Payroll, benefits, taxes and hiring expenses increased a total of $965,000 in the three months ended September 30, 2008 over the same period in 2007 due to the staffing of our manufacturing facilities in Lake Charles, Louisiana and Phoenix, Arizona, along with the addition of key management positions in our corporate offices in Phoenix, Arizona.

Sales and marketing expenses decreased $679,000 in the three months ended September 30, 2008 compared to the same period in 2007 due to a $434,000 decrease in advertising costs, and a $252,000 decrease in commission expense.

Professional fees

 

Professional fees were $303,000 and $747,000 in the three months ended September 30, 2008 and 2007, respectively, a decrease of $444,000. Professional fees include costs related to accounting, legal and consulting services.

Other income and expense

 

Other expenses (net of income) were $245,000 and $742,000 for the three months ended September 30, 2008 and 2007, respectively. This $497,000 net decrease in other income (expense) is detailed in the following table.

Other income (expense)		September 30, 2008			September 30, 2007			(Increase)/Decrease
Interest income		$	176,000		$	778,000		$	(602,000	)
Interest expense			(107,000	)		-			(107,000	)
Gain or (loss) on disposal of assets			211,000			-			211,000
Loss on equity investments			(35,000	)		(36,000	)		1,000
Total other income		$	245,000		$	742,000		$	(497,000	)

Interest income decreased $602,000 due to lower cash balances available for investment.

 

Interest expense increased $107,000 for the three months ended September 30, 2008 due to $103,000 of interest expense on our Irgovel subsidiary for interest on notes payable and $4,000 of interest incurred in our NutraCea segment for our note payable for the leasehold improvements for our warehouse/office in West Sacramento, California (see Note 12 to the consolidated condensed financial statements included herein).

 

Gain or loss on disposal of assets increased $211,000 due the sale of assets of our NutraCea/Cura LLC operation.

 

Income Taxes

 

Income taxes were $222,000 for the nine months ended September 30, 2008 compared to a credit of $67,000 for the nine months ended September 30, 2007. The increase of $289,000 is primarily due to Brazilian income taxes due for our Irgovel subsidiary.

 

NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007

 

For the nine months ended September 30, 2008, the Company’s net loss was $17,378,000, or ($0.12) per share, compared to a net loss of $3,028,000, or $0.02 per share, in the same period of 2007, a decrease of $14,350,000. The decrease for the nine month period was primarily due to the $4,194,000 decrease in gross profits, a $6,453,000 increase in operating expenses, and a $3,703,000 net increase in other expenses and income taxes.

Our NutraCea segment contributed a loss of $18,537,000 and our Irgovel segment contributed income of $1,159,000 for the nine months ended September 30, 2008 (see Note 16 to the consolidated financial statements included herein).

 

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Revenues, cost of sales and gross margin

 

Consolidated net revenues were $26,483,000 and $16,513,000 in the nine months ended September 30, 2008 and 2007, respectively. This increase of $9,970,000 or 60%, is attributable to $16,244,000 in sales contributed by our Irgovel segment, offset by a $1,280,000 decline in product sales and the net decline of $4,994,000 of license and royalty fee revenues by our NutraCea segment. The $1,280,000 decline in product sales from our NutraCea segment is composed of a net increase of $3,401,000 in sales in our core SRB product lines during the nine months ended September 30, 2008 offset by sales in the nine months ended September 30, 2007 of $2,080,000 to a new customer and a $2,601,000 of proprietary products to a single customer.

Gross profits on sales in the nine months ended September 30, 2008 were $5,708,000, or 22%, compared to $9,902,000, or 60%, during the nine months ended September 30, 2007. The decline of $4,194,000 is primarily due to the net decrease of $4,994,000 in licensing and royalty fees during the nine months ended September 30, 2007.

Gross margins on our various product lines vary widely and the gross margins are impacted from period to period by sales mix and utilization of production capacity. Our investment in production capacity during 2007 and the first nine months of 2008 has increased our fixed operating costs in our NutraCea segment by approximately $750,000 per quarter. Our Mermentau plant was idle from May 2008 through July 2008 because the mill that supplies the plant was not milling rice because of business conditions at their mill un-related to our operations. Our Lake Charles plant began operations in May 2008, however full production levels have not been reached because the rice mill was phasing in our contract for rice bran. Additionally, hurricane weather disrupted normal operations at all three of our gulf coast facilities. The combination of increased fixed costs and lower utilization of production capacity, along with the decline of $4,994,000 in license and royalty fees which have no cost component associated with them, contributed to the increase in cost of goods sold in our NutraCea segment from 40% for the nine months ended September 30, 2007 to 86% for the nine months ending September 30, 2008. We anticipate that in the fourth quarter of 2008 the rice mills will be operating near their capacity and our plants will be receiving most of the output from each rice mill. If, however, supplies of raw rice bran remain too low to run our plants at our desired capacity levels we may continue to have lower than expected gross profit margins on our NutraCea product sales.

Also, during the nine months ended September 30, 2008 we recorded a charge of $436,000 on our NutraCea segment relating to a credit to a customer to reimburse the customer for products purchased by it that the customer ultimately determined did not meet its specifications. The customer purchased of total of $903,000 of the product during 2007. This credit relates to a specialty product made for this customer only and is the only significant warranty cost that we have incurred. The customer has agreed to apply the credit against future purchases. We know of no other product warranty contingencies.

The following table illustrates the gross margin contribution by each of our segments during the nine months ended:

 

		September 30,  2008																		September 30,  2007
		Consolidated			%			NutraCea			%			Irgovel			%			NutraCea			%			Increase/ (Decrease)
Total product sales		$	26,563,000					$	10,319,000					$	16,244,000					$	13,031,000					$	13,532,000
Licensing fees															-						5,000,000						(5,000,000	)
Royalty revenue			39,000						39,000						-						33,000						6,000
Total revenues			26,602,000						10,358,000						16,244,000						18,064,000						8,538,000
Less infomercial sales return			(119,000	)					(119,000	)					-						(1,551,000	)					1,432,000
Net revenues			26,483,000			100			10,239,000			100			16,244,000			100			16,513,000			100			9,970,000
Cost of sales
Cost of goods sold			20,339,000			76			8,849,000			86			11,490,000			71			6,611,000			40			13,728,000
Product warranty cost			436,000			2			436,000			4			-			-			-						436,000
Total cost of sales			20,775,000			78			9,285,000			90			11,490,000			71			6,611,000			40			14,164,000
Gross Margin		$	5,708,000			22		$	954,000			10		$	4,754,000			29		$	9,902,000			60		$	(4,194,000	)

 

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Operating expenses:

 

Research and development

 

R&D expenses were $1,268,000 and $446,000 in the nine months ended September 30, 2008, and 2007, respectively, an increase of $822,000. The increase was attributed to higher product development costs and employee related expenses due to increased R&D activities and expanded scientific staff compared to the same period last year. We paid $350,000 to Herbal Science Singapore Pte. LTD, the 20% minority member of our research subsidiary Rice Science, LLC for on-going research programs to commercialize SRB Isolates. The Company expects to continue research and development expenditures to establish the scientific basis for health claims of existing products and to develop new products and applications.

