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USANA Health Sciences, Inc. (NYSE:USNA)

Q4 2008 Earnings Call

February 24, 2009 11:00 AM ET

Executives

Riley Timmer - Vice President of Finance

Jeff Yates - Vice President and Chief Financial Officer

Fred Cooper, Ph.D. - President and Chief Operating Officer

Analysts

Timothy S. Ramey - D.A. Davidson

Douglas M. Lane - Jefferies and Company

Scott Van Winkle - Canaccord Adams

Operator

Good morning, ladies and gentlemen. And thank you for standing by. Welcome to the USANA Health Sciences Fourth Quarter Earnings Conference Call. During today's presentation all parties will be in a listen-only mode. Following the presentation the conference will be open for questions. (Operator Instructions). As a reminder this conference is being recorded today, Tuesday, February 24, 2009.

I would now like to turn the conference over to Riley Timmer, Vice President of Finance. Please go ahead, sir.

Riley Timmer

Thank you. Good morning, everyone. We appreciate you joining us this morning. Today's conference call is being broadcast live via webcast and can be accessed directly from our website at www.usanahealthsciences.com.

Shortly following the call a replay will be available on our website. As a reminder during the course of this conference call, management will make forward-looking statements regarding future events or the future financial performance of our company.

Those statements involve risks and uncertainties that could cause actual results to differ perhaps materially from the results projected in such forward-looking statements. We caution you that these statements should be considered in conjunction with the disclosures including specific risk factors and financial data contained in our most recent filings with the SEC.

Let me now turn the call over to Jeff Yates, our Chief Financial Officer.

Jeff Yates

Thank you, Riley. And good morning, everyone. I am pleased to be accompanied by Dr. Fred Cooper, our President and Chief Operating Officer today. Following my remarks Fred will disuses the top-line results, key indicators and the fundamental drivers of our business.

Yesterday after the close of market we issued final results for the fourth quarter and full year of 2008. We also filed a Form 8-K disclosing that we will restate our financials for 2006 and 2007 due to adjustments arising from an IRS tax audit. In our January preliminary conference call and release, we addressed the IRS tax audit and mentioned that it was ongoing. Recently we settled the outstanding issues relating to this audit and we will now restate our historical financials to reflect the results of this settlement. The impact of this negotiated settlement improved the results we announced in our preliminary release just a few weeks ago.

The press release issued yesterday, reflects these restated financial results. Our results will also be disclosed in detail in our 2008, Form 10-K, which we will file shortly.

It's important to note that these restated numbers are not material to the income statement. We determine to restate, because the cumulative impact of the taxes payable was material to our 2007 and 2008 balance sheets. As such, the restatement primarily, resulted in an increase to current liabilities and corresponding reduction in stockholders equity.

Now, turning to our final quarterly results. Net sales in the 14-week fourth quarter were $111.1 million, an increase of 2.1%, compared with a $108.7 million reported in the fourth quarter of 2007. It was noted in both our preliminary and final earnings releases that the significant strengthening of the U.S. dollar resulted in a $10 million reduction to our top-line.

Excluding this dramatic change in foreign currencies, net sales for the fourth quarter would have been about $121 million, modestly above the top-end of our fourth quarter guidance. We have not historically hedged the top-line or the balance sheet. However, we are currently evaluating the potential costs and benefits of doing this. It has been our practice to hedge expected cash flow from our international operations, which we do plan to continue.

Earnings per share from continuing operations were $0.29 in the fourth quarter, a decrease of 56.1% compared with the fourth quarter of 2007. There were two significant factors that negatively impacted earnings per share in the fourth quarter.

First, an unanticipated arbitration award against the company for approximately $7 million, which reduced earnings per share by $0.28. And second, the dramatic and rapid strengthening of U.S. dollar, which lowered our top-line. While the bottom-line impact is a bit more complex to calculate, we estimate the impact of currency fluctuations on EPS to be about $0.10 to $0.12 in that quarter.

Over the last several years, and as a consequence of our growing global presence, we have benefited from a steady decline in the U.S. dollar. In the fourth quarter, the U.S. dollar strengthened significantly against currencies that are important to USANA, particularly in Canada, Australia and Mexico.

The spike in U.S. dollar from the end of the third quarter through the end of the fourth quarter resulted in a $10 million reduction to our top-line, again, estimated that this had an earnings per share impact of about $0.10 to $0.12.

