Natural Alternatives International Inc: Form 10-Q for the period ended Mar 31, 2024

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, 2024. 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 2023 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, 2024, our net sales were 29% lower than in the nine months ended March 31, 2023. Private-label contract manufacturing sales decreased 31% primarily due to reduced orders from several of our larger customers associated with their efforts to reduce excess on-hand inventories, partially offset by increased shipments from other existing customers and shipments to new customers. Revenue concentration for our largest private-label contract manufacturing customer as a percentage of total net sales for the nine months ended March 31, 2024, was 42%, 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, 2023, was 40%. We expect our annualized fiscal 2024 revenue concentration for our largest customer to be flat to slightly higher as compared to our revenue concentration for our largest customer in fiscal 2023.

During the nine months ended March 31, 2024, patent and trademark licensing revenue increased 28% to $6.6 million, compared to revenue of $5.2 million for the nine months ended March 31, 2023. The increase in patent and trademark licensing revenue during the nine months ended March 31, 2024, was primarily due to an increase in orders from existing customers and increased royalty income.

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 $0.2 million during the first nine months of both fiscal 2024 and fiscal 2023. Our legal expense associated with our CarnoSyn® business has remained relatively low as we have not had any active litigation in recent periods, and our 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 or expand 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 2024, 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 and nine months ended March 31, 2024. This was primarily due to a slowdown in sales across our private-label contract manufacturing segment. On August 16, 2023, we announced the temporary closure of our high-speed powder processing facility in Carlsbad, California due to excess inventory on hand at one of our largest customers and their efforts to rebalance supply and demand. On April 2, 2024, we announced we will be reopening this facility in May 2024.

Based on our current overall sales forecast, we anticipate we will experience a net loss in the fourth quarter of fiscal 2024 and an overall net loss for fiscal 2024.

During fiscal 2024, we 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, 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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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 2023 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 26% during the three months ended March 31, 2024, and 31% for the nine months ended March 31, 2024, when compared to the same periods in the prior year. The decrease in net sales during the three and nine months ended March 31, 2024, was primarily due to reduced orders from several of our larger customers associated with their efforts to reduce excess on-hand inventories, partially offset by increased shipments from other existing customers and shipments to new customers.

Net sales from our patent and trademark licensing segment increased 13% during the three months ended March 31, 2024, and 28% during the nine months ended March 31, 2024, when compared to the same periods in the prior year. The increase in patent and trademark licensing revenue during the three months ended March 31, 2024, was primarily due to increased royalty income and favorable volume rebate activity. The increase during the nine months ended March 31, 2024, was primarily due to an increase in orders from existing customers and increased royalty income.

The change in gross profit margin for the three and nine months ended March 31, 2024, was as follows:

1 Private-label contract manufacturing gross profit margin as a percentage of consolidated net sales increased 1.1 percentage points during the three months ended March 31, 2024, when compared to the comparable prior year period. The increase in gross profit as a percentage of net sales for private-label contract manufacturing during the three months ended March 31, 2024, is primarily related to incremental labor and overhead costs associated with the opening of our new manufacturing facility in Carlsbad, California in the fourth quarter of fiscal 2023 and $300,000 of workforce restructuring costs recorded in the third quarter of 2023 while the third quarter of fiscal 2024 did not include these costs. These favorable differences were partially offset by lower sales during the current quarter, unfavorable sales mix and increased labor rates, rent and utility costs. For the nine months ended March 31, 2024, contract manufacturing gross profit margin as a percentage of consolidated net sales decreased 6.6 percentage points as compared to the comparable prior year period, primarily due to lower sales, unfavorable sales mix, and increased per unit manufacturing costs. Per unit manufacturing costs were negatively impacted by reduced sales, carrying costs of our Carlsbad, California manufacturing plant that was closed beginning in October of fiscal 2024, increased costs associated with higher labor rates, and increased rent and utility costs.

2 Patent and trademark licensing gross profit margin as a percentage of consolidated net sales increased 2.3 percentage points during the three months ended March 31, 2024, and 2.1 percentage points for the nine months ended March 31, 2024, when compared to the comparable prior year periods. The increase in margin contribution during the third quarter of fiscal 2024 was primarily due to increased patent and trademark licensing net sales in total and 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. For the nine months ended March 31, 2024, patent and trademark licensing margin contribution increased when compared to the comparable period in the prior fiscal year, primarily due to increased net sales both in total and as a percentage of total consolidated net sales.

