NATURAL ALTERNATIVES INTERNATIONAL INC - Quarter Report: 2018 March (Form 10-Q)

 

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		March 31, 2018				June 30, 2017
		(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	27,618			$	27,843
Accounts receivable - less allowance for doubtful accounts of $43 at March 31, 2018 and $18 at June 30, 2017			11,325				8,410
Notes receivable			1,556				—
Inventories, net			23,785				13,729
Income tax receivable			—				261
Prepaids and other current assets			1,789				1,456
Total current assets			66,073				51,699
Property and equipment, net			18,832				18,136
Deferred income taxes			2,443				2,002
Other noncurrent assets, net			749				774
Total assets		$	88,097			$	72,611
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable		$	13,799			$	5,116
Accrued liabilities			2,323				1,931
Accrued compensation and employee benefits			1,017				1,594
Forward contract			2,631				422
Income taxes payable			1,041				1,207
Total current liabilities			20,811				10,270
Long-term pension liability			460				557
Deferred rent			558				537
Forward contract, noncurrent			480				99
Income taxes payable, noncurrent			2,950				—
Total liabilities			25,259				11,463
Commitments and contingencies
Stockholders’ equity:
Preferred stock; $.01 par value; 500,000 shares authorized; none issued or outstanding			—				—
Common stock; $.01 par value; 20,000,000 shares authorized; issued and outstanding (net of treasury shares) 7,568,817 at March 31, 2018 and 6,937,018 at June 30, 2017			85				79
Additional paid-in capital			23,832				22,260
Retained earnings			47,955				45,788
Treasury stock, at cost, 1,087,860 shares at March 31, 2018 and 1,044,659 June 30, 2017			(6,579	)			(6,074	)
Accumulated other comprehensive loss			(2,455	)			(905	)
Total stockholders’ equity			62,838				61,148
Total liabilities and stockholders’ equity		$	88,097			$	72,611

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		Three Months Ended								Nine Months Ended
		March 31,								March 31,
		2018				2017				2018				2017
Net sales		$	31,815			$	25,135			$	93,224			$	89,761
Cost of goods sold			25,105				20,017				73,522				70,479
Gross profit			6,710				5,118				19,702				19,282
Selling, general and administrative			4,187				4,125				13,015				11,640
Income from operations			2,523				993				6,687				7,642
Other income (expense):
Interest income			269				109				823				358
Interest expense			(6	)			(1	)			(6	)			(1	)
Foreign exchange (loss) gain			(182	)			(45	)			(413	)			158
Other, net			(5	)			(6	)			(18	)			(21	)
Total other income			76				57				386				494
Income before income taxes			2,599				1,050				7,073				8,136
Provision for income taxes			548				305				4,906				2,435
Net income		$	2,051			$	745			$	2,167			$	5,701
Unrealized (loss) gain resulting from change in fair value of derivative instruments, net of tax			(219	)			(451	)			(1,550	)			401
Comprehensive income		$	1,832			$	294			$	617			$	6,102
Net income per common share:
Basic		$	0.31			$	0.11			$	0.33			$	0.87
Diluted		$	0.30			$	0.11			$	0.32			$	0.86
Weighted average common shares outstanding
Basic			6,639,098				6,581,632				6,620,324				6,569,165
Diluted			6,909,475				6,613,955				6,860,870				6,648,091

