UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT

pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

FOR THE QUARTERLY PERIOD ENDED DECEMBERMARCH 31, 20032004

000-15701

(Commission file number)

NATURAL ALTERNATIVES INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

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

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

As of February 6,May 17, 2004, 5,828,2925,889,992 shares of NAI’s common stock were outstanding, net of 272,40061,000 treasury shares.

TABLE OF CONTENTS

(i)

SPECIAL NOTE—NOTE – FORWARD-LOOKING STATEMENTS

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

The forward-looking statements in this report speak only as of the date of this report. Forward-looking statements are subject to certain events, risks, and uncertainties that may be outside of our control. When considering forward-looking statements, you should carefully review the risks, uncertainties and other cautionary statements in this report as they identify certain important factors that could cause actual results to differ materially from those expressed in or implied by the forward-looking statements. These factors include, among others, the risks described under Items 2 and 3 and elsewhere in this report, as well as in other reports and documents we file with the SEC.

Unless the context requires otherwise, all references in this report to the “Company,” “NAI,” “we,” “our,” and “us” refer to Natural Alternatives International, Inc. and, as applicable, Natural Alternatives International Europe S.A. (NAIE), its wholly-owned subsidiary.

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PART I—I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

NATURAL ALTERNATIVES INTERNATIONAL, INC.

Condensed Consolidated Balance Sheets

(In thousands, except share and per share amounts)

See accompanying notes to condensed consolidated financial statements.

2

NATURAL ALTERNATIVES INTERNATIONAL, INC.

Condensed Consolidated Statements Of Operations And Comprehensive Income

(In thousands, except share and per share amounts)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

3

NATURAL ALTERNATIVES INTERNATIONAL, INC.

Condensed Consolidated Statements Of Cash Flows

(In thousands)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

A. Basis of Presentation and Significant Accounting Policies

Basis of Presentation

The accompanying interim, unaudited, condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and applicable rules and regulations. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. In management’s opinion, all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows have been included and are of a normal, recurring nature. The results of operations for the sixnine months ended DecemberMarch 31, 20032004 are not necessarily indicative of the operating results for the full fiscal year or any future periods.

You should read the financial statements and these notes, which are an integral part of the financial statements, together with our audited financial statements included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2003 (“2003 Annual Report”). The accounting policies used to prepare the financial statements included in this report are the same as those described in the notes to the consolidated financial statements in our 2003 Annual Report unless otherwise noted below.

We have reclassified certain prior period amounts to conform to the current year presentation.

Stock-BasedStock- Based Compensation

We have stock option plans under which we have granted non-qualified and incentive stock options to employees and non-employee directors. We also have an employee stock purchase plan. We account for stock-based awards to employees in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations. We have adopted the disclosure-only alternative of SFAS 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS 148, “Accounting for Stock-Based Compensation—TransitionCompensation –Transition and Disclosure” (“SFAS 148”).

Pro forma information regarding net income and net income per common share is required and has been determined as if we had accounted for our stock-based awards under the fair value method, instead of the guidelines provided by APB 25. The fair value of the awards was estimated at the date of grant using the Black-Scholes option valuation model. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions, including expected life and stock price volatility. Because our options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect fair value estimates, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the fair value of our options.

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For purposes of pro forma disclosures, we have amortized the estimated fair value of the options to expense over the options’ vesting periods. Our pro forma information under SFAS 123 and SFAS 148 is as follows:

Net Income per Common Share

We compute net income per common share in accordance with SFAS 128, “Earnings Per Share.” This statement requires the presentation of basic income per common share, using the weighted average number of shares outstanding during the period, and diluted income per common share, using the additional dilutive effect of all dilutive securities. The dilutive impact of stock options account for the additional weighted average shares of common stock outstanding for our diluted net income per common share computation. We calculated basic and diluted net income per common share as follows:

Shares related to stock options of 20,00055,000 for the three months ended DecemberMarch 31, 2003,2004, and 95,00082,000 for the sixnine months ended DecemberMarch 31, 2003,2004, were excluded from the calculation of diluted net income per share, as the effect of their inclusion would be anti-dilutive.

