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

 

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		March 31, 2019				June 30, 2018
		(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	27,660			$	23,613
Accounts receivable - less allowance for doubtful accounts of $78 at March 31, 2019 and $49 at June 30, 2018			16,790				14,621
Note receivable			—				1,500
Inventories, net			27,016				23,567
Forward contracts			2,770				55
Prepaids and other current assets			2,052				1,827
Total current assets			76,288				65,183
Property and equipment, net			20,882				19,290
Other noncurrent assets, net			1,286				734
Total assets		$	98,456			$	85,207
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable		$	12,374			$	9,649
Accrued liabilities			3,612				2,346
Accrued compensation and employee benefits			1,382				1,498
Income taxes payable			845				787
Total current liabilities			18,213				14,280
Income taxes payable, noncurrent			1,546				1,546
Deferred income taxes			1,034				532
Other long-term liabilities			634				601
Total liabilities			21,427				16,959
Commitments and contingencies (Note K)
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) 7,259,056 at March 31, 2019 and 7,558,408 at June 30, 2018			87				85
Additional paid-in capital			25,817				24,486
Retained earnings			57,573				50,839
Treasury stock, at cost, 1,592,621 shares at March 31, 2019 and 1,098,268 June 30, 2018			(7,529	)			(6,584	)
Accumulated other comprehensive gain/(loss)			1,081				(578	)
Total stockholders’ equity			77,029				68,248
Total liabilities and stockholders’ equity		$	98,456			$	85,207

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		Three Months Ended								Nine months Ended
		March 31,								March 31,
		2019				2018				2019				2018
Net sales		$	35,455			$	31,815			$	108,030			$	93,224
Cost of goods sold			29,128				25,105				88,104				73,522
Gross profit			6,327				6,710				19,926				19,702
Selling, general and administrative			4,492				4,187				13,160				13,015
Income from operations			1,835				2,523				6,766				6,687
Other income (expense):
Interest income			411				269				1,495				823
Interest expense			(11	)			(6	)			(23	)			(6	)
Foreign exchange gain (loss)			232				(182	)			191				(413	)
Other, net			(10	)			(5	)			(1	)			(18	)
Total other income			622				76				1,662				386
Income before income taxes			2,457				2,599				8,428				7,073
Provision for income taxes			463				548				1,694				4,906
Net income		$	1,994			$	2,051			$	6,734			$	2,167
Unrealized gain (loss) resulting from change in fair value of derivative instruments, net of tax			424				(219	)			1,659				(1,550	)
Comprehensive income		$	2,418			$	1,832			$	8,393			$	617
Net income per common share:
Basic		$	0.29			$	0.31			$	0.99			$	0.33
Diluted		$	0.27			$	0.30			$	0.95			$	0.32
Weighted average common shares outstanding
Basic			6,800,375				6,639,098				6,791,105				6,620,324
Diluted			7,394,600				6,909,475				7,119,589				6,860,870

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		Common Stock								Additional Paid-in				Retained				Treasury Stock								Accumulated Other Comprehensive
		Shares				Amount				Capital				Earnings				Shares				Amount				Income (Loss)				Total
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			190,000				2				(2	)			—				—				—				—				—
Compensation expense related to stock compensation plans			—				—				1,291				—				—				—				—				1,291
Repurchase of common stock			—				—				—				—				89,353				(941	)			—				(941	)
Forfeiture of restricted stock			—				—				4				—				405,000				(4	)			—				—
Unrealized gain resulting from change in fair value of derivative instruments, net of tax			—				—				—				—				—				—				1,659				1,659
Net income			—				—				—				6,734				—				—				—				6,734
Balance, March 31, 2019			8,851,677			$	87			$	25,817			$	57,573				1,592,621			$	(7,529	)		$	1,081			$	77,029
Balance as of June 30, 2017			7,981,677				79				22,260				45,788				1,044,659				(6,074	)			(905	)			61,148
Issuance of common stock for restricted stock grants			675,000				6				(6	)			—				—				—				—				—
Compensation expense related to stock compensation plans			—				—				1,578				—				—				—				—				1,578
Repurchase of common stock			—				—				—				—				43,201				(505	)			—				(505	)
Unrealized gain (loss) resulting from change in fair value of derivative instruments, net of tax			—				—				—				—				—				—				(1,550	)			(1,550	)
Net income			—				—				—				2,167				—				—				—				2,167
Balance, March 31, 2018			8,656,667			$	85			$	23,832			$	47,955				1,087,860			$	(6,579	)		$	(2,455	)		$	62,838

