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USANA Health Sciences (NYSE:USNA)

Q2 2013 Earnings Call

July 24, 2013 11:00 am ET

Executives

Patrique Richards

David A. Wentz - Chief Executive Officer

Paul A. Jones - Interim Chief Financial Officer and Principal Accounting Officer

Analysts

Mark Sigal - Canaccord Genuity, Research Division

Timothy S. Ramey - D.A. Davidson & Co., Research Division

John P. San Marco - Janney Montgomery Scott LLC, Research Division

Frank A. Camma - Sidoti & Company, LLC

Operator

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the USANA Health Sciences Second Quarter Earnings Conference Call. [Operator Instructions] I would like to remind everyone that this conference call is being recorded today, Wednesday, July 24, 2013, at 9 a.m. Mountain Time.

I'll now turn the conference over to over to Mr. Patrique Richards. Please go ahead.

Patrique Richards

Good morning, everyone. We appreciate you joining us this morning to review our second quarter results. 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. Examples of these statements include those regarding our personalization initiative, our strategies for each of our regions and our outlook for 2013. 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.

In addition, as we disclosed in Form 8-K filed yesterday, the Securities and Exchange Commission is conducting an investigation, which appears to involve possible issues regarding trading in the company's stock during late 2012 by certain of the company's directors, including the Chairman. The company and members of its Board of Directors are fully cooperating with the SEC in connection with this matter. Because this is a pending matter, we are not able to provide any further comment at this time nor respond to questions about this matter. We are confident, however, that the outcome of this matter will not have a material adverse effect on the company's financial condition or results going forward.

I'm joined this morning by Dave Wentz, our Chief Executive Officer; and Paul Jones, our Chief Financial Officer. Dave will begin with a review of our operational progress and highlights during the quarter. Paul will follow with a more detailed look at our second quarter financial results. And Dave will then conclude by providing a preview of our expectations for the second half of 2013.

I will now turn the call over to Dave.

David A. Wentz

Thanks, Pat. Good morning, everyone. The results we reported after market yesterday afternoon reflect the stellar performance by our team during the second quarter. Sales increased 17.5% and earnings per share increased nearly 55%. The number of worldwide Active Associates increased 8.1% and Preferred Customers increased 6.1%. We believe this growth reflects the continued successful execution of our strategic initiatives. After generating another record quarter, we are on track to report our 11th straight year of record results in 2013.

Net sales for the second quarter were $189.1 million, our sixth consecutive quarter of record sales. The key factors contributing to this growth include: strong sales and customer growth in Asia Pacific, especially in greater China; and continued growth in North America, primarily from increased Associate productivity.

Another factor that influenced sales for the second quarter was our introduction of a worldwide policy focused on customers' purchasing product offered outside their home market. With the global nature of our business and the Internet making it easier for consumers to research and purchase products online, we've experienced some cross-border purchasing by our customers in several of our markets in an effort to get desired formulations, products or pricing, which are not available in their home market.

The price reductions we implemented earlier this year were also intended to minimize cross-border purchasing and to help make our products and business opportunities more equitable across all of our markets. This latest policy change is hopefully our final change to minimize cross-border purchasing. We believe that we realized approximately $7 million in additional sales during the quarter due to increased purchases ahead of the implementation of this policy.

These positive factors were partially offset by an estimated $1.1 million negative impact from the pricing initiative in Canada, Australia and New Zealand that we implemented during the first quarter of this year to increase parity between markets.

I'll now turn it over to Paul to talk about our regional performance.

Paul A. Jones

Thanks, Dave. Sales growth this quarter was led by our Asia Pacific region, where many of our markets continue to generate solid sales growth. Sales increased 36.3% in Greater China and 9.3% in Southeast Asia/Pacific. We were also pleased to see 19% sales growth in South Korea in our North Asia region, which was driven by strong increase in customers as well as price adjustments implemented earlier this year.

