agent’s prime rate as of September 30, 2007 was 8.25%. The credit facility requires that all principal be repaid in August 2009. Additionally, borrowings under the credit facility must be repaid when the borrowings exceed the borrowing base.

 

The credit facility is secured by a first priority lien on all of the Company’s assets and properties (which includes the assets and properties of Prolab Nutrition, the guarantors and the Company’s future subsidiaries), subject to certain exceptions. The obligations under the credit facility are guaranteed by Natrol Products, Inc., Natrol Acquisition Corp. and Natrol Direct, Inc. and by each of the Company’s future subsidiaries.

 

The credit facility contains covenants restricting the Company’s ability to, among other things: (1) incur or guarantee additional debt; (2) engage in any mergers or acquisitions (subject to certain exceptions); (3) engage

 

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in any asset sales or dispose of any assets (other than in the ordinary course); (4) engage in transactions with affiliates; (5) incur liens; (6) make any loans or investments; and (7) declare or pay dividends or redeem or repurchase capital stock.

 

The credit facility also provides for customary events of default, including non-payment defaults, covenant defaults and cross-defaults to the Company’s other material indebtedness.

 

As of September 30, 2007, the Company was in default under certain covenants in the credit facility related to investments in new businesses. The Company cannot borrow under the line of credit until Wachovia agrees to waive the event of default and forbear from exercising its default rights. We expect the Company’s ability to borrow against the line of credit to be reinstated in the normal course of review.

 

7. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS.

 

The Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”) in June 2006. The interpretation clarifies the accounting for uncertainty in income taxes recognized in financial statements in accordance with Statement of Financial Accounting Standard 109. FIN 48 is effective for fiscal years beginning after December 15, 2006. We adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (“FIN 48”), on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement 109, “Accounting for Income Taxes”, and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

 

Based on our evaluation, we have concluded that there are no significant uncertain tax positions requiring recognition in our financial statements. Our evaluation was performed for the tax years ended December 31, 2003, 2004, 2005 and 2006, the tax years which remain subject to examination by major tax jurisdictions as of September 30, 2007.

 

We may from time to time be assessed interest or penalties by major tax jurisdictions, although any such assessments historically have been minimal and immaterial to our financial results. In the event we received an assessment for interest and/or penalties, it was classified in the financial statements as “selling, general and administrative expense”.

 

In February 2007, the FASB issued Statement of Financial Standard No. 159, “ The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115 ” (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value, with unrealized gains and losses related to these financial instruments reported in earnings at each subsequent reporting date. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact this Statement will have on our consolidated financial statements.

 

8. FINAL RULE FOR CURRENT GOOD MANUFACTURING PRACTICES FOR DIETARY SUPPLEMENTS

 

On June 22, 2007, the Food and Drug Administration (“FDA”) issued its final regulations establishing the minimum Current Good Manufacturing Practices (“CGMPs”) necessary for activities related to manufacturing, packaging, labeling, or holding operations for dietary supplements. The final rule applies to all dietary supplements sold or offered for sale in the United States and requires manufacturers to evaluate the identity, purity, strength, and composition of their dietary supplements. An Interim Final Rule has also been issued to allow manufacturers to petition the FDA for an exemption to the 100 percent identity testing requirement for dietary ingredients to be used in dietary supplements; provided that they demonstrate that less than 100 percent identity testing does not materially diminish the assurance that the dietary ingredient is correctly identified. The final CGMP and the interim final rule are effective August 24, 2007 and the compliance date is June 2008, except

 

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that businesses like the Company that employ fewer than 500 but at least 20 or more full-time equivalent employees have until June 2009 to comply with the regulation. We are currently evaluating the potential impact that the new regulations and any applicable exemptions may have on the Company’s financial position, results of operations, or cash flows.

 

9. ACQUISITION OF MEDICAL RESEARCH INSTITUTE, INC. (MRI)

 

On June 1, 2007, we acquired all of the outstanding stock of Medical Research Institute, Inc. for $8.6 million of cash and up to an additional $80.0 million in cash based upon the Earnings Before Interest and Taxes (EBIT), as defined, of MRI during the three years after the acquisition date. The Company allocated the purchase price per SFAS 141 to the fair value of the assets acquired, net of liabilities assumed. Because the net assets acquired were greater than the cash paid, the value of certain fixed assets were adjusted per SFAS 141. These assets will be adjusted should any additional payments be made to the former owners of MRI.

 

The only consideration used to acquire MRI was cash.

