Is USANA Health Sciences A Better Short Than Herbalife?

| About: USANA Health (USNA)

Last week was an eventful one for the multilevel marketing space in the public markets, to say the least. But lost in all of the headlines surrounding Bill Ackman's devastating short thesis on Herbalife (NYSE:HLF) were some even more jaw-dropping developments at peer company USANA Health Sciences (NYSE:USNA). On December 14th, USANA announced the resignation of both its COO and CFO and promoted to the role of CFO its Vice President of Human Resources, someone who has spent most of his career in HR and who has very limited finance experience. And while the former CFO's resignation was tied to "family health matters," no such reason - or any reason whatsoever, for that matter - was given for the concurrent resignation of the COO; the timing here is all the more unusual given that he had been touted and lavishly praised in a company press release less than two months ago. And all this comes only 19 months after the previous CFO, COO, and two other top executives resigned under even more troubling circumstances that are discussed in detail below.

But most shocking of all is that in the three days prior to the announcement of the management changes, Myron Wentz, the founder and chairman of the company, sold 471,050 shares, or more than $20M of stock. While Wentz has been a consistent seller of USANA shares for the past 5 months, these sales were done in different and dramatic fashion: his sales represented an incredible 49% of all the volume traded in the stock over those three days.[1] And so with management fleeing for the exits - their resumes and wallets in hand - and with the recent furor over Herbalife, it seems like an appropriate time to revisit the USANA short thesis, which I believe to be even stronger than Ackman's case against Herbalife.

First and foremost, the central components of what Ackman argues against Herbalife hold for USANA as well, with even less burden of proof. As Ackman emphasizes (see page 60 of his presentation), the FTC's position on multilevel marketing is that an "organization is deemed a pyramid scheme if the participants obtain their monetary benefits primarily from recruitment rather than the sale of goods and services to consumers." Ackman's core argument as to why Herbalife is an illegal pyramid scheme is that it violates this rule by having over 50% of its revenue come from recruiting, a rule which Herbalife is clearly aware of (page 61). While Ackman has to make several well-substantiated assumptions to prove that Herbalife, despite its claims to the contrary, violates this criterion, USANA presents us with no such difficulties. In 2011, USANA reported total revenue of $581.9M. According to USANA's 2011 10-K, 90% of this revenue comes from active distributors. USANA does not provide an estimate of what retail margin is in its financial statements, as Herbalife does, but it is easy enough to calculate what this figure would be by looking at USANA's U.S. price list, which reveals that "retail" prices are at most 20% greater than wholesale distributor prices. Even if one assumes that all products USANA distributors sell are sold at the full 20% retail markup, distributors' margin on that $523.7M of product sales would be a mere $104.7M.[2] At the same time, associate incentives, which USANA helpfully publishes in a single expense line item, totaled $265.9M in 2011.[3] This means that by USANA's own numbers, associate incentives are a whopping 72% of total participant monetary benefit, well above the FTC's pyramid scheme threshold of 50%.[4]

But unlike Herbalife, the regulatory and business risk for USANA doesn't stop with the FTC. USANA generates 36.2% of its revenues and likely a disproportionate amount of its profits from the Greater China region, despite the fact that China has made all forms of multilevel marketing explicitly illegal since 2005 (see the People's Republic of China State Council Directive #444, Prohibiting Multilevel Marketing). USANA has always claimed that it is operating as a legal "direct seller" in China, but as the recent detailed report by Citron Research has made clear, the Hong Kong branch of USANA is seemingly actively recruiting mainland Chinese to join the standard multilevel USANA organization.

Remarkably, the company has actually implied internally that its operations are at odds with Chinese law. On May 8th, 2011, the company sent a letter to its Hong Kong distributors announcing policy changes whose deliberate intent was to make signing up mainland Chinese citizens in Hong Kong in absentia effectively impossible "to make sure that in China we have [a great] reputation with all governing bodies." Only five days later on May 13th - immediately following the resignations of the then COO, CFO, VP of Sales, and VP of Finance - the company issued another letter to its Hong Kong distributors canceling the announced changes.

The company has taken no steps since to re-establish the policy changes outlined in the May 8th letter. With the Chinese government, which has long turned a blind eye to MLM activity, increasingly cracking down on multilevel marketing schemes and even arresting local USANA distributors, USANA is stuck between a rock and a hard place - if the company removes the MLM compensation scheme from its China operations, its distributors will flee to one of many competitors, but if it continues with business as usual, it will eventually face the heavy hand of the Chinese government. It is likely only a matter of time before USANA is kicked out of, or faces dramatic decline in, its second-largest market.

So in USANA you have a $500M (!) market cap company that is potentially violating both U.S. and Chinese laws (the U.S. and Greater China together currently account for 60% of the company's revenues) and a $500M (!) market cap company that has the son of the founder as the CEO, no active COO, a former head of HR as its current CFO, and someone without a college degree as its new CIO (whom USANA initially reported as having a degree). Perhaps it shouldn't be surprising then that the founder and controlling shareholder would risk federal prosecution to aggressively dump his shares in the company less than 24 hours ahead of public disclosure of material news.

Herbalife is down more than 35% since Ackman exposed the company for potential violations of U.S. law. USANA is down only 15% over that period of time. With the added problems of a punchline for a management team and Chinese regulatory risk beginning to boil over, it sure feels as though some catch-up, at a minimum, is in order. And as it would seem to be almost impossible for Herbalife to be found in violation of federal law without similar repercussions for USANA, USANA offers less crowded exposure to the Ackman short thesis with additional ways of getting paid even if the FTC doesn't act.

[1] How does someone sell that much stock without the share price collapsing? I'd suspect that the company was particularly active with its buyback program those very same days.

[2] The Hong Kong price list does show a retail margin of as much as 33% for autoshipped orders, but our 20% assumption is still likely very conservative given the disclosure in the 2011 10-K that only 35% of sales are autoshipped; the FTC threshold is relevant only for the U.S. market, for which the margin is at most 20%; and even if the retail margin for the U.S. were 33% and not 20%, USANA would still violate the FTC threshold with associate incentives amounting to 61% and not 72% of total participant monetary benefit.

[3] This is probably an understated figure - just as Ackman suggests with Herbalife, USANA likely stuffs a good deal of non-monetary associate incentives in the SG&A expense line. As the company reports in its 2011 10-K, "selling, general and administrative expenses include…Associate event costs." And there are plenty of these at USANA. The company takes its top distributors on all-expense-paid vacations to luxurious destinations such as Paris and the Caribbean - see photos of their trips here! - and even supplied its ordinary distributors with free iPads at its annual convention.

[4] Even if you assume the entire amount of USANA's other 10% of revenue (direct sales from USANA to non-distributors) is somehow distributed to participants as a monetary benefit at 100% margin, you'd still be left with 62% of participant compensation coming from recruitment.

Disclosure: I am short USNA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The firm I work for has a significant short position in USNA. We may change our views about, or investment positions in, USNA at any time for any reason, including within the next 72 hours. This is not investment advice or a recommendation to buy or sell any securities, nor is it purporting to provide legal advice to anyone. The article is based only on publicly available information about USNA and therefore could be incomplete. We make no representation or warranty, express or implied, as to the accuracy or completeness of the article. Readers should review the cited sources and other related materials and reach their own conclusions. Readers should consult their own investment and legal counsel on the subjects discussed here before making any investment decisions.

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