10-Q 1 spectrum6302004.txt FORM 10-Q (6-30-2004) SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004. [ ] TRANSITION REPORT UNDER 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. -------------------------------------------------------------- (Exact 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 (707)778-8900 ----------------------------------- ------------------------ (Address of executive offices) (Issuer's telephone number) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [ ] No [ X ] APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEEDING FIVE YEARS: Indicate by check mark whether the Registrant filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan conformed by a court. Yes [ ] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: Common Stock, no par value, 46,386,943 shares issued and outstanding as of August 2, 2004. Transitional Small Business Disclosure Format: Yes [ ] No [ X ] PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS ----------------------------- SPECTRUM ORGANIC PRODUCTS, INC. BALANCE SHEETS

SPECTRUM ORGANIC PRODUCTS, INC. NOTES TO FINANCIAL STATEMENTS 1. Basis of Presentation: These are unaudited interim financial statements and include all adjustments that, in the opinion of Management, are necessary in order to make the financial statements not misleading. The financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include certain disclosures required by accounting principles generally accepted in the United States of America. Accordingly, the statements should be read in conjunction with Spectrum Organic Products, Inc.'s financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2003. Operating results for the six month period ended June 30, 2004 are not necessarily indicative of the results that may be expected for the entire year ending December 31, 2004 or future periods. Certain reclassifications have been made to the prior year unaudited interim financial statements to be consistent with the presentation at June 30, 2004. These reclassifications had no impact on net income or retained earnings. 2. Nature of Operations and Business Segments: Spectrum Organic Products, Inc. ("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." 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. 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: 5

3. 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. 6 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 six months ended June 30, 2004 proceeds received under this note were $460,000. 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 June 30, 2004 the Company was in compliance with all requirements under the Credit Facility. A copy of the Amendment has been filed as Exhibit 10.55 with this quarterly report on Form 10-Q. 4. Manufacturing Facility Relocation and Reconfiguration: During the first quarter of 2004, the Company began the implementation of 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 American Natural Soy Processors, LLC ("ANS"). 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 is replacing most of the equipment currently used in the SpectraVac operation in Petaluma with new, more efficient equipment in Cherokee and will operate both facilities in parallel prior to shutting down the Petaluma facility. The Company plans to disassemble and relocate most of the Petaluma equipment to Cherokee after the shutdown. ANS 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 ANS under a strategic alliance. During the six months ended June 30, 2004 capital spending in Cherokee associated with the Iowa relocation was $492,000. Additionally, the Company incurred $81,200 in consulting fees associated with the relocation to Iowa, which was included in general and administrative expense. The Company anticipates that additional capital spending of approximately $250,000 and moving expenses of approximately $400,000 will be incurred during the third and fourth quarters to complete the relocation to Iowa. 5. 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 will 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 7 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 six months ended June 30, 2004 in connection with the plea were $275,000. On May 25, 2004 the Company settled one of the appeals filed with the Workers' Compensation Appeals Board for $35,000 which was paid on June 3, 2004 and charged against the industrial accident reserve. As of June 30, 2004 the Company had a remaining reserve of $197,600 to cover the remaining fine under CLCS 6425 of $100,000, the anticipated penalties from CAL-OSHA, the remaining appeal filed with the Workers' Compensation Appeals Board of California, and related attorney's fees. CAL-OSHA has 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 has filed a formal appeal with CAL-OSHA in the hopes of reducing the citations and proposed penalties. The remaining workers compensation appeal is for an additional death benefit of $62,500, 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. The Company intends to defend itself vigorously and believes it has meritorious defenses. If actually litigated, the workers compensation appeal is an all-or-nothing proposition under which the Company will either be liable for $62,500 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 $197,600 will be adequate to cover the remaining two installments under the CLCS 6425 fine of $50,000 each, the settlement of the CAL-OSHA penalties, the workers compensation appeal and related attorney's fees. 6. Inventories: Inventories consisted of the following: June 30, December 31, 2004 2003 ---------- ---------- Finished goods $6,950,500 $6,853,400 Raw materials 1,839,400 1,166,100 Deposits on inventory 319,500 236,200 ---------- ---------- Total Inventories 9,109,400 8,255,700 Less: Reserve for obsolete inventory 276,600 248,500 ---------- ---------- Net Inventories $8,832,800 $8,007,200 ========== ========== Deposits on inventory primarily represent flaxseed paid for prior to its receipt at the Company's production facility. 