PART I.

ITEM 1.                BUSINESS

Overview

We are a leading national distributor of natural and organic foods and related products in the United States. We believe that we are the primary distributor of natural and organic products to a majority of our customers. We carry more than 40,000 high-quality natural and organic products, consisting of national brand, regional brand, private label and master distribution products, in six product categories: grocery and general merchandise, produce, perishables and frozen foods, nutritional supplements, bulk and food service products and personal care items. We serve more than 18,00017,000 customers, including independently owned natural products retailers, supernatural chains, which are comprised of large chains of natural foods supermarkets, and conventional supermarkets located across the United States. Our other distribution channels include food service, international and buying clubs. We have been the primary distributor to the largest supernatural chain in the United States, Whole Foods Market, Inc. (“Whole Foods Market”), for more than 10 years. In October 2006, we announced a seven-year distribution agreement with Whole Foods Market, which commenced on September 26, 2006, under which we will continue to serve as the primary U.S. distributor to Whole Foods Market in the regions where we previously served. In January 2007, we expanded our Whole Foods Market relationship in the Southern Pacific region of the United States. In January 2004, we entered into a five year primary distribution agreement with Wild Oats Markets, Inc. (“Wild Oats Markets”), the second largest supernatural chain in the United States. On February 21, 2007, Whole Foods Market and Wild Oats Markets announced that the two companies had entered into an agreement and plan of merger under which Whole Foods Market would commence an offer to purchase all the outstanding shares of Wild Oats Markets and following the tender offer, Wild Oats Markets would merge with and into a subsidiary of Whole Foods Market. This merger was substantially completed in August 2007 and Wild Oats Markets became a subsidiary of Whole Foods Market. Wild Oats Markets is expected to become a wholly-owned subsidiary of Whole Foods Markets in the near future.

In recent years, our sales to existing and new customers have increased through the continued growth of the natural products industry in general, increased market share throughas a result of our high qualityhigh-quality service and a broader product selection, the acquisition of, or merger with, natural products distributors, the expansion of our existing distribution centers, the construction of new distribution centers and the development of our own line of natural and organic branded products. Through these efforts, we believe that we have been able to broaden our geographic penetration, expand our customer base, enhance and diversify our product selections and increase our market share. We also own and operate 12 natural products retail stores, located primarily in Florida, through our subsidiary, the Natural Retail Group, Inc. (“NRG”). We believe that our retail business serves as a natural complement to our distribution business because it enables us to develop new marketing programs and improve customer service. In addition, our subsidiary, Hershey Import Company, Inc. (“Hershey Imports”), specializes in the international importing, roasting and packaging of nuts, seeds, dried fruits and snack items.

Since our formation, we have completed a number of acquisitions of distributors and suppliers, including Hershey Imports, Albert’s Organics, Inc. (“Albert’s”), and NRG, all of which have expanded our distribution network, product selection and customer base. During fiscal 2005,2007, we acquired Select Nutrition Distributors, Inc.expanded our line of branded products through our acquisition of Organic Brands LLC (“Select Nutrition”Organic Brands”), and our subsidiary, Albert’s, acquired substantially all of the assets of Roots & Fruits Cooperative Produce (“Roots & Fruits”).as well as certain additional product lines. Our operations are comprised of three principal divisions:

·       our wholesale division, which includes our broadline distribution business, Albert’s and Select Nutrition;

·       our retail division, which consists of our 12 retail stores; and

·       our manufacturing division, which is comprised of Hershey Imports.Imports, and our branded product lines.

Natural Products Industry

Although most natural products are food products, including organic foods, the natural products industry encompasses a number of other categories, including nutritional, herbal and sports supplements, toiletries and personal care items, naturally- basednaturally-based cosmetics, natural/homeopathic medicines, pet products and cleaning agents. According to the June 20062007 issue of The Natural Foods Merchandiser, a leading trade publication for the natural product industry, sales revenues

for all types of natural products rose to $51.4$56.8 billion in 2005,2006, an increase of approximately 9.1%9.7% over 2004. This2005. According to The Natural Foods Merchandiser, this increase in sales, from a total dollar perspective, was driven primarily by growth in the following categories:

·       packaged grocery and fresh produce;

·       frozen and refrigerated meats, poultry and seafood;

·       packaged bulk items;

·dairy products; and

·       supplements.

The fastest growing categories, although not necessarily the largest dollar volume categories, in the natural and organic products industry were produce, baked goods, food supplementsfresh meat/seafood, beer/wine, personal care, and pet products.

According to The Natural Foods Merchandiser, the continuing growth trend is driven by consumer desire for healthy, tasty and low-cost prepared food.food, as well as ethnic foods and specialty organic produce. More than half of American households represent “mid-level” organic customers, that is, they regularly purchase organic and natural products and want to learn more about nutrition as concerns continue to mount about health claims, food safety, irradiation and genetically modified organism issues.

Competitive Advantages

We benefit from a number of significant competitive advantages including:

Market Leader with a Nationwide Presence

We are one of the few distributors capable of serving local and regional customers as well as the rapidly growing national supernatural and supermarket chains. We believe we have significant advantages over smaller, regional natural and organic products distributors as a result of our ability to:

·       expand marketing and customer service programs across regions;

·       expand national purchasing opportunities;

·       offer a broader product selection;

·       consolidate systems applications among physical locations and regions;

·       invest in people, facilities, equipment and technology;

·       integrate administrative and accounting functions; and

·       reduce geographic overlap between regions.

