NATURAL ALTERNATIVES INTERNATIONAL INC - Quarter Report: 2019 December (Form 10-Q)

 

 

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

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FORM 10-Q

  

QUARTERLY REPORT

pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

  

FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2019

 

000-15701

(Commission file number)

 

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NATURAL ALTERNATIVES INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

 

Delaware	84-1007839
(State of incorporation)	(IRS Employer Identification No.)
1535 Faraday Ave Carlsbad, CA 92008	(760) 736-7700
(Address of principal executive offices)	(Registrant’s telephone number)

 

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class	Trading Symbol(s)	Name of Each Exchange on Which Registered
Common Stock, $0.01 par value per share	NAII	Nasdaq Stock Market

 

Indicate by check mark whether NAI (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that NAI was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    ☒  Yes     ☐  No

 

Indicate by check mark whether NAI has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that NAI was required to submit such files).    ☒  Yes     ☐  No

 

Indicate by check mark whether NAI is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company.

 

Large accelerated filer	☐	Accelerated filer	☐	Emerging Growth Company	☐
Non-accelerated filer	☐	Smaller reporting company	☒

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

 

Indicate by check mark whether NAI is a shell company (as defined in Rule 12b-2 of the Exchange Act): ☐ Yes ☒ No

 

As of February 11, 2020, 6,875,166 shares of NAI's common stock were outstanding, net of 1,981,511 treasury shares.

 

 

TABLE OF CONTENTS

 

		Page
SPECIAL NOTE ABOUT FORWARD-LOOKING STATEMENTS		1
PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets	2
	Condensed Consolidated Statements of Income and Comprehensive Income	3
	Condensed Consolidated Statements of Stockholders’ Equity	4
	Condensed Consolidated Statements of Cash Flows	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	18
Item 4.	Controls and Procedures	18
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	19
Item 1A.	Risk Factors	19
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	19
Item 3.	Defaults Upon Senior Securities	19
Item 4.	Mine Safety Disclosures	19
Item 5.	Other Information	19
Item 6.	Exhibits	20
SIGNATURES		21

 

 

 

		December 31, 2019				June 30, 2019
		(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	26,900			$	25,040
Accounts receivable - less allowance for doubtful accounts of $0 at December 31, 2019 and $25 at June 30, 2019			14,227				15,964
Inventories, net			22,650				26,003
Income tax receivable			1,180				901
Forward contracts			1,636				1,978
Prepaids and other current assets			1,929				1,500
Total current assets			68,522				71,386
Property and equipment, net			20,613				21,085
Operating lease right-of-use assets			19,523				—
Other noncurrent assets, net			863				1,019
Total assets		$	109,521			$	93,490
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable		$	5,437			$	8,634
Accrued liabilities			3,292				2,782
Accrued compensation and employee benefits			882				1,615
Income taxes payable			1,591				1,219
Total current liabilities			11,202				14,250
Long-term liability – operating leases			19,742				—
Long-term pension liability			255				246
Deferred rent			—				543
Income taxes payable, noncurrent			1,349				1,349
Deferred income taxes			853				1,018
Total liabilities			33,401				17,406
Commitments and contingencies (Note L)
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) 7,055,404 at December 31, 2019 and 7,225,072 at June 30, 2019			87				87
Additional paid-in capital			27,172				26,280
Retained earnings			58,500				57,380
Treasury stock, at cost, 1,801,273 shares at December 31, 2019 and 1,626,605 June 30, 2019			(9,287	)			(7,955	)
Accumulated other comprehensive (loss) gain			(352	)			292
Total stockholders’ equity			76,120				76,084
Total liabilities and stockholders’ equity		$	109,521			$	93,490

 

