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USANA Health Sciences (NYSE:USNA)

Q2 2011 Earnings Call

July 27, 2011 11:00 am ET

Executives

James Bramble - Corporate Secretary and General Counsel

David Wentz - Chief Executive Officer

G. Hekking - Chief Financial Officer

Patrique Richards -

Analysts

Timothy Ramey - D.A. Davidson & Co.

John San Marco - Janney Montgomery Scott LLC

Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the USANA Health Sciences Second Quarter Earnings Conference Call. [Operator Instructions] This conference is being recorded today, Wednesday, July 27, 2011. And I'd now like to turn the conference over to Mr. Patrique Richards, Manager of Investor Relations. 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. 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.

I'm joined this morning by Dave Wentz, our Chief Executive Officer; and Doug Hekking, our Chief Financial Officer. We'll hear first from Dave, who will discuss our business activities during the quarter, as well our plans for the remainder of the year. We will then hear from Doug, who will discuss our financial results and updated guidance. I will now turn the call over to Dave.

David Wentz

Thanks, Pat, and good morning, everyone. It's always nice to discuss yet another great quarter for USANA. This quarter's record top and bottom line results reflect the strength of our diversified business and the dedication of our employees and associates. I'll begin by updating you on management's activities during the quarter and then update you on our integration of the USANA brand in China, as well as our plans for North America.

During the quarter, our management team has devoted most of their time to speaking with our sales force leaders to open communication lines and build-out relationships. Kevin Guest, President of North America; Roy Truett, Chief Operating Officer; Jim Bramble, Chief Legal Officer; Dan Macuga, VP of Marketing; Alan Bergstrom, VP of Customer Relations; and our Field Development Managers, Michelle, Belinda and Carlo and Laurie, have all led these efforts and discussions in North America.

Similarly, our President of Asia Pacific, Deborah Woo, and her Regional Vice Presidents, Sherman, Kinghen[ph] and David have done the same in our Asia Pacific markets. These discussions were a priority for us in light of the changes in both management and strategy that occurred during the quarter.

I've spent 19 years in the direct selling industry, building USANA and working with our independent associates. I understand very well that change can be confusing and distracting for a direct selling organization and that maintaining trust and belief between the independent sales force and management is critical. What we have learned through the years is the strength of this relationship and this partnership is directly correlated to the strength of the business.

The recent management changes were the catalyst we needed to remind us how important communications efforts with the field are for the entire management and not just a few individuals. The idea sharing and communication levels are now stronger than ever. Our management team has been with USANA for a very long time and has the trust and loyalty of our associate leaders and our sales organizations, despite new competitive pressures. These discussions serve to assure our associates that the company remains fully committed to supporting them, and I believe that they recognize that USANA is a tested and proven organization, with first-in-class products, the highest compensation plans and a world-class track record. We are working diligently with our sales force leaders on strategies for the business. In August, we will hold our Annual International Convention here in Salt Lake City. Business builders attend this event to meet with management, receive training and motivation and tour our state-of-the-art facility to get a first-hand look at the manufacturing of our premium quality products.

At this event, we will make exciting announcements that we expect to help create momentum across all our markets.

Now turning to our China integration strategy, as we communicated in our June pre-release, we have implemented a revised approach to the integration of our operations in China. The most important takeaway from this is that the original underlying focus remains the same; that is to grow in mainland China, by combining BabyCare's infrastructure and resources with USANA's sales force and direct selling expertise. What has changed is our approach.

Our original approach was focused on compelling our Hong Kong associates to immediately switch over and develop and grow our China business by changing the fundamentals of how they do business in Hong Kong. In recent months, our management team has invested a significant amount of time meeting with our associate leaders on this approach. We've learned a great deal during these meetings. First, we learned that our leaders were concerned that our approach was too aggressive and shortsighted. Our leaders are concerned about shifting their focus before we have an adequate number of USANA products for them to sell in China. And second, we learned that they believe that disrupting the business in Hong Kong was not the best way to drive growth in China. Finally, we learned that many of them do not fully understand how to be successful in the China business.