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		Nine Months Ended March 31,
		2019				2018
Cash flows from operating activities
Net income		$	6,734			$	2,167
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			2,529				2,222
Deferred income taxes			—				306
Non-cash sales discount			82				653
Non-cash compensation			1,209				925
Pension expense, net of contributions			37				(97	)
Loss (gain) on disposal of assets			9				(9	)
Changes in operating assets and liabilities:
Accounts receivable, net			(2,169	)			(2,971	)
Inventories, net			(3,449	)			(10,056	)
Prepaids and other assets			(174	)			(308	)
Accounts payable and accrued liabilities			4,088				8,674
Accrued compensation and employee benefits			(116	)			(577	)
Forward contracts			(1,258	)			715
Income taxes			58				3,045
Net cash provided by operating activities			7,580				4,689
Cash flows from investing activities
Purchases of property and equipment			(4,149	)			(2,937	)
Proceeds from sale of property and equipment			19				28
Issuance of notes receivable			—				(1,500	)
Proceeds from collection of notes receivable			1,500				—
Net cash used in investing activities			(2,630	)			(4,409	)
Cash flows from financing activities
Repurchase of common stock			(941	)			(505	)
Issuance of common stock			38				—
Net cash used in financing activities			(903	)			(505	)
Net increase (decrease) in cash and cash equivalents			4,047				(225	)
Cash and cash equivalents at beginning of period			23,613				27,843
Cash and cash equivalents at end of period		$	27,660			$	27,618
Supplemental disclosures of cash flow information
Cash paid during the period for:
Interest		$	19			$	6
Taxes		$	1,747			$	1,578
Disclosure of non-cash activities:
Unrealized gain (loss) resulting from change in fair value of derivative instruments, net of tax		$	1,659			$	(1,550	)

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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. Pursuant to such 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. 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, 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, 2018 (“2018 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 2018 Annual Report unless otherwise noted below.

 

Recently Adopted Accounting Pronouncements

 

In April 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2017-10, Revenue from Contracts with Customers (Topic 606)(ASU 2017-10), which amends and adds clarity to certain aspects of the guidance set forth in the revenue standard ASU 2014-09 related to identifying performance obligations and licensing. In May 2017, the FASB issued Accounting Standards Update No. 2017-11, Revenue Recognition (Topic 605) and Derivatives and Hedging (Topic 815) (ASU 2017-11), which amends and rescinds certain revenue recognition guidance previously released within ASU 2014-09. In May 2017, the FASB issued Accounting Standards Update No. 2017-12, Revenue from Contracts with Customers (Topic 606) (ASU 2017-12), which provides narrow scope improvements and practical expedients related to ASU 2014-09. All of these ASUs have been codified under Accounting Standards Codification (ASC) 606.

 

ASC 606 outlines a single comprehensive model for companies to use in accounting for revenue arising from contracts with customers and supersedes most current historical revenue recognition guidance, including industry-specific guidance. The core principle of that revenue model is that an entity recognizes revenue to depict the transfer of promised goods and services in an amount that reflects the consideration to which the entity expects to be entitled to receive in exchange for those goods and services. In addition, the new revenue model requires that reporting companies disclose the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with their respective customers.