Shares related to stock options of 105,00065,000 for the three months ended DecemberMarch 31, 2002,2003, and 117,500100,000 for the sixnine months ended DecemberMarch 31, 2002,2003, were excluded from the calculation of diluted net income per share, as the effect of their inclusion would be anti-dilutive.

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B. Inventories

Inventories, (net)net at DecemberMarch 31, 2003,2004, consisted of (in thousands):

C. Property and Equipment

The following is a summary of property and equipment at DecemberMarch 31, 20032004 (in thousands):

D. Debt

We haveAs of March 31, 2004, we had a $6.5 million credit facility that expireswas due to expire on October 24, 2004. The facility iswas comprised of a $4.0 million working capital line of credit and a $2.5 million term loan and iswas secured by all of our assets. The working capital line of credit iswas subject to eligibility requirements for current accounts receivable and inventory balances. As of DecemberMarch 31, 2003,2004, we had $85,000$900,000 outstanding under the line of credit and a $1.8 million outstanding term loan balance. As of March 31, 2004, we had approximately $3.9$2.3 million available under the line of credit. The interest rate on the line of credit and term loan iswas prime plus 0.5%. This entire credit facility was refinanced on May 11, 2004.

AsOn May 11, 2004, we entered into a new $12.0 million credit facility with a bank. The facility is comprised of December 31, 2003,an $8.0 million working capital line of credit and $4.0 million in term loans secured by all of our assets. The working capital line of credit has a 2.5-year term, interest rate of LIBOR plus 1.75% and is subject to eligibility requirements for current accounts receivable and inventory balances. The term loans consist of a $700,000 ten year term loan with a twenty year amortization, secured by our building at an interest rate of LIBOR plus 2.25%; a $1.8 million four year term loan to refinance our outstanding term loan under the outstanding amountprevious credit facility, secured by equipment, at an interest rate of LIBOR plus 2.10%; and a $1.5 million five year term loan, secured by equipment, at an interest rate of LIBOR plus 2.10%. Monthly payments on the term loan was approximately $2.0 million, of which $1.5 million is classified as long-term debt as we intend and, based on our receipt of proposals to refinance our credit facility from two lenders, believe weloans will be able to refinance our existing credit facility for a term greater than one year on or before its expiration.approximately $62,000 plus interest.

On May 2, 1996, we entered into a term loan agreement for $1.1 million, secured by aour building, at an annual interest rate of 8.25%. The loan is due in June 2011 and provides for principal and interest payable in monthly installments of $10,800. The outstanding amount was $714,000$696,000 at DecemberMarch 31, 2003.2004.

The composite interest rate on all outstanding debt was 5.90%6.00% at DecemberMarch 31, 2003,2004, and 6.84%6.74% at DecemberMarch 31, 2002.

72003.

E. Commitments

We lease part of our manufacturing facilities under non-cancelable operating leases.

We lease approximately 74,000 square feet of our manufacturing facilities in Vista, California, from an unaffiliated third party. We have two non-cancelable operating leases, one for approximately 54,000 square feet at 1215 Park Center Drive that we use as a warehousing and blending facility and the other for approximately 20,000 square feet at 1211C Park Center Drive that we use for packaging. Both leases expire in June 2008. However, on October 27, 2003, we entered into a new lease for both facilities, as well as for an additional 46,000 square feet contiguous to our existing space at the 1215 Park Center Drive location. We intend to use the additional space for tableting and encapsulation, which are currently located at our San Marcos, California facility. The new lease begins in April 2004 and expires in March 2014.