		Three Months Ended								Six Months Ended
		December 31,								December 31,
		2019				2018				2019				2018
Net sales		$	29,103			$	36,043			$	58,298			$	72,575
Cost of goods sold			24,042				29,607				48,853				58,976
Gross profit			5,061				6,436				9,445				13,599
Selling, general and administrative			4,363				4,229				8,802				8,668
Income from operations			698				2,207				643				4,931
Other (expense) income:
Interest income			50				529				129				1,084
Interest expense			(7	)			(9	)			(11	)			(12	)
Foreign exchange (loss) gain			(162	)			37				(53	)			(41	)
Other, net			(5	)			(14	)			(12	)			9
Total other (expense) income			(124	)			543				53				1,040
Income before income taxes			574				2,750				696				5,971
Provision for income taxes			98				569				124				1,231
Net income		$	476			$	2,181			$	572			$	4,740
Unrealized (loss) gain resulting from change in fair value of derivative instruments, net of tax			(903	)			852				(516	)			1,235
Comprehensive (loss) income		$	(427	)		$	3,033			$	56			$	5,975
Net income per common share:
Basic		$	0.07			$	0.32			$	0.08			$	0.70
Diluted		$	0.07			$	0.31			$	0.08			$	0.68
Weighted average common shares outstanding
Basic			6,795,269				6,807,979				6,818,249				6,786,470
Diluted			6,885,934				6,999,223				6,935,580				6,982,083

 

		Common Stock								Additional Paid-in				Retained				Treasury Stock								Accumulated Other Comprehensive
		Shares				Amount				Capital				Earnings				Shares				Amount				Income (Loss)				Total
Balance, September 30, 2019			8,851,677			$	87			$	26,713			$	58,024				1,643,322			$	(7,970	)		$	551			$	77,405
Issuance of common stock for restricted stock grants			5,000				—				—				—				—				—				—				—
Compensation expense related to stock compensation plans			—				—				459				—				—				—				—				459
Repurchase of common stock			—				—				—				—				157,951				(1,317	)			—				(1,317	)
Unrealized loss resulting from change in fair value of derivative instruments, net of tax			—				—				—				—				—				—				(903	)			(903	)
Net income			—				—				—				476				—				—				—				476
Balance, December 31, 2019			8,856,677			$	87			$	27,172			$	58,500				1,801,273			$	(9,287	)		$	(352	)		$	76,120
Balance, September 30, 2018			8,676,677			$	85			$	25,177			$	53,398				1,098,942			$	(6,590	)		$	(195	)		$	71,876
Forfeiture of restricted stock			—				—				—				—				5,000				—				—				—
Compensation expense related to stock compensation plans			—				—				646				—				—				—				—				646
Repurchase of common stock			—				—				—				—				43,813				(424	)			—				(424	)
Unrealized gain resulting from change in fair value of derivative instruments, net of tax			—				—				—				—				—				—				852				852
Net income			—				—				—				2,180				—				—				—				2,180
Balance, December 31, 2018			8,676,677			$	85			$	25,823			$	55,579				1,147,755			$	(7,014	)		$	657			$	75,130

		Common Stock								Additional Paid-in				Retained				Treasury Stock								Accumulated Other Comprehensive
		Shares				Amount				Capital				Earnings				Shares				Amount				Income (Loss)				Total
Balance, June 30, 2019			8,851,677			$	87			$	26,280			$	57,380				1,626,605			$	(7,955	)		$	292			$	76,084
Issuance of common stock for restricted stock grants			5,000				—				—				—				—				—				—				—
Compensation expense related to stock compensation plans			—				—				892				—				—				—				—				892
Repurchase of common stock			—				—				—				—				159,668				(1,332	)			—				(1,332	)
Forfeiture of restricted stock			—				—				—				—				15,000				—				—				—
Cumulative-effect adjustment pursuant to adoption of ASU 2016-02 (Note E)			—				—				—				420				—				—				—				420
Reclassification pursuant to adoption of ASU 2018-02 (Note D)			—				—				—				128				—				—				(128	)			—
Unrealized loss resulting from change in fair value of derivative instruments, net of tax			—				—				—				—				—				—				(516	)			(516	)
Net income			—				—				—				572				—				—				—				572
Balance, December 31, 2019			8,856,677			$	87			$	27,172			$	58,500				1,801,273			$	(9,287	)		$	(352	)		$	76,120
Balance, June 30, 2018			8,656,677			$	85			$	24,486			$	50,839				1,098,268			$	(6,584	)		$	(578	)		$	68,248
Issuance of common stock for stock option exercise			5,000				—				38				—				—				—				—				38
Issuance of common stock for restricted stock grants			15,000				—				—				—				—				—				—				—
Forfeiture of restricted stock			—				—				—				—				5,000				—				—				—
Compensation expense related to stock compensation plans			—				—				1,299				—				—				—				—				1,299
Repurchase of common stock			—				—				—				—				44,487				(430	)			—				(430	)
Unrealized gain resulting from change in fair value of derivative instruments, net of tax			—				—				—				—				—				—				1,235				1,235
Net income			—				—				—				4,740				—				—				—				4,740
Balance, December 31, 2018			8,676,677			$	85			$	25,823			$	55,579				1,147,755			$	(7,014	)		$	657			$	75,130