The Greater China growth was driven by strong results in each of the markets in this region, but was led by Mainland China. The number of Active Associates in Greater China increased 18.4%, which was again led by significant Associate growth in Mainland China. We're pleased with our continued success in this region, particularly in Mainland China, where sales were approximately $3.5 million stronger than expected. We believe that these better-than-expected results are due to continued excitement and momentum from our sold-out Asia Pacific Convention that was held in this region during the first quarter and the emergence of new Associate leaders and customers in China, as we are beginning to see a number of Associates in that market advance up through our leadership ranks.

We also believe that the 3 additional direct-selling licenses that were granted during the first quarter, as well as our significant offering of licensed USANA products, are contributing to our success in Mainland China. While we are encouraged by our results in Greater China for the quarter, we are conscious about the events that accelerated our performance in the region. Both the carryover momentum from our Asia Pacific Convention and the sales ahead of our worldwide policy change has meaningfully contributed to our results in this region for the quarter. Additionally, we continue to anticipate that our results in Hong Kong will taper and that we will continue to grow in Mainland China as we focus our efforts and resources on this market.

Now just to clarify some details about our business in China. We maintain a direct-selling license in the province of Beijing and we're also granted direct-selling licenses in 3 additional provinces during the first quarter of this year. In China, we sell 8 USANA-branded products, 6 Sensé-branded products and 10 BabyCare-branded products, all of which has been registered with and approved by the Chinese government. Our Associates around the world are required to comply with local laws and regulations, as well as our internal policies and procedures. We continually update our policies and procedures to ensure that they are in accordance with best practices.

The policy I mentioned a moment ago is simply one example of a policy that we have implemented or modified during the last year to strengthen our business. We are aggressive in ensuring that our Associates comply with our policies and procedures and will continue to be aggressive going forward.

Turning now to Southeast Asia/Pacific. Sales growth in this region was again driven by double-digit sales and customer growth in the Philippines. We continue to see solid growth in the Philippines, albeit at the reduced rate we anticipated. We were also pleased with our results in Australia and New Zealand during the quarter, where the number of Active Associates increased over 5% and the number of Preferred Customers increased 15%. We believe that the success and momentum that we are beginning to see in these markets is directly related to the pricing initiative we announced earlier this year.

As a reminder, we implemented price reductions that were designed to help expand our customer base in several of our mature markets. They better align our product pricing with the economic and competitive environment while incenting Associates to purchase within their home market. We also saw solid sales growth in Singapore this quarter, which can primarily be attributed to the sales of our MyHealthPak product, which have improved noticeably throughout Asia. Remember that our entire Asia Pacific region is serviced by Singapore for our MyHealthPak product.

Turning now to North America. Sales for this region continued to improve and increased 6.9%, which was largely the result of strong sales growth in Mexico, as well as sales growth in the U.S. and Canada. Our sales growth in Mexico was driven by double-digit increases in both Associates and Preferred Customers, as well as price increases that were implemented during the first quarter. Sales growth in the U.S. was driven by increased Associate productivity and price increases on certain of our products that were implemented during the first quarter.

In addition, you may recall Dave discussing on previous calls the iPad promotion and True Health Assessment initiative. Both of these programs generated a lot of excitement with our Associates during the first quarter. The enthusiasm continued to build during the second quarter and we are continuing to utilize and promote the True Health Assessment.

In Canada, we are beginning to see improvements in both customer counts and productivity, which we believe is the early result of the price reductions made in the first quarter. Although this pricing initiative is still in the early stages, we are pleased with the results so far and expect it to generate both customer and sales growth over the long term in Canada and the other mature markets that were targeted.

Let's turn now to the income statement. Gross margins improved 50 basis points year-over-year, largely due to a decrease in cost of goods sold, which can mostly be attributed to production efficiencies. These efficiencies were partially offset by an unfavorable change in sales mix by market. Associate incentives expensed for the quarter decreased to 41.1% of net sales compared to 44.1% in the prior year quarter. This decrease can primarily be attributed to the change -- to the Lifetime Matching Bonus program launched in the second quarter of 2012. In a moment, Dave will walk you through our plans for Associate incentive expenses for the remainder of this year and going forward.

