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An in depth analysis of Nu Skin's accounting reveals some troubling red flags concerning its inventory.

Out of the 4 investigated possible red flags, 2 came back positive, 1 maybe.

Nu Skin reveals nothing about inventory, but its location and size can be estimated.

What happened?

Last week I got an urgent message from a friend who had decided to buy shares of Nu Skin (NYSE:NUS). He promptly lost 30% of his investment after Nu Skin issued a press release about its upcoming second quarter financial results. They were less than stellar, to say the least.

(click to enlarge)

(source: JCHM Capital)

Following this news, analysts are split, some are very bearish and some remain bullish, but neither side has been able to decisively convince the other.

Now my friend was worried that he had made a bad investment, so as a courtesy to him and because I have a small position in the company myself, I decided to find out whether or not he should take his losses and sell his stock, or stick with it and wait for better times.

The first thing I did was read up on the stock on Seeking Alpha, where I came across two articles written by Sam E. Antar, titled Why Nu Skin must come clean on troubling inventory red flags and Do Nu Skin's inventory red flags spell trouble ahead? I recommend reading both articles.

Suffice it to say, my interest was piqued, and fearing I might have invested in a company involved in fraudulent behavior, I decided to do a little digging of my own.

Red Flags

Inventory fraud is a quite common crutch. It usually starts small, but has the potential to grow completely out of control. And it happens more often than you might think.

According to the Journal of Accountancy, there are six signs that can point to possible inventory fraud:

· Inventory increasing faster than sales.

· Decreasing inventory turnover.

· Shipping costs decreasing as a percentage of inventory.

· Inventory rising faster than total assets move up.

· Falling cost of sales as a percentage of sales.

· Cost of goods sold on the books not agreeing with tax returns.

Now I'm an engineer, and therefore a firm believer in The Scientific Method. Therefore, I did not want to take Mr. Antar's word for it and sell my stock outright. Instead, I spent the last week gathering all the information I could find, to see if I could replicate his results. For anyone interested in the information, I have posted the excel file in the downloads section on the website.

To Mr. Antar's credit, I have found roughly the same numbers and calculations that he did.

Inventory vs. Sales

Let's start off with the most important part of his analysis. According to Mr. Antar:

"Since 2011, there is a clear and growing trend of inventory pileup - even as management consistently beats its most optimistic revenue guidance."

This is what I found:

(source: JCHM Capital)

As you can see, Days of Sales Inventory made a huge jump in the first quarter of 2014. But other than that, it remained rather flat for the last two years. The quarter over quarter change is not that spectacular if you just look at it like this. But what if we graph it in percentages? Can that reveal any evidence of skewed accounting?

(source: JCHM Capital)

Except for the unusual 1st quarter of 2014, the percentage change of DSI from quarter to quarter is all over the place. It shows no particular preference either up or down. Even if I compare the DSI to the same quarter last year (DSI y-o-y), the figures are not very conclusive.

Yes, inventory is undeniably up year over year, apart from the 3rd quarter of 2013 and the 2nd quarter of 2012. But, as the journal of accountancy stated, this usually only is a red flag if inventory is rising faster than sales. So is it?

(source: JCHM Capital)

As you can see, in dollar amounts, it isn't. Yes, inventory has roughly doubled over the last year, but sales has roughly doubled too. How about as a percentage of sales then?

(source: JCHM Capital)

When we look at inventory as a percentage of sales, it does show a trend upwards beginning in the 2nd quarter of 2013 at around 26%, to over 31% in the 4th quarter of 2013. But I do not know if that is significant enough to call it a red flag.

Inventory vs. Assets

So, except for the 1st quarter of 2014, inventory is not increasing significantly faster than sales, and inventory turnover might be up, but not exceptionally, except for the 1st quarter of 2014.

What do we have so far?

· Inventory increasing faster than sales. Maybe

· Decreasing inventory turnover. Not dramatically

· Shipping costs decreasing as a percentage of inventory.

· Inventory rising faster than total assets move up.

· Falling cost of sales as a percentage of sales.

· Cost of goods sold on the books not agreeing with tax returns.

What about the other? From the filings of Nu Skin, I cannot make out the shipping costs as a percentage of inventory. So for now, I do not possess the data necessary to analyze that particular question. I can however answer the question is inventory rising faster than total assets are moving up?

(source: JCHM Capital)

As can be seen from the chart, in dollar amounts, total assets moved up more than inventory did. But did inventory rise as a portion of total assets?

(source: JCHM Capital)

Now this shows a definite trend. Even before the 1st quarter of 2014, inventory as a percentage of assets definitely moved up, from around 12% at the end of 2012 to 18% a year later.

So what about the fifth red flag: Falling cost of sales as a percentage of sales?

(source: JCHM Capital)

Here is where things get tricky. As can be seen from the chart, in the quarters that sales grew to record levels (3rd and 4th quarter of 2013) the cost of sales declined, and kept declining when sales slumped by over 36% in the 1st quarter of 2014. But what really stands out is that in the recently announced 2nd quarter of 2014, the cost of sales jumped by over 8%. An unprecedented increase in the cost of sales.

The last potential red flag is cost of goods sold on the books not agreeing with tax returns. However, public companies are not mandated to disclose their tax returns, so I cannot answer that question either.

So what is going on?

This is what we have:

· Inventory increasing faster than sales. Maybe

· Decreasing inventory turnover. Not dramatically

· Shipping costs decreasing as a percentage of inventory. No information

· Inventory rising faster than total assets move up. Yes

· Falling cost of sales as a percentage of sales. Yes

· Cost of goods sold on the books not agreeing with tax returns. No information

So a 'maybe', a 'not dramatically' and twice 'yes'. These results are not conclusive proof of fraud, but it's not exactly a resounding endorsement either. However, it could still be poor management perhaps combined with bad luck.