As required under the terms of the new lease, on January 6, 2004, we provided a letter of credit in the amount of $330,000 to the landlord as collateral. The amount of the letter of credit will automatically be reduced 33.3% each year. The amount of the outstanding letter of credit reduced the availability under our line of credit.

On January 22, 2004, we signed a letter of intent to execute anexecuted our option under the new lease to expand the premises to include an additional 42,000 square feet contiguous to our existing space at 1211C Park Center Drive, for a total of 162,000 square feet of leased space in Vista, California. As we do not require the additional 42,000 square feet immediately, on February 25, 2004, we entered into a sublease agreement with the current tenant. The sublease is for a term of one year beginning April 1, 2004, and provides for monthly rental income equal to our rental expense for the space. We intendplan on using the space to initially subleaseexpand our packaging operations in fiscal 2006.

As required under the terms of the new lease and option to expand the premises, on May 11, 2004, we provided a letter of credit in the amount of $440,000 to the landlord. The amount of the letter of credit will be reduced by approximately 33% each year. The letter of credit reduces the availability under our line of credit by $440,000.

On April 5, 2004, we entered into an agreement with a general contractor to build out the tenant improvements for the additional 46,000 square feet contiguous to our existing space toat the current1215 Park Center Drive location that was leased on October 27, 2003. The agreement is for a term of approximately four months, commencing after building permits are received. We anticipate receiving the permits in June 2004. The agreement includes an approved budget of $3.2 million. Our new lease agreement provides a $960,000 tenant on a monthly basis and to eventually useimprovement allowance that will be funded by our landlord. The remaining $2.2 million will be disbursed over the space for additional packaging operationsterm of the agreement.

Minimum rental commitments as of December 31, 2003, (exclusive of property tax, insurance and maintenance) as of March 31, 2004 for the remainder of fiscal 2004 and the following four fiscal years, under all non-cancelable operating leases, (with initial or remaining lease terms in excess of one year) are set forth below (dollars in(in thousands):

F. Defined Benefit Pension Plan

We sponsor a defined benefit pension plan, which provides retirement benefits to employees based generally on years of service and compensation during the last five years before retirement. Effective June 21, 1999, we adopted an amendment to freeze benefit accruals to the participants. At March 31, 2004, the amortized portion of the unfunded accrued liability for prior service cost, using a 30-year funding period, was approximately $200,000. This amount was accrued. Our policy is to fund the net pension cost accrued. However, we will not contribute an amount less than the minimum funding requirements of the Employee Retirement Income Security Act of 1974 or more than the maximum tax-deductible amount.

The components included in the net periodic benefit cost for the periods indicated are as follows (in thousands):

G. Economic Dependency

We had substantial net sales to twocertain customers during the periods shown in the following table. The loss of any of these customers could have a material adverse impact on our net sales and earnings. Sales by customer, representing 10% or more of the respective period’s total sales, were (dollars in(in thousands):

We buy certain products from a limited number of raw material suppliers. The loss of any of these suppliers could have a material adverse impact on our net sales and earnings.

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Raw material purchases from any one supplier representing 10% or more of the respective period’s total raw material purchases are shown below (dollars in(in thousands):

G.H. Segment Information

Our segment information by geographic area was (dollars in(in thousands):

H.I. Contingencies

We were a plaintiff in an anti-trust lawsuit against several manufacturers of vitamins and other raw materials that we purchased. Other similarly situated companies filed a number of similar lawsuits against some or all of the same manufacturers. Our lawsuit was consolidated with some of the others and captionedIn re: Vitamin Antitrust Litigation. As of June 30, 2003 all of the Company’s claims under theVitamin Antitrust Litigation were settled. Settlement payments received by the Company of $225,000 are included in proceeds from vitamin antitrust litigation in the accompanying statements of operations for the sixnine months ended DecemberMarch 31, 2002.2003.

