Natural Alternatives International Inc: Form 10-Q for the period ended Mar 31, 2023

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, 2023. 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 2022 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 nine months ended March 31, 2023, our net sales were 0.3% lower than in the nine months ended March 31, 2022. Private-label contract manufacturing sales increased 7.7% primarily due to higher sales to our largest customer, partially offset by decreased sales to other customers and lower average exchange rates applied to sales denominated in Euro as compared to the prior year period. Our foreign exchange rates as applied to sales denominated in Euro decreased to a weighted average of 1.13 EUR/USD in the nine months ended March 31, 2023 compared to a weighted average of 1.18 EUR/USD during the nine months ended March 31, 2022. Revenue concentration for our largest private-label contract manufacturing customer as a percentage of total net sales for the nine months ended March 31, 2023 was 40%, and revenue concentration for our largest private-label contract manufacturing customer as a percentage of total net sales for the nine months ended March 31, 2022 was 34%. We expect our annualized fiscal 2023 revenue concentration for our largest customer to increase compared to our revenue concentration for our largest customer in fiscal 2022.

During the nine months ended March 31, 2023, patent and trademark licensing revenue decreased 62.0% to $5.2 million, compared to revenue of $13.5 million for the nine months ended March 31, 2022. The decrease in patent and trademark licensing revenue during the nine months ended March 31, 2023 was primarily due to a decrease in orders from existing customers as a result of market and inflationary factors along with a general slowdown in the Sports Nutrition sales channel. Included in the market factors is the fact that the nine months ended March 31, 2022 benefited from a ramp up of Sports Nutrition sales activity due to easing COVID restrictions on athletic activities with no corresponding activity in the nine months ended March 31, 2023.

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 recent efforts to refine our formulations and product offerings will be positively received and result in significant opportunity for increased SR CarnoSyn® sales.

To protect our CarnoSyn® business and our patents, trademarks and other intellectual property, we incurred legal expenses of approximately $0.1 million during the first nine months of fiscal 2023 as compared to $0.3 million during the comparable period in fiscal 2022. Our legal expense associated with our CarnoSyn® business has remained low as we have no active litigation and the current run-rate of expenses is primarily related to maintenance of our patent and trademark estate. 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 continued compliance by third parties with our license agreements and our patent, trademark and other intellectual property rights. During the remainder of fiscal 2023, 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.

We experienced a loss from operations during the three months ended March 31, 2023. This was primarily due to a slowdown in sales across both of our operating segments. While we previously anticipated a slight decrease in fiscal 2023 consolidated net sales compared to fiscal 2022, sales decreased further than expected during the third quarter of fiscal 2023 as compared to the same quarter in the prior year. We expect our sales during the fourth quarter of fiscal 2023 will increase as compared to the third quarter of fiscal 2023. The primary driver for our sales decline relates to excess on-hand inventory levels for several of our key customers associated with softening consumer demand. In addition, the majority of our customers maintained larger inventory balances during the previous twelve months related to supply constraints and have now begun to release these excess inventory positions associated with improving supply chain conditions. We believe this decline in near term demand from our customer base is consistent with the overall economic trends in our industry.

Based on our current sales order volumes and forecasts we have received from our customers, we now anticipate our fiscal 2023 consolidated net sales will decrease between 10% to 12% compared to fiscal 2022. We also anticipate we will generate net operating income for our fourth quarter of fiscal 2023 and for the fiscal year ended June 30, 2023. Changes in sales mix, unfavorable foreign exchange rates, and inflationary factors including increased operational costs, increased labor rates, raw material, freight and supply chain costs are anticipated to negatively impact our near-term financial results.

In March 2023, due to reduced orders and forecasts from our customers, we implemented a workforce restructuring plan by eliminating 32 employee positions, representing approximately 9% of our global workforce. The reduction in workforce impacted all of our global locations and is expected to result in reduced operating expenses of approximately $1.8 million on an annualized basis. During the quarter ended March 31, 2023, we recognized restructuring charges of $449,000, primarily related to severance payments associated with this workforce restructuring plan.

We continue to evaluate further cost reduction opportunities, including working with both suppliers and customers, to mitigate the impact of these order reductions and higher operational costs on our financial results. There can be no assurance our expectations will result in the currently anticipated net sales or financial results.

During the remainder of fiscal year 2023, 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;
• Beginning commercial production in our new high-volume powder blending and packaging facility, which was fully opened in April 2023;
• 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.

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Impact of COVID-19 on Our Business

The COVID-19 pandemic has resulted, and may continue to result, in significant economic disruption and has and may continue to have some effect on our business. Our facilities, located both in the United States and Europe, maintained operations throughout the duration of the COVID-19 pandemic, however, there can be no assurance our facilities will continue to operate without interruption.

We will continue to 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.

