Natrol, Inc (NTOL) - Description of business


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Company Description


Natrol, Inc. and subsidiaries (collectively, the “Company”) manufactures and markets branded, high-quality dietary supplement products under three branded labels, Natrol, Laci Le Beau and Prolab. Our core Natrol brand markets vitamins, minerals, hormonal supplements, herbal products, and specialty combination formulations. The Laci Le Beau brand sells specialty teas and the Prolab brand markets sports nutrition products to athletes and other health minded individuals. We sell our products through multiple channels of distribution that reach consumers through mass-market retailers, health food stores, fitness centers, the Internet, catalogues and other points of distribution.

We also sell raw materials and market limited contract manufacturing through our EPI division, which operates within our core operating unit.

Principles of Consolidation

The consolidated financial statements include the accounts and operations of Natrol, Inc. and its wholly owned subsidiaries. All significant intercompany accounts have been eliminated in consolidation.

Estimates and Assumptions

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions affecting the reported amounts in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates, although management does not believe any differences would materially affect our consolidated financial position or results of operations.

Significant Risks and Uncertainties

Product returns are a recurring part of our business. Estimating product returns requires significant management judgment. Products may be returned for various reasons including expiration dates or lack of sufficient sales. During 2005, returns and reimbursements for damages and outdated products were 6.2% of gross shipments, an increase from the 3.5% and the 4.7%  of gross shipments experienced in 2004 and 2003, respectively. In past years, the rate of returns has been considerably higher reaching more than 14%. There is no guarantee that future returns will not increase to, or exceed, the levels experienced in the past. Furthermore, the possibility exists that should we lose a major account, we may agree to accept a substantial amount of returns.

We monitor our inventory and analyze it on a regular basis. Cycle counts are taken daily to verify inventory levels. In addition, we analyze the movement of items within our inventory in an effort to determine the likelihood that inventory will be sold or used before expiration dates are reached. We provide an allowance against that portion of inventory that we believe is unlikely to be sold or used before expiration dates are reached. At December 31, 2005, inventory allowances were approximately $2.5 million.

Cash

Substantially all of the Company’s cash was held by one bank at December 31, 2005. The Company does not believe that, as a result of this concentration, it is subject to any unusual financial risk beyond the normal risk associated with commercial banking relationships.

Restricted Cash

Restricted cash represents cash that has been deposited with an insurance company as part of our self-insurance program. The cash earns interest at a current rate of 1.65% per annum, and will be returned should we terminate the policy. The policy, which is cancelable by us, is effective through 2008.

Inventory

Inventory is stated at the lower of cost (determined by the first-in, first-out method) or market.

Property and Equipment

Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets ranging from three-to-ten years for furniture, machinery and equipment. Buildings are depreciated over forty years, and improvements are depreciated over periods ranging from five-to-forty years, using the straight-line method. Amortization of leasehold improvements is computed using the straight-line method over the shorter of the estimated useful lives of the assets or the lease terms. Depreciation expense in the years ended December 31, 2005, 2004 and 2003 amounted to $1,338, $1,277 and $1,496, respectively.

Property held for sale

At December 31, 2005, the Company’s facility in Bloomfield, Connecticut. was for sale. This building became unoccupied when we moved all of our Prolab subsidiary’s shipping and receiving functions from Connecticut to our shipping and warehousing facility in Chatsworth, California.

The book value of the land, building and associated building improvements, net of accumulated depreciation, amounted to approximately $0.8 million on December 31, 2005. The facility was sold in January 2006 for approximately $1.0 million.

Long-Lived Assets

We evaluate long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value.

Goodwill

In June 2001, the Financial Accounting Standards Board (“FASB”) approved two new statements: Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations , and SFAS No. 142, Goodwill and Other Intangible Assets . SFAS No. 141 requires business combinations entered into after June 30, 2001 to be accounted for using the purchase method of accounting. SFAS No. 142 requires that goodwill not be amortized, but be tested for impairment at least annually. We adopted SFAS No. 142 on January 1, 2002. In accordance with such adoption, we began testing goodwill for impairment annually at December 31 in 2002.

We performed our annual impairment test as of December 31 for each of the years presented and concluded that goodwill was not impaired.

As part of our impairment test, we considered a number of variables including, but not limited to, the market capitalization of the Company, estimates of future earnings and discounted cash flows, third party assessments of the value of the Company and transactions involving the purchase and sale of businesses similar to ours.