 

The new revenue model is required to be applied either retrospectively to each prior reporting period presented or prospectively with the cumulative effect of initially applying the model used at the date of the initial application, supplemented with certain disclosures related to the effect of adoption on previously reported amounts, if any (the modified retrospective method). We adopted this revenue model on July 1, 2018 for contracts that were not completed before the adoption date, using the modified retrospective method. We evaluated the effect of the use of the new model and concluded it was not material to the timing or amount of revenues or expenses recognized in our historical consolidated financial statements. As a result, we concluded the application of the new model did not have a material effect that requires a retrospective adjustment for reporting disclosure purposes to any previously reported amounts in our historical consolidated financial statements.

 

In February 2018, the FASB issued ASU 2018-03, Technical Corrections and Improvements to Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2018-03 is intended to improve certain aspects of recognition, measurement, presentation, and disclosure of certain financial instruments, i.e. forward contracts, purchased options and option liabilities. ASU 2018-03 is effective for us beginning in our first quarter of fiscal 2019. This ASU did not have a material impact on our consolidated financial statements.

 

 In August 2018, the SEC issued Release No. 33-10532, Disclosure Update and Simplification, which amends and clarifies certain financial reporting requirements. We adopted this Release in this third quarter of fiscal 2019. The principal change to our consolidated financial statements is the inclusion of the changes in stockholders’ equity in interim unaudited condensed financial statements (Quarterly Reports), which were previously included only in our Annual Report.

 

In March 2019, the SEC issued its Final Rule Release No. 33-10618, FAST Act Modernization and Simplification of Regulation S-K. The guidance in this Release revises certain disclosure requirements in SEC Regulation S-K, with the intent of improving the readability of filed documents and simplifying registrants' compliance efforts. We adopted this Release in this third quarter of fiscal 2019. The adoption of this Release did not have a material impact on our consolidated financial statements.

 

 

Recently Issued 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. In July 2018, the FASB issued ASU 2018-10, Codification Improvements to Topic 842, Leases. This ASU affects narrow aspects of the guidance issued in the amendments in ASU No. 2016-02 including those regarding residual value guarantees, the interest rate implicit in the lease, lessee reassessment of lease classification, lessor reassessment of lease term and purchase option, variable lease payments that depend on an index or a rate, investment tax credits, lease term and purchase option, transition guidance for amounts previously recognized in business combinations, certain transition adjustments, transition guidance for leases previously classified as capital leases under Topic 840, transition guidance for modifications to leases previously classified as direct financing or sales-type leases under Topic 840, transition guidance for sale and leaseback transactions, impairment of net investment in the lease, unguaranteed residual asset, effect of initial direct costs on the interest rate implicit in the lease, and failed sale and leaseback transactions. These ASUs will be effective for us beginning in our first quarter of fiscal 2020. We expect these ASUs will have a material impact on our consolidated balance sheets at that time due to the creation of lease assets and liabilities related to our leased manufacturing and storage facilities.

 

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. Under this ASU, we will record forward points as component of Net Sales, rather than as a component of Other Income. ASU 2017-12 will be effective for us beginning in our first quarter of fiscal 2020.

 

In February 2018, the FASB issued ASU 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. ASU 2018-02 allows for a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. Under this ASU, we currently expect to reclassify $134,000 of gains from OCI to retained earnings. ASU 2018-02 will be effective for us beginning in our first quarter of fiscal 2020.

 

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 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 excluded shares related to restricted stock totaling 175,000 for the three months ended March 31, 2019, as their impact would have been anti-dilutive. We excluded shares related to restricted stock totaling 175,000 for the three months ended March 31, 2018, as their impact would have been anti-dilutive.

 

Included in the diluted weighted average common shares outstanding for the three and nine months ended March 31, 2019, is the weighted average effect of 400,000 shares of unvested restricted stock returned to us from Juice Plus+ as a result of the amendment to the Exclusive Manufacturing Agreement, as discussed below.