8 7. 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 is no longer obligated to pay royalties to Tenere effective April 1, 2003. Final royalties paid during the three months ended March 31, 2003 were $50,700. 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. No impairment charges have been required to date. 8. Commitments and Contingencies: 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 all 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. 9 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. The initial fee to join was a $5,000 retainer, which the Company paid on February 17, 2004. Management believes the Complaint will eventually be shown to be without merit. Accordingly, no provision for loss or future attorney's fees has been recorded at June 30, 2004. Pending Litigation - Patent Infringement Complaint In October 2000 the Company was notified by counsel for GFA Brands, Inc. ("GFA") that nutritional claims pertaining to Spectrum Naturals(R) Organic Margarine were infringing upon two patents (the "first patents") issued in the United States that pertain to particular fat compositions suitable for human consumption. The patent holder, Brandeis University, exclusively licensed each of these patents to GFA. GFA demanded that the Company cease the manufacture and sale of the margarine and threatened legal action if the Company failed to comply. It has always been Management's view that the formula for Spectrum Naturals Organic Margarine(R) fell outside the claims made in the Brandeis University patents. Despite numerous attempts, the Company was unable to convince GFA that its formula for the margarine fell outside the claims of the first patents. Therefore, the Company filed a complaint against GFA for declaratory judgment of non-infringement and invalidity of the two patents on August 28, 2001. The complaint requested a declaratory judgment that the margarine does not infringe either patent, a declaratory judgment that both patents are invalid, that GFA be enjoined from threatening or asserting any action for infringement of either patent, or attorney's fees. Markman briefs, in which each side presents its arguments on how the patent claims should be construed, were submitted by both GFA and Spectrum in July 2003. In most patent infringement cases, the court's determination of how the patent claims should be interpreted is the central issue. A Markman hearing was held by the court on October 16, 2003. The court issued its ruling on the Markman hearing on December 3, 2003 in favor of the Company's interpretation of the patent claims. On July 16, 2004 counsel for the Company and GFA verbally agreed to settle the case with respect to the first patents by a joint stipulation to dismiss all claims without prejudice to either party, with a provision that the Markman ruling will continue to be binding between the Company and GFA in the event of any future litigation. Meanwhile, unbeknownst to the Company, Brandeis University had filed for an additional patent (the "second patent") with the U.S. Patent Office which included patent claims that did encompass the Company's formula for Spectrum Naturals Organic Margarine(R). Unlike trademark law, patents are issued in the United States without pre-publication or notice which would allow for comment or appeal by potentially affected parties. On October 7, 2003 the U.S. Patent Office granted the second patent to Brandeis University. On the advice of counsel, the Company ceased the production of the margarine immediately thereafter and is currently evaluating its options with regards to the second patent. 10 There is no infringement by the Company of the second patent since the Company immediately ceased the production of the margarine upon notification of the patent's issuance. Accordingly, no provision for loss has been recorded at June 30, 2004. Court Supervised Probation Also in connection with the industrial accident on April 25, 2002 the Company entered a plea 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. 9. Stock-based Compensation: Statement of Financial Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure" ("SFAS 148") issued in December 2002 provides alternative methods of accounting for a voluntary transition to the fair value method of accounting for stock-based employee compensation as prescribed in SFAS 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). Additionally, SFAS 148 requires more prominent and more frequent disclosures in financial statements of the effects of stock based compensation effective for fiscal years ending after December 15, 2002. As 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 three and six month periods ended June 30, 2004 and 2003 would have been adjusted to the pro-forma amounts presented below: 11