 

The following table summarizes the allocations of the consideration to the assets acquired net of liabilities assumed.

 

		(000)
Cash and cash equivalents		$	5,105
Accounts Receivable		2,514
Inventory		4,068
Other Current assets		98
Property, Plant & Equipment		114
Patents		258
Total Assets acquired		12,157
Less Liabilities assumed		3,531
Total Consideration		$	8,626

 

If the operating results of MRI had been included since the beginning the nine month period ended September 30, 2007 and 2006, the pro forma revenues, net income and net income per share would be as follows:

 

		Nine Months ended September 30,
		2007			2006
Revenues		$	66,300		$	68,370
Net income		1,721			2,846
Net income per share
Basic		$	0.12		$	0.21
Diluted		$	0.10		$	0.20
Weighted-average shares outstanding—basic and diluted
Basic		14,171,714			13,573,108
Diluted		16,598,885			13,931,927

 

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Our prime reason for acquiring MRI was MRI’s premiere position in the sports nutrition marketplace, allowing us to strengthen our position within this area of the nutraceutical business.

 

The balance sheet of MRI is consolidated with our balance sheet. The statement of income of MRI for the period from June 1, 2007 to September 30, 2007 is consolidated with our statement of income for the three and nine month periods ended September 30, 2007. The statement of cash flows for MRI for the period from June 1, 2007 to September 30, 2007 is included with our statement of cash flows for the nine months ended September 30, 2007.

 

10. ACQUISITION COMMITMENTS

 

Nu Hair and Shen Min Brands

 

Consideration for the acquisition of the NuHair and Shen Min brands includes potential incentive payments based upon the net amount of invoiced sales of the NuHair and Shen Min products during fiscal 2007, 2008 and 2009. For 2007, the Company is obligated to pay the seller of the brands $1.00 (one dollar) for every dollar of net invoiced sales in excess of $7.6 million, calculated on a quarterly basis. The potential incentive payment for 2007 may not exceed $2.0 million. For 2008, the Company is obligated to pay the seller 15% of the amount by which net invoiced sales exceed $11.4 million. For 2009, the Company is obligated to pay the Seller 15% of the amount by which net invoiced sales exceed $13.7 million. As of September 30, 2007, we do not believe that the incentive payments to the former owners of the NuHair and Shen Min brands will be material as net invoiced sales for the nine months ended September 30, 2007 amounted to slightly less than $5.8 million.

 

Promensil and Trinovin

 

Consideration for the license of the exclusive U.S. rights to the Promensil and Trinovin brands includes a royalty on net sales revenue that exceeds $2.0 million. Until 2014, the Company is obligated to pay Novogen a royalty equal to 5.0% of annual net sales between $2.0 to $3.0 million and a royalty equal to 7.5% of annual net sales in excess of $3.0 million. After 2014, the Company is obligated to pay Seller a royalty equal to 2% of annual net sales between $2.0 to $3.0 million and a royalty equal to 3.0% of annual net sales in excess of $3.0 million. During the nine months ended September 30, 2007, net sales revenue of the Promensil and Trinovin brands amounted to $1.7 million and, as a result we do not believe that the incentive payments to the licensor will be material.

 

Medical Research Institute

 

Consideration for the acquisition of MRI, includes incentive payments that would allow the former owners of MRI to earn an additional $80.0 million if the earnout conditions are met.

 

Year one incentives.

 

If earnings before interest and taxes prior to general corporate allocations for the twelve (12) month period following the Closing Date (“ Year One EBIT ”) is between $2.5 million and $4.0 million, the former owners of MRI will be paid an incentive payment of between $4.7 million and $7.5 million. As of September 30, 2007 we believe that it is highly likely that an incentive payment will be made and that the amount will be at the mid to higher end of the range.

 

Also, if Year One EBIT reaches $5.0 million, additional incentives may be earned by the former owners of MRI. These incentives begin at $5.0 million and could exceed $21.5 million depending upon EBIT performance. As of September 30, 2007, it is uncertain as to whether the $5.0 EBIT level will be reached and, as such it is uncertain as to whether an additional incentive payment will be made.

 

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Year two and three incentives.

 

Year two and year three incentive payments are described more fully in our other filings with the SEC. In order to earn incentives in year two, EBIT for year two, as defined, must reach $6.5 million. In order to earn incentives in year three, EBIT for year three as defined must reach $14.0 million. Total incentive payments for the three years in which incentives can be earned could total as much as $80.0 million if all incentive payment conditions are met.