What happened in the 1st quarter of 2014?

By now you'll have seen that the 1st quarter of 2014 stands out from all other quarters in all charts, and by a huge margin. So what is going on there? Why did revenue collapse by over 380 million dollars compared to the previous quarter? And what can we expect in the future?

In its SEC filings, Nu Skin provides a breakdown of its revenue by region. Graphed out, this is what that looks like for the last 10 quarters:

(source: JCHM Capital)

As can be seen from the above chart, the increase in revenue during the 2nd and 3rd quarter of 2013 in China attributed greatly to the increase in overall revenue during that period, and the same holds true for the decline in the 1st quarter of 2014. However, that is not the full picture.

(source: JCHM Capital)

Note: the data for the 2nd quarter of 2014 comes from the company's press release, since no filing data for that period was available from either the company or the SEC at the time of writing.

The decline of revenue in China is at least in part due to the probe by Chinese regulatory agencies launched in January investigating Nu Skin's business practices. This prompted Nu Skin to suspend sales and marketing activities in the country.

Now the investigation and the decline in revenue coincide with an unprecedented rise in DSI from 166 days in 4th quarter of 2013 to 343 days in 1st quarter of 2014.

This seems like a worrying development. In dollar amounts however, a different picture emerges. Between 4th quarter of 2013 and 1st quarter of 2014, the cost of goods sold decreased by $82 million. The total inventory increased by $71 million. So these two figures are quite similar.

Where is the inventory?

Another problem Nu Skin has is that its new product, ageLOC TR90 has been met with underwhelming enthusiasm by the market. As Mr. Antar put it in his analysis:

"Nowhere in the 2014 Q1 10-Q report or in the accompanying management call with shareholders on May 6th did the company disclose A) where the bulk of its inventory is located, and B) what products comprise the majority of its inventory.

These two questions are perhaps the single most important metrics that management needs to disclose on Wednesday in order to determine whether or not Nu Skin is heading for a potentially crippling write-down of inventory. As we noted above, the massive buildup in inventory cannot solely be attributed to planned product launches during the remainder of 2014.

Why is the makeup of the inventory so crucial? This is because a truthful answer to the question would shed light on the biggest question mark hanging over management's performance to date: Is the massive buildup of inventory in any way related to global missteps with ageLOC TR90 rollouts?"

"Clearly the 346 day supply of global inventory is sitting somewhere, made up of something. If a large proportion of it is TR90 goods located in geographies where the reorder levels are poor, it is inevitable that Nu Skin shareholders are staring at an imminent inventory write-down. "

Well that write down came with the 2nd quarter results press release, al $50 million of it, and Nu Skin stock took a 30% nosedive. But are there more write-downs to come?

In order to answer that question, we need to know where that inventory is. Nu Skin doesn't provide this data, but using the information that Nu Skin does provide in the filings I have found a way to estimate where the inventory is located, based on the decline in revenue between 4th quarter of 2013 and 1st of 2014.

Assuming management has not been able to amend its supplier contracts during the 1st quarter of 2014, and that previous inventory has already been shipped waiting to be distributed, I estimated the amount of inventory built up during that quarter as follows:

(source: JCHM Capital)

If we multiply the decline times the average cost of goods sold over the two quarters, we get a total estimated inventory buildup of $58,22 million during the 1st quarter of 2014. Not far off the 71 million dollars increase in inventory provided by Nu Skin in the 10Q.

This shows that the bulk of the recent inventory is located in the Greater China region. It stands to reason that the rest of the inventory follows a similar distribution, given that the company ships to where it anticipates the most demand. Given that logic, there could indeed be more write-downs to be expected in the future. This is given more weight by the fact that Nu Skin still has purchase obligations of 155mln for 2014, adding even more stock to inventory.

On the topic of inventory, this is what Nu Skin had to say about it during their last earnings call:

"We also took a significant charge in the quarter to address inventory risks in China. As you know, we deferred the launch of the TR90 weight management product to get as more time to train on the program and to enable the market to absorb the inventory, which was purchased in the first LTO. We were forecasting a very substantial TR90 LTO in China in 2014, and we're building inventory accordingly. But the results of the June LTO in China led us to conclude that we'd likely have difficulty successfully executing a large LTO of TR90 in the second half of this year. This resulted in the conclusion that we'll likely bump up against some product expiry dates on TR90 inventory, with built up in anticipation of the large LTO this year."

"During the quarter, we took an inventory charge, as Truman mentioned, of $50 million, specifically related to TR90 and associated LTO products in China. While inventory levels for other products in China have increased due to the reset of our business there, we anticipate that we'll be able to sell through these products before the product shelf life expires. And while inventory balances around the world are slightly higher due to the build of inventory, particularly for the TR90 launch this year, we also believe that we'll be able to work through this inventory as well."

The shelf life is mentioned twice during the call, and since the shelf life of the inventory isn't getting any better as time goes by, this could be a veiled warning of more write-offs to come.


So what conclusion can we draw from all this? First of all given the course of events over the last 2 quarters and the location of the inventory, I think any investor in Nu Skin has to be at least aware of a significant possibility of future write-offs.

Secondly, out of 4 analyzed indicators of possible red flags, 2 came back positive, 1 slightly positive and 1 was inconclusive. That's not a resounding endorsement of financial prudence.

Based on these facts - even though I am long in this stock - I could not recommend Nu Skin as a safe investment to anyone not willing to assume significant risk. Therefore I think I'm going to recommend my friend to sell, and I'll do the same.

Disclosure: The author is long NUS. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I intend to sell my shares in the very near future.