SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 (Mark One) [X] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 2004 [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from to --------------- ---------------- Commission File No. 333-22997 Spectrum Organic Products, Inc. ---------------------------------------------- (Name of Registrant as specified in its Charter) California 94-3076294 ---------------------- -------------------- (State of incorporation) (I.R.S. Employer Identification Number) 5341 Old Redwood Highway, Suite 400 Petaluma, California 94954 -------------------------------------- (Address of principal executive offices) Registrant's telephone number: (707) 778-8900 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Without Par Value Common Stock -------------- (Title of Class) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or by amendment to this Form 10-K. [ ] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes[ ] No [X] As of March 4, 2005 there were 46,405,943 shares of the Registrant's common stock outstanding, and the aggregate market value, excluding shares held by affiliates, was $8,922,381 as quoted on the OTC Bulletin Board System. - -------------------------------------------------------------------------------- Page 1 PART I ITEM 1. BUSINESS - ---------------- Introduction Spectrum Organic Products, Inc., a California corporation ("Spectrum", the "Registrant" or the "Company") competes primarily in three business segments: natural and organic foods under the Spectrum Naturals(R) brand, essential fatty acid nutritional supplements under the Spectrum Essentials(R) brand, and industrial ingredients for use by other manufacturers sold under the Spectrum Ingredients name. The vast majority of the Company's products are oil-based and the Company has positioned itself as "The Good Fats Company" by differentiating its products from mass market alternatives in the following ways: 1. All raw ingredients used in Spectrum products, from olives to nut seeds to soybeans are certified to be free of genetically modified organisms ("non-GMO"). 2. Oils are extracted from the raw ingredients via expeller (mechanical) pressing. No harsh chemicals or solvents are ever used. Expeller pressing retains the natural flavor and nutrients and minimizes the damage from the effects of heat, light and oxygen. 3. Spectrum oils are only refined when a more neutral-tasting oil is desired or for oils that need to perform well in high heat culinary applications. Spectrum organic oils are gently refined at the lowest temperatures possible using natural agents like citric acid. 4. Spectrum oils never undergo post-refining. Mass market oils often undergo hydrogenation to prolong shelf lives and to create solid fats from oils that would naturally be liquids at ambient temperatures. Within the natural and organic foods segment, the Company's products include olive oils and other culinary oils, salad dressings, condiments and butter-substitutes such as Spectrum Organic Margarine(R) and Spectrum Spread(R). All of the Company's culinary products feature healthy fats, contain no hydrogenated or trans fats and are offered in a variety of sizes and flavors in both organic and conventional, non-GMO offerings. Within the nutritional supplement segment, the Company's products include organic flax oils, evening primrose oil, borage oil, Norwegian fish oil and other essential fatty acids in both liquid and capsule forms. The Spectrum Essentials(R) products are cold-pressed, nutritionally rich sources of Omega-3 and Omega-6 essential fatty acids and are also offered in a variety of sizes and styles. The Spectrum Ingredients(R) (formerly known as Spectrum Commodities, Inc.) segment includes organic and conventional non-GMO culinary oils, organic vinegar, condiments and nutritional oils offered to other manufacturers for use in their products. In addition, they bring incremental purchasing power to the Company resulting in higher margins for the consumer branded products. This Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially. Business Combination and Subsequent Divestitures The Company was formed on October 6, 1999 by the four-way reverse merger of three private companies: Spectrum Naturals, Inc. ("SNI"), its affiliate Spectrum Commodities, Inc. ("SCI") and Organic Ingredients, Inc. ("OI"), into the public company Organic Food Products, Inc. ("OFPI"). OFPI was the Registrant prior to the merger, but since a controlling interest in the Company is held by former SNI stockholders, the merger was accounted for as a reverse acquisition, with SNI and SCI as the acquirer and OI and OFPI as acquirees. - -------------------------------------------------------------------------------- Page 2 On June 11, 2001 the Company sold the OFPI tomato-based product lines to Acirca, Inc., an unrelated third party. On April 25, 2002 the Company sold the OI industrial ingredient product lines in fruits, vegetables, concentrates and purees to Acirca. Accordingly, operating results for 2002 include the operating results associated with the OI disposed product lines from January 1 until the date of sale. The two dispositions have significantly strengthened the Company from a liquidity and working capital standpoint. Additionally, the Company can now focus its resources on its core business in healthy oils, butter substitutes and essential fatty acid nutrition. History Spectrum was incorporated in 1980 to bring nutrition and quality into the vegetable oil category. In the beginning natural oils were manufactured and distributed in bulk. Six years later the Spectrum Naturals(R) brand was launched. Over time SNI expanded its product lines to include condiments and salad dressings under the Spectrum Naturals(R) brand and nutritional supplements under the Spectrum Essentials(R) brand. The brands are positioned as premium, healthy alternatives to conventional products as a result of the organic sourcing of raw ingredients and the chemical-free extraction of the oils utilizing mechanical (expeller) pressing techniques. SNI has been a leading innovator in the development and marketing of expeller-pressed and certified organic vegetable oils. The Company has also been a leading proponent of testing and verifying the absence of genetically modified organisms in its culinary oils. SNI has marketed natural mayonnaise since 1987, organic vinegar since 1989 and healthy fat salad dressings since 1996. Spectrum Spread(R), a healthy alternative to butter or margarine in baking applications was introduced in 1993. Expanding into the nutritional supplement product category, Spectrum participated in areas of nutritional research and product development, becoming the first company to market organic flax oil in the United States. Spectrum also implemented the proprietary technology known as SpectraVac. SpectraVac, in use since 1989, is an organic method of fresh oil extraction from seed without the use of chemicals that also minimizes the impact of oxygen, light and heat. The SpectraVac system also employs micron filtration technology which eliminates impurities without stripping out the beneficial compounds in the oil. The result is a true, cold-pressed nutritionally rich oil that resists flavor reversion. In 1995 the Company formed Spectrum Commodities, Inc. to serve other natural food manufacturers with similar bulk ingredient needs. SCI's mission was to improve the integrity of ingredients used in food manufacturing by offering expeller-pressed oils in place of those made with harsh chemical solvents. SCI also secured exclusive distribution rights to new products such as organic palm and coconut oils. SCI works with a distribution network that has railcar pumping stations and warehouses on both coasts. SCI provides industrial quantities of organic and expeller-pressed culinary and nutritional oils and organic vinegar to manufacturers, co-packers, private label and food service accounts. The SCI product lines are now offered for sale under the Spectrum Ingredients ("SI") name. OFPI went public in August 1997 and was traded on the NASDAQ Small Cap Market until being delisted in May 1999 due to non-compliance with the net tangible assets requirement. Since then the Company's common stock has traded on the OTC Bulletin Board System under the ticker symbol "OFPI" until the October 1999 merger, after which the Company changed its name to Spectrum Organic Products, Inc. and its ticker symbol to "SPOP.OB." The Company offers its products here in the United States as well as internationally to natural and mainstream retailers and manufacturers. Retail products are sold in, but not limited to, stores such as Whole Foods, Wild Oats, Raley's and Trader Joe's. The Company manages its business under the following three product segments: - -------------------------------------------------------------------------------- Page 3 SPECTRUM NATURALS(R) CULINARY SEGMENT The Company introduces and discontinues products on a regular basis, consistent with customary practices of other firms in the processed food industry. The Company's current culinary products, which include organic and Orthodox Union certified products, include the following: Culinary Oils The Company's largest culinary product line is olive oil. Spectrum markets organic and conventional extra virgin olive oil in various sizes. The Company also offers olive oils from various geographic regions including Greece, Spain, Italy, Tunisia, Argentina and California. Spectrum also markets other refined, unrefined, blended and organic cooking oils under the Spectrum Naturals(R) brand. The other culinary oils include almond, apricot, avocado, canola, coconut, corn, palm fruit, peanut, pumpkin seed, hazelnut, safflower, sesame, soy, sunflower and walnut. Condiments The Company also markets condiments under the Spectrum Naturals brand name. There is both a "lite" and a regular mayonnaise made from expeller-pressed canola oil. The Company introduced the first organic mayonnaise during 2000. Spectrum also markets a vinegar line that is third party certified organic, which includes: apple cider, brown rice, red wine, white wine and balsamic. There is also non-organic balsamic vinegar from Modina, Italy. Spectrum also markets two types of spreads for use as a healthy alternative to butter or margarine: Spectrum Naturals Canola Spread and Essential Omega Spread made with organic flax and soy oils. Salad Dressings The Company also markets organic salad dressings in full-fat, low-fat and fat-free versions in various flavors and sizes. The salad dressing line also includes three Omega-3 vinaigrettes, which are functional full-fat dressings made with organic flax and soy oil to help consumers achieve recommended daily allowances of Omega-3 essential fatty acids in a tasteful product. Cooking Sprays There are five six-ounce cooking sprays that compete with their mass-market counterpart "Pam". The Spectrum Super Canola Spray Oil is made from high-oleic canola oil and the Extra Virgin Olive Spray Oil is made from a blend of extra virgin olive oil and canola oil. Also available in the six-ounce size are Canola Spray Oil with Butter Flavor, Grapeseed Spray Oil and Extra Virgin Olive Spray Oil with Garlic Flavor. There is also a 16-ounce version of the Spectrum Super Canola Spray Oil. Shortening Spectrum markets a non-hydrogenated organic palm shortening that can be used in any cooking application where butter, margarine or shortening is called for. The Spectrum Naturals(R) shortening is a healthy alternative to hydrogenated shortening and partially hydrogenated oils. SPECTRUM ESSENTIALS(R) NUTRITIONAL SUPPLEMENT SEGMENT Spectrum markets essential fatty acid nutritional supplements under the Spectrum Essentials(R) brand. The supplements are available in both liquid and capsule forms. The essential fatty acid supplement oils include Flax, Borage, Evening Primrose, Cod Liver, Norwegian Fish and Wheat Germ oils in various sizes, flavors and blends. The Spectrum Essentials(R) brand also includes two fiber supplements for colon care. - -------------------------------------------------------------------------------- Page 4 SPECTRUM INGREDIENTS/PRIVATE LABEL SEGMENT The Company offers a wide variety of certified organic and non-organic industrial ingredients to other food manufacturers, including olive oils and numerous other vegetable cooking oils in both refined and unrefined states, vinegar, mayonnaise, shortening and nutritional oils (primarily flax oil) sold in institutional sizes and bulk capsules. The private label product lines include programs for natural and organic food retailers such as Whole Foods and Trader Joe's. These programs include canola oil, mayonnaise, olive oil, and flax oil products. Sales and Distribution Spectrum sells its consumer branded products primarily through distributors, independent commissioned food brokers and specialty food brokers to natural food and specialty food stores, retail chains and independent grocery stores. Currently Spectrum products are offered in over 6,000 health food stores nationwide and 2,000 grocery stores located throughout the United States and Canada. In order to increase its distribution and sales, Spectrum offers special promotional pricing and occasionally may pay "slotting fees", which are payments made by food processors and distributors to retail stores in order to acquire retail shelf space for their food products. In 2004 United Natural Foods, Inc. ("UNFI") accounted for approximately 42% of the Company's net sales, versus 36% in 2003 and 50% in 2002. The loss of UNFI as a customer would have a material adverse effect on Spectrum's operations. The Company has one independent Director, Thomas B. Simone, who also serves as Vice Chair and Lead Independent Director of the Board of United Natural Foods, Inc. UNFI's percentage of sales decreased from the 2002 level because of the growth of the Spectrum Ingredients Division as a percent of total sales. The Spectrum Ingredients product lines are sold to domestic food manufacturers. A broker incentive plan has been implemented based on annual quotas to motivate brokers to increase their sales of Spectrum products. Spectrum has also entered into arrangements with certain retail store chains to obtain closer working relationships and enhanced retail merchandising and promotional support. To date the Company has focused on its core natural foods distribution network. Spectrum will enter into new distribution arrangements with mass-market accounts where profitable. Management believes there is an opportunity to enter conventional supermarkets as they become more committed to providing a variety of organic and natural food products, and as consumers become more health conscious. Marketing and New Product Development Spectrum's product marketing emphasizes organic, all natural and healthy oil products containing no hydrogenated fats as a healthy and good-tasting alternative to similar traditional food products. Each brand is targeted toward specific consumer segments with appropriate products, flavor variations, images and messages. Spectrum promotes all its brands to natural food and health food stores and the specialty or gourmet departments of grocery stores. The Company primarily uses outside resources in developing its new consumer branded products. Research and development expenses are included in general and administrative expense. Manufacturing Facilities and Suppliers Spectrum manufactures the Spectrum Essentials flax oil products in a leased facility located at 1510 South 2nd Street, Cherokee, Iowa. The Cherokee facility is managed under a strategic alliance with BIOWA Nutraceuticals, LLC ("BIOWA"). BIOWA provides custom manufacturing services to the Company utilizing the Company's proprietary technology and equipment. During 2004 the Company closed its leased manufacturing facility at 133 Copeland Street, Petaluma, California, where its flax oil products were formerly produced. - -------------------------------------------------------------------------------- Page 5 On July 14, 2003 the Company disassembled its bottling line at Copeland Street and relocated and reconfigured the line at its new bottling co-packer, Interpac Technologies, Inc. ("Interpac"), also located in Petaluma. Interpac provides custom bottling services to the Company utilizing the Company's bottling equipment. On June 2, 2003 the Company relocated its third party warehousing and distribution facility from Southern California to a new facility operated by Interpac in Woodland, California. Spectrum uses co-packers to process and package its vinegars, condiments, dressings, mayonnaise, shortening, spreads and encapsulated nutritional products. The Company's primary co-packer of branded products represented approximately 9%, 11% and 11% of the cost of goods sold in 2004, 2003 and 2002, respectively. While a change in co-packers could cause a delay in production and a possible loss of sales, the Company believes other manufacturers are available who could provide processing at similar prices and terms. Organic raw materials are available from a limited number of sources. The Company maintains long-term relationships with most of its organic suppliers. Purchase arrangements are generally made annually in either U.S. dollars or the local currency of the supplier. The Company had one vendor of canola oil that supplied approximately 17%, 16% and 11% of Spectrum's raw material purchases in 2004, 2003 and 2002, respectively. The Company believes that other suppliers are available who could provide products at similar prices and terms. A change in suppliers, however, could cause a delay in manufacturing and a possible loss of sales, which could adversely affect operating results. Competition The natural food and health food industries in general and the condiment, culinary oil and nutritional supplement businesses in particular, are highly competitive and there are numerous multinational, regional and local firms that currently compete, or are capable of competing, with Spectrum. In the natural foods category Spectrum's principal competitors are private label offerings and the Hain Celestial Group. Spectrum competes with numerous brands in the non-organic vegetable oil category including Puritan and Wesson. In the olive oil category, competitors include Colavita, Hain and Dal Raccolto. The nutritional supplement competitors include Health From The Sun and Barleans. The Company also faces competition in the natural food condiment market from Eden, Canoleo, Nasoya, Annie's and Braggs. Competitors in the non-organic condiments market include H.J. Heinz Company and International Home Foods, which markets Best Foods Mayonnaise. Competitive factors in the specialty foods industry include price, quality, brand image and flavor. Spectrum positions its product lines to be slightly more expensive than their non-organic food counterparts but consistent with prices charged by other organic food marketers. Management believes its products compete favorably against other organic foods with respect to quality and flavor. Trade Names and Trademarks The Company has federal registration for its Spectrum Naturals, Spectrum Essentials, Spectrum Spread and Spectrum Naturals Organic Margarine trademarks. However, there can be no assurance that any trademark or trade name will not be copied or challenged by others. Government Regulation and Independent Certification The Company is subject to various federal, state and local regulations relating to cleanliness, maintenance of food production equipment, food storage and food handling and the Company is subject to unannounced on-site inspections of its manufacturing facilities. As a manufacturer and distributor of foods, the Company is subject to regulation by the United States Food and Drug Administration ("FDA"), the Federal Trade Commission ("FTC"), the United States Department of Agriculture ("USDA") and the Occupational Safety and Health Administration ("OSHA") in connection with the manufacture, sale, safety, advertising, handling, storage, transportation, labeling and processing of food products. In order to offer organic and kosher food products, the Company is also subject to inspection and regulation by third party certification agencies, such as Quality Assurance International and the Orthodox Union. - -------------------------------------------------------------------------------- Page 6 The USDA adopted regulations with respect to the labeling and certification of organic foods which were implemented on October 21, 2002. The Company has made the required label revisions and is in compliance with the additional requirements for third party organic certification. The FDA proposed new guidelines with respect to the labeling of genetically engineered foods on January 18, 2001. Final guidance is expected to be issued in the near future. However, since Spectrum never utilizes genetically engineered seed or raw materials, and has a third party testing program in place to verify the absence of these, the guidelines are not expected to effect the labeling of the Company's products. Additionally, the FDA issued its final ruling amending the nutritional labeling regulations on packaged foods on July 11, 2003. This ruling requires the declaration of trans fatty acids on nutritional labels effective January 1, 2006. Trans fatty acids are found in hydrogenated or partially-hydrogenated oils and are suspected by many health care practitioners to be a contributor to heart disease, diabetes and the obesity epidemic in the United States. None of Spectrum's products contain trans fatty acids; therefore, this ruling is not expected to effect the labeling of the Company's products. In response to the terrorist attacks against the United States on September 11, 2001 the U.S. government has taken aggressive action to protect the nation's food supply. In June 2002 the FDA enacted the Public Health Security and Bioterrorism Preparedness and Responsive Act of 2002 (the "Bioterrorism Act"). The Bioterrorism Act mandated that all food companies comply with four new requirements with regards to the importation of food products to the United States as of December 2003: 1. Registration of all domestic and importing manufacturers directly with the FDA. 2. Pre-notification of inbound food shipments with the Bureau of Customs and Border Protection (the "BCBP"). 3. Maintenance of documentation to support the importation of any food product, by lot, as it flows from the importer to the ultimate customer for a minimum of two years. 4. Detention of food products at the port of entry at the discretion of the FDA, in connection with its efforts to protect the nation's food supply. Spectrum, as a regulated organic producer, has been subject to annual audits to retain its organic certification and maintains records of organic and conventional shipments, by lot, for a minimum of five years. Accordingly, compliance with the Bioterrorism Act has been relatively seamless for the Company. The increased amount of time required to clear items through the port with the BCBP has required the Company to carry higher levels of raw materials in inventory, however. Additionally, the BCBP has initiated a key cooperative program with the importer community called Customs-Trade Partnership Against Terrorism ("C-TPAT"). The BCBP provides participating companies with guidelines for security enhancement throughout the supply chain and encourages their voluntary enrollment into C-TPAT. The Company has secured membership in the C-TPAT program, which lowers the Company's risk profile with BCBP and improves the efficiency of the importation of raw materials by the Company. The Spectrum Essentials(R) brand of nutritional supplements are subject to the Dietary Supplement Health and Education Act of 1994 or "DSHEA", which went into effect in March 1999. DSHEA defines dietary supplements as a new category of food, separate from conventional food. DSHEA requires specific nutritional labeling requirements for dietary supplements and permits substantiated, truthful and non-misleading statements of nutritional support to be made in labeling, such as statements describing general well-being resulting from consumption of a dietary ingredient, or the role of a nutrient or dietary ingredient in affecting or maintaining a structure or function of the body. - -------------------------------------------------------------------------------- Page 7 Regulations in new markets and future changes in the regulations may adversely impact the Company by raising the cost to manufacture and deliver the Company's products or by affecting the perceived healthfulness of the Company's products. A failure to comply with one or more regulatory requirements could interrupt the Company's operations and result in a variety of sanctions, including fines and the withdrawal of the Company's products from store shelves. The Company holds all material licenses and permits required to conduct its operations. The Company is also subject to federal and state laws establishing minimum wages and regulating overtime and working conditions. Employees As of March 4, 2005 Spectrum had 66 full-time employees. Spectrum's employees are not covered by a collective bargaining agreement and the Company considers its employee relations to be satisfactory. Other Information The following additional information can be found at the Company's website, HTTP://WWW.SPECTRUMORGANICS.COM: 1. Annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and definitive proxy statements are made available at the website as soon as practicable after the report is electronically filed with the SEC. 2. Statements of Changes in Beneficial Ownership of Securities on Form 4 as filed by each officer and director of Spectrum are also made available at the website as soon as practicable after the report is electronically filed with the SEC. 3. Charters of the Audit Committee, Compensation Committee and Nominating and Governance Committee of our Board of Directors. 4. Spectrum's Standards of Business Ethics which apply to all our directors, officers and employees. 