After evaluating this feedback, Deborah Woo recommended a revised approach, one that does not alter the fundamentals of our associate Hong Kong business. This revised approach is a softer, more gradual approach that focuses on educating and training our associates on how they can be successful in China. It addresses all aspects of the China business, including their compensation plan, which differs from the plan USANA uses elsewhere in the world. Multinational direct selling companies that do business in China must address the common misperception amongst their sales force that because our China compensation plan is different, it is worse. In reality, this is not the case. It will take time for our associates to understand that our compensation plan in China can be as rewarding as USANA's global compensation plan.

It also takes time to register these -- our products we plan to offer China. We have made excellent progress in this regard in 2011. Earlier this year, we began our introduction of USANA to China by rebranding select products. During the second quarter, we introduced our first 5 Sensé skincare products into China. We strategically timed these introductions with launch events for these products in 4 major cities. Each event went very well, strengthening the excitement for USANA in China.

Currently, we are on schedule to introduce our third phase of products, which will include several of our key optimizer and nutritional supplements. Overall, our product introduction in China have gone very well, and we're excited to promote the USANA, Sensé, and BabyCare brands. We no longer expect our integration to China to cause a significant build client in our Hong Kong business. We still anticipate, however, that as we accomplish each of the objectives I just mentioned, many of our Chinese associates who are doing business in Hong Kong will begin transitioning their organizations to China. Despite these transitions, we now believe that growth in China will be more gradual and organic than it would have been under our initial approach. This new approach has been carefully evaluated and has been well received by our associates.

Speaking on behalf of the management team, we believe that this approach is the best way to drive long-term sustainable growth in this region. To follow-up our recent entry into China, we are expanding our international operations into Thailand in the fourth quarter. We're very excited about this market given that Thailand is one of the top markets in the world for businesses like USANA. We currently have leaders and customers with existing ties to this country who are confident that USANA will succeed in this growing market. Perhaps most importantly, we are confident that we will be able to expand into Thailand and still maintain focus on our primary expansion objective, which is growing the USANA brand in China. As with any new market opening, it's likely that some associates will initially be distracted from their home market and begin building in this new market. In this case, we expect that many of our associates in Malaysia and Singapore will be interested in expanding their businesses to Thailand. As I commented on our release yesterday, we expect to be more aggressive in our market expansion efforts in the near future.

Turning now to our North America region. This region has my full attention and that of our North American leadership team. We are not satisfied with the soft results that this region has produced, and I assure you that growth in North America is a significant focus of our short-term initiative and long-term strategy. Our management team and associate leaders are working closely together to achieve this goal.

In the short-term, our strategy includes offering promotions and incentives to generate excitement in the market and create momentum. We are meeting with our sales force to determine which promotions and initiatives will best accomplish these objectives at a reasonable cost for the business.

The long-term strategies that we are evaluating for this region include product innovation and customization, as well as a longer term incentive offering for our associates to reward top performers.

The meetings we have had thus far have gone very well, and we believe momentum is building in this market.

In closing, I want to convey my confidence to USANA despite increased competition. Competition is not new or surprising to us, it is the nature of the direct selling industry. It is a high competitive space, where both new and mature companies strive to attract top performing sales leaders. Our relationship with our associate leaders and our sales organizations is very strong. Of course, there are always some exceptions with those chasing promises of easy riches. Overall, however, we believe our associates recognize the great value of their USANA businesses and are committed to our organization. Let me also say that while it is gratifying to deliver strong performance during the quarter, it's more important to me to have a strong underlying business that can respond to challenges and is positioned for long-term sustainable growth. With that, I'll now turn the call over to Doug to discuss our financial results.

G. Hekking

Thanks, Dave. Our second quarter financial performance was very strong and resulted in record financial results on both the top and bottom lines. I'll start by discussing the performance of the business during the quarter and then discuss our updated outlook for the year.

