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 nine months endedMarch 31, 2020 . 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 have filed and will 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 with 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.
Impact of COVID-19 on Our Business
OnMarch 11, 2020 , theWorld 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. The Company's facilities, located both inthe United States andEurope continue to operate as an essential and critical manufacturer in accordance with federal, state, and local regulations, however, there can be no assurance our facilities will continue to operate without interruption. Factors that derive from the COVID-19 and the accompanying 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 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.
As a measure to provide our business with liquidity, and out of an abundance of caution, we withdrew$10 million from our credit facility with Wells Fargo. We will continue to actively monitor the situation and may take further actions that 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 are hopeful we will be able to remain operational and our working capital will be sufficient for us to remain operational as the longer term consequences of this pandemic become known.
Analysis of Financial Condition
During the first nine months of fiscal 2020, our net sales were 22% lower than in the first nine months of fiscal 2019. Private-label contract manufacturing sales decreased 22% 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 38%. Revenue concentration risk for our largest private-label contract manufacturing customer as a percentage of our total net sales decreased from 54% to 43% for the nine months endedMarch 31, 2020 compared to the nine months endedMarch 31, 2019 . We expect our annualized fiscal 2020 revenue concentration for this customer to be lower than fiscal 2019. EffectiveMarch 31, 2020 , we terminated our ongoing relationship with one private-label contract manufacturing customer, Kaged Muscle. We are working with this former customer to deliver the remaining products we completed, and to assist them with their obligations to us, transition to a replacement manufacturer, and the transfer of inventory items we hold specific to this customer. Due to uncertainty regarding the future operations of this former customer as ofMarch 31, 2020 , we reserved 100% of their outstanding accounts receivable balance and a majority of the inventory we hold for their products, for a total reserve of$4.3 million . During the first nine months of fiscal 2020, CarnoSyn® beta-alanine revenue decreased 24% to$10.3 million , compared to revenue of$13.5 million for the first nine 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. 15
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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 in the future. To protect our CarnoSyn® business and our patents, trademarks and other intellectual property, we incurred litigation and patent compliance expenses of approximately$1.7 million during the first nine months of fiscal 2020 as compared to$1.6 million 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. 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. We are also closely monitoring the impact of the COVID-19 pandemic but we cannot reasonably estimate the length of time or severity of the pandemic and cannot currently estimate the impact this pandemic may have on our consolidated financial results for the remainder of fiscal 2020 and beyond.
During the remainder of fiscal 2020, 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.
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. Results of Operations
The results of our operations for the three and nine months ended
Three Months Ended Nine Months Ended
March 31, March 31,
2020 2019 % Change 2020 2019 % ChangePrivate label contract manufacturing$ 22,650 $ 31,758 (29 )%$ 73,490 $ 94,505 (22 )% Patent and trademark licensing 2,832 3,697 (23 )% 10,290 13,525 (24 )% Total net sales 25,482 35,455 (28 )% 83,780 108,030 (22 )% Cost of goods sold 22,588 29,128 (22 )% 71,441 88,104 (19 )% Gross profit 2,894 6,327 (54 )% 12,339 19,926 (38 )% Gross profit % 11.4 % 17.8 % 14.7 % 18.4 % Selling, general and administrative expenses 7,117 4,492 58 % 15,919 13,160 21 % % of net sales 27.9 % 12.7 % 19.0 % 12.2 % (Loss) income from operations (4,223 ) 1,835 (330 )% (3,580 ) 6,766 (153 )% % of net sales (16.6 )% 5.2 % (4.3 )% 6.3 % Total other (loss) income (48 ) 622 (108 )% 5 1,662 (100 )% (Loss) income before income taxes (4,271 ) 2,457 (274 )% (3,575 ) 8,428 (142 )% % of net sales (16.8 )% 6.9 % (4.3 )% 7.8 % Provision for income taxes (256 ) 463 (155 )% (132 ) 1,694 (108 )% Net (loss) income$ (4,015 ) $ 1,994 (301 )%$ (3,443 ) $ 6,734 (151 )% % of net sales (15.8 %) 5.6 % (4.1 )% 6.2 % Private-label contract manufacturing net sales decreased 29% during the three months endedMarch 31, 2020 and 22% during the nine months endedMarch 31, 2020 , when compared to the same periods in the prior year. The decrease was due primarily to lower sales to our largest customer. 16