We were the first organic food distribution network in the United States to earn certification by Quality Assurance International, Inc. (“QAI”). This process involved a comprehensive review by QAI of our operating and purchasing systems and procedures. This certification comprises all of our broadline distribution centers.

Efficient Distributor

In addition to our volume purchasing opportunities, a critical component of our position as an efficient provider is our management of warehouse and distribution costs. Our continued growth has created the need for expansion of existing facilities to achieve maximum operating efficiencies and to assure adequate space for future needs. In August 2006,February 2007, we announced plans to buildconstruct a new facilities237,000 square foot distribution center in Ridgefield, Washington, to serve as a regional distribution hub for customers in Portland, Oregon and other Northwest states. The distribution center is scheduled to commence operations in the Pacific Northwest,second quarter of fiscal 2008. In March 2007, we entered into lease agreement to secure warehouse space in Sarasota, Florida. The warehouse in central Florida and Texasis expected to open in the succeeding 18first quarter of fiscal 2008. This will reduce the geographic area served by the Atlanta, Georgia facility and is expected to 24 months.contribute to lower transportation costs. We have made significant capital expenditures and incurred considerable expenses in connection with the opening and expansion of our facilities. In October 2005, we opened our new Rocklin, California distribution center and moved our Auburn, California operations to this facility. The Rocklin distribution center is 487,000 square feet and

serves as a distribution hub for customers in northern California and surrounding states. The Rocklin distribution center is the largest facility in our nationwide distribution network. In August 2005, we expanded our Midwest operations by opening a new 311,000 square foot distribution center in Greenwood, Indiana, which serves as a distribution hub for our customers in Illinois, Indiana, Ohio and other Midwest states. In addition, we expanded our facilities located in Iowa City, Iowa and Dayville, Connecticut during fiscal 2004.

Customer Relationships

We serve more than 18,00017,000 customers across the United States and internationally. We have developed long-standing customer relationships, which we believe are among the strongest in our industry. We have also been the primary supplier of natural and organic products to the largest supernatural chain in the United States, Whole Foods Market, for more than ten years.

Our average distribution service level for fiscal 20062007 was approximately 98%, which we believe is the highest in our industry. Distribution service levels refer to the percentage of items ordered by customers that are delivered by the requested delivery date, excluding manufacturers’ “out of stocks.” We believe that our high distribution service levels are attributable to our experienced purchasing departments and sophisticated warehousing, inventory control and distribution systems. We offer next-day delivery service to a majority of our active customers and offer multiple deliveries each week to our largest customers. We believe that customer loyalty is dependent upon excellent customer service, to ensureincluding accurate fulfillment of orders, timely product delivery, low prices and a high level of product marketing support.

We carry more than 40,000 high-quality natural products, consisting of national brand, regional brand, private label and master distribution products in six product categories: grocery and general merchandise, produce, perishables and frozen foods, nutritional supplements, bulk and food service products and personal care items.

Experienced Management Team and Employees with Significant Equity Stake

Our management team has extensive experience in the natural products industry and has been successful in identifying, consummating and integrating multiple acquisitions. Since 1985,2000, we have successfully completed 17five acquisitions of distributors, manufacturers and suppliers and 11five acquisitions of retail stores.branded product lines. In addition, our executive officers and directors and their affiliates, and theour Employee Stock Ownership Trust, beneficially own in the aggregate approximately 7.6%7.4% of our common stock. Accordingly, senior management and employees have significant incentive to continue to generate strong growth in operating results in the future.

Competition

Our major national competitor is Tree of Life Distribution, Inc. (a subsidiary of Koninklijke Wessanen N.V.) (“Tree of Life”). In addition to its natural and organic products, Tree of Life also distributes specialty food products, thereby diversifying its product selection, and markets its own private label program. Tree of Life has also earned QAI certification and has a European presence. We also compete with over 200 smaller regional and local distributors of natural, ethnic, kosher, gourmet and other specialty foods that focus on niche or regional markets. Additionally, we compete with national, regional and local distributors of conventional groceries and to a lesser extent, companies that distribute to their own retail facilities.

We believe that distributors in the natural products industry primarily compete on distribution service levels, product quality, depth of inventory selection, price and quality of customer service. We believe that we currently compete effectively with respect to each of these factors.

Our retail stores compete against other natural products outlets, conventional supermarkets and specialty stores. We believe that retailers of natural products compete principally on product quality and selection, price, customer service, knowledge of personnel and convenience of location. We believe that we currently compete effectively with respect to each of these factors.

Growth Strategy

Our growth strategy is to maintain and enhance our position as a leading national distributor to the natural and organic products industry. Key elements of

To implement our growth strategy, include:

Increase Market Share of the Growing Natural and Organic Products Industry

Wewe intend to continue to increase our leading market share of the growing natural and organic products industry by expanding our customer base, increasing our share of existing customers’ business and continuing to expand and further penetrate new distribution territories, particularly in the Mid-Atlantic, Southern California and MidwestFlorida markets. Key elements of our strategy include:

Expand Customer Base

We currently serve more than 18,00017,000 customers as of July 29, 2006.28, 2007. We plan to continue to expandexpanding our coverage of the highly fragmented natural and organic products industry by cultivating new customer relationships within the industry and by further developing other channels of distribution, such as traditional supermarkets, mass market outlets, institutional food service providers, international, buying clubs, hotels and gourmet stores.

Increase Market Share of Existing Customers’ Business

We believe that we are the primary distributor of natural and organic products to the majority of our natural products customer base. We intend to continue to seekseeking to become the primary supplier for a majority of our customers by offering the broadest product selection in our industry at the most competitive prices. Since 1993,As a result of our efforts, in January 2007, we have expanded our product offerings from approximately 14,000 to more than 40,000 individual products asWhole Foods Market relationship in the Southern Pacific region of July 29, 2006.the United States.