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		Nine Months Ended
		March 31,
		2018				2017
Cash flows from operating activities
Net income		$	2,167			$	5,701
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			2,222				1,711
Deferred income taxes			306				—
Non-cash sales discount			653				—
Non-cash compensation			925				729
Pension expense, net of contributions			(97	)			149
Gain on disposal of assets			(9	)			(23	)
Changes in operating assets and liabilities:
Accounts receivable and notes receivable, net			(2,971	)			5,298
Inventories, net			(10,056	)			4,802
Prepaids and other assets			(308	)			450
Accounts payable and accrued liabilities			8,674				(8,579	)
Accrued compensation and employee benefits			(577	)			(1,813	)
Forward contracts			715				(268	)
Income taxes			3,045				(291	)
Net cash provided by operating activities			4,689				7,866
Cash flows from investing activities
Purchases of property and equipment			(2,937	)			(4,332	)
Proceeds from sale of property and equipment			28				24
Issuance of notes receivable			(1,500	)			—
Net cash used in investing activities			(4,409	)			(4,308	)
Cash flows from financing activities
Repurchase of common stock			(505	)			(712	)
Net cash used in financing activities			(505	)			(712	)
Net (decrease) increase in cash and cash equivalents			(225	)			2,846
Cash and cash equivalents at beginning of period			27,843				19,747
Cash and cash equivalents at end of period		$	27,618			$	22,593
Supplemental disclosures of cash flow information
Cash paid during the period for:
Interest		$	6			$	—
Taxes		$	1,578			$	2,761
Disclosure of non-cash activities:
Change in unrealized (loss) gain resulting from change in fair value of derivative instruments, net of tax		$	(1,550	)		$	401

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A. Basis of Presentation and Summary of Significant Accounting Policies

 

The accompanying interim unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and applicable rules and regulations. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) have been condensed or omitted pursuant to such rules and regulations. In management’s opinion, all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows have been included and are of a normal, recurring nature. The results of operations for the three and nine months ended March 31, 2018 are not necessarily indicative of the operating results for the full fiscal year or any future periods.

 

You should read the financial statements and these notes, which are an integral part of the financial statements, together with our audited financial statements included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2017 (“2017 Annual Report”). The accounting policies used to prepare the financial statements included in this Quarterly Report are the same as those described in the notes to the consolidated financial statements in our 2017 Annual Report unless otherwise noted below.

 

 

Recent Accounting Pronouncements

 

In March 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases (Topic 842) (ASU 2016-02), which amends existing standards for leases to increase transparency and comparability among organizations by requiring recognition of lease assets and liabilities on the balance sheet and requiring disclosure of key information about such arrangements. ASU 2016-02 will be effective for us beginning in our first quarter of fiscal 2020. Early adoption is permitted. We continue to evaluate the impact of adopting the new standard on our consolidated financial statements and the timing and presentation of our adoption.

 

In April 2016, the FASB issued Accounting Standards Update No. 2016-10, Revenue from Contracts with Customers (Topic 606)(ASU 2016-10), which amends and adds clarity to certain aspects of the guidance set forth in the upcoming revenue standard (ASU 2014-09) related to identifying performance obligations and licensing. In May 2016, the FASB issued Accounting Standards Update No. 2016-11, Revenue Recognition (Topic 605) and Derivatives and Hedging (Topic 815) (ASU 2016-11), which amends and rescinds certain revenue recognition guidance previously released within ASU 2014-09. In May 2016 the FASB issued Accounting Standards Update No. 2016-12, Revenue from Contracts with Customers (Topic 606) (ASU 2016-12), which provides narrow scope improvements and practical expedients related to ASU 2014-09. ASU 2014-09 defines a five step process to achieve this core principle (that we should recognize revenue in an amount that reflects the consideration to which we expect to be entitled in exchange for goods or services provided) and, in doing so, possibly requiring more judgment and estimates may be required within the revenue recognition process than are required under present U.S. GAAP. These judgments and estimates may include identifying each performance obligation in the contract, estimating the amount of variable consideration to include in the transaction price, and allocating the transaction price to each separate performance obligation. ASU 2016-12 also requires additional disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant additional judgments and changes in existing judgments.  All of these new standards will be effective for us concurrently with ASU 2014-09, beginning in our first quarter of fiscal 2019. Currently, we do not expect our annual revenue to be materially different under Topic 606. The most significant change will be to our quarterly and annual financial statement disclosures.  We continue to evaluate the impact of adopting the new standard.

 

In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. ASU 2017-12 is intended to improve and simplify accounting rules around hedge accounting and improve the disclosures of hedging arrangements. We are currently evaluating the impact of adopting the new standard on our consolidated financial statements. ASU 2017-12 will be effective for us beginning in our first quarter of fiscal 2020.