SG&A in the second quarter was 22.7% of net sales, a relative decrease of 10 basis points from the second quarter of 2012. This relative decrease is largely due to leverage gained from higher net sales. On an absolute basis, SG&A increased as a result of the costs associated with supporting a higher sales base, which largely can be attributed to higher wages and benefits.

Our effective tax rate for the quarter was 33.4% of pretax income compared to 32.8% in the prior year. We expect our effective tax rate for the year to range between 33% and 33.5%. Net earnings for the first quarter increased to $24.2 million, an improvement of 44.6% compared with the prior year period. This increase was due to higher net sales, higher relative gross margins and lower relative operating expenses for the quarter.

Earnings per share for the quarter increased nearly 55% to a record $1.72 per diluted share. This increase can be attributed to higher net earnings and a lower number of shares outstanding from share repurchases over the last 12 months. We did not repurchase any shares during the quarter and there's approximately $13.6 million remaining under our board-authorized repurchase program. Our diluted share count as of the end of the quarter was 14.1 million shares.

Turning to the balance sheet. We continue to generate strong cash from operations and ended the quarter with $96 million in cash. Cash generated from operations in the second quarter totaled nearly $27 million.

Before turning the call back over to Dave, I'd like to reiterate how pleased we are with this quarter's results and more specifically, with the underlying strength of our business and the financial strength of the company.

With that, I will turn the call to Dave to review some new initiatives and our guidance.

David A. Wentz

Thanks, Paul. As a management team, we focus on many different areas and goals, but our most important commitment is to the long-term growth of the company. As we have discussed on previous calls, we believe that growing our customer base by sharing our products and opportunities with as many consumers as possible is the best way to drive long-term, sustainable growth for the company. Initiatives during the first 6 months of the year have helped move us in that direction.

In August, we'll hold our annual International Convention here in Salt Lake City. As you know, we often reserve our most exciting and significant announcements for this event. Our announcements this year are very exciting and designed to create lifetime customers and successful entrepreneurs. Because our convention is only a few weeks away, I'm going to keep the details to a minimum at this time. What I can tell you at this point is that these announcements will include significant investments by USANA in initiatives that are designed to reward both new and existing customers who loyally use our products; simplify USANA opportunity for all Associates, helping them to become successful faster; and increase reward for our Associates, who are creating more lifetime customers.

We expect these announcements to be well received and generate a great deal of excitement amongst our Associates. While we believe that this investment will accelerate our growth rate of Associate and customer counts by increasing customer longevity and helping our Associates become successful faster, we also expect short-term pressure on our top line performance during the second half of the year and corresponding pressure on our operating margin.

This past quarter, our Associate incentive expense was 41.1% of net sales and well below our target range for incentives. Over the past year, we have communicated our intent to reinvest the savings in our Associates to create long-term customer growth. We believe the initiatives we will launch at convention will accomplish this. That said, our target operating margin remains around 15% for the full year 2013 and beyond.

As a result of our performance during the first half of 2013, combined with planned investments in the second half of the year, we are reiterating our top line guidance and increasing our EPS guidance as follows. Net sales will be in the range of $700 million to $720 million for the year. Diluted EPS for the year is now expected to be in the range of $5.30 to $5.45. As our guidance and first half results suggest, we expect these initiatives and investments to reduce our operating margins during the second half of 2013.

This reduction can be attributed to, in order of significance: increased Associate incentives that we believe will temporarily increase to around 45% for the second half of 2013; pressure on our top line results for the second half of 2013; and an estimated 100 basis point decrease in gross margins. We anticipate that Associate incentives for 2014 and beyond will settle in between 43% to 44% of net sales. Let me reiterate my confidence in the long-term benefits of these investments and initiatives. I strongly believe that these investments are coming at the right time and will provide the opportunity for more rapid growth of the company over the long term.

Before closing, I'd also like to point out that we recently opened Colombia. This is our 19th market. Our Mexico leaders, who are doing a phenomenal job growing in their own market, have strong ties to Colombia as well. As a result, we have high expectations for this market.

