ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis is intended to help you understand our financial condition and results of operations for the three and nine months ended March 31, 2018. You should read the following discussion and analysis together with our unaudited condensed consolidated financial statements and the notes to the condensed consolidated financial statements included under Item 1 in this Quarterly Report, as well as the risk factors and other information included in our 2017 Annual Report and other reports and documents we file with the SEC. Our future financial condition and results of operations will vary from our historical financial condition and results of operations described below based on a variety of factors.
Executive Overview
The following overview does not address all of the matters covered in the other sections of this Item 2 or other items in this
Quarterly R
eport or contain all of the information that may be important to our stockholders or the investing public. You should read this overview in conjunction with the other sections of this Item 2 and this
Quarterly R
eport.
Our primary business activity is providing private label contract manufacturing services to companies that market and distribute vitamins, minerals, herbs and other nutritional supplements, as well as other health care products, to consumers both within and outside the U.S. Historically, our revenue has been largely dependent on sales to two or three private label contract manufacturing customers, and thus sensitive to variations in the timing of such customers’ orders, which variations in turn have been impacted by such customers’ internal marketing programs, supply chain management, entry into new markets, new product introductions, the demand for such customers’ products, and general industry and economic conditions. Our revenue also includes raw material sales and royalty and licensing revenue generated from our patent estate pursuant to license and supply agreements with third parties for the distribution and use of the ingredient known as beta-alanine sold under our CarnoSyn® and SR CarnoSyn® trademarks.
A cornerstone of our business strategy is to achieve long-term growth and profitability and to diversify our sales base. We have sought and expect to continue to seek to diversify our sales by developing relationships with additional, quality-oriented, private label contract manufacturing customers, and commercializing our patent estate through sales of beta-alanine under our CarnoSyn® and SR CarnoSyn® trade names, royalties from license agreements, and potentially additional contract manufacturing opportunities with these licensees.
During the first nine months of fiscal 2018, our net sales were 4% higher than in the first nine months of fiscal 2017. Private label contract manufacturing sales increased 11% due primarily to the sale of new products to existing customers and higher volumes of current products to existing customers located primarily in Asian and European markets, which increases were partially offset by discontinued customer relationships. During our third quarter of fiscal 2018, our contract manufacturing sales increased 38% as compared to the comparable prior year period due primarily to sales to Asian and European markets returning to historical levels and an increase in sales to our largest customer including shipment of new products under our previously announced expanded relationship. Revenue concentration risk for our largest private label contract manufacturing customer as a percentage of our total net sales increased to 53% for the nine months ended March 31, 2018 compared to 48% in the first nine months of fiscal 2017. We expect our annualized fiscal 2018 revenue concentration for this customer to be higher than fiscal 2017.
During the first nine months of fiscal 2018, CarnoSyn® beta-alanine revenue decreased 20% to $16.0 million as compared to $20.0 million for the first nine months of fiscal 2017. The decrease in beta-alanine revenue was primarily due to decreased material shipments as a result of market and seasonal factors and lower average material sales prices. During the quarter ended December 31, 2017, the sports nutrition retail market conditions declined most notably in the standard “brick and mortar” sales channels as products transitioned to higher levels of internet based sales. This transition resulted in excess inventory in certain channels and delayed the re-order rates for many of our customer brands. Additionally, while we still have active patents covering instant release CarnoSyn® beta-alanine, we experienced increased competition from companies selling generic beta-alanine during the second quarter of fiscal 2018 resulting in certain customers discontinuing the use of our CarnoSyn® beta-alanine. To offset this decline and in addition to legal actions we have prosecuted and others we may institute, we have increased our sales and marketing activities to consumers, customers, potential customers, and brand owners on multiple platforms to promote and reinforce the features and benefits of utilizing CarnoSyn® beta-alanine. During the third quarter of fiscal 2018, our re-order rates improved and reached historical levels suggesting both improved sports nutrition retail market conditions and the positive impact of our marketing activities. Additionally, our SR CarnoSyn® raw material sales continued to rise as more brands adopted product offerings of this sustained release delivery system.
There can be no assurance our sales and marketing efforts or the recent apparent improvement in retail market conditions will reverse or decelerate potential future declines of our CarnoSyn® beta-alanine sales.
