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USANA Health Sciences (NYSE:USNA)

Q2 2014 Earnings Call

July 30, 2014 11:00 am ET

Executives

Patrique Richards -

David A. Wentz - Chief Executive Officer

Kevin G. Guest - President of the Americas, Europe & South Pacific

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

Analysts

Scott Van Winkle - Canaccord Genuity, Research Division

Frank A. Camma - Sidoti & Company, LLC

Rommel T. Dionisio - Wedbush Securities Inc., Research Division

Operator

Good day, and welcome to the USANA Health Sciences Second Quarter Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Patrique Richards. Please go ahead, sir.

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. A replay will be available on our website shortly following the call.

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 strategies and outlook for 2014. We caution you that these statements should be considered in conjunction with disclosures, including specific risk factors and financial data contained in our most recent filings with the SEC.

I'm joined this morning by Dave Wentz, our Chief Executive Officer; Kevin Guest, who has been named President of the USANA Worldwide; and Paul Jones, our Chief Financial Officer. Dave and Kevin will review our operational progress during the quarter and our strategies for 2014 and then Paul will follow with a more detailed look at our second quarter financial results and outlook for 2014.

With that, I'll turn the call over to Dave.

David A. Wentz

Thanks, Pat. Good morning, everyone. The second quarter was another solid quarter for USANA, and we continue to see operational progress in several key areas. For example, the number of active associates for the second quarter increased 11.4% year-over-year and 6.8% sequentially. Our number of preferred customers also increased nearly 13% year-over-year. These increases are largely the results of the initiatives we implemented in 2013 and have continued to promote in 2014.

Customer growth continues to be our leading indicator because it shows that we are increasing the number of individuals and families around the world who are benefiting from improved nutrition through taking USANA products. Customer growth also set the stage for increased sales and our growth in this area is one major factor behind the reiteration of our annual guidance.

Now as we anticipated and communicated to you earlier this year, net sales did not grow in proportion to customers during the second quarter due to the tough year-over-year comparables, which included, first, $7 million of additional sales that we saw in the second quarter of 2013, ahead of the policy changes that require customers to purchase products in their country of residence. Second, $3.3 million from unfavorable changes in currency exchange rates. And finally, the impact of the price discounts that we implemented in 2013. Although we have seen an increase in worldwide unit volume from these discounts, this volume increase has not completely offset the net drop in price.

Now let's turn to our performance in China. Last quarter, our results were impacted by the media and regulatory focus on companies in our industry in China. While that impact certainly carried over to the beginning of the second quarter, our business in China began to accelerate as the quarter progressed. During the second quarter, China produced double-digit sales in customer growth sequentially and triple-digit sales in customer growth on a year-over-year basis. This growth was not immediately apparent in our regional results because it was offset by a sales decline in Hong Kong. This decline in Hong Kong, however, was magnified by the almost $7 million in sales that occurred in that market ahead of the policy changes last year.

China performed well during the quarter and we expect this market to continue to accelerate as the year progresses.

We're also making progress with our capital investments in China. During the second quarter, we broke ground for our new $40 million state-of-the-art production facility in Beijing. We continue to expect this facility to open in late 2015.

We've also completed about half of our scheduled branch remodels, which are making these facilities more modern and customer-friendly.

Turning to the bottom line. Net earnings for the quarter were $19.3 million compared to $24.2 million during the prior year period. This decrease is due to the pressure on our operating margin from lower gross margins and higher associate incentive expenses, which is due to the primarily to the price discounts and compensation plan enhancements we made during the third quarter of 2013. Paul will provide some more color on our P&L in a moment.

Yesterday, we announced the well-deserved promotion of Kevin Guest as the President of the company. Kevin has been extensively involved in USANA since the company was founded more than 20 years ago and has served in a variety of leadership roles. Most recently, he has served as President of the Americas, Europe and South Pacific.

In his expanded role, his primary focus will be on sales growth, customer growth and sales force development. Kevin has worked closely with me for the past several years and will continue to do so as I reduce my time in the office during the next year. I'd like to welcome Kevin to the call in his new role and ask him to provide some comments about our growth expectations for the remainder of the year. Kevin?