5. Profiles of directors and officers and other information about the Company and its products. ITEM 2. PROPERTY - ---------------- In 2002 the Company began a three phased project to close its former offices and manufacturing facility located at 133 Copeland Street, Petaluma, California. All three phases have now been completed as follows: In December 2002 the Company consolidated its office space into its new headquarters facility at 5341 Old Redwood Highway, Suite 400, Petaluma, California. The headquarters facility lease is a non-cancelable operating lease of approximately 18,600 square feet which expires on December 31, 2007. Management believes that the headquarters facility is adequate for the Company's needs. In July 2003 the Company relocated and reconfigured its bottling operation to a third party facility managed by Interpac Technologies, Inc. ("Interpac"), also located in Petaluma, California. Interpac provides custom bottling services to Spectrum utilizing the Company's bottling equipment. In October 2004 the Company unveiled its new leased flax oil manufacturing facility located in Cherokee, Iowa. The Iowa facility is also managed by a third party, Biowa Nutraceuticals, LLC ("Biowa"), which provides custom crushing and refining of oils to Spectrum utilizing the Company's presses, filtering equipment and proprietary technologies known as SpectraVac. - -------------------------------------------------------------------------------- Page 8 Final rent on the Copeland Street facility was paid in November 2004 and the facility has been turned over to the landlord. ITEM 3. LEGAL PROCEEDINGS - ------------------------- In the ordinary course of business the Company is involved in litigation, most of which is not expected to have a material adverse effect on Spectrum's business, results of operations or financial position. The following summarizes the status of the two significant legal proceedings that were not fully resolved at the date of this report: Industrial Accident On February 4, 2004 the Company pleaded no contest to two misdemeanor counts of violations under California Labor Code Section 6425 ("CLCS 6425"), violation of a regulation issued by the California Occupational Health and Safety Administration ("CAL-OSHA"), requiring employers to provide, maintain and ensure employees use required confined space equipment. The plea arose in connection with a tragic production accident on April 25, 2002 that resulted in the death of two of the Company's employees. Under the Terms of Settlement and Probation entered into with the plea, the Company agreed to pay a fine under CLCS 6425 of $150,000 in three annual installments of $50,000 each on June 1, 2004, 2005 and 2006. In addition the Company paid $150,000 in restitution to the California District Attorneys Association Workers Safety Training Account to assist in the prosecution of worker safety cases in the State of California. The Company also reimbursed costs of $25,000 each to the Petaluma Police Department, the Petaluma Fire Department and the Sonoma County District Attorney's Office. Finally, an additional fine of $250,000 under CLCS 6425 was suspended conditioned upon the Company's compliance with the terms of court supervised probation for three years. Accordingly, the Company accrued an expense of $375,000 during the year ended December 31, 2003 to cover the net present value of the above payments, plus attorney's fees. Total payments made during the year ended December 31, 2004 in connection with the plea were $275,000. CAL-OSHA completed their investigation of the accident and issued their report and notice of proposed penalties on October 18, 2002. Their report included nine citations for safety violations with total proposed penalties of $137,900. There were no willful citations and the CAL-OSHA report acknowledged that all the safety violations had been 100% abated prior to the report's issuance. The Company filed a formal appeal with CAL-OSHA and reached a verbal settlement agreement with CAL-OSHA on December 17, 2004 which calls for the Company to pay penalties totaling $70,500 to close the CAL-OSHA appeal. At the date of this report, the Company was awaiting receipt of an Order from the CAL-OSHA Appeals Board, at which time the Company will remit the $70,500 to close this matter. The dependents of both deceased employees filed appeals with the Workers' Compensation Appeals Board of California for serious and willful misconduct penalties against Spectrum. On May 25, 2004 the Company settled one of the appeals for $35,000 which was paid on June 3, 2004 and charged against the industrial accident reserve. As of December 31, 2004 the Company had a remaining reserve of $193,900 to cover the two remaining installments of the fine under CLCS 6425 totaling $100,000, the settlement of the CAL-OSHA appeal for $70,500, and the remaining appeal filed with the Workers' Compensation Appeals Board of California. The remaining workers compensation appeal is for an additional death benefit equal to 50% of the eventual death benefit to be paid by the Company's workers' compensation insurance carrier at the time of the accident. That amount would be payable by the Company to the dependents of the deceased worker if the dependents successfully establish that the Company was guilty of serious and willful misconduct by allowing unsafe working conditions to exist. If actually litigated, the workers compensation appeal is an all-or-nothing proposition under which the Company will either be liable for 50% of the eventual insurance death benefit or nothing. Based on the advice of counsel, the Company expects - -------------------------------------------------------------------------------- Page 9 the remaining workers compensation appeal to be settled rather than litigated. Management believes the remaining reserve of $193,900 will be approximately adequate to cover the present value of the remaining two installments under the CLCS 6425 fine of $50,000 each, the settlement of the CAL-OSHA appeal for $70,500, and the remaining workers compensation appeal. Proposition 65 Complaint On November 26, 2003 the Company was notified by attorneys for the Environmental Law Foundation (the "ELF") that the Spectrum Naturals(R) Organic Balsamic Vinegar contains lead in excess of the allowable quantities under the Safe Drinking Water and Toxic Enforcement Act of 1986, also known as Proposition 65. The ELF is a California non-profit organization that represents itself as dedicated to the preservation of human health and the environment. ELF's attorneys filed a Complaint for Civil Penalties, Statutory, Equitable and Injunctive Relief (the "Complaint") against Cost Plus, Inc., Safeway, Inc., Trader Joe's Company, Williams-Sonoma, Inc., Whole Foods, Inc. and unspecified defendants one through 100 in the Superior Court of the State of California on May 20, 2003 alleging violation of Proposition 65 for the sale of various products that contain lead in excess of the allowable limits without the required warning label. ELF's attorneys later notified Spectrum and dozens of other retailers, importers and manufacturers of vinegar that they would be included as one of the 100 unspecified defendants in the Complaint. While lead has been shown to cause cancer and reproductive toxicity in humans, the Proposition 65 consumption quantity defined as no significant risk level for cancer was set at 15 micrograms per day. Lead is a naturally occurring element in some wine and balsamic vinegars. Based on the Company's tests, a person would need to consume somewhere between 1.3-2.6 cups (270-630ml) daily of the Company's various vinegar products to reach the Proposition 65 lead level. The small lead content in vinegar occurs naturally in the soil and is absorbed by the grapes used to make vinegar. The level of lead in vinegar is not affected by the manufacturing process and, therefore, is not subject to regulation under Proposition 65. The Spectrum Naturals(R) brand was built on the premise of providing consumers with organic healthy oils and condiments. Management does not believe the consumption of its various vinegar products as condiments or salad dressings poses any increased risk for cancer or reproductive toxicity. The Company has joined a Joint Defense Group established by attorneys representing several of the defendants in the Complaint. Total attorney's fees incurred by the Company as a member of the Joint Defense Group for the year ended December 31, 2004 were $12,300. Management believes the Complaint will eventually be shown to be without merit. Accordingly, no provision for loss has been recorded at December 31, 2004. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ During the fourth quarter of 2004, no matters were submitted to a vote of our security holders. - -------------------------------------------------------------------------------- Page 10 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER - --------------------------------------------------------------------------- MATTERS - ------- Market and Historical Prices The Company's common stock was traded on the NASDAQ Small Cap Market under the symbol "OFPI" from August 1997 to May 1999 when it was delisted due to non-compliance with the minimum net book value requirement. Thereafter it traded on the OTC Bulletin Board System and still does under the new symbol "SPOP.OB". The following table sets forth the range of high and low closing prices of the Company's common stock as reported by the OTC Bulletin Board for the periods indicated. Price ----- High Low ---- --- Fiscal Year Ended December 31, 2004: Fourth Quarter $ 0.70 $ 0.51 Third Quarter 0.68 0.45 Second Quarter 0.95 0.48 First Quarter 1.12 0.72 Fiscal Year Ended December 31, 2003: Fourth Quarter $ 0.85 $ 0.58 Third Quarter 0.72 0.41 Second Quarter 0.45 0.21 First Quarter 0.40 0.27 Fiscal Year Ended December 31, 2002: Fourth Quarter $ 0.47 $ 0.28 Third Quarter 0.60 0.36 Second Quarter 0.48 0.24 First Quarter 0.44 0.18 The last recorded sale price of the Company's common stock was $0.50 per share on the OTC Bulletin Board System on March 4, 2005. As of March 4, 2005 the Company had approximately 800 record and beneficial stockholders. Dividend Policy The Company has not in the past nor does it intend to pay cash dividends on its common stock in the future. The Company intends to retain earnings, if any, for use in the operation and expansion of its business. The amount of future dividends, if any, will be determined by the Board of Directors based upon the Company's earnings, financial condition, capital requirements, general economic conditions and such other factors as the Board deems relevant. Moreover, the Company's Credit and Security Agreement with its primary lender prohibits the payment of dividends without the prior approval of the lender. - -------------------------------------------------------------------------------- Page 11 Shares Issued During the Years Ended December 31, 2004, 2003 and 2002 During the years ended December 31, 2004, 2003 and 2002, the Company issued shares of its common stock as follows for the reasons indicated: Cash and Month Shares Non-Cash Issued Issued Proceeds ------ ------ -------- Year Ended December 31, 2004: Shares issued for the exercise of common stock options Various 151,166 $ 51,900 ======== ======== Year Ended December 31, 2003: Shares issued for the exercise of common stock purchase warrants earned under private placement notes Various 405,456 $ 90,000 Shares issued for the exercise of common stock options Dec. 2003 143,750 59,400 -------- -------- Totals for the Year Ended December 31, 2003 549,206 $149,400 ======== ======== Year Ended December 31, 2002: Shares issued for the net exercise of common stock purchase warrants earned under private placement notes Nov. 2002 6,910 $ -- ======== ======== All the shares issued for the exercise of common stock purchase warrants earned under private placement notes were issued under Regulation D of the Securities Act of 1933 (the "Act"), with resale of such shares permitted only pursuant to Rule 144 of the Act. All certificates representing the unregistered shares were endorsed with restrictive legends identifying them as unregistered under the Act. Shares Authorized for Issuance Under Equity Compensation Plans The Company's Amended 1995 Stock Option Plan is the only compensation plan under which equity securities of the Company are issued. That plan has been approved by the Company's shareholders and the following table provides information regarding its status as of December 31, 2004: Available Shares Shares to be Issued Weighted Average Remaining for Future Upon Exercise of Exercise Price of Issuance Under Equity Outstanding Options Outstanding Options Compensation Plan ------------------- ------------------- ----------------- 1995 Stock Option Plan 4,972,415 $ 0.44 1,732,669 The 1995 Stock Option Plan has a ten year life; therefore, no further options can be issued under the Plan after November 15, 2005. Management is in the process of evaluating various alternatives with respect to a future equity incentive compensation plan at the date of this report. ITEM 6. SELECTED FINANCIAL DATA - ------------------------------- The selected financial data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Conditions and Results of Operations" and the financial statements of the Company and the notes thereto included in Item 8 of this Form 10-K. - -------------------------------------------------------------------------------- Page 12 Years Ended December 31, ------------------------ In thousands except per share data 2004 2003 2002 2001 2000 - ---------------------------------- ---- ---- ---- ---- ---- Operating Data: Net Sales $ 49,915 $ 45,677 $ 40,579 $ 41,019 $ 41,442 Gross Profit 11,535 11,870 10,756 11,009 9,418 Income (Loss) from Operations (1,056) 1,526 1,776 (4,251) (688) Net Income (Loss) (833) 2,664 1,120 (5,206) (2,002) Weighted Average Shares Outstanding: Basic 46,345 45,845 45,700 45,279 44,234 Fully Diluted 46,345 47,840 46,306 45,279 44,234 Net Income (Loss) per Share: Basic $ (0.02) $ 0.06 $ 0.02 $ (0.12) $ (0.05) Fully Diluted (0.02) 0.06 0.02 (0.12) (0.05) Cash Dividends Declared per Share (0.00) 0.00 0.00 0.00 0.00 EBITDA as adjusted (1) $ 1,192 $ 2,436 $ 2,289 $ 2,400 $ 1,212 Cash Flow Data: Cash Provided by (Used in) Operating Activities $ (1,243) $ (1,206) $ 717 $ (858) $ 360 Cash Provided by (Used in) Investing Activities (1,459) (1,831) 2,344 2,294 20 Cash Provided by (Used in) Financing Activities 2,705 3,032 (3,075) (1,418) (379) As of December 31, ------------------ 2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- Balance Sheet Data: Working Capital (Deficit) $ 689 $ 1,560 $ 597 $ (1,030) $ (4,257) Total Tangible Assets 19,918 18,634 12,156 12,776 13,057 Total Assets 20,503 19,221 12,198 14,300 22,841 Total Long-term Debt 1,701 1,653 1,084 1,708 2,001 Total Stockholders' Equity 5,306 6,087 3,274 2,098 6,850 (1) EBITDA as adjusted is earnings before interest, taxes, depreciation, amortization, losses on asset writedowns and plant closures, the gain or loss from the sales of product lines and the industrial accident. Management believes this is an important measure of the Company's operating performance because it eliminates the effect of some unusual items in the Company's past that no longer qualify for treatment as "extraordinary" under generally accepted accounting principles. The majority of management incentives are earned based upon the achievement of EBITDA as adjusted targets that are established prior to the beginning of each fiscal year. The calculations to arrive at EBITDA as adjusted are detailed in the following table (dollars in thousands): Years Ended December 31, ------------------------ 2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- Net income (loss) as reported $ (833) $ 2,664 $ 1,120 $(5,206) $(2,002) Provision (benefit) for income taxes (555) (1,567) 190 -- 4 Interest expense 362 404 481 913 1,382 Depreciation and amortization 653 525 454 419 531 Amortization of goodwill -- -- -- 521 910 (Gain) loss on sales of product lines -- -- (210) 4,803 (50) Industrial accident expenses -- 410 254 -- -- Plant relocation and asset impairment writedowns 1,565 -- -- 950 437 -------- -------- -------- -------- -------- EBITDA as adjusted $ 1,192 $ 2,436 $ 2,289 $ 2,400 $ 1,212 ======= ======= ======= ======= ======== - -------------------------------------------------------------------------------------------------------------- Page 13 As described in Note 1 to the financial statements, the Company was formed on October 6, 1999 by the merger of Spectrum Naturals, Inc., its affiliate Spectrum Commodities, Inc. and Organic Ingredients, Inc. with and into Organic Food Products, Inc. Effective with the merger the newly combined entity changed its name to Spectrum Organic Products, Inc. Since a controlling interest in the combined Company is held by former SNI stockholders, the merger was accounted for as a reverse acquisition, with SNI as accounting acquirer and OI and OFPI as accounting acquirees. The number of shares outstanding and per-share amounts have been retroactively restated where applicable for all periods presented. On June 11, 2001 the Company sold the OFPI product lines to a third party; therefore, results for 2001 include the OFPI product lines from January 1 to the date of sale. On April 25, 2002 the Company sold the OI product lines to a third party; therefore, results for 2002 include the OI product lines from January 1 to the date of sale. As a result of the 1999 merger and subsequent divestitures of the product lines acquired in the merger in 2001 and 2002, the net sales data in the selected financial data table above requires additional disclosures. The Company has posted significant annual sales growth within its core categories of healthy oils, butter substitutes and nutritional supplements. The following table discloses net sales by segment and comparable net sales (excluding the impact of acquired and subsequently disposed product lines) for the last five years (dollars in thousands): Years Ended December 31, ------------------------ 2004 2003 2002 2001 2000 ---- ---- ---- ---- ---- Spectrum Naturals(R) Culinary Products $ 24,048 $ 20,606 $ 17,268 $ 15,221 $ 13,121 Spectrum Essentials(R) Nutritional Supplements 9,566 10,354 9,031 7,777 6,626 Spectrum Ingredients/Private Label Products 15,978 14,443 11,066 8,294 8,749 -------- -------- -------- -------- -------- Comparable Net Sales 49,592 45,403 37,365 31,292 28,496 Disposed/Discontinued Product Lines 323 274 3,214 9,727 12,946 -------- -------- -------- -------- -------- Total Net Sales $ 49,915 $ 45,677 $ 40,579 $ 41,019 $ 41,442 ======== ======== ======== ======== ======== ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - ------------------------------------------------------------------------------- General: The following discussion should be read in conjunction with the financial statements and related notes and other information included in this report. The financial results reported herein are not necessarily indicative of the financial results that may be achieved by the Company in any future period. The Company's operating results could vary from period to period as a result of a number of factors. These factors include, but are not limited to, the purchasing patterns of significant customers, the timing of new product introductions by the Company and its competitors, the amount of slotting fees, new product development and advertising expenses incurred by the Company, variations in sales by distribution channels, fluctuations in market prices of raw materials, competitive pricing policies and other situations that the Company cannot foresee. These factors could cause the Company's performance to differ from investor expectations, resulting in volatility in the price of its common stock. Investors should carefully consider the following information as well as other information contained in this Report. Information included in this Report contains forward-looking statements which can be identified by the use of forward-looking terminology such as "believes", "expects", "may", "should" or - -------------------------------------------------------------------------------- Page 14 "anticipates" or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy. No assurance can be given that the future results covered by the forward-looking statements will be achieved. The following matters constitute cautionary statements identifying important factors with respect to such forward-looking statements, including certain risks and uncertainties that could cause actual results to vary materially from the future results covered in such forward-looking statements. Other factors could also cause actual results to vary materially from the future results covered in the forward-looking statements. Introduction: Spectrum Organic Products, Inc. ("Spectrum", the "Company", or the "Registrant") competes primarily in three segments: natural and organic foods sold under the Spectrum Naturals(R) brand, nutritional supplements sold under the Spectrum Essentials(R) brand, and industrial ingredients sold by the Spectrum Ingredients sales force for use by other manufacturers. The vast majority of the Company's products are oil-based and the Company has positioned itself as "The Good Fats Company". Within the Spectrum Naturals(R) brand, the Company's products include olive oils and other culinary oils, salad dressings, condiments and butter-substitutes such as Spectrum Organic Margarine(R) and Spectrum Spread(R). All of the Company's culinary products feature healthy oils, contain no hydrogenated fats and are offered in a variety of sizes and flavors in both organic and conventional offerings. Within the Spectrum Essentials(R) brand, the Company's products include organic flax oil, borage oil, Norwegian fish oil and other essential fatty acids in both liquid and capsule forms. The Spectrum Essentials(R) products are cold-pressed, nutritionally rich sources of Omega-3 and Omega-6 essential fatty acids and are also offered in a variety of sizes and styles. The Spectrum Ingredients (formerly known as Spectrum Commodities, Inc.) sales force offers organic culinary oils, vinegar and nutritional oils to other manufacturers for use in their products. In addition, they bring incremental purchasing power to the Company resulting in higher margins for the consumer branded product lines. The Company was formed on October 6, 1999 by the four-way reverse merger of Spectrum Naturals, Inc. ("SNI"), its affiliate Spectrum Commodities, Inc. ("SCI"), Organic Ingredients, Inc. ("OI"), with and into Organic Food Products, Inc. ("OFPI"). OFPI was the Registrant prior to the merger, but since a controlling interest in the Company is held by former SNI stockholders, the merger was accounted for as a reverse acquisition, with SNI and SCI as the acquirer and OI and OFPI as acquirees. On June 11, 2001 the Company sold the OFPI tomato-based product lines to Acirca, Inc., an unrelated third party. On April 25, 2002 the Company sold the OI industrial ingredient business in fruits, vegetables, concentrates and purees to Acirca. Accordingly, results for 2001 and 2002 include the operating results associated with the disposed product lines until the date of sale. The two dispositions have significantly strengthened the Company from a liquidity and working capital standpoint. The Company now plans to focus its resources on its core business in healthy oils, butter substitutes and essential fatty acid nutrition. Critical Accounting Policies and Estimates: The following discussion and analysis of the Company's financial condition and results of operations is based upon the Company's financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. The Company bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for the carrying values of assets and liabilities that are not readily apparent from other sources. On an on-going basis, the Company re-evaluates all - -------------------------------------------------------------------------------- Page 15 of its estimates, including those related to accounts receivable allowances, inventory reserves, the industrial accident reserve and the deferred tax asset valuation allowance. Actual results may differ materially from these estimates under different assumptions or conditions and as additional information becomes available in future periods. The Company believes the following are the more significant judgments and estimates used in the preparation of its financial statements: Accounts Receivable Allowances - The Company provides allowances against accounts receivable for estimated bad debts, returns and deductions by customers for trade promotions and programs. These allowances are based upon the Company's historical experience with bad debt write-offs and customer deductions, customer creditworthiness, payment trends and general economic conditions. Allowances for bad debts and customer deductions were $500,000 at December 31, 2004 on gross trade accounts receivable of $4,268,800. While this estimate is one of the more significant estimates the Company makes in the preparation of its financial statements, management does not consider it to be highly uncertain. Inventory Reserves - The Company establishes reserves for obsolete, excess and slow-moving inventories in order to properly value its inventory at the lower of cost or market. The reserve estimates are based upon historical inventory usage, spoilage, current market conditions, and anticipated future demand. Reserves for obsolete inventories were $350,000 at December 31, 2004 on total gross inventories of $9,914,800. While this estimate is one of the more significant estimates the Company makes in the preparation of its financial statements, management does not consider it to be highly uncertain. Deferred Tax Asset Valuation Allowance - As of December 31, 2004 the Company had net deferred tax assets of $2,155,500 primarily resulting from net operating loss carryforwards ("NOLs"), which consisted of $5,735,000 of Federal NOLs that expire at various times through 2021, and $3,833,000 of state NOLs that expire at various times through 2011. The majority of the NOLs originated from the pre-merger operations of OFPI. As a result of OFPI's acquisition by SNI, OFPI experienced an ownership change in excess of 50% for federal and state income tax purposes. Therefore, an annual limitation is placed by the taxing authorities on the Company's right to realize the benefit of the pre-merger NOLs. During the three months ended December 31, 2003 management eliminated the deferred tax asset valuation reserve that had been maintained since the 1999 merger. The reserve was reversed because the Company has reported taxable income to the various taxing authorities for 2001, 2002 and 2003. While the Company expects to report a taxable loss for 2004, management believes that it is more likely than not that the Company will continue to report sufficient taxable income in the foreseeable future, allowing utilization of 100% of its deferred tax assets. Management will continue to evaluate the Company's deferred tax assets in the future to determine whether a deferred tax asset reserve should be reinstated at some future point. Industrial Accident Reserve - The Company has an industrial accident reserve to cover future payments anticipated as a result of the industrial accident in 2002. As of December 31, 2004 the balance remaining in the industrial accident reserve was $193,900 which covers the present value of the remaining two installment payments of $50,000 each under the Terms of Settlement and Probation entered into on February 4, 2004 with the Sonoma County District Attorney's Office, and the settlement of the appeal filed by the Company with CAL-OSHA regarding their citations and fines for $70,500. That will leave approximately $30,000 in the reserve to cover the one remaining unsettled issue with regards to the industrial accident, plus related attorney's fees. The remaining unsettled issue is an appeal filed by dependents of one of the deceased employees with the Workers Compensation Appeals Board of California for an additional death benefit equal to 50% of the eventual death benefit to be paid by the Company's workers' compensation insurance carrier at the time of the accident. That amount would be payable by the Company to the dependents of the deceased employee if the dependents successfully establish that the Company was guilty of serious and willful misconduct by allowing unsafe working conditions to exist. If actually litigated, the workers compensation appeal is an all-or-nothing proposition under which the Company will either be liable for 50% of the eventual insurance death benefit or nothing. Based on the advice of counsel, the Company expects the remaining workers compensation appeal to be - -------------------------------------------------------------------------------- Page 16 settled rather than litigated. However, management considers the remaining unsettled workers compensation appeal to be uncertain since expenses in excess of the remaining reserve could be incurred regardless of whether the workers compensation appeal is litigated or settled. - -------------------------------------------------------------------------------- Results of Operations for the Year Ended December 31, 2004 Compared to the Year Ended December 31, 2003 - -------------------------------------------------------------------------------- Summary Discussion: In general, the Company continued to deliver strong sales growth on the culinary side of the business for the year ended December 31, 2004. Net sales growth versus the prior year was 17% for the Spectrum Naturals(R) segment, as both food service customers and the retail consumer continued their shift toward non-hydrogenated oils. The Company benefited from the ongoing media attention paid to the dangers of hydrogenated oils with respect to obesity and cardiovascular health. Obesity has been recognized as an epidemic by many health care providers. The Centers for Disease Control and Prevention estimates that 64% of Americans over age 20 are overweight and 24% are obese. Morbid obesity, defined as a body mass index over 40, now afflicts over 2% of the United States population and has tripled since 1990. As a result, several Fortune 500 food companies took steps to reduce or eliminate hydrogenated oils from their products. The trend to reduce or eliminate hydrogenated oils from packaged foods plays directly to the strength of the Spectrum Ingredients Division, which delivered 11% net sales growth in 2004. The response to the obesity epidemic is expected to continue to drive consumer interest in healthy foods. The FDA has recently revised the daily food guide pyramid, which now advises adults to keep total fat intake between 20 to 35 percent of calories, with most fats coming from sources of polyunsaturated and monounsaturated fatty acids, such as fish, nuts, and vegetable oils. Many health care providers are also recommending that consumers reduce their intake of carbohydrates in response to the obesity epidemic. The FDA's new 2005 Dietary Guidelines take significant steps to decrease the emphasis on carbohydrates and increase the emphasis on healthy oils and essential fatty acid nutrition. The result of all the above is that the average consumer is becoming much more aware of the dangers of hydrogenated oils, which directly benefits the Company's product offerings in both the Spectrum Naturals(R) and Spectrum Ingredients segments. The Spectrum Essentials(R) segment net sales fell 8% versus