 

11. SALE AND LEASEBACK TRANSACTION

 

In April 2007 the company sold its manufacturing and distribution facilities in Chatsworth, California for $26 million, giving rise to a gain of approximately $12 million. Since the facilities are leased back from the buyer, $5.5 million of the gain is deferred and recognized over the lease term, in accordance with SFAS No. 13 and 98. The $6.1 million balance of the gain in excess of the net present value of the lease payments, was recognized upon the sale. During the three months ended September 30, 2007, we offset approximately $92,000 of the future lease benefits against our lease expense, thereby lowering our lease expense.

 

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

 

Forward Looking Statements and Certain Risks

 

The statements contained in this report that are not purely historical are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act. These statements are based on our expectations, hopes, beliefs, commitments, intentions, and strategies regarding the future. They may be identified by the use of words or phrases, such as “believe”, “expect”, “anticipate”, “should”, “could”, “would”, “will”, “might”, “may”, “plan,” “estimate,” and “potential,” among others. Forward-looking statements include, but are not limited to, statements contained in this Item 2 regarding our financial performance, revenue and expense levels in the future, and the sufficiency of our existing assets to fund future operations and capital spending needs. Actual results could differ materially from the anticipated results or other expectations expressed in these forward-looking statements as a result of the risks, uncertainties and contingencies discussed below and in our annual report on Form 10-K for the year ended December 31, 2006. The fact that some of the risks, uncertainties and contingencies may be the same or similar to past reports we have filed with the SEC means only that the risks are present in multiple periods.

 

Our ability to predict results or the effect of certain events on our future operating results is inherently uncertain. Forward-looking statements should not be unduly relied on, since they involve known and unknown risks, uncertainties and other factors, which in many cases are beyond our control and cannot be predicted or quantified. Therefore, we wish to caution you to carefully consider the following factors, which are not exhaustive, together with disclosures in other reports and documents filed with the SEC by the Company from time to time and which may supplement, modify, supersede or update the factors listed in this report. The Company is subject to all of the business risks facing public companies, including business cycles and trends in the general economy, market conditions, potential loss of key personnel, government legislation and regulation and natural causes. Additional factors that could cause or contribute to our actual results differing materially from those discussed herein include, but are not limited to:

 

•                   our ability to develop and execute our business plans;

•                   our ability to replace our Ester-C® business once we have used the remaining inventory of Ester-C;

•                   adverse publicity regarding our products and any similar products distributed by others;

•                   our ability to manage the risks and costs associated with our acquisition strategy, including managing the integration of MRI;

•                   our ability to retain and attract talented management and key employees;

•                   sufficiency of our insurance coverage or third party indemnification rights to cover losses that we incur;

•                   greater than expected product returns;

•                   our failure to adequately anticipate sales needs;

 

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•                   any shortage in the supply of key raw materials;

•                   our ability to protect our intellectual property;

•                   our exposure to product liability claims, as well as the limits of our self insurance program for products liability claims;

•                   our sales and earnings volatility;

•                   our ability to engage in many transactions prohibited by our senior credit facility;

•                   legal actions brought by federal, state and local governmental authorities and private parties;

•                   increased competition from existing competitors and new market entrants, including from private label house brands; and

•                   the impact of natural disasters on our manufacturing facility.

 

The forward-looking statements contained in this report are made as of the date of this report, and we assume no obligation to update or revise them to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time or to update the reasons why actual results could differ from those projected in these forward-looking statements.

 

OVERVIEW

 

General

 

We manufacture and market branded, high-quality dietary supplements, herbal teas, and sports nutrition products under seven primary brands: Natrol®, Laci Le Beau®, Prolab®, Nu Hair® , Shen Min®, Promensil® and MRI. Through our Essentially Pure Ingredients® (EPI) division we also sell nutraceutical grade ingredients to other manufacturers of nutrition products and provide contract manufacturing services to companies within the nutraceutical industry.

 

The majority of our dietary supplements are sold under the Natrol brand, but we are continuing to acquire new brands that we expect will eventually contribute significantly to our product mix sales. Our Natrol brand focuses on supplements that are in high demand as well as specialty niche and proprietary formulations that have potentially strong margins. These supplements include vitamins, minerals, hormonal supplements, herbal products and specialty combination formulas that contribute to an individual’s physical and mental well-being. On June 1, 2007, we acquired Medical Research, Inc, (MRI) which develops and markets products under the MRI brand. Our MRI brand supplies high-quality sports nutrition products including CE2®, NO2®, Pro-Nos(TM) and Anabolic Switch(TM). These products are primarily designed to enhance the workout performance of athletes.