Kevin G. Guest

Thanks, Dave, and good morning, everyone. As Dave mentioned in his opening remarks, our financial results during the first half of the year have trailed our operational results. We anticipated this lag and have communicated that to you over the last few quarters. At the same time, we continue to see significant improvements since several key aspects of our business, including the customer and unit volume growth that Dave mentioned, as well as growth in Auto Order penetration, check earners and rank advancements. Each of these increases is important to sustaining the long-term growth of our business. As we continue to execute our 2014 strategies and as we pass the anniversary date of the significant changes we implemented last year, our team is confident that our financial performance will accelerate and begin to be more in sync with our operational progress. And as a result, we are reiterating our annual sales and EPS guidance, as Paul will discuss in detail in a few minutes.

We have a number of initiatives planned for the second half of the year that is designed to drive sales and customer growth. These include our 22nd Annual International Convention that we will host here in Salt Lake City. As you know, we reserve exciting and significant announcements for this event. We're anticipating great attendance and we expect our sales force to leave convention educated and motivated about USANA.

Next, we have initiatives planned for the latter half of the third and fourth quarter, which are designed to drive sales and customer growth in each of our regions with an emphasis on North America and the United States, in particular. While we expect to see some benefit from these initiatives in the third quarter, most of the benefit will occur in the fourth quarter. Again, our practice is to announce these initiatives first to our salesforce, so I need to limit my comments about them right now.

Finally, we expect our Asia Pacific region to continue to grow and in particular, expect our results in China to continue to accelerate as the year progresses. As we remain focused on executing these 2014 strategies and sharing our world-class products with as many people as possible, I'm confident that our financial performance will continue to accelerate and fully expect 2014 to be another year of record results for USANA.

With that, I'll turn the call over to Paul to review our regional and financial results.

Paul A. Jones

Thanks, Kevin, and good morning, everyone. I'll start by taking you through our regional results and will then turn to the income statement and our 2014 outlook.

Net sales in our Asia Pacific region increased 1.8% year-over-year and 5.1% on a consecutive quarter basis. The year-over-year growth was led by double-digit sales growth in our Southeast Asia Pacific region, where we experienced growth in every market. The nearly 14% sales increase and 12% growth in active associates in the Southeast Asia Pacific region was driven by strong sales and customer growth in Singapore and the Philippines.

Sales in this region were negatively impacted by changes in currency, which reduced sales by $1.7 million. We are also encouraged by our results in Australia and New Zealand, where we continue to see growth in both sales and customers, primarily as the result of our efforts in 2014 to continue promoting the initiatives we launched at our 2013 international convention.

As Dave mentioned a moment ago, Mainland China continued to make a significant contribution to the growth in the Asia Pacific region with triple-digit sales and customer growth on a year-over-year basis. This was offset by the anticipated decrease in sales in Hong Kong, which was magnified by the incremental sales increase we experienced during the second quarter of last year prior to our policy changes. Although sales in Greater China as a whole decreased year-over-year, associate counts did increase 21.4%.

In our North Asia region, South Korea led the way having another solid quarter with 13.6% sales growth.

Turning now to the Americas and Europe. Net sales in the region declined 4.7% to $63.7 million, due primarily to a sales decline in the U.S. Negative impact from the changes in currency exchange rates also reduced sales for the region by $1.4 million. The number of active associates in this region was flat.

Net sales in the United States decreased $4.5 million, due in part to pressure from price discounts, particularly as this market has one of the highest usage rates of our Auto Order program. While we have seen positive results in our other markets as a result of these initiatives, the U.S. has not responded with a similar uptick in unit volume to overcome the impact of price discounts. The U.S. continues to be a focus in our long-term growth plans, and we have initiatives planned for the second half of 2014 that are designed to drive sales and customer growth in North America and the United States in particular.

Regarding the results in the rest of the region, we were pleased to see local currency growth in every market. Local currency sales in Canada and Mexico were the biggest contributors, increasing 4.8% and 12.2%, respectively. Active associates also increased by 4.2% in Canada and 7.1% in Mexico.

Now let's turn to the income statement. Gross margins declined 160 basis points year-over-year, due in large part to the negative impact of changes in currency exchange rates and the strategic price decreases we introduced at our 2013 convention.

This decline was partially offset by annual price increases during the first quarter of 2014 and favorable changes in product and sales market mix. Associate incentives expense for the quarter increased 200 basis points year-over-year to 43.1% of net sales. This increase can be attributed to the compensation plan and price changes introduced at our 2013 convention.