 

On December 22, 2017, the SEC issued guidance under Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (“SAB 118”) directing taxpayers to consider the impact of the U.S. legislation as “provisional” when it does not have the necessary information available, prepared or analyzed (including computations) in reasonable detail to complete its accounting for the change in tax law. In accordance with SAB 118, our estimated income tax is considered provisional and is expected to be finalized by the end of our fiscal year.

 

 

Net Income per Common Share

 

We compute net income per common share using the weighted average number of common shares outstanding during the period, and diluted net income per common share by taking into consideration the additional dilutive effect of all dilutive securities. The dilutive impact of stock options account for the additional weighted average shares of common stock outstanding for our diluted net income per common share computation. We calculated basic and diluted net income per common share as follows (in thousands, except per share data):

 

 

We excluded shares related to restricted stock totaling 175,000 for the three and nine months ended March 31, 2018 as their impact would have been anti-dilutive. No shares related to stock options or restricted stock were excluded for the three and nine months ended March 31, 2017.

 

Revenue Recognition

 

To recognize revenue, four basic criteria must be met: 1) there is evidence that an arrangement with a buyer exists; 2) delivery has occurred; 3) the fee is fixed or determinable; and 4) collectability is reasonably assured. Revenue from sales transactions where the buyer has the right to return the product is recognized at the time of sale only if (a) the seller’s price to the buyer is substantially fixed or determinable at the date of sale; (b) the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product; (c) the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product in its present location; (d) the buyer acquiring the product for resale has economic substance apart from that provided by the seller; (e) the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer; and (f) the amount of future returns can be reasonably estimated. We recognize revenue upon determination that all of the foregoing criteria for revenue recognition have been met. The criteria are usually met at the time title passes to the customer, which usually occurs upon shipment. Revenue from shipments where title passes upon completion of delivery is deferred until the shipment has been delivered.

 

We record reductions to gross revenue for estimated returns of private-label contract manufacturing products and beta-alanine raw material sales. The estimated returns are based on the trailing nine months of private-label contract manufacturing gross sales and our historical experience for both private-label contract manufacturing and beta-alanine raw material sales returns. However, the estimate for product returns does not reflect the impact of a potential large product recall resulting from product nonconformance or other factors as such events are not predictable nor is the related economic impact estimable.

 

On August 7, 2017, we entered into three agreements (“Agreements”), with The Juice Plus+ Company LLC (“Juice Plus+”). The Agreements are an Exclusive Manufacturing Agreement, a Restricted Stock Award Agreement, and an Irrevocable Proxy. Pursuant to the Exclusive Manufacturing Agreement, Juice Plus+ has granted us exclusive rights to manufacture and supply them with certain of their products within 24 countries where Juice Plus+ currently sells those products. Pursuant to the Restricted Stock Award Agreement, NAI has granted 500,000 shares of NAI common stock to Juice Plus+, (the “Shares”), and Juice Plus+ has agreed the Shares are subject to certain restrictions and risk of forfeiture. Pursuant to the Irrevocable Proxy, Juice Plus+ has also granted to the NAI Board of Directors the right to vote the Shares that remain subject to the risk of forfeiture. Each Agreement is for a term of 5 years, and each may be terminated by either party only upon the occurrence of specified events. The expense associated with the shares granted to Juice Plus+ is recorded as a reduction to revenue. We recorded $245,000 of expense as an offset to net sales during the three months ended March 31, 2018 and $653,000 during the nine months ended March 31, 2018.

 

 

We currently own certain U.S. patents and patent applications, and corresponding foreign patents and patent applications. All of these patents and patent rights relate to the ingredient known as beta-alanine which we market and sell under our CarnoSyn® and SR CarnoSyn® trade names. We recorded beta-alanine raw material sales and royalty and licensing income as a component of revenue in the amount of $6.2 million during the three months ended March 31, 2018 and $16.0 million during the nine months ended March 31, 2018. We recorded $6.6 million during the three months ended March 31, 2017 and $20.0 million during the nine months ended March 31, 2017.  These royalty income and raw material sale amounts resulted in royalty expense from payments made to the original patent holders from whom NAI acquired its patents and patent rights. We recognized royalty expense as a component of cost of goods sold in the amount of $215,000 during the three months ended March 31, 2018 and $659,000 during the nine months ended March 31, 2018. We recognized $233,000 of royalty expense during the three months ended March 31, 2017 and $799,000 during the nine months ended March 31, 2017.