		Six Months Ended December 31,
		2019				2018
Cash flows from operating activities
Net income		$	572			$	4,740
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			1,966				1,597
Non-cash sales discount			—				490
Non-cash compensation			892				809
Pension expense, net of contributions			9				25
Loss (gain) on disposal of assets			122				(1	)
Changes in operating assets and liabilities:
Accounts receivable, net			1,737				1,086
Inventories, net			3,353				92
Operating lease right-of-use assets and liabilities, net			96				—
Prepaids and other assets			(612	)			(1,094	)
Accounts payable and accrued liabilities			(2,687	)			(546	)
Accrued compensation and employee benefits			(733	)			380
Income taxes			93				609
Net cash provided by operating activities			4,808				8,187
Cash flows from investing activities
Purchases of property and equipment			(1,633	)			(2,662	)
Proceeds from sale of property and equipment			17				19
Proceeds from collection of notes receivable			—				1,500
Net cash used in investing activities			(1,616	)			(1,143	)
Cash flows from financing activities
Repurchase of common stock			(1,332	)			(430	)
Issuance of common stock			—				38
Net cash used in financing activities			(1,332	)			(392	)
Net increase in cash and cash equivalents			1,860				6,652
Cash and cash equivalents at beginning of period			25,040				23,613
Cash and cash equivalents at end of period		$	26,900			$	30,265
Supplemental disclosures of cash flow information
Cash paid during the period for:
Interest		$	11			$	7
Taxes		$	18			$	733
Disclosure of non-cash activities:
Unrealized (loss) gain resulting from change in fair value of derivative instruments, net of tax		$	(516	)		$	1,235

 

 

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. Pursuant to such rules and regulations certain information and note disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) have been condensed or omitted. In management’s opinion, all adjustments necessary for a fair presentation of the financial position, results of operations, stockholders’ equity, and cash flows have been included and are of a normal, recurring nature. The results of operations for the six months ended December 31, 2019 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, 2019 (“2019 Annual Report”). The accounting policies used to prepare the financial statements included in this Report are the same as those described in the notes to the consolidated financial statements in our 2019 Annual Report unless otherwise noted below.

 

Recently Issued Accounting Pronouncements

 

Other recently issued accounting pronouncements not discussed in this Report did not have, or are not believed by management to have, a material impact on our present or future financial statements. 

 

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 using the additional dilutive effect of all dilutive securities. The dilutive impact of stock options and unvested restricted stock accounts 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 did not exclude any shares for the three or six months ended December 31, 2019 and December 31, 2018 that would have had an anti-dilutive impact.

 

Revenue Recognition

 

We record revenue based on a five-step model which includes: (1) identifying a contract with a customer; (2) identifying the performance obligations in the contract; (3) determining the transaction price; (4) allocating the transaction price among the performance obligations; and (5) recognizing revenue as each of the various performance obligations are satisfied.

 

Revenue is measured as the net amount of consideration expected to be received in exchange for fulfilling one or more performance obligations. We identify purchase orders from customers as contracts. The amount of consideration expected to be received and revenue recognized includes estimates of variable consideration, including estimates for early payment discounts and volume rebates. Such estimates are calculated using historical averages adjusted for any expected changes due to current business conditions and experience. We review and update these estimates at the end of each reporting period and the impact of any adjustments is recognized in the period the adjustments are identified. In assessing whether collection of consideration from a customer is probable, we consider both the customer's ability and intent to pay that amount of consideration when it is due. Payment of invoices is due as specified in the underlying customer agreement, which is typically 30 days from the invoice date. Invoices are generally issued on the date of transfer of control of the products ordered to the customer.

 

Revenue is recognized at the point in time that each of our performance obligation is fulfilled, and control of the ordered products is transferred to the customer. This transfer occurs when the product is shipped, or in some cases, when the product is delivered to the customer.

 

We provide early payment discounts to certain customers. Based on historical payment trends, we expect that these customers will take advantage of these early payment discounts. The cost of these discounts is reported as a reduction to the transaction price. If the actual discounts differ from those estimated, the difference is also reported as a change in the transaction price.

