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USANA Health Sciences (NYSE:USNA)

Q3 2011 Earnings Call

October 26, 2011 11:00 am ET

Executives

Kevin G. Guest - President of North America

David A. Wentz - Chief Executive Officer

G. Douglas Hekking - Chief Financial Officer

Patrique Richards -

Analysts

Scott Van Winkle - Canaccord Genuity, Research Division

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

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

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

Operator

Ladies and gentlemen, welcome to the USANA Health Sciences Third Quarter Earnings Conference Call on Wednesday, 26 of October 2011. [Operator Instructions] I will now hand the conference over to your host, Patrique Richards. Please go ahead, sir.

Patrique Richards

Thank you, and good morning, everyone. We appreciate you joining us this morning to review our third 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; Doug Hekking, our Chief Financial Officer; Kevin Guest, our President for North America; and Roy Truett, our Chief Operating Officer. We'll hear first from Dave, who'll discuss our business activities during the quarter as well as 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 A. Wentz

Thanks Pat. Good morning, everyone. We are pleased by USANA's solid financial performance during the third quarter and that we have continued to lay the foundation for consistent and long-term growth. The highlight during the quarter was our 19th annual International Convention in Salt Lake City. At this event we hosted thousands of our Associate leaders and made several important announcements, including our plans to open France and Belgium in the first quarter of 2012. These new markets together with Thailand, which we plan to open near the end of this year, will bring USANA's country count to 18 markets worldwide.

In recent years, our new market openings have been concentrated in our Asia Pacific region. Our European markets of France and Belgium will provide our North American distributors further opportunity to expand their business internationally. This is particularly true for many of our Canadian Associates who have direct ties to France. France is considered the world's 10th largest direct-selling market with estimated sales of more $2.4 billion annually. Our regional office headquarters will be located in Paris, France and our distribution facilities will be located in the Netherlands. Having an office and distribution set in a location in Europe will not only allow us to service our customers in France and Belgium, but will also allow us to better service our customers in the U.K. and in the Netherlands.

The opening of these new markets is consistent with our plans to be more aggressive in our international expansion efforts. That said, however, we remain focused on our largest expansion opportunity, which is growing our business in mainland China. In China, we generated continued growth in both sales and Associate counts during the quarter, sales increased $2.7 million year-over-year compared with partial third quarter 2010 operating results. As USANA acquired BabyCare in mid-August 2010, we only have a partial quarter. Associate counts in China also increased 50% year-over-year to 15,000 Associates. To this point, growth in China has been almost entirely organic as we continue with our China integration strategy. This strategy focuses on first educating our Hong Kong Associates on BabyCare's compensation plan and introducing USANA products in mainland China. We have made excellent products in 2011 on product introductions in China and we'll introduce 4 more USANA products during the fourth quarter, which we believe will be very well received by our Associates. By the end of the year, we plan to have a total of 13 USANA products available in China as well as 11 existing BabyCare products. Although this integration process takes time and requires patience, we believe it is the right process to position USANA for long-term growth in China.

I'd now like to touch on our results in Asia Pacific during the quarter.

Sales in Asia Pacific grew by 12.6% to $84.5 million. For the first time, this growth was led entirely by emerging markets including the Philippines, South Korea and China. Sales grew 158% in the Philippines and 66% in Korea year-over-year. These markets also had very strong customer growth. We are pleased with the recent growth in these markets and look forward to further growth as well. Sales in Hong Kong during the quarter were, as we expected, essentially flat year-over-year and declined sequentially. Customer count also declined during the quarter.