In closing, I want to be clear that our guidance does not signal a slowdown in our business but rather an investment in the future. I'm very pleased with the performance of our business and excited about the direction of the company. Our business has never been stronger and our expectation is that we will report our 11th consecutive year of record sales and another year of record earnings per share for the full year 2013.

While it's premature to offer specifics about 2014, we are quite confident that we will extend our record to 12 years. It is my expectation that the implementation of our upcoming initiatives will support our growth in the years to come. I fully expect our business to continue to produce excellent results as we continue to focus on rewarding our Associates for increasing the growth of lifetime customers, which must be the foundation for long-term growth for the company.

With that, I will now ask the operator to facilitate the Q&A session.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Scott Van Winkle from Canaccord Genuity.

Mark Sigal - Canaccord Genuity, Research Division

It's Mark Sigal in for Scott. I was wondering if you guys can provide a little more detail on the rule change you implemented during the quarter. Is it a strict prohibition on purchases outside of the Associates' home market? Or are there other aspects of the rule as well? And then perhaps as a corollary to that, the $7 million onetime benefit you saw, could you give us a geographic breakdown of what comprised that?

David A. Wentz

Yes. The main gist of the rule was to stop people from buying products, where they had a similar product in their own market. If they have a similar product in their own market, they're not allowed to buy it from another country. If there are still other products that they don't have available that they're interested in and we want to take care of their long-term health, so for personal use, they might buy some other products but not the ones that they have in their own markets. And primarily, we saw the greatest impact in Asia as we saw stock up before the change of the policy.

Mark Sigal - Canaccord Genuity, Research Division

Okay. And can you give us any more breakdown in Asia, Hong Kong versus Mainland?

David A. Wentz

Greater China was definitely a large aspect of that with the different -- difference in products between markets.

Mark Sigal - Canaccord Genuity, Research Division

Okay. And then in respect to your earlier commentary regarding the SEC investigation, I was just trying to get a sense of the timeframe that's being called into question. Does it strictly just relate to late 2012? Or are there any other timeframes that go along with that?

Patrique Richards

Because it's pending, we can't comment on that.

Mark Sigal - Canaccord Genuity, Research Division

Okay. You spoke a little bit about Colombia coming online in the back half of the year. Can you give us a sense of what your expectations are at this time? Are the expectations more robust than some of your more recent market openings, such as France or Belgium? Or can you just sort of give us a sense of how you're thinking about it?

David A. Wentz

Yes. We're only 1 week into it, but -- well, 1.5 weeks now as of today. But very optimistic, a much better response and experience than in France and Thailand. We're off to a much too faster start and better run rate and great prospects based on what we saw with the meetings going on throughout the country with thousands of people. It is going to be a great market for us. Very smooth opening, without any glitches that I know of. It's one of the best openings we've ever had, so we're very excited.

Operator

Your next question comes from the line of Tim Ramey from D.A. Davidson.

Timothy S. Ramey - D.A. Davidson & Co., Research Division

The sales shift, I'm assuming -- the way I read that was it pushed sales out of the 3Q into the 2Q and didn't place as much impact in my analysis on the 4Q. But how would you react to that? Does that sound about right? And I know you're not going to give us quarterly guidance. But it seems to me that the brunt of that would be in the 3Q.

Paul A. Jones

Yes. That would be correct. And it will have some impact on the third quarter. But I think we will anticipate that we would see -- continue the great run rate that we were seeing in the first quarter. The second quarter is a bit of an anomaly because of this. But we'll continue to see going forward the run rates that we've seen from the first quarter and prior.

Timothy S. Ramey - D.A. Davidson & Co., Research Division

And the Associate incentive expense being as low as it was on a percentage of sales in the 2Q, did that reflect anything about mix and structural differences in terms of how Mainland China sales roll up into the P&L? Or is that just kind of the...

David A. Wentz

No, it really didn't. We've been managing that line and working on it for a number of years, all to put us in a position to make these investments that we're looking to make at convention. So that number hasn't moved on accident. We've managed it to a point where we want to get it so that we can put this investment back into our leaders to grow the company faster. And so it's been a process in place for a year or more to get to this position. And we're very excited about what this allows us to do at the coming convention.