For the quarter, we delivered record net sales of $148.9 million, an 18.2% increase over the prior year. We also delivered record earnings per share of $0.88, which represented a 27.5% increase year-over-year. Excluding the onetime recapture of equity compensation expense, diluted earnings per share still increased 18.8% over the prior year.

Now Asia-Pacific region, net sales for the quarter increased by $25 million or 38.7% compared to the prior year. Net sales for this region totaled $89 million during the quarter, which represents 59.5% of our total sales. Keep in mind that we had our AP Convention during the first quarter of this year, compared to the second quarter of 2010. This obviously creates a timing issue as you compare the year-over-year top line performance for this region.

Additionally, when we saw sales increase significantly in Hong Kong during the quarter for several weeks following the communication of our initial BabyCare integration strategy, as associates purchased in anticipation of these changes. We estimate that this added approximately $4 million to the top line for Hong Kong during the quarter. The net effect of these events provided a modest benefit to the current year quarter. Sales growth in this region was primarily due to 22.9% year-over-year increase in the number of active associates. On a sequential quarter basis, sales increased 6.1%, and associates increased by 6.9%.

Hong Kong continues to drive this region where sales increased 44.8% over last year, and the number of active associates increased 21.2%. We were pleased by the year-over-year topline growth in other Asia-Pacific markets, most notably South Korea, which grew 99%, and the Philippines, which grew 94%.

Results for our North America region were down over the previous year. Sales in the quarter decreased by 3% to $60.3 million compared to the prior year, with the number of active associates declining 12.6%.

On a consecutive quarter basis, however, sales were up modestly and customer accounts were essentially flat.

As Dave mentioned, we have both short- and long-term strategic plans in mind for this region. Our management team and sales force are working together on these plans. Our intent is to incent and engage leaders in the region in a variety of ways with the overall goal being sales and customer growth. North America is and will continue to become a significant part of our long-term growth strategy. Now I'd like to comment on some of the highlights of our income statement.

Our gross profit margin for the second quarter improved as a percentage of net sales to 82.4%, compared with 82% for the second quarter of 2010. This 40-basis point improvement was primarily a result of a weaker U.S. dollar compared to the prior-year quarter.

Associated incentive expense for the quarter increased 20 basis points to 45.5% of sales, compared to the second quarter of the prior year. This increase was due to more associates taking advantage of our matching bonus program.

SG&A in the second quarter decreased on a relative basis, 40 basis points to 22.7% of net sales. This decrease resulted from leverage gained on our higher sales. The company holding its AP Convention during the first quarter of 2011 compared to the second quarter of 2010, as well as lower equity compensation expenses due to the recapture of the unvested equity awards for certain executives who left the company during the quarter.

These benefits were largely offset by costs associated with BabyCare's operations, higher relative wages and benefits and expenses incurred in connection with our brand awareness campaigns.

Overall, our improved gross margins and lower relative operating expenses result in a 28.7% increase in net earnings for the second quarter to $13.9 million or $0.88 per diluted share.

During the quarter, we repurchased 576,000 shares for a total investment of $16.8 million. These repurchases benefited EPS by $0.02 for the quarter. Although we made significant investment in share repurchases, we are pleased to finish the quarter with approximately $25 million in cash while remaining debt-free.

I'd now like to comment on our guidance for the rest of the year. Based on the strength of our results, in the first half of the year, we raised our outlook for 2011. We now project consolidated net sales to be between $565 million and $575 million for the year, which is an increase from our previously issued guidance of $530 million to $550 million. Additionally, we now project earnings per share to be between $3.05 and $3.10 compared to our previous estimates of $2.85 to $2.95. As you consider our guidance and model our performance for the rest of 2011, keep the following in mind:

First, with respect to the top line, we had a few events during the first half of the year that increased our topline performance and will not reoccur during the remainder of the year. Also, our topline guidance anticipates an impact during the remainder of the year from distractions impacting our sales force surrounding the change in our China integration approach and the competitive pressures in the U.S. and Hong Kong. While we are confident in our associate sales force and the strength of the business, we believe it is appropriate to factor these things into our outlook.