 

 

Notes Receivable

 

On September 30, 2017, we accepted a 12-month note from Kaged Muscle, LLC (“Kaged Muscle”), one of our contract manufacturing customers, in exchange for $1.5 million of trade receivables due to us from Kaged Muscle. Kaged Muscle is one of our fastest growing sports nutrition customers and we executed this note receivable conversion to assist them with their near term financing needs. The note carries an interest rate of fifteen percent (15%) per annum and is an interest only note secured by the assets of Kaged Muscle and a personal guarantee by the co-founder and President of Kaged Muscle. Interest is due quarterly and the note can be paid down at any time without penalty.  We recognized $56,000 in interest income during the three months ended March 31, 2018 and $114,000 during the nine months ended March 31, 2018 associated with this note from Kaged Muscle.

 

Stock-Based Compensation

 

We have an omnibus incentive plan that was approved by our Board of Directors effective as of October 15, 2009 and approved by our stockholders at the Annual Meeting of Stockholders held on November 30, 2009. Under the plan, we may grant nonqualified and incentive stock options and other stock-based awards to employees, non-employee directors and consultants.

 

We estimate the fair value of stock option awards at the date of grant using the Black-Scholes option valuation model. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully and freely transferable. Option valuation models require the input of highly subjective assumptions. Black-Scholes uses assumptions related to volatility, the risk-free interest rate, the dividend yield (which we assume to be zero, as to date we have not paid any cash dividends) and employee exercise behavior. Expected volatilities used in the model are based on the historical volatility of our stock price. The risk-free interest rate is derived from the U.S. Treasury yield curve in effect on the date of grant. The expected life of stock option grants is derived from historical experience. The fair value of restricted stock shares granted is based on the market price of our common stock on the date of grant. We amortize the estimated fair value of our stock awards to expense over the related vesting periods.

 

We did not grant any options during the three month or nine month periods ended March 31, 2018 or 2017. All remaining outstanding stock options are fully vested. No options were exercised during the three month or nine month periods ended March 31, 2018 or 2017. There were no forfeitures during the three months ended March 31, 2018. During the nine months ended March 31, 2018, 5,000 options were forfeited. There were no forfeitures during the three month or nine month periods ended March 31, 2017.

 

During the three and nine months ended March 31, 2018, we granted 175,000 shares of restricted stock to the members of our Board of Directors and certain key members of our management team. During the three months ended March 31, 2017, we granted 140,000 shares of restricted stock to the members of our Board of Directors and certain key members of our management team. During the nine months ended March 31, 2017, we granted 150,000 shares of restricted stock to the members of our Board of Directors and certain key members of our management team. Our net income included stock based compensation expense of approximately $322,000 for the three months ended March 31, 2018, and $925,000 for the nine months ended March 31, 2018. Our net income included stock based compensation expense of approximately $223,000 for the three months ended March 31, 2017, and $729,000 for the nine months ended March 31, 2017.

 

 

Fair Value of Financial Instruments

 

Fair value is defined as the exchange price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. We use a three-level hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from independent sources. Unobservable inputs are inputs that reflect our assumptions about the inputs that market participants would use in pricing the asset or liability and are developed based on the best information available under the circumstances.  

 

The fair value hierarchy is broken down into three levels based on the source of inputs. In general, fair values determined by Level 1 inputs use quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access. We classify cash, cash equivalents, and marketable securities balances as Level 1 assets. Fair values determined by Level 2 inputs are based on quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active and models for which all significant inputs are observable or can be corroborated, either directly or indirectly by observable market data. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. These include certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.

 

As of March 31, 2018, and June 30, 2017, we did not have any financial assets or liabilities classified as Level 1 except for cash and cash equivalents, and assets related to our pension plan. We classify derivative forward exchange contracts as Level 2 assets. The fair value of our forward exchange contracts as of March 31, 2018 was a net liability of $3.1 million. The fair value of our forward exchange contracts as of June 30, 2017 was a net liability of $521,000. As of March 31, 2018 and June 30, 2017 we did not have any financial assets or liabilities classified as Level 3. We did not transfer any assets or liabilities between Levels during fiscal 2017 or the nine months ended March 31, 2018. 