the prior year, primarily as a result of the Fresh and Cold program and increased competition in the organic flax oil category. The Fresh and Cold program calls for distributors to treat the Company's liquid flax oil products like a perishable product in order to improve the freshness of products at the retail shelf. Previously distributors purchased forward when the Spectrum Essentials(R) brand was on promotion. One of the Company's primary competitors in the organic flax oil category has made fresh-dated product a cornerstone of their marketing efforts. The Fresh and Cold program calls for distributors to maintain the Spectrum Essentials(R) products under refrigeration at all times and will enable the Company to compete more effectively against that effort. However, it entailed a one-time reduction in distributor inventories to launch it during 2004, which had a negative impact on the Company's sales in 2004 of approximately $750,000. Sales returned to normal levels following the launch of the Fresh and Cold program. Consumer awareness of the importance of essential fatty acid nutrition also rose during 2004, albeit not as significantly as with non-hydrogenated oils. Still, there was increased awareness of the importance of Omega-3 and Omega-6 essential fatty acids to overall health, which is the foundation supporting the Company's Spectrum Essentials(R) line of nutritional supplements. The two primary sources of Omega-3 essential fatty acids are flax and fish. The Company's sales of its various fish oil products increased by 46% versus 2003 on the strength of increased demand fueled by recommendations from influential health practitioners that garnered attention in the mainstream media. - -------------------------------------------------------------------------------- Page 17 Also contributing to the reduction in flax oil sales in 2004 was the strength in fish oils. Many consumers are seeking to supplement their diets with Omega-3 essential fatty acids and flax or fish oils are largely interchangeable in that regard. The Company reported a net loss of $832,700 for the year ended December 31, 2004 versus net income of $2,663,600 for the prior year. The net loss was primarily due to expenses associated with the manufacturing facility relocation of $1,565,300 and higher sales and marketing expenses, which increased by $1,089,000 versus the prior year. Also contributing to the reduced profitability in 2004 was margin pressure in the Spectrum Naturals(R) segment as a result of increased costs for certain key organic raw materials such as canola oil and olive oil. Gross margin in the Spectrum Naturals(R) segment was down over three points versus the prior year as a result of the increased raw material costs, which were driven by unfavorable exchange rates, an unfavorable commodity cycle and increased demand for organic raw materials. The Company has taken multiple price increases within the Spectrum Naturals(R) segment during 2004 and further price increases in olive oil products and in the Canadian market during February 2005. Despite these price increases, management has been unable to pass on all of its cost increases to consumers. Management anticipates that margins will improve in 2005 as a result of several issues in 2004 that are not expected to recur. In addition to the trade inventory reduction of flax oil necessary to implement the Fresh and Cold program, the following are additional items that had a detrimental impact on gross margin during the year ended December 31, 2004 that are not expected to recur: 1. During the first four months of 2004, the Company sold through all the high cost Chinese flax seed purchased during 2003. Since then, the Company's raw material cost for flaxseed has been 40%-50% less. 2. The commodity cycle has been particularly unfavorable during 2004, with the edible fats and oils index hitting a twenty year high as a result of increased demand, short crops and transportation and importation cost increases. Like all commodity cycles, the Company anticipates a reversion to the mean to eventually occur, primarily due to factors outside its control, such as weather and crop harvest sizes. Management believes that earnings before interest, taxes, depreciation and amortization, the plant relocation and expenses associated with the industrial accident ("EBITDA as adjusted") is an important measure of the Company's operating performance, because it eliminates the effect of some unusual items in the Company's past that no longer qualify for treatment as "extraordinary" under generally accepted accounting principles. The majority of management incentives are earned based upon the achievement of EBITDA as adjusted targets that are established prior to the beginning of each fiscal year. Therefore, management believes EBITDA as adjusted is useful to investors since it discloses the on-going economic performance of the business in the absence of the unusual events and transactions. For the year ended December 31, 2004 EBITDA as adjusted was $1,192,000 compared to $2,436,100 for the prior year, a decrease of $1,244,100 or 51%. The reduced EBITDA as adjusted in 2004 is discussed in detail below, but was primarily attributable to increased sales and marketing expenses. While management believes that EBITDA as adjusted is a useful measure of the Company's financial performance, it should not be construed as an alternative to income from operations, net income or cash flows from operating activities as determined in accordance with accounting principles generally accepted in the United States of America. Furthermore, the Company's calculation of EBITDA as adjusted may be different from the calculation used by other companies, thereby limiting comparability. - -------------------------------------------------------------------------------- Page 18 The Company's calculations to arrive at EBITDA as adjusted are detailed in the following table: Years Ended December 31, ------------------------ 2004 2003 ---- ---- Net income (loss) $ (832,700) $ 2,663,600 Provision (benefit) for income taxes (555,200) (1,566,600) Interest expense 361,900 404,200 Depreciation and amortization expense 652,700 524,700 Manufacturing facility relocation 1,565,300 -- Industrial accident expenses -- 410,200 ----------- ----------- EBITDA as adjusted $ 1,192,000 $ 2,436,100 =========== =========== The following is management's discussion and analysis of the significant line items within the financial statements and the reasons behind the trends and variances versus the prior year. Revenues: Spectrum's net sales for the year ended December 31, 2004 were $49,915,400 compared to $45,676,500 for 2003, an increase of $4,238,900 or 9%. The increase is detailed by segment in the following table: Years Ended December 31, ------------------------ 2004 2003 % Change ---- ---- -------- Spectrum Naturals(R) Culinary Products $ 24,048,400 $ 20,606,100 +17% Spectrum Essentials(R) Nutritional Supplements 9,566,100 10,353,900 -8% Spectrum Ingredients/Other 16,300,900 14,716,500 +11% ------------ ------------ -------- Total Net Sales $ 49,915,400 $ 45,676,500 +9% ============ ============ ======== Within the Spectrum Naturals(R) culinary products, sales were significantly higher than prior year in olive oil (+46%), food service oils (+20%), packaged culinary oils (+20%), vinegar (+24%) and mayonnaise (+12%). Most of the net sales increase in the Spectrum Naturals(R) segment was volume-related, although there was some impact from price increases taken during 2004. In general, the Company's culinary oils continued to benefit from increased consumer awareness of the importance of avoiding hydrogenated oils. The Company's olive oil sales were positively impacted by the allowance for a limited health claim on olive oil labels by the FDA and additional mainstream media attention to the benefits of the Mediterranean Diet on overall health and wellness. Spectrum Essentials(R) nutritional supplement sales decreased 8% versus the prior year, primarily as a result of the Fresh and Cold program which entailed a one-time reduction in trade inventory levels in order to improve the freshness of product at the retail shelf. Also contributing to the lower sales was increased competition in the organic flax oil category. All of the net sales decrease in the Spectrum Essentials(R) segment was volume-rated. Packaged liquid supplements, which encompass the majority of the Spectrum Essentials(R) line, decreased by 10% versus the prior year. Sales of encapsulated nutritional supplements, primarily flax and fish oil, increased 8% versus the prior year on the strength of increased consumer demand for fish oil. The increased demand for fish oil is expected to continue in the foreseeable future due to increased mainstream media coverage of the benefits of Omega-3 diet supplementation with cold water fish oils. The Spectrum Ingredients sales increased 11% versus the prior year on the strength of increased customer demand for non hydrogenated oils. Many small and mid-sized food manufacturers are eliminating partially hydrogenated oils from their products, which lends itself directly to the Spectrum Ingredients product offerings. This trend is also expected to continue as the FDA-mandated disclosure of trans fats on packaged food labels becomes effective on January 1, 2006. - -------------------------------------------------------------------------------- Page 19 Cost of Goods Sold: The Company's cost of goods sold for the year ended December 31, 2004 was $38,380,700 versus $33,806,800 for the prior year, an increase of 14%. The increase was primarily volume-related with respect to the Spectrum Essentials(R) and Spectrum Ingredients segments and both volume and rate driven with respect to the Spectrum Naturals(R) segment as detailed in the following table: Years Ended December 31, ------------------------ 2004 2003 % Change ---- ---- -------- Spectrum Naturals(R) Culinary Products $18,645,000 $15,240,600 +22% Spectrum Essentials(R) Nutritional Supplements 5,268,800 5,694,200 -7% Spectrum Ingredients/Other 14,466,900 12,872,000 +12% ----------- ----------- ------- Total Cost of Goods Sold $38,380,700 $33,806,800 +14% =========== =========== ======= Cost of goods sold as a percent of net sales increased to 76.9% in 2004 versus 74.0% in 2003. The increase was primarily due to increased raw material costs in most of the Company's culinary packaged product lines and an unfavorable sales mix that featured a higher concentration of Spectrum Ingredients products, the Company's lowest margin items. The cost of imported olive oils and vinegars from Europe were sharply higher than the prior year as a result of the dollar's weakness versus the euro. Organic canola oil, a key raw material in many of the culinary products, was also higher in cost as a result of increased demand and the dollar's weakness versus the Canadian dollar. Gross Profit: Gross profit for the year ended December 31, 2004 was $11,534,700 versus $11,869,700 for the prior year, a decrease of 3%. The decrease was primarily attributable to the raw material cost increases on the Spectrum Naturals(R) brand described above, and the impact of the Fresh and Cold program on the Spectrum Essentials(R) brand, the Company's most profitable segment. Gross profit by segment is detailed in the following table: Years Ended December 31, ------------------------ 2004 2003 % Change ---- ---- -------- Spectrum Naturals(R) Culinary Products $ 5,403,400 $ 5,365,500 +1% Spectrum Essentials(R) Nutritional Supplements 4,297,300 4,659,700 -8% Spectrum Ingredients/Other 1,834,000 1,844,500 -1% ----------- ----------- -------- Total Gross Profit $11,534,700 $11,869,700 -3% =========== =========== ======== Gross profit as a percent of net sales (gross margin) was 23.1% for 2004 versus 26.0% for 2003, primarily as a result of the increased raw material costs in the Company's culinary segment described above and an unfavorable sales mix. The unfavorable sales mix was due to reduced sales of flax oil products, the Company's highest margin product line and increased sales of the Spectrum Ingredients industrial products, the Company's lowest margin product lines. Sales and Marketing Expenses: The Company's sales and marketing expenses for the year ended December 31, 2004 were $7,293,600 or 14.6% of net sales, versus $6,204,600 or 13.6% of net sales for the prior year. The increase in spending of $1,089,000 is detailed in the following table which reconciles sales and marketing spending for 2004 versus 2003, and discloses the significant variances by spending category: - -------------------------------------------------------------------------------- Page 20 Total sales and marketing expenses for 2003 $ 6,204,600 Increased advertising 582,500 Increased compensation and benefits 280,600 Increased sponsorships 117,100 Increased trade shows 93,200 Increased market research spending 97,300 Decreased broker commissions (20,800) Decreased professional and website fees (23,600) Decreased product label development expenses (22,800) All other, net (14,500) ----------- Total sales and marketing expenses for 2004 $ 7,293,600 =========== The increased advertising spending was related to the launch of the new "I am Spectrum" campaign for 2004. The increased compensation and benefits was primarily associated with increased staffing in the Marketing Department. The increased sponsorships have enabled the Company to maintain a greater presence with influential health practitioners with regards to the importance of healthy oils. The increased trade show spending enabled the Company to continue to increase its presence as an industry leader through educational presentations and seminars at major trade events. The increased market research spending was primarily attributable to research conducted in 2004 on several new product categories for the Spectrum Naturals(R) brand. The decreased broker commissions were primarily attributable to the lower Spectrum Essentials(R) sales this year as a result of the Fresh and Cold program. The Company expects its sales and marketing expenses to continue to increase in dollar amount, but to remain steady at approximately 15% of net sales for 2005 and beyond. General and Administrative Expenses: The Company's general and administrative expenses for the year ended December 31, 2004 were $3,731,700 or 7.5% of net sales, versus $3,729,100 or 8.2% of net sales for the prior year. The increase in spending of $2,600 is detailed in the following table which reconciles general and administrative spending for 2004 versus 2003, and discloses significant variances by spending category: Total general and administrative expenses for 2003 $ 3,729,100 Increased professional fees 32,600 Iowa production facility grand opening event 28,500 Donations 25,200 Decreased compensation and benefits expense (107,800) All other, net 24,100 ----------- Total general and administrative expenses for 2004 $ 3,731,700 =========== The increased professional fees were primarily associated with increased information systems consulting services. The Iowa facility grand opening event was attended by local media and government officials and resulted in some very favorable press for the Company. The increased donations were primarily due to the initiation of a structured company-wide donation program in 2004. The decreased compensation and benefits expense was primarily associated with reduced accruals in 2004 for incentive compensation as a result of the lower profitability levels achieved by the Company in 2004. The Company expects its general and administrative expenses to increase modestly in dollar amount, but continue to decrease as a percent of net sales for 2005 and beyond. Manufacturing Facility Relocation: During 2004 the Company completed the final phase of its efforts to close the manufacturing facility located in Petaluma California where flax oil production formerly occurred. Production ceased at the Petaluma facility on September 24, - -------------------------------------------------------------------------------- Page 21 2004 and the Company disassembled and relocated some of the Petaluma equipment to its new leased manufacturing facility in Cherokee, Iowa. The Iowa facility will be managed under a strategic alliance with BIOWA Nutraceuticals, LLC. The Company incurred expenses of $1,565,300 in 2004 in connection with the manufacturing facility relocation and reconfiguration. Included in that amount were non-cash write-offs of $919,500 for infrastructure and leasehold improvements at the Copeland Street facility which could not be relocated to Iowa, plus $237,100 in writedowns to fair market value for certain equipment that was relocated to Iowa which management deemed was impaired at December 31, 2004. In addition, cash expenses of $408,700 were incurred for relocation costs and project management expenses associated with the move to Iowa. Interest Expense: The Company's interest expense for 2004 was $361,900 versus $404,200 for 2003. The decrease of $42,300 or 11% is detailed in the following table which reconciles interest expense for 2004 versus 2003 and discloses the significant variances by item: Total interest expense for 2003 $ 404,200 Early termination expense on former credit agreement (70,400) Decreased interest on fixed long-term debt (27,100) Increased interest on variable long-term debt 34,500 Increased interest on revolving line of credit 18,200 All other, net 2,500 --------- Total interest expense for 2004 $ 361,900 ========= The early termination expense was a contractual obligation paid to the Company's former primary lender of $62,400 plus the write-off of the remaining unamortized loan fee of $8,000 as a result of terminating that credit facility prior to its maturity date of October 6, 2004. The decreased interest on fixed long-term debt was due to principal payments made during 2004 on the related party notes and capital lease obligations. The increased interest on variable long-term debt was due to increased borrowing on the CAPEX facility note with Comerica Bank. The increased interest expense under the revolving line of credit was primarily due to increased average borrowings during 2004 to finance the higher levels of inventory, partially offset by the lower rates available during 2004 from Comerica Bank. On July 11, 2003 the Company entered into a new banking relationship with Comerica which lowered the Company's interest rate on term debt by 1% per annum and lowered the effective interest rate under the line of credit by approximately 1.75% per annum. Provision for Income Taxes: The Company recorded a benefit from income taxes of $555,200 for the year ended December 31, 2004 versus a benefit of $1,566,600 for the prior year. The benefit for 2004 was estimated at 40% of the Company's loss before taxes. The benefit for 2003 was the result of the elimination of the 100% valuation reserve that had previously been maintained against the Company's deferred tax assets. Seasonality: Historically, the Company has experienced little seasonal fluctuation in revenues. With regards to product purchasing, the Company will seasonally contract for certain raw materials for the entire year at harvest time or at planting time. These purchases take place annually from early spring to mid-summer and are affected to reduce the risk of price swings due to demand fluctuations. These annual purchases can create overages and shortages in inventory. Liquidity and Capital Resources: On June 4, 2004 the Company entered into the First Amendment to its Credit Facility with Comerica Bank ("Comerica") which extended the maturity date of the Credit Facility to June 30, 2006. The Amendment also increases the revolving line of credit up to a maximum of $9,000,000, and extends the drawdown period - -------------------------------------------------------------------------------- Page 22 under the capital expenditure term loan of $1,000,000 by six months to December 31, 2004. The Credit Facility is secured by substantially all assets of the Company and enables the Company to borrow below prime, using a LIBOR rate option. The Company could not operate its business without the Credit Facility with Comerica or one similar to it. The Credit Facility calls for continued satisfaction of various financial covenants for 2004 and beyond related to profitability levels, debt service coverage, and the ratio of total liabilities to tangible net worth. As of December 31, 2004 the Company was in technical default of the liabilities to tangible net worth ratio due to the expenses associated with the manufacturing facility relocation. Comerica has granted the Company a waiver on the covenant violation. At December 31, 2004 the Company had working capital of $688,600 which reflected a decline of $870,900 versus December 31, 2003. The decrease was primarily attributable to increased borrowings outstanding under the line of credit to finance the higher inventories, partially offset by lower accrued expenses for incentive compensation. During 2004 the Company used $1,242,600 in cash from operating activities, compared to using $1,206,400 in cash in 2003. The increase in cash used in 2004 was primarily due to the lower profitability level in 2004, partially offset by decreases in the cash used for inventory and working capital items. As a result of a crop shortage, during 2003 the Company was required to hold significant quantities of flaxseed in inventory prior to production in order to lock in its supply, which was less prevalent in 2004 as flaxseed stocks returned to normal levels. Cash used in investing activities was $1,458,800 in 2004 compared to $1,831,100 in 2003. In 2004 the cash was primarily invested in the new production facility in Iowa. In 2003 the cash was invested in the purchase of the SpectraVac intellectual property and in machinery and equipment, primarily a new rotary labeler for the bottling facility and six used expeller presses which were subsequently installed in the new Iowa facility during 2004. Cash provided by financing activities was $2,705,100 in 2004 compared to cash provided of $3,032,100 in 2003. The cash provided in 2004 was primarily from proceeds under the revolving line of credit and the capital expenditures term note. The cash provided in 2003 was primarily increased borrowing under the revolving line of credit and the refinancing of the Company's bank term debt to finance the equipment purchases and the cash used for operating activities. Based on its forecasts for 2005 and beyond, management believes that future cash flows from operations and available borrowing capacity under the revolving line of credit should provide adequate funds to meet the Company's estimated cash requirements for the foreseeable future. Excess borrowing capacity under the revolving line of credit was $2,015,600 and $2,105,800 at December 31, 2004 and 2003, respectively. The Company has contractual cash obligations for future periods in excess of twelve months primarily with regards to debt service, non-cancelable leases and the terms of settlement with the Sonoma County District Attorney and CAL-OSHA in connection with the industrial accident. The following table discloses the Company's expected cash obligations for future periods in connection with contractual commitments extending beyond twelve months: Contractual Cash Obligations ($ Thousands) ------------------------------------------ 2005 2006 2007 2008 2009+ Total ---- ---- ---- ---- ----- ----- Long-term Debt $ 739 $ 500 $ 500 $ 375 $ 513 $ 2,627 Operating Leases 312 312 312 30 30 996 Industrial Accident 121 50 -- -- -- 171 Capital Leases (1) 15 -- -- -- -- 15 ------- ------- ------- ------- ------- ------- Total Contractual Cash $ 1,187 $ 862 $ 812 $ 405 $ 543 $ 3,809 Obligations ======= ======= ======= ======= ======= ======= (1) Includes amounts representing interest - -------------------------------------------------------------------------------- Page 23 In addition to the above, the Company had outstanding commitments for raw material purchases of $15,212,000 at December 31, 2004. None of the raw material purchase commitments were in excess of normal requirements or at prices in excess of current market prices available to the Company. Off-Balance Sheet Arrangements: The Company does not utilize off-balance sheet financing arrangements. There were no transactions with special purpose entities that give the Company access to assets or additional financing or carry debt that is secured by the Company. The Company was a guarantor in the amount of $25,000 for a portion of the outstanding borrowings under a line of credit for The Olive Press, LLC a third party that the Company held an investment in of $15,000 as of December 31, 2004. - -------------------------------------------------------------------------------- Results of Operations for the Year Ended December 31, 2003 Compared to the Year Ended December 31, 2002 - -------------------------------------------------------------------------------- Summary Discussion: In general 2003 was a good year for the Company, featuring strong comparable net sales growth (+22%) and 6% growth in EBITDA as adjusted. All three segments of the Company's business posted double-digit annual sales growth on the strength of increased demand for non-hydrogenated culinary oils and Omega-3 essential fatty acid nutritional supplements. Management believes that earnings before interest, taxes, depreciation, amortization, expenses associated with the industrial accident and gains on the sales of product lines ("EBITDA as adjusted") is an important measure of the Company's operating performance. Management incentives are earned, in part, based on the achievement of EBITDA as adjusted targets. Additionally, EBITDA as adjusted eliminates the impact of a number of unusual transactions and events that management believes are unlikely to recur. Therefore, EBITDA as adjusted is useful to investors since it discloses the on-going economic performance of the Company in the absence of the unusual transactions and events. For the year ended December 31, 2003 EBITDA as adjusted was $2,436,100 compared to $2,288,500 for the prior year, an increase of $147,600 or 6%. The increase in 2003 is discussed in detail below, but was primarily attributable to increased sales, partially offset by pressure on gross margins and increased operating expenses in 2003. While management believes that EBITDA as adjusted is a useful measure of the Company's financial performance, it should not be construed as an alternative to income from operations, net income or cash flows from operating activities as determined in accordance with accounting principles generally accepted in the United States of America. Furthermore, the Company's calculation of EBITDA as adjusted, which is detailed in the following table, may be different from the calculation used by other companies, thereby limiting comparability: Years Ended December 31, ------------------------ 2003 2002 ---- ---- Net income as reported $ 2,663,600 $ 1,120,000 Provision (benefit) for income taxes (1,566,600) 189,800 Interest expense 404,200 480,600 Depreciation and amortization 524,700 454,300 Industrial accident expenses 410,200 254,100 Gain on sales of product lines -- (210,300) ----------- ----------- EBITDA as adjusted $ 2,436,100 $ 2,288,500 =========== =========== - -------------------------------------------------------------------------------- Page 24 The following is management's discussion and analysis of the significant line items within the financial statements and the reasons behind the trends and variances versus the prior year: Revenues: Spectrum's net sales for the year ended December 31, 2003 were $45,676,500 compared to $40,579,300 for 2002, an increase of $5,097,200 or 13%. The increase in net sales was primarily volume-related and was driven by significant increases in all three of the Company's segments, as detailed in the following table: Years Ended December 31, ------------------------ 2003 2002 % Change ---- ---- -------- Spectrum Naturals(R) Culinary Products $ 20,606,100 $ 17,268,200 +19% Spectrum Essentials(R) Nutritional Supplements 10,353,900 9,030,400 +15% Spectrum Ingredients/Private Label Products 14,443,400 11,065,900 +31% ------------ ------------ -------- Comparable Net Sales 45,403,400 37,364,500 +22% Disposed/Discontinued Product Lines 273,100 3,214,800 -92% ------------ ------------ -------- Total Net Sales $ 45,676,500 $ 40,579,300 +13% ============ ============ ======== Within the Spectrum Naturals(R) culinary products, sales were significantly higher than prior year in consumer packaged oils (+42%), institutional and food service oils (+34%) olive oils (+22%) and mayonnaise (+28%). All of Spectrum's culinary oils are expeller-pressed and contain no trans fatty acids as a result of hydrogenation. Therefore, the Company's culinary oils continued to benefit from