Timothy S. Ramey - D.A. Davidson & Co., Research Division

And Dave, the statement -- I think you made it this morning and maybe you made it in the P&L as well or in the press release as well, that Mainland China really was the growth driver, which is somewhat counterintuitive if we were thinking that some of this rule change was about minimizing gray market importation through Hong Kong.

David A. Wentz

That's just how amazing Mainland China is doing right now. It is growing very fast and doing very well. So we're excited that we've been able to accomplish this switch and focus for our leaders. And they are taking off with it in, as we know, the biggest market. So we see a great run rate there in Mainland China.

Timothy S. Ramey - D.A. Davidson & Co., Research Division

And if we think back, I think it was 2011, you attempted a similar thing, and then reversed it in the 2Q of '11, I believe it was. But I mean, it makes sense that you didn't have the approval, so you didn't have the product listings, you didn't have a lot of the infrastructure that you do on the ground now. Is that kind of why this makes sense for today that it didn't stick in 2011?

David A. Wentz

Yes. There's a number of steps over the years to get to this point. And now I feel like we've pretty much taken the final step and are seeing the great growth now in China that we were trying to get to over the last years. And so yes, things had to be put in place. They had to take time. It couldn't happen overnight. And we feel like, as we said, kind of the final step. And now we're just ready to roll and grow in Mainland China.

Operator

Your next question comes from John San Marco from Janney Montgomery Scott.

John P. San Marco - Janney Montgomery Scott LLC, Research Division

I may have missed a part of your answer earlier in Q&A. But will the policy that you've already put in place aimed at getting customers to buy product in their home market, should that have an impact outside of Hong Kong? Or is that -- will that just be a Hong Kong issue?

David A. Wentz

No. It has effects in many different markets. We've tried to create parity between markets, and we'll continue to take more steps to do that. But there are still differences in formulas, difference in prices due to exchange rates, et cetera, between markets. And we've become such an Internet, well-researched. Everyone knows what the prices are in different places. They now think about exchange rates. So it's created challenges where we needed to put this policy in place going forward so that it didn't increase our cross-border purchases and will, in fact, send them in the other direction. And that's just the nature of the world that we're living in now and took the corrective step to make sure that we keep people buying the products in their country, even if for personal use.

John P. San Marco - Janney Montgomery Scott LLC, Research Division

Okay. And then on that same topic, and I guess more broadly, the policies you'll put in place at convention, can you just talk about your compliance and oversight programs? What do you do to ensure that distributors who say they reside in one country truly reside there? How do you ensure that product -- I guess, the other big issue you hit on earlier was that product purchases for self-consumption are indeed self-consumed, when they need to be, rather than being resold from the gray market. Can you just talk about your compliance efforts there, how you'll step that up, et cetera?

David A. Wentz

Yes. Well, we have -- I mean, in order to be doing business in a country, we're looking at federal ID numbers. We're looking at addresses, bank accounts, a number of different things to find for them to pick a market. People do move, change countries. There are snowbirds that come down from Canada to the U.S., et cetera. We take that into account. If they can prove residency for a few months, then we can allow them to switch their purchasing through their market they're living in for a few months, et cetera. All of these things we're able to monitor because we have so much information on our customers and Associates to know who they are, where they are and be able to find out if things have changed or if that's not the case. And so it's part of the information, it's part of the technology and information systems we have to know more about them and where they are. And that allows us to help keep an eye on things.

John P. San Marco - Janney Montgomery Scott LLC, Research Division

And I guess, when it comes to your compliance and you said your monitoring, do you think that it's already where it needs to be? Or do you think there's incremental investment you've got to make there?

David A. Wentz

I think we might just see purchasing more from one market than another. It's not an issue for us. We're in a good spot right now, the policy is in place, it's been accepted. And moving forward, we've seen the changes in habits already. And people are -- have accepted the policy and are moving forward.

