Natural Alternatives International Inc: Form 10-Q for the period ended Sep 30, 2024

The following discussion and analysis are intended to help you understand our financial condition and results of operations for the three months ended September 30, 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 2024 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®, SR CarnoSyn® trademarks, and TriBsyn™ trade name, royalties from license agreements, and potentially additional contract manufacturing opportunities with licensees.

During the three months ended September 30, 2024, our net sales were 2% lower than in the three months ended September 30, 2023. Private-label contract manufacturing sales decreased 5% primarily due to reduced orders from one of our larger customers, partially offset by increased shipments to a majority of our 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 three months ended September 30, 2024 was 37%, and revenue concentration for our largest private-label contract manufacturing customer as a percentage of total net sales for the three months ended September 30, 2023 was 36%. We expect our annualized fiscal 2025 revenue concentration for our largest customer to be slightly lower as compared to our revenue concentration for our largest customer in fiscal 2024.

During the three months ended September 30, 2024, patent and trademark licensing revenue increased 42% to $2.5 million compared to revenue of $1.8 million for the three months ended September 30, 2023. The increase in patent and trademark licensing revenue during the three months ended September 30, 2024, was primarily due to decreased volume rebates and an increase in orders from existing customers.

We continue to invest in research and development for the expansion of our CarnoSyn® product offerings. We believe SR CarnoSyn® may provide a unique opportunity within the growing Wellness and Healthy Aging markets but acceptance of this product offering has been limited as we only offer this product in tablet form. In August 2024, we announced our new product called TriBsyn™. We believe TriBsyn™ may allow us to better penetrate the Wellness and Healthy Aging channel. This groundbreaking new product is a carnosine booster that utilizes CarnoSyn® beta-alanine and other patent-pending technology to increase beta-alanine bioavailability and absorption while effectively eliminating beta-alanine related paresthesia. This product is available as a raw material powder, which allows formulation flexibility for our customers. The elimination of paresthesia while maintaining efficacy of dosage creates a new opportunity to reach segments of the market that to date have been untapped, including older adults, vegetarians, and vegans. We believe our efforts to refine our formulations and product offerings will be positively received and result in significant opportunity for increased sales of our patented products. We are also working on several additional innovations that could lead to new patentable products for CarnoSyn® Brands in the future.

To protect and grow our CarnoSyn® product offerings, we incurred litigation and patent compliance expenses of approximately $0.2 million during the three months ended September 30, 2024 and $0.1 million during the three months ended September 30, 2023. Our legal expense associated with our CarnoSyn® business has remained relatively low as we have no active litigation, 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 and our new TriBsyn™ product, maintain our patent rights, the availability and the cost of the raw material when and in the amounts needed, the ability to 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 2025, 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®, SR CarnoSyn®, and TriBsyn™, beta-alanine products.

We experienced a loss from operations during the three months ended September 30, 2024 primarily due to reduced sales and a change in sales mix from our private-label contract manufacturing segment and increased manufacturing costs. Manufacturing costs were negatively impacted by increased labor, supplies, rent, and freight costs. Although our overall sales forecast for fiscal 2025 includes a significant increase in sales as compared to fiscal 2024, we now anticipate we will experience a net loss in the first half of fiscal 2025, net income in the second half of fiscal 2025, and an overall net loss for the fiscal 2025 year.

During fiscal 2025, 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 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, developing a market for our new TriBsyn™ beta-alanine product, 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.

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 our 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 A of Item 1 in Part I of this report and as disclosed in our 2024 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, our estimates of future sales used to assess the volume rebate 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 months ended September 30 were as follows (dollars in thousands):

Private-label contract manufacturing net sales decreased 5% during the three months ended September 30, 2024 when compared to the same periods in the prior year. The decrease in net sales during the three months ended September 30, 2024 was primarily due to reduced orders from one of our larger customers, partially offset by increased shipments to a majority of other existing customers and shipments to new customers.

Net sales from our patent and trademark licensing segment increased 42% during the three months ended September 30, 2024 when compared to the same period in the prior year. The increase in patent and trademark licensing revenue during the three months ended September 30, 2024 was primarily due to decreased volume rebates, and an increase in orders from existing customers.