To protect our CarnoSyn® business and its underlying patent estate, we incurred litigation and patent compliance expenses of approximately $2.4 million during the first nine months of fiscal 2018 and $3.0 million during the comparable period in fiscal 2017. We describe our efforts to protect our patent estate in more detail under Item 1 of Part II of our 2017 Annual Report. Our ability to maintain or further increase our beta-alanine royalty and licensing revenue will depend in large part on our ability to develop a market for our sustained release form of beta-alanine marketed under our SR Carnosyn® tradename, maintenance of our patent rights, the availability of the raw material beta-alanine when and in the amounts needed, the ability to expand distribution of beta-alanine to new and existing customers, the ability to further commercialize our existing patents, and the continued compliance by third parties with our license agreements and patent and trademark rights.
During the remainder of fiscal 2018, we plan to continue our focus on:
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•
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Leveraging our state-of-the-art, certified facilities to increase the value of the goods and services we provide to our highly valued private-label contract manufacturing customers, and develop relationships with additional quality oriented customers;
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•
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Expanding the commercialization of our beta-alanine patent estate through raw material sales, developing a market for our sustained release form of beta-alanine marketed under our SR Carnosyn® tradename, new contract manufacturing opportunities, license agreements and protecting our proprietary rights;
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•
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Improving operational efficiencies and managing costs and business risks to improve profitability.
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Critical Accounting Policies and Estimates
The preparation of our financial statements requires that we make estimates and assumptions that affect the amounts reported in our financial statements and their accompanying notes. We have identified certain policies we believe are important to the complete and accurate portrayal of our financial condition and results of operations. These policies require the application of significant judgment by our management. We base our estimates on our historical experience, industry standards, and various other assumptions we believe are reasonable under the circumstances. Actual results could differ from these estimates where actual circumstances differ from our assumptions or if these conditions are not satisfied. An adverse effect on our financial condition, changes in financial condition, and results of operations could occur if circumstances change that alter the various assumptions used in, or satisfaction (or failure) of conditions used in such estimates and assumptions.
Our critical accounting policies are discussed under Item 7 of our 2017 Annual Report and recent accounting pronouncements are discussed under Item A to our Notes to Condensed Consolidated Financial Statements contained in this Quarterly Report. There have been no significant changes to these policies or pronouncements during the nine months ended March 31, 2018.
Results of Operations
The results of our operations for the three and nine months ended March 31 were as follows (in thousands):
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Three Months Ended
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Nine Months Ended
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|
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March 31
,
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March 31
,
|
|
|
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2018
|
|
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2017
|
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% Change
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2018
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|
|
2017
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|
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% Change
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Private label contract manufacturing
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$
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25,648
|
|
|
$
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18,544
|
|
|
|
38
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%
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|
$
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77,225
|
|
|
$
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69,787
|
|
|
|
11
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%
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Patent and trademark licensing
|
|
|
6,167
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|
|
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6,591
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|
|
|
(6
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)%
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|
|
15,999
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|
|
|
19,974
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|
|
|
(20
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)%
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Total net sales
|
|
|
31,815
|
|
|
|
25,135
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|
|
|
27
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%
|
|
|
93,224
|
|
|
|
89,761
|
|
|
|
4
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%
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Cost of goods sold
|
|
|
25,105
|
|
|
|
20,017
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|
|
|
25
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%
|
|
|
73,522
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|
|
|
70,479
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|
|
|
4
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%
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Gross profit
|
|
|
6,710
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|
|
|
5,118
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|
|
|
31
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%
|
|
|
19,702
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|
|
|
19,282
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|
|
|
2
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%
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Gross profit %
|
|
|
21.1
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%