 

The key elements of our business strategy are to

 

•                   Control our cost and improve margins;

 

•                   Develop or acquire new products and product lines that can help us capitalize upon our infrastructure;

 

•                   Expand the distribution of our products to new markets, including internationally; and,

 

•                   Improve the marketing of our products.

 

Management Overview

 

During the third quarter of 2007, we recorded a net loss of approximately $3.2 million. There are many reasons for the loss, but the most significant causes reflect specific events that management considers uncommon in the ordinary course of business.

 

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In 2006, we entered into an exclusive manufacturing and distribution arrangement with H57 Nutrition for Original South African H57™ Hoodia (“H57”). During 2007, sales of H57 were far less than anticipated and we made the decision to limit future losses by immediately taking steps to reduce the Company’s exposure in connection with the hoodia business. As a result, we expensed approximately $2.3 million during the quarter related to the promotional cost of reducing inventories at customer locations, anticipated future returns, impairment charges for raw material inventory with current value less than when purchased, and the write off of an advance payment to the owners of H57 Nutrition that we have concluded is not collectible. These expenses reduced our gross margin approximately $1.7 million or 7.0% and increased our general and administrative expenses by $620,000.

 

During the third quarter we also increased our reserves by approximately $1.8 million because one of our larger customers reduced our product set. The reduction negatively affects revenue by approximately $2.0 million on an annualized basis or 2.5% of our business. The reserves are for anticipated returns and promotional expenses we expect to incur in connection with the elimination of inventory at the retailer. This expense reduced our gross margin in the third quarter by approximately 5.9%.

 

As noted in our past filings our customers generally do not have an absolute right to return product, but, as a practical business matter, we often work with customers and accept returns as we try to obtain new placements for different products that can replace revenue lost due to discontinuations. We regularly monitor our historical patterns of returns from customers as well as current and ongoing sales to customers and, when information is available, consumer purchases of the Company’s products from our customers.

 

In order to reduce the amount of subjectivity when analyzing sales trends and reserving for future returns, we perform a detailed analyses of trends at each of our major customers, i.e., those customers who have historically accounted for the bulk of returns. This analyses takes into account sales patterns of individual products at each customer on a customer-by-customer basis as well as: inventory levels at the customer, scheduled promotional events, and the probability that items will be discontinued. And, we believe that this analysis provides appropriate estimates of necessary future reserves. The Company’s use of the term returns includes estimates of its liability for damaged and outdated product within its channels of trade.

 

Unfortunately, the reduction in the product set that occurred during the third quarter of 2007, did not, in our estimation, follow patterns that have been well established for many years. However, in following our policy of reserving for the impact of negative financial events as soon as the impact is estimatable, we expensed the full impact of the item discontinuations in the third quarter of 2007.

 

A third factor affecting the quarter was legal expenses. The Company settled its last unresolved suit involving ephedrine-based products and incurred legal costs in connection with that case, as well as in connection with a number of business transactions involving the Company during the third quarter. Combined, those events resulted in legal expenses of approximately $725,000. Our policy is to expense the cost of legal settlements as soon as they can be reasonably estimated and attorney’s fees and costs as soon as incurred.

 

Despite the Company’s poor overall performance, gross shipments in the quarter increased 47.4% when compared to the third quarter of 2006, or $8.6 million. Approximately $6.5 million of the increase was due to the acquisition of MRI. Natrol’s gross shipments declined $1.4 million due to a decrease of $1.9 million in Ester-C sales, a product line we will be unable to sell after March 2008. Prolab shipments, including the sales of Prolab products by our subsidiary in the United Kingdom, increased approximately $1.3 million in the quarter. The balance of the growth in shipments was due to the NuHair, Shen Min, Promensil and Trinovin brands that were acquired in October of 2006.

 

Compared to the third quarter of 2006, net sales revenue in the quarter grew 24.3%, versus the 47.4% increase in shipments, due to the expenses recorded for H57 and the reduction in our vitamin set described above.

 

As noted, our gross margins were reduced approximately 10.9% due to the above-described events. We expect our margins to return to historical norms in future quarters.