 

Except for product defects, no right of return exists on the sale of our products. We estimate returns based on historical experience and recognize a returns liability for any estimated returns. As of December 31, 2019, we have no liability recorded for estimated returns of products.

 

 

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 granted 500,000 shares of NAI common stock to Juice Plus+, (the “JP Shares”), and Juice Plus+ agreed the JP Shares are subject to certain restrictions and risk of forfeiture. Pursuant to the Irrevocable Proxy, Juice Plus+ also granted the NAI Board of Directors the right to vote the JP Shares that remain subject to 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.

 

On March 31, 2019, we amended our original Agreements with Juice Plus+ and extended the term of the Exclusive Manufacturing Agreement through August 6, 2025. In addition, pursuant to that Amended and Restated Exclusive Manufacturing Agreement, Juice Plus+ returned 400,000 shares of restricted common stock in exchange for an annual cash sales discount. The expense associated with the return of those shares and the related cash discount granted to Juice Plus+ are each recorded as a reduction to sales. As a result of the amendments contained in the Amended and Restated Exclusive Manufacturing Agreement, we made a one-time adjustment to reverse the expense associated with unvested shares that were returned as a result of such amendments. Amounts associated with the new cash discount began to be recorded in our fourth quarter of fiscal 2019 and will be amortized ratably over extended remaining life of the Amended and Restated Exclusive Manufacturing Agreement based on the full value of the cash discount expected to be given over the same period. We recorded $395,000 of “Cash Sales Discount” during the three months ended December 31, 2019 and $790,000 for the six months ended December 31, 2019. We recognized $245,000 of “Non-cash Sales Discount” during the three months ended December 31, 2018 and $490,000 during the six months ended December 31, 2018.

 

We currently own certain U.S. patents, and each patent’s corresponding foreign patent applications. All of these patents and patent rights relate to the ingredient known as “beta-alanine”, which is marketed and sold 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 $4.3 million during the three months ended December 31, 2019 and $7.5 million during the six months ended December 31, 2019. We similarly recorded $4.4 million during the three months ended December 31, 2018 and $9.8 million during the six months ended December 31, 2018.  These royalty income and raw material sale amounts resulted in royalty expense paid 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 $192,000 during the three months ended December 31, 2019 and $359,000 during the six months ended December 31, 2019. We similarly recognized $178,000 of royalty expense during the three months ended December 31, 2018 and $441,000 during the six months ended December 31, 2018.

 

Notes Receivable

 

On September 30, 2017, we accepted a 12-month note (the “KM Loan Agreement”) 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. On September 30, 2018, we entered into a First Amendment (the “First Amendment”) with Kaged Muscle in connection with the KM Loan Agreement. The First Amendment modified the KM Loan Agreement and related promissory note by extending the loan’s maturity date from September 30, 2018 to December 28, 2018 in exchange for an extension fee in the amount of $25,000. We executed this note receivable conversion, and subsequent amendment, to assist Kaged Muscle with their near term financing needs. The note carried an interest rate of fifteen percent (15%) per annum with payments of interest only. The note was paid in full before the amended maturity date.  In association with this note, we did not recognize any interest income during the three or six months ended December 31, 2019. During the three months ended December 31, 2018 we recognized $46,000 and during the six months ended December 31, 2018 we recognized $104,000 in interest income associated with this note.

 

Stock-Based Compensation

 

We had an omnibus equity incentive plan that was approved by our Board of Directors effective October 15, 2009 and approved by our stockholders at the Annual Meeting of Stockholders held on November 30, 2009 ("2009 Plan"). The 2009 Plan expired on October 15, 2019. The Board of Directors approved a new omnibus equity incentive plan effective October 15, 2019 (“2019 Plan”) and this plan was approved by our stockholders at the Annual Meeting of Stockholders held on December 6, 2019. Under the 2019 Plan, we may grant nonqualified and incentive stock options, restricted stock grants, restricted stock units, stock appreciation rights, and other stock-based awards to employees, non-employee directors and consultants.

 

We did not grant any options during each of the three and six month periods ending December 31, 2019 and December 31, 2018. All remaining outstanding stock options are fully vested. No options were exercised during the three or six month period ended December 31, 2019. No options were exercised during the three month period ended December 31, 2018. During the six months ended December 31, 2018, 5,000 options were exercised. There were no option forfeitures during the three or six month periods ended December 31, 2019 or December 31, 2018.