Our guidance for EPS reflects: Pressure on gross margins during the second half of the year, primarily related to an expected increase in cost in certain raw materials; associated incentives to be modestly higher during the second half of the year due to targeted incentive designed to reward our top performing associates; SG&A for the second half of the year to be roughly in line on relative levels reported in the first half of the year. We expect a second tax rate of 34.5% and diluted shares outstanding of about $15.6 million.

In closing, I'd like to reassure you that we remain committed to the goal of delivering growth in each of our markets. We are focused on continually improving our operational efficiency with the intent of maximizing return to our shareholders. Overall, we are confident that USANA will finish off a strong 2011 and deliver our ninth consecutive year of record financial performance. With that, I will now ask the operator to facilitate the question-and-answer session.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line up Tim Ramey with D. A. Davidson & Co.

Timothy Ramey - D.A. Davidson & Co.

Dave, I'm curious to know a little bit more about your thoughts on the competitive pressure. In my discussions with folks last night, it seemed like there's an awful lot of concern over the new startup Erics [ph] and you got, obviously, folks like Herbalife, Nu Skin, Sunrider, everybody else is big factors in China and big factors in Asia. Why the overemphasis or heightened concern over this startup?

David Wentz

Well I definitely think there is a lot of concern initially because the unknowns, due to the relationships and other factors that were new with the competitor, but as we've gone on with more and more, we're feeling better and better, that it won't be any different than any other competitor over the past years. We've lost hundreds of leaders over the years and that's just a normal course of business. But individuals leave, but they're not able to take organizations with them. And so even though we've had many competitors come along and take -- try to take a few leaders, the organizations have not followed because of the depth of our compensation plan and the leaders below. We're very confident that with all the leaders below who are staying, that they will maintain the organization and actually are inspired and motivated to work harder than ever. So we're excited that with the increased line to communications now with these leaders, between all the management team and they're invigorated, anxiousness to grow faster that hopefully they will build on this and creates momentum.

Timothy Ramey - D.A. Davidson & Co.

That's the answer I hoped to hear from you. But you did cite increased competitive pressure, and so I mean what are you worried about? What's the focus right now?

David Wentz

Well we always don't know if there's something out there that we are unaware of. So far, things look great from our standpoint, but we are always cautious that there are other factors that we may not foresee but we're feeling extremely confident at this point and hopefully as the quarters progress, we can put this in our rearview mirror very quickly.

Timothy Ramey - D.A. Davidson & Co.

Okay. And then just relative to the guidance. I mean it obviously stock's down because your guidance implies a huge deceleration of growth or no growth, actually declines in the second half versus 2010. Is that -- I mean, can you give us a little bit more sense of why you see your business declining year-over-year for the next 2 quarters?

David Wentz

Over the next 2 years?

Timothy Ramey - D.A. Davidson & Co.

No, next 2 quarters.

David Wentz

Okay. I see what you're saying, sorry. We have a number of things that are unknown out there, with the transition in China, if there is any more to this competitor than we are aware of, and so we just want to be cautious. We feel confident. We had some unusual events in the first 2 quarters that definitely elevated those numbers higher than they normally would be, and so with the run rate, they skewed things a bit. But we're feeling this to be a strong year and to post that much growth during these tough economic times is really impressive to have yet another record year and continue to grow. In my mind, my job is to grow the company, and that's what we've been doing for -- this will be our 17th out of 19 years growing the company, and the guidance aspect isn't what decides things in the long run. What we have to do is continue to show quarter after quarter of strong results and that's my plan.

Operator

[Operator Instructions] Our next question comes from the line of John San Marco with Janney Capital Market.

John San Marco - Janney Montgomery Scott LLC

Do you know what the percentage of your Hong Kong associates that are actually Chinese nationals? Do you know what that percentage is, by any chance?

David Wentz

No, we do not.