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

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis is intended to help you understand our financial condition and results of operations for the sixthree and nine months ended DecemberMarch 31, 2003.2004. You should read the following discussion and analysis together with our unaudited financial statements and the notes to the financial statements included under Item 1 in this report, as well as the information included in our 2003 Annual Report. Our future financial condition and results of operations will vary from our historical financial condition and results of operations as described below.

Executive Overview

The following Executive Overview does not address all of the matters covered in the other sections of this Item 2 or other items in this report or contain all of the information that may be important to our stockholders or the investing public. This Executive Overview should be read in conjunction with the other sections of this Item 2 and this report.

Our primary business activity is to provide private label contract manufacturing services to companies that market and distribute vitamins, minerals, herbs, and other nutritional supplements, as well as other health and personal care products, to consumers both within and outside the United States. Our private label contract manufacturing customers include companies that market nutritional supplements through direct sales marketing channels, direct response television and retail stores. Additionally, under our direct-to-consumer (“DTC”) marketing program, we develop, manufacture and market our own products. Under the DTC marketing program, we work with nationally recognized physicians and other personalities to develop brand name products that reflect their individual approaches to restoring, maintaining or improving health. DTC marketing program products are sold through a variety of distribution channels including television programs, print media, radio and the internet. We manufacture products in a variety of forms, including capsules, tablets, chewable wafers, and powders to accommodate a variety of consumer preferences.

We believe the lack of relevant and reliable consumer education about nutrition and nutritional supplementation combined with the duplication of brands and products in the retail sales channel creates a significant opportunity for the direct sales marketing channel. The direct sales marketing channel has proved, and we believe will continue to prove, to be a highly effective method for marketing high quality nutritional supplements as associates personally educate consumers on the benefits of science based nutritional supplements. We believe this education process can lead to premium product pricing and avoid competing with brands of inferior quality and lower pricing in the retail distribution channel. Our two largest customers operate in the direct sales marketing channel and, therefore; our growth has been fueled by the effectiveness of this marketing channel.

We believe the DTC marketing program can be an effective method for marketing our high quality nutritional supplements, as consumers are able to purchase science based nutritional supplements that are explained and recommended by a recognized physician. In March 2000, we launched Basic Nutrient Support^™, our first product developed in collaboration with Dr. Reginald B. Cherry, M.D. In fiscal 2001, we launched Dr. Cherry’s Pathway to Healing^™ product line. As of March 31, 2004, the product line had grown to include nineteen condition specific custom formulated products. The products are primarily marketed through a weekly television program. This brand has comprised 100% of our DTC net sales as of March 31, 2004. We believe the recent decline in net sales for this brand has been largely due to the reduced effectiveness of the television programming to attract new customers in our primary television market and reduced media spending in new television markets. We are currently investing in upgrading the content and style of the television programs in an effort to attract new customers. We anticipate introducing the upgraded television programs in the second quarter of fiscal 2005. There can be no assurance that our investment in the upgraded television programs will produce higher net sales for this brand.

In April 2003, we introduced our Jennifer O’Neill Signature Line^™ of nutritional supplements and skin care products. The products were marketed through print media and personal appearances. The marketing program did not produce favorable results and, therefore; was terminated in the third quarter of fiscal 2004.

In March 2004, we introduced our Chopra Center Essentials^™ product line. As of March 31, 2004, the product line included eight condition specific custom formulated products. The product line was initially marketed through print media and the transformativehealth.com website. We plan to implement a direct mail marketing strategy in the second quarter of fiscal 2005.

Establishing, building and maintaining brands in the DTC marketing program requires significant cash outlays for product development, initial inventory build, introducing the brand, testing alternative marketing channels, upgrading marketing programs and performing fulfillment activities. Our investments in building new brands for the DTC marketing channel can be of a higher risk than growing our private label contract manufacturing business. We believe, however, that established DTC brands have the long-term potential to improve our operating margins due to higher gross margins than those derived from products sold to private label contract manufacturing customers.