 

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Overall, general and administrative expenses increased $2.3 million when compared to the third quarter of 2006. Approximately $1.0 million of the increase was due to the acquisition of MRI. Net of the $0.7 million extra legal cost outlined above and the $0.6 million charge for H57, general and administrative expenses were approximately the same during the third quarter of 2007 as in the third quarter of 2006, despite the addition of the NuHair, Shen Min, Promensil and Trinovin brands.

 

Total selling and marketing expense were $2.0 million greater in the third quarter of 2007 than in the third quarter of 2006. Approximately $0.6 million was due to the acquisition of MRI, $0.5 million was due to the acquisition of the NuHair, Shen Min and Promensil brands, $0.3 million was due to increased Prolab expenditures in the UK and the United States, and the remainder was due to increased advertising and coop spending on the Natrol brands.

 

The largest immediate challenges for our business include: continuing to managing through the loss of our Ester-C business; to replace the revenue lost from the reset of our shelf space noted above; to fully integrate MRI; and, to identify products and product lines that would positively affect the business if acquired or developed internally. We will continue to work to improve internal efficiencies and to strengthen our core business by following our business plan.

 

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Results of Operations

 

THREE MONTHS ENDED SEPTEMBER 30, 2007 AND SEPTEMBER 30, 2006

 

NET SALES. We recognize revenue from sales only after product is shipped. We have no consignment sales. Net sales represent product shipped less actual and estimated future returns, spoilage allowances, allowances for product deemed to be unsaleable by customers, free goods shipped to customers for promotional or other purposes, rebates, slotting fees and other promotional expenditures. Estimates and allowances are based upon known claims and an estimate of additional returns when the amount of future returns from customers can be reasonably estimated.

 

Net sales increased 22.3%, or $3.5 million, to $19.2 million for the three months ended September 30, 2007 from $15.7 million for the three months ended September 30, 2006. Increased sales of $7.3 million from the acquired NuHair, Shen Min, Promensil and MRI brands and an increase in Prolab product sales of approximately $1.2 million were partially offset by a decline in the remaining Natrol segment business. Natrol’s net revenue was affected by returns in the quarter, accruals for promotional activity instituted to reduce the economic impact of returns, as well as a decline of $1.9 million in Ester-C sales. Ester-C is being discontinued because the supplier of Ester-C will no longer sell raw material to us after March 2008. Returns were $2.3 million more in the third quarter of 2007 than in the third quarter of 2006. The primary reason is a reduction of the number of items that will be carried by one of our customers in 2008. The items involved, accounted for approximately 2.5% of invoiced revenue during the 12 months ended September 30, 2007. A second, but important reason for the high returns were accruals for the eventual return of H-57 hoodia.

 

GROSS PROFIT. Gross profit declined 9.0%, or $0.6 million, to $6.1 million for the three months ended September 30, 2007, from $6.7 million for the three months ended September 30, 2006. Gross margin decreased to 31.5% for the three months ended September 30, 2007, from 42.7% for the three months ended September 30, 2006. The decrease was primarily due to the large difference in the quarter between gross revenue and net revenue caused by large accruals promotional expenditures and returns for the reasons noted in the overview section of this document. Those accruals due to H57 hoodia reduced the gross margin 7.0% and accruals due to the reduction of the number of items being carried from a significant customer reduced the gross margin by 5.9%.

 

SELLING AND MARKETING EXPENSES. Selling and marketing expenses consist primarily of advertising and promotional expenses, costs of distribution, and related payroll expenses and commissions. Selling and marketing expenses increased 54.7%, or $2.1 million, to $5.9 million for the three months ended September 30, 2007, from $3.8 million for the three months ended September 30, 2006. Selling and marketing expenses increased approximately $1.2 million due to increased staffing and promotion required by our MRI, NuHair, Shen Min, and Promensil acquisitions and the establishment of a subsidiary in the United Kingdom. The remainder of the increase was primarily due to additional cooperative advertising expenditures in the mass market channel of trade.

 

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses consist primarily of personnel costs related to general management functions, finance, accounting and information systems, as well as professional fees related to legal, audit and tax matters and depreciation. General and administrative expenses increased 88.3%, or $2.3 million to $5.0 million for the three months ended September 30, 2007 from $2.7 million for the three months ended September 30, 2006. The settlement of the last of the ephedrine based lawsuits against the Company and other transactional legal fees accounted for $0.7 million of the increase; the write down as a bad debt of an advance payment to the owners of the H-57 brand accounted for $0.6 million of the increase; and, the acquisition of NuHair, Shen Min, Promensil, and MRI accounted for a $1.1 million increase in general and administrative expenses. These increase were offset slightly by miscellaneous other savings.

