NATURAL ALTERNATIVES INTERNATIONAL, INC. The following discussion and analysis is intended to help you understand our financial condition and results of operations for the three and six months endedDecember 31, 2019 . You should read the following discussion and analysis together with our unaudited condensed consolidated financial statements and the notes to the condensed consolidated financial statements included under Item 1 in this Report, as well as the risk factors and other information included in our 2019 Annual Report and other reports and documents we file with theSEC . Our future financial condition and results of operations will vary from our historical financial condition and results of operations described below based on a variety of factors. Executive Overview The following overview does not address all of the matters covered in the other sections of this Item 2 or other items in this Report nor does it contain all of the information that may be important to our stockholders or the investing public. You should read this overview in conjunction with the other sections of this Item 2 and this Report. Our primary business activity is providing private-label contract manufacturing services to companies that market and distribute vitamins, minerals, herbs and other nutritional supplements, as well as other health care products, to consumers both within and outside theU.S. Historically, our revenue has been largely dependent on sales to two or three private-label contract manufacturing customers and subject to variations in the timing of such customers' orders, which in turn is impacted by such customers' internal marketing programs, supply chain management, entry into new markets, new product introductions, the demand for such customers' products, and general industry and economic conditions. Our revenue also includes raw material sales and royalty and licensing revenue generated from license and supply agreements with third parties, granting them the right to use our patents, trademarks and other intellectual property in connection with the distribution and use of the ingredient known as beta-alanine sold under our CarnoSyn® and SR CarnoSyn® trademarks. A cornerstone of our business strategy is to achieve long-term growth and profitability and to diversify our sales base. We have sought and expect to continue to seek to diversify our sales by developing relationships with additional, quality-oriented, private-label contract manufacturing customers, and commercializing our patent estate through sales of beta-alanine under our CarnoSyn® and SR CarnoSyn® trade names, royalties from license agreements, and potentially additional contract manufacturing opportunities with licensees. During the first six months of fiscal 2020, our net sales were 20% lower than in the first six months of fiscal 2019. Private-label contract manufacturing sales decreased 19% due primarily to lower sales to our largest customer partially offset by increased sales to other new and existing customers. Sales to our largest private-label contract manufacturing customer declined over 31%. Revenue concentration risk for our largest private-label contract manufacturing customer as a percentage of our total net sales decreased from 55% to 46% for the six months endedDecember 31, 2019 compared to the six months endedDecember 31, 2018 . We expect our annualized fiscal 2020 revenue concentration for this customer to be lower than fiscal 2019. During the first six months of fiscal 2020, CarnoSyn® beta-alanine revenue decreased 24% to$7.5 million , compared to revenue of$9.8 million for the first six months of fiscal 2019. The decrease in beta-alanine revenue was primarily due to decreased material shipments resulting from market and seasonal factors and lower average sales prices. We believe this decline was impacted by certain of our customers discontinuing the use of our CarnoSyn® beta-alanine in favor of generic beta-alanine and lower overall consumer demand for our customers' CarnoSyn® products. InFebruary 2019 , we received New Dietary Agreement ("NDI") status from the FDA for our patented CarnoSyn® beta-alanine. CarnoSyn® beta-alanine is the only beta-alanine that has received this status and we plan to work with the FDA and other agencies and/or courts to enforce rights connected with this NDI status. We believe the NDI strengthens our position in the market place and we intend, where applicable, to seek to curtail the importation and use of generic beta-alanine to the extent not in compliance with the law. In March of 2019, we received a favorable ruling from theU.S. Court of Appeals for the Federal Circuit that vindicated our patents and held them as "patent eligible" under existing law. We plan on leveraging this legal victory and our recent NDI approval by aggressively pursuing those who illegally violate our patents or import or use beta-alanine in violation of the law. Also, inMarch 2019 , as a result of our efforts over the last three years, the Ministry of Health, Labor, and Welfare ofJapan officially approved beta-alanine for sale in Japanese food markets. We believe this opens a new market for our CarnoSyn® beta-alanine. We have entered into a Distribution Agreement with