Continue to Expand our Branded Products Business

We have launched a number of private label or branded product lines in order to provide our customers with a broader selection of product offerings. In fiscal 2006,2007, our branded product revenues increased to approximately 3%3.3% of our overall net sales. Going forward, ourOur intention is to further expand our branded product revenues to represent 5% of our net sales by the end of fiscal 2008. We plan to achieve this goal through organic growth and through brand acquisitions. We believe this initiative givesdifferentiates us a point of differentiation in comparison tofrom other distributors within our industry, enables us to build long term brand equity for the Company and

allows us to generate higher gross margins, as company-owned branded product revenues generally yield relatively higher margins.margins than do third party branded product revenues.

Expand into Other Channels of Distribution

We believe that we will be successful in expanding into the food service channel as well as further enhancing our presence in the international channel. We will continue to develop regional relationships and alliances with companies such as Aramark Corporation, the Compass Group North America, MedAssets, Inc. and Sodexho Inc. in the food service channel and seek other alliances in the international channel.

Continue to Expand into and Penetrate into New Regions of Distribution

As discussed under “Competitive Advantages” above, we have made significant capital expenditures and incurred considerable expenses in connection with the construction of new or the expansion of existing distribution facilities. We will continue to selectively evaluate opportunities to build new facilities or to acquire distributors to better serve existing markets and expand into new markets. As discussed under “Increase Market Share of Existing Customers’ Business,” in January 2007, we expanded our Whole Foods Market relationship in the Southern Pacific region of the United States. In March 2007, we entered into a lease agreement to secure warehouse space in Sarasota, Florida. This warehouse is expected to open in the first quarter of fiscal 2008 and is expected to reduce our transportation expenses attributable to serving the Florida market. We are also constructing warehouse space in Ridgefield, Washington which is scheduled to commence operations in the second quarter of fiscal 2008. We expect the addition of this facility to alleviate the current overcapacity in our existing facilities in the northwestern United States.

Continue to Improve Efficiency of Nationwide Distribution Network

We continually seek to improve our operating results by integrating our nationwide network utilizing the best practices within our industry and within each of our regions, which have formed our foundation. This focus on achieving improved economies of scale in purchasing, warehousing, transportation and general and administrative functions has led to continued improvements in our operating margin.

Continue to Provide the Leading Distribution Solution

We believe that we provide the leading distribution solution to the natural and organic products industry through our national presence, regional responsiveness, highfocus on customer service focus and breadth of product offerings. We offer our customers a selection of inventory management, merchandising, marketing, promotional and event management services to increase sales and enhance customer satisfaction. These marketing services, many of which are supplier-sponsored, include monthly and thematic circular programs, in-store signage and assistance in product display. Our high service levels, which we believe to be the highest in our industry, are attributable to our experienced purchasing departments and our sophisticated warehousing, inventory control and distribution systems. See “Technology” below for more information regarding our use of technology in our warehousing, inventory control and distribution systems. Since 2002, we have had a strategic alliance with Living Naturally, LLC, a leading provider of marketing promotion and electronic ordering systems to the natural and organic products industry. We provide our customers with access to Living Naturally’s suite of products at preferred prices and terms. These products include an intelligent electronic ordering system and turnkey retailer website services, which create new opportunities for our retailers to increase their inventory turns, reduce their costs and enhance their profits.

Products

Our extensive selection of high-quality natural and organic products enables us to provide a primary source of supply to a diverse base of customers whose product needs vary significantly. We carry more than 40,000 high-quality natural and organic products, consisting of national brand, regional brand, private label and master distribution products, in six product categories: grocery and general merchandise, produce, perishables and frozen, nutritional supplements, bulk and food service products and personal care items. Our private label productsbranded product lines address certain needs or preferences of our customers, which are not otherwise being met by other suppliers.

We continuously evaluate potential new private branded and other products based on both existing and anticipated trends in consumer preferences and buying patterns. Our buyers regularly attend regional and national natural, organic, specialty, ethnic and gourmet product shows to review the latest products which are likely to be of interest to retailers and consumers. We also actively solicit suggestions for new products from our customers. We make the majority of our new product decisions at the regional level. We believe that our decentralized purchasing practices allow our regional buyers to react quickly to changing consumer preferences and to evaluate new products and new product categories regionally. Additionally, many of the new products that we offer are marketed on a regional basis or in our own retail stores prior to being offered nationally, which enables us to evaluate local consumer reaction to the products without incurring significant inventory risk. Furthermore, by exchanging regional product sales information between our regions, we are able to make more informed and timely new product decisions in each region.

Suppliers

We purchase our products from approximately 5,0004,300 suppliers. The majority of our suppliers are based in the United States, but we also source products from suppliers throughout Europe, Asia, South America, Africa and Australia. We believe the reason natural and organic products suppliers seek distribution of their products through us is because we provide access to a large and growing national customer base, distribute the majority of the suppliers’ products and offer a wide variety of marketing programs to our customers to help sell the suppliers’ products. Substantially all product categories that we distribute are available from a number of suppliers and, therefore, we are not dependent on any single source of supply for any product category. Our largest supplier, Hain Celestial Group, Inc. (“Hain”), accounted for approximately 8%7.3% of our total purchases in fiscal 2006.2007. However, the product categories we purchase from Hain can be purchased from a number of other suppliers. In addition, although we have exclusive distribution arrangements and vendor support programs with several suppliers, none of these suppliers accounts for more than 10% of our total purchases. Generally,We have positioned ourselves as the largest purchaser of organically grown bulk products in the natural and organic products industry by centralizing our purchase of nuts, seeds, grains, flours and dried foods. As a result, we are able to negotiate purchases from suppliers on the basis of volume and other considerations that may include discounted pricing or prompt payment discounts. Furthermore, many of our purchase arrangements include the right of return to the supplier with respect to products that we are not able to sell in a certain period of time. We have commodity contracts with certain suppliers to purchase bulk items such as dried fruits, nuts, peas and beans. Our outstanding commitments for the purchase of inventory were approximately $20.4$25.5 million as of July 29, 2006.28, 2007.