Now let me explain Hong Kong's performance during that quarter. First as we explained last quarter, many of our customers in Hong Kong increased their volume of purchases and enrollments during the second quarter ahead of policy changes they thought USANA would make in Hong Kong during the quarter. These policy changes were part of our initial China integration plan which, based on Associate feedback, was ultimately not implemented. Because of the run-up in the second quarter, many of our Hong Kong Associates did not purchase from us or enroll new customers during the third quarter. Because we only count as active those customers who purchase from us within the most recent 3-month period, these individuals do not appear in our quarter-end customer numbers. During the third quarter, we continued to see the lingering effects of the confusion that was created in Hong Kong when we changed our integration approach for China. As a result of this confusion, we have lost business from some Associates and there are other associates who have adopted a wait-and-see-you approach, and are not building their business as they did in the past. Our Asia Pacific management team led by Deborah Woo is working aggressively to put these concerns to rest and resolve any remaining confusion among the sales force.

Nevertheless, as a result of this confusion and the second quarter run-up in sales, Hong Kong experienced some softening during the third quarter, as we anticipated. I think it's also important to remember that with respect to Hong Kong, we are working off a tough comparable from 2010.

During the last 3 quarters of 2010, we had several significant announcements in advance that generated momentum in Hong Kong. These announcements included our intention to enter China, the BabyCare acquisition which accelerated our entry into China and an additional qualification period for the matching bonus program. Our Hong Kong sales force capitalized on the momentum from these announcements and as a result, sales and customer counts increased meaningfully. In contrast to 2010, the second and third quarters of 2011 have presented challenges to our Associates such as the change to our China integration strategy and unanticipated distractions from increased competition. I believe that we have responded well and met these challenges head-on, but the challenges have certainly impacted the momentum in Hong Kong. Despite these challenges, we believe that our business in Hong Kong remains strong and will respond favorably in the future.

Turning now to North America, stability and growth in this region remains a significant focus of our short-term initiatives and long-term strategy. We continue to develop our North American strategy, which focuses on personalization coupled with market specific incentive offerings. This strategy resulted from extensive market research and will initially be implemented in North America over several years beginning 2012. It is designed to help return excitement to our business in this region and drive long-term growth. We believe this region will grow with time, effort and a successful execution of our strategy.

In closing, our team is confident in our business and our relationship with our Associate leaders. Our management team, employees and Associates have responded impressively to many challenges throughout the year while remaining focused on our many operational initiative and overall growth strategies.

With that, I'll now turn the call over to Doug to discuss our financial results.

G. Douglas Hekking

Thanks, Dave. And good morning, everyone. I'll start by discussing the financial performance for the quarter and then discuss our updated outlook for the year. For the quarter, we reported net sales of $143.5 million, a 6.3% increase over the prior year. We also reported earnings per share of $0.81, which represents about a 2.5% increase year-over-year. Gross profit margins for the third quarter improved as a percentage of net sales to 82.4% compared with 81.4% for the third quarter of 2010. This 100-basis-point improvement was primarily the result of a weaker U.S. dollar compared to the prior year. Associate Incentives expense for the quarter increased 120 basis points to 46.1% sales compared to the third quarter of the prior year. This increase was due to more Associates taking advantage of our matching bonus program, as well as the negative effect of changes in currency. Selling, general and administrative expense in the third quarter increased 50 basis points to 23.3% of net sales. This increase resulted primarily from costs associated with BabyCare's operations, as well as expenses associated with our increased brand awareness efforts. The negative impact of changes in currency also contributed to the increase in SG&A during the quarter.

Overall, higher relative operating expense resulted in a 3.6% decrease in net earnings for the third quarter to $12.4 million. Earnings per share, however, increased to $0.81 per diluted share from $0.79 reported for the prior year quarter. This increase was a result of a decreased number of diluted shares outstanding resulting from the repurchases over the last 12 months.

During the quarter, we repurchased an additional 268,000 shares for a net investment of $7.4 million or $27.46 per share. Share repurchases over the last 12 months benefited earnings per share by $0.06 during the quarter. Although we made significant investments in share repurchases, we were pleased to finish the quarter with approximately $36 million in cash and remained debt-free. The increase in cash and cash equivalents was driven by cash flows from operations of $22 million during the quarter.