Selling, general and administrative expenses remained consistent at $3.9 million during the three ended March 31, 2024, and increased approximately $0.1 million during the first nine months of fiscal 2024 as compared to the same periods in the prior fiscal year.

Other expense decreased $0.3 million during the three months ended March 31, 2024, and decreased $0.1 million during the nine months ended March 31, 2024, when compared to the comparable periods during the prior year. The decrease during the third quarter is primarily associated with reduced interest expense due to less use of our credit facility and reduced foreign currency volatility. The decrease during the nine months ended March 31, 2024 is primarily associated with increased interest income and reduced interest expense partially offset by unfavorable foreign currency rate fluctuations.

Our income tax benefit decreased during the third quarter of fiscal 2024 as compared to the third quarter of fiscal 2023 primarily due to a smaller pre-tax loss. During the first nine months of fiscal 2024, we recorded a $1.3 million tax benefit due to a pre-tax loss during the period while the same period in fiscal 2023 included tax expense of $0.3 million due to pre-tax income recorded during that period.

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 provided by operating activities was $1.2 million for the nine months ended March 31, 2024, compared to net cash used by operating activities of $0.5 million in the comparable period during the prior fiscal year.

At March 31, 2024, changes in accounts receivable, consisting of amounts due from our private-label contract manufacturing customers and our patent and trademark licensing activities, used $4.2 million in cash compared to providing $9.8 million of cash during the comparable nine month period in the prior year. The increase in cash used in accounts receivable during the nine months ended March 31, 2024, primarily resulted from the timing of sales and related collections. Days sales outstanding was 30 days during the nine months ended March 31, 2024, as compared to 29 days for the prior year period.

Changes in inventory provided $8.6 million in cash during the nine months ended March 31, 2024, compared to using $6.8 million in the comparable prior year period. The change in cash related to inventory during the nine months ended March 31, 2024, 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 $0.7 million in cash during the nine months ended March 31, 2024, compared to using $6.2 million during the nine months ended March 31, 2023. 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, 2024, was $2.0 million compared to $13.2 million in the comparable prior year period. The increase during the nine months ended March 31, 2023, was related to capital purchases associated with retrofitting our new powder manufacturing and warehouse facility in Carlsbad, California. Construction on this new facility was completed during the fourth quarter of fiscal 2023. Capital equipment purchased during the first nine months of fiscal 2024 was primarily for manufacturing equipment and solar power generation equipment for our Vista and Carlsbad, California production facilities.

Cash used by financing activities for the nine months ended March 31, 2024, was $0.4 million compared to providing $7.4 million in the comparable prior year period. The change in financing activities is primarily due to reduced stock repurchase activity and no outstanding balance on our credit facility during the first nine months of fiscal 2024 compared to $9.1 million in borrowings against our credit facility during the first nine months of fiscal 2023.

At March 31, 2024, we had no outstanding balances due on our line of credit with $6.4 million available, and we owed $9.3 million on the term loan borrowed as part of the purchase of our Carlsbad, California manufacturing facility in August 2021. At June 30, 2023, we also had no outstanding balances due and $20.0 million available in connection with our line of credit. On March 31, 2024, we were in compliance with the financial covenants as modified by the Fourth Amendment to our credit facility.

As of March 31, 2024, we had $12.4 million in cash and cash equivalents. Of these amounts, $12.1 million of cash and cash equivalents were held by NAIE. Overall, we believe our available cash, cash equivalents, potential cash flows from operations, and our credit facility 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 of March 31, 2024, 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 that would be 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, 2024. 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, 2024.

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, 2024 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 2023 Annual Report, as well as the other information in our 2023 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.

Geopolitical Instability and Conflict in the Region

Our business operations may be adversely affected by ongoing geopolitical instability including conflicts in Ukraine and the Middle East. These regional tensions may lead to increased political, economic, and security risks, including disruptions in the global supply chain, fluctuations in energy prices, and financial market volatility. Such uncertainties could impact our ability to operate efficiently, access markets, and secure resources. Our financial performance and results may be influenced by these external factors, and we cannot predict the future impact of geopolitical events on our business with certainty.