 

Concentrations of Credit Risk

 

Financial instruments that subject us to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. We place our cash and cash equivalents with highly rated financial institutions. Credit risk with respect to receivables is concentrated with our three largest customers, whose receivable balances collectively represented 65.4% of gross accounts receivable at March 31, 2018 and 65.6% at June 30, 2017. Additionally, amounts due related to our beta-alanine raw material sales were 26.1% of gross accounts receivable at March 31, 2018, and 21.3% of gross accounts receivable at June 30, 2017. Concentrations of credit risk related to the remaining accounts receivable balances are limited due to the number of customers comprising our remaining customer base.

 

 

B. Inventories, net

 

Inventories, net consisted of the following (in thousands):

 

 

 

 

C. Property and Equipment

 

Property and equipment consisted of the following (in thousands):

 

 

 

 

 

D. Other Comprehensive (Loss) Income

 

Other comprehensive (loss) income (“OCL” and “OCI”) consisted of the following during the three and nine months ended March 31, 2018 and March 31, 2017 (in thousands):

 

 

 

 

 

 

 

E. Debt

 

On March 20, 2018, we executed an amendment to our credit facility with Wells Fargo Bank, N.A. to extend the maturity date for our working line of credit from February 1, 2020 to February 1, 2021. In addition, the amendment removed any restrictions included in the credit facility on our ability to repurchase our stock. The Credit Agreement provides us with a credit line of up to $10.0 million. The line of credit may be used to finance working capital requirements. There is no commitment fee under this agreement. There are no amounts currently drawn under the line of credit.

 

Under the terms of the Credit Agreement, borrowings are subject to eligibility requirements including maintaining (i) a ratio of total liabilities to tangible net worth of not greater than 1.25 to 1.0 at any time; and (ii) a ratio of total current assets to total current liabilities of not less than 1.75 to 1.0 at each fiscal quarter end. 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 1.25% 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 1.25% 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 the maturity date. 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.

 

On March 31, 2018, we were in compliance with all of the financial and other covenants required under the Credit Agreement.

 

We also have a foreign exchange facility with Wells Fargo Bank, N.A. in effect until January 31, 2019, and with Bank of America, N.A. in effect until August 15, 2019. 

 

We did not use our working capital line of credit nor did we have any long-term debt outstanding during the nine months ended March 31, 2018. As of March 31, 2018, we had $10.0 million available under our credit facilities.

 

 

F. Economic Dependency

 

We had substantial net sales to certain customers during the periods shown in the following table. The loss of any of these customers, or a significant decline in sales to these customers, the growth rate of sales to these customers, or in these customers’ ability to make payments when due, could have a material adverse impact on our net sales and net income. Net sales to any one customer representing 10% or more of the respective period's consolidated net sales were as follows (in thousands):

 

 

(a)

Sales were less than 10% of the respective period’s total revenues.

 

 

We buy certain products, including beta-alanine, from a limited number of raw material suppliers. The loss of any of these suppliers could have a material adverse impact on our net sales and net income. Raw material purchases from any one supplier representing 10% or more of the respective period’s total raw material purchases were as follows (in thousands):

 

 

(a)

Purchases were less than 10% of the respective period’s total raw material purchases.

 

 

 

G. Segment Information

 

Our business consists of two segments for financial reporting purposes, identified as (i) private label contract manufacturing, which primarily relates to the provision of private label contract manufacturing services to companies that market and distribute nutritional supplements and other health care products; and (ii) patent and trademark licensing, which primarily includes direct raw material sales and related royalty income from our license and supply agreements associated with the sale and use of beta-alanine under our CarnoSyn® and SR CarnoSyn® trade names.

 

We evaluate performance based on a number of factors. The primary performance measures for each segment are net sales and income or loss from operations before corporate level expense allocations. Operating income or loss for each segment does not include corporate general and administrative expenses, interest expense and other miscellaneous income and expense items. Corporate general and administrative expenses, which are not allocated to any segment, include, but are not limited to: human resources, corporate legal, finance, information technology, and other corporate level related expenses. The accounting policies of our segments are the same as those described in Note A above and in the consolidated financial statements included in our 2017 Annual Report.