aShimizu Chemical Corporation , and we shipped our first orders of CarnoSyn® beta-alanine toJapan in the fourth quarter of fiscal 2019. Our distribution partner is actively working to develop this new market and we believeJapan represents a previously untapped market for potential sales growth. We continue to invest in research and development for our SR CarnoSyn® sustained release delivery system. We believe SR CarnoSyn® may provide a unique opportunity within the growing Wellness and Healthy Aging markets. We launched efforts to sell SR CarnoSyn® into the Wellness and Healthy Aging markets in early fiscal 2019 and while we have not yet had substantive sales into this market, we believe our recent efforts to refine our formulations and product offerings will be positively received and result in significant opportunity for increased SR CarnoSyn® sales later this fiscal year. To protect our CarnoSyn® business and our patents, trademarks and other intellectual property, we incurred litigation and patent compliance expenses of approximately$1.4 million during the first six months of fiscal 2020 as compared to$958,000 during the comparable period in fiscal 2019. Our ability to maintain or further increase our beta-alanine licensing revenue will depend in large part on our ability to develop a market for our sustained release form of beta-alanine marketed under our SR CarnoSyn® trademark, maintain our patent rights, obtain the raw material beta-alanine when and in the amounts needed, expand distribution of beta-alanine to new and existing customers, and further commercialize our existing patents, and will also depend on the continued compliance by third parties with our license agreements and our patent, trademark and other intellectual property rights. For the second half of fiscal 2020, as compared to the same period in the prior year, we expect sales levels to our largest contract manufacturing customer to decline 20% to 25% and our CarnoSyn® beta-alanine revenue to be comparable to the prior year. As a result, on an annualized basis, we now expect our consolidated fiscal 2020 revenue to decline approximately 10% to 15% as compared to the prior fiscal year. 15
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During the remainder of fiscal 2020, we will continue our sales and marketing activities to customers, potential customers, and brand owners on multiple platforms to promote and reinforce the features and benefits of utilizing NAI's contract manufacturing services and CarnoSyn® and SR CarnoSyn® beta-alanine.
There can be no assurance that our customer's sales and marketing activities as well as our own sales and marketing and litigation efforts will reverse or decelerate potential future sales declines.
During the remainder of fiscal 2020, given the following strategies and business trends, we expect our consolidated operating income to be flat to slightly favorable as compared to the same period in fiscal 2019:
• Continued litigation to support our patents, trademarks, and NDI status for
our CarnoSyn® brands;
• Marketing, advertising, and promotion costs expected to be deployed for our
launch into the Wellness and Healthy Aging markets for SR CarnoSyn®;
• Decreased sales expectations from our largest private-label contract
manufacturing customer;
• Expected lower average Euro exchange rates for fiscal 2020 as compared to
fiscal 2019; and
• Expansion of the Japanese marketplace for our CarnoSyn® brands.
During the remainder of fiscal 2020, we also plan to continue our focus on:
• Leveraging our state-of-the-art, certified facilities to increase the value of
the goods and services we provide to our highly valued private-label contract
manufacturing customers, and to assist us in developing relationships with
additional quality oriented customers;
• Expanding the commercialization of our beta-alanine patent estate through raw
material sales, developing a new sales distribution channel under the Wellness
and Healthy Aging category for our sustained release form of beta-alanine
marketed under our SR CarnoSyn® trademark, and exploiting new contract
manufacturing opportunities, license and royalty agreements, and protecting
our proprietary rights; and
• Improving operational efficiencies and managing costs and business risks to
improve profitability.
Critical Accounting Policies and Estimates
The preparation of our financial statements requires that we make estimates and
assumptions that affect the amounts reported in our financial statements and the
accompanying notes. We have identified certain policies we believe are important
to the accurate and complete portrayal of our financial condition and results of
operations. These policies require the application of significant judgment by
our management. We base our estimates on our historical experience, industry
standards, and various other assumptions we believe are reasonable under the
circumstances. Actual results could differ from these estimates under different
assumptions or conditions. An adverse effect on our financial condition, changes
in financial condition, and results of operations could occur if circumstances
change that alter the various assumptions or conditions used in such estimates
or assumptions.