SG&A in the second quarter was 23% of net sales, an increase of 30 basis points from the second quarter of 2013. On an absolute basis, SG&A increased as a result of the costs associated with supporting higher unit sales. Our effective tax rate for the second quarter was 34.3% and 90 basis points higher than the second quarter of the prior year. This is due primarily to a lower U.S. manufacturing credit as a result of higher China sales where products are manufactured locally.

Earnings per share for the quarter decreased to $1.36 per share -- per diluted share due to lower net earnings and a higher weighted average diluted share count. We were very active during the quarter with our share repurchase program and repurchased approximately 682,000 shares for an investment of $49.1 million. As of July 25, 2014, we have purchased an additional 285,000 shares for an investment of $21.4 million under our rule 10b5-1 trading plan that we implemented during the second quarter.

As of July 25, there was $129.5 million remaining under the current share repurchase authorization.

Turning briefly to the balance sheet. We ended the quarter with $118.3 million in cash and $113.2 million in net working capital. We are reiterating our sales and EPS guidance today. As you know, we provide guidance on an annual basis, and we continue to expect net sales to be in the range of $770 million to $790 million for the year and diluted earnings per share to be in the range of $5.50 and $5.65.

For the full year 2014, we estimate earnings from operations in the range of 14.5% to 15% of net sales. As we have indicated on prior calls and as our guidance reflects, we expect our results to accelerate in the second half of the year and particularly in the fourth quarter, as a result of the initiatives Kevin mentioned. I would also like to point out that because of our reporting structure, 2014 is a 53-week year for USANA. Accordingly, the fourth quarter will include an additional week of sales.

Finally, our EPS guidance does not reflect any further impact from our buyback activity since the close of the second quarter. However, if we continue to buy back at the rate we did during the second quarter, we estimate that we would exceed the high end of our guidance by $0.05 to $0.08.

In closing, I'd like to express my confidence in the financial strength of USANA's business. I believe that we are well positioned to deliver another year of record results in 2014. With that, I will now ask Patrique to cover one last item before taking questions.

Patrique Richards

Thanks, Paul. Before moving to Q&A, one housekeeping item regarding the format of our quarterly earnings calls going forward. Beginning next quarter, with our Q3 results scheduled to be released in late October, the company will issue management's prepared remarks regarding the quarter shortly following our earnings release. These management remarks, which we're calling management commentary results and outlook, will be available on our website at www.usanahealthsciences.com. That will be under the Investor Relations section.

The following morning, we will conduct our customer live earnings call with only brief remarks by the management's team before moving directly into Q&A. Management will not be responding to any questions prior to our live earnings call, but investors and analysts are encouraged to ask questions on the call. Our goal in providing management's commentary in advance of the live earnings call is to, one, provide the most efficient method of communicating our earnings results; two, to allow time for a meaningful question-and-answer period on our call; and three, to encourage and maximize investor participation and understanding of our business and operating results. Details of these earnings call enhancements will be restated with our press release announcing the date for our Q3 earnings call in October.

With that, thank you. Operator, may we please have the first question.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question will come from Scott Van Winkle from Cannacord Genuity.

Scott Van Winkle - Canaccord Genuity, Research Division

A few questions. First, on the U.S. In this typically a sequential increase from Q1 to Q2, the changes with the compensation plan and pricing obviously, certainly, explains the year-over-year comparison. I'm wondering why we didn't see that kind of typical uptick from Q1 to Q2. I assume there wasn't any changes made in the last 3 months or something of that nature?

Kevin G. Guest

This is Kevin. One of the things that we've done here that hasn't been typical from the perspective of USANA in our normal course of business is that the changes that we made were significant to the compensation plan at our last convention and we had to get some visibility on where that was going to take us and give us some -- give us a feel for how the individual markets would respond. As mentioned in the comments, the response in the U.S. was different than it was in other markets. But we did hold back on some incentives and other things that we would normally do to drive enrollments in sales, which are coming, that we mentioned in the latter part of the year. But I think that is a key reason why you see it different this year that you've seen in the past, because we did behave a bit differently this year with the changes that we've made with the compensation plan.

Scott Van Winkle - Canaccord Genuity, Research Division

Hey, Dave, I can appreciate the family move certainly. Anything to the timing here? Why now versus a few years ago when you had your first child or something like that?

