Most pharmaceutical companies are hard to analyze, and even harder to forecast earnings and FCF over time, which makes them good candidates to be kicked to the curb for research. However, sometimes a company, even a pharmaceutical, can have tremendous balance sheets and generate consistent free cash flow that compounds over time. One such company is Natural Alternatives International, Inc. Let’s take a look!
What is NAII? What Do They Do?
Natural Alternatives (NAII) has a very informative website when it comes to their Investors Relations. Under the Business Development page, the company outlines its Core Business Approach, which is:
NAI’s business approach is aimed at achieving long-term growth through sales channel diversity. The Company’s program to expand its business is spearheaded by a direct-to-consumer marketing program for its own products. NAI also has manufacturing contracts with companies in areas including: direct selling organizations, weight-loss centers, health and fitness facilities, e-commerce and various media channels. Through this synergistic approach, NAI believes it will maximize its business opportunities in both domestic and international markets.
NAII is also a scientific/nutritional supplement conglomerate. More clearly, they’re a one-stop-shop for companies looking to test, develop, review, and market their nutritional supplements to the consumer. On top of all of this, NAII has partnerships with many reputable companies both globally and abroad. One partnership to highlight is their partnership with NSA International, based in Memphis, TN. NAII claims that NSA is, “pioneers in the areas of Whole Food Based nutrition and original clinical research on products manufactured by NAI (the company) and marketed by NSA under the brand name JuicePlus+.” This, according to the company, is a great example of how NAII combines nature, biology and biochemistry with nutraceutical GMP manufacturing.
The company also generates revenues through working directly with physicians who are interested in developing their own branded products to meet the specific needs of their clients. Such products are sold through various channels such as direct mail, websites, books, and audiotapes.
Establishing a Fundamental Baseline
The company trades at 12x earnings (7x Owner Earnings), 1.39x book, 0.65x sales, and only 6x its FCF. All of those metrics make NAII better (from a ratio standpoint) than at least 70% of its competitors. The company sports an EV to EBITDA of 5x, better than 91% of its competitors, and only 2x its NCAV. With an Earnings Yield of 14.86% and a Forward Rate of Return of 31.89%, the company proves better than 90% of its competitors.
The company has zero debt, increasing cash position for the last four years, increase in revenue over the last four years, as well as a substantial increase in Operating Cash Flow from the last three years. To top it all off, the company increased its free cash flow over the last two years.
Contrary to a lot of under the radar pharmaceutical companies, NAII sports healthy margins to help support its growth in revenues and FCF. The stats include an operating margin of 7%, Net Margin of 5.33%, a ROE of 10.35%, ROA of 8.32%, and an ROC of 24.17%. Their three-year revenue growth comes in at 19.40%, coupled with a 32.10% 3 year EBITDA growth.
The Jockey & Insider Ownership
NAII is led by Mark A. LeDoux, who founded the company back in 1980. LeDoux has over 40 years of experience in the nutritional supplement industry, which makes him one of the longest-serving active executives in the nutritional supplements industry. LeDoux is also a recognized participant of the Codex Alimentarius Commission, which is the United Nations’ food and dietary supplement standard-setting body under joint supervision of its Food and Agriculture Organization and World Health Organization.
The company has an insider ownership of 18.90%, institutional ownership of 28.88%, and a float percentage of 70.84%. The trend in insider ownership is extremely favorable considering the company had a mere 8% ownership a mere 7 years ago. The top two institutional holders of NAII are Dimensional Fund Advisors LP, which own 7.41% of the shares outstanding, and Jim Simons (who seems to own nearly every company you search) who owns 6.5% of the shares.
Another important trend to look at when evaluating insider ownership is dilution of shares. In other words, is the company issuing shares like mad in an effort to decrease the value per share that a shareholder holds. For example, if there are 100 shares in the market and you hold 10 shares, that is 10% ownership. However, if the company decides to issue another 200 shares, now you only own 5% of the company. Since 2009, NAII’s shares outstanding has declined from 7.0M to 6.6M, thus increasing the value of each share for its shareholders.
Assessing the Reports
Total assets have increased since 2009, and over the last period increased from $75M to $81M. Total liabilities increased as well from $11M to $19M.
Net sales for the three months ended decreased 17%, but overall sales have increased on a CAGR of 18.25% over the last four years. Operating income decreased 3% YoY, but over the last four years averaged a CAGR of 7.3%.
Cash flow provided by Operating Activities increased over the last three years from $3M in 2015 to $14M in 2017. The company is also growing its cash balances, with $28MM in liquid cash in 2017 compared to $19M in cash in 2015.
When it comes to debt, the company acknowledges that it has a credit facility with Wells Fargo and Bank of America of $10MM. The company did not use their working capital line of credit, nor did they have any long-term debt outstanding during the latest reporting quarter.
Although sales and revenues decreased, management isn’t worried about this slight fluctuation, and they expect 2018 sales and revenues to be just as (if not) higher in some categories. The company says, “we expect our Fiscal Q2 2018 sales to our largest customer to increase as we begin shipping products under our previously announced expanded relationship.” Also, the company is executing on its diversification of sales strategy by decreasing its revenue concentration from 50% in 2016 to 47% in 2017.