As part of a legal settlement with the former owners of Prolab, in 2004, we received $2.0 million, which was recorded as reduction of goodwill. The balance of goodwill as of December 31, 2004, therefore, was reduced to approximately $2 million.

The changes in the carrying value of goodwill for the years ended December 31, 2003, 2004 and 2005 were as follows (in thousands):

Balance, December 31, 2002 and 2003

 

$

4,026

 

Reduction of goodwill from legal settlement in 2004

 

(2,000

)

Balance, December 31, 2005 and 2004

 

$

2,026

 



Income Taxes

Deferred income taxes are provided for temporary differences between the financial statement and income tax bases of assets and liabilities, based on enacted tax rates. Management provides a valuation allowance when it believes it is more likely than not that some portion or all of the deferred income tax assets will not be realized.

Revenue Recognition

We sell our products to retail outlets through a direct sales force and a national broker network. We recognize revenue from sales when product is shipped and risk of loss is transferred. We currently have no consignment accounts. If we had consignment accounts we would not recognize revenue until product was sold by the consignment account to the consumer. Net sales represent product shipped less actual and estimated returns, spoilage allowances, allowances for product deemed to be unsaleable by customers, and slotting fees, rebates and other expenditures which, using Generally Accepted Accounting Principles (GAAP) in the United States should be accounted for as reductions of revenue. Estimates and allowances are based upon known claims and an estimate of additional returns when the amount of future returns can be reasonably estimated.

Advertising Costs

Advertising and promotional costs are expensed as incurred. Advertising and promotional costs were (in thousands) $7,056, $6,122, and $5,427 for the years ended December 31, 2005, 2004 and 2003, respectively. These amounts are exclusive of brochure and public relations expenses, as well as promotional and other costs that are netted against sales revenue.

Research and Development Costs

Our research and development costs are expensed as incurred and were (in thousands) $964, $752 and $608 for the years ended December 31, 2005, 2004 and 2003, respectively.

Shipping and Handling Costs

We record all amount charged to customers for shipping and handling as revenue. All shipping and fulfillment costs are classified as selling and marketing expenses and were (in thousands) $3,340, $3,432 and $3,172 for the years ended December 31, 2005, 2004 and 2003, respectively.

Stock-Based Compensation

We account for our employee stock option plan under the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. We have a stock-based compensation plan. Our operating results do not include a compensation charge related to this plan, as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on the operating results and per share amounts if the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based compensation, had been applied to stock-based employee compensation. SFAS 123 was adopted on January 1, 2006 and option expenses will be included in our operating results beginning on that date.

Years Ended December 31,

2005

2004

2003

(in thousands)

Income (loss) from continuing operations

 

$

(2,633

)

$

1,868

 

$

19

 

Total stock-based employee compensation expense determined under the fair value-based method for all awards, net of related tax benefits (“Stock Compensation”)

 

(38

)

(53

)

(222

)

Income (loss) from continuing operations—pro forma

 

$

(2,671

)

1,815

 

(203

)

Loss from discontinued operations

 

 

 

(1,487

)

Net profit (loss)—pro forma

 

$

(2,671

)

$

1,815

 

$

(1,690

)

Income (loss) per share from continuing operations:

 

 

 

 

 

 

 

Basic—as reported

 

$

(0.20

)

$

0.14

 

$

0.00

 

Basic—pro forma

 

$

(0.20

)

$

0.14

 

$

(0.02

)

Diluted—as reported

 

$

(0.20

)

$

0.14

 

$

0.00

 

Diluted—pro forma

 

$

(0.20

)

$

0.14

 

$

(0.02

)

Net loss per share:

 

 

 

 

 

 

 

Basic—as reported

 

$

(0.20

)

$

0.13

 

$

(0.11

)

Basic—pro forma

 

$

(0.20

)

$

0.13

 

$

(0.13

)

Diluted—as reported

 

$

(0.20

)

$

0.13

 

$

(0.11

)

Diluted—pro forma

 

$

(0.20

)

$

0.13

 

$

(0.13

)



The fair value of the options is estimated using a Black-Scholes option-pricing model with the following weighted-average assumptions for grants:

Years Ended December 31,

2005

2004

2003

Expected dividend yield

 

0.0

%

0.0

%

0.0

%

Expected stock price volatility

 

63.0

 

64.6

 

68.7

 

Risk free interest rate

 

3.9

%

3.6

%

3.0

%

Expected life of options

 

5 years

 

5 years

 

5 years

 



These assumptions resulted in weighted-average fair values of $1.54, $1.66 and $0.87 for each stock option granted in 2005, 2004 and 2003, respectively.