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|
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20.4
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%
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|
|
|
|
|
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21.1
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%
|
|
|
21.5
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%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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|
Selling, general and administrative expenses
|
|
|
4,187
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|
|
|
4,125
|
|
|
|
1
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%
|
|
|
13,015
|
|
|
|
11,640
|
|
|
|
12
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%
|
% of net sales
|
|
|
13.2
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%
|
|
|
16.4
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%
|
|
|
|
|
|
|
14.0
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%
|
|
|
13.0
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income from operations
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|
|
2,523
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|
|
|
993
|
|
|
|
154
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%
|
|
|
6,687
|
|
|
|
7,642
|
|
|
|
(12
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)%
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% of net sales
|
|
|
7.9
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%
|
|
|
4.0
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%
|
|
|
|
|
|
|
7.2
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%
|
|
|
8.5
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%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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Total other income
|
|
|
76
|
|
|
|
57
|
|
|
|
33
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%
|
|
|
386
|
|
|
|
494
|
|
|
|
(22
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)%
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Income before income taxes
|
|
|
2,599
|
|
|
|
1,050
|
|
|
|
148
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%
|
|
|
7,073
|
|
|
|
8,136
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|
|
|
(13
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)%
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% of net sales
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|
|
8.2
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%
|
|
|
4.2
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%
|
|
|
|
|
|
|
7.6
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%
|
|
|
9.1
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%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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Provision for income taxes
|
|
|
548
|
|
|
|
305
|
|
|
|
80
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%
|
|
|
4,906
|
|
|
|
2,435
|
|
|
|
101
|
%
|
Net income
|
|
$
|
2,051
|
|
|
$
|
745
|
|
|
|
175
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%
|
|
$
|
2,167
|
|
|
$
|
5,701
|
|
|
|
(62
|
)%
|
% of net sales
|
|
|
6.4
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%
|
|
|
3.0
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%
|
|
|
|
|
|
|
2.3
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%
|
|
|
6.4
|
%
|
|
|
|
|
Private-label contract manufacturing net sales increased 38% during the three months ended March 31, 2018 and 11% during the nine months ended March 31, 2018, when compared to the same periods in the prior year. These increases were due primarily to the sale of new products to existing customers, including shipment of new products to our largest customer under our previously announced expanded relationship, and higher volumes of current products to existing customers primarily in Asian and European markets, which increases were partially offset by discontinued customer relationships.
Net sales from our patent and trademark licensing segment decreased 6% during the three months ended March 31, 2018 and decreased 20% during the nine months ended March 31, 2018, when compared to the same periods in the prior year. The decrease in beta-alanine raw material sales was primarily due to decreased shipments of beta-alanine as a result of market and seasonal factors and lower average sales prices for the material.
The change in gross profit margin between the three and nine month periods ended March 31, 2018 was as follows:
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|
Three Months
|
|
|
Nine month
s
|
|
|
|
Ended
|
|
|
Ended
|
|
|
|
|
|
|
|
|
|
|
Contract manufacturing
(1)
|
|
|
3.3
|
%
|
|
|
1.4
|
%
|
Patent and trademark licensing
(2)
|
|
|
(2.6
|
)
|
|
|
(1.8
|
)
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Total change in gross profit margin
|
|
|
0.7
|
%
|
|
|
(0.4
|
)%
|
1
|
Private label contract manufacturing gross profit margin as a percentage of consolidated net sales increased 3.3 percentage points during the three months ended March 31, 2018 and increased 1.4 percentage points during the nine months ended March 31, 2018 when compared to the comparable prior year periods. These increases were primarily due to increased sales and favorable product sales mix.
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|
|
2
|
Patent and trademark licensing gross profit margin as a percentage of consolidated net sales decreased 2.6 percentage points during the three months ended March 31, 2018 and decreased 1.8 percentage points during the nine months ended March 31, 2018 when compared to the comparable prior year periods. These decreases were primarily due to decreased raw material sales and decreased royalty income as a percentage of total consolidated net sales which decreases were partially offset by favorable raw material costs.
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Selling, general and administrative expenses increased $62,000, or 2%, during the three months ended March 31, 2018 and increased $1.4 million, or 12%, during the nine months ended March 31, 2018, as compared to the comparable prior year periods. These increases were primarily related to increased compensation costs and increased marketing, advertising, and research and development costs supporting our CarnoSyn® and SR CarnoSyn® brands, which increases were partially offset by a reduction in patent litigation costs.
Other income, net increased $19,000 during the three months ended March 31, 2018 and decreased $108,000 during the nine months ended March 31, 2018, when compared to the comparable prior year periods. These changes were primarily due to fluctuations in foreign exchange rates and our currency hedge contracts associated with foreign denominated sales.