 

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 March 31, 2019, we have no known returns liability.

 

 

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 “Shares”), and Juice Plus+ agreed the 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 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 amendment to the Exclusive Manufacturing Agreement, we made a one-time adjustment to reverse the expense associated with unvested shares that were returned as a result of the Amended and Restated Exclusive Manufacturing Agreement. Amounts associated with the new cash discount will begin to be recorded in our fourth quarter of fiscal 2019 and will be amortized ratably over the remaining life of the extended agreement based on the full value of the cash discount expected to be given over the same period. We recorded $408,000 of income during the three months ended March 31, 2019 and $82,000 of expense for the nine months ended March 31, 2019 as a “Non-cash Sales Discount” which is an adjustment to net sales. We recorded $245,000 of expense during the three months ended March 31, 2018 and $653,000 of expense during the nine months ended March 31, 2018 as a "Non-cash Sales Discount."

 

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 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 $3.7 million during the three months ended March 31, 2019 and $13.5 million during the nine months ended March 31, 2019. We recorded $6.2 million during the three months ended March 31, 2018 and $16.0 million during the nine months ended March 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 $156,000 during the three months ended March 31, 2019 and $597,000 during the nine months ended March 31, 2019. We similarly recognized $215,000 of royalty expense during the three months ended March 31, 2018 and $659,000 of royalty expense during the nine months ended March 31, 2018.

 

Notes Receivable

 

On September 30, 2017, we accepted a 12-month note (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 Loan Agreement. The First Amendment modified the Loan Agreement and related promissory note by extending the maturity date from September 30, 2018 to December 28, 2018 in exchange for an extension fee in the amount of $25,000. Kaged Muscle is one of our fastest growing sports nutrition customers and we executed this note receivable conversion, and subsequent amendment, to assist them 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 months ended March 31, 2019 and recognized $104,000 in interest income during the nine months ended March 31, 2019. During the three months ended March 31, 2018 we recognized $56,000 and $114,000 during the nine months ended March 31, 2018 in interest income associated with this note.

 

Stock-Based Compensation

 

We have 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"). Under the 2009 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 transferable. Option valuation models require the use 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 we have not to date ever 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 in the period 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 recognize forfeitures as they occur.   

 

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

 

During the three months ended March 31, 2019, we granted a total of 175,000 restricted stock shares to members of our Board of Directors and certain key members of our management team. During the nine months ended March 31, 2019, we granted a total of 190,000 restricted stock shares to members of our Board of Directors and certain key members of our management team. 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. Our net income included stock based compensation expense of approximately $400,000 for the three months ended March 31, 2019, and $1.2 million for the nine months ended March 31, 2019. 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.

 

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. The approximate fair value of cash and cash equivalents, accounts receivable, accounts payable and short-term borrowings is equal to book value due to the short-term nature of these items. 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.

 

Except for assets and liabilities related to our pension plan, as of March 31, 2019, and June 30, 2018, we did not have any financial assets or liabilities classified as Level 1. We classify derivative forward exchange contracts as Level 2 assets. The fair value of our forward exchange contracts as of March 31, 2019 was a net asset of $3.4 million. The fair value of our forward exchange contracts as of June 30, 2018 included a net asset of $55,000 and a net liability of $55,000, with no right of offset. As of March 31, 2019, and June 30, 2018, 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 2018 or the nine months ended March 31, 2019. 

 

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 78.0% of gross accounts receivable at March 31, 2019 and 76.6% at June 30, 2018. Additionally, amounts due related to our beta-alanine raw material sales were 12.9% of gross accounts receivable at March 31, 2019, and 17.3% of gross accounts receivable at June 30, 2018. 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

 

Other comprehensive (loss) income (“OCL” and “OCI”) consisted of the following during the three and nine months ended March 31, 2019 and March 31, 2018 (in thousands):

 

 

During the three months ended March 31, 2019, the amounts reclassified from OCI were comprised of $450,000 of gains reclassified to net revenues, $368,000 related to the amortization of forward points reclassified to interest income and $122,000 related to partially terminated hedging contracts to other income. During the nine months ended March 31, 2019, the amounts reclassified from OCI were comprised of $619,000 of gains reclassified to net revenues, $1.3 million related to the amortization of forward points reclassified to interest income and $122,000 related to partially terminated hedging contracts to other income.   