In connection with his appointment as President and CEO, Mr. Bos was awarded fully vested options to purchase 6,029,500 shares of the Company’s common stock with a strike price of $2.282 per share. The strike price was equal to the price of the last reported trade immediately prior to the time the Board determined to grant this option and therefore reflects the fair market value of our common stock at the time of the grant. For a period of three years, Mr. Bos’s ability to sell the majority of the shares he receives upon exercise of these options is restricted, with the restrictions lapsing based upon the stock price reaching defined hurdles. The grant is subject to shareholder approval. The grant will result in a charge to operating earnings during the first quarter of 2006. The amount of the charge has not yet been determined.

Income (Loss) Per Share

We calculate income (loss) per share in accordance with SFAS No. 128, Earnings per Share . Basic income (loss) per share has been computed by dividing net income (loss) by the weighted-average number of common shares outstanding during the period. Diluted income (loss) per share has been computed by dividing net income (loss) by the weighted average number of common shares and dilutive common stock equivalents (stock options).

Stock options to purchase 2,310,820, 2,442,000 and 2,950,000 shares of common stock at December 31, 2005, 2004 and 2003, respectively, were outstanding and of these shares, 2,310,820, 520,000 and 2,950,000 were respectively considered anti-dilutive.

Fair Value of Financial Instruments

The carrying value of certain financial instruments, including cash, accounts receivable, accounts payable and accrued expenses approximates fair market value based on their short-term nature. The fair value of the our long-term notes payable is estimated using discounted cash flow analyses, based on our current incremental borrowing rates for similar types of borrowing arrangements. The estimated fair value of long-term notes payable exceeded the carrying value by approximately $0.3 million at December 31, 2005.

Concentration of Credit Risk

Financial instruments, which potentially subject us to concentration of credit risk, consist principally of cash and accounts receivable. We believe our exposure as it relates to cash is limited due to the fact that the cash we have is placed with our bank, which has a strong financial position. Significant portions of our sales are made directly to mass merchandisers and national retailers. Due to the increased volume of sales to these channels, we have experienced an increased concentration of credit risk, and as a result, may at anytime have individually significant receivable balances with such mass merchandisers and national retailers. While we monitor and manages this risk, financial difficulties on the part of one or more major customers may have a material adverse effect. We perform ongoing credit evaluations of customers and maintain an allowance for potential credit losses.

One customer represented more than 10% of our net sales in 2005 and no customer represented 10% or more of our net sales in 2004 and 2003, respectively. Two accounts represented more than 10% of our net accounts receivable as of December 31, 2005.  At December 31, 2004 no customer accounted for more than 10% our trade receivables and one customer represented approximately 16% of net accounts receivable at December 31, 2003.

Recently Issued Accounting Standards

In May 2005, the FASB issued FASB Statement No. 154, Accounting Changes and Error Corrections. This new standard replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements , and represents another step in the FASB’s

goal to converge its standards with those issued by the IASB. Among other changes, Statement 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. Statement 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a “restatement.” The new standard is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. Early adoption of this standard is permitted for accounting changes and correction of errors made in fiscal years beginning after June 1, 2005.

In March 2005, the SEC released Staff Accounting Bulletin No. 107, “Share-Based Payment” (“SAB 107”), which provides interpretive guidance related to the interaction between SFAS 123 and certain SEC rules and regulations. It also provides the SEC staff’s views regarding valuation of share-based payment arrangements. In April 2005, the SEC amended the compliance dates for SFAS 123, to allow companies to implement the standard at the beginning of their next fiscal year, instead of the next reporting period beginning after June 15, 2005.

In February 2006, the FASB issued FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments. This Statement amends FASB Statements No. 133, Accounting for Derivative Instruments and Hedging Activities, and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. As we do not issue or expect to issue hybrid financial instruments, we do not believe this pronouncement will have any material effect on our financial reporting.

