NATURAL ALTERNATIVES INTERNATIONAL INC 10-Q

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis is intended to help you understand our financial condition and results of operations for the three and nine months ended March 31, 2021. 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 2020 Annual Report and other reports and documents we file with the SEC. 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, herbal and other nutritional supplements, as well as other health care products, to consumers both within and outside the U.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 nine months of fiscal 2021, our net sales were 60% higher than in the first nine months of fiscal 2020. Private-label contract manufacturing sales increased 70% due to higher sales from a majority of our distribution channels worldwide primarily due to increased shipments of existing products and sales of newly awarded products to new and existing customers. This sales increase was partially offset by a reduction in sales as a result of a discontinued customer relationship. Revenue concentration risk for our largest private-label contract manufacturing customer as a percentage of our total net sales increased from 43% for the first nine months of fiscal 2020 to 54% for the first nine months of fiscal 2021. We expect our annualized fiscal year 2021 revenue concentration for this customer to be higher than fiscal year 2020. During the first nine months of fiscal 2021, CarnoSyn® beta-alanine revenue decreased 7% to $9.6 million, compared to revenue of $10.3 million for the first nine months of fiscal 2020. The decrease in beta-alanine revenue was due to decreased material shipments primarily resulting from certain of our former customers discontinuing the use of CarnoSyn® beta-alanine in favor of generic beta-alanine and the negative impact COVID-19 has had on the sports nutrition industry due to limitations on athletic activities and gyms. However, a majority of this decline occurred during the first nine months of fiscal 2021 while sales from this channel during the third quarter of fiscal 2021 included a 46% year over year increase, primarily due to easing COVID-19 restrictions throughout the country, especially for athletic activities and gyms. 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 believe our ongoing efforts to refine our formulations and product offerings will be positively received and result in further opportunities for increased SR CarnoSyn® sales. To protect our CarnoSyn® business and our patents, trademarks and other intellectual property, we incurred litigation and patent compliance expenses of approximately $1.0 million during the first nine months of fiscal 2021 as compared to $1.7 million during the comparable period in fiscal 2020. The decrease in these legal expenses on a year over year basis was primarily due to the successful resolution of several cases that were settled. Our ability to maintain or further increase our beta-alanine royalty and 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 on the continued compliance by third parties with our license agreements and our patent, trademark and other intellectual property rights. During the remainder of fiscal 2021, we will continue our sales and marketing activities to consumers, customers, potential customers, and brand owners on multiple platforms to promote and reinforce the features and benefits of utilizing CarnoSyn® and SR CarnoSyn® beta-alanine. Based on our current sales order volumes and future period sales forecasts received from our customers, we now expect our annualized fiscal 2021 net sales to increase between 45% and 55% as compared to fiscal 2020. We also expect to generate operating income between 7% and 9% of net sales for our fiscal year ending June 30, 2021. There can be no assurance our expectations will result in the currently anticipated increase in net sales, or operating income. Notwithstanding, we are closely monitoring the impact of the COVID-19 pandemic. Currently we cannot reliably estimate the length of time or severity of the pandemic, and cannot reliably estimate the total impact this pandemic may have on our consolidated financial results for the remainder of fiscal 2021 and beyond. 18 Table of Contents Impact of COVID-19 on Our Business On March 11, 2020, the World Health Organization classified the novel coronavirus, or COVID-19, as a pandemic. The COVID-19 pandemic has resulted, and is likely to continue to result, in significant economic disruption and has and will likely affect our business. Significant uncertainty exists concerning the magnitude of the impact and duration of the COVID-19 pandemic. Our facilities, located both in the United States and Europe, continue to operate as an essential and critical manufacturer in accordance with applicable federal, state, and local regulations, however, there can be no assurance our facilities will continue to operate without interruption. Factors that derive from COVID-19 and the accompanying regulatory and market response, and that have or may negatively impact sales and gross margin in the future include, but are not limited to the following: ● Limitations on the ability of our suppliers to manufacture, or procure from manufacturers, the products we sell, or to meet delivery requirements and commitments; ● Limitations on the ability of our employees to perform their work due to illness caused by the pandemic or due to other restrictions on our employees to keep them safe and the increased cost of measures taken to ensure employee health and safety; ● Local, state, or federal orders requiring employees to remain at home; ● Limitations