 

Our operating results by business segment were as follows (in thousands):

 

 

 

 

 

Our private label contract manufacturing products are sold both in the U.S. and in markets outside the U.S., including Europe, Australia and Asia, as well as Canada, Mexico and South Africa. Our primary market outside the U.S. is Europe. Our patent and trademark licensing activities are primarily based in the U.S.

 

Net sales by geographic region, based on the customers’ location, were as follows (in thousands):

 

 

 

Products manufactured by NAIE accounted for 89% of net sales in markets outside the U.S. for the three months ended March 31, 2018, and 82% for the nine months ended March 31, 2018. Products manufactured by NAIE accounted for 62% of net sales in markets outside the U.S. for the three months ended March 31, 2017, and 55% for the nine months ended March 31, 2017. No products manufactured by NAIE were sold in the U.S. during the three month or nine month periods ended March 31, 2018 and 2017.

 

Assets and capital expenditures by geographic region, based on the location of the company or subsidiary at which they were located or made, were as follows (in thousands):

 

 

 

H. Income Taxes

 

The Tax Cuts and Jobs Act (the “Act”) was enacted on December 22, 2017. Among other things, the Act reduces the U.S. federal corporate tax rate to 21% and requires companies to pay a one-time deemed repatriation transition tax on earnings of U.S.-owned foreign subsidiaries that were previously tax deferred. At March 31, 2018, we had not completed our accounting for the tax effects of the Act; however, in certain cases, as described below and in accordance with SAB 118, we made a reasonable estimate of the effects on our existing deferred tax balances and the one-time transition tax. In other cases, we were not able to make a reasonable estimate and continue to account for those items based on our existing accounting under ASC 740, Income Taxes. For the items for which we did determine a reasonable estimate, we recognized a provisional amount as a discrete component of our provision for income taxes. The impact of the Tax Legislation may differ from these estimates, possibly materially, during the one-year measurement period ending December 22, 2018 due to, among other things, further refinement of our calculations, changes in interpretations and assumptions we made, guidance that may be issued and actions we may take as a result of the Act.

 

To determine our quarterly provision for income taxes, we use an estimated annual effective tax rate that is based on expected annual income, statutory tax rates and tax planning opportunities available in the various jurisdictions to which we are subject. Certain significant or unusual items are separately recognized as discrete items in the quarter in which they occur and can be a source of variability in the effective tax rate from quarter to quarter. We recognize interest and penalties related to uncertain tax positions, if any, as an income tax expense.

 

 

The effective tax rate for the three months ended March 31, 2018 was 21.1% and the effective tax rate for the nine months ended March 31, 2018 was 69.4%. In comparison, the effective tax rate for the three months ended March 31, 2017 was 29.0 % and the effective tax rate for the nine months ended March 31, 2017 was 29.9%. The effective tax rate for the three months ended March 31 2018 differs from the estimated U.S. federal statutory rate of 28.06% primarily due to the favorable impact of foreign earnings taxed at less than the U.S. statutory rate. The effective tax rate for the nine months ended March 31, 2018 differ from the estimated U.S. federal statutory rate of 28.06% primarily due to the impact of the Act’s required one-time transition tax and the reevaluation of our deferred taxes, offset by the favorable impact of foreign earnings taxed at less than the U.S. statutory rate. As a fiscal taxpayer, our U.S. federal statutory rate for the year ending June 30, 2018 is estimated to be 28.06% and is a blended rate of the historic 35% statutory rate and the newly enacted 21% rate. We expect our U.S. federal statutory rate to be 21% for fiscal years beginning after June 30, 2018.