The fair value of the 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 rate of 2.0%, no dividend yield and volatility of 95%. The weighted average fair value of the option grants during the first quarter of 2004 was $0.61 per share. The fair value of the 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 weighted average fair value of the option grants during the first quarter of 2003 was $0.25 per share. ITEM 2. 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 channel, fluctuations in market prices and availability of raw materials, competitive pricing policies and 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 the 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 "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 12 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 such 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. 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 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: 13 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 $470,000 at June 30, 2004 on gross trade accounts receivable of $4,735,500. 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 $276,600 at June 30, 2004 on total gross inventories of $9,109,400. 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. Industrial Accident Reserve - During the fourth quarter of 2003 the Company accrued an expense of $375,000 to record the Terms of Settlement and Probation (the "Settlement") entered into on February 4, 2004 with the Sonoma County District Attorney's Office with regards to an industrial accident that occurred on April 25, 2002 (see Note 5 to the financial statements). As of June 30, 2004 the industrial accident reserve was $197,600. In addition to covering the Settlement, the reserve also covers the estimated settlement of citations and fines from CAL-OSHA, the remaining application to the Workers' Compensation Appeals Board of the State of California for serious and willful misconduct penalties to be levied against the Company, and attorney's fees. This reserve is somewhat uncertain because the CAL-OSHA proposed fines of $137,900 have been appealed and the application to the Workers' Compensation Appeals Board for serious and willful misconduct penalties, if litigated, is an all-or-nothing proposition under which the Company will either be liable for $62,500 in total or nothing. The Company does not anticipate that the Workers' Compensation Appeal will be litigated based upon the advice of its attorneys; however expenses in excess of the reserve could be incurred if the Worker's Compensation Appeal is litigated. Deferred Tax Asset Valuation Allowance - As of December 31, 2003 the Company had net deferred tax assets of $1,601,900 primarily resulting from net operating loss carryforwards ("NOLs"), which consisted of $4,431,000 of Federal NOLs that expire at various times through 2020, and $3,150,000 of state NOLs that expire at various times through 2010. 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. Management eliminated the deferred tax asset valuation reserve that had been maintained since the 1999 merger as of December 31, 2003. The Company has reported taxable income to the various taxing authorities for 2001 and 2002 and will do so again for 2003. The reserve was reversed because 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. 14 -------------------------------------------------------------------------------- Results of Operations for the Three Month Periods Ending June 30, 2004 and June 30, 2003 -------------------------------------------------------------------------------- Summary Discussion: In general, the Company continued to benefit from the ongoing trend away from hydrogenated culinary oils towards a healthier alternative during the second quarter. The Company's Spectrum Naturals(R) brand of expeller-pressed oils, condiments and butter substitutes delivered 20% net sales growth in the second quarter. Additionally, small and medium sized food manufacturers continued their push to eliminate partially hydrogenated oils from their products which drove the Spectrum Ingredients industrial sales up 21% versus the prior year. The Spectrum Essentials(R) brand of nutritional supplements posted a decline in net sales of 16% versus the prior year, as a result of increased competition in that category. The Company will be responding later this year with new positioning and packaging to strengthen the brand's position in this category. The Company reported net income of $178,400 for the second quarter, which was down 44% versus the prior year. The reduced profitability was primarily due to margin pressure on the Spectrum Naturals(R) and Spectrum Essentials(R) branded consumer product lines as a result of increased raw material costs for certain key organic raw materials such as olive oil, canola oil and flaxseed. Gross margin (gross profit expressed, as a percentage of net sales) was down three points versus the prior year. The Company has increased its selling prices in certain culinary product lines and has announced