Overall, we believe there is an opportunity to enhance consumer confidence in the quality of our nutritional supplements and their adherence to label claims through the education provided by direct sales and DTC marketing programs. We believe our Good Manufacturing Practices (“GMP”) certified manufacturing operations, science based product formulation, clinical studies and regulatory expertise provide us with a sustainable competitive advantage by providing our customers with a high degree of confidence in our products.

Critical Accounting Policies and Estimates

The preparation of our financial statements requires that we make estimates and assumptions that affect the amounts reported in our financial statements and their accompanying notes. We have identified certain policies that we believe are important to the portrayal of our financial condition and results of operations. These policies require the application of significant judgment by our management. We base our estimates on our historical experience, industry standards, and various other assumptions that we believe are reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. An adverse effect on our financial condition, changes in financial condition, and results of operations could occur if circumstances change that alter the various assumptions or conditions used in such estimates or assumptions.

Revenue Recognition

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

Additionally, we record reductions to gross revenue for estimated returns of private label contract manufacturing products and DTC products. The estimated returns are based upon the trailing six months of private label contract manufacturing gross sales and our historical experience for both private label contract manufacturing and DTC product returns. However, the estimate for product returns does not reflect the impact of a large product return resulting from changes in regulatory requirements, product nonconformance or other factors as such events are not predictable nor is the related economic impact estimable.

Inventory Reserve

We operate primarily as a private label contract manufacturer that builds products following receipt of customer specific purchase orders. As a result, we have limited realization risk in finished goods and work-in-process inventories. Our critical accounting policiesinventory reserve primarily relates to realization risk for raw materials. Our estimate to reduce inventory to net realizable value is based upon expiration of the raw materials’ efficacy, foreseeable demand of raw materials, market conditions and specific factors that arise from time to time related to regulatory and other factors. The reserve level reflects our historical experience. If demand and/or market conditions are discussedless favorable than we estimate, additional inventory reserves may be required.

Accounting for Income Taxes

We estimate income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure, together with assessing temporary differences resulting from differing treatment of items, such as property and equipment depreciation, for tax and financial reporting purposes. Actual income taxes could vary from these estimates due to future changes in income tax law or results from final tax examination reviews. At March 31, 2004, we assessed the need for a valuation allowance on our deferred tax assets. A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based on the limited historical taxable income and the uncertainty about sufficient near term taxable income, we believe that this evidence creates sufficient uncertainty about the realizability of the net deferred tax assets. Therefore, a full valuation allowance was recorded at March 31, 2004.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts to reflect our estimate of current and past due receivable balances that could not be collected. The allowance for doubtful accounts is based upon the current month private label contract manufacturing gross sales and a review of specific accounts. We believe that the allowance for doubtful accounts is adequate to cover anticipated losses in the receivable balance under Item 7current conditions; however significant deterioration in the financial condition of our customers, resulting in an impairment of their ability to make payments, could materially change these expectations and additional allowance may be required.

Defined benefit pension plan

The plan obligation and related assets of the defined benefit retirement plan are presented in the Notes to Consolidated Financial Statements included in our 2003 Annual Report. TherePlan assets, which consist primarily of marketable equity and debt instruments, are valued based upon third party market quotations. Independent actuaries through the use of a number of assumptions determine plan obligation and annual pension expense. Key assumptions in measuring the plan obligation include the discount rate and estimated future return on plan assets. In determining the discount rate, the actuary utilizes an average long-term bond yield. Asset returns are based upon the historical returns of multiple asset classes to develop a risk free rate of return and risk premiums for each asset class. The overall rate for each asset class was developed by combining a long-term inflation component, the risk free rate of return and the associated risk premium. A weighted average rate is developed based on the overall rates and the plan’s asset allocation.

We have been no significant changesdiscussed the development and selection of these critical accounting policies with the Audit Committee of our Board of Directors and the Audit Committee has reviewed our disclosure relating to these policies during the six months ended December 31, 2003.policies.