 

 

 

During the three months ended March 31, 2018, the amounts reclassified from OCI were comprised of $974,000 of losses reclassified to net revenues and $206,000 related to the amortization of forward points reclassified to interest income. During the nine months ended March 31, 2018, the amounts reclassified from OCI were comprised of $1.8 million of losses reclassified to net revenues and $691,000 related to the amortization of forward points reclassified to interest income.

 

 

 E. Debt

 

On March 20, 2018, 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, 2020, to February 1, 2021. 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 for each month from the month of prepayment through the month in which the then applicable fixed rate term matures.

 

Our obligations under the Credit Agreement are secured by our accounts receivable and other rights to payment, general intangibles, inventory, equipment and fixtures. We also have a foreign exchange facility with Wells Fargo Bank, N.A. in effect until January 31, 2021, and with Bank of America, N.A. in effect until August 15, 2019. 

 

On March 31, 2019, we were in compliance with all of the financial and other covenants required under the Credit Agreement.

 

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, 2019. As of March 31, 2019, 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 (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):

 

 

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.

 

 

G. 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 2018 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 74% of net sales in markets outside the U.S. for the three months ended March 31, 2019, and 78% for the nine months ended March 31, 2019. 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. No products manufactured by NAIE were sold in U.S. markets during the three month or nine month periods ended March 31, 2019 and 2018.

 

 

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 effective tax rate for the three months ended March 31, 2019 was 18.9% and the effective tax rate for the nine months ended March 31, 2019 was 20.1%. The rates differ slightly from the fiscal 2019 U.S. federal statutory rate of 21% primarily due to the favorable impact of foreign earnings of NAIE, which are taxed at less than the U.S. statutory rate, as well as discrete tax items related to vesting of employee restricted stock.

 

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%. The effective tax rates for the three and nine months ended March 31, 2018 differ from our fiscal 2018 U.S. federal statutory rate of 28.06% primarily due to discrete items related to the Tax Cuts and Jobs Act (“the Tax Act”) enacted in December 2017. Our U.S. federal statutory rate for the year ending June 30, 2018 was 28.06%, which is a blended rate of the historic 35% statutory rate and the 21% rate stipulated by the Act.

 

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 or nine months ended March 31, 2019. Included in our tax expenses for the three and nine months ended March 31, 2018, is $3.3 million of discrete tax items related to the Tax Act. The discrete items include:

 

●

$1.8 million associated with a one-time transition tax that was calculated 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 outside the U.S. thereby allowing us to defer recognizing any U.S. income taxes on the amount of such E&P. However, under the Tax Act we are required to pay this tax based on a deemed repatriation into the U.S. of such E&P. In accordance with the provisions of the Tax Act, we elected to pay this tax over an eight-year period.

 

●

As of and since March 31, 2018, we no longer consider undistributed foreign earnings from NAIE earned before March 31, 2018 to be indefinitely reinvested. As a result, we recorded $775,000 in estimated foreign withholding taxes on the amounts deemed repatriated under the Act.

 

●

We remeasured certain deferred tax assets and liabilities based on the rates at which they were expected to reverse in the future. The amount recorded during the second quarter of fiscal 2018 was based on whether the amounts were expected to reverse in fiscal 2018 at a blended U.S. rate of 28.06% or reverse in future periods at a rate of 21%. This amount was considered provisional under implementation of the Tax Act as we were still analyzing various aspects of the Act. The provision amount recorded during nine months ended March 31, 2018 from the remeasurement of our deferred tax balance was $664,000.