another price increase to the trade effective August 15, 2004. Also contributing to the reduced profitability for the second quarter was increased spending on several new sales and marketing initiatives in 2004. In particular, there was increased spending on the Company's new advertising campaign and increased sponsorships. Management believes that Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA") is an important measure of the Company's operating performance. Management incentive compensation is earned, in part, based on the achievement of EBITDA targets that are established and approved by the Company's Board of Directors prior to the beginning of the year. For the three months ended June 30, 2004 EBITDA was $529,100 compared to $532,900 for the prior year, a decrease of $3,800 or 1%. The reduced performance in 2004 is discussed in detail below, but was primarily attributable to the decreased gross profit and increased sales and marketing expenses. While Management believes that EBITDA 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 may be different from the calculation used by other companies, thereby limiting comparability. 15 The Company's calculations to arrive at EBITDA are detailed in the following table: Three Months Ended June 30, 2004 2003 -------- -------- Net income $178,400 $316,200 Add back: Provision for income taxes 118,900 26,500 Interest expense 77,800 82,700 Depreciation and amortization expense 154,000 107,500 -------- -------- EBITDA $529,100 $532,900 ======== ======== The following is Managements' 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 three months ended June 30, 2004 were a new quarterly record of $12,811,400 compared to $11,380,800 for 2003, an increase of $1,430,600 or 13%. The increase is detailed by segment in the following table:

Within the Spectrum Naturals(R) culinary products, sales were significantly higher than prior year in olive oil (+94%), food service oils (+23%), vinegar (+53%) and packaged mayonnaise (+18%). The Company's culinary oils continued to benefit from increased consumer awareness of the importance of avoiding hydrogenated oils. Spectrum Essentials(R) nutritional supplement sales decreased 16% versus the prior year, primarily as a result of increased competition in the organic flax oil category. Packaged liquid supplements, which encompass the majority of the Spectrum Essentials(R) line, decreased by 18% versus the prior year. Sales of encapsulated nutritional supplements, primarily flax and fish oil, increased 6% versus the prior year. The Spectrum Ingredients sales were up 21% 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. Cost of Goods Sold: The Company's cost of goods sold for the three months ended June 30, 2004 was $9,851,900 versus $8,414,900 for the prior year, an increase of 17%. The increase was primarily volume-related with respect to the Spectrum Ingredients segment and both volume and rate driven in the Spectrum Naturals(R) and Spectrum Essentials(R) segments, as detailed in the following table: 16

Gross profit as a percent of net sales (gross margin) was 23.1% for 2004 versus 26.1% for 2003, primarily as a result of the increased raw material costs in the Company's consumer packaged product lines and the unfavorable sales mix. Sales and Marketing Expenses: The Company's sales and marketing expenses for the three months ended June 30, 2004 were $1,722,900 or 13.4% of net sales, versus $1,632,100 or 14.3% of net sales for the prior year. The increase in spending of $90,800 is detailed in the following table which reconciles sales and marketing spending for the second quarter of 2004 versus 2003, and discloses the significant variances by spending category: 17 Total sales and marketing expenses, second quarter 2003 $ 1,632,100 Increased advertising 231,000 Decreased broker commissions (77,100) Decreased market research (62,500) All other, net (600) ----------- Total sales and marketing expenses, second quarter 2004 $ 1,722,900 =========== The increased advertising spending was related to the launch of the new "I am Spectrum" campaign for 2004. The decreased broker commissions were related to the decreased sales of the Spectrum Essentials(R) products. The decreased market research spending was primarily the result of focus group research conducted during the prior year. General and Administrative Expenses: The Company's general and administrative expenses for the three months ended June 30, 2004 were $874,400 or 6.8% of net sales, versus $917,700 or 8.1% of net sales for the prior year. The decrease in spending of $43,300 is detailed in the following table which reconciles general and administrative spending for the second quarter of 2004 versus 2003, and discloses significant variances by spending category: Total general and administrative expenses, second quarter 2003 $ 917,700 Iowa relocation expenses 31,600 Decreased compensation and benefits expense (98,800) All other, net 23,900 --------- Total general and administrative expenses, second quarter 2004 $ 874,400 ========= The Iowa relocation expenses were primarily associated with consulting in conjunction with the Company's upcoming relocation of its manufacturing facility to Cherokee, Iowa. The decreased compensation and benefits expense was primarily associated with reduced accruals