Selling, general and administrative

SG&A expenses were $17,534,000 and $12,546,000 in the nine months ended June 30, 2008 and 2007 respectively, an increase of $4,988,000, or 40%. This increase is due to a $2,455,000, or 20%, increase in our Nutracea segment to expand investment in personnel, infrastructure, and sales and marketing activities to meet anticipated future demands and $2,533,000 of SG&A from our Irgovel subsidiary. SG&A expenses for our Irgovel subsidiary consist of marketing, selling, and administrative expenses.

Specific changes in SG&A expense is detailed in the following schedule for the nine months ended:

 

Selling, General, and Administrative Expenses		September 30, 2008			September 30, 2007			Increase /(Decrease)
Payroll, benefits, taxes and hiring expenses		$	6,041,000		$	3,938,000		$	2,103,000
Sales and marketing			1,058,000			2,114,000			(1,056,000	)
Allowance for bad debt expense, net			726,000			800,000			(74,000	)
Operations			975,000			745,000			230,000
Travel and entertainment			770,000			673,000			97,000
Rent, administration, insurance and other costs			2,197,000			2,100,000			97,000
Stock based compensation, net of amounts allocated to R&D and professional fees			1,856,000			1,667,000			189,000
Amortization			645,000			246,000			399,000
Depreciation, net of allocation to cost of goods sold			733,000			263,000			470,000
Total NutraCea segment			15,001,000			12,546,000			2,455,000
Total Irgovel segment			2,533,000			-			2,533,000
Total selling, general and administrative expenses		$	17,534,000		$	12,546,000		$	4,988,000

Payroll and related benefits and hiring expenses increased a total of $2,103,000 in the nine months ended September 30, 2008 over the same period in 2007 due to the staffing of our facilities in Lake Charles, Louisiana and Phoenix, Arizona, along with the addition of key management positions in our corporate offices in Phoenix, Arizona.

Sales and marketing expenses decreased $1,056,000 in the nine months ended September 30, 2008 compared to the same period in 2007 due to a $889,000 decrease in advertising costs, and a $171,000 decrease in commission expense, net of other increases.

Professional fees

Professional fees were $3,385,000 and $2,742,000 in the nine months ended September 30, 2008 and 2007, respectively, an increase of $643,000. The higher professional fees in the nine months ended September 30, 2008 is primarily due to legal fees for our acquisitions of Irgovel and our joint venture agreement with Bright. Professional fees include costs related to accounting, legal and consulting services.

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Other income and expense

 

The net decrease of other income and expense of $3,250,000 is shown in the following table for the nine months ended:

Other (expenses) income		September 30, 2008			September 30, 2007			(Increase)/Decrease
Interest income		$	597,000		$	2,167,000		$	(1,570,000	)
Interest expense			(448,000	)		-			(448,000	)
Gain on lawsuit settlement			-			1,250,000			(1,250,000	)
Loss on disposal of assets			(462,000	)		(309,000	)		(153,000	)
Loss on equity investments			(115,000	)		(286,000	)		171,000
Total other (expenses) income		$	(428,000	)	$	2,822,000		$	(3,250,000	)

Interest income decreased $1,570,000 due to lower cash balances being available for investment.

 

Interest expense increased $448,000 for the nine months ended September 30, 2008 due to $341,000 of interest expense on our Irgovel subsidiary for interest on notes payable and $10,000 of interest incurred in our NutraCea segment for our note payable for the leasehold improvements for our warehouse/office in West Sacramento, California, and the $97,000 of interest incurred during the second quarter for the 90 day note payable issued for the purchase of our new building in Phoenix, Arizona.

 

In the nine months ended September 30, 2007 we received a $1,250,000 payment for the settlement of a lawsuit (see Note 3 to the consolidated financial statements included herein).

 

Loss on disposal of assets increased $153,000 due to a write-down of $331,000 of inventory related to an infomercial product line offset by a $204,000 gain on the disposal of assets in the sale of our NutraCea/Cura LLC.

 

The loss on equity investments decreased $171,000. Our loss on the equity investments in GE and PIN from operations was $115,000. The $286,000 loss in the prior period was primarily composed of the payment of $250,000 for the broker’s commission relating to the formation of GE.

 

Income Taxes

 

Income taxes were $541,000 and $18,000 for the nine months ended September 30, 2008 and 2007, respectively. The increase of $523,000 is primarily due to Brazilian income taxes due for our Irgovel subsidiary.

 

LIQUIDITY AND CAPITAL RESOURCES

As of September 30, 2008, our source of liquidity was cash and cash equivalents in the amount of $8,702,000, exclusive of restricted cash. Our cash decreased by $32,596,000 in the nine months ended September 30, 2008 from our cash position of $41,298,000 at December 31, 2007. The decrease in cash was primarily due to our $14,970,000 (net of cash acquired with the purchase) investment in Irgovel, the purchase of property, plant, and equipment of $21,989,000 (including $8,400,000 for an industrial building in Phoenix) and our purchase of 51% of PIN (see Note 10 to our consolidated financial statements contained herein) for $10,675,000, offset by the receipt of approximately $19,416,000 (net of expenses) from the our registered direct offering and the exercise of warrants.

On April 1, 2008 we received $5,000,000 from PAHL in payment of the note receivable entered into in June 2007 for the sale to PAHL of licensing rights. Originally due over five year terms, the note was modified in January 2008 to allow for the forgiveness of accrued interest on the note if the full principal was paid by March 31, 2008. As the payment was in transit on that date the company agreed to honor the forgiveness of interest due thru March 31, 2008 of approximately $175,000.

For the nine months ended September 30, 2008, net cash used in operations was $8,740,000, compared to cash used in operations in the same period of 2007 of $1,566,000, an increase of $7,174,000. This increase in cash used in operations resulted from the increase in our net loss of $14,350,000, offset by the net increase in non-cash charges against income of $1,301,000 and the net increase in the change in operating assets and liabilities of $5,875,000.

 

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Inventories increased in the nine months ended September 30, 2008 by $3,137,000, from the $1,808,000 balance at December 31, 2007. $1,068,000 of this increase is due to our acquisition of Irgovel. The remaining increase, or $2,069,000, is made up of a $777,000 increase in our Irgovel segment and a $1,292,000 increase in our NutraCea segment. We have been intentionally growing our inventory levels in anticipation of future orders. With the completion of our Mermentau and Lake Charles, Louisiana, plants, our production capacity now is able to meet current demand. We have increased sales of our core SRB product lines by $1,850,000 in the nine months ended September 30, 2008 compared to the same period last year, and believe that such sales growth will continue.