We believe we are well positioned to respond to regional and local customer preferences for natural and organic products by decentralizing the majority of our purchasing decisions for most of our products. We believe that regional buyers are better suited to identify and to respond to local demands and preferences. Although eachEach region is responsible for placing its own orders and can select the products that it believes will most appeal to its customers, eachcustomers. Each region is requiredable to participate in companywideour company-wide purchasing programs that enable us to take advantage of our consolidated purchasing power. For example, we have positioned ourselves as the largest purchaser of organically grown bulk products inextent these programs meet the natural and organic products industry by centralizing our purchase of nuts, seeds, grains, flours and dried foods.region’s supply needs. In addition, we have

implemented a number of national consumer circular programs, which have resulted in incremental sales growth for our customers, suppliers and ourselves.

Our purchasing staff works closely with suppliers to provide new and existing products. The suppliers assist in training our customer service representatives in marketing new products, identifying industry trends and coordinating advertising and other promotions.

We maintain a comprehensive quality assurance program. All of the products we sell that are represented as “organic” are required to be certified as such by an independent third-party agency. We maintain current certification affidavits on all organic commodities and produce in order to verify the authenticity of the product. All potential suppliers of organic products are required to provide such third-party certification to us before they are approved as a supplier. In 2003, we became the first organic food distribution network in the United States to gain organic certification coast-to-coast. This certification comprisescovers all of our broadline distribution centers.

Customers

We market our products to more than 18,000 customers across the United States and internationally. We maintain long-standing customer relationships with independently owned natural products retailers, supernatural chains and supermarket chains, and have continued to emphasize our relationships with new customers, such as national conventional supermarkets, mass market outlets and gourmet stores, all of which are continually increasing their natural product offerings. Among our wholesale customers for fiscal 20062007 were the following:

·       leading supernatural chains, representing Whole Foods Market (including Harry’s Farmers Market and Fresh & Wild)Market) and Wild Oats Markets (including Capers Community Market, Henry’s Farmers Market and Sun Harvest);

·       conventional supermarket chains, including Kroger, Wegman’s, Haggen’s, Stop and Shop, Shaw’s, Star Market,Giant, Peapod, Quality Food Centers, Hannaford, Food Lion, Bashas’, Lunds, Byerly’s, Rainbow, Lowe’s, Publix, Fred Meyer and Publix;United Supermarkets; and

·       mass market chains, including BJ’s Wholesale Club and Costco.

Whole Foods Market accounted for approximately 26%28% of our net sales in fiscal 2006.2007. In October 2006, we announced a seven-year distribution agreement with Whole Foods Market, which commenced on September 26, 2006, under which we will continue to serve as the primary U.S. distributor to Whole Foods Market in the regions where we previously served. In January 2007, we expanded our Whole Foods Market relationship in the Southern Pacific region of the United States. In January 2004, we entered into a five-year primary distribution agreement with Wild Oats Markets. Wild Oats Markets accounted for approximately 10%9% of our net sales in fiscal 2006.2007.

On February 21, 2007, Whole Foods Market and Wild Oats Markets announced that the two companies had entered into an agreement and plan of merger under which Whole Foods Market would commence an offer to purchase all the outstanding shares of Wild Oats Markets and following the tender offer, Wild Oats Markets would merge with and into a subsidiary of Whole Foods Market. This merger was substantially completed in August 2007and Wild Oats Markets became a subsidiary of Whole Foods Market. Wild Oats Markets is expected to become a wholly-owned subsidiary of Whole Foods Markets in the near future. At this time, we cannot accurately estimate the impact, if any, that this merger will have on our business, financial condition or results of operations.

The following table lists the percentage of sales by customer type for fiscalthe years ended July 28, 2007 and July 29, 2006:

Sales by channel have been adjusted to properly reflect changes in customer types resulting from a review of our customer lists. As a result of this adjustment, sales to the independents sales channel decreased 1.0% for the year ended July 29, 2006 and 2005:

sales to the supermarket sales channel increased 0.6% for the year ended July 29, 2006.

Marketing

We have developed a variety of supplier-sponsored marketing services, which cater to a broad range of retail formats. These programs are designed to educate consumers, profile suppliers and increase sales for retailers, the majority of which do not have the resources necessary to conduct such marketing programs independently.

We offer multiple, monthly, regional specific, consumer circular programs featuring the logo and address of the participating retailer imprinted on a circular advertising products, which are sold by the retailer to its customers. The four-color circulars are designed by our in-house marketing department utilizing modern digital photography and contain detailed product descriptions and pricing information. We also offer retailers the ability to customize our standard circulars—including item selection, retail price points, and exclusive editorial content—through a sophisticated internet-based application. Additionally, each circular generally includes detailed information on selected suppliers, recipes, and product features. The monthly circular programs are structured to pass through to the retailer the benefit of our negotiated discounts and advertising allowances. The program also provides retailers with posters, window banners and shelf tags to coincide with each month’s promotions.