David A. Wentz

Well, the kids are 3 and 5. They're ecstatic for me to be home some more. I don't know if my wife is as excited, but we're about to have our 12th record year, consecutive record of sales, management team is strong. Just from a family perspective and to recharge after 22 years of going at this hard. I'm still going to be out on the road a lot, going to more field meetings than I've gone in the past year, more than doubling the amount of field meetings. So I'll still be out there, but just a little less of the day to day in the office, a little more time at home. I wanted to do it now versus possibly wait 10 years to when my kids don't like me at all. So catch them now early, and company's doing great, management team is strong, record sales again this year. Everything's going smooth. So I'll just be cutting back, reducing my time some but still quite active in many ways. And also focusing on some major projects that I'm very excited about for our long-term growth.

Scott Van Winkle - Canaccord Genuity, Research Division

Great. And then if I could turn to China. I mean you mentioned the media attention around direct selling that popped up in Q1 had an impact at the beginning of Q2. Recently, there's been a little more media attention specific to USANA. Does that have an impact here early in Q3?

David A. Wentz

We've seen a little bit of minor impact as you've seen in stock pressure, but as far as the activity in China, we have a very strong team over there that immediately when those kinds of things happen, they get out to the field and help them to focus on the business and not the garbage that is in the media. We also proactively reach out to regulators and to our employees to make sure everybody's getting accurate information. And so it's been -- actually, I think a very positive thing for us and we look forward to the future. We think China, again, is very strong for us.

Scott Van Winkle - Canaccord Genuity, Research Division

Great. And then try to help us measure the transition that's happened over in Greater China over the last year. Can you give us any metrics about the mix between Hong Kong and Greater China, either in dollar or as a percentage of sales or anything like that to break down that Greater China region?

David A. Wentz

Yes. Let me take a look really quickly, maybe to help out a little bit. We're certainly seeing the -- as we anticipated, the decreases in Hong Kong, but they're more than being offset by the growth in Mainland China. And if we're looking at -- we're getting some specific numbers here, but looking at the enrollments, the people that are coming into the business, it's very strong. We have seen about 143% increase in our sales in Mainland China with a double-digit decrease in Hong Kong. So we're looking good in that area.

Scott Van Winkle - Canaccord Genuity, Research Division

And that was a Q2 number?

David A. Wentz

Yes.

Scott Van Winkle - Canaccord Genuity, Research Division

Perfect. And then last question about the buyback, and I'm not saying that's not big enough. I just -- I wonder how big it could be from a standpoint. What kind of limitations do you have on a buyback relative to volume? You've got kind of a family traded stock. I'm wondering if that 250,000 shares a month, which is a nice, big number, if that's kind of the limit you can do or kind of flexibility you have, if you wanted to step it up even further?

David A. Wentz

Any share repurchase we do operate under the safety harbor and so we have natural limitations from that. As we mentioned, we have the 10b5-1 in there. Our total share repurchase is up to $200 million, and I would anticipate going forward that we'll see repurchase. As long as we see that we have undervalued -- what we consider to be undervalued stock, we have cash that is virtually -- it's almost 0 expense to use at this point, we anticipate that we'll continue buying back as long as those conditions are in place. As far as limitations, the top end would be $200 million and we would watch our cash flow, of course, very closely. We would not anticipate really going much below $60 million in cash on the balance sheet, and we would anticipate even going into a line of credit if that makes sense, if the repurchase makes sense from a returning share value to shareholders. So we'll watch that as it goes along.

Operator

[Operator Instructions] We'll take our next question from Frank Camma from Sidoti.

Frank A. Camma - Sidoti & Company, LLC

Just a follow-up on the China situation here, more qualitatively speaking though. I mean, obviously, you called out the $7 million buy-in on the prior year's quarter from the policy change and you had, last quarter, mentioned a negative media on direct sellers there. I was just wondering, in your opinion, I mean, is -- if you just had to pick one of these between the negative media or the policy change going forward, what's going to have the greater lasting impact on your sales results there?

David A. Wentz

The greatest [Audio Gap] the impact of the media issue, that certainly has a short-term effect on the share price. I think the more that happens, the more it just becomes noise out there. And we've -- the information that's being fed to the newspapers is researched and funded by short sellers, so we understand their intent on all of that. And we believe that the impact will be more driven by what Wall Street pays attention to as opposed to what our associates pay attention to. Because they're out there working and we're keeping them focused. So I think the bigger issues would be us trying to continue, as we will do, work towards best practices in all aspects of our China business.

