Business context and reporting period
Natural Alternatives International, Inc. (NAI) filed this unaudited Form 10-Q for the quarter and six months ended December 31, 2015, its fiscal 2016 second quarter. NAI principally manufactures nutritional supplements for customers under private labels and also sells beta-alanine and licenses related CarnoSyn patents and trademarks. The company discontinued its Pathway to Healing branded product line; the wind-down was substantially complete by December 31, 2014.
Financial performance
Amounts below are in millions of dollars except per-share data. Comparisons are with the corresponding prior-year periods.
| Metric | Three months ended Dec. 31, 2015 | Three months ended Dec. 31, 2014 | Six months ended Dec. 31, 2015 | Six months ended Dec. 31, 2014 |
|---|---|---|---|---|
| Net sales | $26.911 | $18.618 | $48.496 | $37.313 |
| Gross profit | $5.669 | $3.977 | $10.402 | $6.774 |
| Gross margin | 21.1% | 21.4% | 21.4% | 18.2% |
| Operating income | $2.735 | $1.381 | $4.463 | $1.950 |
| Net income | $1.868 | $1.081 | $3.081 | $1.568 |
| Diluted EPS | $0.28 | $0.16 | $0.46 | $0.23 |
- Quarterly sales increased 45%, operating income 98%, and net income 73%. Six-month sales rose 30%, operating income 129%, and net income 96%.
- Quarterly operating margin improved to 10.2% from 7.4%; six-month operating margin improved to 9.2% from 5.2%. SG&A rose 13% in the quarter and 23% over six months, primarily from compensation, litigation and patent-compliance costs, and CarnoSyn sales and marketing.
- Private-label manufacturing sales were $21.619 million for the quarter, up 29%, and $37.884 million for six months, up 11%. Patent and trademark licensing segment sales were $5.292 million and $10.612 million, respectively, compared with $1.458 million and $2.419 million. Branded-product sales were zero after discontinuation.
- NAI began direct beta-alanine sales and distribution on April 1, 2015, after its CSI agreement expired. The filing attributes the sharp increase in the licensing segment principally to direct raw-material sales; it reports $10.6 million of beta-alanine raw-material sales for the six-month period, versus none in the prior-year period.
- Quarterly gross margin declined 0.3 percentage point, while six-month gross margin increased 3.2 points. Management cited product and material mix as a headwind, partly offset by improved manufacturing throughput, lower per-unit costs, and increased contribution from beta-alanine.
Cash, liquidity and balance sheet
- At December 31, 2015, cash and cash equivalents were $22.626 million, up from $18.551 million at June 30, 2015. Current assets were $50.540 million and current liabilities $12.676 million, giving a current ratio of approximately 4.0.
- Operating cash flow for the six months was $5.129 million, versus $1.971 million a year earlier. Inventory growth used $5.657 million of cash, mainly to support direct beta-alanine sales and increased manufacturing demand. Accounts receivable provided $2.322 million.
- Investing activities used $0.842 million; capital expenditures were $1.410 million, partly offset by $0.568 million in equipment-sale proceeds. Financing activities used $0.212 million for share repurchases.
- NAI reported no consolidated debt outstanding at December 31, 2015. It reported $5.5 million available under credit facilities at that date. A February 1, 2016 post-quarter agreement replaced the prior facility with a $10 million Wells Fargo line, secured by specified company assets; no amount was drawn when disclosed. The new line includes financial covenants.
- Management stated that cash, available credit and expected operating cash flow should fund working capital and capital expenditures for at least the next 12 months.
Changes, outlook and risks
- Management’s stated priorities for the remainder of fiscal 2016 are to grow contract-manufacturing relationships, expand commercialization of the beta-alanine patent estate, protect proprietary rights, improve operating efficiency and manage costs. The filing gives no numerical earnings or revenue guidance.
- Foreign exchange was a notable factor: the weighted-average euro exchange rate applied to sales fell to 1.11 EUR/USD in the first half from 1.35 a year earlier. Quarterly other expense included a $96,000 foreign-exchange loss; the six-month loss was $104,000. Forward contracts had a $322,000 net asset value at December 31, with approximately $15.3 million notional value, and were expected to settle through August 2016.
- Customer concentration remains material. The filing warns that loss of a major customer could adversely affect results. Its six-month customer table shows the two largest customers at 49% and 17% of private-label contract-manufacturing sales, while the narrative says the historically two largest customers represented 59%; investors should reconcile this apparent discrepancy.
- NAI relies on a limited number of suppliers for certain raw materials, including beta-alanine. Availability and supply interruptions could affect sales and profitability.
- Patent litigation and re-examinations create uncertainty around the CarnoSyn business. The PTAB affirmed rejection of claims in the ’381 patent in July 2015; NAI’s rehearing request was pending. The ’422 patent appeal was pending, with a hearing scheduled for March 16, 2016. Related consolidated litigation remained pending. NAI also had a separate pending lawsuit against Creative Compounds, Inc. The filing says an adverse patent outcome could materially harm the business; litigation expenses were approximately $779,000 for the first half, up from $524,000.
- NAI had agreements to sell its San Marcos headquarters and potentially purchase a building in Carlsbad. Significant contingencies remained, so completion, timing, sale proceeds and purchase price were uncertain.
- The company reported that its disclosure controls were effective as of December 31, 2015, and that no material change in internal control over financial reporting occurred during the quarter.
Important facts for investors to verify
- Reconcile the filing’s customer-concentration narrative (59% for the two largest customers) with its table (49% plus 17% of contract-manufacturing sales for the six months).
- Track the contribution, margins and working-capital needs of direct beta-alanine sales, including inventory levels and supplier availability.
- Monitor the ’381 and ’422 patent proceedings and related litigation, including potential effects on the company’s patent rights and litigation costs.
- Confirm terms, covenant compliance and availability under the new $10 million credit line, and progress on the headquarters sale and proposed purchase.
- Assess whether revenue growth and operating improvement persist despite customer concentration, euro movements, mix changes and higher SG&A.