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NAII > SEC Filings for NAII > Form 10-Q on 14-Nov-2012All Recent SEC Filings

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Form 10-Q for NATURAL ALTERNATIVES INTERNATIONAL INC


14-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis is intended to help you understand our financial condition and results of operations for the three months ended September 30, 2012. 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 2012 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 or contain all of the information that may be important to our stockholders or the investing public. This overview should be read 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, herbs 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 one or two 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 royalty, licensing revenue, and raw material sales generated from our patent estate pursuant to license and supply agreements with third parties for the distribution and use of the ingredient known as beta-alanine and sold under the CarnoSyn® trade name.

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, commercializing our patent estate through contract manufacturing, royalty and license agreements, and developing and growing our own line of branded products.

During the first three months of fiscal 2013, our net sales were 10.3% lower than in the first three months of fiscal 2012. Private label contract manufacturing sales decreased 11.2% due primarily to lower volumes of existing products to existing customers partially offset by new product sales to new customers. Revenue concentration risk for our two largest private label contract manufacturing customers decreased to 72% as a percentage of our total private label contract manufacturing sales for the first three months of fiscal 2013 compared to 77% in the first three months of fiscal 2012. We expect our contract manufacturing revenue concentration percentage for our two largest customers to decrease marginally during the remainder of fiscal 2013 with the anticipated addition of new customer sales and increased sales to existing customers.

During the first three months of fiscal 2013, CarnoSyn® beta-alanine royalty and licensing revenue increased 3.0% to $1.4 million as compared to $1.3 million for the first three months of fiscal 2012. Included in the royalty and licensine revenue during the first quarter of fiscal 2013 was $103,000 of raw material sales of beta-alanine as compared to zero raw material sales in the same period in fiscal 2012. During the second and third quarters of fiscal 2012, we purchased approximately $3.2 million of beta-alanine raw material to help ensure sufficient inventory to meet anticipated future customer demand. During the third and fourth quarters of fiscal 2012, we sold or used a majority of this inventory. As of September 30, 2012, our beta-alanine raw material inventory level had been reduced to zero. We do not anticipate the direct purchase and sale of material quantities of beta-alanine raw material during the remainder of fiscal 2013.

To protect our CarnoSyn® business and its underlying patent estate, we incurred litigation and patent compliance expenses of approximately $897,000 during the first quarter of fiscal 2013 and $419,000 during the comparable period in fiscal 2012. We describe our efforts to protect our patent estate in more detail under Item 1 of Part II of 2012 Annual Report. Our ability to maintain or further increase our beta-alanine royalty and licensing revenue will depend in large part on the availability of the raw material beta-alanine when and in the amounts needed, the ability to expand distribution of beta-alanine to new and existing customers, maintaining our patent rights, and the continued compliance by third parties with our patent and trademark rights.

Net sales from our branded products declined 14.7% in the first three months of fiscal 2013 as compared to the first three months of fiscal 2012 due to the continued softening of sales of our Pathway to Healing® product line. During fiscal 2011 and 2012, we re-launched our Pathway to Healing® product line with updated product formulation, packaging, and marketing activities.


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During the remainder of fiscal 2013, we plan to continue to 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 contract manufacturing, royalty and license agreements and protecting our proprietary rights;

• Implementing focused initiatives to grow our Pathway to Healing® product line; 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 their accompanying notes. We have identified certain policies that we believe are important to the 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 that 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 2012 Annual Report and recent accounting pronouncements are discussed under Item A to our Notes to Condensed Consolidated Financial Statements contained in this Quarterly Report. There have been no significant changes to these policies or pronouncements during the three months ended September 30, 2012 other than as listed under Item A to our Notes to Condensed Consolidated Financial Statement contained in this Quarterly Report.

Results of Operations

The results of our operations for the three months ended September 30 were as
follows (dollars in thousands):



                                                                Three Months Ended
                                                   September 30,                  September 30,
                                                        2012                           2011                   Increase (Decrease)
Private label contract manufacturing          $  14,744          89.6%       $  16,606          90.5%      $   (1,862)    (11.2)%
Patent and trademark licensing                    1,374           8.3%           1,334           7.3%               40       3.0%
Branded products                                    342           2.1%             401           2.2%             (59)   (14.7)%

Total net sales                                  16,460        100.0%           18,341        100.0%           (1,881)    (10.3)%
Cost of goods sold                               12,876          78.2%          13,658          74.5%            (782)     (5.7)%

Gross profit                                      3,584         21.8%            4,683         25.5%           (1,099)    (23.5)%
Selling, general & administrative expenses        2,555          15.5%           2,336          12.7%              219       9.4%

Income from operations                            1,029           6.3%           2,347         12.8%           (1,318)   (56.2)%
Other income, net                                  (12)          0.1%               83          0.5%              (95)   (114.5)%