Our income tax expense increased $0.2 million, or 80%, during the three months ended March 31, 2018 compared to the comparable period in the prior year, primarily due to an increase in pretax income. Income tax expense increased $2.5 million, or 101%, during the nine months ended March 31, 2018, as compared to the comparable prior year periods. The increases were primarily due to the discrete income tax expense amounts recorded as a result of the Tax Cuts and Jobs Act enacted on December 22, 2017. Among other things, the Act reduces the U.S. federal corporate tax rate to 21% and requires companies to pay a one-time deemed repatriation transition tax on earnings of U.S.-owned foreign subsidiaries that were previously tax deferred. We have not completed our accounting for all of the tax effects of the Act; however, in certain cases, as described below and in accordance with SAB 118, we have made a reasonable estimate of the effects on our existing deferred tax balances and of the one-time transition tax. In other cases, we have not been able to make a reasonable estimate and continue to account for those items based on our existing accounting under ASC 740, Income Taxes. For the items for which we were able to determine a reasonable estimate, we recognized a provisional amount as a discrete component of our provision for income taxes. The impact of the Act may differ from these estimates, possibly materially, during the one-year measurement period ending December 22, 2018 due to, among other things, further refinement of our calculations, changes in the interpretations and assumptions we made, guidance that may be issued and actions we may take as a result of the Act.
Included in our tax expense for the nine months ended March 31, 2018 is $3.3 million of discrete tax items related to the Act. The discrete tax items include:
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●
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$1.8 million associated with a one-time transition tax that is 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 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 Act, we will elect to pay this tax over an eight-year period.
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●
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As of March 31, 2018, we no longer consider undistributed foreign earnings from NAIE as indefinitely reinvested. As a result, we have recorded $775,000 in estimated foreign withholding taxes on the amounts deemed repatriated under the Act, which was also treated as a discrete expense during the period.
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●
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As of December 31, 2017, we remeasured certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future. For balances we expect to reverse during fiscal 2018 we used the blended U.S. statutory rate of 28.06% and for amounts expected to reverse in future periods we used the newly enacted 21% tax rate. However, we are still analyzing certain aspects of the Act and refining our calculations, which could potentially affect the measurement of these balances or potentially give rise to new deferred tax amounts. The provisional amount recorded from the remeasurement of our deferred tax balance was $664,000.
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Our effective tax rate, excluding the impact of the above noted discrete items, for the three months ended March 31, 2018 was 21.1% as compared to an effective tax rate of 29.0% for the three months ended March 31, 2017. As a fiscal taxpayer, our U.S. federal statutory rate for the year ended June 30, 2018 is estimated to be 28.06% and is a blended rate of the historic 35% statutory rate and the newly enacted 21% rate. The year over year improvement in our third fiscal quarter effective tax rate is primarily due to the reduction of the U.S. federal tax rate used in our estimated tax calculation, which reduced to a blended rate of 28.06% as compared to 34.0% used in the same period in the prior year. Our effective tax rate, for the nine months ended March 31, 2018 excluding the impact of the above noted discrete items, was 23.3% as compared to an effective tax rate of 29.9% for the nine months ended March 31, 2017. The improvement in our year to date fiscal 2018 effective tax rate as compared to the same period in the prior year is primarily due to the reduction of the U.S. federal tax rate used in our estimated tax calculation, which reduced to a blended rate of 28.06% as compared to 34.0% used in the effective tax rate calculation in the same period in the prior year.
We expect our U.S. federal statutory rate to be 21% for fiscal years beginning after June 30, 2018, which should further reduce our effective tax rate on an annualized basis.
Liquidity and Capital Resources
Our primary sources of liquidity and capital resources are cash flows provided by operating activities and the availability of borrowings under our credit facility. Net cash provided by operating activities was $4.7 million during the nine months ended March 31, 2018 as compared to net cash provided by operating activities of $7.9 million during the comparable period in the prior fiscal year.
During the nine months ended March 31, 2018, changes in accounts receivable used $3.0 million in cash compared to having provided $5.3 million of cash during the comparable nine month period in the prior year. The decrease in cash provided by accounts receivable during the nine month period ended March 31, 2018 primarily resulted from timing of sales and the related collections. Days sales outstanding was 29 days during the nine months ended March 31, 2018 and 32 days during the nine months ended March 31, 2017.