Cash used in investing activities in the nine months ended September 30, 2008 was $42,027,000, compared to $19,527,000 for the same period of 2007. This increase of $22,500,000 was primarily caused by our $25,646,000 (net of $79,000 cash acquired with the purchases) investment in Irgovel and PIN (see Note 10 in our consolidated financial statements contained herein), and an increase of $13,781,000 in expenditures for plant expansions and other fixed assets. The following table lists the amounts invested in subsidiaries during the nine months ended;

		September 30, 2008			September 30, 2007
Investment in Irgovel		$	14,970,000		$	-
Investment in PIN			10,675,000			-
Investment in Vital Living, Inc.			-			5,143,000
Investment in Grainnovations, Inc.			-			2,169,000
Total investment in subsidiaries		$	25,646,000		$	7,312,000

Cash provided by financing activities for the nine months ended September 30, 2008 and 2007 was $18,177,000, and $55,772,000, respectively, a decrease of $37,595,000. This decrease is due to the $28,030,000 decrease in the proceeds of our direct offerings, and a decrease of $8,222,000 decrease in proceeds from the exercise of common stock options and warrants.

Issuance of preferred stock:

 

On October 20, 2008 we issued to two institutional investors, for the purchase of $5 million, shares of our Series D Convertible Preferred Stock ("Preferred Stock") and five-year warrants to purchase up to 4,545,455 shares of NutraCea Common Stock. The securities were offered in "units" at a price of $1,000 per unit. The units immediately separated upon issuance. Each unit consisted of one share of Preferred Stock convertible into 1,818.18 shares of Common Stock at a conversion price per share of Common Stock of $0.55, and a warrant to purchase 909.09 shares of NutraCea Common Stock at an exercise price of $0.55 per share. The investors also received additional warrants that grant the investors the right, for a period of 60 days after the initial issuance, to purchase an additional $5 million of Preferred Stock and associated warrants on the same terms as the initial issuance. For the sale of 5,000 units we received an aggregate of $5,000,000 less $300,000 placement fees and $200,000 estimated expenses.

 

The Preferred Stock will accrue dividends at 8.0% per annum preferred dividend. These dividends are payable quarterly in arrears, commencing on January 1, 2009. Subject to the satisfaction of certain conditions, the dividends are payable in shares of NutraCea Common Stock, but may be paid in cash at NutraCea's election. NutraCea will redeem all of the Preferred Stock (unless converted) over nine months and in nine equal monthly installments commencing on February 1, 2009. The redemption amount is payable in shares of NutraCea Common Stock, but may be paid in cash at NutraCea's election. The conversion price of the Preferred Stock and the exercise price for the warrants are each subject to anti-dilution adjustments upon certain stock issuances at a price per share less than the conversion price. Subject to certain limitations, we may redeem the Preferred Stock at any time upon 10 days notice at a price equal to 110% of the aggregate state value of the Preferred Stock being redeemed plus accrued and unpaid dividends thereon. The proceeds will be used by NutraCea for the completion and further expansion of projects in the U.S. and Brazil as well as for general working capital.

 

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Cash raised in equity financing:

In April 2008 we issued in a registered offering, common stock and warrants for aggregate gross proceeds of approximately $20,000,000 ($18,775,000 after offering expenses). We issued an aggregate of 22,222,223 shares of common stock and warrants to purchase an aggregate of 6,666,664 shares of our common stock combined in “units” at a price of $0.90 per unit. Each unit consists of one share of Nutracea common stock and a five year warrant to purchase 0.30 of a share of NutraCea common stock at an exercise price of $1.20 per share. An advisor for the financing received a customary 6.0% cash fee, base on aggregate gross proceeds received from the investors, reasonable expenses and a warrant to purchase 1,333,333 shares of our common stock at an exercise price of $1.20. Using the Black-Scholes method, the fair value of these warrants to purchase 7,999,997 shares of common stock is approximately $3,102,000. If exercised, we would receive approximately $9,600,000.

 

On February 15, 2007, we sold an aggregate of 20,000,000 shares of our common stock at a price of $2.50 per share in connection with a private placement for aggregate gross proceeds of $50,000,000 ($46,805,000 after offering expenses). Additionally, the investors were issued five-year warrants to purchase an aggregate of 10,000,000 shares of our common stock at an exercise price of $3.25 per share. An advisor for the financing received a customary 6.0% cash-fee, based on aggregate gross proceeds received from the investors, reasonable expenses and a warrant to purchase 1,200,000 shares of common stock at an exercise price per share of $3.25. The warrants have a term of five years and are exercisable after August 16, 2007.

Based on our current plans and business conditions we believe we have sufficient cash and cash equivalents to meet our anticipated operating requirements for the next twelve months. However, we may require additional funds for operations if our revenues or expenses fail to meet our current projections or if other operational requirements develop beyond those anticipated during this period. In such event, we anticipate we would use any available facilities from bank financing of receivables, equipment and/or real estate, which we currently are seeking, or additional equity funding. There can be no assurance, however, that such funding would be available on favorable terms or any terms.

Purchase of customer list

During the fourth quarter of 2008 we anticipate the purchase of a customer list and existing book of business from one of our rice mill suppliers for $3,100,000.

Long-term financing needs

In January 2008 we entered into an agreement to construct a wheat mill in Indonesia and acquired 51% of an Indonesian company, PIN (see Note 10 to the financial statements included herein), which owns lands and has the approvals necessary for the construction of such a mill. We anticipate that this project will require additional funding of approximately $25,000,000, of which approximately $12,500,000 will be invested each by the minority partner and NutraCea.

In April 2008 we announced an agreement to form a joint venture with Bright Holdings (Hong Kong) Company, Ltd. (“Bright”), to develop, construct, and operate facilities in China to produce, market, distribute and sell rice oil, defatted rice bran and other products derived from rice bran. NutraCea will have an approximate 72% interest in the joint venture, but will designate 80% of the board members and contribute 80% of the capital investment. NutraCea and Bright’s capital contributions to the joint venture are to total approximately $64,000,000, of which NutraCea will be required to contribute approximately $51,000,000 over the next twenty-four months.

We plan to meet these funding needs by raising additional capital through sales of equity or debt or a combination thereof. There can be no assurance, however, that such funding would be available on favorable terms or any terms.

OFF BALANCE SHEET ARRANGEMENTS

We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments or other contingent arrangements that expose us to material continuing risk, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing and liquidity support or market risk or credit risk support to the Company.

 

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CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of our financial condition and results of operations are based upon unaudited consolidated condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements in accordance with generally accepted accounting principles requires management to make judgments, estimates and assumptions regarding uncertainties that affect the reported amounts presented and disclosed in the financial statements. Management reviews these estimates and assumptions based on historical experience, changes in business conditions and other relevant factors that they believe to be reasonable under the circumstances. In any given reporting period, actual results could differ from the estimates and assumptions used in preparing our financial statements.

 

Critical accounting policies are those that may have a material impact on our financial statements and also require management to exercise significant judgment due to a high degree of uncertainty at the time the estimate is made. Management has discussed the development and selection of our accounting policies, related accounting estimates and the disclosures set forth below with the Audit Committee of our Board of Directors. We believe our critical accounting policies include those addressing revenue recognition, allowance for doubtful accounts, and valuation of goodwill and intangible assets.