on the ability of carriers to deliver materials need for production or for delivery of our products to customers; ● Limitations on the ability of our customers to conduct their business and purchase our products and services; and ● Limitations on the ability of our customers to pay us on a timely basis. We will continue to actively monitor the situation and may take further actions to alter our business operations as may be required by federal, state or local authorities or that we determine are in the best interests of our employees, customers, suppliers and shareholders. While we are unable to determine or predict the nature, duration, or scope of the overall impact the COVID-19 pandemic will have on our business, results of operations, liquidity or capital resources, we believe we will be able to remain operational and our working capital will be sufficient for us to remain operational even as the longer term consequences of this pandemic become known. During the remainder of fiscal year 2021, 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 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, 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 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 2020 Annual Report and recently adopted and issued accounting pronouncements are discussed under Item 1, Note A to our Notes to Condensed Consolidated Financial Statements contained in this Report. 19 Table of Contents Results of Operations The results of our operations for the three and nine months ended March 31 were as follows (dollars in thousands): Three Months Ended Nine Months Ended March 31, March 31, 2021 2020 % Change 2021 2020 % Change Private label contract manufacturing $ 42,196 $ 22,650 86 % $ 124,569 $ 73,490 70 % Patent and trademark licensing 4,124 2,832 46 % 9,560 10,290 (7 )% Total net sales 46,320 25,482 82 % 134,129 83,780 60 % Cost of goods sold 39,484 22,588 75 % 111,614 71,441 56 % Gross profit 6,836 2,894 136 % 22,515 12,339 82 % Gross profit % 14.8 % 11.4 % 16.8 % 14.7 % Selling, general and administrative expenses 4,136 7,117 (42 )% 12,338 15,919 (22 )% % of net sales 8.9 % 27.9 % 9.2 % 19.0 % Income from operations 2,700 (4,223 ) 164 % 10,177 (3,580 ) 384 % % of net sales 5.8 % (16.6 )% 7.6 % (4.3 )% Total other (loss) income (326 ) (48 ) (579 )% (1,453 ) 5 (29,160 )% Income before income taxes 2,374 (4,271 ) 156 % 8,724 (3,575 ) 344 % % of net sales 5.1 % (16.8 )% 6.5 % (4.3 )% Provision (benefit) for income taxes 458 (256 ) — 918 (132 ) — Net income (loss) $ 1,916 $ (4,015 ) 148 % $ 7,806 $ (3,443 ) 327 % % of net sales 4.1 % (15.8 )% 5.8 % (4.1 )% Private-label contract manufacturing net sales increased 86% during the three months ended March 31, 2021 and 70% during the nine months ended March 31, 2021, when compared to the same period in the prior year. The increase was due primarily to sales of new products to new and existing customers and higher sales of existing product to existing customers, partially offset by a reduction due to a discontinued customer relationship. Net sales from our patent and trademark licensing segment increased 46% during the three months ended March 31, 2021 and decreased 7% during the nine months ended March 31, 2021, when compared to the same period in the prior year. The increase for the three months ended March 31, 2021 was primarily due to an increase in material shipments primarily resulting from higher sales to existing customers and the increase in athletic activities as gyms and athletic facilities began to reopen in accordance with easing COVID-19 guidelines for various cities and states across the USA. This increase was partially offset by lower average sales prices. The decrease in beta-alanine sales during the nine months ended March 31, 2021 was primarily due to decreased material shipments resulting from certain of our former customers discontinuing the use of CarnoSyn® beta-alanine in favor of generic beta-alanine and the negative impact COVID-19 has had on the sports nutrition industry due to continued limitations on athletic activities and gyms in the early portion of our fiscal year. The change in gross profit margin for the three and nine months ended March 31, 2021, was as follows: Three Months Nine Months Ended Ended Contract manufacturing (1) 5.3 % 5.0 % Patent and trademark licensing (2) (1.9 ) (2.9 ) Total change in gross profit margin 3.4 % 2.1 % 1 Private-label contract manufacturing gross profit margin as a percentage of consolidated net sales increased 5.3 percentage points during the three months ended March 31, 2021 and 5.0 percentage points during the nine months ended March 31, 2021, when compared to the comparable prior year periods. The increase in gross profit as a percentage of sales for private-label contract manufacturing is primarily due to a decrease in per unit manufacturing costs due to increased sales as well as a $1.0 million inventory reserve recorded in the three and nine months ended March 31, 2020, with no such comparable reserve in the three and nine months ended March 31, 2021. These decreases were partially offset by unfavorable product and customer sales mix. 2 Patent and trademark licensing gross profit margin as a percentage of consolidated net sales decreased 1.9 percentage points during the three months ended March 31, 2021 and 2.9 percentage points during the nine months ended March 31, 2021, when compared to the comparable prior year period. The decrease in margin contribution during the three and nine months ended March 31, 2021 was primarily due to decreased patent and trademark licensing net sales as a percentage of total consolidated net sales. The