Now, let's go through the major line items on the fourth quarter income statement. Our gross margin in the fourth quarter of 2008 improved slightly as a percentage of net sales to 79.1%, compared with 78.9% in the fourth quarter of '07. This modest improvement is due primarily, to improved operating efficiencies, resulting from a new high-speed bottling line, and the introduction of a new state-of-the-art pick-to-light shipping line system.

Associated incentives in the fourth quarter of 2008 were 48.4% of sales, compared with 41% in the fourth quarter of last year. This increase was due primarily to the $7 million arbitration award. Excluding this award, associated incentives were 42.1% of net sales. This increase of a 110 basis points was expected, and can primarily be attributed to the two compensation plan enhancements introduced at our Annual International Convention in August of 2008.

Selling, general, and administrative expenses relative to net sales increased to 23.8% during the fourth quarter of 2008, compared with 22.4% in the fourth quarter of the prior year. The year-over-year increase in SG&A was due mainly to the following factors. An increase in equity-based compensation expense due to the long-term grants that were issued in July of 2008 and increases in wage-related expenses primarily, due to adding additional human resources over the past two years, and increased executive salaries.

These increases in SG&A were partially offset by a decrease in the amount spent on legal and other professional services.

Now, regarding the balance sheet, cash at the end of the fourth quarter was $13.3 million compared with $12.9 million at the end of 2007. Inventories at the end of the fourth quarter were up year-over-year to $23.9 million compared with $19.4 million at year-end '07. The factor in the greater investment in inventory relates to our preparations for opening the new market in the Philippines.

Net sales for the full year of 2008 were $429 million, an increase of 1.4%, compared with the year ended 2007.

Net sales growth during the year was primarily driven by a 12.5% increase in the number of active associates, compared with last year. As you know, the number of associates is a key indicator of the strength of our business. I'm pleased that this key indicator is showing positive momentum. Fred will address the growth and the number of active associates in his remarks.

For the full year, earnings per share from continuing operations were $1.85, a decrease of 30.2%, compared with $2.65 in 2007. This decrease is due to the one-time arbitration award and higher overall operating costs.

The following higher operating costs impacted earnings per share by approximately $0.26 for increased wage related expenses, $0.09 for the change in net other income and expense, $0.08 for higher depreciation and rent expense, $0.06 for higher equity-based compensation expense, $0.04 for the increases in non-recurring legal cost and other professional services, and $0.03 for increased spending on associate events and support activities.

Capital expenditures for the year totaled about $16 million, which were primarily related to the expansion of facilities in the U.S. and Australia. We anticipate capital expenditures in 2009 to be about $4 million to $6 million.

Now, to update you on our share buyback program. During the fourth quarter, we repurchased 307,000 shares for a total of $11.8 million. For the full year, we purchased approximately 1.1 million shares for $39.9 million. The retirement of these shares resulted in an earnings per share benefit of $0.04 in 2008. Currently, we have about $10.4 million available under our share repurchase authorization.

Now, before we hear from Fred, I will comment on our guidance. Yesterday in our press release we provided guidance for the full year of 2009. Excluding changes in currency, we expect sales to grow 8% to 10%. We believe however, that the effect of the strong U.S. dollar will reduce our consolidated net sales by 6% to 8%.

Accordingly, we project a modest increase in consolidated net sales of about 2% in 2009. We also expect earnings per share to be dramatically reduced by changes in currency. We believe that earnings per share for 2009 will increase about 4% compared with 2008. This estimate is in comparison to our reported GAAP results of $1.85, and is based on an effective tax rate of 36%.

Our 2009 guidance also assumes that consolidated gross profit margin will be approximately 79% of sales, associate incentives will be approximately 43% of net sales, and SG&A could approach 25% of net sales, which now importantly, includes R&D expenses of approximately 1%.

While we are excited about the momentum and enthusiasm we see among our associates, we are expecting challenging year-over-year comparisons for the first nine months of 2009, because of the current strength of the U.S. dollar. To illustrate this, we estimate that if exchange rates remain at current levels, sales for the first three quarters of 2009 will be negatively affected by over $30 million or approximately $0.40 per share, in comparison with that same period in 2008.

Notwithstanding these currency pressures, we are seeing positive momentum in our fundamental business drivers, and expect net sales and earnings per share to increase modestly in 2009. Early signs, such as double-digit growth in the number of active associates and local currency sales growth in the majority of our markets indicate that the compensation planned enhancements introduced are working.