 

Revenue Recognition

 

We derive our revenue primarily from product sales. Product is shipped when an approved purchase order is received. Products shipped by us are generally sold FOB Origin, with the customer taking title to the product once it leaves our plant via common carrier as that is when risk of loss is transferred. At this point, the price to the customer is fixed and determinable, and collectability is reasonably assured. Deposits are deferred until either the product has shipped or conditions relating to the sale have been substantially performed.

On occasion, we receive purchase orders for multiple product deliveries. In these situations, each delivery is individually evaluated to determine appropriate revenue recognition. Each delivery is generally considered to be a separate unit of accounting for the purposes of revenue recognition and, in all instances, persuasive evidence of an arrangement, delivery, pricing and collectability must be determined or accomplished, as applicable, before revenue is recognized. In addition, if the purchase order includes customer acceptance provisions, no revenue is recognized until customer acceptance occurs. Revenue is accounted for at the point of shipment FOB Origin, unless accompanied by a memorandum of understanding detailing the requirement of customer acceptance in order to transfer title, in which case revenue is recognized at the time of such acceptance.

Sometimes a customer order is completed and such order is stored at the warehouse at the customer’s request. In these cases, we refer to Staff Accounting Bulletin No. 104, "Revenue Recognition" (SAB 104), which requires four basic criteria be met before we recognize revenue on bill and hold transactions:

(1) our purchase orders demonstrates that persuasive evidence of an arrangement exists;

(2) risk of ownership has passed to those customers requesting that the transaction be on a bill and hold basis  because of their fulfillment business practices for ensuring goods are available to meet their customers demands; all  our obligations and no further performance obligations by us are required; our customers have made arrangements  for future shipping instructions with our third party manufacture where they store their inventory occupy warehouse  space; and the customer has acknowledged taking title and risk of loss for the product purchased.

(3) the selling price has been fixed and determinable; and

(4) collectability is reasonably assured.

In order to assess whether the price is fixed and determinable, we ensure there are no refund rights. If payment terms are based on future performance or a right of return exists, we defer revenue recognition until the price becomes fixed and determinable. We assess collectability based on a number of factors, including past transaction history with the customer and the creditworthiness of the customer. If we determine that collection of a payment is not reasonably assured, revenue recognition is deferred until the time collection becomes reasonably assured, which is generally upon receipt of payment. Changes in judgments and estimates regarding application of SAB No. 104 might result in a change in the timing or amount of revenue recognized.

Occasionally, we will grant exclusive use of our labels by customers in specific territories in exchange for a nonrefundable fee. Under EITF 00-21, "Revenue Recognition with Multiple Deliverables," each label licensing provision is considered to be a separate unit of accounting. Each agreement is individually evaluated to determine appropriate revenue recognition in accordance with SAB 104. If all of the following four SAB 104 basic criteria are met, revenue will be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectability is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the selling prices of the products delivered and the collectability of those amounts.

 

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Additionally, the license agreement is expressly not contingent on any future performance requirements by NutraCea or customers, nor tied to special discount to market pricing. The license agreement is not a vehicle for favored, discounted pricing.

Allowance for Doubtful Accounts

 

The allowance for doubtful accounts is based on our assessment of the collectability of specific customer accounts and the aging of accounts receivable and notes receivable.  We analyze historical bad debts, the aging of customer accounts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment patterns when evaluating the adequacy of the allowance for doubtful accounts.  From period to period, differences in judgments or estimates utilized may result in material differences in the amount and timing of our bad debt expenses.

We continuously monitor collections from our customers and maintain an allowance for doubtful accounts based upon our historical experience and any specific customer collection issues that we have identified. Credit losses have historically exceeded our expectations and the provisions established. Accordingly, there is a risk that credit losses in the future also may exceed our provisions in which case our operating results would be adversely affected. In 2008 and 2007, NutraCea recorded significant credit losses of $726,000 (as of the nine months ended September 30, 2008) and $3,233,000, respectively. These sales were made to customers that had good payment history, fit our strategic business plan and, depending on the transaction size, provided a substantial down payment. However, these customers encountered business difficulties and were unable to make payments. In addition, another customer had difficulties funding their marketing plan. We continue to evaluated our credit policy to ensure that the customers are worthy of terms and will support our business plans.

Valuation of Goodwill and Long-Lived Assets

 

Long-lived assets, consisting primarily of property and equipment, patents and trademarks, and goodwill, comprise a significant portion of our total assets. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that their carrying values may not be recoverable. We assess the impairment of goodwill and long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Impairment is reviewed at least annually, generally in the fourth quarter of each year.

 

Factors we consider important that could trigger an impairment, include the following:

§

significant underperformance relative to expected historical or projected future operating results;

 

§

Significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

 

§

Significant negative industry or economic trends;

 

§

Significant declines in our stock price for a sustained period; and

 

§

Decreased market capitalization relative to net book value.

When there is an indication that the carrying value of goodwill or a long-lived asset may not be recoverable based upon the existence of one or more of the above indicators, an impairment loss is recognized if the carrying amount exceeds its fair value.

Our impairment analyses require management to make assumptions and to apply judgment to estimate future cash flows and asset fair values, including estimating the profitability of future business strategies. We have not made any material changes in our impairment assessment methodology during the past two fiscal years. We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate long-lived asset impairment losses. However, if actual results are not consistent with our estimates and assumptions used in estimating future cash flows and asset fair values, we may be exposed to losses that could be material.

 

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Recoverability of assets is measured by a comparison of the carrying value of an asset to the future net cash flows expected to be generated by those assets. The cash flow projections are based on historical experience, management’s view of growth rates within the industry, and the anticipated future economic environment. 

When we determine that the carrying value of patents and trademarks, long-lived assets and related goodwill and enterprise-level goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, it measures any impairment based on a projected discounted cash flow method using a discount rate determined by its management to be commensurate with the risk inherent in its current business model. During 2007, in connection with the annual impairment testing, NutraCea recorded an impairment loss of $1.3 million in association with the Vital Living transaction. This is the first impairment loss incurred by us.

Goodwill Impairment

In accordance with Statement of Financial Accounting Standards, No. 142, “Goodwill and Other Intangible Assets”, (“SFAS No. 142”), the Company is required to test goodwill for impairment at least annually. The goodwill impairment test compares the fair value of individual reporting units to the carrying value of these reporting units. If fair value is less than carrying value then a goodwill impairment may be present. The market value of the Company’s common stock is an indicator of fair value and a consideration in determining the fair value of the company’s reporting units. SFAS No. 142 also requires goodwill to be tested for impairment between the annual test if an event occurs or circumstances change that “more likely than not” reduce the fair value of a reporting unit below its carrying value.

For the nine months ended September 30, 2008 we assessed the fair value of our reporting units (NutraCea and Irgovel) compared to their respective carry values as of September 30, 2008 and determined that the fair value exceeded the carry value and therefore no goodwill impairment was deemed to have occurred.