During the nine months ended March 31, 2018, changes in inventory used $10.1 million in cash compared to having provided $4.8 million in the comparable prior year period. The increase in cash used by inventory during the period ended March 31, 2018 was primarily related to increased inventory levels as of March 31, 2018 in order to support increased sales to our largest private label contract manufacturing customer, including orders expected to ship in the coming quarter, and timing of orders and shipments to all other customers. Changes in accounts payable and accrued liabilities provided $8.7 million in cash during the nine months ended March 31, 2018 compared to having used $8.6 million during the nine months ended March 31, 2017. The change in cash flow activity related to accounts payable and accrued liabilities is primarily due to increases in inventory associated with increased sales associated with our largest customer and timing of inventory receipts and payments.
During the nine months ended March 31, 2018, NAIE’s operations used $1.0 million of our operating cash flow primarily due to the timing of inventory receipts, payments and sales.
Cash used in investing activities during the nine months ended March 31, 2018 was $4.4 million, compared to $4.3 million during the comparable nine month period last year. The primary reason for the change is the conversion of $1.5 million of accounts receivable into a note receivable during the first quarter of fiscal 2018. This was partially offset by lower capital equipment purchases of $2.9 million during the nine months ended March 31, 2018 as compared to $4.3 million during the same nine month period of fiscal 2017. Capital expenditures for both years were primarily for manufacturing equipment used in our Vista, California and Manno, Switzerland facilities.
Cash used in financing activities during the nine months ended March 31, 2018 primarily related to treasury shares returned to NAI by employees whose restricted stock vested during the quarter. In exchange for the shares returned, NAI paid each employee’s required tax withholding.
We did not have any consolidated debt as of March 31, 2018 or June 30, 2017.
On March 20, 2018, we executed an amendment to our credit facility with Wells Fargo Bank, N.A. to extend the maturity date for our working line of credit from February 1, 2020 to February 1, 2021. In addition, the amendment removed any restrictions included in the credit facility on our ability to repurchase our stock. The Credit Agreement provides us with a credit line of up to $10.0 million. The line of credit may be used to finance working capital requirements. There is no commitment fee under this agreement. There are no amounts currently drawn under the line of credit.
Under the terms of the Credit Agreement, borrowings are subject to eligibility requirements including maintaining (i) a ratio of total liabilities to tangible net worth of not greater than 1.25 to 1.0 at any time; and (ii) a ratio of total current assets to total current liabilities of not less than 1.75 to 1.0 at each fiscal quarter end. Any amounts outstanding under the line of credit will bear interest at a fixed or fluctuating interest rate as elected by NAI from time to time; provided, however, that if the outstanding principal amount is less than $100,000 such amount shall bear interest at the then applicable fluctuating rate of interest. If elected, the fluctuating interest rate per annum would be equal to 1.25% above the daily one month LIBOR rate as in effect from time to time during the period loan amounts are outstanding. If a fixed interest rate is elected, the interest rate would equal a per annum rate of 1.25% above the LIBOR rate in effect on the first day of the term for which the fixed rate is elected. 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 differences in monthly payments (calculated by comparing the fixed rate to the variable rate that would have been applied, had it been elected) 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. that is effect until January 31, 2019, and a similar facility with Bank of America, N.A. that is in effect until August 15, 2019.
On March 31, 2018, we were in compliance with all of the financial and other covenants required under the Credit Agreement.
As of March 31, 2018, we had $27.6 million in cash and cash equivalents and $10.0 million available under our credit facilities. We believe our available working capital, cash and cash equivalents and potential cash flows from operations will be sufficient to fund our current working capital needs and planned capital expenditures through at least the next 12 months.
Off-Balance Sheet Arrangements
As of March 31, 2018, we did not have any off-balance sheet debt nor did we have any transactions, arrangements, obligations (including contingent obligations) or other relationships with any unconsolidated entities or other persons that have or are reasonably likely to have a material current or future adverse effect on our financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenue or expenses that are or could be material to investors.
Recent Accounting Pronouncements
Recent accounting pronouncements are discussed in the notes to our consolidated financial statements included under Item 1 of this Quarterly Report. Other than those pronouncements, we are not aware of any other pronouncements that materially affect our financial position or results of operations.