Income before income taxes                        1,017           6.2%           2,430          13.2%          (1,413)    (58.1)%
Income tax expense                                  320           1.9%             902           4.9%            (582)    (64.5)%

Net income                                    $     697           4.2%       $   1,528           8.3%      $     (831)    (54.4)%

The percentage decrease in private label contract manufacturing net sales was primarily attributed to the following:

                                          Mannatech, Incorporated (1)     (8.3)%
                                          NSA International, Inc. (2)     (4.2)
                                          Other customers (3)              1.3

                                          Total
                                                                          (11.2)%

1 Net sales to Mannatech, Incorporated decreased primarily as a result of lower volumes of established products in existing markets.


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2 The decrease in net sales to NSA International, Inc. included a decrease in international sales of 14.8% and a decrease in domestic sales of 4.0%. These sales decreases were due to lower consumer demand and unfavorable foreign currency exchange rates which generated lower average sales prices during the current year period.

3 The increase in net sales to other customers was primarily due to sales of new products for new and existing customers and a net increase in sales of existing products for existing customers.

Net sales from our patent and trademark licensing segment increased 3.0% during the first quarter of fiscal 2013 primarily due to a license fee of $354,000 received from Abbott and $103,000 of beta-alanine raw material sales, partially offset by decreased market demand for CarnoSyn® beta-alanine.

Net sales from our branded products segment decreased 14.7% during the first quarter of fiscal 2013 due primarily to the continued softening of the Pathway to Healing® product line.

Gross profit margin decreased 3.7 percentage points primarily due to the following:

                Contract manufacturing:
                Shift in sales mix and material cost        (1.8)(1)%
                Changes in overhead expenses                 (0.4)(1)
                Changes in direct and indirect labor         (2.1)(1)
                Patent and trademark licensing                0.8(2)
                Branded products operations                  (0.2)(3)

                Total                                         (3.7) %

1 Private label contract manufacturing gross profit margin decreased 4.7 percentage points in the first quarter of fiscal 2013 as compared to the comparable period in fiscal 2012. The decrease in gross profit as a percentage of sales was primarily due to increase material costs as a percentage of sales and increased labor and overhead costs as compared to the prior year.

2 Patent and trademark licensing gross profit margin decreased 0.8 percentage points to 79.6% in the first quarter of fiscal 2013 from 80.4% in the first quarter of fiscal 2012 due to a change in the mix of the source of revenue in fiscal 2013 as compared to fiscal 2012. Fiscal 2013 revenue included $103,000 of beta-alanine raw material sales which generated a gross profit margin of 19.3% while beta-alanine raw material sales were zero during the first quarter of fiscal 2012.

3 Branded products gross profit margin decreased 6.0 percentage points to 37.0% in the first quarter of fiscal 2013 from 43.0% in the first quarter of fiscal 2012 due primarily to increased material costs and higher inventory write-offs.

Selling, general and administrative expenses increased $219,000, or 9.4% during fiscal 2013. This increase was attributed to a $487,000 increase in patent and trademark licensing costs primarily attributed to increased patent litigation and prosecution expenses partially offset by a $235,000 decrease in operating costs from our domestic contract manufacturing operation primarily related to decreased employee compensation. Selling, general and administrative expenses for our branded products business decreased $32,000 as compared to the same prior year period.

Other income, net decreased $95,000 during the first quarter of fiscal 2013 as compared to the same period in the prior fiscal year primarily due to unfavorable foreign currency exchange activity associated with the Euro.

Our income tax expense decreased $582,000 during the first quarter of fiscal 2013 as compared to the same period in the prior fiscal year. The decrease was primarily due to the lower pre-tax income in the first quarter of fiscal 2013 as compared to the comparable prior year period. Additionally, the net effective tax rate decreased due to a larger percentage of pre-tax income generated by our foreign operations which has a lower 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 facility. Net cash provided by operating activities was $288,000 for the three months ended September 30, 2012 compared to net cash used by operating activities of $1.4 million in the comparable quarter last year.


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At September 30, 2012, changes in accounts receivable, consisting primarily of amounts due from our private label contract manufacturing customers and our patent and trademark licensing activities, provided $1.5 million in cash during the three months ended September 30, 2012 compared to using $3.4 million of cash used in the comparable prior year quarter. The increase in cash provided by accounts receivable during the quarter ended September 30, 2012 primarily resulted from lower sales and royalty and licensing revenue as compared to the prior year period. Days sales outstanding was 45 days during the three months ended September 30, 2012 as compared to 25 days for the prior year period. This increase is primarily attributable to increased receivables from our patent and trademark licensing business and the change in our private label contract manufacturing customer sales mix.