Stock-Based Compensation

 

We have a stock incentive plan that provides for the issuance of stock options, restricted stock and other awards to employees and service providers. We calculate compensation expense according to the provisions of revised Statement of Financial Accounting Standards No. 123(R), or SFAS No. 123(R), “Share-Based Payment.” Under SFAS No. 123(R), stock-based compensation cost is measured at the grant date, based on the estimated fair value of the award, and is recognized as expense over the employee’s requisite service period. We have awards with performance conditions. We adopted the provisions of SFAS No. 123(R) on January 1, 2006, using a modified prospective application. Accordingly, prior periods have not been revised for comparative purposes. Stock-based compensation expense recognized is based on the value of share-based payment awards that are ultimately expected to vest, which coincides with the award holder’s requisite service period.

We estimate the value of our share-based payment awards using the Black-Scholes-Merton option-pricing model, and amortize all new grants as expense on a straight-line basis over the vesting period.

Our stock options have characteristics significantly different from those of traded options, and changes in the assumptions can materially affect the fair value estimates. Because valuation model assumptions are subjective, in our opinion, existing valuation models, including the Black-Scholes-Merton model, may not provide reliable measures of the fair values of our share-based compensation awards. There is not currently a generally accepted market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models. Although we estimate the fair value of employee share-based awards in accordance with SFAS No. 123(R) and the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107, or SAB No. 107, the option-pricing model we use may not produce a value that is indicative of the fair value achieved in a willing buyer/willing seller market transaction.

The determination of fair value of share-based payment awards on the date of grant using the Black-Scholes-Merton model is affected by our stock price and the historical volatility on our traded options, as well as the input of other subjective assumptions. These assumptions include, but are not limited to, the expected term of stock options and our expected stock price volatility over the term of the awards.

 

SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We assess the forfeiture rate on a quarterly basis and revise the rate when deemed necessary.

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Adoption of recent accounting pronouncements

 

Fair Value Measurements

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 provides guidance for using fair value to measure assets and liabilities. It also responds to investors’ request for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair valued measurements on earnings. SFAS No. 157 applies whenever standards require (or permit) assets or liabilities to be measured at fair value, and does not expand the use of fair value in any new circumstances. SFAS No. 157 is effective for financial assets and liabilities in financial statements issued for fiscal years beginning after November 15, 2007.

 

The Company adopted this statement for financial assets and liabilities measured at fair value effective January 1, 2008. There was no financial statement impact as a result of adoption. In accordance with the guidance of FASB Staff Position No. 157-2, the Company has postponed adoption of the standard for non-financial assets and liabilities that are measured at fair value on a non-recurring basis, until the fiscal year beginning after November 15, 2008. The adoption of SFAS No. 157 did not have a material impact on the Company’s fair value measurements. The provisions of SFAS No. 157 have not been applied to non-financial assets and non-financial liabilities.

 

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115" ("SFAS No. 159"). SFAS No. 159 permits companies to measure many financial instruments and certain other items at fair value. The Company adopted SFAS No. 159 in the first quarter of 2008; as the Company did not apply the fair value option to any of its outstanding instruments, SFAS No. 159 did not have an impact on the Company's consolidated financial statements.

Recent accounting pronouncements

Business Combinations and Non-controlling Interests

In December 2007, the FASB released SFAS No. 141R, “Business Combinations” (“SFAS No. 141R”) and SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements.” (“SFAS No. 160”) Both standards will be effective for transactions that occur after January 1, 2009.

SFAS No. 141R applies to all business combinations and will require the acquiring entity to recognize the assets and liabilities acquired at their respective fair value.  This standard changes the accounting for business combinations in several areas.  If we complete an acquisition after the effective date of SFAS No. 141R, some of these changes could result in increased volatility in our results of operations and financial position.  For example, transaction costs, which are currently capitalized in a business combination, will be expensed as incurred.  Additionally, pre-acquisition contingencies (such as in-process lawsuits acquired) and contingent consideration (such as additional consideration contingent on specified events in the future) will be recorded at fair value at the acquisition date, with subsequent changes in fair value reflected in our results of operations.  Under current accounting guidance, adjustments to these contingencies are reflected in the allocation of purchase price if they occur within a certain period of time after the acquisition date.

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, “Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133” (“SFAS No. 161”). This Standard requires enhanced disclosures regarding derivatives and hedging activities, including: (a) the manner in which an entity uses derivative instruments; (b) the manner in which derivative instruments and related hedged items are accounted for under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities; and (c) the effect of derivative instruments and related hedged items on an entity’s financial position, financial performance, and cash flows. The Standard is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. As FAS No. 161 relates specifically to disclosures, the Standard will have no impact on our financial condition, results of operations or cash flows.

In May 2008, the FASB issued Statement of Financial Accounting Standards No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS No. 162”). This Standard identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles. FAS 162 directs the hierarchy to the entity, rather than the independent auditors, as the entity is responsible for selecting accounting principles for financial statements that are presented in conformity with generally accepted accounting principles. The Standard is effective 60 days following SEC approval of the Public Company Accounting Oversight Board amendments to remove the hierarchy of generally accepted accounting principles from the auditing standards. SFAS No. 162 is not expected to have an impact on our financial condition, results of operations or cash flows.

In May 2008, the Financial Accounting Standards Board ("FASB") issued FASB Staff Position ("FSP") APB 14-1, "Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)". FSP No. APB 14-1 clarifies that convertible debt instruments that may be settled in cash upon either mandatory or optional conversion (including partial cash settlement) are not addressed by paragraph 12 of APB Opinion No. 14, "Accounting for Convertible Debt and Debt issued with Stock Purchase Warrants". Additionally, FSP No. APB 14-1 specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity's nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. FSP No. APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. We will adopt FSP No. APB 14-1 beginning in the first quarter of fiscal 2009, and this standard must be applied on a retrospective basis. We are evaluating the impact the adoption of FSP No. APB 14-1, if any, will have on our consolidated financial position and results of operations.

In April 2008, the FASB issued FSP No. 142-3, "Determination of the Useful Life of Intangible Assets" ("FSP No. 142-3"). FSP No. 142-3 amends the factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of recognized intangible assets under FASB Statement No. 142, "Goodwill and Other Intangible Assets". This new guidance applies prospectively to intangible assets that are acquired individually or with a group of other assets in business combinations and asset acquisitions. FSP No. 142-3 is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008. Early adoption is prohibited. We are currently evaluating the impact, if any, that FSP No. 142-3 will have on our consolidated financial statements.

 

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Item 3.Quantitative and Qualitative Disclosures About Market Risk

 

Our cash and cash equivalents have been maintained only with maturities of 30 days or less. Our short-term investments have interest reset periods of 30 days or less. These financial instruments may be subject to interest rate risk through lost income should interest rates increase during their limited term to maturity or resetting of interest rates. As of September 30, 2008, we had approximately $4,379,000 of long-term debt bearing interest at rates from 6% to 21.4%. Future borrowings, if any, would bear interest at negotiated rates and would be subject to interest rate risk. We do not believe that a hypothetical adverse change of 10% in interest rates would have a material effect on our financial position.

 

Foreign Exchange Risks

Our financial results are affected by changes in foreign currency exchange rates and economic conditions in the foreign markets in which our products are manufactured and/or sold.  