We have increased the number of national marketing programs that we offer in order to maximize our national leverage and utilize our internal marketing resources. Our supplier focusedsupplier-focused Most Valued Partner program helps build incremental, mutually profitable sales for vendors and us, while fostering a sense of

partnership. New this year is a data richWe also provide an information-sharing program that helps our suppliers understand their business better, in order to support generatinggenerate mutually beneficial incremental sales in an efficient manner. We also have introducedoffer a truck advertising program that allows our suppliers to purchase ad space on the sides of our hundreds of trailers nationally, tremendously increasingwhich we believe increases their potential consumer ad impressions.

Other retailer initiative programs, such as a coupon booklet and separate supplement product themedand personal care product-themed sales and educational brochurebrochures we offer to independent retailers, allow us to explore new marketing avenues.

We keep current with the latest trends in the industry. Periodically, we conduct focus group sessions with certain key retailers and suppliers in order to ascertain their needs and allow us to better service them. We also:

·       offer in-store signage and promotional materials, including shopping bags and end-cap displays;

·provide assistance with planning and setting up product displays;

·       provide shelf tags for products;

8

occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. We have elected to perform our annual tests for indications of goodwill impairment during the fourth quarter of each year. Impairment losses are determined based upon the excess of carrying amounts over discounted expected future cash flows of the underlying business. The assessment of the recoverability of long-lived assets will be impacted if estimated future cash flows are not achieved. For reporting units that indicated potential impairment, we determined the implied fair value of that reporting unit using a discounted cash flow analysis and compared such values to the respective reporting units’ carrying amounts. As of July 29, 2006,28, 2007, our annual assessment of each of our reporting units indicated that no impairment of goodwill existed. Total goodwill as of July 28, 2007 and July 29, 2006 was $79.9 million and July 31, 2005 was $78.0 million, and $73.8 million, respectively.

Results of Operations

The following table presents, for the periods indicated, certain income and expense items expressed as a percentage of net sales:

Net Income

Net income increased $6.9 million to $50.2 million, or $1.17 per diluted share for the year ended July 28, 2007, compared to $43.3 million, or $1.02 per diluted share, for the year ended July 29, 2006. We expect earnings per diluted share in the range of $1.40 to $1.45 for fiscal 2008.

Year ended July 29, 2006 compared to Year ended July 31, 2005

Net Sales

Our net sales increased approximately 18.2%, or $374.0 million, to $2.43 billion for the year ended July 29, 2006 from $2.06 billion for the year ended July 31, 2005. This increase was primarily due to organic growth in our wholesale distribution segment, excluding acquisitions, of 17.4%. Our organic growth iswas due to the continued growth of the natural products industry in general, increased market share throughas a result of our focus on service and added value services, and the opening of new, and expansion of existing, distribution centers, which allowsallowed us to carry a broader selection of products. In addition to our organic growth, we also benefited from the inclusion of sales related to our acquisitions of Roots & Fruits in July 2005 and Select Nutrition in December 2004.

In the year ended July 29, 2006, Whole Foods Market comprised approximately 26% of net sales and Wild Oats Markets comprised approximately 10% of net sales. In the year ended July 31, 2005, Whole Foods Market comprised approximately 26 % of net sales and Wild Oats Markets comprised approximately 11% of net sales.

The following table lists the percentage of sales by customer type for the yearyears ended July 29, 2006 and July 31, 2005:

For the year ended July 31, 2005, we experienced growth in all customer channels with the most significant growth in the supernatural chains customer channel, which consists of sales to Whole Foods Market and Wild Oats Markets.

Whole Foods Market accounted for approximately 26% of our net sales during the years ended July 31, 2005 and 2004. In January 2004, we entered into a five-year distribution agreement as the primary distributor for Wild Oats Markets. For the year ended July 31, 2005, Wild Oats Markets accounted for approximately 11% of our net sales.

The following table lists the percentage of sales by customer channel for the fiscal years ended July 31, 2005 and 2004:

The shift to supernatural chains sales from independently owned natural products retailers in fiscal 2005 was the result of a full year of sales to Wild Oats Markets following the implementation of the primary distribution agreement in the third quarter of fiscal 2004.

Gross Profit

Our gross profit increased approximately 19.5%, or $64.6 million, to $395.0 million for the year ended July 31, 2005 from $330.5 million for the year ended July 31, 2004. Our gross profit as a percentage of net sales was 19.2% and 19.8% for the years ended July 31, 2005 and 2004, respectively. This decrease in gross profit as a percentage of net sales was primarily the result of the change in our sales channel mix to supernatural chains, as we implemented our primary distribution agreement with Wild Oats Markets during the third quarter of fiscal 2004. In addition, we initiated an aggressive product rationalization program in the second quarter of fiscal 2005 which continued through the fiscal year.

Operating Expenses

Our total operating expenses, excluding special items, increased approximately 19.0%, or $51.3 million, to $321.7 million for the year ended July 31, 2005 from $270.4 million for the year ended July 31, 2004. Our total operating expenses, including special items, increased approximately 18.6%, or $50.5 million, to $322.5 million for the year ended July 31, 2005 from $272.0 million for the year ended July 31, 2004. Special items are discussed below under “Special Items.”  The increase in total operating expenses for the year ended July 31, 2005 was due to the increase in our infrastructure to support our continued sales growth, an increase in fuel costs as a percentage of net sales of 20 basis points and the inclusion of operating expenses related to Select Nutrition that were not included in the year ended July 31, 2004.

