Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide a reader of our financial statements with a narrative of our financial condition, results of operations, liquidity and certain other factors that may affect our future results from the perspective of management.
Our MD&A should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Form 10-K. A more comprehensive description of our products and markets for such products is provided in Part I. Item 1. Business.
We are an agricultural company and a world leader in the production of natural products derived from microalgae grown in complex and intricate agricultural systems on the Kona coast of Hawaii. We have a core competency in cultivating and processing microalgae into high-value, high-quality natural products for the human dietary supplement market. We are unique in that our microalgae are grown in open ponds which, similar to natural land and plant-based horticulture, require favorable weather conditions. In our case these conditions include consistent light, warm temperatures and low rainfall to achieve optimum production. Equally important is a nutrient-rich environment, which requires the proper control and balance of necessary nutrients to support growth and yields. Greater variability in these environmental factors more commonly occur in our winter growing season.
Our products are sold as consumer-packaged goods through natural products distributors, retailers and online channels, and direct to consumers, primarily in the U.S., as well as in bulk form to manufacturers, formulators and distributors worldwide in the health foods, nutraceuticals and dietary supplement markets.
We will continue to focus on growing the market for our high quality, higher margin consumer products by emphasizing the higher nutritional content of our Hawaiian Spirulina Pacifica® and the multiple health benefits of our BioAstin® Hawaiian Astaxanthin®. We generated 32%, 34% and 22% of our revenues outside of the United States during the years ended March 31, 2022, 2021 and 2020, respectively. Competing in a global marketplace, we are influenced by the general economic conditions of the countries in which our customers operate, including adherence to our customers' local governmental regulations and requirements. Since substantially all sales are made in U.S. currency, we have no material foreign exchange exposure.
Our production levels have a significant impact on our gross profit margin, as well as our ability to meet customer demand. Because our processes are agricultural and a large percentage of our production costs are fixed, it is important to maintain production volumes to support the minimal resource levels required to sustain a large-scale open culture agricultural facility. Our production costs include customary variables such as availability and costs of personnel, raw materials, energy, water and freight. These variables fluctuate based on changes in the local, national and world economies. More complex variables include cultivation methods, feeding formulations and harvesting processes, all of which include efforts to anticipate the extent of weather and environmental events and make timely and sufficient adjustments. Although the variability of such costs cannot be fully anticipated, we have focused increased effort in this area in order to produce both spirulina and astaxanthin at levels sufficient to fully absorb production costs into inventory.
Fresh water is critical for our natural astaxanthin and spirulina production, and while we have not experienced any long-term constraint on fresh water availability, future availability could be negatively impacted by significant growth in the local population as well as by throughput constraints on the water delivery infrastructure owned by the County of Hawaii. Given the criticality of fresh water to our operations and the community, we recycle fresh water where possible and have developed additional water recycling systems in our efforts to utilize fresh water efficiently. Both fresh and sea water require electricity for pumping; and the cost of our electricity depends on the cost of fuel which is, in turn, tied to the global price of crude oil.
Complex biological processes in the cultivation and processing of our microalgae are influenced by factors beyond our control-the weather, for example. As a result, we cannot assure that adequate production levels will be consistent period over period. To the extent that our production levels are not sufficient to absorb these costs on a period basis, we recognize abnormal and non-inventoriable production costs, including fixed cost variances from normal production capacity, as an expense in the period incurred. Abnormal amounts of freight, handling costs and wasted material (spoilage) are recognized as current-period charges and fixed production overhead costs are allocated to inventory based on the normal capacity of production facilities. Normal capacity is defined as the production expected to be achieved over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. To offset increased production costs, we seek ways to increase production efficiencies in volume yield, potency, and quality consistent with our commitment to produce high-value, high-quality products.
We utilize several third-party contractors for encapsulation of our gelcaps and for the packaging of our finished products. Although these services are available from a limited number of sources, we believe that we have the ability to use other parties if any of the current contractors become unavailable.