Paul A. Jones

And if I could just add, this is Paul, we already have in place a very strong and robust compliance team with individuals located throughout the world, and a large team here in Salt Lake that are constantly and continually looking at behaviors through customer reports. So we're very confident and very strong in the compliance area, I think, that we really look at best practices continually in that area. So the policies that we put in place are just augmentations of a very robust compliance plan already.

John P. San Marco - Janney Montgomery Scott LLC, Research Division

Okay. And then just last question, more of a clarification. It sounds -- what I've heard in the script and in the press release is you're going to make these incremental investments at the convention. I think you're referring to them as investments, but it's going to have a dampening second half impact on revenues. I'm just trying -- did I mishear that is it not an investment? Are these new restrictions? Or just -- what type of announcement is it that we should be waiting for at the convention?

David A. Wentz

As I alluded to, we are going to invest more in our business builders to grow the business faster and give incentives to our lifetime customers. As a result, we want to see our customer count, Associate count, grow faster, accelerate that growth, which will lead to acceleration and growth of sales and earnings. But that one-step initial investment is what will cause the comparables to be different for a quarter or 2.

Operator

Your next question comes from Frank Camma from Sidoti & Company.

Frank A. Camma - Sidoti & Company, LLC

I was wondering if you could be a little more granular on the growth, specifically Mainland China. I mean, you gave us some delta, some numbers. Can you just tell us what the Associate count has grown to now and what the sales now is?

Paul A. Jones

Yes. If we take a look at -- and as you know, we try to keep it at regional results. But I think it's an important point here. From a year-over-year growth in China, we're over 200%. If you look at sales -- let's see, I'm trying to get my numbers here, so I make sure I give you the accurate numbers. But year-over-year sales were well over 250%.

Frank A. Camma - Sidoti & Company, LLC

Okay. So the first number, the 200%, is the Associate count?

Paul A. Jones

Yes, correct. So what's so exciting about this, Frank, is that we're really poised and in a position, what I would say, very quickly into our experience in China to be able to really start to see that market grow and expand with the things we've put in place. Now if you look at some of our competitors in that market, it's taken them several years. So we're pretty excited about our position there.

Frank A. Camma - Sidoti & Company, LLC

Just a clarification. I know you're not going to get into what exactly the initiatives are here at the convention. But I mean, wouldn't it be fair to say, I mean, if you're going to crank up Associate incentive, I mean, pretty significantly to build the sales leaders, I mean, wouldn't you expect a positive revenue impact from that, like almost pretty much immediately? I'm just trying to grasp -- because you've said in the past that margins would top out at around 15%, and that obviously wasn't the case this quarter. It hasn't been the case for some time. I'm just trying to grapple with that a little bit.

David A. Wentz

Well, without giving too many details and give away the big announcement, as I've said, we're making investment in our business builders and in our customers. So it's not just on the incentive side.

Paul A. Jones

And let me -- if I can take just a second and clarify one point that I made earlier. I want to make sure we're clear on it. When we're talking about the Associate growth in China, we're looking at year-over-year, we're not looking at run rate. So that's important to look at.

Frank A. Camma - Sidoti & Company, LLC

Right. From quarter Q2 of last year is what you're talking about, correct?

Paul A. Jones

Yes, correct.

Operator

Next, we have a follow-up question from Tim Ramey from D.A. Davidson.

Timothy S. Ramey - D.A. Davidson & Co., Research Division

Yes, just a confirmation, and maybe you haven't thought about this yet. But according to my model, 2014 will be a 53-week year for you. Is that right that the 4Q will be a 14-week quarter?

Paul A. Jones

Yes. 2014 will be a 53-week year for us.

Operator

There are no further questions at this time. I will turn it over to Mr. Richards for closing remarks.

Patrique Richards

Thank you for your questions and for your participation on today's conference call. If you have any remaining questions, please feel free to contact Investor Relations at (801) 954-7961.

Operator

Ladies and gentlemen, that does conclude your conference call for today. Thanks for participating. You may now disconnect your lines.

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