increased consumer awareness of the dangers of hydrogenated oils with regards to obesity and cardiovascular disease. Spectrum Essentials(R) nutritional supplement sales increased 15% versus the prior year, primarily as a result of increased demand for organic flax oil and refined coconut oil sold as a health and beauty aid. Liquid flax oil sales, which represented approximately 65% of the Spectrum Essentials(R) sales during 2003 were up 15% versus the prior year as a result of increased demand and the non-recurrence of out-of-stocks during the fourth quarter of 2002 as a result of a flaxseed shortage. The Spectrum Ingredients sales increased 31% versus the prior year on the strength of increased customer demand for non-hydrogenated culinary oils. During 2003 there was prominent media coverage of commitments by several Fortune 500 companies to eliminate or sharply reduce hydrogenated oils from their products. Cost of Goods Sold: The Company's cost of good sold for the year ended December 31, 2003 was $33,806,800 versus $29,823,000 for 2002, an increase of 13%. The increase was primarily volume-related and was driven by significant increases in all three of the Company's primary segments, as detailed in the following table: Years Ended December 31, ------------------------ 2003 2002 % Change ---- ---- -------- Spectrum Naturals(R) Culinary Products $ 15,240,600 $ 12,882,800 +18% Spectrum Essentials(R) Nutritional Supplements 5,694,200 4,706,500 +21% Spectrum Ingredients/Private Label Products 12,725,300 9,854,700 +29% ------------ ------------ -------- Comparable Cost of Goods Sold 33,660,100 27,444,000 +23% Disposed/Discontinued Product Lines 146,700 2,379,000 -94% ------------ ------------ -------- Total Cost of Goods Sold $ 33,806,800 $ 29,823,000 +13% ============ ============ ======== Cost of goods sold as a percent of net sales increased during 2003 to 74.0% compared to 73.5% for 2002. The increase was due primarily to increased raw material costs in the Company's flax oil, olive oil and mayonnaise product lines, a $50,300 write-down incurred for the obsolete bottling equipment that - -------------------------------------------------------------------------------- Page 25 was not relocated to Interpac and an unfavorable sales mix. The flax oil products continued to be impacted by higher flaxseed costs in 2003 while olive oil imported from Europe was impacted by all-time lows in the dollar versus euro exchange rate. Gross Profit: Gross profit for 2003 was $11,869,700 versus $10,756,300 for 2002, an increase of $1,113,400 or 10%. The increase was primarily volume-related and was driven by significant increases in all three of the Company's primary segments, as detailed in the following table: Years Ended December 31, ------------------------ 2003 2002 % Change ---- ---- -------- Spectrum Naturals(R) Culinary Products $ 5,365,500 $ 4,385,400 +22% Spectrum Essentials(R) Nutritional Supplements 4,659,700 4,323,900 +8% Spectrum Ingredients/Private Label Products 1,718,100 1,211,200 +42% ------------ ------------ -------- Comparable Gross Profit 11,743,300 9,920,500 +18% Disposed/Discontinued Product Lines 126,400 835,800 -85% ------------ ------------ -------- Total Gross Profit $ 11,869,700 $ 10,756,300 +10% ============ ============ ======== Gross profit as a percentage of net sales (gross margin) was 26.0% for 2003 versus 26.5% for 2002, primarily as a result of the increased raw material costs in the Company's flax oil, olive oil and mayonnaise product lines, the bottling line relocation and an unfavorable sales mix. The Company implemented price increases on certain product lines effective November 1, 2003 in order to pass on some of the raw material cost increases to consumers. Partially offsetting the increased costs was improved management of sales discounts and promotions, particularly with respect to the Spectrum Naturals(R) segment. Sales and Marketing Expenses: The Company's sales and marketing expenses for 2003 were $6,204,600 or 13.6% of net sales, versus $5,987,500 or 14.8% of net sales for 2002. The increase in spending of $217,100 in 2003 is detailed in the following table which reconciles sales and marketing spending for 2003 versus 2002 and discloses the significant variances by spending category: Total sales and marketing expense for 2002 $ 5,987,500 Increased broker commissions 325,000 Increased market research expenses 161,600 Increased trade show expenses 74,000 Increased spending on label revisions 40,500 Increased spending on Company website 42,800 Increased spending on public relations 35,300 Decreased advertising (289,400) Decreased compensation and benefits (137,500) All other, net (35,200) ----------- Total sales and marketing expense for 2003 $ 6,204,600 =========== The increased broker commissions were attributable to the double-digit sales growth in both branded product lines in 2003. The increase in market research expenses in 2003 was primarily attributable to a focus group conducted on the Spectrum Essentials(R) product line for the first time in the Company's history. The increased spending on trade shows, label revisions, the website and public relations was primarily attributable to upgrades made by the Company's marketing staff. The decreased advertising spending was the result of a new advertising campaign that was under development during 2003 to improve the Company's advertising message and its overall consistency. The decreased compensation and benefits was primarily attributable to the elimination of eleven full-time employees formerly associated with the OI product lines that were sold on April 25, 2002. Partially offsetting that were three full-time positions added to the Marketing Department during 2003. - -------------------------------------------------------------------------------- Page 26 General and Administrative Expenses: The Company's general and administrative expenses for 2003 were $3,729,100 or 8.2% of net sales, versus $2,949,500 or 7.3% of net sales for 2002. The increase in spending of $779,600 is detailed in the following table which reconciles general and administrative spending for 2003 versus 2002 and discloses the significant variances by spending category: Total general and administrative expense for 2002 $ 2,949,500 Increased compensation and benefits 346,700 Increased rent expense 149,700 Increased board expenses 88,900 Increased consulting and site evaluation 83,900 Increased legal fees 45,100 Increased telephone expense 41,100 All other, net 24,200 ----------- Total general and administrative expense for 2003 $ 3,729,100 =========== The increased compensation and benefits were primarily attributable to increased executive compensation expense in 2003, $34,800 of expense in connection with a shareholder advance that was forgiven, a severance payment to a former officer and increased incentive accruals for 2003. The increase in rent expense was primarily associated with the move to the Company's new headquarters in December 2002. The increased board expenses were the result of cash compensation paid to the external board members for the first time since the merger. The consulting and site evaluation expenses were incurred in connection with the evaluation of alternative locations for the Company's SpectraVac flax oil manufacturing operation. The increased spending in legal fees was primarily attributable to an S-8 filing with the SEC and employment law advice related to the relocation of the bottling line to Interpac. The increase in telephone spending was due to a change in phone service providers and early termination of the previous contract. Industrial Accident Expenses: During 2003 the Company incurred $410,200 in expenses associated with an industrial accident that occurred on April 25, 2002. Two of the Company's employees died due to asphyxiation in a confined space accident. Included in the $410,200 was an accrual of $375,000 at December 31, 2003 to record the Terms of Settlement and Probation entered into on February 4, 2004 with a plea of no contest to two misdemeanor violations of a regulation issued by the California Occupational Health and Safety Administration ("CAL-OSHA"). Under the Terms of Settlement and Probation, the Company will pay a fine of $150,000 in three annual installments of $50,000 each on June 30, 2004, 2005 and 2006. In addition the Company paid $150,000 in restitution to the California District Attorneys Association Workers Safety Training Account to assist with the prosecution of worker safety cases in the State of California. The Company also reimbursed costs of $25,000 each to the Petaluma Police Department, the Petaluma Fire Department and the Sonoma County District Attorney's Office. During 2002 the Company incurred expenses of $254,100 in connection with the same industrial accident. Included in that amount was a remaining reserve of $141,900 at December 31, 2003 to cover anticipated penalties from CAL-OSHA, appeals filed by the dependants of the two employees with the Worker's Compensation Appeals Board of California, and related attorney's fees. Gain on Sale of Product Lines: The Company recorded a net gain from the sale of product lines during 2002 of $210,300 which consisted primarily of the collection of the remaining escrowed funds from the sale of OI. - -------------------------------------------------------------------------------- Page 27 Interest Expense: The Company's interest expense for 2003 was $404,200 versus $480,600 for 2002. The decrease of $76,400 or 16% is detailed in the following table which reconciles interest expense for 2003 versus 2002 and discloses the significant variances by item: Total interest expense for 2002 $ 480,600 Decreased interest on private placement notes (75,500) Decreased interest on fixed long-term debt (51,000) Early termination expense on former credit agreement 70,400 Increased interest on revolving line of credit 10,600 All other, net (39,900) --------- Total interest expense for 2003 $ 404,200 ========= The decreased interest on the private placement notes was due to the early retirement of the notes on December 27, 2002. The decreased interest on fixed long-term debt was due to principal payments made during 2003 on the related party notes. The early termination fee was a contractual obligation due to the Company's former primary lender as a result of terminating that credit facility prior to its maturity date of October 6, 2004. The increased interest expense under the revolving line of credit was primarily due to increased average borrowings during 2003 to finance the higher levels of inventory, partially offset by the lower rates available during the second half of 2003 from Comerica Bank. On July 11, 2003 the Company entered into a new banking relationship with Comerica which lowered the Company's interest rate on term debt by 1% per annum and lowered the effective interest rate under the line of credit by approximately 1.5% per annum. Provision for Income Taxes: At December 31, 2003 the Company reversed the 100% valuation allowance that had been maintained against its deferred tax assets since the merger. As a result, the Company recorded a net benefit for income taxes of $1,566,600 for 2003. The Company has federal net operating loss carryovers sufficient to offset all federal income taxes due on its estimated taxable income for 2003 with the exception of $9,900 due as a result of the alternative minimum tax. However, the State of California imposed a two-year moratorium on the use of net operating loss carryovers, as a result of a budget crisis, for 2002 and 2003. Consequently, the Company paid $176,000 in estimated state income taxes due for 2002 during the first quarter of 2003 and made estimated state income tax payments for 2003 of $140,400. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - ------------------------------------------------------------------- The Company is exposed to market risk from changes in foreign currency exchange rates and interest rates that could impact its results of operations and financial position. The Company manages its exposure to these risks through financing activities and foreign currency forward contracts, when deemed appropriate. The Company utilizes foreign currency forward contracts as risk management tools and not for speculative purposes. Spectrum's risk management objective is to minimize the volatility on its cash flows by identifying the forecasted transactions exposed to these risks and hedging them appropriately. In January 2005 the Company began utilizing foreign currency forward contracts to minimize the volatility of foreign currency cash flows resulting from changes in exchange rates. Foreign currency forward contracts are entered into for firmly committed or anticipated raw material purchases. The use of these contracts enables Spectrum to reduce its exposure to foreign currency exchange rate movements since the gains and losses on the contracts substantially offset the gains and losses on the transactions being hedged. As of December 31, 2004 the Company's primary foreign currency exchange rate exposures were the euro and Canadian dollar. The Company had no outstanding foreign currency forward contracts at December 31, 2004. However, forward contracts to hedge anticipated euro purchases during 2005 were entered into in January 2005. - -------------------------------------------------------------------------------- Page 28 The table below provides information about the Company's foreign currency forward contracts in U.S. dollar equivalents. All foreign currency contracts were for euros and are expected to mature during 2005. Expected Maturity Date Fair Value ------------- ---------- Foreign Currency Forward Contracts: (Pay euros / receive U.S. $) 2005 Contract Amount 1,267,000 $1,685,200 Average Contractual Exchange Rate $1.33 Throughout the course of its fiscal year, the Company utilizes a variable interest rate line of credit at various borrowing levels. For the year ended December 31, 2004 the average outstanding balance under the line of credit was approximately $5,974,200 with a weighted average effective interest rate of 4.0% per annum. For the year ended December 31, 2003 the average outstanding balance under the line of credit was approximately $4,707,700 with a weighted average effective interest rate of 4.6% per annum. For the year ended December 31, 2002 the average outstanding balance under the line of credit was approximately $3,153,000 with a weighted average effective interest rate of 6.5% per annum. The increased average borrowing levels in 2004 reflect the funds necessary to finance the increased inventory levels and increased level of operations in general. The reduction in the weighted average effective interest rate in 2004 reflects the lower interest rates available under the new banking relationship with Comerica. Certain other debt items are also sensitive to changes in interest rates. The following table summarizes principal cash flows and related weighted average interest rates by expected maturity date for long-term debt, excluding capital lease obligations (dollars in thousands): Outstanding Expected Principal Payments Dec. 31, (Periods Ended December 31) ---------- -------------------------------------------------------------------- 2004 2005 2006 2007 2008 2009 2010 ---- ---- ---- ---- ---- ---- ---- Long Term Debt: Fixed Rate $ 228.2 $ 228.2 $ -- $ -- -- -- -- Avg. Int. Rate 9.2% 9.2% -- -- -- -- -- Variable Rate $1,875.0 $ 500.0 $ 500.0 $ 500.0 $ 375.0 -- -- Avg. Int. Rate 5.5% var. var. var. var. -- -- Imputed Rate $ 326.2 -- -- -- -- -- $ 326.2 Avg. Int. Rate 7.6% -- -- -- -- -- 7.6% In the ordinary course of its business the Company enters into commitments to purchase raw materials over a period of time, generally six months to one year, at contracted prices. At December 31, 2004 these future commitments totaled $15,212,000 and were not at prices in excess of current market, nor in quantities in excess of normal requirements. The Company does not utilize derivative contracts either to hedge existing risks or for speculative purposes. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - --------------------------------------------------- Spectrum Organic Products, Inc. Financial Statements Years Ended December 31, 2004, 2003 and 2002 Reports of Independent Registered Public Accounting Firms Financial Statements: Balance Sheets Statements of Operations Statement of Stockholders' Equity Statements of Cash Flows Notes to Financial Statements =================================================================== - -------------------------------------------------------------------------------- Page 29 Report of Independent Registered Public Accounting Firm To the Stockholders and Board of Directors of Spectrum Organic Products, Inc. We have audited the accompanying balance sheets of Spectrum Organic Products, Inc. (the "Company") as of December 31, 2004 and 2003 and the related statements of operations, stockholders' equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board of the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principals used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Spectrum Organic Products, Inc. as of December 31, 2004 and 2003 and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. /s/ Grant Thornton, LLP - ----------------------------- Grant Thornton, LLP San Francisco, California February 25, 2005 - -------------------------------------------------------------------------------- Page 30 Report of Registered Public Accounting Firm To the Stockholders and Board of Directors of Spectrum Organic Products, Inc. We have audited the accompanying statements of operations, stockholders' equity, and cash flows of Spectrum Organic Products, Inc. (the "Company") for the year ended December 31, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Spectrum Organic Products, Inc. for the year ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. /s/ BDO Seidman, LLP - ----------------------------- BDO Seidman, LLP San Francisco, California February 21, 2003 - -------------------------------------------------------------------------------- Page 31 Spectrum Organic Products, Inc. Balance Sheets ========================================================================================= As of December 31, 2004 2003 ------------ ------------ Assets Current Assets: Cash $ 11,000 $ 7,300 Accounts receivable, net 3,799,800 4,163,200 Inventories, net 9,564,800 8,007,200 Deferred income taxes - current 630,000 514,200 Prepaid expenses and other current assets 141,400 297,500 ------------ ------------ Total Current Assets 14,147,000 12,989,400 Property and Equipment, net 3,990,200 4,338,700 Other Assets: Deferred income taxes - long-term 1,529,500 1,087,700 Intangible assets, net 584,800 586,800 Other assets 251,200 218,300 ------------ ------------ Total Assets $ 20,502,700 $ 19,220,900 ============ ============ Liabilities and Stockholders' Equity Current Liabilities: Bank overdraft $ 843,300 $ 513,800 Line of credit 6,984,400 4,833,000 Accounts payable, trade 4,033,800 4,168,000 Accrued expenses 854,100 1,307,700 Current maturities of notes payable & capital lease obligations 514,600 322,300 Current maturities of notes payable, related parties 228,200 275,200 Income taxes payable -- 9,900 ------------ ------------ Total Current Liabilities 13,458,400 11,429,900 Notes payable & capital lease obligations, less current maturities 1,375,000 1,104,200 Notes payable, related parties, less current maturities 326,200 549,200 Deferred rent 37,000 50,700 ------------ ------------ Total Liabilities 15,196,600 13,134,000 ------------ ------------ Commitments and Contingencies Stockholders' Equity: Preferred stock, 5,000,000 shares authorized, no shares issued or outstanding -- -- Common stock, without par value, 60,000,000 shares authorized, 46,405,943, 46,254,777 and 45,705,571 issued and outstanding at December 31, 2004, 2003 and 2002, respectively 9,631,400 9,579,500 Accumulated deficit (4,325,300) (3,492,600) ------------ ------------ Total Stockholders' Equity 5,306,100 6,086,900 ------------ ------------ Total Liabilities and Stockholders' Equity $ 20,502,700 $ 19,220,900 ============ ============ See accompanying notes to financial statements. - ------------------------------------------------------------------------------------------ Page 32 Spectrum Organic Products, Inc. Statements of Operations ============================================================================================== For the years ended December 31, 2004 2003 2002 ------------ ------------ ------------ Net sales $ 49,915,400 $ 45,676,500 $ 40,579,300 Cost of goods sold 38,380,700 33,806,800 29,823,000 ------------ ------------ ------------ Gross profit 11,534,700 11,869,700 10,756,300 ------------ ------------ ------------ Operating Expenses: Sales and marketing 7,293,600 6,204,600 5,987,500 General and administrative 3,731,700 3,729,100 2,949,500 Manufacturing facility relocation (Note 2) 1,565,300 -- -- Industrial accident expenses (Note 3) -- 410,200 254,100 (Gain) loss on sale of product lines (Note 7) -- -- (210,300) ------------ ------------ ------------ Total Operating Expenses 12,590,600 10,343,900 8,980,800 ------------ ------------ ------------ Income (Loss) From Operations (1,055,900) 1,525,800 1,775,500 Other Income (Expense): Interest expense (361,900) (404,200) (480,600) Other, net 29,900 (24,600) 14,900 ------------ ------------ ------------ Income (Loss) Before Taxes (1,387,900) 1,097,000 1,309,800 Benefit (Provision) for income taxes 555,200 1,566,600 (189,800) ------------ ------------ ------------ Net Income (Loss) $ (832,700) $ 2,663,600 $ 1,120,000 ============ ============ ============ Basic and Fully Diluted Income (Loss) Per Share $ (0.02) $ 0.06 $ 0.02 ============ ============ ============ Weighted Average Shares Outstanding: Basic 46,344,585 45,845,140 45,699,627 Fully Diluted 46,344,585 47,839,765 46,306,077 See accompanying notes to financial statements. - ---------------------------------------------------------------------------------------------- Page 33 Spectrum Organic Products, Inc. Statement of Stockholders' Equity For the Years Ended December 31, 2002, 2003 and 2004 ======================================================================================================== Retained Earnings Total Common Stock (Accumulated Stockholders' Shares Amount Deficit) Equity ----------- ----------- ----------- ----------- Balances, January 1, 2002 45,698,661 $ 9,373,700 $(7,276,200) $ 2,097,500 Warrants net exercised by the note holders under the private placement 6,910 -- -- -- Warrants issued in connection with the private placement notes -- 49,500 -- 49,500 Non-qualified stock options issued -- 6,900 -- 6,900 Net income for the year -- -- 1,120,000 1,120,000 ----------- ----------- ----------- ----------- Balances, December 31, 2002 45,705,571 $ 9,430,100 $(6,156,200) $ 3,273,900 Warrants exercised by the note holders under the private placement 405,456 90,000 -- 90,000 Exercise of common stock options 143,750 59,400 -- 59,400 Net income for the year -- -- 2,663,600 2,663,600 ----------- ----------- ----------- ----------- Balances, December 31, 2003 46,254,777 $ 9,579,500 $(3,492,600) $ 6,086,900 Exercise of common stock options 151,166 51,900 -- 51,900 Net loss for the year -- -- (832,700) (832,700) ----------- ----------- ----------- ----------- Balances, December 31, 2004 46,405,943 $ 9,631,400 $(4,325,300) $ 5,306,100 =========== =========== =========== =========== See accompanying notes to financial statements. - ------------------------------------------------------------------------------------------------------- Page 34 Spectrum Organic Products, Inc. Statements of Cash Flows ============================================================================================================ For the years ended December 31, 2004 2003 2002 ------------ ------------ ------------ Cash Flows From Operating Activities: Net Income (Loss) $ (832,700) $ 2,663,600 $ 1,120,000 Adjustments to Reconcile Net Income (Loss) to Net Cash Provided by (Used in) Operating Activities: Provision for allowances against receivables 56,300 103,400 47,000 Provision for inventory obsolescence 332,800 210,800 262,200 Provision for industrial accident -- 410,200 254,100 Depreciation and amortization 652,700 524,700 454,300 Gain on sale of product lines -- -- (210,300) Write-off of equipment due to plant closure 919,500 50,300 -- Writedown on equipment to fair market value 237,100 -- -- Imputed interest on notes payable and warrants issued 20,800 19,000 71,300 Imputed expense on non-qualified stock options -- -- 6,900 Changes in Assets and Liabilities: Accounts receivable 307,100 (1,191,400) 430,400 Inventories (1,890,400) (2,948,400) (1,057,700) Deferred income taxes (557,600) (1,601,900) -- Other assets 123,200 (224,300) (54,300) Accounts payable (134,200) 871,700 (500,300) Accrued expenses and other liabilities (477,200) (94,100) (106,200) ------------ ------------ ------------ Net Cash Provided by (Used in) Operating Activities (1,242,600) (1,206,400) 717,400 ------------ ------------ ------------ Cash Flows From Investing Activities: Purchase of property and equipment (1,474,100) (1,281,100) (719,300) Proceeds from sale of assets 15,300 -- -- Purchase of intellectual property -- (550,000) -- Proceeds from sale of product lines and related inventories -- -- 3,215,200 Transaction fees on sale of product lines -- -- (152,000) ------------ ------------ ------------ Net Cash Provided by (Used in) Investing Activities (1,458,800) (1,831,100) 2,343,900 ------------ ------------ ------------ Cash Flows From Financing Activities: Increase (decrease) in bank overdraft 329,500 (87,200) 29,300 Proceeds from lines of credit 21,866,000 36,210,000 43,931,000 Repayment of lines of credit (19,714,600) (33,856,600) (46,050,000) Proceeds of notes payable 754,800 1,495,200 -- Repayment of notes payable (250,000) (553,800) (545,200) Repayment of notes payable, related parties (290,800) (275,300) (371,200) Repayment of capitalized lease obligations (41,700) (49,600) (69,000) Proceeds from exercise of common stock options 51,900 59,400 -- Proceeds from exercise of common stock warrants -- 90,000 -- ------------ ------------ ------------ Net Cash Provided by (Used in) Financing Activities 2,705,100 3,032,100 (3,075,100) ------------ ------------ ------------ Net Increase (Decrease) in Cash 3,700 (5,400) (13,800) Cash, beginning of the year 7,300 12,700 26,500 ------------ ------------ ------------ Cash, end of the year $ 11,000 $ 7,300 $ 12,700 ============ ============ ============ Supplemental Disclosure of Cash Flow Information: Cash paid for income taxes $ 16,000 $ 323,500 $ 13,800 Cash paid for interest $ 359,800 $ 384,400 $ 446,300 See accompanying notes to financial statements. - ------------------------------------------------------------------------------------------------------------ Page 35 Spectrum Organic Products, Inc. Notes to Financial Statements - -------------------------------------------------------------------------------- 1. Basis of Presentation and Significant Accounting Policies The Company manufactures, packages and sells nutritional supplements and organic and natural food products, including cooking and nutritional oils, condiments, dressings and butter substitutes on a wholesale basis to distributors throughout the United States and Canada, and to other manufacturers as industrial organic ingredients. Company headquarters, bottling, warehousing and distribution are located in Northern California. The Company's manufacturing facility is located in Cherokee, Iowa. Business Combination and Subsequent Divestitures The Company was formed on October 6, 1999 by the four-way reverse merger of Spectrum Naturals, Inc. ("SNI"), its affiliate Spectrum Commodities, Inc. ("SCI"), Organic Ingredients, Inc. ("OI") with and into Organic Food Products, Inc. ("OFPI"). On June 11, 2001 and April 25, 2002 the Company divested the OFPI and OI product lines, respectively, in order to raise working capital and focus on its core business in healthy fats and oils. Accordingly, results of operations for the year ended December 31, 2002 includes the operating results of the OI disposed product lines until the date of sale. Business Segments The Company operates in three primary business segments: Spectrum Naturals(R) culinary products, Spectrum Essentials(R) nutritional supplements, and Spectrum Ingredients industrial products for use by other manufacturers and private label products for key retailers. Operating results are captured by segment to the gross profit level. However, operating statement data below gross profit and balance sheet information have not been disaggregated and captured by business segment since the information is presently unavailable to the Company's chief operating decision maker. Risk Factors The Company is