in 2004 for incentive compensation as a result of the lower profitability of the Company versus the prior year. Interest Expense: The Company's interest expense for the three months ended June 30, 2004 was $77,800 versus $82,700 for the prior year. The decrease of $4,900 or 6% is detailed in the following table which reconciles interest expense for 2004 versus 2003, and discloses the significant variances by type of debt: Total interest expense, second quarter 2003 $ 82,700 Increased interest on bank term notes payable 11,100 Decreased interest on revolving line of credit (11,900) All other, net (4,100) -------- Total interest expense, second quarter 2004 $ 77,800 ======== The increased interest on the bank term notes payable was the result of the refinancing of the Company's variable-rate term debt effective July 11, 2003 with the change in primary lenders to Comerica Bank. The decreased interest on the revolving line of credit was due to the lower rates available to the Company under the Comerica relationship, partially offset by higher average borrowings in 2004 to support the increased level of operations. The Company's weighted average effective interest rate under the line of credit was 3.6% in 2004 versus 5.5% in 2003. 18 Provision for Income Taxes: The Company recorded a provision for income taxes of $118,900 for the three months ended June 30, 2004 versus a provision for state income taxes of $26,500 for the prior year. The provision for 2004 was estimated at 40% of the Company's income before income taxes. -------------------------------------------------------------------------------- Results of Operations for the Six Month Periods Ending June 30, 2004 and June 30, 2003 -------------------------------------------------------------------------------- Summary Discussion: Management believes that Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA") is an important measure of the Company's operating performance. For the six months ended June 30, 2004 EBITDA was $569,700 compared to $1,380,300 for the prior year, a decrease of $810,600 or 59%. The reduced performance in 2004 is discussed in detail below, but was primarily attributable to decreased gross profit and increased sales and marketing expenses. While Management believes that EBITDA 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 may be different from the calculation used by other companies, thereby limiting comparability. The Company's calculations to arrive at EBITDA are detailed in the following table: Six Months Ended June 30, 2004 2003 ---------- ---------- Net income $ 69,400 $ 951,700 Add back: Provision for income taxes 46,300 64,300 Interest expense 151,800 153,100 Depreciation and amortization expense 302,200 211,200 ---------- ---------- EBITDA $ 569,700 $1,380,300 ========== ========== 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 six months ended June 30, 2004 were $25,544,500 compared to $21,689,400 for 2003, an increase of $3,855,100 or 18%. The increase is detailed by segment in the following table: 19

Gross profit as a percent of net sales (gross margin) was 22.9% for 2004 versus 27.8% for 2003, primarily as a result of the increased raw material costs in the Company's consumer packaged product lines and the unfavorable sales mix. Sales and Marketing Expenses: The Company's sales and marketing expenses for the six months ended June 30, 2004 were $3,704,800 or 14.5% of net sales, versus $3,064,800 or 14.1% of net sales for the prior year. The increase in spending of $640,000 is detailed in the following table which reconciles sales and marketing spending for 2004 versus 2003, and discloses the significant variances by spending category: Total sales and marketing expenses, first half 2003 $ 3,064,800 Increased advertising 438,100 Increased compensation and benefits 133,800 Increased trade show spending 65,200 Increased sponsorships 34,500 All other, net (31,600) ----------- Total sales and marketing expenses, first half 2004 $ 3,704,800 =========== 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 of three positions in the Marketing Department. The increased trade show spending and sponsorships has enabled the Company to maintain a greater presence within the industry. General and Administrative Expenses: The Company's general and administrative expenses for the six months ended June 30, 2004 were $1,903,800 or 7.5% of net sales, versus $1,815,300 or 8.4% of net sales for the prior year. The increase in spending of $88,500 is detailed in the following table which reconciles general and administrative spending for 2004 versus 2003, and discloses significant variances by spending category: 21 Total general and administrative expenses, first half 2003 $ 1,815,300 Iowa relocation expenses 81,200 Increased professional fees 33,200 Decreased compensation and benefits expense (104,000) All other, net 78,100 ----------- Total general and administrative expenses, first half 2004 $ 1,903,800 =========== The Iowa relocation expenses were primarily associated with consulting in conjunction with the Company's upcoming relocation of its manufacturing facility to Cherokee, Iowa. The increased professional fees were primarily associated with increased tax consulting services. 