2. Inventory

Inventory consists of the following:

December 31,

2005

2004

(in thousands)

Raw material and packaging supplies

 

$

7,547

 

$

5,357

 

Finished goods

 

4,250

 

4,366

 

 

 

$

11,797

 

$

9,723

 



Two of our suppliers each accounted for more than 10% of our inventory purchases in 2005. The loss of either supplier could have a material adverse effect on our ability to produce and sell goods. We do not have a long-term supply agreement with these suppliers.

3. Financing

During 1999, we entered into two mortgage notes payable in the aggregate amount of approximately $8,900,000, collateralized by our facilities. These notes are payable in monthly installments of approximately $74,000 in the aggregate, including interest ranging from 7.75% to 8.32%, maturing in 2014 and 2019.

In November 4, 2004, we executed a Revolving Note in favor of CNB for the principal sum of $3,000,000. This revolving note expired in December 2005 and we are currently renegotiating the terms of a potential line of credit. We also executed a Promissory Note in favor of CNB for the original principal sum of $750,000. The $750,000 note payable is collateralized by our non-real estate assets. This note is payable in monthly installments of approximately $12,500  over 5 years plus interest at a variable rate based upon prime plus a premium of .75%. The initial rate upon entering into the note was 5.5%. The prime rate at December 31, 2005 was 7.25%.

Future maturities of long-term debt at December 31, 2005 are as follows (in thousands):

2006

 

$

532

 

2007

 

564

 

2008

 

598

 

2009

 

637

 

2010

 

527

 

Thereafter

 

4,841

 

Total

 

$

7,699

 



4. Income Taxes

The income tax (benefit) provision consists of the following (in thousands):

Years Ended December 31,

2005

2004

2003

Current:

 

 

 

 

 

 

 

Federal

 

$

(402

)

$

540

 

$

526

 

State

 

(32

)

34

 

2

 

Total current

 

(434

)

574

 

528

 

Deferred

 

(1,484

)

570

 

(494

)

Total income taxes (benefit) for continuing operations

 

$

(1,918

)

$

1,144

 

$

34

 

Income tax benefit from discontinuing operations

 

 

$

 

$

(821

)



The difference between actual income tax provision (benefit) and the amount computed using the U.S. federal statutory income tax rate is as follows (in thousands):

Years Ended December 31,

2005

2004

2003

Statutory rate applied to income (loss) from continuing operations

 

$

(1,547

)

$

1,008

 

 

$

19

 

 

State tax provision

 

(172

)

115

 

 

2

 

 

Other

 

(199

)

21

 

 

13

 

 

Income tax provision from continuing operations

 

$

(1,918

)

$

1,144

 

 

$

34

 

 



The significant components of our deferred income tax assets and liabilities are as follows (in thousands):

Years Ended December 31,

2005

2004

2003

Deferred income tax assets:

 

 

 

 

 

 

 

Accounts receivable allowances

 

$

98

 

$

167

 

$

253

 

Inventory

 

883

 

573

 

565

 

Accrued liabilities

 

1,235

 

838

 

780

 

Goodwill impairment

 

2,808

 

3,191

 

3,572

 

Net operating loss carryforward

 

1,317

 

 

107

 

Other

 

0

 

107

 

72

 

 

 

6,341

 

4,876

 

5,349

 

Deferred tax income liabilities:

 

 

 

 

 

 

 

Federal effect of state taxes

 

(282

)

(223

)

(271

)

Depreciation

 

(133

)

(211

)

(66

)

Net deferred tax assets

 

$

5,926

 

$

5,012

 

$

5,012

 



As of December 31, 2005 and 2004 the Company had net operating loss carryforwards for federal and state income tax purposes of approximately $3,333 and $3,143 respectively which begin to expire in the years 2025 and 2015.

5. Stockholders’ Equity

Stock Repurchase Program

In 2000, the Board of Directors authorized a stock repurchase program for our common stock. Under the stock repurchase program, we can effect common stock repurchases from time to time up to an aggregate of $10,000,000. The stock repurchase program does not have an expiration date. No such repurchases were made in 2005 or 2004.

Stock Options

Under our 1996 Stock Option and Grant Plan, as amended (the “Plan”), the Board of Directors is authorized to grant incentive stock options or non-qualified stock options. Incentive stock options may be granted only to employees. Non-qualified stock options may be granted to officers and employees as well as to non-employees. The maximum number of shares to be issued under the Plan is 3,468,568 shares, as amended. All options granted under the Plan have been made at prices not less than the fair market value of the stock at the date of grant. Generally, the options granted under the Plan vest over three-to-five years. Options granted under the Plan have a term of not more than 10 years.