Recent Developments

On January 22, 2004, in an effort to enhancewe executed the option under our long-term manufacturing capacity and improve efficiency of our operations, we signed a letter of intent to execute our optionoperating lease to expand the premises contiguous to our packaging operations. Theinclude an additional 42,000 square feet will initially be subleasedcontiguous to our existing space at 1211C Park Center Drive, for a total of 162,000 square feet of leased space in Vista, California. As we do not require the additional 42,000 square feet immediately, on February 25, 2004, we entered into a sublease agreement with the current tenanttenant. The sublease is for a term of one year beginning April 1, 2004, and provides for monthly rental income equal to our monthly rental expense for the space. We plan on a monthly basis. We intend to utilizeusing the space to expand our packaging operations in fiscal 2006.

On April 5, 2004, we entered into an agreement with a general contractor to build out the tenant improvements for additional packaging operations.46,000 square feet contiguous to our existing space at the 1215 Park Center Drive location that was leased on October 27, 2003. The agreement is for a term of approximately four months, commencing after building permits are received. The agreement includes an approved budget of $3.2 million. Our new lease agreement provides a $960,000 tenant improvement allowance that will be funded by our landlord. The remaining $2.2 million will be disbursed over the term of the agreement.

On May 11, 2004, we entered into a new $12.0 million credit facility with a bank. The facility is comprised of an $8.0 million working capital line of credit and $4.0 million in term loans and is secured by all of our assets. The working capital line of credit has a 2.5-year term, interest rate of LIBOR plus 1.75% and is subject to eligibility requirements for current accounts receivable and inventory balances. The term loans consist of a $700,000 ten year term loan with a twenty year amortization, secured by our building at an interest rate of LIBOR plus 2.25%; a $1.8 million four year term loan to refinance our outstanding term loan under the previous credit facility, secured by equipment, at an interest rate of LIBOR plus 2.10%; and a $1.5 million five year term loan, secured by equipment, at an interest rate of LIBOR plus 2.10%. Monthly payments on the term loans will be approximately $62,000 plus interest.

Additionally, we continue to evaluate expansion opportunities that could increase product lines, enhance our manufacturing capabilities or reduce risks associated with reliance on a limited numbervariety of customers.factors.

Results of Operations—Operations – Three Months Ended DecemberMarch 31, 20032004 vs. Three Months Ended DecemberMarch 31, 20022003

Net Sales

Total net sales for the quarter ended DecemberMarch 31, 20032004 increased $4.2$7.5 million, or 32%55% over the comparable quarter last year. The net sales growth resulted from a $4.1$7.7 million, or 39%68%, increase in private label contract manufacturing sales andoffset by a $49,000,($194,000), or 2%8%, increasedecrease in DTC net sales from our direct-to-consumer marketing program. sales.

The increase in private label contract manufacturing sales was due primarily to an increase of $2.5$4.8 million in net sales forto our two largest customers, due toincluding $1.4 million from new product salesproducts and an increase in volumes of$3.4 million from established products. Additionally, we had netthe increase in private label contract manufacturing sales of $1.8included $3.2 million of new products formulated for new private label contract manufacturing customers. Looking forward, we anticipate moderate growth in private label contract manufacturing sales in the fourth quarter of approximately 4% to 6% over the third quarter of fiscal 2004.

The decrease in DTC sales was partially offset bydue to a slightreduction in our media spending investment in new television markets for the Dr. Cherry Pathway to moderate declineHealing^™ brand, as the investment did not produce what we considered to be adequate results. Additionally, we experienced a reduction in net salesnew customer acquisitions from our direct-to-consumer marketing program.primary television market, while the average order value remained consistent. During the third quarter we identified opportunities to improve the content and style of the television programs. We anticipate introducing the upgraded television programs in the second quarter of fiscal 2005. Looking forward, we anticipate a further reduction in DTC sales over the near term.

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Gross Profit