The COVID-19 pandemic has caused volatility in global markets. The COVID-19 pandemic has resulted in the extended shutdown of certain businesses, which may in turn result in disruptions or delays to our supply chain and restrictions on the export or shipment of our products. Since our Company is an agricultural business, which is deemed an essential business in Hawaii, we have remained open for business with no material interruptions to our operations due to local pandemic-related regulations. We rely on third-party suppliers, global manufacturers and freight forwarders to export or ship our products, however, as of the date of this Annual Report, this reliance has not resulted in any material adverse impact on our operations.
Results of Operations for the 2022, 2021, and 2020 Fiscal Years
The following tables present selected consolidated financial data for each of the past three fiscal years ($ in thousands):
Consolidated Performance Summary 2022 2021 2020 Net sales
Operating expenses as % of net sales 30.6 % 34.1 % 36.5 % Operating income
Astaxanthin packaged sales (decrease) increase 2.9 % (18.5 )% (5.2 )% Spirulina packaged
Spirulina packaged sales (decrease) increase (0.2 )% (4.6 )% 1.5 % Total Packaged sales
Fiscal 2022 results compared with Fiscal 2021
Net Sales Net sales increased $3.6 million, or 11.2%, in fiscal year ended March 31, 2022 compared with fiscal year 2021. This increase was primarily driven by a $3.3 million, or 45.9%, increase in spirulina bulk sales and $0.4 million, or 2.9%, increase in astaxanthin packaged sales, offset by a decrease in contract extraction sales of $0.2 million, when compared with fiscal year 2021. The bulk sales increasewas primarily due to strong demand from our existing customers combined with higher production levels of spirulina.
Gross Profit Gross profit as a percent of net sales increased by 3.3 percentage points compared to fiscal 2021, which was the result of lower cost of both spirulina and astaxanthin due to higher production volumes and production efficiencies, respectively.
Operating Expenses Operating expenses remained flat in fiscal year 2022 as compared to fiscal year 2021 but decreased as a percentage of net sales by 3.5 percentage points. General and administrative expenses increased primarily due to higher bonus and profit sharing based on higher income from operations compared to the prior year, while sales and marketing expenses were lower as a result of overall lower advertising spend.
Income Taxes We recorded an income tax expense of $28,000 in fiscal 2022 for state taxes, compared to income tax expense of $3,000 in fiscal 2021.
Fiscal 2021 results compared with Fiscal 2020
Net Sales Net sales increased $0.4 million, or 1.4%, in fiscal year ended March 31, 2021 compared with fiscal year 2020. This increase was primarily driven by a $2.7 million, or 61.6%, increase in spirulina bulk sales and an increase in contract extraction sales of $0.3 million, offset by $3.7 million, or 14.2%, decrease in total packaged sales when compared with fiscal year 2020. The bulk and contract extraction sales increases in the current year were primarily due to strong demand from our existing customers. The decrease in packaged sales was primarily due to lower demand for one of our major customers related to decreased promotional spending and reductions in certain of their retail locations, as well as lower consumer demand related to restrictions surrounding the COVID-19 pandemic in fiscal 2021, such as store restrictions, limitations of store demonstrations and loss of tourism in Hawaii.
Gross Profit Gross profit as a percent of net sales decreased by 5.4 percentage points compared to fiscal 2020, which was the result of sales product mix, with bulk sales at lower gross profit margin and current year higher spirulina costs per kilo driven by lower production volumes in the fiscal year.
Operating Expenses Operating expenses decreased $0.6 million, or 5.2%, in fiscal year 2021 as compared to fiscal year 2020 and decreased as a percentage of net sales by 2.4 percentage points. The decreases were primarily due to lower general and administrative expenses of $0.4 million, or 7.7%, and lower sales and marketing costs of $0.2 million, or 4.2%, compared to the same expenses and costs in fiscal year 2020. The decrease in general and administrative expenses was primarily due to lower legal and audit expenses of $0.2 million and the prior year's inclusion of expenses related to the severance of a former executive of $0.5 million, offset by increases in corporate insurance of $0.2 million and recruiting expenses of $0.1 million. Sales and marketing expenses were lower as a result of COVID-19 restrictions on promotional activities.