It's important to note that we will manage spending closely to ensure that our overall costs remain in line with both reported sales and our long-term financial goals.

I'll now turn the call over to Fred.

Fred Cooper, Ph.D.

Thanks Jeff. Good morning, everyone. I want to begin by discussing some regional and operational results, and then provide you with some insight regarding our 2009 strategies going forward.

Net sales during the fourth quarter in North America, were down 1.3% compared with the fourth quarter of 2007. Now, this decline was primarily due to an 8.8% decline in Canadian net sales, which reduced by $4.2 million due to the strengthening U.S. dollar. This decrease was offset by an increase in sales of 1.6% in the U.S. and 4.6% increase in Mexico.

Notably though, active associates in North America have increased to 107,000 and that's a 7% increase compared to the previous year.

I'd like to talk about the results next in our Asia-Pacific region. During the fourth quarter of 2008, net sales in Asia-Pacific increased 7.8% to $44 million. The increase in this region was led primarily year-over-year from growth in our Hong Kong region, up 56%, and 43.8% in Malaysia. The number of our active associates in Asia-Pacific increased as well, up to 19.7% to 91,000 associates, compared with only 76,000 in the fourth quarter of 2007. Once again, Hong Kong and Malaysia were our main contributors to this growth.

Additionally, the opening of the Philippines in January has really helped to build our momentum in the region. Remember, we selected this country because it was one of the top 25 direct selling markets globally, and also because we had strong ties with many of our current associate leaders in the Filipino communities worldwide. We expect this market to be a nice addition to the Asia-Pacific region going forward.

Although our 2008 results were not as strong as expected, I remain optimistic for USANA in 2009. Our fundamental indicators are signaling that our strategies for long-term growth are working. For example, at the end of the fourth quarter, our total number of active associates reached 198,000, up 22,000 associates compared to the year-end 2007.

In particular, we saw the second highest number of associates ever coming into the business during the fourth quarter of 2008. It's encouraging because the number of new associates coming into the business is strongly correlated with sales. The improvement in associate count is specifically related to two new components of our compensation plan, the Elite Bonus and the Matching Bonus. These changes were introduced in our 2008 international convention last fall.

The Elite Bonus is an incentive paid to our top 25 income earners each quarter, and it's designed to create competition in our top 50 to 60 associates. We have found that by motivating just a few of these key individuals, it will have a significant impact in bringing in new customers.

Next, the Matching Bonus, allows all associates at virtually any level to earn additional commissions based on new associates achieving a Platinum Pace Setter status within the first six weeks of joining the business. Platinum status is obtained by sponsoring four new associates to become active and are involved in producing sales of products within that same timeframe.

Before this enhancement, only 2.5% of new associates attained the status of Platinum Pace Setter but in the fourth quarter alone that metric increased 160%. This means more people are building their business earlier, resulting in a more rapid increase in customers and sales.

Also, our monthly auto ship rate in the fourth quarter improved to 49.4%, compared to 46.4% in the third quarter. This again, is a strong indicator of long-term associate commitment and retention.

Ongoing our objectives in 2009 include continuing to promote USANA's outstanding home-based business opportunity, including the benefits of the new Elite Bonus and the Matching Bonus.

We're going to continue helping our associates build their USANA business, by enhancing their experience with us, utilizing great business building tools. We are going to introduce a broader spectrum of our current products in the markets where only a limited number of products are currently being offered, and we're also continuing to evaluate new market opportunities.

We're looking forward to another successful year at USANA in 2009, I am confident that our long-term objectives will be met as we continue to promote and support the fundamental drivers of our business.

With that, I'll now ask the operator to facilitate the question-and-answer session.

Question-and-Answer Session

Operator

Thank you, sir. Ladies and gentlemen, we will now begin the question-and-answer session. (Operator Instructions). And our first question comes from Tim Ramey with D.A. Davidson and Company. Go ahead, please.

Timothy Ramey - D.A. Davidson

Good morning, guys.

Jeff Yates

Good morning.

Fred Cooper, Ph.D.

Hi, Tim.

Timothy Ramey - D.A. Davidson

It looks like the, may be I'm reading this wrong but even if I normalize for the extra week and then normalized for foreign currency, it looked to me like the sales performance for associate was... you were losing effectiveness per associate. Do you think that's true, is it the leading edge of a curve and so may be that picks up? But even your sales forecast of 2% growth, even giving effect for the extra week and giving effect for the currency. I think we have to imply some kind of degradation of sales performance per associate. How do you react to that?