decrease during the three months ended March 31, 2021 also include lower average sales prices. Selling, general and administrative expenses decreased $3.0 million, or 42%, during the three months ended March 31, 2021, and decreased $3.6 million, or 22%, during the nine months ended March 31, 2021, as compared to the comparable prior year period. Selling, general, and administrative expenses decreased primarily due to $3.3 million of bad debt expense recorded during the three and nine months ended March 31, 2020 related to a receivable from a former customer with no such comparable reserve during the three and nine months ended March 31, 2021. During the three months ended March 31, 2021, the reduction related to bad debt expense was partially offset by increased compensation expense. During the nine months ended March 31, 2021, the decrease in selling, general, and administrative expenses also included reduced litigation costs associated with our patent and trademark licensing business. 20 Table of Contents Other income, net, decreased $0.3 million during the three months ended March 31, 2021, and decreased $1.5 million during the nine months ended March 31, 2021, when compared to the comparable periods during the prior year. The decreases were primarily due to the unfavorable foreign exchange revaluation activity due to volatility in the Euro and Swiss Franc impacting our balance sheet. Our income tax provision (benefit) increased $0.7 million during the three months ended March 31, 2021, and increased $1.1 million during the nine months ended March 31, 2021. The increase for the three months ended March 31, 2021 was primarily related to an increase in pre-tax income as compared to the three months ended March 31, 2020. The increase for the first nine months of fiscal year 2021 as compared to the comparable period in fiscal year 2020 was primarily related to an increase in pre-tax income, partially offset by a discrete tax benefit of $0.9 million recorded during the nine months ended March 31, 2021. 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 $16.0 million for the nine months ended March 31, 2021 compared to net cash provided by operating activities of $5.2 million in the comparable period in the prior fiscal year. At March 31, 2021, changes in accounts receivable, consisting of amounts due from our private-label contract manufacturing customers and our patent and trademark licensing activities, provided $0.2 million in cash compared to providing $0.3 million of cash during the comparable nine month period in the prior year. The decrease in cash provided by accounts receivable during the nine months ended March 31, 2021 primarily resulted from timing of sales and related collections. Days sales outstanding was 35 days during the nine months ended March 31, 2021 as compared to 47 days for the same period during the prior year. Changes in inventory used $1.1 million in cash during the nine months ended March 31, 2021 compared to using $0.1 million in the comparable prior year period. The change in cash related to inventory during the nine months ended March 31, 2021 was primarily related to the difference in the amount and timing of orders and anticipated sales as compared to same period in the prior year. Changes in accounts payable and accrued liabilities provided $4.1 million in cash during the nine months ended March 31, 2021 compared to providing $1.7 million during the nine months ended March 31, 2020. 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 nine months ended March 31, 2021 was $4.2 million compared to $3.4 million in the comparable period during the prior year. The primary reason for the change was due to increased capital equipment purchases during the nine months ended March 31, 2021 as compared to the nine months ended March 31, 2020. Capital expenditures during fiscal 2021 and fiscal 2020 were primarily for manufacturing equipment used in our Vista, California and Manno, Switzerland facilities. Cash used in financing activities for the nine months ended March 31, 2021 was $14.1 million compared to providing $6.5 million in the comparable period during the prior year. This change is primarily due to $10.0 million in proceeds from our line of credit, withdrawn as a measure to provide our business with liquidity out of an abundance of caution due to the COVID-19 pandemic during the third quarter of fiscal 2020, which was repaid in the third quarter of fiscal 2021. Our stock repurchase activity also increased to $4.3 million in the first nine months of fiscal 2021 as compared to $3.4 million in the first nine months of fiscal 2020. On February 2, 2021 we repaid the entire balance of our $10.0 million credit line with Wells Fargo Bank, N.A. bringing our outstanding debt under the line to zero and increasing our amount available for borrowing to $10.0 million. During the nine months ended March 31, 2021, we were in compliance with all of the financial and other covenants required under the Credit Agreement. Refer to Item 1, Note F., "Debt," in this Quarterly Report, for terms of our Credit Agreement and additional information. As of March 31, 2021, we had no outstanding balances due in connection with our loan facility. As of March 31, 2021, we had $28.1 million in cash and cash equivalents. We believe our available cash, cash equivalents and cash flows from operations will be sufficient to fund our current working capital needs and capital expenditures through the next 12 months. Off-Balance Sheet Arrangements As of March 31, 2021, 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, Note A. 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.