Gain on Extinguishment of Debt The gain on extinguishment of debt represents the forgiveness of the PPP loan of $1.4 million and the accrued interest of $8,000, under the Coronavirus Aid, Relief, and Economics Security Act ("CARES Act").
Income Taxes We recorded an income tax expense of $3,000 in fiscal 2021 primarily for minimum state taxes, compared to income tax expense of $9,000 in fiscal 2020 due to an increase in the valuation allowance, offset by adjustments of federal and state effective tax rate.
Sources of Liquidity As of March 31, 2022, we had cash of $2.6 million and working capital of $11.4 million compared to $3.8 million and $9.3 million, respectively, at March 31, 2021. We have a Revolving Credit Agreement ("the Credit Agreement") with First Foundation Bank ("the Bank") that allows us to borrow up to $2.0 million on a revolving basis. At March 31, 2022 and 2021, we had outstanding borrowings of $0 million and $1.0 million respectively, on the line of credit. The line of credit is subject to renewal on August 30, 2022, and we intend to renew or replace it with another line of credit on or before the expiration date.
As of March 31, 2022, we had $3.9 million in long-term debt ("Term Loans") payable to the Bank that require the payment of principal and interest monthly through August 2032. Pursuant to the Term Loans and the Credit Agreement, we are subject to annual financial covenants, customary affirmative and negative covenants and certain subjective acceleration clauses. As of March 31, 2022 and 2021, we met all required annual financial and debt covenants.
In response to the COVID-19 pandemic and the uncertainty surrounding the pandemic, in May 2020, we obtained a PPP loan in the amount of $1.4 million under the CARES Act. The proceeds were used for certain payroll costs in accordance with the PPP and the PPP Flexibility Act of 2020. In December 2020, we received notice of forgiveness of the PPP loan in whole, including all accrued interest to date (see Note 6 in the notes to our consolidated financial statements). In April 2019, we obtained a loan in the amount of $1.5 million from a related party. The proceeds were used to pay down accounts payable and for general operating capital purposes. On April 12, 2021, we amended this loan (see Note 6 and 16 in the notes to our consolidated financial statements). As of March 31, 2022, we had $1.0 million outstanding on the loan.
Funds generated by operating activities and available cash are expected to continue to be our most significant sources of liquidity for working capital requirements, debt service and funding of maintenance levels of capital expenditures.
Based upon our operating plan and related cash flow and financial projections, cash flows expected to be generated by operating activities and available financing are expected to be sufficient to fund our operations through at least June 30, 2023, and our debt service coverage ratio and current ratio covenants are expected to be in compliance with the annual Term Loans and Credit Agreement covenant requirements as of March 31, 2023, the next measurement date. However, no assurances can be provided that we will achieve our operating plan and cash flow projections for the next fiscal years or our projected consolidated financial position as of March 31, 2023. Such estimates are subject to change based on future results and such change could cause future results to vary significantly from expected results.
As indicated above, we were in compliance with all of our covenants as of March 31, 2022, however, there is no assurance that we will remain in compliance at any future measurement date, and there is no assurance that the Bank will waive such violations, if any, in the future. If the Bank does not waive a future violation, it could pursue remedies under the relevant agreements, including charging a higher interest rate on outstanding borrowings and calling repayment of outstanding borrowings. If this occurs, we would need to raise additional funds to repay the loans; however, we may not be able to secure such funding on acceptable terms, or at all.
As further described in the Risk Factors located in Item 1A of this Annual Report on Form 10-K, our results of operations and financial condition can be affected by numerous factors, many of which are beyond our control and could cause future results of operations to fluctuate materially as it has in the past.
Future operating results may fluctuate as a result of changes in sales volumes to our largest customers, weather patterns, increased competition, increased materials, nutrient and energy costs, government regulations and other factors beyond our control.
A significant portion of our expense levels are relatively fixed, so the timing of increases in expenses is based in large part on forecasts of future sales. If net sales are below expectations in any given period, the adverse impact on results of operations may be magnified by our inability to adjust spending quickly enough to compensate for the sales shortfall. We may also choose to reduce prices or increase spending in response to market conditions, which may have a material adverse effect on financial condition and results of operations.