Fred Cooper, Ph.D.

My take sir would be, first of all you are early in the curve as you denoted, right? Our fourth quarter results are out, it usually takes a bunch amongst to find out the proportion of the associates that have just been recruited that will continue on and progress up the rates in the commission plan. So when you have a disproportional number of new incomings relative to our stable base, it's going to appear that way initially.

Timothy Ramey - D.A. Davidson

So we had a decent associate recruiting performance also in the third quarter doing that at least on a year-over-year base?

Fred Cooper, Ph.D.

Yes, not as good as fourth.

Timothy Ramey - D.A. Davidson

Yes, okay. So I shouldn't assume that this means that there is a reduction in effectiveness per associate?

Fred Cooper, Ph.D.

No, the other item of this is that Platinum Pace Setter is a pretty motivating program to try to get our associates to talk to other customers. And in so doing there is also a desire to get more customers for the same wallet share on the initial purchase. So that also has a little bit of an impact on this.

Timothy Ramey - D.A. Davidson

Okay. And Jeff, on the subject to share repurchase you did note, even though your average purchase price was quite a bit above market, that it was accretive to earnings. What's your stance on share repurchase right now, I know you only have 10 million remaining. Would you recommend to the Board, that this is effective use of cash going forward or should we be husbanding resources more tightly in this environment?

Jeff Yates

I would say the latter, the outset Tim. It's important to maintain the cash to invest in any opportunity that we have but obviously the impact of the arbitration award and the payment of the settlement with the IRS has put a demand on the cash and so we'll probably hold off for a bit. But obviously, that remains an option for us later in the year.

Timothy Ramey - D.A. Davidson

Okay, thanks Jeff and Fred.

Operator

Thank you. (Operator Instructions). And our next question comes from Doug Lane with Jeffries and Company. Go ahead please.

Douglas Lane - Jefferies and Company

Hi, good morning, everybody.

Fred Cooper, Ph.D.

Hi, Doug.

Douglas Lane - Jefferies and Company

Can you give us an update Fred on your view point, where you stand on China these days, you haven't mentioned it. In a little bit and I wondered where we stand in that market?

Fred Cooper, Ph.D.

There hasn't been any changes in the laws in China to-date, that would help us get into China and use a multilevel marketing in our direct sales industry to able to go into there. So from that standpoint there isn't a change. However, we are looking into two items; one, better utilization of our Tianjin facility that we have in China now.

And the second is we do all the time spend time exploring alternatives that might allow us to go into China with the key driver on this being in a way that will allow our associates to benefit from participation in China. When we can accomplish that goal and stay within the guidelines and the laws of China, we would like to get into China sooner rather than later.

Douglas Lane - Jefferies and Company

I see, in the meantime are you looking to may be manufacture in China, because if I am, am I right that most of your product manufacturing is done in the United States and then shipped around the world?

Fred Cooper, Ph.D.

Correct.

Douglas Lane - Jefferies and Company

So the currency being what it is, that's sort of a double whammy for you. So I wanted if you were thinking about at least diversifying your manufacturing base and may be using China that way?

Fred Cooper, Ph.D.

Actually in the short-term, it isn't going to be an option but in the long-term we are looking at the need ultimately to diversify in manufacturing. Not necessarily China but not excluding it either, but for the reasons that you speak of.

Douglas Lane - Jefferies and Company

Okay, thank you.

Operator

Okay, thank you. And our next question comes from Scott Van Winkle with Canaccord Adams. Go ahead please.

Scott Van Winkle - Canaccord Adams

Hi, Jeff. Can I go through some of the currency impact on earnings. What percent of your SG&A, non-volume incentive SG&A is in U.S. dollars?

Jeff Yates

Stick on, I'd look here Scott. It's a very high percentage probably 60 to 70%.

Scott Van Winkle - Canaccord Adams

And all of your markets have international on the ground operations, is that correct?

Jeff Yates

The most part, yes. Service centers, and network development, and finance managers, yes.

Scott Van Winkle - Canaccord Adams

And the volume incentives are paid in local currency in every case. Is there any change to the points per product sale depending on currency or it's just a straight math?

Jeff Yates

The points are similar throughout the world because of the seamlessnature of our program. But there are subtle differences obviously, and particularly in relation to price, because of different tax or duty or VAT requirements that we have. But the points are pretty consistent.