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. Interest Expense: The Company's interest expense for the six months ended June 30, 2004 was $151,800 versus $153,100 for the prior year. The decrease of $1,300 is detailed in the following table which reconciles interest expense for 2004 versus 2003, and discloses the significant variances by type of debt: Total interest expense, first half 2003 $ 153,100 Increased interest on bank term notes payable 20,100 Decreased interest on revolving line of credit (18,900) All other, net (2,500) --------- Total interest expense, first half 2004 $ 151,800 ========= The increased interest on the bank term notes payable was the result of the refinancing of the Company's variable-rate term debt effective July 11, 2003 with the change in primary lenders to Comerica Bank. The decreased interest on the revolving line of credit was due to the lower rates available to the Company under the Comerica relationship, partially offset by higher average borrowings in 2004 to support the increased level of operations. The Company's weighted average effective interest rate under the line of credit was 3.6% in 2004 versus 5.5% in 2003. Provision for Income Taxes: The Company recorded a provision for income taxes of $46,300 for the six months ended June 30, 2004 versus a provision for state income taxes of $64,300 for the prior year. The provision for 2004 was estimated at 40% of the Company's income before income taxes. 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. 22 Liquidity and Capital Resources: On June 4, 2004 the Company entered into the First Amendment to its Credit Facility with Comerica Bank ("Comerica") that extends 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 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 June 30, 2004 the Company was in compliance with all requirements under the Credit Facility. At June 30, 2004 the Company had working capital of $1,626,100 which reflected an improvement of $1,555,400 versus June 30, 2003. The increase was primarily attributable to higher accounts receivable as a result of the double-digit sales growth and the reinstatement of $764,300 of net short-term deferred tax assets, partially offset by increased borrowings outstanding under the line of credit to finance the higher level of operations in general. During 2004 the Company used $143,800 in cash from operating activities, compared to using $308,700 in cash in 2003. The decrease in cash used in 2004 was primarily due to the lower profitability levels in 2004, partially offset by reductions in the cash used for working capital items. During 2003 the Company was required to hold significant quantities of flaxseed in inventory prior to production, which was no longer necessary in 2004. Cash used in investing activities was $782,200 in 2004 compared to $1,190,000 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 and six used expeller presses, which were subsequently installed in the new Iowa facility. Cash provided by financing activities was $923,200 in 2004 compared to cash provided of $1,505,700 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 to finance the equipment purchases and the cash used for operating activities. 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 $967,000 and $1,722,900 at June 30, 2004 and 2003, respectively. 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. 23 Related Party Transactions and Other Relationships: There was one significant transaction with a related party during the six months ended June 30, 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 (see Item 5 - Other Information in this report). 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. Mr. Thomas 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 36% of the Company's net sales for the year ended December 31, 2003. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK -------------------------------------------------------------------------------- The Company does not hold market risk sensitive trading instruments, nor does it use financial instruments for trading purposes. All sales, operating items and balance sheet data are denominated in U.S. dollars; therefore, the Company has no foreign currency exchange rate risk. The Company will occasionally purchase inventories in foreign currencies; however, in most cases payment is made at the time title to the inventory passes to the Company. Therefore, any foreign currency gain or loss has been immaterial to date. The book value of all financial instruments approximates 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 Company's interest-bearing term notes payable and capital lease obligations approximate fair value based on rates currently available for debt with similar terms and maturities. The fair value of the line of credit approximates book value because the interest rate fluctuates with changes in the LIBOR or prime rate. Throughout the course of its fiscal year, the Company utilizes a variable interest rate line of credit at various borrowing levels. For the six months ended June 30, 2004 the average outstanding balance under the line of credit was $5,126,900 with a weighted average effective interest rate of 3.6% per annum. For the six months ended June 30, 2003 the average outstanding balance under the line of credit was $4,072,700 with a weighted average effective interest rate of 5.5% per annum. Effective July 11, 2003 with the change in the primary banking relationship to Comerica Bank, the line of credit agreement called for the interest rate to float at the prime rate or LIBOR plus 2.25%, at the Company's option. The previous line of credit agreement called for the interest rate to float at the prime rate plus 1.0%. Certain other debt items are also sensitive to changes in interest rates. The following table summarizes estimated fair values, future principal payments and related weighted average interest rates by expected maturity date for long-term debt, excluding capital leases ($ thousands): 24