 

As part of the Act, we are required to recognize a one-time deemed repatriation transition tax based on our total post-1986 earnings and profits (E&P) from our Swiss subsidiary, NAIE. This accumulated E&P amount has historically been considered permanently reinvested thereby allowing us to defer recognizing any U.S. income tax on the amount. As a result of the Act we recorded a provisional amount for our one-time transition tax liability resulting in an increase in income tax expense during the nine months ended March 31, 2018 of $1.8 million, which was treated as a discrete expense. In accordance with the provisions of the Act, we will elect to pay this tax over an eight-year period. Further, the transition tax is based in part on the amount of those earnings held in cash and other specified assets. This amount may change when we finalize the calculation at the conclusion of fiscal 2018. As of March 31, 2018, we no longer consider undistributed foreign earnings from NAIE as indefinitely reinvested. As a result, we have recorded $775,000 in estimated foreign withholding taxes on the amounts deemed repatriated under the Act, which was also treated as a discrete expense during the period.

 

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are measured using enacted tax rates for each of the jurisdictions in which we operate, and the tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. As of December 31, 2017, we remeasured certain deferred tax assets and liabilities based on the tax rates expected to apply in the future. For deferred tax asset and liability balances we expect to reverse during fiscal 2018 we used the blended U.S. statutory rate of 28.06% and for amounts expected to reverse in future periods we used the newly enacted 21% tax rate. However, we are still analyzing certain aspects of the Act and refining our calculations accordingly. This analysis and refinement could potentially affect the measurement of these balances or give rise to new deferred tax amounts. The provisional amount we recorded from remeasuring our deferred tax balance was $664,000 and was treated as a discrete expense for the nine months ended March 31, 2018.

 

We record valuation allowances to reduce our deferred tax assets to an amount that we believe is more likely than not to be realized. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will ultimately be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. During the three and nine months ended March 31, 2018, there was no change to our valuation allowance.

 

We are subject to taxation in the U.S., Switzerland and various U.S. state jurisdictions. Our tax returns for the fiscal years ended June 30, 2015 and forward are subject to examination by U.S. tax authorities and for fiscal years ended June 30, 2007 and forward are subject to examination by state tax authorities. Our tax filings for the fiscal year ended June 30, 2015 and forward are subject to examination by Swiss tax authorities.

 

It is our policy to establish reserves based on management’s assessment of exposure for certain positions taken in previously filed tax returns that may become payable upon audit by tax authorities. Our tax reserves are analyzed quarterly and adjustments are made as events occur that we believe warrant adjustments to the reserves. There were no adjustments to these reserves in the three and nine months ended March 31, 2018.

 

 

I. Treasury Stock

 

On June 2, 2011, the Board of Directors authorized the repurchase of up to $2.0 million of our common stock. On February 6, 2015, the Board of Directors authorized a $1.0 million increase to our stock repurchase plan bringing the total authorized repurchase amount to $3.0 million. On May 11, 2015, the Board of Directors authorized a $2.0 million increase to our stock repurchase plan bringing the total authorized repurchase amount to $5.0 million. On March 28, 2017, the Board of Directors authorized a $2.0 million increase to our stock repurchase plan bringing the total authorized repurchase amount to $7.0 million. Under the repurchase plan, we may, from time to time, purchase shares of our common stock, depending upon market conditions. Purchase of the shares of our common stock may be in open market or privately negotiated transactions.

 

 

During the three and nine months ended March 31, 2018, we did not repurchase any shares under this repurchase plan. During the nine months ended March 31, 2017, we repurchased 39,547 shares under this plan at a weighted average cost of $8.74 per share and a total cost of $345,000 including commissions and fees.

 

During the three months ended March 31, 2018, we acquired 35,203 shares in connection with restricted stock shares that vested during that period at a weighted average cost of $11.90 per share and a total cost of $419,000. During the nine months ended March 31, 2018, we acquired 43,201 shares in connection with restricted stock shares that vested during that period at a weighted average cost of $11.69 per share and a total cost of $505,000. During the three months ended March 31, 2017, we acquired 32,325 shares from employees in connection with restricted stock shares that vested during the period at a weighted average cost of $8.75 per share and a total cost of $283,000. During the nine months ended March 31, 2017, we acquired 38,729 shares from employees in connection with restricted stock shares that vested during the period at a weighted average cost of $9.47 per share and a total cost of $367,000.

 

These shares were returned to NAI by the related employees and in return NAI paid each employee’s required tax withholding required as a result of the income recognized upon vesting of the restricted shares. The valuation of the shares acquired and thereby the number of shares returned to NAI was calculated based on the closing share price on the date the restricted shares vested.