A summary of our stock option activity and related information is as follows (in thousands, except per share data):

Number of
Options
(000’s)

Weighted-Average
Exercise Price
Per Share

Exercise Price
Per Share

Outstanding at December 31, 2002

 

 

2,916

 

 

 

$

3.10

 

 

$

1.10—$13.00

 

Granted

 

 

361

 

 

 

1.31

 

 

1.10—2.04

 

Forfeited

 

 

(111

)

 

 

2.23

 

 

1.45—6.03

 

Exercised

 

 

(217

)

 

 

1.48

 

 

1.15—1.50

 

Outstanding at December 31, 2003

 

 

2,949

 

 

 

2.89

 

 

1.10—13.00

 

Granted

 

 

90

 

 

 

2.84

 

 

2.67—3.04

 

Forfeited

 

 

(405

)

 

 

3.35

 

 

1.10—6.03

 

Exercised

 

 

(192

)

 

 

1.30

 

 

1.15—1.50

 

Outstanding at December 31, 2004

 

 

2,442

 

 

 

3.07

 

 

1.10—13.00

 

Granted

 

 

65

 

 

 

2.72

 

 

1.74—3.09

 

Forfeited

 

 

(49

)

 

 

5.16

 

 

1.32—10.40

 

Exercised

 

 

(147

)

 

 

1.38

 

 

1.10—1.94

 

Outstanding at December 31, 2005

 

 

2,311

 

 

 

3.07

 

 

1.15—13.00

 



At December 31, 2005, 951,617 shares were available for future grant. The weighted-average remaining contractual life for the outstanding options in years was 4.84, 5.57, and 6.91 at December 31, 2005, 2004 and 2003, respectively.

Options Outstanding

Weighted Average

Weighted Average

Range of Exercise Prices

Number
Outstanding
(000’s)

Remaining
Contractual Life
(Years)

Weighted
Average
Exercise Price

Shares
Exercisable
(000’s)

Weighted
Average
Exercise Price

$1.15—$2.35

 

 

1,726

 

 

 

5.04

 

 

 

$

1.71

 

 

 

1,698

 

 

 

$

1.71

 

 

$2.67—$6.03

 

 

310

 

 

 

5.73

 

 

 

4.12

 

 

 

238

 

 

 

4.48

 

 

$7.75—$13.00

 

 

275

 

 

 

2.60

 

 

 

10.90

 

 

 

275

 

 

 

10.90

 

 

Total

 

 

2,311

 

 

 

4.84

 

 

 

$

3.13

 

 

 

2,211

 

 

 

$

3.14

 

 



6. Commitments and Contingencies

We lease some equipment under noncancelable operating leases that expire in various years through 2006. Rent expense under operating leases totaled approximately $160,000, $162,000 and $155,000, for the years ended December 31, 2005, 2004 and 2003, respectively.

Future minimum lease payments under noncancelable operating leases with initial terms of one year or more consisted of the following at December 31, 2005 (in thousands):

2005

 

$

110

 

2006

 

73

 

2007

 

12

 

2008

 

11

 

2009

 

4

 

Total minimum lease payments

 

$

210

 



We lease part of our shipping facility and future minimum lease payments due to us are (in thousands):

2005

 

$

393

 

2006

 

404

 

2007

 

417

 

2008

 

429

 

2009

 

367

 

Total

 

$

2,010

 



However, as of year-end, our tenant was in arrears. In February 2006, this tenant formally notified us of its intent to vacate the facility and we have commissioned a broker to find a new tenant. Although the tenant is responsible for all rent through the term of the lease, and although we are attempting to collect rent due us, there is no guarantee that the tenant will be able to pay us for rent owed even if a formal legal settlement is reached.

We are party to certain legal actions arising in the normal course of business. In the opinion of management, the ultimate outcome of such litigations will not have a material adverse effect on our financial position or results of operations.

7. Employee Benefits Plans

We have a profit sharing 401(k) plan that covers substantially all of our employees. Eligible employees may contribute up to the maximum allowed under law. Contributions are discretionary. However, we generally match 10.0% of the employees’ contributions up to the maximum of 1.0% of eligible compensation. Amounts recognized as expense were approximately $22,000, $33,000 and $26,000, for the years ended December 31, 2005, 2004 and 2003, respectively.