Frank A. Camma - Sidoti & Company, LLC

Okay. And so we obviously only get the translation of these articles in the headline news and what you're accused of doing there. So just to be clear, the company's position is, you haven't been contacted by any regulators that you've been doing anything out of what you're able to legally do in that market. Is that correct? I mean, is that...

David A. Wentz

That's correct. We have not been contacted by any regulatory agencies. We proactively work with them to make sure that we're doing things the way that they would like us to do.

Frank A. Camma - Sidoti & Company, LLC

Okay. And obviously, for a number of years, Hong Kong was a very important market. Just wondering if you could qualify -- quantify, where -- at what point does that stabilize in your model? Where do you see that kind of -- it's probably going to be an important market going forward, but where does it -- where does sales kind of -- is it a time frame, is it a level? I'm just trying to quantify that in our projections.

David A. Wentz

Well, Hong Kong's a fairly small market, population wise. And so we believe it will be -- I mean, if you were to compare it to other markets at the same population size, we expect it to be more successful than a number of them. But there will be a level that hits it right, that matches the market size and the number of leaders that we have there. But a lot of focus has moved from Hong Kong to China, as we all know, and that's where a much bigger opportunity is. So we look forward to a nice base in Hong Kong, but China is absolutely our future and where a huge amount of opportunity with the population size and are just scratching the surface penetration and just getting started. So we hope it will level off by the end of this year. Where that level will be exactly, we don't know. But we would hope in 2015, we'll have a good solid base to start growing it from, as those who are going to focus on China doing those, we're going to focus on Hong Kong, focus there, we'll know what our size would be. In 2015, I think we'll have a good feel for it.

Frank A. Camma - Sidoti & Company, LLC

Okay, good. Final question, just housekeeping on that. You had mentioned that the guidance doesn't include any further purchases, which is typical with what you do. But I was wondering if you could give us approximation for your full year, fully diluted share count that's tied to your guidance.

Kevin G. Guest

That's going to really depend, really, on what happen in the third and fourth quarter. So I don't have a good number for you on that. But we can take a look at a little bit. But that really is fully dependent on what we do in this -- in the third and fourth quarter.

Frank A. Camma - Sidoti & Company, LLC

Okay. Just trying to like -- I mean, you've almost -- so far, you've almost bought back 1 million shares, but we would have to wait that for the time, obviously. So we'll just -- we'll make an estimate and if there's anything additional, we'll follow up.

Kevin G. Guest

Based on no share repurchase going forward and based -- without that building to our guidance, we would anticipate by the year end, we'd be at about 14 million in diluted share count. But that's with no factored in buy back.

Operator

At this time, we have one question remaining in the queue. [Operator Instructions] We'll take our next question from Rommel Dionisio from Wedbush Securities.

Rommel T. Dionisio - Wedbush Securities Inc., Research Division

In the past, you guys talked about some programs in China to enhance your stores there. I wonder if you can just give us an update on how that's going and then what potential impact you could see on the business going forward as a result of that initiative?

David A. Wentz

We've just been going through all of our branches and remodeling, retrofitting them, modernizing them, taking them up to -- I mean, USANA's facilities around the world, if you ever traveled around to our different facilities, they are beautiful places that our associates and customers can be extremely proud of, and we have been investing to take all of our branches up, 20 some branches. It's taking some time getting through all, I think half of them to 2/3 of them this year with some more to go into next year, just because there's so many. Trying to get them all done as fast as possible because as you can tell from our $40 million investment in the manufacturing facility and our investment in the remodels of all the branches, we have a lot of excitement about where China is going to go and the potential there. And so we're -- we continue to invest to raise the standards and quality, but also to ramp up to be able to handle larger and larger sales in that region. So we just keep investing in that market, knowing it's a huge opportunity for us.

Operator

And at this time, it appears there are no further questions. Mr. Richards, I'd like to turn the conference back to you for any additional or closing remarks.

Patrique Richards

Well, thank you for your questions and for your participation on today's conference call. If you have any remaining questions, please contact Investor Relations at 801-954-7961.

Operator

And this does conclude today's conference. Thank you for your participation.

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