I'd now like to comment on our updated guidance for the remainder of 2011. Based on the strength of our results in the first 3 quarters of the year, we are increasing our outlook for both net sales and earnings per share. We now project consolidated net sales to be between $577 million to $581 million for the year, which is an increase from our previously issued guidance of $565 million to $575 million. Additionally, we now expect projected earnings per share to be between $3.20 and $3.25 compared to our previous estimate of $3.05 to $3.10. Our guidance for EPS reflects the following: modest sequential net sales growth in the fourth quarter; gross margin and Associate incentives roughly in line with levels we saw in the third quarter; a decrease in SG&A expense in absolute terms resulting from the timing of certain expenses that do not typically occur during the fourth quarter. Additionally, both lower-than-expected equity comp expense and depreciation expense contributed to stronger earnings per share in the third quarter and is expected in Q4 as well.

In closing, let me assure you that we remain focused on our operational efficiency and as we continue to integrate China into our business and work to successfully launch 3 new markets in the coming quarters. Overall, we are pleased with how the company's responded to these challenges presented in 2011 and expect to finish the year strong.

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 Tim Ramey from D.A. Davidson.

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

Doug, I could be wrong, but I think you just said sequential growth in the 4Q versus 3Q. Wouldn't that take you above the high end of your revenue guidance range for the 4Q?

G. Douglas Hekking

No. Modest sequential when we mentioned the $581 million as top represents some modest sequential growth. On the top end of that.

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

Okay, I'll have to go back and revisit that. With regard to the Hong Kong situation, I guess I feel like we've been sort of -- well, 3 months ago, I would've said we're sort of back to normal there, but it doesn't feel like we're back to normal now. Do you feel like there's been lasting damage done to that market? I know you're bullish longer-term on Hong Kong and I'm sure you should be, but did we essentially take a hit from the events from the past whatever 5 months, I guess?

G. Douglas Hekking

Absolutely, some momentum was damaged in Hong Kong, but that is a very resilient group. And so even though we had a quarter where we had a lot of sales pushed into with the Q2 and Q3, a lot of inventory out there, that group is a hard-working group that is very resilient and Deborah Woo and Sherman Ying are doing a fantastic job of communicating and getting the word out so people understand the long-term strategy and plan there involving China as well because they have to take that into account. I'm not worried about that group; they will continue to grow that business. They've done a fantastic job for a decade or more and I have no worries going forward in the future with that group.

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

Dave, did they feel somewhat disenfranchised by BabyCare or threatened by BabyCare? Or how should we think about their interpretation and hesitancy to grow their business?

David A. Wentz

Yes. Well, they're working off on their own and isolated in some cases, and they don't really understand what it means to their business and so we've been trying to reach out to the thousands and thousands of people that are involved to communicate to them to explain what it means to them. And with any change there's always fear in that group wondering if it's going help or hurt. And a lot of times during that change and that fear, they take that wait-and-see to -- and which sometimes unfortunately makes things slow down and makes them worry more because they take that wait-and-see approach. But that's just been normal throughout this industry forever that with all changes, you have to get the communications out, get people comfortable again and then they realize that it's the same company going forward, doing what we've been doing for 19 years and have a great future ahead of them with even more opportunities than they have in the past.

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

And just one more, if I can. I mean you alluded to the competitive threat from Eric's, earlier. Has there been any meaningful defections or success? I mean, I understand it's a competitive market and you compete with lots of multilevel opportunities, but has that new entry into the market posed any specific threat to your business?

David A. Wentz

I don't think so. No more so than we see a new competitor open in any of our countries. I know that every time a new competitor opens in Taiwan or Australia or Korea, people get a little bit nervous and we'll lose a leader or 2, absolutely. It's just the nature of this business that when a new opportunity arise in the countries, people will look and some people would move. But that is the nature of this business and yet if you have the masses and a good growth strategy, good competitiveness you'll lose a couple, but the majority will continue to grow once that distraction passes and their fears, once again, are not confirmed that there is any threat there. People get a little bit nervous, but then they see the reality that it's just like every other company that's coming along and they continue to build their business. But it is emotionally stressful for them for a time period and then they bounce right back each and every time, no matter what the company is or what the country is.