Industry Growth For 2018 & Beyond
The Nutrition Business Journal put out a great slide deck on the industry trends for 2018 and beyond, which I’ve attached here. Natural, “Whole Food” based products sales grew 7.7% in 2016, and the journal is predicting over $250B in sales for that category by 2020. Supplement sales grew 6.6% in 2016, adding $2.6B in new sales. The report anticipates sales reaching over $50B by 2020.
The top growing categories for nutritional products for 2016 were probiotics (17%), Sports Nutrition (8.3%), and Meals with 7.6%.
Internet is showing the highest growth (unsurprisingly) for several years in a row. Most of this is due to Amazon starting to sell their own supplement products direct to consumers through Amazon Elements.
The journal also conducted a survey which questioned people on what is their greatest health issue they’re facing right now. Nearly 35% of people reported to having sleeping issues, 30% reported a lack of energy, and nearly 24% reported skin or hair issues. If NAII can grab market share of energy supplements and nutritional products, it could be a huge tailwind for them.
Looking Ahead to 2018
The company outlined its goals for 2018, which are the following:
- Leveraging their state-of-the-art certified facilities to increase the value of the goods and services they provide to their highly valued private-label contract manufacturing customers. They also plan to develop relationships with additional quality oriented customers.
- The company plans on expanding the commercialization of their beta-alanine patent estate through raw material sales, develop a market for their sustained release form of beta-alanine marketed under their SR Carnosyn trademark. They also plan on developing new contract manufacturing opportunities, and license those agreements and protect their proprietary rights.
- Finally, the company plans on improving operational efficiencies and managing costs and business risks to improve profitability.
Earnings and FCF Trends
The most recent trend for earnings is down, but taking a larger sample size going back to 2013, the company appears to be reaching a higher average number of both revenues, income, and cash flow from operations. With regards to earnings, the last three quarters have trended downward from the Sep-16 high of $1.66, to where it currently stands at $0.92. Revenues, however, have increased in each of the last three fiscal years from $79.5M in 2015 to $121.9M in 2017. The company has increased its cash from operations from its June 2015 bottom of $2.7M to where it currently stands at $16.6M. This goes hand in hand with their increase in operating cash flow margin each of the last three years from 3.4% in 2015 to 14.3% in 2017.
Final Remarks & Valuation
The recent downward trend in earnings doesn’t scare me only as long as the company remains fiscally responsible and sticks to their plans for 2018. The company trades well below the average book value of 2.32 for its peers, and has a successful operating model with relatively high net profit margins and asset turns. The company’s changes in annual revenues are better than the change in its earnings (relative to its peers), which suggests that the company is focused more on revenue growth than earnings growth. It has sustainable ROA figures which suggest that its high operating returns can advance into the future without much change or hiccups.
The market seems to be discounting the internal rate of growth in both the operating cash flow side, as well as the revenue side, given its trading at a P/E of 13.65 (amidst an industry average of 36.01), all the while sporting some of the highest margins and ROE in the industry. The company averages an ROE of 10.48% while its peers barely reach 2%. Going back to its operations, the company appears dominant in its industry. Net profit margins of 5.33% while its competitors fail to achieve 1% coupled with high asset turns of 1.49x versus 0.76x its peers seems to mean NAII is operating at a much higher efficiency level. The company does have a lower gross margin percentage compared to its competitors (21.48% vs. 43.33%), but when it comes to pre – tax margins, NAII appears to be more tightly controlled of its operating costs; 7.34% vs. 3.45%.
I don’t think the market is pricing this correctly. Using a DCF model IO can evaluate a range in which I think the ‘fair intrinsic’ business value should be. Note, just because a business should be trading above a certain price range, it doesn’t mean the market will act accordingly, let alone even care. Nevertheless, I’m assuming a discount rate of 8%, perpetuity growth rate of 2.0%, 10Y Avg EBITDA Margin of 10.1%, and a unlevered FCF 10Y CAGR of -3.3%. I’m assuming capital expenditures of around 4% of Revenues, and a tax rate of 23%. Taking those metrics into consideration, the range for fair value is roughly between $14 – $17. This puts the company at a discount of around 25% – 50%.
Price action broke out of its wedge/triangle consolidation pattern and I went long at 11.35 yesterday before the close in my paper account. I put my stop-loss at 10.00 which is below both the bottom end of the triangle/wedge as well as below the 50MA. Price hitting my stop loss would signal a false breakout, and a chance for me to reanalyze the company. Right now I’m risking 46bps, but I am considering adding to this position. It’s a broader trend I am thinking about doing more of … That is, establishing a small baseline position, then add once price breaks directly in my favor, pyramiding up if you will.
There are no options available for NAII.
Where is My Fallibility?
Below is a list of events / circumstances that could impale NAII’s chances of reaching its intrinsic business value:
- It relies on suppliers for its beta-alanine, and a decrease in raw materials or a decrease in the amount of suppliers could affect its ability to generate enough product to increase revenues.
- If one or more of the companies biggest buyers fails to meet certain quotas, or all together decides to start buying from another seller, this could have significant material impact on the bottom line.
- If the company pursues an aggressive debt financing option to expand an area of business that isn’t generating significant returns to shareholder capital.
- Decreases in margins due to tightening revenues & increased operating costs.
- Increased cash burn. Currently the company is bringing in income, but if the company starts to burn through its cash, it will eat away at the intrinsic value.
Of course there are more immaterial events that could cause the value of the business to deteriorate, but these seemed most applicable to my analysis. If you find any more, or you think there is one glaring headwind that I am missing, please don’t hesitate to let me know.