subject to a wide variety of risks in the ordinary course of its business. Some of the more significant risks include heavy concentrations of sales with a few key customers; heavy concentrations of raw material supply with a few key suppliers; heavy reliance on several key processors for its dressings, condiments and butter substitutes; reliance on one processor for bottling of its oils as well as warehousing and distribution of its finished case goods; regulation by various federal, state and local agencies with regards to the manufacture, handling, storage and safety of food products; regulation of its manufacturing facilities for cleanliness and employee safety; and regulation by various agencies with regards to the labeling and certification of organic and kosher foods. The Company is also subject to competition from other food companies, the risk of crop shortages due to weather or other factors, and is dependant on the continued demand for healthy oils and nutritional supplements by consumers. Critical Accounting Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. The Company bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for the carrying values of assets and liabilities that are not readily apparent from other sources. On an on-going basis, the Company re-evaluates all of its estimates utilizing the most recent information available to it. Actual results may differ materially from these estimates under different assumptions or conditions and as additional - -------------------------------------------------------------------------------- Page 36 information becomes available in future periods. The most significant estimates made by the Company are those concerning reserves against accounts receivable and inventory, the industrial accident reserve and the deferred tax asset valuation allowance. Accounts Receivable and Allowances for Doubtful Accounts The majority of the Company's accounts receivable are due from distributors that serve the natural products industry. Credit is extended based on evaluation of a customers' financial condition. Credit terms of sale are generally net 30 days, with a 1% cash discount offered for payment within ten days. The Company provides allowances for estimated credit losses, product returns, spoilage and other customer adjustments (for advertising allowances, etc.) at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. These allowances are based upon the Company's historical experience with bad debt write-offs and customer deductions, customer creditworthiness, payment trends and general economic conditions. The Company writes-off accounts receivable when they are deemed uncollectible. Any subsequent recovery on such receivables is recorded as an addition to the allowance for doubtful accounts. Inventory Inventory is stated at the lower of cost (first-in, first-out method) or market. Reserves are maintained for obsolete or unsaleable inventories to reduce the carrying cost of such inventories to market value. The reserve estimates are based upon historical inventory usage, spoilage, current market conditions and anticipated future demand. Income Taxes The Company accounts for corporate income taxes in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes", which requires an asset and liability approach. This approach results in the recognition of deferred tax assets (future tax benefits) and deferred tax liabilities for the expected future tax consequences of temporary timing differences between the financial statement amounts and the tax basis of assets and liabilities. Deferred tax assets are subject to a valuation allowance in the event management believes there is risk that the future tax benefits may not be realized. Property and Equipment Property and equipment are recorded at cost. Depreciation is provided using the straight-line method over the estimated useful lives of the assets, ranging from three to 25 years. Maintenance and repairs that neither significantly add to the value of the property nor appreciably prolong its life are charged to expense as incurred. Betterment or renewals are capitalized when incurred. Intangible Assets The Company evaluates whether events and circumstances have occurred that indicate that intangible assets with an indefinite life may have been impaired at least annually. An impairment in the carrying value of an asset is assessed when the undiscounted, expected future operating cash flows to be derived from the asset are less than its carrying value. Trademarks and other intangible assets without an indefinite life are amortized under the straight-line method over their estimated useful lives. Long-Lived Assets Pursuant to applicable accounting rules, the Company periodically assesses whether long-lived assets have been impaired. The Company deems an asset to be impaired if the carrying amount of a long-lived asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. If the asset is deemed impaired, the Company then recognizes an impairment loss for the amount by which the carrying amount of a long-lived asset exceeds its fair value. - -------------------------------------------------------------------------------- Page 37 Cash Surrender Value Life Insurance The Company has one whole life insurance policy on its Chairman of the Board which features cash surrender value. Monthly premiums on the policy are included in general and administrative expense, with the amount of the premium that serves to increase the cash surrender value of the policy recorded as a non-current other asset. Fair Value of Financial Instruments In accordance with SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," the Company is required to disclose the fair value of all financial instruments that it is practical to estimate. In the Company's case, the book values of all financial instruments approximate fair value. For trade accounts receivable and trade accounts payable, the book value approximates fair value due to the short-term maturity of these items. The fair value of the line of credit approximates book value because the interest rate fluctuates with changes in the LIBOR or prime rate. The Company's notes payable and capital lease obligations approximate fair value based on rates currently available for debt with similar terms and maturities. The Company's commitments to purchase inventory approximate fair value because they do not differ materially from current market prices available to the Company and they do not exceed 12 months in duration. Deferred Rent The difference between monthly rent payments and the simple average of the minimum lease payments over the term of operating leases is recorded as deferred rent. The deferred rent is then amortized to occupancy expense over the term of the lease in a manner which equates the monthly rent payments with the straight-line amortization of the total minimum lease payments during the lease term. Revenue Recognition and Sales Incentives to Customers The Company recognizes revenue once there is evidence of an arrangement (such as a customer purchase order), the price and terms are final, delivery has occurred and collectibility is reasonably assured. Accordingly, sales and cost of goods sold are recognized when goods are shipped, at which time title and risk of loss have passed to the customer. The vast majority of the Company's sales are shipped under customer-arranged freight terms. In all other cases, shipping charges to customers are included in revenue with an offsetting expense included in cost of sales. Sales incentives offered to customers such as promotions, advertising allowances and slotting fees are accounted for as reductions to revenue. Advertising Magazine advertising is expensed at the on-stand date when the consumer or trade is first exposed to the ad. Costs associated with the production of pamphlets and similar advertising literature are expensed at the time of initial distribution. Other advertising costs are expensed as incurred. Advertising expenses for the years ended December 31, 2004, 2003 and 2002 were $1,465,300, $882,700 and $1,172,100, respectively. Net Income or Loss per Share Basic income or loss per share is computed by dividing net income or loss attributable to common shares by the weighted average number of common shares outstanding during each period. Fully diluted income or loss per share is similar to basic income or loss per share except that the weighted average number of common shares outstanding is increased to reflect the dilutive effect of potential common shares, such as those issuable upon the exercise of stock options or warrants, as if they had been issued. For fiscal year 2004 there was no difference between basic and fully diluted loss per common share because the effects of the exercise of common stock options and warrants were anti-dilutive, given the net loss incurred in that year. - -------------------------------------------------------------------------------- Page 38 For fiscal years 2003 and 2002 there was no difference between basic and fully diluted income per common share because the dilutive effect of the exercise of common stock options and warrants was insignificant. For each year presented, the following potential convertible common shares were outstanding as of December 31: 2004 2003 2002 ---- ---- ---- Stock Options 4,972,415 4,152,115 3,898,115 Stock Warrants 160,000 160,000 682,606 --------- --------- --------- Total Potential Convertible Shares 5,132,415 4,312,115 4,580,721 ========= ========= ========= Due to the net loss incurred in fiscal year 2004, the outstanding stock options and warrants disclosed above were excluded from the calculation of the fully diluted shares outstanding and loss per common share due to their anti-dilutive effect. Stock-Based Compensation Statement of Financial Accounting Standards ("SFAS") No. 123R, "Share Based Payment" ("SFAS 123R") issued in December 2004 will require the Company to record an expense associated with stock option grants in the Company's statement of operations effective with the third quarter of 2005. As currently permitted under SFAS 123, the Company has chosen to continue to account for employee stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Accordingly, compensation expense for employee stock options is measured as the excess, if any, of the fair market price of the Company's stock at the date of grant over the amount an employee must pay to acquire the stock. Options granted to non-employees are recorded over the service period at the estimated fair value of the option granted. All stock options issued to employees have an exercise price not less than the fair market value of the Company's common stock on the date of grant. In accordance with the accounting for such options utilizing the intrinsic value method prescribed in APB 25, there is no related compensation expense recorded in the Company's financial statements. Had compensation cost for stock-based compensation been determined based on the fair value of the options at the grant dates consistent with SFAS 123, the Company's net income or loss and net income or loss per share for the years ended December 31, 2004, 2003 and 2002 would have been adjusted to the pro-forma amounts presented below: Years ended December 31, ------------------------ 2004 2003 2002 ---- ---- ---- Net income (loss) as reported $ (832,700) $ 2,663,600 $ 1,120,000 Less: Total compensation expense under fair value method for all stock-based awards, net of related tax effects (365,600) (264,000) (182,800) ----------- ----------- ----------- Pro-forma net income (loss) $(1,198,300) $ 2,399,600 $ 937,200 =========== =========== =========== Basic and fully diluted income (loss) per share: As reported $ (0.02) $ 0.06 $ 0.02 Pro-forma $ (0.03) $ 0.05 $ 0.02 The fair value of option grants for 2004 was estimated on the date of grant utilizing the Black-Scholes option-pricing model, with the following assumptions: expected life of five years, risk-free interest rates of 2.0% to 3.0%, no dividend yield and volatility of 64% to 95%. - -------------------------------------------------------------------------------- Page 39 The fair value of option grants for 2003 was estimated on the date of grant utilizing the Black-Scholes option-pricing model, with the following assumptions: expected life of five years, risk-free interest rate of 2.5%, no dividend yield and volatility of 115%. The fair value of option grants for 2002 was estimated on the date of grant utilizing the Black-Scholes option-pricing model, with the following assumptions: expected life of five years, risk-free interest rate of 2.5%, no dividend yield and volatility of 142% to 214%. New Applicable Accounting Pronouncements In December 2004, the Financial Accounting Standards Board ("FASB") issued SFAS 123R, "Share-Based Payment," a revision of SFAS No. 123, "Accounting for Stock-Based Compensation" and superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123R requires the Company to expense grants made under the Company's stock option program. That cost will be recognized over the vesting period of the stock option grants. SFAS 123R is effective for interim periods beginning after June 15, 2005. Upon adoption of SFAS 123R, amounts previously disclosed under SFAS No. 123 will be recorded in the Company's statement of operations. The Company is evaluating the alternatives allowed under the standard, which the Company is required to adopt effective for its third quarter of fiscal 2005. In November 2004, the FASB issued SFAS No. 151, "Inventory Costs," an amendment to ARB No. 43, Chapter 4, "Inventory Pricing." SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company believes there will be no material effect on its financial statements upon adoption of this standard. During 2004 the FASB published a revision to Interpretation 46 ("46R") to clarify some of the provisions of FASB Interpretation No. 46, "Consolidation of Variable Interest Entities", and to exempt certain entities from its requirements. The additional guidance is being issued in response to input received from constituents regarding certain issues arising in implementing Interpretation 46. Under the new guidance, special effective date provisions apply to enterprises that have fully or partially applied Interpretation 46 prior to issuance of this revised Interpretation. Otherwise, application of Interpretation 46R (or Interpretation 46) is required in financial statements of public entities that have interests in structures that are commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application by public entities, other than small business issuers, for all other types of variable interest entities is required in financial statements for periods ending after March 15, 2004. Application by small business issuers to variable interest entities other than special-purpose entities and by nonpublic entities to all types of variable interest entities is required at various dates in 2004 and 2005. In some instances, enterprises have the option of applying or continuing to apply Interpretation 46 for a short period of time before applying this revised Interpretation. The Company believes that adoption of Interpretation 46R (or Interpretation 46) will have no effect on its financial statements. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150"). SFAS 150 provides new rules on the accounting for certain financial instruments that, under previous guidance, would be accounted for as equity. It requires that an issuer classify a financial instrument that is within its scope as a liability. Such financial instruments include mandatorily redeemable shares, instruments that require the issuer to buy back some of its shares in exchange for cash or other assets, or obligations that can be settled with shares, the monetary value of which is fixed. SFAS 150 shall be effective for financial instruments entered into or modified after May 31, 2003 and otherwise shall be effective at the beginning of the first interim period beginning after June 15, 2003. However certain modifications and FASB Staff Positions relating to SFAS 150 are being deliberated. The adoption of SFAS 150 has no effect on the Company's financial statements. - -------------------------------------------------------------------------------- Page 40 Reclassifications Certain reclassifications have been made to the prior year financial statements to be consistent with the current year presentation. These reclassifications had no impact on net income or retained earnings for the prior years presented. 2. Manufacturing Facility Relocation and Reconfiguration During the first quarter of 2004, the Company began to implement its plan to relocate its SpectraVac manufacturing operation from its leased facility at 133 Copeland Street, Petaluma, California to a leased facility located in Cherokee, Iowa managed by Biowa Nutraceuticals, LLC ("BIOWA"). The SpectraVac operation utilizes the Company's intellectual property purchased on April 15, 2003 for the benign extraction of oil from vegetable seeds, and is currently used primarily for the production of flax oil. The Company replaced most of the equipment used in the SpectraVac operation in Petaluma with new, more efficient equipment in Cherokee. Production ceased at the Copeland Street facility on September 24, 2004 and the Company disassembled and relocated some of the former Petaluma equipment to Cherokee during the fourth quarter. The Company incurred an expense of $1,565,300 in 2004 in connection with the manufacturing facility relocation and reconfiguration. Included in that amount were non-cash write-offs of $919,500 for infrastructure and leasehold improvements at the Copeland Street facility which could not be relocated to Iowa, plus $237,100 in writedowns to fair market value for certain equipment that was relocated to Iowa which management deemed was impaired at December 31, 2004. In addition, cash expenses of $408,700 were incurred for relocation costs and project management expenses associated with the move to Iowa. BIOWA will provide labor and management services to the Company for the SpectraVac operation in Cherokee under contract. The Company will continue to own the equipment and also intends to enter into other oil seed crushing arrangements with BIOWA under a strategic alliance. During the year ended December 31, 2004 capital spending in Cherokee associated with the Iowa facility was $1,008,300. 3. Industrial Accident On February 4, 2004 the Company pleaded no contest to two misdemeanor counts of violations under California Labor Code Section 6425, violation of a regulation issued by the California Occupational Health and Safety Administration ("CAL-OSHA"), requiring employers to provide, maintain and ensure employees use required confined space equipment. The plea arose in connection with a tragic production accident on April 25, 2002 that resulted in the death of two of the Company's employees. Under the Terms of Settlement and Probation entered into with the plea, the Company will pay a fine of $150,000 in three annual installments of $50,000 each on June 30, 2004, 2005 and 2006. In addition the Company paid $150,000 in restitution to the California District Attorneys Association Workers Safety Training Account to assist in the prosecution of worker safety cases in the State of California. The Company also reimbursed costs of $25,000 each to the Petaluma Police Department, the Petaluma Fire Department and the Sonoma County District Attorney's Office. Finally, an additional fine of $250,000 under California Labor Code Section 6425 was suspended conditioned upon the Company's compliance with the terms of court supervised probation for three years. Accordingly, the Company accrued an expense of $375,000 against the year ended December 31, 2003 to cover the net present value of the above payments, plus attorney's fees. Total payments made during the year ended December 31, 2004 in connection with the plea were $275,000. CAL-OSHA completed their investigation of the accident and issued their report and notice of proposed penalties on October 18, 2002. Their report included nine citations for safety violations with total proposed penalties of $137,900. There were no willful citations and the CAL-OSHA report acknowledged that all the safety violations had been 100% abated prior to the report's issuance. The Company filed a formal appeal and executed a verbal settlement agreement with CAL-OSHA on December 17, 2004 which calls for the Company to pay penalties totaling $70,500 to close the CAL-OSHA appeal. - -------------------------------------------------------------------------------- Page 41 The dependents of both deceased employees filed appeals with the Workers' Compensation Appeals Board of California for serious and willful misconduct penalties against Spectrum. On May 25, 2004 the Company settled one of the appeals for $35,000 which was paid on June 3, 2004 and charged against the industrial accident reserve. As of December 31, 2004 the Company had a remaining reserve of $193,900 to cover the two remaining installments of the fine under CLCS 6425 totaling $100,000, the settlement of the CAL-OSHA appeal for $70,500, and the remaining appeal filed with the Workers' Compensation Appeals Board of California. The remaining workers compensation appeal is for an additional death benefit equal to 50% of the eventual death benefit to be paid by the Company's workers' compensation insurance carrier at the time of the accident. That amount would be payable by the Company to the dependents of the deceased worker if the dependents successfully establish that the Company was guilty of serious and willful misconduct by allowing unsafe working conditions to exist. If actually litigated, the workers compensation appeal is an all-or-nothing proposition under which the Company will either be liable for 50% of the eventual insurance death benefit or nothing. Based on the advice of counsel, the Company expects the remaining workers compensation appeal to be settled rather than litigated. Management believes the remaining reserve of $193,900 will be approximately adequate to cover the present value of the remaining two installments under the CLCS 6425 fine of $50,000 each, the settlement of the CAL-OSHA appeal for $70,500, and the remaining workers compensation appeal. 4. Amendment to Loan and Security Agreement On June 4, 2004 the Company entered into the First Amendment (the "Amendment") to the Loan and Security Agreement (the "Credit Facility") with its primary lender, Comerica Bank. The Amendment provides the Company with additional borrowing capacity and flexibility via four significant changes to the Credit Facility: a) The maturity date of the Credit Facility was extended an additional twelve months to June 30, 2006. b) The maximum borrowing available under the revolving line of credit was increased from $7,000,000 to $9,000,000, subject to eligible collateral levels. c) The maximum borrowings available for eligible inventory under the revolving line of credit was increased from $1,500,000 in excess of eligible accounts receivable to $2,000,000 in excess of eligible accounts receivable, or 60% of eligible inventory collateral, whichever is less. d) The drawdown period under the Company's $1,000,000 capital expenditures term note was extended an additional six months to December 31, 2004. During the year ended December 31, 2004 proceeds received under this note were $754,800. The Amendment continues to require that the Company meet various financial covenants for 2004 and beyond related to profitability levels, debt service coverage, and the ratio of total liabilities to tangible net worth. As of December 31, 2004 the Company was in technical default of the liabilities to tangible net worth covenant due to the non-cash writeoff associated with the Company's former manufacturing facility incurred during the fourth quarter of 2004. Comerica has granted the Company a waiver of the loan covenant default. The revolving line of credit is subject to a borrowing base consisting of certain eligible accounts receivable and inventory and bears interest at the prime rate or LIBOR plus 2.25%, at the Company's option. The outstanding term debt is secured by property and equipment, bears interest at the prime rate plus 25 basis points (0.25%) and features an even monthly amortization schedule through June 2008. The Credit Facility with Comerica replaced a similar arrangement with Wells Fargo Business Credit, Inc. ("WFBC"), the Company's former primary lender. All amounts due to WFBC were retired on July 11, 2003 in the amount of $5,023,600. Included in that amount was an early termination fee of $62,400 paid to WFBC for - -------------------------------------------------------------------------------- Page 42 terminating that credit facility prior to its maturity date of October 6, 2004. The early termination fee and the remaining unamortized loan fee of $8,000 associated with the WFBC agreement were recorded as interest expense in 2003. 5. Intellectual Property Purchase On April 15, 2003 the Company entered into an intellectual property purchase agreement (the "IP Agreement") with Tenere Life Sciences, Inc. ("Tenere") and Mr. Rees Moerman, both unaffiliated third parties. Mr. Moerman is an engineer and lipid scientist who developed proprietary techniques for the benign extraction of oil from vegetable seeds. The Company has utilized Mr. Moerman's techniques under the SpectraVac and LOCET Technology License Agreement (the "License Agreement") for the production of flax oil and other nutritional oils since 1990. Under the License Agreement, the Company paid royalties to Mr. Moerman on its sales of products that were manufactured utilizing the intellectual property. Mr. Moerman assigned his rights to the intellectual property to Tenere on January 21, 2003. In accordance with the IP Agreement, the Company purchased the intellectual property for $550,000 which was paid in two equal installments on April 30, 2003 and October 7, 2003. As a result, the Company was no longer obligated to pay royalties to Tenere effective April 1, 2003. Royalties paid during the years ended December 31, 2003 and 2002 were $50,700 and $162,500, respectively. In accordance with Statement of Financial Accounting Standard No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), the Company has determined that the IP Agreement has an indefinite useful life since it represents trade secrets utilized in the manufacture of flax oil and other nutritional oils. Accordingly, there is no periodic amortization expense. The Company evaluates the intangible asset carrying value of $550,000 for impairment in relation to the anticipated future cash flows of its nutritional oils at least annually. 6. Bottling Equipment Relocation and Reconfiguration On July 14, 2003 the Company disassembled its bottling line at its leased manufacturing facility located at 133 Copeland Street, Petaluma, California and relocated and reconfigured the line at its new co-packer, Interpac Technologies, Inc. ("Interpac"), also located in Petaluma. Interpac provides custom bottling services to the Company utilizing the Company's bottling equipment. The bottling line was reconfigured for better efficiency and higher bottling speeds and included a new labeler and new conveying equipment. As a result, there was $30,600 in net book value of equipment at Copeland Street which was scrapped rather than being relocated. Additionally, the Company recorded a writedown of $19,700 to reduce the net book value of equipment that has been sold to its estimated market value. The combined amount of $50,300 was included in cost of sales for 2003. 7. Sale of Product Lines On April 25, 2002 the Company entered into an Asset Purchase Agreement with Acirca, Inc. pursuant to which the Company sold certain product lines from the Company's Aptos-based industrial ingredients business. The product lines sold included the Organic Ingredients ("OI") business in fruits, vegetables, concentrates and purees as well as certain key retailer private label product lines. The total consideration was $3,167,000 in cash, which included $1,417,000 for saleable inventory sold to Acirca. Since the product line sale comprised all of the remaining assets of OI, the remaining net goodwill of $1,470,200 associated with the reverse acquisition of OI in October 1999 was written off as a result of the sale. After accounting for transaction costs, the Company recorded a net gain on the OI product line sale of $210,300 for the year ended December 31, 2002. - -------------------------------------------------------------------------------- Page 43 8. Accounts Receivable Accounts receivable consisted of the following: As of December 31, ------------------ 2004 2003 2002 ---- ---- ---- Trade $ 4,268,800 $ 4,604,800 $ 3,306,800 Stockholder -- -- 20,000 Other 31,000 8,400 164,400 ----------- ----------- ----------- Total accounts receivable 4,299,800 4,613,200 3,491,200 Less allowance for doubtful accounts and customer allowances (500,000) (450,000) (416,000) ----------- ----------- ----------- Net Accounts Receivable $ 3,799,800 $ 4,163,200 $ 3,075,200 =========== =========== =========== During the years ended December 31, 2004, 2003 and 2002 the Company had one customer that accounted for approximately 42%, 36% and 50% of total net sales, respectively. As of December 31, 2004, 2003 and 2002 that same customer accounted for 28%, 25% and 23% of trade accounts receivable, respectively. The sales to this customer consisted of Spectrum Naturals(R) and Spectrum Essentials(R) consumer packaged products only. The loss of this customer would have a material adverse effect on the Company's operations and cash flows. During 2004, 2003 and 2002 foreign sales comprised 5%, 4% and 7%, respectively, of total net sales and approximately 6%, 4% and 4% of trade accounts receivable at December 31, 2004, 2003 and 2002, respectively. All foreign sales were denominated in United States dollars. 