 

Item 4.Controls and Procedures

 

Disclosure Controls and Procedures

We carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this quarterly report. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that, as of September 30, 2008, our disclosure controls and procedures were effective to ensure that information we are required to disclose by NutraCea in reports that we file or submit under the Securities and Exchange Act of 1934, as amended, is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms.

 

Changes in Internal Control Over Financial Reporting

During the quarter covered by this report, there was no change in NutraCea’s internal control over financial reporting that has materially affected, or is reasonably likely to materially effect, the Company’s internal control over financial reporting.

 

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PART II.  OTHER INFORMATION

 

Item 1. Legal Proceedings

 

From time to time we are involved in litigation incidental to the conduct of our business. While the outcome of lawsuits and other proceedings against us cannot be predicted with certainty, in the opinion of management, individually or in the aggregate, no such lawsuits are expected to have a material effect on our financial position or results of operations.

Vital Living, Inc.

 

As discussed elsewhere in this quarterly report on Form 10-Q, NutraCea holds secured promissory notes of Vital Living, Inc. that have aggregate principal amounts of $4,226,000. Vital Living’s obligations under the notes are secured by a security interest in substantially all of the assets of Vital Living, and the principal and accrued and unpaid interest on the notes become due and payable on December 15, 2008.

On August 7, 2008 we delivered a notice of default to Vital Living declaring that an event of default has occurred under the notes and that all amounts payable under the notes be immediately due and payable. We declared an event of default based upon Vital Living’s written admission to NutraCea that it is unlikely to be able to meet its obligations under the notes and, among other things, Vital Living’s low levels of cash and cash equivalents.

On September 3, 2008, we filed a complaint against Vital Living in Superior Court of Arizona, Maricopa County (CV2008-021291) alleging that Vital Living has breached its obligations to us under the notes and the security agreement relating to the notes. We are seeking, among other things, immediate payment of all outstanding amounts under the notes and a judgment foreclosing our security interest in Vital Living’s assets that secure the notes. No assurance can be given that we will be able to achieve any of our objectives in the litigation or otherwise.

 

Item 1A. Risk Factors

 

Investors or potential investors in our stock should carefully consider the risks described below. Our stock price will reflect the performance of our business relative to, among other things, our competition, expectations of securities analysts or investors, and general economic market conditions and industry conditions. One should carefully consider the following factors in connection with any investment in our stock. Our business, financial condition and results of operations could be materially adversely affected if any of the following risks occur. Should any or all of the following risks materialize, the trading price of our stock could decline, and investors could lose all or part of their investment.

 

Risks Related to Our Business

 

We have a limited operating history and have generated losses in each quarter of 2008 and for each year other than 2006.

 

We began operations in February 2000 and incurred losses in each reporting period other than the second, third, and fourth quarters of 2006 and the second quarter of 2007. Our prospects for financial success are difficult to forecast because we have a relatively limited operating history. Our prospects for financial success must be considered in light of the risks, expenses and difficulties frequently encountered by companies in new, unproven and rapidly evolving markets. Our business could be subject to any or all of the problems, expenses, delays and risks inherent in the establishment of a new business enterprise, including limited capital resources, possible delays in product development, possible cost overruns due to price and cost increases in raw product and manufacturing processes, uncertain market acceptance, and inability to respond effectively to competitive developments and attract, retain and motivate qualified employees. Therefore, there can be no assurance that our business or products will be successful, that we will be able to achieve or maintain profitable operations or that we will not encounter unforeseen difficulties that may deplete our capital resources more rapidly than anticipated.

 

There are significant market risks associated with our business.

 

We have formulated our business plan and strategies based on certain assumptions regarding the size of the rice bran market, our anticipated share of this market, and the estimated price and acceptance of our products. These assumptions are based on the best estimates of our management; however, there can be no assurance that our assessments regarding market size, potential market share attainable by us, the price at which we will be able to sell our products, market acceptance of our products, or a variety of other factors will prove to be correct. Any future success may depend upon factors including changes in the dietary supplement industry, governmental regulation, increased levels of competition, including the entry of additional competitors, increased success by existing competitors, changes in general economic conditions, increases in operating costs including costs of production, supplies, personnel, equipment, and reduced margins caused by competitive pressures.

 

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We may face difficulties integrating businesses we acquire.

 

As part of our strategy, we expect to review opportunities to buy other businesses or technologies that would complement our current products, expand the breadth of our markets or enhance technical capabilities, or that may otherwise offer growth opportunities. In the event of any future acquisitions, we could:

 

·

issue stock that would dilute current shareholders’ percentage ownership;

 

·

incur debt; or

 

·

assume liabilities.

 

These purchases also involve numerous risks, including:

 

·

problems combining the purchased operations, technologies or products;

 

·

unanticipated costs;

 

·

diversion of management’s attention from our core business;

 

·

adverse effects on existing business relationships with suppliers and customers;

 

·

risks associated with entering markets in which we have no or limited prior experience; and

 

·

potential loss of key employees of purchased organizations.

 

We cannot assure you that we will be able to successfully integrate any businesses, products, technologies or personnel that we might purchase in the future.

We intend to pursue significant foreign operations and there are inherent risks in operating abroad.

An important component of our business strategy is to build rice bran stabilization facilities in foreign countries and to market and sell our products internationally. For example, we recently entered into a joint ventures to produce and market our SRB products in Southeast Asia and China and purchased a company in Brazil that manufactures rice bran oil. There are risks in operating stabilization facilities in developing countries because, among other reasons, we may be unable to attract sufficient qualified personnel, intellectual property rights may not be enforced as we expect, power may not be available as contemplated. Should any of these risks occur, we may be unable to maximize the output from these facilities and our financial results may decrease from our anticipated levels. The inherent risks of international operations could materially adversely affect our business, financial condition and results of operations. The types of risks faced in connection with international operations and sales include, among others:

 

	·	cultural differences in the conduct of business;
	·	fluctuations in foreign exchange rates;
	·	greater difficulty in accounts receivable collection and longer collection periods;
	·	impact of recessions in economies outside of the United States;
	·	reduced protection for intellectual property rights in some countries;
	·	unexpected changes in regulatory requirements;

 

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	·	tariffs and other trade barriers;
	·	political conditions in each country;
	·	management and operation of an enterprise spread over various countries;
	·	the burden and administrative costs of complying with a wide variety of foreign laws; and
	·	currency restrictions.

Fluctuations in foreign currency exchange could adversely affect our financial results.

We earn revenues, pay expenses, own assets and incur liabilities in countries using currencies other than the U.S. dollar, including primarily the Brazilian real. Currently, a significant portion of our revenues and expenses occur with our Brazilian subsidiary, Irgovel. Because our consolidated financial statements are presented in U.S. dollars, we must translate revenues, income and expenses, as well as assets and liabilities, into U.S. dollars at exchange rates in effect historically, during or at the end of each report period. Therefore, increases or decreases in the value of the U.S. dollar against the Brazilian real and any other currency which affects a material amount of our operations, will affect our revenues, cost of sales, gross profit (loss), operating expenses, or other income and expenses and the value of balance sheet items denominated in foreign currencies. These fluctuations may have a material adverse effect on our financial results. Moreover, recent disruptions in financial markets have resulted in significant changes in foreign exchange rates in relatively short periods of time which further increases the risk of an adverse currency effect. Since we plan to expand our international operations through capital contributions, we will likely increase our exposure to foreign currency risks. We do not hedge our currency risk, and do not expect to as currency hedges are expensive and do not necessarily reduce the risk of currency fluctuations over longer periods of time.