As a percentage of net sales, operating expenses, excluding special items, decreased to 15.6% for the year ended July 31, 2005 from 16.2% for the year ended July 31, 2004. As a percentage of net sales, operating expenses, including special items, decreased from 16.3% for the year ended July 31, 2004 to 15.7% for the year ended July 31, 2005. The decrease in total operating expenses as a percentage of net sales was primarily attributable to a decrease in salaries and wages as a percentage of net sales due to improved operating efficiencies and sales growth. The improved operating efficiencies were a result of our recent facility expansions and recent integration of management information systems following our fiscal

2003 acquisition of Blooming Prairie Cooperative, a distributor of natural foods and related products. The decrease in total operating expenses as a percentage of net sales was partially offset by higher fuel costs and the inclusion of more than seven months of operating expenses related to Select Nutrition that were not included in the year ended July 31, 2004.

Total operating expenses for the year ended July 31, 2005 included a special item of $0.5 million for certain non-recurring labor and other costs associated with the discontinuance of the use of our Mounds View, Minnesota facility for broadline distribution, the closing of our Hawaii facility and $0.3 million in costs related to the opening of the Greenwood, Indiana facility. Total operating expenses for the year ended July 31, 2004 included a special item of $1.6 million in start-up and transition costs for certain equipment rental and labor costs incurred in connection with the implementation of our primary distribution agreement with Wild Oats Markets.

Operating Income

Operating income, excluding the special items discussed below under “Special Items,” increased approximately 22.1%, or $13.3 million, to $73.3 million for the year ended July 31, 2005 from $60.1 million for the year ended July 31, 2004. As a percentage of net sales, operating income, excluding special items, was 3.6% for the years ended July 31, 2005 and 2004. Excluding special items, the impact of increased fuel costs, the operating loss from Select Nutrition, and the costs incurred to comply with Sarbanes-Oxley, our operating margin would have been approximately 3.9%. Operating income, including special items, increased approximately 24.0%, or $14.0 million, to $72.5 million, or 3.5% of sales, for the year ended July 31, 2005 from $58.5 million, or 3.5% of sales, for the year ended July 31, 2004.

Other Expense (Income)

Other expense (income) decreased $0.6 million to $5.5 million for the year ended July 31, 2005 from $6.0 million for the year ended July 31, 2004. Interest expense for the year ended July 31, 2005 decreased to $6.6 million from $7.3 million in the year ended July 31, 2004. The decrease in interest expense was due to a combination of the novation of two of our interest rate swap agreements in December 2003, as further discussed below under “Special Items,” and a reduction in the interest rates on our borrowings under the credit facility, both of which served to lower our effective interest rate. Other expense (income) included a special income item of $0.6 million related to the early termination of an interest rate swap agreement.

Provision for Income Taxes

Our effective income tax rate was 38.0% and 39.0% for the years ended July 31, 2005 and 2004, respectively. The effective rates were higher than the federal statutory rate primarily due to state and local income taxes.

Net Income

Net income, excluding special items, increased approximately 28.3%, or $9.2 million, to $41.7 million, or $1.00 per diluted share, for the year ended July 31, 2005, compared to $32.5 million, or $0.79 per diluted share, for the year ended July 31, 2004. Net income, including special items, increased approximately 30.0%, or $9.6 million, to $41.6 million, or $1.00 per diluted share, for the year ended July 31, 2005 compared to $32.0 million, or $0.78 per diluted share, for the year ended July 31, 2004.

Special Items

Special items for fiscal 2005 included: (i) certain costs associated with the discontinuance of the use of our Mounds View, Minnesota facility for broadline distribution and closing the Hawaii facility, (ii) certain costs associated with opening the new Greenwood, Indiana facility, and (iii) other income related to the

early termination of the interest rate swap agreement on July 29, 2005, which was originally entered into in May 2003. Special items for the fiscal year ended July 31, 2004 included: (i) start-up and transition costs of the Wild Oats Markets primary distribution agreement consisting of certain equipment rental and labor costs and (ii) non-cash income from the change in fair value on interest rate swap agreements which were caused by favorable changes in interest rate yield curves. In December 2003, we assigned and transferred all of our obligations of our two “ineffective” interest rate swaps to a third party. As a result of this novation, these “ineffective” swaps will no longer be included as a special item for future fiscal periods. These “ineffective” swaps were included as a special item through the second quarter of fiscal 2004.

We entered into interest rate swap agreements in October 1998, August 2001 and May 2003. The October 1998 and August 2001 agreements were “ineffective” hedges as a result of the options held by the counter parties that could extend the original term of the interest rate swap agreements. Applicable accounting treatment required that we record the changes in fair value of the October 1998 and August 2001 agreements in our consolidated statement of income, rather than within “accumulated other comprehensive income” in our statement of stockholders’ equity. The changes in fair value are dependent upon the forward looking yield curves for each swap. The May 2003 agreement was an “effective” hedge and therefore did not require this treatment.

We believe that our October 1998 and August 2001 agreements were special items that are excludable as non-recurring items. First, we only intend to enter into “effective” hedges going forward. This stated intention began with the May 2003 agreement. Second, we believe that the October 1998 and August 2001 agreements may distort and confuse investors if the change in fair value cannot be treated as a special item because their inclusion directly impacts our reported earnings per share. A change in fair value, whether positive or negative, can significantly increase or decrease our reported earnings per share. For example, we recorded a positive change in fair value for the second quarter of fiscal 2004 that increased our diluted earnings per share by $0.01, and in the first quarter of fiscal 2003, we recorded a negative change in fair value that decreased our diluted earnings per share by $0.03. If we were prohibited from excluding this item as a special item, it would artificially inflate our reported earnings per share and thereby mislead investors as to our results of operations and our financial condition.