In 1998, the Board of Directors approved the Natrol, Inc. Employee Stock Purchase Plan (ESPP), which allows substantially all employees to purchase shares of our common stock, through payroll deductions, at 85.0% of the fair market value of the shares at the beginning or end of the offering period, whichever is lower. We expense two thirds of the 15.0% discount given to employees under the plan. The ESPP provides for employees to authorize payroll deductions of up to 10.0% of their compensation for each pay period. In conjunction with the ESPP, we registered with the SEC 225,000 shares of the Company’s common stock reserved for purchase under the ESPP. As of December 31, 2005 and 2004, 64,920 and 93,453, respectively were available for issuance under this plan. For the year ended December 31, 2005, 28,533 shares were issued at prices ranging from $1.36 to $2.39. For the year ended December 31, 2004, 34,419 shares were issued at $2.33 per share. For the year ended December 31, 2003, 38,267 shares were issued at $0.98 per share.

In 2004 and 2005, we adopted a bonus program for certain employees. The bonuses granted are dependent upon a formula based on corporate profits before taxes and interest. No bonus payments were issued to employees under the plan in 2005. The amount of bonus expensed in 2004 relative to this plan was approximately $600,000.

8. Impairment of Goodwill

In 2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 requires that goodwill not be amortized. Beginning in 2002, we have evaluated goodwill for impairment annually, or whenever events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. We have performed this evaluation annually, ever since, as of December 31 of each year.

The remaining goodwill balance at December 31, 2003 was approximately $4 million. In the fourth quarter of 2003, we completed our annual goodwill impairment testing and determined that goodwill was not impaired. Additionally, during March 2004, we settled litigation with the former owners of Prolab Nutrition, Inc. We received $2.0 million in cash, which was reflected in the financial statements for the quarter ending March 31, 2004 as a reduction of goodwill. We determined that this was the proper accounting for the settlement because the sellers did not deliver a key asset in the condition warranted, which was a clear and direct link to the purchase price, and accordingly resulted in a purchase price adjustment reducing goodwill, as opposed to a charge to income.

We performed an annual impairment test as of December 31 for each of the years presented and determined that no impairment existed. In all years in which impairment was tested, we considered a number of variables including, but not limited to, the market capitalization of the Company, estimates of future earnings and discounted cash flows, third party assessments of the value of the Company and transactions involving the purchase and sale of businesses similar to ours.

9. Discontinued Operations

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

Summarized financial information for the discontinued operations is as follows (in thousands):

December 31,
2003

Annasa:

 

 

 

 

 

Revenue

 

 

$

667

 

 

Gross Margin

 

 

452

 

 

Selling and Marketing expenses

 

 

1,224

 

 

General and administrative

 

 

994

 

 

Loss from operations

 

 

(1,766

)

 

Income tax benefit

 

 

616

 

 

Net loss

 

 

$

(1,150

)

 

Tamsol:

 

 

 

 

 

Revenue

 

 

$

30

 

 

Gross Margin

 

 

30

 

 

Selling and Marketing expenses

 

 

152

 

 

General and administrative

 

 

420

 

 

Loss from operations

 

 

(542

)

 

Income tax benefit

 

 

205

 

 

Net loss

 

 

$

(337

)

 

Net assets of discontinued operations:

 

 

 

 

 

Current assets

 

 

$

115

 

 

Total assets

 

 

150

 

 

Current liabilities

 

 

115

 

 

Net assets of discontinued operations

 

 

35

 

 



10. Operating Segments

Prior to the fourth quarter of 2003, we reported revenue and income through three operating segments: Natrol, Annasa and Prolab. As discussed in Note 9, Annasa was discontinued in the fourth quarter of 2003. Additionally, we consolidated the Prolab operating unit into the core Natrol operating unit as of October 1, 2003 and as of that date Prolab began operating as a brand within the core operating unit similar to our other brands. As of October 1, 2003, we no longer considered Prolab a separate operating segment. As a result, segment operating results are no longer being reported.