  

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 nine months ended March 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, 2008, 2009, as well as for the fiscal years ended June 30, 2015 and forward are subject to examination by the state tax authorities. Our tax years for the fiscal year ended June 30, 2015 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 nine month periods ended March 31, 2019.

 

 

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, in open market or privately negotiated transactions.

 

During the three months ended March 31, 2019, we purchased 5,748 shares under this plan at a weighted average cost of $10.17 per share and a total cost of $58,000 including commissions and fees. During the nine months ended March 31, 2019 we purchased 42,697 shares under this plan at a weighted average cost of $9.75 and a total cost of $416,000 including commission and fees. During the three and nine months ended March 31, 2018, we did not repurchase any shares under this repurchase plan.

 

During the three months ended March 31, 2019, we acquired 39,118 shares from employees in connection with restricted stock shares that vested during that year at a weighted average cost of $11.58 per share and a total cost of $453,000. During the nine months ended March 31, 2019, we acquired 46,656 shares from employees in connection with restricted stock shares that vested during that period at a weighted average cost of $11.27 per share and a total cost of $525,000. During the three months ended March 31, 2018, we acquired 35,203 shares from employees in connection with restricted stock shares that vested during the 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 from employees in connection with restricted stock shares that vested during the period at a weighted average cost of $11.69 per share and a total cost of $505,000. 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.

 

As part of the Amended and Restated Exclusive Manufacturing Agreement with Juice Plus+, Juice Plus returned 400,000 shares of restricted common stock to us, which was added to our treasury stock as of March 31, 2019.

 

 

J. 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 March 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 2020. 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. No hedging relationships were terminated as a result of ineffective hedging for the three and nine months ended March 31, 2019 and March 31, 2018.

 

We monitor the probability of forecasted transactions as part of the hedge effectiveness testing on a quarterly basis. As of March 31, 2019, we determined that a portion of forecasted sales for our fourth quarter of Fiscal Year 2019 were no longer probable of occurring by the end of the specified time period. Therefore, we partially terminated hedging contracts for 2.3 million Euro and recorded a $132,000 gain to other income related to this termination. During the three and nine months ended March 31, 2018, we did not have any losses or gains related to the ineffective portion of our hedging instruments.

 

As of March 31, 2019, the notional amounts of our foreign exchange contracts designated as cash flow hedges were approximately $58.0 million (EUR 45.0 million). As of March 31, 2019, a net gain of approximately $1.8 million related to derivative instruments designated as cash flow hedges was recorded in OCI. It is expected that $1.6 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, 2019, the fair value of our cash flow hedges was an asset of $3.4 million, of which $2.8 million was classified as a current asset, and $650,000 was classified in other non-current assets in our Consolidated Balance Sheets. During the three months ended March 31, 2019, we recognized $1.4 million of net gains in OCI, reclassified $450,000 of gains from OCI to Sales, and reclassified $490,000 of gains from OCI to Other Income. During the nine months ended March 31, 2019, we recognized $4.1 million of net gains in OCI, reclassified $619,000 of gains from OCI to Sales, and reclassified $1.4 million of gains from OCI to Other Income. As of June 30, 2018, $55,000 of the fair value of our cash flow hedges was classified in prepaids and other current assets, $46,000 was classified in other non-current assets, and $101,000 was classified in accrued liabilities in our Consolidated Balance Sheets. During the three months ended March 31, 2018, we recognized $987,000 of net losses in OCI, reclassified $974,000 of losses from OCI to Sales, and reclassified $206,000 of gains from OCI to Interest Income. During the nine months ended March 31, 2018, we recognized $3.4 million of net losses in OCI, reclassified $1.8 million of losses from OCI to Sales, and reclassified $691,000 of gains from OCI to Interest Income.

 

 

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, 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.

 

 

 

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