 

During the three and six months ended December 31, 2019, we granted 5,000 shares of restricted stock shares to a new member of our management team. During the six months ended December 31, 2018, we granted 15,000 shares of restricted stock shares to a new member of our management team. We did not grant any shares to employees during the three months ended December 31, 2018. During the three months ended December 31, 2019, there were no restricted stock forfeitures. During the six months ended December 31, 2019, 15,000 restricted stock shares were forfeited. During the three and six months ended December 31, 2018, 5,000 restricted stock shares forfeited. Our net income included stock based compensation expense of approximately $459,000 for the three months ended December 31, 2019, and $892,000 for the six months ended December 31, 2019. Our net income included stock based compensation expense of approximately $400,000 for the three months ended December 31, 2018 and $809,000 for the six months ended December 31, 2018.

 

Fair Value of Financial Instruments

 

Except for cash and cash equivalents and assets and liabilities related to our pension plan, as of December 31, 2019, and June 30, 2019, we did not have any financial assets or liabilities classified as Level 1. We classify derivative forward exchange contracts as Level 2 assets and liabilities. The fair value of our forward exchange contracts as of December 31, 2019 was a net asset of $1.6 million. The fair value of our forward exchange contracts as of June 30, 2019 included a net asset of $2.3 million. The fair values were determined based on obtaining pricing from our bank and corroborating those values with a third party bank. As of December 31, 2019, and June 30, 2019, 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 2019 or the three or six months ended December 31, 2019. 

 

 

B. Inventories, net

 

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

 

 

The inventory reserve as of December 31, 2019 and June 30, 2019, included a reserve of $39,000 and $686,000, respectively, related to our first generation SR CarnoSyn® powder.

 

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 six months ended December 31, 2019 and December 31, 2018 (in thousands):

 

 

 

 

On July 1, 2019, we adopted ASU 2018-02, “Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income”. ASU 2018 allows for a reclassification from accumulated other comprehensive income (OCI) to retained earnings for stranded tax effects resulting from the 2017 Tax Cuts and Jobs Act. Under this ASU, we reclassified $128,000 of gains from OCI to retained earnings.

 

 

E. Leases

 

On July 1, 2019, we adopted FASB Accounting Standards Codification, or ASC, Topic 842, Leases, or ASC 842, which requires the recognition of the right-of-use assets and related operating and finance lease liabilities on the balance sheet. As permitted by ASC 842, we elected the adoption date of July 1, 2019, which is the date of initial application. As a result, the consolidated balance sheet prior to July 1, 2019 was not restated, continues to be reported under ASC Topic 840, Leases, or ASC 840, which did not require the recognition of operating lease assets or liabilities on the balance sheet, and is not comparative. Under ASC 842, all leases are required to be recorded on the balance sheet and are classified as either operating leases or finance leases. The lease classification affects the expense recognition in the income statement. Operating lease expenses are recorded entirely in operating expenses. Finance lease charges are split, where amortization of the right-of-use asset is recorded in operating expenses and an implied interest component is recorded in interest expense. The expense recognition for operating leases and finance leases under ASC 842 is substantially consistent with ASC 840. As a result, there is no material difference in our results of operations presented in our Condensed Consolidated Statement of Income and Comprehensive Income for each period presented.

 

We adopted ASC 842 using a modified retrospective approach for all leases existing at July 1, 2019. The adoption of ASC 842 had a substantial impact on our balance sheet. The most significant impact was the recognition of the operating lease right-of-use assets and the liability for operating leases. As of July 1, 2019, we had no finance leases. Upon adoption, leases that were previously classified as operating leases under ASC 840 were classified as operating leases under ASC 842, and we recorded an adjustment of $20.7 million to operating lease right-of-use assets and an adjustment of $20.9 million to the related lease liability. The lease liability is based on the present value of the remaining minimum lease payments, determined under ASC 840, discounted using our secured incremental borrowing rate at the effective date of July 1, 2019, and using the expected lease term, including any optional renewals, as the tenor. As permitted under ASC 842, we elected several practical expedients that permit us to not reassess (1) whether existing contracts are or contain a lease, (2) the classification of existing leases, and (3) whether previously capitalized costs continue to qualify as initial indirect costs. The application of the practical expedients did not have a significant impact on the measurement of the operating lease liability.