11. Selected Quarterly Financial Data (unaudited)

2005 Quarters Ended

March 31,

June 30,

September 30,

December 31,

(in thousands, except per share amounts)

Net sales

 

 

$

17,669

 

 

$

19,604

 

 

$

15,390

 

 

 

$

14,867

 

 

Gross profit

 

 

6,265

 

 

7,528

 

 

5,506

 

 

 

4,125

 

 

Net income

 

 

(592

)

 

291

 

 

(742

)

 

 

(1,590

)

 

Basic and diluted income per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic income per share

 

 

$

(0.04

)

 

$

0.02

 

 

$

(0.05

)

 

 

$

(0.12

)

 

Diluted income per share

 

 

$

(0.04

)

 

$

0.02

 

 

$

(0.05

)

 

 

$

(0.12

)

 



2004 Quarters Ended

March 31,

June 30,

September 30,

December 31,

(in thousands, except per share amounts)

Net sales

 

 

$

20,425

 

 

$

20,682

 

 

$

20,879

 

 

 

$

17,283

 

 

Gross profit

 

 

7,830

 

 

9,344

 

 

8,665

 

 

 

6,610

 

 

Net income

 

 

450

 

 

769

 

 

384

 

 

 

265

 

 

Basic and diluted income per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic income per share

 

 

$

0.03

 

 

$

0.06

 

 

$

0.03

 

 

 

$

0.02

 

 

Diluted income per share

 

 

$

0.03

 

 

$

0.05

 

 

$

0.03

 

 

 

$

0.02

 

 



Natrol, Inc. and Subsidiaries Schedule II—Valuation and Qualifying Accounts Years Ended December 31, 2005, 2004 and 2003

Description

Balance at
Beginning
of Year

Charged to
Cost and
Expense

Deductions

Balance at
End of Year

Allowance for Doubtful Accounts:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year ended December 31, 2003

 

 

$

409

 

 

 

$

397

 

 

 

$

171

 

 

 

$

635

 

 

Year ended December 31, 2004

 

 

$

635

 

 

 

$

(223

)

 

 

$

(9

)

 

 

$

421

 

 

Year ended December 31, 2005

 

 

$

421

 

 

 

$

147

 

 

 

$

321

 

 

 

$

247

 

 

Allowance for Sales Returns:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year ended December 31, 2003

 

 

$

1,593

 

 

 

$

4,014

 

 

 

$

4,372

(1)

 

 

$

1,235

 

 

Year ended December 31, 2004

 

 

$

1,235

 

 

 

$

3,172

 

 

 

$

3,340

(1)

 

 

$

1,067

 

 

Year ended December 31, 2005

 

 

$

1,067

 

 

 

$

4,874

 

 

 

$

3,664

(1)

 

 

$

2,277

 

 



(1)           Represents actual returns of goods

ITEM 9.                 CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

On December 22, 2004, the Audit Committee of the Board of Directors of Natrol informed Deloitte & Touche, LLP (Deloitte), our  independent public accountants for the fiscal year ended December 31, 2003, of our decision to no longer engage Deloitte & Touche, LLP as the Company’s independent public accountants. On December 22, 2004, the Audit Committee of the Board of Directors of Natrol engaged Stonefield Josephson, Inc. to serve as our independent public accountants for the fiscal year ended December 31, 2004. On December 28, 2004, Natrol filed a Form 8-K announcing this change in independent public accountants.

Deloitte’s independent auditors’ reports on our consolidated financial statements for each of the fiscal years in the two-year period ended December 31, 2003 did not contain an adverse opinion, or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles. During the two fiscal years ended December 31, 2003 and the subsequent interim period through December 22, 2004, there were no disagreements with Deloitte on any matter of accounting principles or practice, financial statement disclosure, or auditing scope or procedure which, if not resolved to Deloitte’s satisfaction, would have caused them to make reference to the subject matter of the disagreement in connection with their reports on our consolidated financial statements for such periods; and there were no reportable events as defined in Item 304(a)(1)(v) of Regulation S-K during the two fiscal years ended December 31, 2003 and the subsequent interim period through December 22, 2004.

During the fiscal years ended December 31, 2002 and 2003 and through December 22, 2004, we did not consult Stonefield Josephson, Inc. with respect to the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on our consolidated financial statements, or any other matters or reportable events as set forth in Items 304(a)(2)(i) and (ii) of Regulation S-K.

Item 9A.                 Disclosure 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 Securities and Exchange Commission’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 SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our principal executive and principal financial officers, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the year covered by this report. Based on the foregoing, our principal executive and principal financial officers have concluded that our disclosure controls and procedures were effective at a reasonable assurance level.

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.

Item 9B.                Other Information

None.

PART III

Information required under Part III (Items 10, 11, 12, 13, and 14 other than the information required by

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