Natural Alternatives International, Inc. — Q2 FY2012 Form 10-Q
Reporting period: Three and six months ended December 31, 2011. Dollar amounts below are in millions unless noted. The company manufactures nutritional supplements under contract, licenses patents and trademarks—principally for beta-alanine sold as CarnoSyn—and sells branded products.
Financial performance
| Metric | Q2 FY2012 | Q2 FY2011 | Six months FY2012 | Six months FY2011 |
|---|---|---|---|---|
| Net sales | $16.161 | $14.754 | $34.502 | $28.109 |
| Gross profit | $3.353 | $2.849 | $8.036 | $5.524 |
| Gross margin | 20.7% | 19.3% | 23.3% | 19.7% |
| Operating income | $1.226 | $1.114 | $3.573 | $2.049 |
| Net income | $0.785 | $0.854 | $2.313 | $1.766 |
| Diluted earnings per share | $0.11 | $0.12 | $0.33 | $0.25 |
- Sales rose 10% in the quarter and 23% for the six-month period. First-half contract manufacturing sales increased 19%, while patent and trademark licensing revenue rose 233% to $2.054 million. Branded-product sales fell 16% in the first half.
- First-half operating income increased 74%; operating margin was 10.4%, versus 7.3%. Q2 net income declined 8%, despite higher sales and operating income, primarily because income tax expense increased to $414,000 from $214,000. The prior-year periods benefited from domestic net operating loss carryforwards.
- First-half net cash used in operating activities was $3.103 million, versus $3.207 million provided in the prior-year period. The main working-capital use was a $6.194 million inventory increase; accounts receivable used $1.658 million. Capital expenditures were $963,000.
- Cash and cash equivalents were $11.193 million at December 31, down from $15.461 million at June 30. Current assets were $32.348 million and current liabilities $6.118 million.
- No consolidated debt was outstanding. The company reported $5.5 million available under its credit facilities and was in compliance with Wells Fargo facility covenants. The $5 million Wells Fargo line is secured by specified assets; the Swiss subsidiary also had an undrawn facility.
Material changes and business developments
- Management attributed manufacturing growth to higher volumes of existing products and sales to new customers, partly offset by lower sales to other existing customers. Sales outside the U.S. increased; first-half U.S. sales were $19.059 million and non-U.S. sales $15.443 million.
- Two customers accounted for 71% of first-half sales, down from 73% a year earlier; customer concentration remains substantial. Management expected a marginal further decline in concentration during the rest of FY2012 as new and existing customer sales develop.
- Inventory increased to $12.693 million from $6.499 million at June 30. The company purchased approximately $2.9 million of beta-alanine in Q2 to support expected demand and help remove allegedly infringing product from the supply chain. Management expected to liquidate this inventory over the next several quarters, subject to demand and economic conditions.
- The company began reporting three segments in FY2012: contract manufacturing, patent and trademark licensing, and branded products. Pathway to Healing sales continued to weaken, which management linked partly to the 2007 end of its principal television customer-acquisition program.
Outlook, risks and unusual items
- Management stated that cash, cash equivalents and expected operating cash flows should fund working capital and capital expenditures for at least the next 12 months. It intends to keep foreign subsidiary earnings indefinitely reinvested; repatriation could result in additional U.S. taxes.
- Management anticipated $300,000–$400,000 of litigation and patent-compliance expenses per quarter for the remainder of FY2012. Such expenses were $601,000 for the first half, versus $282,000 a year earlier.
- Under the Abbott Laboratories agreement, Abbott paid an additional $300,000 in January 2012. Abbott could terminate through March 31, 2012; conditional additional license fees include $150,000 and, if the agreement continues, $4.25 million in six annual payments beginning March 31, 2012. Future royalties and purchases are also conditional. No royalties had been received through December 31, 2011.
- Patent litigation is ongoing, including claims brought by NAI and declaratory-judgment actions brought by competitors. The company cautioned that outcomes and litigation costs are uncertain; it gave no assurance of prevailing.
- Foreign-exchange forward contracts had a $16.2 million notional amount. A net gain of approximately $1.3 million was recorded in accumulated other comprehensive income at quarter-end, with approximately $1.1 million expected to be reclassified into earnings over the next 12 months alongside the related forecast transactions.
- Key risks include customer and supplier concentration, availability of beta-alanine, customer order timing, product demand, foreign exchange, competition, regulatory and manufacturing compliance, and the cost and outcome of patent disputes. Management reported disclosure controls were effective and no material change in internal control over financial reporting.
Important facts for investors to verify
- Whether the large inventory build, including beta-alanine stock, converts into sales and cash as management expects.
- Whether licensing growth continues and whether Abbott’s agreement survives its termination window and triggers the potential fees, supply commitments and royalties.
- Trends in customer concentration, new-customer sales, and the declining Pathway to Healing business.
- Operating cash flow, receivables collection, and liquidity as inventory and litigation spending affect working capital.
- Developments and expenses in the patent litigation, as well as the availability of raw materials and the company’s ability to protect its patent rights.