Scott Van Winkle - Canaccord Adams

Okay. I am just, kind of back of the envelope here, kind of struggling to get to the guidance, even on the revenue guidance, even on the currency assumptions that are currently in place today. I would assume the expectations that you just had a very good quarter of distributor growth, to Tim's question earlier about the productivity on a distributor basis, not changing dramatically. According to Fred's answer, I would assume that you're looking at the fourth quarter and just tempering expectations from here a little bit, on the local currency basis, and implying currency?

Jeff Yates

Yeah. There is no question, Scott. Keep it in mind that what impact that we had benefited from over what six such years on a subtle but meaningful decline in the value of that dollar, reversed itself in probably six weeks.

And predicting forward into that even further degradation of the foreign currency values in the January, albeit flattening, it's hard to predict against us. So there is no question that we would want to be conservative in our projections. That said the impact to the first three quarters considering the value of the currency today is significant.

And particularly, as you compare that with the average rate that we exchanged at in Q1 of '08 Q2 and Q3 of '08, even through Q3 of '08. And so that assuming we don't have much change in currency, it's going to be tough to do, to get over those comparisons.

Now obviously, with an increase in that rate because of the currencies that we trade in, that opportunity would be significant for us. We should see a nice lift from that. We are hoping that you'd be able to tell us where those currencies are going to go?

Scott Van Winkle - Canaccord Adams

Yes, yes. Keep waiting.

Jeff Yates

Yes, indeed. We'll hold our breath though.

Scott Van Winkle - Canaccord Adams

Hey, Fred I want to go back to that question about productivity on distributor basis, I understand where your comming from on that. But, if you see the preferred customer totals declining, wouldn't that lead you to believe that there is going to be a little less productivity on a per distributor basis that is offset hopefully in this economic environment, by better recruiting?

Fred Cooper, Ph.D.

I wouldn't argue with that.

Scott Van Winkle - Canaccord Adams

Good answer, okay. That's it. Thank you very much.

Jeff Yates

Thanks Scott.

Operator

Thank you. And we have a follow-up question from Tim Ramey. Go ahead please.

Jeff Yates

Welcome back Tim.

Timothy Ramey - D.A. Davidson

Sorry.

Jeff Yates

No, no, no.

Timothy Ramey - D.A. Davidson

I'm following up on Scott's question. I guess I really wanted to, and I'm sure he knows, and I need to catch up, the understanding of how currency impacts the associate incentive expense, because it seemed to me and may be Jeff, this was your answer, that this is really paid effectively in U.S. dollars. And so, the associates are now getting a slight currency benefit. Am I wrong on that? Is that how you answered that, is there a way to may be take some of that currency volatility out of the associate expense? If--

Jeff Yates

It's an excellent question Tim. Truth is that the commission rates that we pay to our associates in foreign countries is at a fixed rate, we establish a commission payout rate in a country typically near its opening, and have held those firm traditionally, in the organization for years. So they don't experience fluctuations as we do relative to our sales. Those commission rates on their local sales remain fixed. So it works for us in some exchanges, and it works against us in others.

Timothy Ramey - D.A. Davidson

So it's really working against you right now?

Jeff Yates

Indeed, indeed.

Timothy Ramey - D.A. Davidson

Okay. I mean is that the type of thing that is sacrosanct, because it's part of the compensation plan, or is that the type of thing the Board or that management can review?

Jeff Yates

We obviously are looking at it all the time. It's an important component to our compensation plan overall. And it does afford us the opportunity to adjust prices when necessary. It gives us the opportunity to adjust our model to accommodate those, and we are always looking at that. And obviously, at this point still doing so. We love the benefit that it provides us, and are dealing with the challenge that we currently have.

Timothy Ramey - D.A. Davidson

Okay, thank you.

Jeff Yates

You bet. Thanks Tim.

Operator

Thank you. And we have no further audio questions. I would like to turn the conference back over to Riley Timmer for any closing statements.

Riley Timmer

Thanks everybody for your questions. If you have any remaining questions, please feel free to contact Patrique Richards in Investor Relations at area code 801-954-7961. Thank you.

Operator

Ladies and gentlemen, this does concludes the USANA Health Sciences fourth quarter earnings conference call. If you'd like to listen to a replay of today's conference, please dial 800-405-2236 or 303-590-3000, with the pass code 11126618. ACT would like to thank you for your participation. And you may now disconnect.

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