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Net sales from our patent and trademark licensing segment decreased 23% during the three months endedMarch 31, 2020 and decreased 24% during the nine months endedMarch 31, 2020 , when compared to the same periods in the prior year. The decrease in beta-alanine sales during the three and nine months endedMarch 31, 2020 was primarily due to decreased material shipments resulting from market and seasonal factors and lower average sales prices. We believe this decline was due in part 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 nine months endedMarch 31, 2020 , was as follows: Three Months Nine Months Ended Ended Contract manufacturing(1) (8.0 %) (3.5 %) Patent and trademark licensing(2) 1.6 (0.2 ) Total change in gross profit margin (6.4 %) (3.7 %)
1 Private-label contract manufacturing gross profit margin as a percentage of
consolidated net sales decreased 8.0 percentage points during the three months
ended
ended
decrease in gross profit as a percentage of consolidated net sales is primarily
due to a
former customer and 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 nine 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 1.6 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 0.2 percentage points during the
nine 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 58% for the three months endedMarch 31, 2020 when compared to the comparable prior year period. The increase was primarily due to$3.3 million of bad debt expense recorded related to the receivable from a former customer, partially offset by a decrease in advertising, consulting, and litigation. Selling, general and administrative expenses increased by 21% for the nine months endedMarch 31, 2020 when compared to the comparable prior year periods. The increase was primarily due to$3.3 million of bad debt expense recorded related to the receivable from a former customer. This bad debt expense was partially offset by a decrease in compensation and consulting. Other income, net, decreased$670,000 during the three months endedMarch 31, 2020 , and decreased$1.7 million during the nine months endedMarch 31, 2020 , when compared to the comparable prior year periods. The decrease was primarily due to the exclusion of the amortization of forward points from cash flow hedge instruments during the three and nine months endedMarch 31, 2020 as compared to including$368,000 and$1.3 million , respectively, 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. The remaining portion of the decrease primarily related to foreign currency exchange losses associated with fluctuations in various foreign exchange rates used to revalue our balance sheet.
Our income tax expense decreased
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$5.2 million for the nine months endedMarch 31, 2020 compared to net cash provided by operating activities of$7.6 million in the comparable period in the prior fiscal year. AtMarch 31, 2020 , changes in accounts receivable, consisting of amounts due from our private-label contract manufacturing customers and our patent and trademark licensing activities, provided$303,000 in cash compared to using$2.2 million of cash during the comparable nine month period in the prior fiscal year. The decrease in cash provided by accounts receivable during the nine months endedMarch 31, 2020 primarily resulted from timing of sales and related collections. Days sales outstanding was 47 days during the nine months endedMarch 31, 2020 as compared to 40 days for the prior year period. 17
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Changes in inventory used$108,000 in cash during the nine months endedMarch 31, 2020 compared to using$3.5 million in the comparable prior year period. The change in cash related to inventory during the nine months endedMarch 31, 2020 was primarily related to the timing of sales and new order activity and includes a$1.0 million reserve associated with a former customer recorded during the nine months endedMarch 31, 2020 . Changes in accounts payable and accrued liabilities provided$1.7 million in cash during the nine months endedMarch 31, 2020 compared to providing$4.1 million during the nine months endedMarch 31, 2019 . 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 endedMarch 31, 2020 was$3.4 million compared to$2.6 million in the comparable prior year period. The primary reason for the change was due the collection of a note receivable during the nine months endedMarch 31, 2019 , as well as a decrease in capital equipment purchases during the nine months endedMarch 31, 2020 as compared to the comparable prior year period. Cash provided in financing activities for the nine months endedMarch 31, 2020 was$6.5 million compared to$903,000 used in the comparable prior year period. 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, offset by increased repurchases of our stock. AtMarch 31, 2020 we had$10.0 million due in connection with our loan facility. As ofJune 30, 2019 , we had no outstanding balances due in connection with our loan facility. During the nine months endingMarch 31, 2020 , 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 of
Off-Balance Sheet Arrangements
As ofMarch 31, 2020 , 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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