Our critical accounting policies are discussed under Item 7 of our 2019 Annual
Report and recently adopted and issued accounting pronouncements are discussed
in the Notes to Condensed Consolidated Financial Statements contained in this
Quarterly Report.
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Table of Contents Results of Operations
The results of our operations for the three and six months ended
Three Months Ended Six Months Ended
December 31, December 31,
2019 2018 % Change 2019 2018 % ChangePrivate label contract manufacturing$ 24,831 $ 31,660 (22 )%$ 50,841 $ 62,746 (19 )% Patent and trademark licensing 4,272 4,383 (3 )% 7,457 9,829 (24 )% Total net sales 29,103 36,043 (19 )% 58,298 72,575 (20 )% Cost of goods sold 24,042 29,607 (19 )% 48,853 58,976 (17 )% Gross profit 5,061 6,436 (21 )% 9,445 13,599 (31 )% Gross profit % 17.4 % 17.9 % 16.2 % 18.7 % Selling, general and administrative expenses 4,363 4,229 3 % 8,802 8,668 2 % % of net sales 15.0 % 11.7 % 15.1 % 11.9 % Income from operations 698 2,207 (68 )% 643 4,931 (87 )% % of net sales 2.4 % 6.1 % 1.1 % 6.8 % Total other (loss) income (124 ) 543 (123 )% 53 1,040 (95 )% Income before income taxes 574 2,750 (79 )% 695 5,971 (88 )% % of net sales 2.0 % 7.6 % 1.2 % 8.2 % Provision for income taxes 98 569 (83 )% 124 1,231 (90 )% Net income$ 476 $ 2,181 (78 )%$ 572 $ 4,740 (88 )% % of net sales 1.6 % 6.1 % 1.0 % 6.5 % Private-label contract manufacturing net sales decreased 22% during the three months endedDecember 31, 2019 and 19% during the six months endedDecember 31, 2019 , when compared to the same periods in the prior year. The decrease was due primarily to lower sales to our largest customer. Net sales from our patent and trademark licensing segment decreased 3% during the three months endedDecember 31, 2019 and decreased 24% during the six months endedDecember 31, 2019 , when compared to the same periods in the prior year. The decrease in beta-alanine sales during the three and six months endedDecember 31, 2019 was primarily due to decreased material shipments resulting from market and seasonal factors and lower average sales prices. We believe this decline was impacted by certain of our customers discontinuing the use of our CarnoSyn® beta-alanine in favor of generic beta-alanine and lower overall consumer demand for our customer's CarnoSyn® products. The change in gross profit margin for the three and six months endedDecember 31, 2019 , was as follows: Three Months Six Months Ended Ended Contract manufacturing(1) (1.2 )% (1.5 )% Patent and trademark licensing(2) 0.7 (1.0 ) Total change in gross profit margin (0.5 )% (2.5 )%
1 Private-label contract manufacturing gross profit margin as a percentage of
consolidated net sales decreased 1.2 percentage points during the three months
ended
months ended
period. The decrease in gross profit as a percentage of consolidated net sales
is primarily due to a marginal increase in per unit manufacturing costs,
partially offset by favorable product sales mix and inclusion of the
amortization of forward points from cash flow hedge instruments in the three
and six month results of fiscal 2020 and none in the same periods of fiscal
2019. As a result of the adoption of ASU No. 2017-12, amortization of forward
points are now included as a component of net revenues while they were
previously included as a component of other income.
2 Patent and trademark licensing gross profit margin as a percentage of
consolidated net sales increased 0.7 percentage points during the three months
ended
increase was primarily due to an increase in patent and trademark licensing net
sales as a percentage of consolidated net sales partially offset by lower
average net sales prices. Patent and trademark licensing gross profit as a
percentage of consolidated net sales decreased 1.0 percentage point during the
six months ended
period. The decrease was primarily due to decreased patent and trademark
licensing net sales as a percentage of total consolidated net sales and lower
average sales prices.