 

INTEREST EXPENSE. We recorded interest expense of $18,000 for the three months ended September 30, 2007 as compared to interest expense of $149,000 for the three months ended September 30, 2006. The decrease was due to the low level of debt during the quarter.

 

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INCOME TAX EXPENSE. Our effective tax rate was 35.2 % in the three months ended September 30, 2007 and 45.2% in the three months ended September 30, 2006. The differences are primarily due to the different levels of income and loss and the relative differences in deductible and non-deductible items relative to the overall level of income or loss.

 

NINE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO SEPTEMBER 30, 2006

 

Net sales increased 16.9%, or $8.3 million, to $57.5 million for the nine months ended September 30, 2007 from $49.2 million for the nine months ended September 30, 2006. Sales of $14.0 million from the acquired NuHair, Shen Min, Promensil and MRI brands and an increase in our Prolab business of $0.8 million, were partially offset by a declines in other segments of our business. We sold $2.6 million less Ester-C during the first three quarters of 2007 and in the first three quarters of 2006. During the same period, net sales from our EPI division has fallen

 

GROSS PROFIT. Gross profit increased 16.1%, or $3.3 million, to $24.1 million for the nine months ended September 30, 2007 from $20.8 million for the nine months ended September 30, 2006. Gross margin decreased to 42.0% for the nine months ended September 30, 2007 from 42.3% for the nine months ended September 30, 2006. Although the gross margin for the nine months ended September 30, 2007 was essentially the same as for the nine months ended September 30, 2006, it is substantially lower than the gross margin for the six months ended June 30, 2007 due to the events of the third quarter when return and promotional expenses increased the difference between gross sales and net revenue. Also affecting our gross margin was the write down of our hoodia inventory which caused us to expense $1.1 million to cost of goods sold during the nine months ended September 30, 2007.

 

SELLING AND MARKETING EXPENSES. Selling and marketing expenses increased 37.4%, or $4.5 million, to $16.5 million for the nine months ended September 30, 2007 from $12.0 million for the nine months ended September 30, 2006. Selling and marketing expenses increased approximately $2.8 million due to our acquisitions and the establishment of a subsidiary in the United Kingdom. Prolab marketing expenditures increased $0.4 million and the balance of the increase was a result of increased cooperative advertising for the Natrol brand.

 

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses increased 32.8%, or $2.7 million to $11.0 million for the nine months ended September 30, 2007 from $8.3 million for the nine months ended September 30, 2006. Legal expenses during the third quarter accounted for $0.7 million of the increase and expenses for H-57 including the bad debt of $0.6 million recorded in the third quarter also accounted for $0.7 million. Our acquisitions and the establishment of a subsidiary in the UK accounted for another $1.6 million of additional expenditures. These increases were offset by savings in other areas.

 

INTEREST EXPENSE. We recorded interest expense of $309,000 for the nine months ended September 30, 2007 as compared to interest expense of $456,000 for the nine months ended September 30, 2006. The decrease was due to the reduction of our debt.

 

INCOME TAX EXPENSE. Our effective tax rate was 46.5% in the nine months ended September 30, 2007 and 42.2% in the nine months ended September 30, 2006. The differences are primarily due to the different levels of income and loss and the relative differences in deductible and non-deductible items relative to the overall level of income or loss.

 

SALE OF BUILDINGS. During the first nine months of 2006, we sold a building we owned in Bloomfield, Connecticut that was formerly used as a shipping facility for our Prolab brand. The approximate net book value of the property, plant and plant improvements that were sold was $759,000 and the gain, net of brokerage, legal and other related expenses was approximately $230,000.

 

In April 2007, we sold our 94,000 square foot manufacturing, distribution and office facility and our 132,000 square foot shipping facility both located in Chatsworth, California. The sales price for the properties was $26.0 million. After paying expenses associated with the transaction, taxes, and extinguishing the mortgage debt on the

 

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buildings, we netted approximately $12.0 million in cash. We recorded a gain of approximately $6.1 million and a future lease benefit of $5.5 million, which will be amortized over 5 years.

 

LIQUIDITY AND CAPITAL RESOURCES

 

As of September 30, 2007, we had working capital of $24.6 million as compared to $12.1 million in working capital at December 31, 2006. Our cash balance at September 30, 2007 was approximately $5.9 million.