Operator

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

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

Can you explain why the -- why you think the enrollments in Hong Kong may have been pulled forward into the second quarter? I get the forward purchasing ahead of what they thought would be real changes, but why would they have been more motivated to enroll in the second quarter and pull that forward?

David A. Wentz

They were afraid they wouldn't be able to enroll anymore after that time period, so they pressured people or encouraged people to get in quickly before they lost that opportunity and so people who they would've been working with and talking to over time, they now have a very set deadline in their mind. And so people who may have taken a month or 2 to sign up ended up trying to get in before that deadline. And so, people they -- because they work with people over months, 6 months before they get them in a lot of times but when you have a deadline or a contest or promotion, we'll see that they'll get people based on that deadline to sign up sooner than they normally would so that they don't have an opportunity lost by signing up after a promotion or contest, et cetera. And so we see that even with promotions and contests; that we'll have a whole bunch of people come in before a certain deadline and then things will ease off afterward because the pipeline isn't as full anymore.

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

Got it. And so is it safe to assume you'll feel some of that in the fourth quarter is into some of that sort of depleted prospect full?

David A. Wentz

I hope it would ease off fairly quickly. It shouldn't take more than a quarter with these. Yes it was a huge portion and it might be bigger than a normal contest or promotion, but I would hope it would not go throughout the entire quarter, maybe a portion of the fourth quarter.

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

Okay. And then I was hoping for some additional detail on the SG&A reduction. I'm just sort of looking at the comps in the first half looked like, on an absolute basis you'd sort of grown SG&A between $6 million and $9 million, and now it looks like you pared that growth back to $2.5 million in the third quarter. Were there large expenses that drove that deceleration or were there buckets of expenses that you can detail?

G. Douglas Hekking

Really the 2 things that are probably most notable is our Asia Pacific Convention that was held in the first quarter and our North American Convention in the third quarter. Those are 2 primary things. On a year-over-year comparison, you got to remember that we had BabyCare mid-third quarter of 2010, so BabyCare has added quite a bit to our SG&A structure. And we have seen a little bit of relief in SG&A equity comps a little bit lower than we expected, depreciations coming a little bit lower than what we had built on our model.

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

All right. And then I'm wondering if there's an update on the North American strategy you outlined at the beginning of the year. As I recall, I sort of recall 3 prongs to this strategy, the WTA increasing your sponsorship, there's book signings and I believe there were some digital investments. I guess first of all, has anything changed this year in your strategy? And then secondly, what do you think has gone wrong and what do you think has gone right?

Kevin G. Guest

Well hello, this is Kevin Guest speaking, and I'll address that. First and foremost, we were really pleased in the first quarter with our book initiative which netted us the New York Times' bestsellers with Dave and Dr. Wentz as we did our tour and we're in front of over 10,000 Associates as we toured around the United States. Our strategy is still in place with that book as we continue to see our media outlets and national media be interested in the message, and you'll see some upcoming things happening from a media perspective on a national level as it relates to our healthy home book initiatives and other things related in those areas, so we are pleased with that. We have increased our presence with the WTA. As many of you are aware, we have many of the top women's tennis players in the world who are using USANA products. We had some at our International Convention and we've used them in events in China and other events around the world to draw interest. One of the interesting things as it relates to our athletes, we did some marketing research from a credibility perspective and our athletes score actually highest on the list, even above medical doctors and speaking about trust in using our products. And so we continue to be involved from a -- from that perspective with our WTA relationship and we're excited to see that relationship grow. Also at our International Convention, we expanded our athlete relationship with our -- with the announcement of our involvement with the U.S. snowboard and ski team. Our strategy there is Olympic athletes love and trust our products and we want to be the #1 company, nutritional company in the world supplying products to gold-medal athletes around the world, which is the method to the madness behind that strategy, which our Associates who are out spreading this message love to talk about. So we have seen that expanded. We also have an expanded strategy that we announced at our International Convention around personalization. You'll see over the next 5 years USANA sticking it's stake in the ground, so to speak, becoming -- we've already done that with MyHealthPak in other areas where we are the industry leader in personalization as it relates to nutrition. But we will become the world's leader in personalized nutrition meeting the individual needs of our customers around the world. And that strategy is exciting and resonating with our Associates. We're seeing a groundswell especially in North America in the United States, Canada and Mexico as they embrace the notion of personalization and something new and fresh and a mature market for them to talk about. And so the answer is yes, those strategies are in place, they have grown, we've expanded upon them and they seem to be working. And there is a great groundswell as we've -- I'm excited about what the future holds for North America.