 

 

 

J. Derivatives and Hedging

 

We are exposed to gains and losses resulting from fluctuations in foreign currency exchange rates relating to forecasted product sales and other transactions of NAIE, our foreign subsidiary denominated in foreign currencies. As part of our overall strategy to manage the level of exposure to the risk of fluctuations in foreign currency exchange rates, we sometimes use foreign exchange contracts in the form of forward contracts. To the extent we enter into such contracts, there can be no guarantee any such contracts will be effective hedges against our foreign currency exchange risk.

 

As of March 31, 2018, we had forward contracts designated as cash flow hedges primarily to protect against the foreign exchange risks inherent in our forecasted sales of products at prices denominated in currencies other than the U.S. Dollar. These contracts are expected to be settled through August 2019. For derivative instruments that are designated and qualify as cash flow hedges, we record the effective portion of the gain or loss on the derivative in other comprehensive income (loss) as a separate component of stockholders’ equity and subsequently reclassify these amounts into earnings in the period during which the hedged transaction is recognized in earnings.

 

For foreign currency contracts designated as cash flow hedges, hedge effectiveness is measured using the spot rate. Changes in the spot-forward differential are excluded from the test of hedge effectiveness and are recorded currently in earnings as interest expense or income. We measure effectiveness by comparing the cumulative change in the hedge contract with the cumulative change in the hedged item. We did not have any losses or gains related to the ineffective portion of our hedging instruments during the three and nine months ended March 31, 2018. During the three months ended March 31, 2017, we recorded a $97,000 gain related to the ineffective portion of our hedging instruments to other income. During the nine months ended March 31, 2017, we recorded a $189,000 gain related to the ineffective portion of our hedging instruments to other income. None of our foreign currency forward contracts were terminated as a result of ineffective hedging or as a result of forecasted transactions no longer probable of occurring for foreign currency forward contracts. We monitor the probability of forecasted transactions as part of our hedge effectiveness testing on a quarterly basis.

 

As of March 31, 2018, the notional amounts of our foreign exchange contracts designated as cash flow hedges were approximately $47.1 million (EUR 40.0 million). As of March 31, 2018, a net loss of approximately $2.9 million related to derivative instruments designated as cash flow hedges was recorded in OCI. It is expected that $2.4 million will be reclassified into earnings in the next 12 months along with the earnings effects of the related forecasted transactions.

 

As of March 31, 2018, the fair value of our cash flow hedges was a liability of $3.1 million, of which $2.6 million was classified as a current liability, and $480,000 was classified in other noncurrent liabilities in our Consolidated Balance Sheets. During the three months ended March 31, 2018, we recognized $1.2 million of net losses in OCI and reclassified $974,000 of losses from OCI to revenue. During the nine months ended March 31, 2018, we recognized $4.1 million of net losses in OCI and reclassified $1.8 million of losses from OCI to revenue. As of June 30, 2017, $422,000 of the fair value of our cash flow hedges was classified in accrued liabilities, and $99,000 was classified other noncurrent liabilities in our Consolidated Balance Sheets. During the three months ended March 31, 2017, we recognized $322,000 of losses in OCI and reclassified $278,000 of gains from OCI to revenue. During the nine months ended March 31, 2017, we recognized $1.5 million of net gains in OCI and reclassified $549,000 of gains from OCI to revenue. 

 

 

K. Contingencies

 

From time to time, we become involved in various investigations, claims and legal proceedings that arise in the ordinary course of our business. These matters may relate to product liability, employment, intellectual property, tax, regulation, contract or other matters. The resolution of these matters as they arise will be subject to various uncertainties and, even if such claims are without merit, could result in the expenditure of significant financial and managerial resources. While unfavorable outcomes are possible, based on available information, we generally do not believe the resolution of these matters, and if and when they arise, will result in a material adverse effect on our business, consolidated financial condition, or results of operations. However, a settlement payment or unfavorable outcome could adversely impact our results of operations. Our evaluation of the likely impact of these actions could change in the future and we could have unfavorable outcomes we currently do not expect.

 

 

 

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