9. Inventories Inventories consisted of the following: As of December 31, ------------------ 2004 2003 2002 ---- ---- ---- Finished goods $ 7,590,100 $ 6,853,400 $ 4,351,900 Raw materials 2,170,200 1,166,100 1,408,100 Deposits on Inventory 154,500 236,200 57,600 ----------- ----------- ----------- Total inventories 9,914,800 8,255,700 5,817,600 Less provision for obsolete inventory (350,000) (248,500) (548,000) ----------- ----------- ----------- Net Inventories $ 9,564,800 $ 8,007,200 $ 5,269,600 =========== =========== =========== For 2004, 2003 and 2002 the Company had one supplier of raw materials that accounted for approximately 17%, 16% and 11%, respectively, of total purchases of raw materials and one supplier of processing that accounted for approximately 9%, 11% and 11%, respectively, of total cost of sales. At December 31, 2004, 2003 and 2002 approximately $698,000, $954,500 and $564,500 was owed to these suppliers and included in accounts payable. 10. Valuation and Qualifying Accounts The Company maintains valuation and qualifying accounts in three significant areas: reserves for obsolete inventories, allowances against receivables, and reserves for the 2002 industrial accident. With regards to inventory and receivables, the reserves serve to lower the gross carrying amount of these assets to their net realizable value. With regards to the industrial accident, the reserve serves to cover estimated future payments associated with the accident. - -------------------------------------------------------------------------------- Page 44 The following table summarizes the activity under each of the valuation and qualifying accounts for the years ended December 31, 2002, 2003 and 2004: Reserve for Allowances Reserve for Obsolete Against Industrial Inventories Receivables Accident --------- --------- --------- Balances, January 1, 2002 $ 350,000 $ 475,000 $ -- Additions charged to profit and loss 262,200 47,000 254,100 Deductions for amounts written-off against reserves (64,200) (106,000) (100,400) --------- --------- --------- Balances, December 31, 2002 548,000 416,000 153,700 Additions charged to profit and loss 210,800 103,400 410,200 Deductions for amounts written-off against reserves (510,300) (69,400) (47,000) --------- --------- --------- Balances, December 31, 2003 248,500 450,000 516,900 Additions charged to profit and loss 332,800 56,300 -- Deductions for amounts written-off against reserves (231,300) (6,300) (323,000) --------- --------- --------- Balances, December 31, 2004 $ 350,000 $ 500,000 $ 193,900 ========= ========= ========= 11. Property and Equipment Property and equipment consisted of the following: As of December 31, ------------------ 2004 2003 2002 ---- ---- ---- Machinery and equipment $ 5,273,600 $ 5,434,200 $ 4,338,600 Furniture and fixtures 795,500 978,900 873,500 Construction in progress 75,700 227,400 442,200 Leasehold improvements 312,800 310,400 244,600 Vehicles 84,000 84,000 84,000 ----------- ----------- ----------- Total property and equipment 6,541,600 7,034,900 5,982,900 Less accumulated depreciation (2,551,400) (2,696,200) (2,535,500) ----------- ----------- ----------- Net Property and Equipment $ 3,990,200 $ 4,338,700 $ 3,447,400 =========== =========== =========== In connection with the relocation of the Company's manufacturing facility to Iowa (see Note 2), Spectrum recorded a non-cash writedown of $1,156,600 against its property and equipment formerly located at the Copeland Street manufacturing facility. Included in that amount was $919,500 of infrastructure and leasehold improvements which were written-off since they could not be relocated to Iowa, plus $237,100 in writedowns to fair market value for certain equipment that was relocated to Iowa that management deemed was impaired at December 31, 2004. During the years ended December 31, 2004, 2003 and 2002, the Company capitalized interest of $27,800, $24,500 and $27,800 respectively, on construction in progress. The Iowa facility was capitalized and placed in service on December 1, 2004. There was equipment with a book value of $224,500 located in Iowa which was not in service and not being depreciated at December 31, 2004 related to the Company's LOCET operation (low oil content extraction technology). Management is evaluating the future use of the LOCET equipment in Iowa and does not believe these assets are impaired relative to the future cash flows they may generate. Depreciation expense was $650,700, $519,600 and $442,300 for 2004, 2003 and 2002, respectively. - -------------------------------------------------------------------------------- Page 45 12. Intangible Assets Intangible assets consisted of the following: As of December 31, ------------------ 2004 2003 2002 ---- ---- ---- Intellectual property $ 550,000 $ 550,000 $ -- Trademarks 74,100 74,100 74,100 --------- --------- --------- Total intangible assets 624,100 624,100 74,100 Less accumulated amortization (39,300) (37,300) (32,100) --------- --------- --------- Net Intangible Assets $ 584,800 $ 586,800 $ 42,000 ========= ========= ========= The intellectual property has an indefinite life and is evaluated annually for potential impairment based on the forecasted future cash flows of the Company's flax oil products. The trademarks are being amortized on a straight-line basis over their estimated useful lives. Amortization expense was $2,000, $5,100 and $12,000 for the years ended December 31, 2004, 2003 and 2002, respectively. 13. Line of Credit The Company has available a $9,000,000 revolving line of credit, subject to a borrowing base limitation based upon a percentage of eligible accounts receivable and inventory, bearing interest at the prime rate or LIBOR plus 2.25% which expires on June 30, 2006 unless renewed earlier. Borrowings under the revolving line of credit totaled $6,984,400 at December 31, 2004 versus $4,833,000 at December 31, 2003 and $2,479,800 at December 31, 2002. The credit line is secured by substantially all assets of the Company. As of December 31, 2004 the Company had $2,015,600 in excess borrowing capacity available under the line of credit versus $2,105,800 at December 31, 2003 and $1,696,700 at December 31, 2002. 14. Notes Payable and Capital Lease Obligations Notes payable and capital lease obligations consisted of the following: As of December 31, ------------------ 2004 2003 2002 ---- ---- ---- Term notes payable secured by substantially all assets of the Company (a) $ 1,875,000 $ 1,370,200 $ 429,000 Capital lease obligations secured by the related property and equipment (b) 14,600 56,300 105,900 ----------- ----------- ----------- Total Notes Payable and Capital Lease obligations 1,889,600 1,426,500 534,900 Less current maturities (514,600) (322,300) (256,000) ----------- ----------- ----------- Long-term Portion of Notes Payable and Capital Lease Obligations $ 1,375,000 $ 1,104,200 $ 278,900 =========== =========== =========== (a) Under the Comerica relationship, the Company has two term notes that are secured by property and equipment, with even monthly principal amortization of $20,800 for each note. Both notes bear interest at prime plus 25 basis points (5.5% per annum at December 31, 2004). (b) The cost of assets securing the capital lease obligations was $74,700, $243,000 and $438,900 at December 31, 2004, 2003 and 2002 with accumulated amortization of $60,100, $83,100 and $240,000 at December 31, 2004, 2003 and 2002, respectively. - -------------------------------------------------------------------------------- Page 46 Aggregate maturities or principal payments required on notes payable and capital lease obligations for each of the succeeding years are disclosed in Note 15. 15. Notes Payable, Related Parties Notes payable with related parties consisted of the following: As of December 31, ------------------ 2004 2003 2002 ---- ---- ---- Note payable with interest due monthly at 9% per annum. Principal is due in monthly installments of $15,625 until paid in full. The note is secured by unissued shares of common stock in an amount equivalent to the unpaid principal and interest due under the note. The note is subordinated to the line of credit and all bank debt. (a) $ 187,500 $ 390,600 $ 578,100 Non-interest bearing, unsubordinated and unsecured balloon note due on December 31 of the fifth year following the calendar year which includes the final payment on the above note, expected to be 2010. Interest has been imputed at an effective interest rate of 7.6% per annum 326,200 305,400 286,200 Unsecured notes due in monthly installments including principal and interest at 10% per annum 40,700 128,400 216,000 ----------- ----------- ----------- Total Notes Payable - Related Parties 554,400 824,400 1,080,300 Less current maturities (228,200) (275,200) (275,100) ----------- ----------- ----------- Long-term Portion of Notes Payable - Related Parties $ 326,200 $ 549,200 $ 805,200 =========== =========== =========== (a) On November 20, 2004 the Company voluntarily made one extra principal payment on this note, in an accommodation to the note holder, which advanced the payoff date to December 20, 2005 instead of January 20, 2006. That, in turn, advanced the maturity date of the balloon note by one full year from December 31, 2011 to December 31, 2010. Under the Seventh Amendment to the Redemption Agreement entered into on November 1, 2002 the note holder retained the unilateral right to force the same outcome upon 60 days prior written notice to the Company. The Company accounted for the one year advance in the maturity date for the balloon note by revising the imputed rate of interest from 6.5% per annum to 7.6% per annum. Aggregate maturities or principal payments required on all types of long-term debt and capital lease obligations for each of the succeeding years are as follows: Bank Term Related Cap. Lease Total Long- Years Ended December 31, Notes Party Notes Obligations Term Debt ------------------------ ----------- ----------- ----------- ----------- 2005 $ 500,000 $ 228,200 $ 20,100 $ 748,300 2006 500,000 -- -- 500,000 2007 500,000 -- -- 500,000 2008 375,000 -- -- 375,000 2009 -- -- -- -- 2010 -- 513,300 -- 513,300 ----------- ----------- ----------- ----------- Total Future Payments 1,875,000 741,500 20,100 2,636,600 Less amounts representing interest -- (187,100) (5,500) (192,600) ----------- ----------- ----------- ----------- Total Long-Term Debt, including current maturities $ 1,875,000 $ 554,400 $ 14,600 $ 2,444,000 =========== =========== =========== =========== - ----------------------------------------------------------------------------------------- Page 47 16. Provision for Income Taxes and Deferred Income Taxes As of December 31, 2004 the Company had a net benefit from income taxes equal to 40% of its net loss before income taxes. During the fourth quarter of 2003, the Company reversed the 100% valuation allowance that had been maintained against its deferred tax assets since the merger. As a result, the Company recorded a net benefit from income taxes of $1,566,600 for 2003. For the years ended December 31, 2004, 2003 and 2002 the provision or benefit from income taxes consisted of the following: 2004 2003 2002 ---- ---- ---- Current: Federal $ (77,700) $ 9,900 $ -- State (13,800) 25,400 189,800 ----------- ----------- ----------- Subtotal Current (91,500) 35,300 189,800 ----------- ----------- ----------- Deferred: Federal (393,600) (1,409,100) -- State (70,100) (192,800) -- ----------- ----------- ----------- Subtotal Deferred (463,700) (1,601,900) -- ----------- ----------- ----------- Total Provision (Benefit) for Income Taxes $ (555,200) $(1,566,600) $ 189,800 =========== =========== =========== A reconciliation of the federal statutory rate to the tax provision for the years ended December 31 follows: 2004 2003 2002 ---- ---- ---- Tax expense (benefit) at effective federal statutory rate (34%) $ (471,900) $ 373,000 $ 445,300 Disposal of non-deductible goodwill -- -- 499,900 Other non-deductible expense 10,600 53,800 11,800 State income tax expense, net of federal effect (80,500) 71,500 51,600 Valuation allowance -- (1,997,900) (867,200) Tax credits and other (13,400) (67,000) 48,400 ----------- ----------- ----------- Total Provision (Benefit) for Income Taxes $ (555,200) $(1,566,600) $ 189,800 =========== =========== =========== - -------------------------------------------------------------------------------------- Page 48 Deferred tax assets and liabilities consisted of the following: 2004 2003 2002 ---- ---- ---- Deferred Tax Assets: Federal net operating loss carryovers $ 1,950,000 $ 1,506,500 $ 1,761,400 Inventory allowances 119,000 84,500 182,300 Accounts receivable allowances 170,000 153,000 141,400 Accrued compensation 72,200 63,500 51,100 State income taxes 276,200 192,800 335,000 Accruals and reserves 7,900 88,900 -- Other 169,800 50,500 13,800 ----------- ----------- ----------- 2,765,100 2,139,700 2,485,000 Deferred Tax Liabilities: Depreciation and fixed asset write-down (609,600) (537,800) (443,800) Other -- -- (43,300) ----------- ----------- ----------- Net Deferred Tax Assets, Before Allowance 2,155,500 1,601,900 1,997,900 Valuation allowance -- -- (1,997,900) ----------- ----------- ----------- Net Deferred Tax Assets $ 2,155,500 $ 1,601,900 $ -- =========== =========== =========== As of December 31, 2004 the Company had federal net operating loss carryforwards ("NOLs") totaling approximately $5,735,000 that expire at various times through 2021. For state purposes, the Company had net operating loss carryforwards totaling approximately $3,833,000 which expire at various times through 2011. The majority of the NOLs originated primarily from pre-merger operations of OFPI. As a result of OFPI's acquisition by SNI (Note 1), OFPI experienced a more than 50% change in ownership for federal and state income tax purposes. Therefore, an annual limitation is placed upon the Company's ability to realize the benefit of the pre-merger NOLs. Management believes that it is more likely than not that the Company will continue to report sufficient taxable income in the foreseeable future, allowing utilization of 100% of its deferred tax assets. 17. Common Stock Options Prior to the merger discussed in Note 1, SNI had an Equity Incentive Plan under which options were granted to one officer in 1998. As a result of the merger, the Company assumed the options outstanding under OFPI's 1995 Stock Option Plan (the "1995 Plan"). Because OFPI was the surviving legal entity after the merger, SNI's existing options were absorbed into the 1995 Plan and restated at their equivalent number of shares and strike price using the merger conversion ratio, and the SNI Equity Incentive Plan was discontinued. The Company subsequently amended the 1995 Plan twice, increasing the aggregate number of shares of common stock which could be issued under the 1995 Plan to 7,000,000. Both amendments were approved by a vote of the Company's shareholders. Under the amended 1995 Plan, each option represents the right to purchase one share of the Company's common stock at a fixed price per share at some future date. The option strike price shall not be less than the fair market value on the date of grant and options expire unless exercised within ten years after the date of grant. Options generally vest ratably over four years for employees and two years for directors. - -------------------------------------------------------------------------------- Page 49 The following table summarizes the activity under the 1995 Plan for the years ended December 31, 2004, 2003 and 2002: 2004 2003 2002 ----------------------- ------------------------ ---------------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Options Price Options Price Options Price --------- -------- ---------- -------- ---------- -------- Beginning Balance 4,152,115 $ 0.33 3,898,115 $ 0.34 3,225,315 $ 0.48 Options granted 1,158,250 0.85 809,500 0.31 1,325,000 0.30 Options exercised (151,166) 0.34 (143,750) 0.41 -- -- Options expired (186,784) 0.56 (411,750) 0.34 (652,200) 0.21 ---------- -------- ---------- -------- ---------- -------- Ending Balance 4,972,415 $ 0.44 4,152,115 $ 0.33 3,898,115 $ 0.34 ========== ======== ========== ======== ========== ======== Options exercisable at year end 3,087,719 $ 0.35 2,368,973 $ 0.34 1,784,282 $ 0.35 ========== ======== ========== ======== ========== ======== Weighted average fair value of options granted during the year $ 0.60 $ 0.25 $ 0.30 ======== ======== ======== The following table discloses exercise prices and remaining lives of options outstanding or exercisable as of December 31, 2004: Options Outstanding Options Exercisable ------------------- ------------------- Weighted Weighted Average Average Range of Number Remaining Weighted Number Remaining Weighted Exercise Outstanding Contractual Average Exercisable Contractual Average Prices at 12/31/04 Life (Years) Exercise Price at 12/31/04 Life (Years) Exercise Price ------ ----------- ----------- -------------- ----------- ----------- -------------- $0.01-$0.25 1,030,200 6.9 $ 0.24 850,150 6.8 $ 0.24 $0.26-$0.50 2,857,965 6.2 0.35 2,120,319 5.6 0.36 $0.51-$2.50 1,084,250 8.8 0.86 117,250 8.4 0.99 - ----------- ----------- ----------- -------------- ---------- ----------- -------------- $0.01-$2.50 4,972,415 6.9 $ 0.44 3,087,719 6.1 $ 0.35 =========== =========== =========== ============== ========== =========== ============== As of December 31, 2004 there were 1,732,669 options remaining that are available for future issuance under the 1995 Plan. The 1995 Plan has a ten year life; therefore, no further options can be issued under the Plan after November 15, 2005. Management is in the process of evaluating various alternative equity incentive compensation plans at the date of this report. 18. Common Stock Warrants Each common stock warrant represents the right to purchase one share of the Company's common stock at a fixed price per share at some future date. On October 6, 1999 the Company assumed 590,656 outstanding common stock purchase warrants of OFPI at exercise prices ranging from $2.00 to $4.00 per share, all of which expired unexercised during the ensuing years. Also in connection with the 1999 merger, the Company issued 400,000 penny warrants in conjunction with a private placement of unsecured subordinated notes necessary to close the merger. All of the penny warrants were subsequently exercised during 2000 and 2001. In addition, in connection with the renegotiation of the private placement notes, the Company issued quarterly common stock purchase warrants at the closing bid price of Spectrum shares at each quarter-end starting December 31, 2000 and ending on December 31, 2002. All of those warrants were exercised during 2002 and 2003. - -------------------------------------------------------------------------------- Page 50 The following table summarizes the activity related to common stock purchase warrants for the years ended December 31, 2004, 2003 and 2002: 2004 2003 2002 ---------------------- --------------------- --------------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Warrants Price Warrants Price Warrants Price -------- ----- -------- ----- -------- ----- Beginning Balance 160,000 $ 0.31 682,606 $ 0.50 843,156 $ 1.43 Private placement warrants issued -- -- -- -- 200,200 0.32 IPO warrants expired -- -- (60,656) 2.63 (330,000) 2.79 Private placement warrants exercised (a) -- -- (461,950) 0.28 (30,750) 0.33 --------- -------- --------- ------ -------- ------ Ending Balance 160,000 $ 0.31 160,000 $ 0.31 682,606 $ 0.50 ========= ======== ========= ====== ======== ====== (a) These warrants included a net exercise feature which enabled the holder to convert the net equity in the warrants into common stock in a cash-less transaction. Accordingly, common shares issued in connection with the exercise of the warrants were 405,456 and 6,910 for the years ended December 31, 2003 and 2002, respectively. The remaining common stock warrants outstanding as of December 31, 2004 were issued at an exercise price of $0.31 per share and expire on February 15, 2006 unless exercised earlier. 19. Business Segments The Company operates in three primary business segments: Spectrum Naturals(R) culinary products, Spectrum Essentials(R) nutritional supplements and Spectrum Ingredients industrial products for use by other manufacturers and private label products for key retailers. The Spectrum Naturals(R) culinary products is the Company's largest segment, representing approximately 45% of total net sales. The Spectrum Naturals(R) culinary products are manufactured on behalf of the Company by third parties and are sold primarily through distributors and specialty food brokers to natural food and specialty food stores. The Spectrum Essentials(R) nutritional supplements segment represents approximately 23% of total net sales and is sold through the same distribution and broker network as the Spectrum Naturals(R) products. However, the Company manufactures the majority of the Spectrum Essentials(R) products at its leased manufacturing facility in Cherokee, Iowa. The gross margins of the two consumer product line segments are also markedly different, with the Spectrum Essentials(R) brand delivering higher gross margins. The final segment identified by management is the Spectrum Ingredients and private label product lines. The Spectrum Ingredients products are sold directly to other food manufacturers in industrial sizes for use in their products at substantially lower margins than the two branded consumer products segments. The private label products are sold directly to key retailers such as Whole Foods and Trader Joe's and also feature lower margins than the branded consumer product segments. Operating data is captured by segment to the gross profit level. However, operating statement data below gross profit and balance sheet data have not been disaggregated and captured by business segment since the information is presently unavailable to the Company's chief operating decision maker. Accordingly, the following segment information is currently captured by the Company: - -------------------------------------------------------------------------------- Page 51 Years Ended December 31, ------------------------ 2004 2003 2002 ---- ---- ---- Net Sales: Spectrum Naturals(R) $24,048,400 $20,606,100 $17,268,200 Spectrum Essentials(R) 9,566,100 10,353,900 9,030,400 Spectrum Ingredients 15,978,000 14,443,400 11,065,900 All Other 322,900 273,100 3,214,800 ----------- ----------- ----------- Total Net Sales $49,915,400 $45,676,500 $40,579,300 =========== =========== =========== Gross Profit: Spectrum Naturals(R) $ 5,403,400 $ 5,365,500 $ 4,385,400 Spectrum Essentials(R) 4,297,300 4,659,700 4,323,900 Spectrum Ingredients 1,812,200 1,718,100 1,211,200 All Other 21,800 126,400 835,800 ----------- ----------- ----------- Total Gross Profit $11,534,700 $11,869,700 $10,756,300 =========== =========== =========== Included in the all other category are the disposed and discontinued product lines associated with the OI business sold on April 25, 2002. 20. 401(k) Plan The Company provides a defined contribution plan covering substantially all employees meeting certain age and service requirements. Plan contributions are made under a matching formula and totaled $38,400, $33,500 and $34,800 for the years ended December 31, 2004, 2003 and 2002, respectively. 21. Commitments and Contingencies Lease Agreements The Company's operating lease for its corporate headquarters at 5341 Old Redwood Highway, Petaluma, California is a non-cancelable operating lease that terminates on December 31, 2007. Total monthly rent under this lease was $23,500 at December 31, 2004. Future minimum lease payments for the corporate headquarters facility are $281,700 annually for 2005, 2006 and 2007. The Company was in negotiation of an operating lease for the manufacturing facility in Cherokee, Iowa as of the date of this report. Monthly rent is expected to be fixed at $2,500 over a ten year term. Accordingly, future minimum lease payments under the manufacturing facility operating lease are expected to be $30,000 annually for 2005 through 2014. Total rent expense for 2004, 2003 and 2002 was $458,100, $488,400 and $360,800, respectively. Royalty Agreements The Company has entered into royalty agreements with various unrelated parties for licensed technologies which provide for a percentage royalty to be paid on sales of certain products. Included in accrued expenses were royalties of $17,600, $23,800 and $51,700 as of December 31, 2004, 2003 and 2002, respectively, in connection with these agreements. Royalty expense included in cost of sales under these agreements for the years ended December 31, 2004, 2003 and 2002 were $70,900, $134,000 and $243,500, respectively. Inventory Purchase Commitments In the ordinary course of business, the Company enters into commitments to purchase raw materials over a period of time, generally six months to a year, at contracted prices. At December 31, 2004, 2003 and 2002 these future commitments, which are at prices not in excess of those currently obtainable nor in quantities in excess of normal requirements, aggregated approximately $15,212,000, $9,820,900 and $6,623,000, respectively. - -------------------------------------------------------------------------------- Page 52 Pending Litigation - Proposition 65 Complaint On November 26, 2003 the Company was notified by attorneys for the Environmental Law Foundation (the "ELF") that the Spectrum Naturals(R) Organic Balsamic Vinegar contains lead in excess of the allowable quantities under the Safe Drinking Water and Toxic Enforcement Act of 1986, also known as Proposition 65. The ELF is a California non-profit organization that represents itself as dedicated to the preservation of human health and the environment. ELF's attorneys filed a Complaint for Civil Penalties, Statutory, Equitable and Injunctive Relief (the "Complaint") against Cost Plus, Inc., Safeway, Inc., Trader Joe's Company, Williams-Sonoma, Inc., Whole Foods, Inc. and unspecified defendants one through 100 in the Superior Court of the State of California on May 20, 2003 alleging violation of Proposition 65 for the sale of various products that contain lead in excess of the allowable limits without the required warning label. ELF's attorneys later notified Spectrum and dozens of other retailers, importers and manufacturers of vinegar that they would be included as one of the 100 unspecified defendants in the Complaint. While lead has been shown to cause cancer and reproductive toxicity in humans, the Proposition 65 consumption quantity defined as no significant risk level for cancer was set at 15 micrograms per day. Lead is a naturally occurring element in some wine and balsamic vinegars. Based on the Company's tests, a person would need to consume somewhere between 1.3-2.6 cups (270-630ml) daily of the Company's various vinegar products to reach the Proposition 65 lead level. The small lead content in vinegar occurs naturally in the soil and is absorbed by the grapes used to make vinegar. The level of lead in vinegar is not affected by the manufacturing process and, therefore, is not subject to regulation under Proposition 65. The Spectrum Naturals(R) brand was built on the premise of providing consumers with organic healthy oils and condiments. Management does not believe the consumption of its various vinegar products as condiments or salad dressings poses any increased risk for cancer or reproductive toxicity. The Company has joined a Joint Defense Group established by attorneys representing several of the defendants in the Complaint. Total attorney's fees incurred by the Company as a member of the Joint Defense Group for the year ended December 31, 2004 were $12,300. Management believes the Complaint will eventually be shown to be without merit. Accordingly, no provision for loss has been recorded at December 31, 2004. Court Supervised Probation In connection with the industrial accident on April 25, 2002 the Company entered a plea on February 4, 2004 of no contest to two misdemeanor counts of violations under CLCS 6425, violation of a regulation issued by the California Occupational Health and Safety Administration requiring employers to provide, maintain and ensure employees use required confined space equipment. Under the Terms of Settlement and Probation entered into with the plea, the Company received a suspended fine of $250,000 conditioned upon the Company's compliance with the terms of court supervised probation for three years. The probation terms require that the Company submit to a warrant-less search of its premises during business hours by any local or state law enforcement, safety or health officer; and that the Company shall be of good conduct and obey all laws, particularly those laws relating to worker safety and health. Should the Company fail to honor the probation terms, the suspended fine of $250,000 may be reimposed by the Sonoma County District Attorney. Contingent Guarantee The Company was a guarantor in the amount of $25,000 for that portion of the outstanding borrowings under a line of credit for the Olive Press, LLC a third party that the Company held an investment in of $15,000 at December 31, 2004. In the event of a default by the Olive Press of its obligations under its line of credit, Spectrum would be liable for an amount not to exceed $25,000. - -------------------------------------------------------------------------------- Page 53 22. Related Party Transactions and Other Relationships In connection with the sale of the Organic Ingredients product lines in 2002, the Company entered into a private label consulting agreement with Running Stream Food and Beverage, Inc. ("RSFB"). RSFB is owned and operated by a former non-executive Director of the Company. During 2004, 2003 and 2002 the Company paid fees of $33,000, $99,000 and $66,000, respectively, plus expenses incurred to RSFB for private label consulting and management services. The RSFB consulting agreement terminated on April 16, 2004. The Company paid interest at 9%-12% per annum under notes payable to several stockholders of $38,200, $62,300 and $110,900 for the years ended December 31, 2004, 2003 and 2002, respectively. On July 29, 2003 the Compensation Committee of the Company's Board of Directors unanimously approved forgiving the $20,000 shareholder advance that had been outstanding for several years from the Company's Chairman of the Board. The advance was imputed as income and grossed-up to include the income tax impact. Accordingly, the Company incurred $34,800 of compensation expense in 2003, which was included in general and administrative expenses, to forgive the shareholder advance. The Company paid an investment banking fee of $79,000 in 2002 to Moore Consulting in connection with the sale of the OI product lines. Moore Consulting is owned and operated by a non-executive Director of the Company. The fee was a 2.5% success fee, based on the total consideration received by the Company. The Company has one member of its Board of Directors who also serves as Vice Chair and Lead Independent Director of the Board of United Natural Foods, Inc. UNFI is the Company's largest single customer, representing 42% of total net sales in 2004. The Company has another member of its Board of Directors who also sits on the Board of Whole Foods Market, Inc. Whole Foods is the largest retailer in the natural products industry; however, sales made by the Company directly to Whole Foods were insignificant. 