 

We depend on limited number of customers.

 

During 2007, our NutraCea segment received approximately 51% of product sales revenue from six customers and approximately 15% of our revenue from one customer. During the nine months ended September 30, 2008, three customers accounted for 17% of our sales in our NutraCea segment, and in our Irgovel segment three customers accounted for 27% of sales. A loss of any of these customers could have a material adverse effect on our revenues and results of operations.

 

The inability of our significant customers to meet their obligations to us may adversely affect our financial results.

We are subject to credit risk due to concentration of our trade accounts receivables and notes receivables. On our Irgovel segment as of September 30, 2008 one customer accounted for 30% of Irgovel’s $1,667,000 gross trade accounts receivable. For our NutraCea segment, as of September 30, 2008, two customers accounted for 64% of our $4,729,000 gross trade accounts receivables. Both of these customers balances are past due and we have recorded a 100% allowance for doubtful accounts of $3,084,000. In addition, we acquired secured promissory notes of Vital Living, Inc. with aggregate principal amounts of $4,226,000 in connection with our entering into an asset purchase agreement with Vital Living to acquire Vital Living’s assets. While we obtain personal guarantees and security interests backing these obligations when possible, many of these obligations are not guaranteed or secured. The inability of our significant customers and obligors to meet their obligations to us, or, in the case of Vital Living, the deterioration of Vital Living’s financial condition or assets before we are able to consummate our acquisition of their assets through foreclosure or otherwise, may adversely affect our financial condition and results of operations.

 

We rely upon a limited number of product offerings.

 

The majority of our products are based on stabilized rice bran. Although we will market stabilized rice bran as a dietary supplement, as an active food ingredient for inclusion in our products and in other companies’ products, and in other ways, a decline in the market demand for our products, as well as the products of other companies utilizing our products, could have a significant adverse impact on us.

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We are dependent upon our marketing efforts.

 

We are dependent on our ability to market products to animal food producers, food manufacturers, mass merchandise and health food retailers, and to other companies for use in their products. We must increase the level of awareness of dietary supplements in general and our products in particular. We will be required to devote substantial management and financial resources to these marketing and advertising efforts and there can be no assurance that it will be successful.

 

We rely upon an adequate supply of raw rice bran.

 

The majority of our current products depend on our proprietary technology using unstabilized or raw rice bran, which is a by-product from milling paddy rice to white rice. Our ability to manufacture stabilized rice bran raw is currently limited to the production capability of our production equipment at Farmers’ Rice Co-operative and Archer Daniels Midland, our own plants located next to the Louisiana Rice Mill in Mermentau, Louisiana, Farmer’s Rice Inc. in Lake Charles, Louisiana, and American Rice, Inc. in Freeport, Texas, and our single value-added products plant in Dillon, Montana. We currently are capable of producing enough finished products at our facilities to meet current demand. With the exception of our newly acquired rice bran oil facility in Pelotas, Brazil, our existing plants do not allow for dramatic expansion , therefore additional domestic production capacity will be needed if demand increases.

 

We are pursuing other supply sources in the United States and in foreign countries and anticipate being able to secure alternatives and back-up sources of rice bran. However, there can be no assurance that we will continue to secure adequate sources of raw rice bran to meet our requirements to produce stabilized rice bran products. For example, our Mermentau plant was idle from May through July, 2008, because the rice mill that supplies the plant was not milling rice due to business reasons un-related to our operations. In addition, since rice bran has a limited shelf life, the supply of rice bran is affected by the amount of rice planted and harvested each year. If economic or weather conditions adversely affect the amount of rice planted or harvested, the cost of rice bran products that we use may increase. We are not generally able to pass cost increases to our customers and any increase in the cost of stabilized rice bran products would have an adverse effect on our results of operations.

We face risks in our wheat bran stabilization efforts.

In January 2008, through a newly formed wholly owned subsidiary, we entered an agreement to develop and lease Wheat Bran Stabilization equipment to an Indonesian company. Our efforts to prove our Wheat Bran Stabilization technology on an industrial scale may not be successful and the demand for stabilized wheat bran products may not grow as we anticipate.

 

 

Our products may require clinical trials to establish efficacy and safety.

 

Certain of our products may require clinical trials to establish our benefit claims or their safety and efficacy. Such trials can require a significant amount of resources and there is no assurance that such trials will be favorable to the claims we make for our products, or that the cumulative authority established by such trials will be sufficient to support our claims. Moreover, both the findings and methodology of such trials are subject to challenge by the FDA and scientific bodies. If the findings of our trials are challenged or found to be insufficient to support our claims, additional trials may be required before such products can be marketed.

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We may be required to record a significant charge to earnings if our goodwill becomes impaired.

Goodwill comprises a significant portion of our total assets. We tested our goodwill for impairment for the nine months ended September 30, 2008 and determined that no goodwill impairment had occurred. Consistent with past years, we also will be conducting our annual test for goodwill impairment in the fourth quarter of 2008. If we determine that impairment of our goodwill exists during a period in the future, we may be required to record a significant charge to earnings in our consolidated financial statements during that period. This would adversely impact our results of operations. Factors that may be considered a change in circumstances indicating that the carrying value of our goodwill may not be recoverable include declines in stock prices and market capitalization. In October 2008, our stock price declined significantly, and if our stock price were to decline further, our goodwill impairment test would be negatively impacted during the fourth quarter of 2008. Please see Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations for our critical accounting policies related to goodwill.

If we fail to maintain an effective system of internal controls, we may not be able to accurately report financial results or prevent fraud. 

 

Effective internal controls are necessary to provide reliable financial reports and to assist in the effective prevention of fraud. Any inability to provide reliable financial reports or prevent fraud could harm our business. We must annually evaluate our internal procedures to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, which requires management and auditors to assess the effectiveness of internal control over financial reporting. In prior periods, we have identified material weaknesses in our internal controls. Although we believe we have addressed those weaknesses, no assurance can be given that these or other material weaknesses will not occur in the future. If we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we could be subject to regulatory scrutiny, civil or criminal penalties or shareholder litigation. In addition, failure to maintain adequate internal controls could result in financial statements that do not accurately reflect our financial condition.

 

Risks Related to Our Stock

 

Our Stock Price is Volatile.