The change in gross profit margin for the three months ended September 30, 2024, was as follows:

1 Private-label contract manufacturing gross profit margin as a percentage of consolidated net sales decreased 4.6 percentage points during the three months ended September 30, 2024, when compared to the comparable prior year period. The decrease in gross profit as a percentage of net sales for private-label contract manufacturing during the three months ended September 30, 2024 is primarily related to an unfavorable change in product sales mix and increased manufacturing costs. Manufacturing costs were negatively impacted by increased labor, supplies, rent, and freight costs.

2 Patent and trademark licensing gross profit margin as a percentage of consolidated net sales increased 2.2 percentage points during the three months ended September 30, 2024 when compared to the comparable prior year period. The increase in margin contribution 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.

Selling, general and administrative expenses increased approximately $0.4 million, or 11%, during the three months ended September 30, 2024. The increase compared to the same period in the prior year is primarily related to an increase in compensation and benefits expenses, and legal and professional fees.

Other expense, net increased $0.2 million during the three months ended September 30, 2024 when compared to the comparable period during the prior year. The increase is primarily due to unfavorable foreign currency volatility, and increased interest expense due to usage of our credit facility, partially offset by an increase in interest income.

Our income tax benefit increased during the three-month period ended September 30, 2024 to approximately $0.4 million when compared to our tax benefit of $0.2 million during the three-month period ended September 30, 2023. The increase in our tax benefit during the comparable periods is primarily due to an increase in our loss before income taxes, partially offset by a decrease in the effective tax rate.

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 in operating activities was $3.4 million for the three months ended September 30, 2024, compared to net cash provided by operating activities of $4.5 million in the comparable period during the prior fiscal year.

At September 30, 2024, changes in accounts receivable, consisting of amounts due from our private-label contract manufacturing customers and our patent and trademark licensing activities, used $0.7 million in cash compared to using $2.7 million of cash during the comparable three-month period in the prior year. The decrease in cash used in accounts receivable during the three months ended September 30, 2024, primarily resulted from the timing of sales and related collections. Days sales outstanding was 48 days during the three months ended September 30, 2024, as compared to 23 days for the prior year period.

Changes in inventory used $1.7 million in cash during the three months ended September 30, 2024, compared to providing $6.4 million in the comparable prior year period. The change in cash related to inventory during the three months ended September 30, 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 $2.3 million in cash during the three months ended September 30, 2024, compared to providing $0.2 million during the three months ended September 30, 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 three months ended September 30, 2024, was $0.3 million compared to $1.3 million in the comparable prior year period. The decrease during the three-months ended September 30, 2024 was related to reduced capital expenditures during the first quarter of fiscal 2025 as compared to the first quarter of fiscal 2024.

Cash provided by financing activities for the three months ended September 30, 2024, was $1.9 million compared to using $0.1 million in the comparable prior year period. The change in financing activities is primarily due to increased usage of our credit facility during the three-month period ended September 30, 2024 compared to the three-month period ended September 30, 2023.

As of September 30, 2024, we had $12.5 million of borrowing capacity on our credit facility of which we had outstanding borrowings of $5.4 million. We also owed $9.2 million on a term loan secured by our Carlsbad, California powder processing and storage facility. As of June 30, 2024, we had outstanding borrowings of $3.4 million on our line of credit, and we also owed $9.2 million on our term loan.

On September 30, 2024, we had $10.2 million in cash and cash equivalents of which, $9.9 million was held by NAIE. Overall, we believe our available cash, cash equivalents, potential cash flows from operations, and our line of credit will be sufficient to fund our current working capital needs and capital expenditures through at least the next 12 months. On September 30, 2024, we were not in compliance with the financial covenants related to net income requirements associated with the fourth amendment to our credit facility. In the next two quarters of fiscal 2025, we anticipate we will not be in compliance with the financial covenants associated with the fourth amendment to our credit facility related to net income requirements and the fixed charge coverage ratio. We have advised the lender and are currently negotiating a potential revised credit facility or waiver. Wells Fargo has advised us that while they consider our request for a waiver or modification, they will not be exercising any of their options pursuant to the Credit Agreement, but they are reserving all of their rights. There can be no assurance we will be able to successfully negotiate a revised credit facility, or what the differences in amount, cost and other factors may be. Please see Note F, Item 1 of Part I of this report for terms of our current modified line of credit.

Off-Balance Sheet Arrangements

As of September 30, 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 Part I 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 September 30, 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 September 30, 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 September 30, 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 2024 Annual Report, as well as the other information in our 2024 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.