We believe that the start-up and transition costs of the Wild Oats Markets primary distribution agreement were special items, as we expected to generate net sales that represented approximately 9% of our net sales for the fiscal year ended July 31, 2004. As a result, we needed to hire and train additional employees and rent extra equipment beyond existing capacity for training purposes in order to be prepared to assume the role of primary distributor on the dates specified in the agreement. We believe these costs are non-recurring in nature and comply with the restrictions in Item 10(e)(1)(ii)(B) of Regulation S-K regarding adjusting non-GAAP measures for the following reasons:

·       We had not incurred a similar charge relating to a new primary distribution arrangement in the prior two fiscal years.

·       We had previously incurred charges relating to the loss of our primary distribution relationship with Wild Oats Markets, but, given the five year term of the distribution agreement between Wild Oats Markets and the other distributor, we did not foresee that charges relating to this relationship would be incurred for at least five years, if ever.

·       Our new agreement with Wild Oats Markets entered into in January 2004 is for a five year period, and we did not foresee any additional similar charges during that period.

·       With the signing of this agreement, we currently serve as the primary distributor for two of the largest natural and organic retail markets, Whole Foods Market and Wild Oats Markets. We are not aware of any other existing natural and organic retail customers that could individually have an impact in excess of 5% on our revenues. As a result, it would be unlikely that we would incur

substantial additional costs to transition to the role of primary distributor for any other customer, unless the customer’s business was concentrated within a limited geographical area.

The following tables detail the amounts and effect of these special items and the reconciliation of net income, excluding special items (Non-GAAP basis), to net income, including special items (GAAP basis) for the years ended July 31, 2005 and 2004:

All non-GAAP numbers have been adjusted to exclude special items. A reconciliation of specific adjustments to GAAP results for the year ended July 31, 2005 and the same period last year is included in the financial tables shown above. A description of our use of non-GAAP information is provided under “Use of Non-GAAP Results” below.

Liquidity and Capital Resources

We finance operations and growth primarily with cash flows from operations, borrowings under our credit facility, operating leases, trade payables and bank indebtednessindebtedness. From time to time, depending on our capital needs and the sale ofmarket conditions, we may also sell equity and debt securities.securities to finance our operations and growth.

On April 30, 2004, we entered into an amended and restated four-year $250 million revolving credit facility with a bank group that was led by Bank of America Business Capital (formerly Fleet Capital Corporation) as the administrative agent. OurThe credit facility replaced an existing $150 million revolving credit facility. The terms and conditions of our amended and restated credit facility provides for improved terms and conditions that provide us with more financial and operational flexibility, reduced costs and increased liquidity. The credit facility replaced an existing $150 million revolvingliquidity than did our prior credit facility. We amended this facility effective as of January 1, 2006, reducing the rate at which interest accrues on LIBOR

borrowings from one-month LIBOR plus 0.90% to one-month LIBOR plus 0.75%. Our amended and restated credit facility, which matures on March 31, 2008, supports our working capital requirements in the ordinary course of business and provides capital to grow our business organically or through acquisitions. We are currently investigating options for renewing or renegotiating this credit facility in fiscal 2008. As of July 29, 2006,28, 2007, our borrowing base, based on accounts receivable and inventory levels, was $250.0$250 million, with remaining availability of $113.9$117.9 million.

In April 2003, we executed a term loan agreement in the principal amount of $30 million secured by the real property that was released from the lien under our $150 million revolving credit facility in accordance with an amendment to the loan and security agreement related to the $150 million revolving creditthat facility. The $30 million term loan is repayable over seven years based on a fifteen-year amortization schedule. Interest on the term loan accrued at one-month LIBOR plus 1.50%. In December 2003, we amended this term loan agreement by increasing the principal amount from $30 million to $40 million under the existing terms and conditions. On July 29, 2005, we entered into an amended term loan agreement which further increased the principal amount of this term loan from $40 million to up to $75 million and decreased the rate at which interest accrues to one-month LIBOR plus 1.00%. As of July 29, 2006, $6128, 2007, $66.3 million was outstanding under the term loan agreement.

We believe that our capital requirements for fiscal 20072008 will be between $40$50 and $45$55 million. We will finance these requirements with cash generated from operations and the use of our existing credit facilities. TheseOur planned capital projects will provide both expanded facilities and technology that we believe will provide us with the capacity to continue to support the growth and expansion of our customers.business. We believe that our future capital requirements will be higher thansimilar to our anticipated fiscal 20072008 requirements, as a percentage of net sales, as we plan to continue to invest in our growth by upgrading our infrastructure and expanding our facilities. Future investments in acquisitions will be financed through either equity or long-term debt negotiated at the time of the potential acquisition.

Net cash provided by operations was $35.5 million for the year ended July 28, 2007, an increase of $10.3 million from $25.2 million for the year ended July 29, 2006, an increase of $14.2 million from $11.0 million in the year ended July 31, 2005.2006. The increase was primarily due to an increase in net income, depreciationnon-cash expenses related to deferred income taxes and amortizationlosses on disposals of property and share-based compensation. This increase wasequipment, increases in accounts payable and decreases in accounts receivable. These increases in net cash provided by operations were partially offset by an increase in accounts receivable dueinventory levels in order to the increase insupport increased sales with wider product assortment and availability and to build up inventory to support our Sarasota, Florida facility, and an increase in inventory levels related to the opening of the Greenwood, Indianaprepaid expenses and the Rocklin, California facilities in August 2005 and October 2005, respectively. This was also offset by certain tax benefits, which totaled $8.1 million for the year ended July 31, 2005, that have been classified as financing activities in fiscal 2006.other assets. Days in inventory was 49 days at July 28, 2007 compared to 47 days at July 29, 2006 compared2006. Days sales outstanding improved to 4822 days at July 31, 2005. Days sales outstanding improved28, 2007, compared to 23 days at July 29, 2006 compared to 24 days at July 31, 2005.2006. Working capital increased by $63.5$33.6 million, or 53.2%18.4%, to $216.5 million at July 28, 2007 compared to working capital of $182.9 million at July 29, 2006 compared to working capital of $119.4 million at July 31, 2005.2006.