 

The market price of a share of our common stock has fluctuated significantly in the past and may continue to fluctuate significantly in the future. The high and low closing prices of a share of common stock for the following periods were:

 

		High			Low
Three months ended September 30, 2008		$	0.70		$	0.39
Nine months ended September 30, 2008		$	1.56		$	0.39
Twelve months ended December 31, 2007		$	5.00		$	0.75
Twelve months ended December 31, 2006		$	2.74		$	0.60

 

The market price of a share of our common stock may continue to fluctuate in response to a number of factors, including:

 

·

announcements of new products or product enhancements by us or our competitors;

 

·

fluctuations in our quarterly or annual operating results;

 

·

developments in our relationships with customers and suppliers;

 

·

the loss of services of one or more of our executive officers or other key employees;

 

·

announcements of technological innovations or new systems or enhancements used by us or our competitors;

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·

developments in our or our competitors intellectual property rights;

 

·

adverse effects to our operating results due to impairment of goodwill;

 

·

failure to meet the expectation of securities analysts’ or the public; and

 

·

general economic and market conditions.

 

We have significant “equity overhang” which could adversely affect the market price of our common stock and impair our ability to raise additional capital through the sale of equity securities.

 

As of October 31, 2008, 168,124,554 shares of our common stock were outstanding and 4,945 shares of our Series D Preferred Stock were outstanding. Additionally, as of November 3, 2008, options and warrants to purchase approximately 60,802,000 shares of our common stock were outstanding and our currently outstanding Series D Preferred Stock was convertible into 8,990,798 shares of our common stock. In addition, warrants to acquire an additional 5,000 shares of our Series D Preferred Stock were outstanding, which if exercised to acquire additional Series D Preferred Stock, would be convertible into 9,090,909 shares of our common stock and would also have accompanying warrants to acquire an additional 4,545,455 shares of our common stock. Further, dividends on the Series D Preferred Stock may be paid in common stock depending on compliance with the terms of such preferred stock and we have the right to convert the Series D Preferred Stock into common stock, subject to certain conditions, which may result in greater number of shares of common stock being issued than in a voluntary conversion by holders of the Series D Preferred Stock. The possibility that substantial amounts of our outstanding common stock may be sold by investors or the perception that such sales could occur, often called “equity overhang,” could adversely affect the market price of our common stock and could impair our ability to raise additional capital through the sale of equity securities in the future.

 

Sales of our stock pursuant to registration statements may hurt our stock price.

 

We granted registration rights to the investors in our October 2005, May 2006 and February 2007 capital stock and warrant financings. As of October 31, 2008, approximately 23,622,000 shares of our common stock remained eligible for resale pursuant to outstanding registration statements filed for these investors. In addition, we have filed a registration statement to cover our issuance and sale of up to $125,000,000 of common stock, preferred stock, and warrants to purchase common or preferred stock. We sold an aggregate of 22,222,223 shares of common stock and warrants to purchase an aggregate 6,666,664 shares of our common stock for gross proceeds of $20,000,000 pursuant to that registration statement in April 2008 and we sold 5,000 shares of our Series D Preferred Stock, warrants purchase 4,545,455 shares of our common stock, and warrants to acquire an additional 5,000 shares of Series D Preferred Stock together with warrants to acquire an additional 4,545,455 shares of common stock for gross proceeds of $5,000 in October, 2008. Additional sales or potential sales of a significant number of shares into the public markets may negatively affect our stock price.

 

The exercise of outstanding options and warrant sand conversion of Preferred Stock may dilute current shareholders.

 

 

We likely will need to raise funds through debt or equity financings in the future to achieve our business objectives, which would dilute the ownership of our existing shareholders and possibly subordinate certain of their rights to the rights of new investors.

 

We likely will need to raise funds through debt or equity financings in order to complete our planned capital expenditures and ultimate business objectives. We also may choose to raise additional funds in debt or equity financings if they are available to us on terms we believe reasonable to increase our working capital, strengthen our financial position or to make acquisitions. Any sales of additional equity or convertible debt securities would result in dilution of the equity interests of our existing shareholders, which could be substantial. Additionally, if we issue shares of preferred stock or convertible debt to raise funds, the holders of those securities might be entitled to various preferential rights over the holders of our common stock, including repayment of their investment, and possibly additional amounts, before any payments could be made to holders of our common stock in connection with an acquisition of the company. Such preferred shares, if authorized, might be granted rights and preferences that would be senior to, or otherwise adversely affect, the rights and the value of our common stock. Also, new investors may require that we and certain of our shareholders enter into voting arrangements that give them additional voting control or representation on our board of directors.

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The authorization and issuance of our preferred stock may have an adverse effect on the rights of holders of our common stock.

 

We may, without further action or vote by holders of our common stock, designate and issue shares of our preferred stock. The terms of any series of preferred stock could adversely affect the rights of holders of our common stock and thereby reduce the value of our common stock. The designation and issuance of preferred stock favorable to current management or shareholders could make it more difficult to gain control of our Board of Directors or remove our current management and may be used to defeat hostile bids for control which might provide shareholders with premiums for their shares. W have designated and issued four series of preferred stock, of which only our Series D Preferred Stock remains outstanding as of October 31, 2008. In October 2008 we sold 5,000 shares of our Series D Preferred Stock and warrants to acquire an additional 5,000 shares of Series D Preferred Stock. We may issue additional series of preferred stock in the future.

 

The Series D Preferred Stock we have issued has significant rights and benefits and is senior in priority to our common stock or any class of equity security we may issue in the future.

 

In October 2008 we sold 5,000 shares of our Series D Preferred Stock and we granted warrants to acquire an additional 5,000 shares of Series D Preferred Stock. The Series D Preferred Stock has significant rights and benefits which are not available to holders of our common stock. Holders of the Series D Preferred Stock may elect to convert into common stock at any time at a conversion rate of $0.55 per share, subject to adjustment downwards in the event we issue common stock, warrants or options at a price less than $0.55 per share, except in certain limited circumstances. The Series D Preferred Stock entitles its holders to dividends on a quarterly basis at an annual rate of 8%, which dividends may be payable in common stock if certain conditions are satisfied. The Series D Preferred Stock may be converted into common stock over a nine month period in equal installments commencing February 1, 2009, based on the lesser of the then current conversion price or 90% of the volume weighted average price of our common stock over the 10 trading days immediately prior to conversion as long as certain conditions are satisfied. If those conditions are not satisfied, we must pay cash to redeem the Series D Preferred Stock on the applicable dates, and if we do not have such cash, we will be in default on the Series D Preferred Stock and subject to penalty provisions. The Series D Preferred Stock are senior in priority to our common stock and any class of equity security we may issue in the future unless the Series D Preferred Stock is converted or redeemed in its entirety. Thus, in the event of our liquidation, the payment of the outstanding stated amount of the Series D Preferred Stock and any accrued but unpaid dividends on such preferred stock must be satisfied before any payments to common stock holders or the holders of any other class of preferred stock. If we fail to comply with the terms of the Series D Preferred Stock, we will be subject significant penalties, including in certain circumstances the requirement to pay additional interest at the rate of 2% per month or the issuance of additional shares of common stock. The Series D Preferred Stock also has certain rights in connection with a fundamental transaction, generally involving a change in control of our company, including the right to be redeemed at a premium price of 135% of the outstanding amount of the Series D Preferred Stock, plus any accrued but unpaid dividends.

 

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