Selling, general and administrative expenses increased by 3% for the three
months ended
Other income, net, decreased$667,000 during the three months endedDecember 31, 2019 , and decreased$987,000 during the six months endedDecember 31, 2019 , when compared to the comparable prior year period. The decrease was primarily due to the exclusion of the amortization of forward points from cash flow hedge instruments during the three and six months endedDecember 31, 2019 as compared to including$464,000 and$951,000 in the comparable periods of fiscal 2019. This change in classification of forward points is the result of the adoption of ASU No. 2017-12 that now requires the amortization of forward points be included as a component of net revenues while they were previously included as a component of other income. Our income tax expense decreased$471,000 , or 83%, during the three months endedDecember 31, 2019 , and decreased$1.1 million , or 90%, during the six months endedDecember 31, 2019 , primarily related to the decrease in income before taxes. 17
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Liquidity and Capital Resources
Our primary sources of liquidity and capital resources are cash flows provided by operating activities and the availability of borrowings under our credit facility. Net cash provided by operating activities was$4.8 million for the six months endedDecember 31, 2019 compared to net cash provided by operating activities of$8.2 million in the comparable period in the prior fiscal year. AtDecember 31, 2019 , changes in accounts receivable, consisting of amounts due from our private-label contract manufacturing customers and our patent and trademark licensing activities, provided$1.7 million in cash compared to providing$1.1 million of cash during the comparable six month period in the prior fiscal year. The increase in cash provided by accounts receivable during the six months endedDecember 31, 2019 primarily resulted from timing and the amount of sales and related collections. Days sales outstanding was 48 days during the six months endedDecember 31, 2019 as compared to 36 days for the prior year period. Changes in inventory provided$3.4 million in cash during the six months endedDecember 31, 2019 compared to providing$92,000 in the comparable prior year period. The change in cash related to inventory during the six months endedDecember 31, 2019 was primarily related to the timing of sales and new order activity. Changes in accounts payable and accrued liabilities used$2.7 million in cash during the six months endedDecember 31, 2019 compared to using$546,000 during the six months endedDecember 31, 2018 . The change in cash flow activity related to accounts payable and accrued liabilities was primarily due to the timing of inventory receipts and payments. Cash used in investing activities during the six months endedDecember 31, 2019 was$1.6 million compared to$1.1 million in the comparable prior year period. The primary reason for the change was due the collection of a note receivable during the six months endedDecember 31, 2018 , as well as a decrease in capital equipment purchases during the six months endedDecember 31, 2019 as compared to the comparable prior year period. Cash used in financing activities for the six months endedDecember 31, 2019 was$1.3 million compared to$392,000 used in the comparable prior year period. This change is primarily due to increased repurchases of our stock. AtDecember 31, 2019 andJune 30, 2019 , on a consolidated basis, we had no outstanding balances due in connection with our loan facility. During the six months endingDecember 31, 2019 , we were in compliance with all of the financial and other covenants required under the Credit Agreement. Refer to Note F, "Debt," in this Quarterly Report, for terms of our Credit Agreement and additional information. As ofDecember 31, 2019 , we had$26.9 million in cash and cash equivalents and$10.0 million available under our credit facilities. We believe our available cash, cash equivalents and potential cash flows from operations will be sufficient to fund our current working capital needs and capital expenditures through at least the next 12 months.
Off-Balance Sheet Arrangements
As ofDecember 31, 2019 , we did not have any off-balance sheet debt nor did we have any transactions, arrangements, obligations (including contingent obligations) or other relationships with any unconsolidated entities or other persons that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenue or expenses material to investors.
Recent Accounting Pronouncements
Recent accounting pronouncements are discussed in the notes to our consolidated financial statements included under Item 1 of this Report. Other than those pronouncements, we are not aware of any other pronouncements that materially affect our financial position or results of operations.
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