The fair value of all long-term debt is equal to the sum of the expected future principal payments with the exception of the non-interest bearing note payable due in one lump sum of $513,300 on December 31, 2011. Interest has been imputed on that note at an effective rate of 6.5% per annum, leaving a fair value at June 30, 2004 of $315,500. 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 June 30, 2004 these future commitments approximated fair value because they 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. 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. Item 4. DISCLOSURE 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 six months ended June 30, 2004. Management is not aware of any significant deficiencies in the design or operation of internal controls. 25 PART II - OTHER INFORMATION Item 1. Legal Proceedings -------------------------- Industrial Accident On February 4, 2004 the Company pleaded no contest to two misdemeanor counts of violations under 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 will pay a fine 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 Dept. 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 against the year ended December 31, 2003 to cover the net present value of the above payments, plus estimated attorney's fees to reach agreement on the plea with the District Attorney's Office. Total payments made in connection with the plea during the six months ended June 30, 2004 were $275,000. At June 30, 2004 the remaining unsettled issues in connection with the industrial accident were the CAL-OSHA proposed penalties of $137,900 which have been appealed by the Company, and one remaining appeal filed with the Workers' Compensation Appeals Board of California for serious and willful misconduct penalties of $62,500. The Company intends to defend itself vigorously and believes it has meritorious defenses, since the CAL-OSHA citations did not include any willful penalties. If actually litigated, the workers compensation appeal is an all-or-nothing proposition under which the Company will either be liable for $62,500 or nothing. Based on the advice of counsel, the Company expects the workers compensation appeal to be settled rather than litigated. The Company had a reserve of $197,600 at June 30, 2004 to cover the anticipated settlement of these outstanding issues plus attorney's fees and the two remaining installments of $50,000 each under the CLCS 6425 fine, which Management believes will be adequate. 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 included in the Complaint. 26 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 all 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. The initial fee to join was a $5,000 retainer, which the Company paid on February 17, 2004. Management believes the Complaint will eventually be shown to be without merit. Accordingly, no provision for loss or future attorney's fees has been recorded at June 30, 2004. Patent Infringement Complaint In October 2000 the Company was notified by counsel for GFA Brands, Inc. ("GFA") that nutritional claims pertaining to Spectrum Naturals(R) Organic Margarine were infringing upon two patents (the "first patents") issued in the United States that pertain to particular fat compositions suitable for human consumption. The patent holder, Brandeis University, exclusively licensed each of these patents to GFA. GFA demanded that the Company cease the manufacture and sale of the margarine and threatened legal action if the Company failed to comply. It has always been Management's view that the formula for Spectrum Naturals Organic Margarine(R) fell outside the claims made in the Brandeis University patents. Despite numerous attempts, the Company was unable to convince GFA that its formula for the margarine fell outside the claims of the first patents. Therefore, the Company filed a complaint against GFA for declaratory judgment of non-infringement and invalidity of the two patents on August 28, 2001. The complaint requested a declaratory judgment that the margarine does not infringe either patent, a declaratory judgment that both patents are invalid, that GFA be enjoined from threatening or asserting any action for infringement of either patent, or attorney's fees. Markman briefs, in which each side presents its arguments on how the patent claims should be construed, were submitted by both GFA and Spectrum in July 2003. In most patent infringement cases, the court's determination of how the patent claims should be interpreted is the central issue. A Markman hearing was held by the court on October 16, 2003. The court issued its ruling on the Markman hearing on December 3, 2003 in favor of the Company's interpretation of the patent claims. On July 16, 2004 counsel for the Company and GFA verbally agreed to settle the case with respect to the first patents by a joint stipulation to dismiss all claims without prejudice to either party, with a provision that the Markman ruling will continue to be binding between the Company and GFA in the event of any future litigation. 