Net cash used in investing activities decreased $60.0increased $29.3 million to $51.7 million for the year ended July 28, 2007, compared to $22.4 million for the year ended July 29, 2006 compared to $82.3 million for the same period last year and was primarily due to the acquisitionincreased purchases of Select Nutrition in December 2004, purchaseacquired businesses of the Rocklin, California facility$6.0 million and increased capital expenditures of $27.5 million, partially offset by increased proceeds of $5.2 million recorded in the third quarter of fiscal 2005 and expendituresyear ended July 28, 2007 related to the openingsale of one of our Auburn, California facilities. Increased capital expenditures were primarily to fund the Greenwood, Indianaconstruction of our new facility in Ridgefield, Washington.

Net cash provided by financing activities was $13.1 million for the year ended July 28, 2007, primarily due to $10.0 million in proceeds received from the increase in borrowings under our term loan, the increase in our bank overdraft and proceeds from, and the tax benefit due to, the exercise of stock options; partially offset by capital expenditures related to opening the Rocklin, California facility in October 2005.

repayments of long-term debt and notes payable. Net cash provided by financing activities was $4.6 million for the year ended July 29, 2006, primarily due to $24.0 million in proceeds from, and the tax benefit due to, the exercise of stock options,options; partially offset by purchases of treasury stock, a decrease in our bank overdraft, repayments on our credit facility and long-term debt. Net cash provided by financing activities was $70.3 million for the year ended July 31, 2005, due primarily to a $30.3 million increase in our term loan and $10.9 million increase in net borrowings under our revolving credit facility which were primarily to finance the purchase of the Rocklin, California facility, the expenditures related to opening the Rocklin, California and Greenwood, Indiana facilities, and the acquisitions of Select Nutrition and Roots & Fruits in the fiscal year. The remaining increase was primarily due to a $27.3 million increase in our bank overdraft. This was partially offset by repayments on our long-term debt and capital lease obligations.

On December 1, 2004, our Board of Directors authorized the repurchase of up to $50 million of common stock from time to time in the open market or in privately negotiated transactions. As part of the stock repurchase program, we purchased 228,800 shares of our common stock for our treasury during the year ended July 29, 2006 at an aggregate cost of approximately $6.1 million. All shares were purchased at prevailing market prices. No such purchases were made during the year ended July 28, 2007. We may continue or, from time to time, suspend repurchases of shares under our stock repurchase program, depending on prevailing market conditions, alternate uses of capital and other factors. Whether and when to initiate and/or complete any purchase of common stock and the amount of common stock purchased will be determined in our complete discretion.

In August 2005, we entered into an interest rate swap agreement effective July 29, 2005. This agreement provides for us to pay interest for a seven-year period at a fixed rate of 4.70% on a notional principal amount of $50 million while receiving interest for the same period at theone-month LIBOR rate on the same notional principal amount. The swap has been entered into as a hedge against LIBOR interest rate movements on current variable rate indebtedness totaling $65 million at LIBOR plus 1.00%, thereby fixing our effective rate on the notional amount at 5.70%. LIBOR was 5.40%5.32% as of July 29, 2006.28, 2007. The swap agreement qualifies as an “effective” hedge under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”).

In May 2003, we entered into an additional interest rate swap agreement. The agreement provided for us to pay interest for a seven-year period at a fixed rate of 3.68% on a notional principal amount of $30 million while receiving interest for the same period at theone-month LIBOR rate on the same notional principal amount. The swap hashad been entered into as a hedge against LIBOR interest rate movements on current variable rate indebtedness totaling $30 million at LIBOR plus 1.50%, thereby fixing the effective rate on the notional amount at 5.18%. The swap agreement qualified as an “effective” hedge under SFAS 133. On July 29, 2005, this agreement was

terminated and income of $0.6 million was recorded in other expense (income) in our statement of income for the year ended July 31, 2005.

In October 1998 and August 2001, we entered into interest rate swap agreements which were later determined to be “ineffective.” This was due to the inclusion of an option for the counterparty to extend the term of the agreements, which prohibited accounting for the swap as an effective hedge under SFAS 133. On December 29, 2003, we assigned and transferred all of our obligations of our two “ineffective” interest rate swaps to a third party at a cost of $5.4 million plus accrued interest, which was recorded in other expense (income) in our consolidated statement of income for the year ended July 31, 2004.

We enteredenter into commodity swap agreements to reduce price risk associated with anticipated purchases of diesel fuel. The outstanding commodity swap agreements hedgehedged a portion of our expected fuel usage for the periods set forth in the agreements. We monitor the commodity (NYMEX #2 Heating oil) used in our swap agreements to determine that the correlation between the commodity and diesel fuel is deemed to be “highly effective.”  At July 29, 2006, we had two outstandingOur commodity swap agreements which maturematured on October 31, 2006 and June 30, 2007. At July 28, 2007, we had no outstanding commodity swap agreements.

Commitments and Contingencies