At September 30, 2012, changes in inventory used $940,000 in cash during the three months ended September 30, 2012 compared to $2.6 million of cash used in the comparable prior year quarter. The decrease in cash used by inventory during the quarter ended September 30, 2012 was primarily related to timing of inventory shipments and receipts along with decreased sales demand.

During the three months ended September 30, 2012, NAIE's operations used $240,000 of operating cash flow primarily due to timing of inventory receipts and sales. As of September 30, 2012, NAIE's undistributed retained earnings were considered indefinitely reinvested.

Cash used in investing activities in the three months ended September 30, 2012 was $233,000 compared to $420,000 in the comparable quarter last year and were exclusively associated with capital purchases. Capital expenditures for both years were primarily for manufacturing equipment in our Vista, California and Manno, Switzerland facilities.

Cash used in financing activities in the three months ended September 30,2 2012 was $113,000 compared to $19,000 in the comparable quarter last year. Activity for both years was comprised primarily of amounts used to purchase treasury stock.

We did not have any consolidated debt as of September 30, 2012 or June 30, 2012.

On December 16, 2010, we executed a new Credit Agreement with Wells Fargo Bank, N.A. This Credit Agreement replaced our previous credit facility and provides us with a line of credit of up to $5.0 million. The line of credit may be used to finance working capital requirements. In consideration for granting the line of credit, we paid a commitment fee of $12,500 upon execution of the agreement and paid an additional commitment fee of $12,500 in December 2011. There are no amounts currently drawn under the line of credit and the credit agreement expires on November 1, 2013.

Under the terms of the Credit Agreement, borrowings are subject to eligibility requirements including maintaining (i) net income after taxes of not less than $750,000 on a trailing four quarter basis as of the end of each calendar quarter beginning with the four quarter period ended December 31, 2010; and (ii) a ratio of total liabilities to tangible net worth of not greater than 1.25 to 1.0 at any time. Any amounts outstanding under the line of credit will bear interest at a fixed or fluctuating interest rate as elected by NAI from time to time; provided, however, that if the outstanding principal amount is less than $100,000 such amount shall bear interest at the then applicable fluctuating rate of interest. If elected, the fluctuating rate per annum would be equal to 2.75% above the daily one month LIBOR rate as in effect from time to time. If a fixed rate is elected, it would equal a per annum rate of 2.50% above the LIBOR rate in effect on the first day of the applicable fixed rate term. Any amounts outstanding under the line of credit must be paid in full on or before November 1, 2013; provided, however, that we must maintain a zero balance on advances under the line of credit for a period of at least 30 consecutive days during each fiscal year. Amounts outstanding that are subject to a fluctuating interest rate may be prepaid at any time without penalty. Amounts outstanding that are subject to a fixed interest rate may be prepaid at any time in minimum amounts of $100,000, subject to a prepayment fee equal to the sum of the discounted monthly differences for each month from the month of prepayment through the month in which the then applicable fixed rate term matures.

Our obligations under the Credit Agreement are secured by our accounts receivable and other rights to payment, general intangibles, inventory, equipment and fixtures. We also have a foreign exchange facility with Wells Fargo in effect until November 1, 2013, and with Bank of America, N.A. in effect until March 15, 2013.

At September 30, 2012, we were in compliance with all of the financial and other covenants required under the Credit Agreement.

On September 22, 2006, NAIE, our wholly owned subsidiary, entered into a credit facility to provide it with a credit line of up to CHF 1.3 million, or approximately $1.4 million, which was the initial maximum aggregate amount that could be outstanding at any one time under the credit facility. This maximum amount is reduced annually by CHF 160,000, or approximately $170,000. On February 19, 2007, NAIE amended its credit facility to provide that the maximum aggregate amount that may be outstanding under the facility cannot be reduced below CHF 500,000, or approximately $532,000. As of September 30, 2012, there was no outstanding balance under this credit facility.

Under its credit facility, NAIE may draw amounts either as current account loan credits to its current or future bank accounts or as fixed loans with a maximum term of 24 months. Current account loans will bear interest at the rate of 5% per annum. Fixed loans will bear interest at a rate determined by the parties based on current market conditions and must be repaid pursuant to a repayment schedule established by the parties at the time of the loan. If a fixed loan is repaid early at NAIE's election or in connection with the termination of the credit facility, NAIE will be charged a pre-payment penalty equal to 0.1% of the principal amount of the fixed loan or CHF 1,000 (approximately $1,064), whichever is greater. The bank reserves the right to refuse individual requests for an advance under the credit facility, although its exercise of such right will not have the effect of terminating the credit facility as a whole.


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As of September 30, 2012, we had $14.4 million in cash and cash equivalents and $5.5 million available under our credit facilities. We believe our available cash, cash equivalents and potential cash flows from operations 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 September 30, 2012, 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 1of 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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