 

The impact of the adoption of ASC 842 on the balance sheet at June 30, 2019 was (in thousands):

 

 

We lease substantially all of our product manufacturing and support office space used to conduct our business. We adopted ASC 842 effective July, 1 2019. For contracts entered into on or after that effective date, at the inception of a contract we assess whether the contract is, or contains, a lease. Our assessment is based on: (1) whether the contract involves the use of a distinct identified asset, (2) whether we obtain the right to substantially all the economic benefit from the use of the asset throughout the period of the contract, and (3) whether we have the right to direct the use of the asset during such time period. At inception of a lease, we allocate the consideration in the contract to each lease component based on its relative stand-alone price to determine the lease payments.

 

Leases are classified as either finance leases or operating leases. A lease must be classified as a finance lease if any of the following criteria are met: the lease transfers ownership of the asset by the end of the lease term, the lease contains an option to purchase the asset that is reasonably certain to be exercised, the lease term is for a major part of the remaining useful life of the asset or the present value of the lease payments equals or exceeds substantially all of the fair value of the asset. A lease is classified as an operating lease if it does not meet any of these criteria. Substantially all our operating leases are comprised of payments for the use of manufacturing space leases.

 

For all leases at the lease commencement date, a right-of-use asset and a lease liability are recognized. The right-of-use asset represents the right to use the leased asset for the lease term. The lease liability represents the present value of the lease payments under the lease.

 

The right-of-use asset is initially measured at cost, which primarily comprises the initial amount of the lease liability, plus any initial direct costs incurred, consisting mainly of brokerage commissions, less any lease incentives received. All right-of-use assets are reviewed for impairment. The lease liability is initially measured at the present value of the lease payments, discounted using the interest rate implicit in the lease or, if that rate cannot be readily determined, our secured incremental borrowing rate for the same term as the underlying lease. For our real estate and other operating leases, we use our secured incremental borrowing rate. For our finance leases, we will use the rate implicit in the lease or our secured incremental borrowing rate if the implicit lease rate cannot be determined.

 

Lease payments included in the measurement of the lease liability comprise the following: the fixed noncancelable lease payments, payments for optional renewal periods where it is reasonably certain the renewal period will be exercised, and payments for early termination options unless it is reasonably certain the lease will not be terminated early.

 

Some of our manufacturing leases contain variable lease payments, including payments based on an index or rate. Variable lease payments based on an index or rate are initially measured using the index or rate in effect at lease commencement and separated into lease and non-lease components based on the initial amount stated in the lease or standalone selling prices. Lease components are included in the measurement of the initial lease liability. Additional payments based on the change in an index or rate, or payments based on a change in our portion of the operating expenses, including real estate taxes and insurance, are recorded as a period expense when incurred. Lease modifications result in remeasurement of the lease liability.

 

Lease expense for operating leases consists of the lease payments plus any initial direct costs, primarily brokerage commissions, and is recognized on a straight-line basis over the lease term. Included in lease expense are any variable lease payments incurred in the period that were not included in the initial lease liability. Lease expense for finance leases consists of the amortization of the right-of-use asset on a straight-line basis over the lease term and interest expense determined on an amortized cost basis. The lease payments are allocated between a reduction of the lease liability and interest expense.

 

We have elected not to recognize right-of-use assets and lease liabilities for short-term leases that have a term of 12 months or less. The effect of short-term leases on our right-of-use asset and lease liability was not material.

 

 

 

F. Debt

 

On July 1, 2019, we executed an amendment to our credit facility with Wells Fargo Bank, N.A. to extend the maturity for our working line of credit from February 1, 2021, to November 1, 2022. 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 was no commitment fee required as part of this amendment.

 

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 us 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 between payment under a fixed rate versus payment under the variable rate for each month from the month of prepayment through the month in which the then applicable fixed rate term matures. On December 31, 2019, we were in compliance with all of the financial and other covenants required under the Credit Agreement.

 

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 credit approval with Wells Fargo Bank, N.A. which allows us to hedge foreign currency exposures up to 30 months in the future. We also have credit approval with Bank of America which allows us to hedge foreign currency exposures up to 24 months in the future.

 

We did not use our working capital line of credit nor did we have any long-term debt outstanding during the three months ended December 31, 2019. As of December 31, 2019, we had $10.0 million available under our credit facilities.