John San Marco - Janney Montgomery Scott LLC

Okay. I mean ballpark? I mean it's pretty -- is it substantial? Or you can't even render a guess? A ballpark guess?

David Wentz

We definitely have a number of people who are building in Hong Kong. We do not have a percentage or have a number that we could point to with any accuracy.

John San Marco - Janney Montgomery Scott LLC

Got it. Okay, that's fine. Are there any laws, Chinese laws that discourage -- that sort of limit what Chinese nationals can do with respect to multilevel marketing outside of their borders?

David Wentz

Jim, are you aware of any rules? Jim Bramble, our CLO.

James Bramble

Yes, this Jim Bramble, I'm the Chief Legal Officer. We currently have a majority of our Hong Kong associates can qualify to do business in China as well, but they have historically focused on building in Hong Kong as what they are doing now and of course our efforts are to gradually get them to start building in China but they're both, they have a legal ability to build on either market, the majority of those associates.

John San Marco - Janney Montgomery Scott LLC

Okay. And what would preclude -- what about the minority? You implied minority, what precludes either a Hong Kong resident from participating in China or vice versa?

James Bramble

Well if an individual does not have residency in Hong Kong and the ability to build in Hong Kong, then they can only build in China. And that's one of the reasons that our initial approach was not successful or we thought it would not be successful is because those associates who are building in Hong Kong, who only build in Hong Kong, who will continue to build did in Hong Kong, would have had a competitive disadvantage. So that's why we've seen an increase in interest from our Hong Kong associates to continue building there without the restrictions and the hope for the continued -- the integration to be stronger in the future.

John San Marco - Janney Montgomery Scott LLC

Okay. That's a helpful explanation. And then just really quickly on associate incentive comp. It's drifted upwards a couple of quarters. I heard you reference some, I think, what you said, called targeted incentives. Could you be more specific on kind of what the qualification levels are for those target incentives? How many people are benefiting? And then what impact do you think that has on your relative comp expense? I don't think it was that long ago when the target was to get down below or down to 44%, and now it seems to be headed in the other direction.

David Wentz

Yes. The promotions of the contest can be targeted at the masses or targeted at the leaders. We do different types to hit the different groups. And the key is to see that they have -- they change activity and create more growth, more sales. And so we can have some that go to everyone, just whether there are discounts or small promotions for the masses as we say. And then there are also some promotions that are just toward the top few percent to drive those who are opinion leaders and drive the strength of their organizations. So those promotions will be a mix of the 2. Doug, from a dollars and incentive standpoint, the goal is to drive activity.

G. Hekking

Yes. And what we've seen just to put a little color on it is we've seen, for example, our matching bonus program be very successful in certain markets. In fact, the markets that we saw the most growth in really take advantage of the matching bonus in Hong Kong, the Philippines and South Korea. And so what we look to do is go back and provide incentives that are going to excite people in each of our markets. So we continually go out and look for those. As far as expectations for the remainder of the year, like we said in the script, we expect the second half of the year to be modestly higher than we saw in the first half of the year relative to net sales.

David Wentz

Economic times is a good time to be changing that percentage. We want to continue to motivate our sales force as much as possible and be a highly compensating company. We've done such a great job of managing SG&A and cogs that we can give to our leaders who are going to grow the company.

John San Marco - Janney Montgomery Scott LLC

That makes sense to me. So just to be abundantly clear, the second, the third and fourth quarter, you guys would expect to be higher than 45.3%, I'm getting for the first half of the year?

David Wentz

Yes. We would expect that.

Operator

And I show no further questions in my queue at this time. Mr. Richards, please continue.

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 me in Investor Relations at (801) 954-7961.

David Wentz

Thank you.

Operator

Ladies and gentlemen, this concludes the USANA Health Sciences Second Quarter Earnings Conference Call. If you'd like to listen to a replay of today's call, please dial 1 (800) 406-7325 and enter the access code of 4457946. Thank you very much for your participation. You may now disconnect.

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