As of March 31, 2022, we had no off-balance sheet arrangements or obligations.
Inflationary factors such as increases in the costs of materials and labor directly affect our operations. Most of our leases provide for cost-of-living adjustments and require us to pay for insurance and maintenance expenses, all of which are subject to inflation. Additionally, our future lease costs for new facilities may include potentially escalating costs of real estate and construction. There is no assurance that we will be able to pass on increased costs to our customers.
Depreciation expense is based on our historical cost of fixed assets and is therefore potentially less than it would be if it were based on current replacement cost. While property and equipment acquired in prior years will ultimately have to be replaced at higher prices, it is expected that replacement will be a gradual process over many years.
Cash Flows The following table summarizes our cash flows from operating, investing and financing activities for each of the past three fiscal years ($ in thousands):
Cash provided by operating activities in fiscal 2022 was the result of $2.2 million net income and non-cash charges of $2.4 million, offset by working capital of $2.2 million. The changes in working capital were primarily due to a $1.3 million increase in accounts receivable and $0.7 million increase in inventories.
Cash provided by operating activities in fiscal 2021 was the result of $0.9 million net income and non-cash charges of $1.1 million, offset by working capital of $0.4 million. The changes in working capital were primarily due to a $0.5 million decrease from other liabilities, offset by a decrease of $1.2 million in inventories.
Cash used in investing activities in fiscal years 2022 and 2021 includes costs for acquiring equipment and leasehold improvements at our Kona facility, and for fiscal 2022, also included costs associated software implementation.
Cash used in financing activities in fiscal 2022 consists of $0.7 million in principal payments on debt and payments on short-term contract obligations, $1.0 million payments on the line of credit and $0.5 million paydown of the related party loan.
Cash used in financing activities in fiscal 2021 consists of a $0.7 in principal payments on debt and payments on short-term contract obligations and $1.0 million payments on the line of credit, offset by $1.4 million increase for the PPP loan obtained in fiscal 2021.
Except as discussed in Note 2, Significant Accounting Policies, in the notes to our consolidated financial statements included in this Annual Report on Form 10-K, we have considered all new accounting pronouncements and have concluded that there are no new pronouncements that may have a material impact on our results of operations, financial condition, or cash flows, based on current information.
Application of Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The preparation of financial statements in conformity with those accounting principles requires management to make judgments and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Management regularly re-evaluates its judgments and estimates which are based upon historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Management believes that of its significant accounting policies, policies that may involve a higher degree of judgment and complexity are inventory valuations, valuation of equipment and leasehold improvements and long-lived assets, and income taxes.
Revenue - We record revenue based on the five-step model which includes: (1) identifying the contract with the customer; (2) identifying the performance obligations in the contract; (3) determining the transaction price; (4) allocating the transaction price to the performance obligations; and (5) recognizing revenue when the performance obligations are satisfied. Substantially all of our revenue is generated by fulfilling orders for the purchase of our microalgal dietary supplements to retailers, wholesalers, or direct to consumers via online channels, with each order considered to be a distinct performance obligation. These orders may be formal purchase orders, verbal phone orders, e-mail orders or orders received online. Shipping and handling activities for which we are responsible under the terms and conditions of the order are not accounted for as performance obligations but as fulfillment costs. These activities are required to fulfill our promise to transfer the goods and are expensed when revenue is recognized.
Revenue is measured as the net amount of consideration expected to be received in exchange for fulfilling a performance obligation. We have elected to exclude sales, use and similar taxes from the measurement of the transaction price. The amount of consideration expected to be received and revenue recognized includes estimates of variable consideration, which includes costs for trade promotion programs, coupons, returns and early payment discounts. 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 are recognized in the period the adjustments are identified. In assessing whether collection of consideration from a customer is probable, we consider 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, typically 30 days from the invoice date, which occurs on the date of transfer of control of the products to the customer. Revenue is recognized at the point in time that control of the ordered products is transferred to the customer. Generally, this occurs when the product is delivered, or in some cases, picked up from one of our distribution centers by the customer. Revenue from extraction services is recognized when control is transferred upon completion of the extraction process.