23. Quarterly Information (Unaudited) The summarized quarterly financial data presented below reflects all adjustments which, in the opinion of management, are of a normal and recurring nature and necessary to present fairly the results of operations for the periods presented. In thousands, First Second Third Fourth Full except per share data Quarter Quarter Quarter Quarter Year - ------------------------ -------- -------- -------- -------- -------- Year ended December 31, 2004: Net Sales $ 12,733 $ 12,811 $ 12,189 $ 12,182 $ 49,915 Gross Profit 2,903 2,960 2,778 2,894 11,535 Operating Income (Loss) (109) 362 148 (1,427) (1,056) Net Income (Loss) (109) 178 32 (934) (833) Basic and Fully Diluted Income (Loss) per Share $ (0.00) $ 0.00 $ 0.00 $ (0.02) $ (0.02) Year ended December 31, 2003: Net Sales $ 10,309 $ 11,381 $ 12,169 $ 11,818 $ 45,677 Gross Profit 3,073 2,966 3,100 2,731 11,870 Operating Income (Loss) 743 416 506 (139) 1,526 Net Income 636 316 325 1,387 2,664 Basic and Fully Diluted Income per Share $ 0.01 $ 0.01 $ 0.01 $ 0.03 $ 0.06 Year ended December 31, 2002: Net Sales $ 11,279 $ 10,078 $ 9,718 $ 9,504 $ 40,579 Gross Profit 2,945 2,325 2,746 2,740 10,756 Operating Income 512 54 671 539 1,776 Net Income (Loss) 331 (51) 575 265 1,120 Basic and Fully Diluted Income (Loss) per Share $ 0.01 $ (0.00) $ 0.01 $ 0.00 $ 0.02 - --------------------------------------------------------------------------------------- Page 54 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH INDEPENDENT AUDITORS ON ACCOUNTING AND FINANCIAL DISCLOSURE - ---------------------------------------------------------------------------- None. ITEM 9A. CONTROLS AND PROCEDURES - --------------------------------- The Company's Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of both the design and the operation of its disclosure controls and procedures and have found them to be adequate. The Company has formed a Disclosure Review Committee (the "DRC") which consists of various senior managers from each functional area of the Company. The DRC considers the materiality of new information and reports to the Company's Chief Financial Officer. There were no material changes in the Company's internal control system during the year ended December 31, 2004. Management is not aware of any significant deficiencies in the design or operation of internal controls. - -------------------------------------------------------------------------------- Page 55 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------------------------------------------------------------ Directors and Executive Officers The name, age, position and term of office of each of the Company's executive officers and directors are set forth below: Held Name Age Position Since ---- --- -------- ----- Jethren P. Phillips 54 Chairman of the Board 10/6/99 Neil G. Blomquist 53 President and CEO, Director 9/1/02 Phillip L. Moore 55 Director (2) 10/6/99 Charles A. Lynch 77 Director (1)(2)(3)(4) 4/1/00 Thomas B. Simone 62 Director (1)(2)(3)(4) 12/15/00 Conrad W. Hewitt 67 Director (1)(3)(4) 11/6/02 John B. Elstrott 56 Director (1)(3)(4) 7/29/04 Robert B. Fowles 49 Chief Financial Officer and Secretary 6/26/00 N. Michael Langenborg 46 Vice President - Marketing 11/4/02 Steven L. Terre 56 Vice President - Sales 11/18/02 Duane W. Chase 62 General Manager - Spectrum Ingredients 11/1/03 Randall H. Sias 36 Vice President - Operations 1/1/05 (1) Member of the Audit Committee. (2) Member of the Compensation Committee. (3) Member of the Nominating and Governance Committee. (4) Member of the Capital Committee. Directors hold office for a period of one year from their election at the annual meeting of shareholders or until their successors are duly elected and qualified. Officers of the Company are elected by and serve at the discretion of the Board of Directors. Background The following is a brief summary of the business experience of each executive officer and director of the Company for at least the last five years: Jethren P. Phillips has been Chairman of the Board of Directors since the merger in October 1999 which created Spectrum Organic Products, Inc. He also served as Chief Executive Officer of the Company from the merger until September 1, 2002. Mr. Phillips founded Spectrum Naturals, Inc. in 1980 and served as its Chief Executive Officer and Chairman of the Board of Directors since its inception. In 1995 he founded Spectrum Commodities, Inc., an organic and natural food ingredients affiliate. Mr. Phillips has been involved in the natural product industry since 1972. He attended California State University at Los Angeles and Humboldt and is a member of the National Association of Corporate Directors. Neil G. Blomquist was appointed President and Chief Executive Officer of the Company on September 1, 2002 and became a Director of the Company in November 2002. Prior to that he served as SNI's President and Chief Operating Officer since January 1994, and served as its Director of Sales and Marketing from 1989 - -------------------------------------------------------------------------------- Page 56 to 1994. Mr. Blomquist has served on the Board of Directors of the California Olive Oil Council since 1996 and has been involved in the organic and natural foods industry for more than 25 years. Mr. Blomquist holds a Bachelor of Science degree in Business Management and Economics from the University of South Dakota. Mr. Blomquist is a member of the National Association of Corporate Directors. Phillip L. Moore has been a Director of the Company since October 6, 1999 and is the Principal of Moore Consulting, a management consulting business established in 1996 to provide advisory services to the food industry. Mr. Moore has also served as Managing Partner of Monterey Bay Corporate Development since 1996. Monterey Bay Corporate Development also provides advisory and consulting services to the food industry. Mr. Moore has 25 years of experience in the food industry and was President of Perimeter Sales and Merchandising prior to founding Moore Consulting. Mr. Moore holds a Bachelor of Science degree in Accounting and Business from Guilford College of North Carolina. Mr. Moore is a member of the Compensation Committee and is a member of the National Association of Corporate Directors. Charles A. Lynch became a Director on April 1, 2000 and is Chairman of Market Value Partners Company, a management and advisory source for existing and emerging businesses. He has had executive management responsibility for 70-plus companies, primarily in consumer related businesses, and has been a director of over 20 major corporations. Mr. Lynch currently serves as Chairman of the Board of Fresh Choice, Inc. and nSpired Natural Foods, Inc. Mr. Lynch also serves as a director or advisor to a number of privately-held organizations. Mr. Lynch received his Bachelor of Science degree from Yale University and an Honorary Degree of Doctors of Law from Golden Gate University. He is also a member of the National Association of Corporate Directors. Mr. Lynch is Chairman of the Compensation Committee and a member of the Audit Committee, Nominating and Governance Committee and Capital Committee. Thomas B. Simone has been a Director of the Company since December 2000, and is Chairman and CEO of Simone & Associates, LLC a management and advisory firm that invests in and consults with healthcare and natural products companies. Mr. Simone also serves as Vice Chair and Lead Independent Director of the Board of United Natural Foods, Inc., the largest distributor of natural products in the industry and serves as a director or advisor to a number of privately-held organizations. Prior to forming Simone & Associates, Mr. Simone was President of McKesson Drug Company, America's largest pharmaceutical wholesaler. During his twenty-year career with McKesson, Mr. Simone also served as Vice President of Finance for McKesson Corporation, Executive Vice President of PCS Health Systems, and Vice President and Controller. Mr. Simone holds Bachelor of Science and Master of Business Administration degrees from DePaul University and is a member of the National Association of Corporate Directors. Mr. Simone is Chairman of the Capital and Nominating and Governance Committees and a member of the Audit Committee and Compensation Committee. Conrad W. Hewitt has been a Director of the Company since November 2002. Prior to that, he was a consultant and served as the Commissioner for the State of California Department of Financial Institutions from 1997 to 1998, and as the State of California Superintendent of Banking from 1995 to 1997. From 1962 to 1995, Mr. Hewitt was a Managing Partner with Ernst & Young's offices in San Francisco, Seattle, and Honolulu. Mr. Hewitt currently serves as a Director on the boards of North Bay Bancorp and Varian, Inc. He also serves as a director or advisor to a number of privately-held organizations. Mr. Hewitt holds a Bachelor of Science degree in Finance and Banking from the University of Illinois, and did his post graduate study at the University of Southern California. He is a member of the National Association of Corporate Directors and the American Institute of CPAs. Mr. Hewitt is Chairman of the Audit Committee and a member of the Nominating and Governance Committee and Capital Committee. Spectrum's Board of Directors has determined that Mr. Hewitt qualifies as an audit committee financial expert, as that term has been defined by the SEC. Mr. Hewitt also qualifies as an independent director under the Exchange Act. Dr. John B. Elstrott joined the Board on July 29, 2004. Dr. Elstrott is a Clinical Professor of Entrepreneurship and the Director of the Levy-Rosenblum Institute for Entrepreneurship at Tulane University's A. B. Freeman School of Business in New Orleans, Louisiana. Dr. Elstrott is an active entrepreneur in - -------------------------------------------------------------------------------- Page 57 several areas including the venture capital, telecommunications, music, and natural food industries. He has won numerous prestigious teaching awards and was named the Ernst and Young Louisiana Entrepreneur of the Year in 1997 for his support of entrepreneurship education. Prior to joining Tulane, Dr. Elstrott was Chief Financial Officer for Celestial Seasonings, Inc. Today he serves on the boards of several public and private corporations and non-profit community service organizations, and serves as the lead director and chair of the audit committee for Whole Foods Market, Inc. Dr. Elstrott holds bachelors and masters degrees in economics from Louisiana State University and a doctorate in economics from the University of Colorado at Boulder. Dr. Elstrott is a member of the National Association of Corporate Directors and serves as a member on the Audit, Nominating and Governance and Capital Committees. Robert B. Fowles joined Spectrum as Chief Financial Officer in June 2000 and brings over twenty years of financial expertise in packaged consumer products. From June 1999 until June 2000, Mr. Fowles was CFO of Cedco Publishing Company, a privately held publisher of books, calendars and CD ROMS. Prior to that Mr. Fowles served for 19 years in various capacities within the food and beverage businesses of Diageo, PLC, the last seven of which as CFO of Heublein Wines Group. Mr. Fowles is a Certified Public Accountant and received a Bachelor of Science degree in Business Administration from the University of Connecticut. Nils Michael Langenborg joined Spectrum as Vice President-Marketing in November 2002. Prior to joining Spectrum Mr. Langenborg was the principal of Natural Planograms, a category management company that he founded in April 2001 to provide consumer-focused solutions to retailers and manufacturers of natural products. Prior to that Mr. Langenborg served as Vice President of Marketing for Traditional Medicinals, Inc. from July 1995 through March 2001 where he was responsible for the creation, development and execution of all national marketing support programs. Mr. Langenborg is a graduate of San Francisco State University with dual majors in Marketing and Advertising and Small Business Management. Steven L. Terre joined Spectrum as Vice President-Sales in November 2002. Prior to joining Spectrum Mr. Terre served for 18 years as Vice President of Sales for Traditional Medicinals, Inc. where he was responsible for all aspects of the Company's sales efforts. Mr. Terre has devoted his entire career to the natural foods industry and is a graduate of the University of California, San Diego. Duane W. Chase joined Spectrum as Director of Sales and Marketing for Spectrum Ingredients on September 1, 2000. Mr. Chase was subsequently promoted to General Manager - Spectrum Ingredients on November 1, 2003. Prior to joining Spectrum Mr. Chase served for two years as North American Sales Director for Institute Rosell (a division of Lallemand, Inc.) Prior to that Mr. Chase spent thirty years in sales, marketing and technical support roles for a variety of ingredient products in the food and nutraceutical industries. Mr. Chase earned a Bachelor of Science degree in Food Science and Technology from the University of California at Davis. Randall H. Sias joined Spectrum on October 13, 2003 as Director of Operations and was promoted to Vice President - Operations on January 1, 2005. Prior to joining Spectrum Mr. Sias served as Director of Operations for Splash-O-Rama, Inc., a candy distributor for almost three years. Prior to that Mr. Sias served as Vice President of Supply Chain/Operations for Calio Groves, LLC, an olive oil bottling company for two years. Mr. Sias began his career at PowerBar, Inc. where he worked for over nine years in numerous capacities. Mr. Sias earned an MBA degree in International Business from the University of Oregon and a Bachelor of Arts in Management, also from the University of Oregon. Compliance with Section 16(a) of the Securities Exchange Act of 1934 Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company's directors and executive officers and persons who own more than 10% of a registered class of the Company's equity securities to file with the SEC initial reports of ownership and reports of changes in ownership of common stock and other equity securities of the Company. The Company files all the reports required under Section 16(a) on behalf of its officers, directors and greater than 10% beneficial owners. - -------------------------------------------------------------------------------- Page 58 To the Company's knowledge, based solely on its information concerning changes in ownership of common stock and other equity securities and written representations that no other reports were required, all Section 16(a) filing requirements applicable to its officers, directors and greater than 10% beneficial owners were complied with during the fiscal year ended December 31, 2002 with the exception of the following reports, which were filed late: 1. The Statement of Changes in Beneficial Ownership of Securities filed for Mr. Sias reporting the grant of 25,000 incentive stock options to him on January 28, 2004 was filed late on March 19, 2004. 2. The Statement of Changes in Beneficial Ownership of Securities filed for Mr. Phillips reporting the sale of 200,000 shares of common stock on August 13, 2004 was filed late on August 18, 2004. 3. The Statement of Changes in Beneficial Ownership of Securities filed for Mr. Simone reporting the grant of 3,750 non qualified stock options to him on November 5, 2004 was filed late on November 17, 2004. Code of Ethics The Company has adopted a code of ethics entitled "Spectrum Standards of Business Ethics" which applies to all employees. The code of ethics has been filed as an exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 2003. The code of ethics has also been posted on the Company's internet website which can be found at HTTP://WWW.SPECTRUMORGANICS.COM. Any person may request a copy of the code of ethics free of charge by writing to the Company's CFO at 5341 Old Redwood Highway, Suite 400, Petaluma, California 94954. ITEM 11. EXECUTIVE COMPENSATION - ------------------------------- The following table summarizes the annual compensation awarded or paid during the last three fiscal years for the Company's President and CEO and the next five most highly compensated officers (hereinafter, the "Named Executive Officers"). Summary Compensation Table Long-term Annual Compensation Compensation ------------------------------------ ------------ Other Securities Fiscal Compen- Underlying Name and Position Year Salary Bonus sation Options ----------------- ---- ------ ----- ------------- ------- Neil G. Blomquist (1) 2004 $ 208,300 $ 13,800 $ 10,100 75,000 President and 2003 200,000 60,700 9,000 -- Chief Executive Officer 2002 183,300 26,400 9,000 650,000 Jethren P. Phillips (2) 2004 209,400 19,400 33,900 75,000 Chairman of the Board 2003 202,300 40,900 53,600 -- 2002 208,000 32,500 9,000 -- Robert B. Fowles 2004 148,800 12,700 300 50,000 Chief Financial Officer 2003 141,300 28,100 -- 50,000 and Secretary 2002 136,300 22,000 -- 100,000 N. Michael Langenborg (3) 2004 120,000 5,500 -- 40,000 Vice President, Marketing 2003 115,000 20,900 -- 75,000 2002 13,900 -- -- -- Steven L. Terre (3) 2004 120,000 7,200 7,200 40,000 Vice President, Sales 2003 115,000 21,700 7,200 75,000 2002 9,600 -- 300 -- Duane W. Chase (4) 2004 100,000 7,500 -- 40,000 General Manager - SI 2003 95,900 14,000 -- 20,000 2002 88,000 -- -- 30,000 - -------------------------------------------------------------------------------------------------------- Page 59 (1) Mr. Blomquist was appointed President and Chief Executive Officer on September 1, 2002. Prior to then he was President-Consumer Brands. (2) Mr. Phillips also served as Chief Executive Officer until September 1, 2002. (3) Mr. Langenborg and Mr. Terre joined the Company on November 4, 2002 and November 18, 2002, respectively. (4) Mr. Chase was appointed General Manager - SI on November 1, 2003. Prior to then he was Director of Sales and Marketing - SI. Other compensation for Mr. Blomquist included life insurance and automobile allowances. Other compensation for Mr. Phillips included life insurance, automobile and office allowances. Also included in other compensation for Mr. Phillips in 2003 was imputed income of $34,800 to retire the shareholder advance that was previously outstanding to him. Option Grant Table The following table sets forth the options granted to the Named Executive Officers for the year ended December 31, 2004. Individual Grants ----------------- Number of % of Total Securities Options Underlying Granted to Exercise Fair Value Options Employees or Base Expiration at Date of Granted In 2004 Price Date Grant ------- ------- ----- ---- ----- Neil G. Blomquist 75,000 10.0% $ 0.85 3/24/14 $ 46,400 Jethren P. Phillips 75,000 10.0% 0.85 3/24/14 46,400 Robert B. Fowles 50,000 6.7% 0.85 3/24/14 30,900 N. Michael Langenborg 40,000 5.3% 0.85 3/24/14 24,800 Steven L. Terre 40,000 5.3% 0.85 3/24/14 24,800 Duane W. Chase 40,000 5.3% 0.85 3/24/14 24,800 The above options vest ratably over a four-year period beginning March 24, 2004. The fair value at the date of grant of $0.62 per share was calculated using the Black-Scholes option pricing model with the following assumptions: expected life of five years, risk-free interest rate of 2%, no dividend yield and price volatility of 95%. Option Exercises During 2004 There were no exercises of stock options during 2004 for the Named Executive Officers. Fiscal Year-End Option Value Table The following table sets forth the number of shares underlying outstanding options at December 31, 2004 and their related value for the Named Executive Officers. Number of Securities Value of Unexercised Underlying Unexercised Options In-the-money Options at December 31, 2004 at December 31, 2004 (1) ---------------------------- ----------------------------- Name Vested Unvested Vested Unvested - ---- ------ -------- ------ -------- Neil G. Blomquist 1,215,515 400,000 $ 220,000 $ 47,800 Jethren P. Phillips -- 75,000 -- -- Robert B. Fowles 500,000 200,000 83,700 37,200 N. Michael Langenborg 18,750 96,250 4,000 12,100 Steven L. Terre 18,750 96,250 4,000 12,100 Duane W. Chase 27,500 62,500 8,300 5,600 --------- --------- --------- --------- Totals 1,780,515 930,000 $ 320,000 $ 114,800 ========= ========= ========= ========= (1) Based on a closing stock price of $0.52 per share at December 31, 2004. - -------------------------------------------------------------------------------- Page 60 Compensation of Directors Under new arrangements which began January 1, 2003 the Company's non-executive directors received a compensation package consisting of a base quarterly retainer paid in cash plus non-qualified stock options issued under the Company's Amended and Restated 1995 Stock Option Plan. Non-executive directors who serve as Chairman of one of the Committees of the Board received an additional cash retainer and additional options above the base package as disclosed in the following table: Retainer Options -------- ------- Base annual compensation package $ 15,000 40,000 Additional compensation for Chairmanship of the Capital, Compensation or Nominating and Governance Committees 5,000 5,000 Additional compensation for Chairmanship of the Audit Committee 6,000 6,000 The Chairman of the Audit Committee is the most highly compensated non-executive director in recognition of the importance of that role and the additional scrutiny of audit committees in the wake of the Sarbanes-Oxley Act of 2002. All directors receive reimbursement of expenses incurred in attending meetings. Executives of the Company who also serve as Board members receive only reimbursement of expenses incurred. During 2002 the Company's non-executive directors were offered a choice between the following two compensation packages for Board service: (1) annual cash compensation of $10,000 and 25,000 non-qualified stock options at the market price on the date of grant with a four year vesting schedule, or (2) 80,000 non-qualified stock options for serving on the Board and 20,000 additional non-qualified stock options for Chairmanship of a Committee, at the market price on the date of grant, with one-third vested immediately and the remainder vesting ratably over two years. Messrs. Hewitt, Lynch, Moore and Simone all chose the option package for 2002. Employment Contracts and Termination of Employment and Change-in-Control Arrangements The Company is a party to an employment agreement with Jethren P. Phillips covering the period commencing October 6, 1999 and ending October 6, 2002, subject to automatic extension for successive one-year terms unless terminated via 90 days prior written notice by either party. The agreement provides for Mr. Phillips to serve as Chairman of the Board of the Company's Board of Directors. The agreement includes a non-competition clause under which Mr. Phillips agrees that during the term of the agreement and for three years thereafter he will not, directly or indirectly, engage in, become financially interested in, be employed by or have any business connection with any other person, corporation, firm, partnership or other entity whatsoever which were known to him to directly compete with the Company, throughout the world, in any line of business engaged in (or planned to be engaged in) by the Company. In the event of any termination of Mr. Phillips's employment other than voluntary termination or termination for "cause," Mr. Phillips is entitled to a severance package equal to one year's base annual salary, plus a prorated portion of his annual incentive award paid in an amount equal to the incentive that would otherwise be paid for the fiscal year in which his employment terminated. Mr. Phillips would also maintain his benefit package during the one year severance period and would be eligible for outplacement services or an equivalent cash payment equal to 10% of his annual base salary. "Cause" is defined as conduct unbecoming an executive as determined by a majority of the Board of Directors or the conviction or no contest plea in respect of a felony. The Company is a party to an employment agreement with Neil G. Blomquist covering the period commencing October 1, 2002 and ending October 1, 2004, subject to automatic extension for successive one-year terms unless terminated via 60 days prior written notice by either party. The agreement provides for Mr. Blomquist to serve as the Company's President and Chief Executive Officer. The agreement includes a non-competition clause under which Mr. Blomquist agrees that during the term of the agreement and for a period of one year after - -------------------------------------------------------------------------------- Page 61 termination of the agreement, he will not, directly or indirectly, divert or attempt to divert from the Company any business of any kind in which it is engaged, employ or recommend for employment any person employed by the Company, engage in any business activity that is or may be competitive with that of the Company, or solicit any customer of the Company to the detriment of the Company. In the event of a change-in-control event as a