 

G. 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 (i) sales to these customers, (ii) the growth rate of sales to these customers, or (iii) these customers’ ability to make payments when due, each individually 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 net sales.

 

We buy certain products, including beta-alanine, from a limited number of raw material suppliers who meet our quality standards. 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 (dollars in thousands):

 

 

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

 

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 three of our largest customers, whose receivable balances collectively represented 77.1% of gross accounts receivable at December 31, 2019 and 76.8% at June 30, 2019. Additionally, amounts due related to our beta-alanine raw material sales were 16.1% of gross accounts receivable at December 31, 2019, and 8.0% of gross accounts receivable at June 30, 2019. Concentrations of credit risk related to the remaining accounts receivable balances are limited due to the number of customers comprising our remaining customer base.

 

 

H. Segment Information

 

Our business consists of two segments for financial reporting purposes. The two segments are 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 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 the allocation of certain corporate level expenses. 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 include, but are not limited to: human resources, corporate legal, finance, information technology, and other corporate level related expenses, which are not allocated to any segment. Transfers of raw materials between segments are recorded at cost. The accounting policies of our segments are the same as those described in the summary of significant accounting policies in Note A above and in the consolidated financial statements included in our 2019 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, Canada, Australia, New Zealand, and Asia. Our primary markets outside the U.S. are Europe and Asia. 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 our Swiss subsidiary ("NAIE") accounted for 91% of net sales in markets outside the U.S. for the three months ended December 31, 2019 and 90% for the six months ended December 31, 2019. Products manufactured by NAIE accounted for 90% of net sales in markets outside the U.S. for the three months ended December 31, 2018 and 80% for the six months ended December 31, 2018. No products manufactured by NAIE were sold in U.S. markets during the three or six month periods ended December 31, 2019 and 2018.

 

 

Long-lived assets by geographic region, based on the location of the company or subsidiary at which they were located or made, were as follows (in thousands):

 

 

As a result of the implementation of ASC 842, operating lease right-of-use assets are now recorded as part of long-lived assets for segment reporting.

 

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

 

 

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):

 

 

 

I. Income Taxes

 

The effective tax rate for the three months ended December 31, 2019 was 17.0% and the effective tax rate for the six months ended December 31, 2019 was 17.8%. The rates differ slightly from the fiscal 2019 U.S. federal statutory rate of 21% primarily due to research and development credits, and the favorable impact of foreign earnings taxed at less than the U.S. statutory rate. The effective tax rate for the three months ended December 31, 2018 was 20.7% and the effective tax for the six months ended December 31, 2018 was 20.6%.

 

To determine our quarterly provision for income taxes, we use an estimated annual effective tax rate, which 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 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. There were no significant discrete items for the three months or six months ended December 31, 2019 and three or sixth months ended December 31, 2018.  

 

We record valuation allowances to reduce our deferred tax assets to an amount 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 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 or six months ended December 31, 2019, there was no change to our valuation allowance for our deferred tax assets.

 

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, 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 as income or expense in the period that includes the enactment date for such new rates.

 

We are subject to taxation in the U.S., Switzerland and various state jurisdictions. Our tax years for the fiscal year ended June 30, 2016 and forward are subject to examination by the U.S. tax authorities. Our tax years for the fiscal years ended June 30, 2007 and forward are subject to examination by the state tax authorities. Our tax years for the fiscal year ended June 30, 2018 and forward are subject to examination by the 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 those reserves. There were no adjustments to reserves in the three or six month periods ended December 31, 2019.

  

 

J. Treasury Stock

 

The Board of Directors has authorized a total of $7.0 million under our stock repurchase plan as of December 31, 2019. On January 8, 2020, the Board of Directors authorized a $2.0 million increase to our stock repurchase plan bringing the total authorized repurchase amount to $9.0 million. Under the repurchase plan, we may, from time to time, purchase shares of our common stock, depending upon market conditions, in open market or privately negotiated transactions.

 

During the three months ended December 31, 2019 we repurchased 150,307 shares at a weighted average cost of $8.33 and a total cost of $1.3 million under this repurchase plan. During the six months ended December 31, 2019 we repurchased 151,338 shares at a weighted average cost of $8.33 and a total cost of $1.3 million under this repurchase plan. During the three and six months ended December 31, 2018, we repurchased 36,949 shares at a total cost of $358,000 under this repurchase plan.