27 Meanwhile, unbeknownst to the Company, Brandeis University had filed for an additional patent (the "second patent") with the U.S. Patent Office which included patent claims that did encompass the Company's formula for Spectrum Naturals Organic Margarine(R). Unlike trademark law, patents are issued in the United States without pre-publication or notice which would allow for comment or appeal by potentially affected parties. On October 7, 2003 the U.S. Patent Office granted the second patent to Brandeis University. On the advice of counsel, the Company ceased the production of the margarine immediately thereafter and is currently evaluating its options with regards to the second patent. There is no infringement by the Company of the second patent since the Company immediately ceased the production of the margarine upon notification of the patent's issuance. Accordingly, no provision for loss has been recorded at June 30, 2004. Item 2. Changes in Securities and Use of Proceeds -------------------------------------------------- During the six months ended June 30, 2004 the Company issued 132,200 shares of its common stock for the exercise of stock options. Total proceeds received by the Company were $45,900. 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. Item 3. Defaults Upon Senior Securities ---------------------------------------- None. Item 4. Submission of Matters to a Vote of Security Holders ------------------------------------------------------------ An annual meeting of shareholders was held on April 29, 2004 at the Company's headquarters in Petaluma, California. A definitive Proxy Statement was filed with the SEC on April 1, 2004 and is incorporated herein by reference. There were four matters brought before the shareholders for their approval: 1. To elect six Director Nominees to another term. 2. To amend the Company's Amended and Restated Articles of Incorporation to increase the number of common shares authorized for issuance from 60,000,000 to 100,000,000 and to increase the number of preferred shares authorized for issuance from 5,000,000 to 10,000,000. 3. To amend the Company's Amended and Restated Articles of Incorporation to effect a reverse stock split at one of two ratios, to be selected by the Board of Directors, in order to reduce the aggregate number of shares of common stock outstanding: A) One new share for each five currently held B) One new share for each ten currently held 28 4. To ratify the appointment of Grant Thornton, LLP as the Company's independent certified public accountants for the current fiscal year. All four matters were approved by the shareholders. The following table summarizes the results of the voting:

Mr. John R. Battendieri was included in the definitive Proxy Statement as a Director Nominee; however, Mr. Battendieri elected to resign from the Company's Board of Directors effective April 1, 2004. Item 5. Other Information -------------------------- Effective April 1, 2004 Mr. John R. Battendieri resigned as a non-executive Director of the Company's Board of Directors. Mr. Battendieri's decision to resign was not the result of any disagreement between himself and the Company or the Company's other Board members. Mr. Battendieri has also served the Company as a consultant for the past two years, managing the Company's private label product offerings. As a result, Mr. Battendieri does not meet the requirements of the Securities and Exchange Commission as an independent director, and would be required to meet a three year "cooling off" period, during which time he could not be compensated in any way by the Company beyond board fees. The Company intends to upgrade its stock listing to an AMEX or NASDAQ small-cap listing as soon as it meets the requirements for such. An independent Board of Directors is required by both exchanges and Mr. Battendieri's resignation will assist the Company toward meeting that requirement. Item 6. Exhibits and Reports on Form 8-K ----------------------------------------- (a) Exhibits: 10.55 First Modification to Loan and Security Agreement dated June 4, 2004 by and between Spectrum Organic Products, Inc. and Comerica Bank. 31.07 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 29 31.08 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.07 Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.08 Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K during the quarter ended June 30, 2004: The Company filed a Current Report on Form 8-K on May 11, 2004 disclosing the Company's unaudited financial position and results of operations as of and for the three months ended March 31, 2004. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: August 2, 2004 SPECTRUM ORGANIC PRODUCTS, INC. By: /s/ Robert B. Fowles ---------------------------------- Robert B. Fowles Duly Authorized Officer & Chief Financial Officer 30

SPECTRUM ORGANIC PRODUCTS INC 10-Q