Discussion of Critical Accounting Estimates

We have identified the following as our most critical accounting estimates, which are those that are most important to the portrayal of the Company’s financial condition and results, and that require management’s most subjective and complex judgments. Information regarding our other significant accounting estimates and policies is disclosed in Note 1 of Item 1 of this report and as disclosed in the 2022 Annual Report.

Revenue Recognition — Revenue is measured as the net amount of consideration expected to be received in exchange for fulfilling one or more performance obligations. For certain contracts with volume rebates and discounts, our estimates of future sales used to assess the volume rebate and discount estimates are subject to a high degree of judgement and may differ from actual sales due to, among other things, changes in customer orders and raw material availability.

Results of Operations

The results of our operations for the three and nine months ended March 31 were as follows (dollars in thousands):

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Private-label contract manufacturing net sales decreased 19% during the three months ended March 31, 2023, and increased 8% for the nine months ended March 31, 2023, when compared to the same periods in the prior year. The decrease in sales during the three months ended March 31, 2023 was primarily due to decreased sales to two of our three largest customers, partially offset by increased sales to our largest customer. The decline in sales to two of our largest customers is due to reduced orders due to their efforts to reduce excess on-hand inventory. Sales were also negatively impacted by Euro to USD foreign exchange rates. Our foreign exchange rates as applied to sales denominated in Euro decreased to a weighted average of 1.14 EUR/USD in the three months ended March 31, 2023 compared to a weighted average of 1.17 EUR/USD during the three months ended March 31, 2022.

The increase in sales during the nine months ended March 31, 2023 was primarily due to increased sales to our largest customer, partially offset by decreased sales to other customers and unfavorable Euro to USD foreign exchange rates. Our foreign exchange rates as applied to sales denominated in Euro decreased to a weighted average of 1.13 EUR/USD in the nine months ended March 31, 2023 compared to a weighted average of 1.18 EUR/USD during the nine months ended March 31, 2022.

Net sales from our patent and trademark licensing segment decreased 51% during the three months ended March 31, 2023, and 62% for the nine months ended March 31, 2023, when compared to the same periods in the prior year. The decrease in patent and trademark licensing revenue during the three and nine months ended March 31, 2023 was primarily due to a decrease in orders from existing customers as a result of market and inflationary factors along with a general slowdown in the Sports Nutrition sales channel. Included in the market factors is the fact that the three and nine months ended March 31, 2022 benefited from a ramp up of Sports Nutrition sales activity due to easing COVID restrictions on athletic activities with no corresponding activity in the three and nine months ended March 31, 2023.

The change in gross profit margin for the three and nine months ended March 31, 2023, was as follows:

1 Private-label contract manufacturing gross profit margin as a percentage of consolidated net sales decreased 11.5 percentage points during the three months ended March 31, 2023 when compared to the comparable prior year periods. The decrease in gross profit as a percentage of sales for private-label contract manufacturing during the three months ended March 31, 2023 is primarily due to lower sales and unfavorable sales mix, increased costs related to labor, utilities, operating supplies, freight and other costs resulting in an increase in per-unit manufacturing costs. Included in the increased labor costs for the three months ended March 31, 2023 is a restructuring charge of $300,000 due to a workforce restructuring plan completed in March of 2023. For the nine months ended March 31, 2023, the contract manufacturing gross profit margin as a percentage of consolidated net sales decreased 3.6 percentage points as compared to the comparable prior year period, primarily due to an increase in per-unit manufacturing costs driven by increased labor costs and other overhead costs, including operating supplies, utilities, freight, and depreciation. Included in the increased labor costs for the nine months ended March 31, 2023 is a restructuring charge of $300,000.

2 Patent and trademark licensing gross profit margin as a percentage of consolidated net sales decreased 1.7 percentage points during the three months ended March 31, 2023 and 4.2 percentage points for the nine months ended March 31, 2023 when compared to the comparable prior year periods. The decrease in margin contribution was primarily due to decreased patent and trademark licensing net sales as a percentage of total consolidated net sales, as patent and trademark licensing historically provides higher profit margins than our private-label contract manufacturing business. The nine months ended March 31, 2022 also included a favorable change in our estimates of certain volume rebate programs while the nine months ended March 31, 2023 included an unfavorable change in our estimates of certain volume rebate programs.

Selling, general and administrative expenses decreased $0.3 million, or 6%, during the three months ended March 31, 2023 and $0.9 million, or 7%, as compared to the comparable prior year periods. The decrease during the three months ended March 31, 2023 as compared to the same period in the prior fiscal year is primarily related to a partial recovery of accounts receivable that had been reserved as uncollectible in a prior fiscal year and lower legal expenses. The decrease during the nine months ended March 31, 2023 as compared to the same period in the prior fiscal year is primarily related to a partial recovery of accounts receivable that had been reserved for in a prior fiscal year and lower legal expenses.

Other expense increased $0.2 million during the three months ended March 31, 2023 and $0.6 million during the nine months ended March 31, 2023 when compared to the comparable periods during the prior year. The increase in both the three and nine month periods is primarily associated with increased expenses related to our CHF balance sheet hedge and interest expense related to usage of our line of credit.