 

During the three months ended December 31, 2019 we acquired 7,644 shares from employees in connection with restricted stock shares that vested during that period at a weighted average cost of $8.67 per share and a total cost of $66,000. During the six months ended December 31, 2019, we acquired 8,330 shares from employees in connection with restricted stock shares that vested during that year at a weighted average cost of $8.74 per share and a total cost of $73,000. During the three months ended December 31, 2018, we acquired 6,864 shares from employees in connection with restricted stock shares that vested during the period at a weighted average cost of $9.66 per share and a total cost of $66,000. During the six months ended December 31, 2018, we acquired 7,538 shares in connection with restricted stock shares that vested during that period at a weighted average cost of $9.66 per share and a total cost of $72,000. These shares were returned to us by the subject employees and in exchange we paid each employee’s required tax withholding liability incurred due to the vesting of their restricted stock shares during that period. The valuation of the shares acquired and the number of shares returned to us was calculated based on the closing share price on the date the shares vested.

 

K. Derivatives and Hedging

 

We are exposed to gains and losses resulting from fluctuations in foreign currency exchange rates relating to forecasted product sales denominated in foreign currencies and to other transactions of NAIE, our foreign subsidiary. As part of our overall strategy to manage the level of exposure to the risk of fluctuations in foreign currency exchange rates, we may 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 December 31, 2019, 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 2021. 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 accumulated other comprehensive income (“OCI”) 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 income or expense. We measure effectiveness by comparing the cumulative change in the hedge contract with the cumulative change in the hedged item as well as ensuring the assumptions we made at hedge inception have not materially changed. No hedging relationships were terminated as a result of ineffective hedging for the three or six months ended December 31, 2019 and December 31, 2018.

 

We monitor the probability of forecasted transactions as part of the hedge effectiveness testing on a quarterly basis. During the three and six months ended December 31, 2019 and December 31, 2018, we did not have any losses or gains related to the ineffective portion of our hedging instruments.

 

As of December 31, 2019, the notional amounts of our foreign exchange contracts designated as cash flow hedges were approximately $40.5 million (EUR 34.2 million). As of December 31, 2019, a net gain of approximately $276,000 related to derivative instruments designated as cash flow hedges was recorded in OCI. It is expected that $305,000 will be reclassified into earnings in the next 12 months along with the earnings effects of the related forecasted transactions.

 

As of December 31, 2019, the fair value of our cash flow hedges was an asset of $1.6 million, all of which was classified as forward contracts in our Consolidated Balance Sheets. During the three months ended December 31, 2019, we recognized $369,000 of net losses in OCI, and reclassified $808,000 of gains and forward point amortization from OCI to Sales. During the six months ended December 31, 2019, we recognized $932,000 of net gains in OCI, reclassified $1.6 million of gains and forward point amortization from OCI to Sales, and reclassified $54,000 of gains from OCI to Other Income. As of June 30, 2019, $2.0 million of the fair value of our cash flow hedges was classified in forward contracts, and $312,000 was classified in other non-current assets in our Consolidated Balance Sheets. During the three months ended December 31, 2018, we recognized $1.3 million of net gains in OCI and reclassified $211,000 of gains from OCI to revenue. During the six months ended December 31, 2018, we recognized $1.8 million of net gains in OCI and reclassified $169,000 of gains from OCI to revenue.

 

On July 1, 2019, we adopted ASU No. 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” The ASU better aligns an entity’s risk management activities and financial reporting for hedging relationships through changes to both the designation and measurement guidance for qualifying hedging relationships and the presentation of hedge results. We applied ASU No. 2017-12 using a modified retrospective approach for cash flow and fair value hedges existing at the date of adoption and prospectively for the presentation and disclosure guidance. As a result of the adoption of this ASU, amortization of forward points are now included as a component of net revenues while they were previously included as a component of other income. We included $261,000 of forward point amortization in Net Sales for the three months ended December 31, 2019, and $498,000 of forward point amortization in Net Sales for the six months ended December 31, 2019. We included $464,000 of forward point amortization in Other Income for the three months ended December 31, 2018, and $951,000 of forward point amortization in Other Income for the six months ended December 31, 2018.

 

L. 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, regulatory, contract or other matters. The resolution of these matters as they arise may 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 currently do not believe the resolution of these matters 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 be greater than we currently anticipate and if they were they 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 do not expect.