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Company overview

Natural Alternatives International (NASDAQ:NAII) is a leading formulator and manufacturer of customized nutritional supplements. Operating segments include private label contract manufacturing, patent and trademark licensing and branded products (sold under Pathway to Healing product line).

Ticker:NAII
Exchange:NASDAQ
Country:U.S.A.
Sector:Healthcare
Industry:Pharmaceuticals
Price:$4.43
Shares outstanding:6,853,409
Dividend yield:None
Insider ownership:21%
52 week high/low:$8.34/$4.01
Market cap:$30.4 million

Source: Company filings, ttm

Industry overview and outlook

Positive factors:

  • Favorable demographics should lead to higher demand as industry led education efforts highlight benefits of dietary supplements (e.g. reduce hip fractures in the elderly/lower Medicare costs)
  • Industry maturing with stricter federal regulations associated with Good Manufacturing Practices, passage of adverse event reporting legislation and cracking down on blatantly false advertising claims through self regulation
  • Recent trend towards consolidation of stronger companies and elimination of weaker ones (due to previously mentioned GMPs creating higher barrier to entry) expected to continue and reduce competitive pressures

Negative factors:

  • Recent negative publicity (e.g. Herbalife, Nu Skin Enterprises, Fortune Hi-Tech Marketing - discussed below)
  • Higher expected costs (transportation, labor, raw materials, packaging) offset somewhat by price increases

NAII competitive advantages include:

  • GMP certified manufacturing facilities
  • Customized, innovative formulations with proprietary ingredients
  • Clinical research and evaluations
  • Marketing management and support
  • Package, label and delivery system design
  • International regulatory and label law compliance
  • International product registration assistance

Investment thesis

NAII is collateral damage in the war against Herbalife waged by Bill Ackman. Just as in traditional military engagements, there is (and will always be) an opportunity to profit. NAII fell 33% in the past year.

The following factors invalidate the short thesis against HLF to some extent (and in turn the industry business model of selling nutritional products through direct sales force):

  • Huge rebound in Herbalife stock since low on 12/24/12 (up 62.5%)
  • Strong financial results at Herbalife released on 4/29/13 (textbook "beat and raise" quarter)
  • Significant stakes by large and respected investors (Icahn, Loeb) provide much needed credibility

The existential risk to the industry (in the form of government action) falls with each passing day as the number of cases of true misconduct (e.g. Fortune Hi-Tech Marketing) prove that these companies are the exception rather than the rule.

The significant FCF generated by the stronger industry leaders (USANA Health Services, Herbalife larger cap and Bond Laboratories, Cyanotech, Nature's Sunshine Products, Lifevantage smaller cap) highlights the overall attractiveness of the business model. The undeserved industry criticism provides investors with a rare opportunity to buy a company with strong fundamentals and multiple value catalysts at a distressed valuation.

Peer comp valuation

TickerP/B
PHLI0.88
RBCL0.40
BNLB1.50
CYAN1.41
NATR1.86
LFVN7.40
USNA3.95
Average2.49
Median1.50

Highlights

  • Financial strength ($17 million in cash or ~ 56% of market cap and no debt)
  • Low valuation (P/TBV of 0.81x, EV $13.4 million, EV/EBITDA of 2.09x)
  • High cash flow (EBITDA of $6.4 million, FCF yield of 22%) expected to increase due to lower capex spending on manufacturing equipment ($2.3 million FY12 and $1.7 million FY11) and lower patent litigation expense (~$1.8 million in FY12 vs ~ $1 - $1.5 million in FY13)
  • Undervalued assets (owns corporate headquarters in San Marcos, CA valued at depreciated cost on balance sheet)
  • Shareholder friendly management completed more than 75% of $2 million buyback plan from 2011
  • Strong history of margin improvement (gross margin 21.22% in FY12 vs. 12.72% in FY09, operating margin 8.51% in FY12 vs. 0.54% in FY09, EBIT 6.2% in FY12 vs. 0.96% in FY09)

Value catalysts

Sell branded products segment (~2.5% of revenues in mrq) and patent estate (~6% of revenues in mrq) and focus on private label contract manufacturing. The sale of Real Health Laboratories in 2009 shows willingness to exit non-core businesses. Selling the branded products division will eliminate higher expected marketing and advertising costs required in order to increase sales.

Selling the patent estate (ideally to current customer Compound Solutions) is a better way to extract maximum value as opposed to continuing to engage in license agreements for two reasons. First, this will eliminate the need to spend millions of dollars every year on patent litigation. Second, the NPV of the proceeds should be much higher than receiving an uncertain revenue stream in the next several years. The patents should command a significant premium due to strong customer demand.

The sale of the company via MBO, LBO or to a strategic buyer is the best way to maximize shareholder value due to the premium received, significantly higher IRR compared to alternative shareholder friendly measures (e.g. starting a dividend, increasing buyback or leveraged recap) and elimination of high and increasing compliance and regulatory costs (mentioned below). The sale should ideally take place after the sale of the branded products and patent estate.

The below comments are from a 2009 interview the CEO gave to the Nutrition Business Journal.

Still, the significant costs associated with being a public entity under the Sarbanes-Oxley Act of 2002 are quickly changing the equation in favor of other potential alternatives, such as going private. The costs of being a public entity are significant, probably in excess of $1.5 million dollars annually. Hopefully, the current economic environment will return to some element of normalcy, allowing real valuations to shine through in a landscape littered with demolished balance sheets and excessive leverage.

The cost/benefit analysis of remaining a public company with a market cap below $100 million is increasingly one-sided. On average larger public companies receive a significantly higher valuation than their private peers so it makes economic sense to spend the money on regulatory and compliance costs. NAII must spend ~5% of its market cap every year to receive a low valuation relative to its strong fundamentals (strong balance sheet and no leverage) and peers. This is even after the significant economic and stock market recovery.

The benefit of being a public company is the transparency of the business and the evidence of a strong balance sheet in these trying times.

There is no benefit to being transparent to investors that continually undervalue your company. You can still have a strong balance sheet as a private company.

Short-term fluctuations in profits or losses, many of which are often caused by currency translations or discontinued operations costs, are a good way to keep score in a baseball game, but our long-term goal remains long-term success.

While it is always encouraging to hear a CEO talk like this, it underscores the benefits of going private given the short term focus of investors.

Go private via MBO. This is the most practical option given the relatively high level of insider ownership and small number of significant holders. Supporting factors include an EV/EBITDA multiple of 2.09x and favorable financing conditions, which should not be expected to continue indefinitely.

Sell to strategic buyer* (USANA Health Services, Nature's Sunshine Products, Lifevantage) that can realize better economies of scale.

Go private via LBO*. There should be a long list of PE firms willing to buy a company trading at such a low valuation with high FCF and no debt. Another benefit (mentioned in previous research reports) is the small absolute size of the company exponentially expands the number of firms able to participate in the bidding process.

*A potential obstacle to a takeover is that the board can issue up to 500,000 shares of preferred stock to prevent a hostile takeover. Any approach by an activist investor to encourage such a sale would need to be friendly.

Source: How To Maximize Shareholder Value In Natural Alternatives International