result of the sale of the Company or substantially all of its assets, or a merger or reorganization which results in a change of control, Mr. Blomquist is entitled to a severance package equal to one year's base annual salary, plus a prorated portion of his annual incentive award paid in an amount equal to the incentive that would otherwise be paid for the fiscal year in which his employment terminated. Mr. Blomquist would also maintain his insurance benefits during the one year severance period. In the event Mr. Blomquist enters into a new employment agreement on substantially the same or better terms with the Company's successor in interest, all of his rights to the compensation described above are forfeited. Compensation Committee Interlocks and Insider Participation The current members of the Company's Compensation Committee are Messrs. Lynch, Moore and Simone. No executive officer of the Company has served as a director or member of the compensation committee (or other committee serving an equivalent function) of any other entity, one of whose executive officers served as a director of or member of the Compensation Committee of the Company. Report of the Compensation Committee of the Board on Executive Compensation Overview and Philosophy The Compensation Committee of the Company's Board of Directors (for purposes of this report, the "Committee") is responsible for making recommendations concerning salaries and incentive compensation for the Company's Chief Executive Officer and the other executive officers. The Committee currently consists of Messrs. Lynch, Moore and Simone. This report addresses the Company's compensation policies for fiscal 2004 as they affected the Chief Executive Officer and the Company's other executive officers. The objectives of the Company's executive compensation program are to: o Provide executives with competitive compensation that maintains a balance between cash and stock compensation and provides a significant portion of total compensation at risk, tied both to annual and long-term performance of the Company as well as to the creation of stockholder value. o Align the executive officers' interests with the interests of shareholders and the overall success of the Company. o Recognize and reward individual performance and responsibility so that the Company's strongest performers receive a highly competitive compensation package. Compensation Program The Company's executive compensation program generally consists of a base salary, participation in the management incentive plan, and long-term incentive compensation in the form of stock options. Executives also participate in benefit programs that are generally available to all employees of the Company, including medical and dental insurance, the Company's 401(k) Plan, life insurance plan and the Company's vacation policy. - -------------------------------------------------------------------------------- Page 62 All compensation decisions are determined following a review of many factors that the Committee believes are relevant, including third-party data, the Company's achievements over the past year, the individual's contributions to the Company's success, any significant changes in role or responsibility, and the internal equity of compensation relationships. In general, the Committee intends that the overall total compensation opportunities provided to the executive officers should reflect competitive compensation for executives with corresponding responsibilities in comparable firms providing similar products and services. To the extent determined to be appropriate, the Committee also considers general economic conditions, the Company's financial performance and individual merit in setting compensation policies for its executive officers. For 2004, the Committee reviewed the appropriate mix between salary and other forms of compensation and set annual compensation guidelines for the Company's executives. The Committee also evaluated expensing stock options under SFAS 123 and elected to continue the current treatment of not recording an expense for employee and director stock options under the provisions of SFAS 148, which requires footnote disclosure of the impact on the Company's financial statements as if the expensing of stock options had been elected. Long-term incentives for executive officers and key employees are provided through individual stock ownership and the Company's Amended 1995 Stock Option Plan. The objectives of these plans are to align executive and shareholder long-term interests by creating a direct link between executive compensation and shareholder return, and to enable executives to develop and maintain a significant, long-term stock ownership position in the Company. Stock options are granted at an option price equal to the fair market value or, in the case of owners of 10% or more of the Company's common stock, 10% above the fair market value of the Company's common stock on the date of grant and will only have value if the Company's stock price increases. In selecting executives eligible to receive option grants and determining the amount and frequency of such grants, the Company evaluates a variety of factors, including (i) the job level of the executive, (ii) option grants awarded by competitors to executives at a comparable job level, and (iii) past, current and prospective service to the Company rendered, or to be rendered, by the executive. Compensation for the Chief Executive Officer The Committee makes an annual recommendation to the Board for the compensation of Mr. Blomquist, President and Chief Executive Officer. Mr. Blomquist was promoted to that position on September 1, 2002 at an annual base salary of $200,000 plus a target management incentive award equal to 50% of his base annual salary. In addition, Mr. Blomquist was granted incentive stock options representing the right to acquire 500,000 shares of the Company's common stock at an option price that was equal to the market price on the date of grant. The option grant at the time of Mr. Blomquist's promotion was viewed as a future incentive mechanism rather than a reward for past performance. The Committee considered the fact that Mr. Blomquist was a significant shareholder of the Company in determining the size of the option grant. Mr. Blomquist was granted a merit increase of 5% of his base salary effective March 1, 2004. Mr. Blomquist was also granted incentive stock options representing the right to acquire 75,000 shares of the Company's common stock at an option price of $0.85, the closing market price on March 24, 2004, the date of grant. Mr. Blomquist's annual cash incentive award for 2004 of $13,800 was based on an 80%/20% mix of Company EBITDA as adjusted achievement and the individual key performance objectives established for 2004 by the Committee. For 2004 the Company did not achieve the EBITDA as adjusted target that had been set by the Committee prior to the beginning of the year. The Committee evaluated Mr. Blomquist's achievement against the key performance objectives set for him at the beginning of the year. Based on its evaluation, the Committee recommended that the Board approve Mr. Blomquist's annual cash incentive award for 2004 of $13,800. - -------------------------------------------------------------------------------- Page 63 Tax Deductibility of Executive Compensation Section 162(m) of the Internal Revenue Code (the "Code") limits the Company to a deduction for federal income tax purposes of no more than $1 million for compensation paid to certain Named Executive Officers in a taxable year. Compensation above $1 million may be deducted if it is "performance-based compensation" within the meaning of the Code. The statute containing this law and the applicable proposed Treasury regulations offer a number of transitional exceptions to this deduction limit for pre-existing compensation plans, arrangements and binding contracts. As a result, the Compensation Committee believes that at the present time it is quite unlikely that the compensation paid to any Named Executive Officer in one taxable year, which is subject to the deduction limit, will exceed $1 million. Therefore, the Compensation Committee has not yet established a policy for determining which forms of incentive compensation awarded to its Named Executive Officers shall be designed to qualify as "performance-based compensation." The Compensation Committee intends to continue to evaluate the effects of the statute and any final Treasury regulations and to comply with Code Section 162(m) in the future to the extent consistent with the best interests of the Company. This report respectfully submitted by: Charles A. Lynch, Chairman Phillip L. Moore Thomas B. Simone Members of the Compensation Committee Comparative Stock Performance Graph The graph and table below compares the cumulative total shareholder return on the common stock of the Company for the five year period ended December 31, 2004 with the cumulative total return on (i) an index of organic food and nutritional supplement companies and (ii) the Russell 2000 Index. The comparison assumes the investment of $100 on December 31, 1999 in the Company's common stock and in each of the indices and, in each case, assumes reinvestment of all dividends. The index of organic food and nutritional supplement companies includes Galaxy Nutritional Foods, Inc., Gardenburger, Inc., Green Mountain Coffee Roasters, Inc., Hain Celestial Group, Inc., Hansen Natural Corp., Lifeway Foods, Inc., Monterey Gourmet Foods Company, Tofutti Brands, Inc., Vermont Pure Holdings, Ltd., and Next Generation Tech Holdings, Inc. - -------------------------------------------------------------------------------- Page 64 COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* AMONG SPECTRUM ORGANIC PRODUCTS, INC., THE RUSSELL 200 INDEX AND A PEER GROUP [GRAPHIC OMITTED] * $100 invested on 12/31/99 in stock or index-included reinvestment of dividends. Fiscal year ending December 31. Cumulative Total Return -------------------------------------------------------------- 12/99 12/00 12/01 12/02 12/03 12/04 ----- ----- ----- ----- ----- ----- Spectrum Organic Products, Inc. 100.00 65.00 74.00 60.00 166.00 110.00 Russell 2000 100.00 96.98 99.39 79.03 116.38 137.71 Peer Group 100.00 139.07 133.03 79.72 115.04 130.94 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS - --------------------------------------------------------------------------- Excluding management, there is only one beneficial owner of more than 5% of the Company's common stock outstanding. Mr. John R. Battendieri, a non-executive Director of the Company until his resignation from the Board effective April 1, 2004 is the owner of 2,737,499 shares (5.9%) of common stock, beneficially and of record. The address of Mr. Battendieri is in care of Running Stream Food and Beverage, P.O. Box 1385, Soquel, California. The following table sets forth information concerning the holdings of common stock and vested common stock options and warrants by each director and executive officer and by all directors and executive officers as a group as of March 15, 2005. All shares are owned beneficially and of record. The address of all persons is in care of the Company at 5341 Old Redwood Highway, Suite 400, Petaluma, California. - -------------------------------------------------------------------------------- Page 65 Percent Name and Title No. of Shares(1) of Class - -------------- ---------------- -------- Jethren P. Phillips, Chairman of the Board 27,300,000 53.0% Neil G. Blomquist, President and CEO, Director 2,070,183 4.0% Thomas B. Simone, Director 585,394 1.1% Robert B. Fowles, CFO and Secretary 537,500 1.0% Phillip L. Moore, Director 500,993 1.0% Charles A. Lynch, Director 330,478 * Conrad W. Hewitt, Director 93,977 * N. Michael Langenborg, Vice President - Marketing 37,500 * Steven L. Terre, Vice President - Sales 37,500 * Duane W. Chase, General Manager - SI 32,500 * John B. Elstrott, Director 14,985 * Randall H. Sias, Vice President - Operations 6,250 * ---------- ------ All officers and directors as a group (12 persons) 31,547,260 61.2% ========== ====== * Less than 1% (1) The number of shares shown represent the total shares beneficially owned by each individual and shares which are issuable upon the exercise of all stock options and warrants which are currently exercisable or will become exercisable within 60 days of December 31, 2004. Specifically, the following individuals have the right to acquire the following shares upon the exercise of such stock options and warrants: Mr. Blomquist - 1,253,015 shares, Mr. Simone - 425,394 shares, Mr. Fowles - 537,500 shares, Mr. Moore - 244,980 shares, Mr. Lynch - 302,478 shares, Mr. Hewitt - 93,977 shares, Mr. Langenborg - 37,500 shares, Mr. Terre - 37,500 shares, Mr. Chase - 32,500 shares, Dr. Elstrott - 14,985 shares and Mr. Sias - 6,250 shares. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------------------------------------------------------- Mr. Thomas B. Simone is one of the Company's external Directors and also sits on the Board of United Natural Foods, Inc. ("UNFI"). UNFI is the Company's largest customer, representing approximately 42% of the Company's net sales for the year ended December 31, 2004. Dr. John B. Elstrott became an external Director of the Company on July 29, 2004. Dr. Elstrott also sits on the Board of Whole Foods Market, Inc. which is the largest retailer in the natural products industry. The vast majority of the Company's products offered for retail sale at Whole Foods Market are purchased through UNFI. Sales made directly to Whole Foods Market by the Company have been insignificant. There was one transaction with a related party during the year ended December 31, 2004. The Company paid consulting fees of $33,000, plus expenses incurred, to Running Stream Food and Beverage, Inc. ("RSFB"). RSFB provided private label consulting and management services to the Company until April 16, 2004 and is owned and operated by John R. Battendieri, a non-executive Director of the Company until his resignation from the Board of Directors effective April 1, 2004. The Company elected to terminate the consulting services agreement with RSFB at the end of its two-year term on April 16 in order to focus on its core business in healthy oils and nutritional supplements. In the opinion of management, the consulting fees paid to RSFB were fair, reasonable and consistent with terms the Company could have obtained from an unaffiliated third party. - -------------------------------------------------------------------------------- Page 66 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES - ------------------------------------------------ Grant Thornton, LLP was appointed as the Company's independent public accountants on April 15, 2003. The following summarizes the fees paid to them since then for the various services they have provided. Audit Fees Grant Thornton's fees for the 2004 and 2003 annual audits were $122,000 and $105,900, respectively. Included in those amounts were fees for quarterly reviews, attendance at Audit Committee Meetings and assistance with SEC financial statement disclosures. Tax Fees Grant Thornton's fees during 2004 and 2003 for tax services rendered were $51,000 and $56,300, respectively. The 2004 fees included the preparation of the Company's 2003 federal and state income tax returns and assistance with tax-related financial statement disclosures. The 2003 fees included the amendment of the Company's 2000 and 2001 income tax returns as well as the preparation of the Company's 2002 returns. There were no other services provided by the independent auditors in 2004 and 2003. The Audit Committee of the Board of Directors believes the provision of the tax services by Grant Thornton is compatible with maintaining their independence. It is the Audit Committee's policy to approve all Grant Thornton fees in advance. The Chairman of the Audit Committee has the authority to approve Grant Thornton fees of up to $50,000, subject to subsequent ratification by the Committee. The Company's Chief Financial Officer has the authority to approve Grant Thornton fees of up to $10,000, subject to subsequent ratification by the Audit Committee. All of the Grant Thornton fees in each category enumerated above were approved in advance by the Audit Committee. The Audit Committee has discussed with the Company's management and Grant Thornton the overall scope and plans for their audits. The Audit Committee meets quarterly with Grant Thornton, with and without management present, to discuss the results of their examinations, their evaluations of the Company's internal accounting and financial reporting controls, and the overall quality of the Company's financial reporting. - -------------------------------------------------------------------------------- Page 67 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - ------------------------------------------------------------------------ (a) Documents filed as part of this Report: (1) Index to Financial Statements: Page Reports of Independent Registered Public Accounting Firms 30-31 Balance Sheets as of December 31, 2004 and 2003 32 Statements of Operations for the years ended December 31, 2004, 2003 and 2002 33 Statement of Stockholders' Equity for the years ended December 31, 2004, 2003 and 2002 34 Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002 35 Notes to Financial Statements 36-54 (2) Exhibits: Exhibit No. Description ------- ----------- 2.10 Asset Purchase Agreement dated April 25, 2002 by and among Spectrum Organic Products, Inc., Organic Ingredients, Inc. and Acirca, Inc. (9) 2.11 Escrow and Security Agreement dated April 25, 2002 by and among Spectrum Organic Products, Inc., Organic Ingredients, Inc. and Webster Trust Company, NA. (9) 2.12 Transition Services Agreement dated April 25, 2002 by and between Spectrum Organic Products, Inc. and Acirca, Inc. (9) 2.13 Non-competition Agreement dated April 25, 2002 by and among Spectrum Organic Products, Inc., Organic Ingredients, Inc., Jethren Phillips, and Neil Blomquist. (9) 2.14 Sales Representative Services Agreement dated April 25, 2002 by and between Spectrum Organic Products, Inc. and Organic Ingredients, Inc. (9) 2.15 Assignment and Assumption Agreement dated April 25, 2002 by and between Spectrum Organic Products, Inc. and Organic Ingredients, Inc. (9) 3.01 Amended and Restated Articles of Incorporation of Spectrum Organic Products, Inc. (4) 3.03 Audit Committee Charter of the Registrant (1) 3.04 Amended Bylaws of Spectrum Organic Products, Inc. (3) 3.05 Nominating and Governance Committee Charter of the Registrant (3) 3.06 Amended Compensation Committee Charter of the Registrant as adopted on March 3, 2005. 3.07 Amended Nominating and Governance Committee Charter of the Registrant as adopted on March 3, 2005. 10.13 Agreement and Plan of Merger and Reorganization dated May 14, 1999 by and between Organic Food Products, Inc. and Organic Ingredients, Inc. (4) 10.14 Agreement and Plan of Merger and Reorganization dated May 14, 1999 by and between Organic Food Products, Inc. and Spectrum Naturals, Inc. (4) 10.15 Form of Organic Food Products, Inc. Employment Agreement which continues to serve as the Employment Agreement between Spectrum Organic Products, Inc. and Jethren P. Phillips. (4) 10.16 Form of Organic Food Products, Inc. Shareholder Lock-up Agreement (4) - -------------------------------------------------------------------------------- Page 68 10.17 Form of Voting Agreement dated May 14, 1999 between Spectrum Naturals, Inc. and certain shareholders of Organic Food Products, Inc. (4) 10.18 October 6, 1999 Credit and Security Agreement by and between Organic Food Products, Inc., Organic Ingredients, Inc., Spectrum Naturals, Inc. and Spectrum Commodities, Inc. and Wells Fargo Business Credit, Inc. (5) 10.19 September 23, 1999 Private Placement Memorandum by Organic Food Products, Inc. (5) 10.22 Fifth Amendment to Redemption Agreement dated October 6, 1999 by and between Spectrum Naturals, Inc., Organic Food Products, Inc., Jethren Phillips and Debora Bainbridge Phillips. (6) 10.23 Fourth Amendment to Redemption Agreement dated July 12, 1999 by and between Spectrum Naturals, Inc., Jethren Phillips and Debora Bainbridge Phillips. (6) 10.24 Third Amendment to Redemption Agreement dated July 9, 1999 by and between Spectrum Naturals, Inc., Jethren Phillips and Debora Bainbridge Phillips. (6) 10.25 Second Amendment to Redemption Agreement dated July 2, 1999 by and between Spectrum Naturals, Inc., Jethren Phillips and Debora Bainbridge Phillips. (6) 10.26 First Amendment to Redemption Agreement dated September 11, 1998 by and between Spectrum Naturals, Inc., and Debora Bainbridge Phillips. (6) 10.27 Redemption Agreement dated November 1, 1996 by and between Spectrum Naturals, Inc. and Debora Bainbridge Phillips. (6) 10.28 Guaranty Agreement dated June 6, 1997 by and between Spectrum Naturals, Inc., Debora Bainbridge Phillips and Jethren Phillips. (6) 10.29 Pledge Agreement dated June 6, 1997 by and between Spectrum Naturals, Inc., Debora Bainbridge Phillips and Richard W. Abbey, Attorney at Law. (6) 10.30 Promissory Note dated June 6, 1997 by and between Spectrum Naturals, Inc. and Debora Bainbridge Phillips. (6) 10.34 Letter dated February 16, 2001 from Spectrum Organic Products, Inc. to the note holders under the private placement completed on October 6, 1999, offering them the option of converting their notes, which were in default, to equity or a new note with a three year payment schedule, interest at 10% and common stock purchase warrants. (6) 10.35 First Amendment to Credit and Security Agreement dated October 18, 2001 by and between Spectrum Organic Products, Inc. and Wells Fargo Business Credit, Inc. (8) 10.37 Sixth Amendment to Amended and Restated Redemption Agreement dated June 13, 2001 by and between Spectrum Organic Products, Inc., Debora Bainbridge Phillips and Jethren P. Phillips. (2) 10.38 Employment Agreement effective as of October 1, 2002 by and between Spectrum Organic Products, Inc. and Neil G. Blomquist. (2) 10.39 Second Amendment to Credit and Security Agreement dated October 30, 2002 by and between Spectrum Organic Products, Inc. and Wells Fargo Business Credit, Inc. (2) 10.40 Seventh Amendment to Amended and Restated Redemption Agreement and Amended and Restated Promissory Note effective November 1, 2002 by and between Spectrum Organic Products, Inc., Debora Bainbridge Phillips and Jethren P. Phillips. (2) 10.41 Sublease Agreement dated October 23, 2002 by and between Spectrum Organic Products, Inc. and Alcatel USA Sourcing, L.P. (2) 10.42 Consent to Sublease Agreement dated November 13, 2002 by and between Spectrum Organic Products, Inc., Alcatel USA Sourcing, L.P. and Redwood Business Park IV, LLC. (2) 10.43 Agreement for the Purchase and Sale of Intellectual Property dated April 15, 2003 by and between Spectrum Organic Products, Inc., Tenere Life Sciences, Inc. and Rees Moerman. (11) - -------------------------------------------------------------------------------- Page 69 10.44 Loan and Security Agreement dated June 12, 2003 effective as of July 11, 2003 by and between Spectrum Organic Products, Inc. and Comerica Bank. (12) 10.45 LIBOR Addendum to Loan and Security Agreement dated June 12, 2003 effective as of July 11, 2003 by and between Spectrum Organic Products, Inc. and Comerica Bank. (12) 10.46 Variable Rate-Installment Note dated June 12, 2003 effective as of July 11, 2003 by and between Spectrum Organic Products, Inc. and Comerica Bank. (12) 10.47 Variable Rate-Single Payment Note dated June 12, 2003 effective as of July 11, 2003 by and between Spectrum Organic Products, Inc. and Comerica Bank. (12) 10.48 Subordination Agreement dated June 12, 2003 effective as of July 11, 2003 by and between the Debora Bainbridge Phillips Trust, Spectrum Organic Products, Inc. and Comerica Bank. (12) 10.49 Subordination Agreement dated June 12, 2003 effective as of July 11, 2003 by and between Steven Reedy, Spectrum Organic Products, Inc. and Comerica Bank. (12) 10.50 Amended 1995 Stock Option Plan of the Registrant (13) 10.51 Form of Incentive Stock Agreement used in connection with the Amended 1995 Stock Option Plan (13) 10.52 Form of Non-qualified Stock Option Agreement used in connection with the Amended 1995 Stock Option plan (13) 10.53 First Amendment to Sublease Agreement dated November 15, 2003 by and between Spectrum Organic Products, Inc. and Alcatel USA Sourcing, L.P. (3) 10.54 Spectrum Organic Products, Inc. "Standards of Business Ethics" as adopted in 2003. (3) 23.05 Consent of Independent Registered Public Accounting Firm dated March 24, 2005 by Grant Thornton, LLP, San Francisco, CA. 23.06 Consent of Registered Public Accounting Firm dated March 24, 2005 by BDO Seidman, LLP, San Francisco, CA. 31.10 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.11 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.10 Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.11 Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99.02 Press release of the Company dated May 1, 2002 titled "Spectrum Organic Products Reports Sale of Organic Ingredients". (9) 99.05 Press release of the Company dated August 29, 2002 titled "Spectrum Organic Products, Inc. Appoints new CEO". (10) 99.06 Press release of the Company dated February 4, 2004 titled "Spectrum Organic Products, Inc. Announces Settlement with Sonoma County District Attorney". (14) 99.07 Press release of the Company dated March 1, 2004 titled "Spectrum Organic Products Reports Record Sales and Profits for 2003". (15) (1) Incorporated by reference to exhibits filed with the Registrant's Form 10-K on March 20, 2002. (2) Incorporated by reference to exhibits filed with the Registrant's Form 10-K on March 17, 2003. (3) Incorporated by reference to exhibits filed with the Registrant's Form 10-K on March 29, 2004. (4) Incorporated by reference to annexes filed with the Registrant's Joint Proxy Registration Statement on Form S-4, File No. 333-83675, declared effective July 30, 1999. - -------------------------------------------------------------------------------- Page 70 (5) Incorporated by reference to exhibits filed with the Registrant's Form 10-KSB on October 13, 1999. (6) Incorporated by reference to exhibits filed with the Registrant's Form 10-KSB on April 2, 2001. (7) Incorporated by reference to exhibits filed with the Registrant's Form 8-K on June 26, 2001. (8) Incorporated by reference to exhibits filed with the Registrant's Form 10-Q on November 6, 2001. (9) Incorporated by reference to exhibits filed with the Registrant's Form 8-K on May 9, 2002. (10) Incorporated by reference to exhibits filed with the Registrant's Form 8-K on September 6, 2002. (11) Incorporated by reference to exhibits filed with the Registrant's Form 10-Q on May 14, 2003. (12) Incorporated by reference to exhibits filed with the Registrant's Form 10-Q on November 6, 2003. (13) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-8 on October 1, 2003. (14) Incorporated by reference to exhibits filed with the Registrant's Form 8-K on February 5, 2004. (15) Incorporated by reference to exhibits filed with the Registrant's Form 8-K on March 2, 2004. (b) Reports on Form 8-K during the quarter ended December 31, 2004: The Company filed a Current Report on Form 8-K on November 10, 2004 disclosing the Company's unaudited financial position and results of operations as of and for the three and nine month periods ended September 30, 2004. - -------------------------------------------------------------------------------- Page 71 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, in Petaluma, California on March 15, 2005. Spectrum Organic Products, Inc. By: /s/ Robert B. Fowles -------------------------------- Robert B. Fowles Chief Financial Officer and Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- -------- /s/ Jethren P. Phillips Chairman of the Board of Directors 3/4/05 - ----------------------------- JETHREN P. PHILLIPS /s/ Neil G. Blomquist President and Chief Executive 3/4/05 - ----------------------------- Officer, Director NEIL G. BLOMQUIST /s/ Robert B. Fowles Chief Financial Officer and 3/4/05 - ----------------------------- Secretary ROBERT B. FOWLES /s/ Sandra R. Gustafson Controller (Principal Accounting 3/4/05 - ----------------------------- Officer) SANDRA R. GUSTAFSON /s/ Phillip L. Moore Director 3/4/05 - ----------------------------- PHILLIP L. MOORE /s/ Charles A. Lynch Director 3/4/05 - ----------------------------- CHARLES A. LYNCH /s/ Thomas B. Simone Director 3/4/05 - ----------------------------- THOMAS B. SIMONE /s/ Conrad W. Hewitt Director 3/4/05 - ----------------------------- CONRAD W. HEWITT /s/ John B. Elstrott Director 3/4/05 - ----------------------------- JOHN B. ELSTROTT - -------------------------------------------------------------------------------- Page 72