Customer contract liabilities consist of customer deposits received in advance of fulfilling an order and are shown separately on the consolidated balance sheets. During the years ended March 31, 2022 and 2021, we recognized $55,000 and $251,000, respectively, of revenue from deposits that were included in contract liabilities as of March 31, 2021 and 2020, respectively. Our contracts have a duration of one year or less and therefore, we have elected the practical expedient of not disclosing revenues allocated to partially unsatisfied performance obligations.
Inventories - We record inventories at the lower of cost or net realizable value. Cost is defined as the sum of the applicable expenditures and charges directly or indirectly incurred in bringing inventories to their existing condition and location. Our inventories are stated using the first-in, first-out method. Inventory values are subject to many critical estimates, including production levels and capacity, changes in the prices paid for raw materials, supplies, and labor, changes in yield, potency, and quality of biomass, changes in processing or production methods, and changes in the carrying value of our inventories resulting from the prices our customers are willing to pay for our products. Such estimates are revised quarterly. Changes in management's estimates could result in increases or decreases in the recorded amounts of inventory and cost of sales.
To the extent that our production levels are not sufficient to absorb all production costs on a period basis, we recognize abnormal production costs, including fixed cost variances from normal production capacity, fixed production overhead costs, idle facilities, freight handling costs and spoilage, as an expense in the period incurred, without adjusting overhead absorption rates. Normal capacity is defined as the production expected to be achieved over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. Changes in management's estimates could result in increases or decreases in the recorded amounts of inventory and cost of sales.
In fiscal 2022, cultivation of astaxanthin was completed in the first six months of the fiscal year during the most productive months of the year due to the best growing conditions, similar to the prior fiscal year. Total production costs are calculated for the year based on normal capacity of production expected to be achieved in a year under normal circumstances. These costs are then allocated into inventory based on the period of production, not including abnormal production costs. Allocating fixed and overhead costs requires management's judgement to determine when production is outside of the normal range of expected variation in production.
Management reviews inventory levels, inventory turnover, product age and product marketability quarterly to evaluate recoverability and determine if a reserve for inventory is deemed necessary.
Equipment and leasehold improvements - Equipment and leasehold improvements are reported at cost less accumulated depreciation and amortization. Self-constructed leasehold improvements include design, construction and supervision costs. These costs are recorded in construction in progress and are transferred to equipment and leasehold improvements when construction is completed, and the facilities are placed in service. Long-lived assets, such as property and equipment and purchased intangibles subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized to the extent that the carrying amount exceeds the asset's fair value. We recognized $21,000 and $64,000 impairment of long-lived assets as of March 31, 2022 and 2021, respectively, which are included in other income (expense) on the consolidated statements of operations.
Stock-Based Compensation - We provide compensation benefits in the form of stock options, restricted stock units and restricted stock grants to employees and non-employee directors. Our stock-based compensation expense is based on the fair value of awards, adjusted for estimated forfeitures, and amortized on a straight-line basis over the requisite service period for stock options and restricted stock units ("RSUs"). The fair value of stock options is estimated as of the date of grant using the Black-Scholes option-pricing model. This model requires input assumptions for our expected dividend yield, expected stock price volatility, risk-free interest rate and the expected option term. Restricted stock and RSUs are valued at the fair value of our common stock as of the date of the grant. See Note 10 in the notes to our consolidated financial statements.
Income taxes - Income taxes are accounted for under the asset and liability method. The asset and liability method require the recognition of deferred tax assets and liabilities for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using income tax rates applicable to the period in which the tax difference is expected to reverse.
Our judgment is required in determining any valuation allowance recorded against deferred tax assets, specifically net operating loss carryforwards, tax credit carryforwards and deductible temporary differences that may reduce taxable income in future periods. In assessing the need for a valuation allowance, we consider all available evidence including past operating results, estimates of future taxable income and tax planning opportunities. In the event we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to income tax expense in the period in which such determination is made.
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