 

Operating Activities

 

Net cash used by operating activities was $6.8 million for the nine months ended September 30, 2007 compared to net cash provided of approximately $2.4 million for the nine months ended September 30, 2006. Cash used by operating activities during the nine months ended September 30, 2007 consisted of our profit of $1.3 million offset by non-cash charges of $4.7 million and by cash used because of changes in operating assets and liabilities of $3.4 million.

 

During the nine months ended September 30, 2007, non-cash charges for depreciation and amortization had the effect of providing $0.9 million of cash, the expensing of stock options provided $0.4 million of cash, and a small increase in the provision for bad debts and foreign currency translation had the effect of providing $0.1 million. The gain on the sale of our property of $6.1 million had the effect of using cash. This use was offset by the proceeds for the sale of the property of $26.0 million described under investing activities.

 

Cash used by operating assets and liabilities consisted primarily of an increase in accounts payable of $2.5 million, an increase in accrued expenses of $2.3 million, an increase in accrued payroll of $0.4 million, and a decrease in prepaid expenses of $1.1 million, each of which provided cash, offset by a decrease of $2.0 million in income taxes payable, an increase in accounts receivable of $1.1 million and an increase in inventory of $6.8 million. The large changes in accounts receivable, accounts payable and inventory were primarily due to the acquisition of MRI.

 

Investing Activities

 

Net cash provided by investing activities was $21.8 million for the nine months ended September 30, 2007 compared to net cash provided of $0.4 million during the nine months ended September 30, 2006. During the nine months ended September 30, 2007, we invested $0.2 million in new equipment and realized $26.0 from the sale of property which was partially offset by a net cash outlay of $3.2 million for the acquisition of MRI. The acquisition of other assets used $0.7 million of cash.

 

Financing Activities

 

Net cash used by financing activities was $10.2 million for the nine months ended September 30, 2007 compared to cash used of $0.8 during the nine months ended September 30, 2006. During the nine months ended September 30, 2007, we repaid $3.7 million of our line of credit and $6.7 million of our long-term debt. During the nine months ended September 30, 2007, we received $0.2 million from the exercise of stock options. All of our long and short-term debt was extinguished during the nine months ended September 30, 2007 other than a small automobile loan acquired as part of the MRI transaction.

 

Senior Credit Facility

 

In August 2006, we entered into a loan and security agreement with Wachovia Capital Finance (Western), as agent, the lenders party thereto, Prolab Nutrition, our wholly owned subsidiary, and certain of our other subsidiaries, as guarantors. The loan agreement provides for a three-year, secured, revolving credit facility of up to $10.0 million. Borrowings under the facility will be used for ongoing outstanding working capital purposes and certain future acquisitions. At September 30, 2007, we had no borrowings under the facility.

 

Under the credit facility, we may borrow up to the lesser of $10.0 million or the borrowing base

 

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(calculated based upon eligible inventory and eligible accounts). The interest rate on borrowings under the credit facility is equal to: (1) agent’s publicly announced prime rate for prime rate loans or (2) 2.25% plus the applicable Eurodollar rate for any Eurodollar rate loans. Interest is payable monthly in arrears not later than the first day of each calendar month.

 

The credit facility requires that all principal be repaid in full on the third anniversary of the closing date. Additionally, borrowings under the credit facility must be repaid when the borrowings exceed the borrowing base.

 

The credit facility is secured by a first priority lien on all our assets and properties (which includes the assets and properties of Prolab Nutrition, the guarantors and our future subsidiaries), subject to certain exceptions. The obligations under the credit facility are guaranteed by Natrol Products, Inc., Natrol Acquisition Corp. and Natrol Direct, Inc. and by each of our future subsidiaries.

 

The credit facility contains covenants restricting our ability to, among other things: (1) incur or guarantee additional debt; (2) engage in any mergers or acquisitions (subject to certain exceptions); (3) engage in any asset sales or dispose of any assets (other than in the ordinary course); (4) engage in transactions with affiliates; (5) incur liens; (6) make any loans or investments; and (7) declare or pay dividends or redeem or repurchase capital stock.

 

The credit facility also provides for customary events of default, including non-payment defaults, covenant defaults and cross-defaults to our other material indebtedness.

 

As of September 30, 2007, the Company was in default under certain covenants in its credit facility related to investments in new businesses and cannot borrow under the line of credit until Wachovia agrees to waive the event of default and forbear from exercising its default rights. Wachovia is now reviewing the acquisition of Medical Research Institute, Inc. on June 1, 2007, which triggered the event of default. The Company expects its ability to borrow against the line of credit to be reinstated in the normal course of review.