Our income tax (benefit) expense decreased $1.1 million to a benefit of $0.4 million for the three months ended March 31, 2023 when compared to the same period in fiscal 2022. The change in tax rate is primarily due to a pre-tax loss in the third quarter of fiscal 2023 as compared to pre-tax income in the third quarter of fiscal 2022. There was also a difference in the effective tax rate recorded in the third quarter of fiscal 2023 as compared to the same period in fiscal 2022 due to foreign income tax rate differential, the recognition of a prior year bad debt reserve as a tax loss in the current year, the timing of other forecasted permanent tax items, and discrete tax items related to employee stock vesting and return-to-provision adjustments.

Our income tax expense decreased $1.8 million for the nine months ended March 31, 2023 when compared to the same period in 2022. The decrease in income tax expense for the nine months was primarily related to lower pre-tax income partially offset by an unfavorable effective tax rate due primarily to foreign income tax rate differential, the recognition of a prior year bad debt reserve as a tax loss in the current year, the timing of other forecasted permanent tax items, and discrete tax items related to employee stock vesting and return-to-provision adjustments.

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 facilities. Net cash used by operating activities was $0.5 million for the nine months ended March 31, 2023 compared to net cash provided by operating activities of $3.1 million in the comparable period during the prior fiscal year.

At March 31, 2023, changes in accounts receivable, consisting of amounts due from our private-label contract manufacturing customers and our patent and trademark licensing activities, provided $9.8 million in cash compared to providing $1.2 million of cash during the comparable nine month period in the prior year. The increase in cash provided by accounts receivable during the nine months ended March 31, 2023 primarily resulted from the timing of sales and related collections and a partial recovery of one account receivable that had been reserved as uncollectible in a prior fiscal year. Days sales outstanding was 29 days during the nine months ended March 31, 2023 as compared to 40 days for the prior year period.

Changes in inventory used $6.8 million in cash during the nine months ended March 31, 2023 compared to using $9.8 million in the comparable prior year period. The change in cash related to inventory during the nine months ended March 31, 2023 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 used $6.2 million in cash during the nine months ended March 31, 2023 compared to providing $4.4 million during the nine months ended March 31, 2022. 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 in the nine months ended March 31, 2023 was $13.2 million compared to $21.4 million in the comparable prior year period. The primary reason for the change was due to the purchase of a new manufacturing and warehouse facility in Carlsbad, CA during the nine months ended March 31, 2022 while the nine months ended March 31, 2023 included capital improvement costs and equipment purchases associated with the on-going project to improve the new facility to become a high capacity powder processing and storage facility.

Cash provided by financing activities for the nine months ended March 31, 2023, was $7.4 million, compared to $4.8 million provided in the comparable prior year period. The difference is primarily due to higher treasury stock repurchase activity during the nine months ended March 31, 2022.

At March 31, 2023, we had $9.6 million outstanding under the Term Note we used to purchase our new Carlsbad, California warehouse and manufacturing facility in August 2021. We had $9.1 million outstanding on our working capital line of credit with Wells Fargo Bank, with $10.9 million remaining available for borrowing. During the nine months ended March 31, 2023, we were in compliance with all of the financial and other covenants required under the Credit Agreement for this credit line. Refer to Item 1, Note F., "Debt," in this Quarterly Report, for the terms of this Credit Agreement.

As of March 31, 2023, we had $15.6 million in cash and cash equivalents. We believe our available cash, cash equivalents, credit facility and potential cash flows from operations will be sufficient to fund our current working capital needs, capital expenditures, and minimum debt and interest payments through the next 12 months. Our planned improvements to our powder blending, packaging and storage facility we purchased in August 2021 were substantially complete as of March 31, 2023 and we anticipate capital expenditures to be minimal for the remainder of the fiscal year.

Off-Balance Sheet Arrangements

As of March 31, 2023, 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.

We maintain certain disclosure controls and procedures as defined under the Securities Exchange Act of 1934. They are designed to help ensure that material information: (1) is gathered and communicated to our management, including our principal executive and financial officers, in a manner that allows for timely decisions regarding required disclosures; and (2) recorded, processed, summarized, reported and filed with the SEC as required under the Securities Exchange Act of 1934 and within the time periods specified by the SEC.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer (principal financial and accounting officer), evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2023. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective for their intended purpose as of March 31, 2023.

There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarterly period ended March 31, 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

When evaluating our business and future prospects you should carefully consider the risks described under Item 1A of our 2022 Annual Report, as well as the other information in our 2022 Annual Report, this Report and other reports and documents we file with the SEC. If any of the identified risks actually occur, our business, financial condition and results of operations could be seriously harmed. In that event, the market price of our common stock could decline, and you could lose all or a portion of the value of your investment in our common stock.