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

God, that's a helpful update. So it sounds like -- I mean it sounds like you're satisfied with the way they work from an awareness and branding perspective, but I imagine the financial translation hasn't met your own expectations. Is that a fair characterization?

Kevin G. Guest

Yes. Obviously, we're not happy with where we're seeing North America short-term but from a long-term perspective, we're seeing traction. And with that long-term view, we feel confident that we will see that return that we're expecting through these relationships.

Operator

Our next question comes from Rommel Dionisio from Wedbush Securities.

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

I wondered if you could just provide us an update of the MyHealthPak initiative and I don't know if you can share with us some quantifiable targets that you may be hitting or so forth, and just describe the progress that, that initiative has made with the North American sales growth.

David A. Wentz

MyHealthPak has been growing over the years since we launched it, becoming more popular, and it's definitely a differentiator. It's something that our distributors can talk about because no one else in our industry has it. And so that excites people in this business to have something that they can claim as their own and they don't have to worry about competing with others. So MyHealthPak is growing. The people who use it, there's definitely a more personal tie with the products with your name on it that's designed specifically for you, and it connects them more with the company and with our nutritional program versus more generic products. And so we're excited about the future of that and expanding it to -- into more places around the world.

G. Douglas Hekking

Rommel, this is Doug. From a financial perspective, really the MyHealthPak we're seeing as a platform to build off of. And the strategy that we have is a 5- to 7-year strategy that we're currently in the process of implementing. And it'll be executed systematically over that time. So we hope to see sequential progress on that, but that's not going to happen day one.

Operator

Our next question comes from Scott Van Winkle of Canaccord Genuity.

Scott Van Winkle - Canaccord Genuity, Research Division

Most of my questions have been answered. I guess, a question in Southeast Asia, just trying to model how it plays out and the growth was excellent there. Last year from Q3 to Q4, and I apologize, Doug, if I'm making you dig into the numbers here, there was a sequential decline in distributors and I'm wondering if that happens again this year if there's something seasonal when I think about forecasting that particular business. That's the one number that kind of jumped out at me that I can't kind of rationalize on a year-over-year basis.

G. Douglas Hekking

Yes. Scott, the one thing that I think that maybe hasn't been talked about enough is at our conventional last year, we implemented a couple of changes that essentially required an associate, it increased the barrier to entry. So what we've seen is we've seen a decrease in the number of people that are coming into the business. But on average, they're spending more. So we do have some tough comps on customer accounts on a year-over-year basis, but we understand primarily where those are coming from.

Scott Van Winkle - Canaccord Genuity, Research Division

Okay. Okay. And that's just -- that's globally; that's not just in any particular region?

G. Douglas Hekking

That's correct.

Scott Van Winkle - Canaccord Genuity, Research Division

But that would kind of lead into the fact that revenue per distributor, just a quick map in the U.S., I mean it's at a point now where I don't think it's ever been before as far as the level, not just feeding off of that trend.

G. Douglas Hekking

That's correct.

Operator

Thank you. We have no further questions at this time. Please continue with any further points you wish to raise.

David A. Wentz

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 concludes today's USANA Health Sciences Third Quarter Earnings Conference Call. Thank you for your participation. You may now disconnect.

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