 

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

 

We believe that our cash balance together with cash generated from operations and the potential to borrow funds and raise capital should be sufficient to fund our anticipated working capital needs and planned capital expenditures for the next 12 months. However, if we do not meet our operating plan, we may be required to obtain additional borrowings to fund working capital needs.

 

New Accounting Standards

 

The Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”) in June 2006. The interpretation clarifies the accounting for uncertainty in income taxes recognized in financial statements in accordance with Statement of Financial Accounting Standard 109. FIN 48 is effective for fiscal years beginning after December 15, 2006. We adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (“FIN 48”), on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement 109, “Accounting for Income Taxes”, and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

 

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Based on our evaluation, we have concluded that there are no significant uncertain tax positions requiring recognition in our financial statements. Our evaluation was performed for the tax years ended December 31, 2003, 2004, 2005 and 2006, the tax years which remain subject to examination by major tax jurisdictions as of September 30, 2007.

 

We may from time to time be assessed interest or penalties by major tax jurisdictions, although any such assessments historically have been minimal and immaterial to our financial results. In the event we received an assessment for interest and/or penalties, it was classified in the financial statements as “selling, general and administrative expense”.

 

In February 2007, the FASB issued Statement of Financial Standard No. 159, “ The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115 ” (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value, with unrealized gains and losses related to these financial instruments reported in earnings at each subsequent reporting date. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact this Statement will have on our consolidated financial statements.

 

Critical Accounting Policies

 

Management’s beliefs regarding significant accounting policies have not changed significantly from those discussed in Item 7 of our annual report on Form 10-K for the year ended December 31, 2006.

 

Item 3.                           Quantitative and Qualitative Disclosures About Market Risk

 

Our exposure to market risks is limited to interest rate risks. The risks related to foreign currency exchange rates are immaterial and we do not use derivative financial instruments.

 

We are subject to interest rate market risk associated with our bank debt. Even so, we do not believe the risk associated with such borrowing is significant. We currently have no long-term debt other than for a small automobile loan and, as of September 30, 2007, we had no borrowings under our line of credit. The line of credit is collateralized by our general assets.

 

Item 4.                           Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures. We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and we are required to apply our judgment in evaluating the cost-benefit relationship of possible controls and procedures.

 

As required by Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, we carried out an evaluation, under the supervision and with the participation of our management, including our principal executive and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures and internal controls over financial reporting as of the end of the period covered by this report. Based on the foregoing, our principal executive and principal financial officer have concluded that, as of the period covered by this report, our disclosure controls and procedures were effective.

 

Changes in Internal Control Over Financial Reporting. There were no changes in our internal control over financial reporting that occurred during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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Attached as exhibits to this Form 10-Q are certifications of the Company’s Chief Executive Officer and Chief Financial Officer, which are required in accordance with Rule 13a-14 of the Securities Exchange Act of 1934. This “Controls and Procedures” section includes information concerning the controls and evaluation thereof referred to in the attached certifications, and it should be read in conjunction with the attached certifications for a more complete understanding of the topics presented.

 

PART II-OTHER INFORMATION

 

Item 1A.                  Risk Factors

 

Information concerning certain risks and uncertainties appears in Part I, Item 1A “Risk Factors” of our annual report on Form 10-K for the year ended December 31, 2006. You should carefully consider these risks and uncertainties before making an investment decision with respect to shares of our common stock. Such risks and uncertainties could materially adversely affect our business, financial condition or operating results.

 

During the three months ended June 30, 2007, there has been no material change from the risk factors previously disclosed in our annual report on Form 10-K for the year ended December 31, 2006.

 

Item 5.    Other Information

 

Our 2007 annual meeting of stockholders was delayed by more than 30 days from June 8, 2007, the anniversary date of the 2006 annual meeting of stockholders and has been scheduled to occur on December 3, 2007 as announced in the Form 8-K filed on September 17, 2007 and in the Notice of Annual Meeting and Proxy Statement sent to shareholders on or after November 2, 2007.

 

Item 6.    Exhibits

 

(a)           Index to Exhibits

 

Exhibit No.		Description
Exhibit 31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted by Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 31.2		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted by Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.2		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002.

 

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SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Date: November 14, 2007	NATROL, INC.
	By:	/s/ Dennis R. Jolicoeur
		Dennis R. Jolicoeur
		Chief Financial Officer, Treasurer and Executive Vice President (Duly Authorized Officer and Principal Financial and Accounting Officer)

 

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