Natural Health Trends Corp. (NHTC) engages in the provision of direct selling and e-commerce. It involves the sale of products via a multi-level marketing member network, as well as through an e-commerce platform for the Chinese market. Given the loss of the China Revenues (88% of revenues), the firm is dramatically overvalued. We believe that the cash on the company's balance sheet offers investors little security, as the company's recent $32 million buyback program is currently being used to purchase Director George Broady's shares - the buyback program is roughly equal to the market value of the shares insiders own. We view the US/China trade war as a barrier to NHTC re-entering China for the foreseeable future for two reasons: 1) China is serious about stemming all unnecessary capital outflows and 2) If China makes any concessions that are disadvantageous to the country's growth, this makes them even more likely to strongly enforce the existing anti multi-level marketing regulation. We believe the stock should currently trade at a significant discount to book value to reflect the company's rapidly deteriorating fundamentals.
The Loss of China Revenues
On January 5th, 2019 China's state run television operator CCTV aired a piece questioning the company's sales practices in China. The company denied the allegations, yet shortly afterwards, the company pre-released (negative), highlighting China's "100-Day Campaign" crackdown on multi-level-marketing schemes. Even though the company has been through this same exact scenario before and fully understands the implications, they couldn't resist the urge to put a positive spin on what they know to be a draconian situation:
"While the results of this program are not yet clear, the company believes this is a positive development that will benefit Chinese consumers and NHT Global in the long-term."
The Company released full year results shortly afterwards on February 21st, 2019 where they disclosed potential material adverse effects:
"...we voluntarily decided in January to temporarily suspend our member activities while proactively cooperating with all relevant government agencies to ensure we continue to conduct our business in compliance with all applicable laws in China. While I am confident this is the best approach to position our Company to successfully operate in the long-term, this suspension of member activities may have a material adverse effect on our business in the near-term."
National Health Trends Corp., China revenues account for 88% of total revenues:
Image created by author, data pulled from Bloomberg Professional.
Needless to say, the use of the word "may" as it relates to material adverse effects here is rather comical. Particularly because Chris Sharng (CEO with formal label of President and Director) joined the company in August 2004 and experienced the same exact scenario in September, 2005 when China "lifted" its ban on direct selling by foreign firms, while simultaneously enacting anti multi-level-marketing regulations.
In the 2018 10-K filed (late) April 26, 2019 the company stated:
"In January 2019 we, like some of our peers, voluntarily decided to temporarily suspend our member activities, such as product roadshows, product trainings and larger company-sponsored events, in China as we did in 2007."
While the company only first disclosed that it stopped selling into China in 2007 (Via 2006 10-K), the business was materially adversely affected when the ban was put in place (Sept 2005). For the next four years, members and revenues evaporated.
A glimpse at the risk factors within the 2005 10-K highlighted the company's awareness of the potential headwinds of operating a multi-level-marketing scheme within China:
"Since 1998, direct selling has been restricted in China... In November 2005, the Chinese government adopted an anti-multilevel marketing legislation ahead of its December 2005 adoption of legislation to legalize direct selling. The government has rigorously monitored multi-level marketing activities and enforced these laws. In the past, the government has taken significant actions against companies that the government found in violation of applicable laws. Governmental actions included shutting down their businesses and arresting alleged perpetrators... currently the Company is generating revenue from its members in China in a manner that, while the Company does not believe violates the anti-multilevel marketing legislation in China, could be deemed by the Chinese government to violate such legislation."
The current situation is exactly the same as 2005 (from 2005 10-K as well):
"in April 2004, an investigative television program was aired in the People’s Republic of China with respect to the operations of the Company’s Hong Kong subsidiary and the Lexxus representative office located in Beijing. The television program made allegations that Lexxus’s Hong Kong operations engaged in fraudulent activities and sold products without proper permits."
Just as it did in Q4, 2005, the loss of China revenues has had a swift material adverse impact as highlighted in the May 7th, 2019 Q1 earnings release.
- Revenues were down 63% year-over-year, down 53.52% quarter-over-quarter.
- Cash & ST Investments down 18.2% year-over-year, down 10.5% quarter-over-quarter to $118.7 million.
- No conclusion to the 100-Day Campaign for the foreseeable future.
- $32 million stock repurchase program to dilute shareholders with purchases above book value.
Everyone Loves Share Buybacks
As stated above, the company announced a $32 million share buyback. in our opinion, to buy back shares of a company at a premium to a soon-to-be rapidly declining book value ranks one step above burning the cash in a fireplace to heat your home (frankly, management should be liquidating the company). On May 17th, the company filed an 8-K announcing that they had entered into a stock repurchase agreement with NHTC board member George Broady. Pursuant to the agreement:
"As a part of Current Repurchase, the Company has also entered into a Rule 10b5-1 Issuer Repurchase Plan with its broker (the “Purchase Plan”) under which the Company’s broker is authorized to purchase shares of the Company’s common stock in the open market in accordance with Rule 10b-18 under the Securities Exchange Act of 1934. The Stock Repurchase Agreement with the Broady Trust requires that the Company report to the Broady Trust on a weekly basis information regarding the broker’s open market purchases, and that the Company purchase from the Broady Trust 0.4105 of the number of shares purchased by the Company’s broker in the open market, which shares shall be purchased on a weekly basis from the Broady Trust at a per share purchase price equal to the weighted average price per share paid by the Company’s broker to purchase shares in the open market."
In other words; Mr. Broady is selling .41 shares directly to the company for every 1 share the company purchases in the open market. This allows Mr. Broady to sell without driving a price decline that typically comes with a large holder selling into the market. Mr. Broady is able to exit his position at an extreme premium (in our opinion) to the intrinsic value of the shares.
To date, (according to FactSet) George Broady has unloaded 178,324 shares at a weighted average price of $10.89 per share.
If the company will spend $8 million, with 40% being used to purchase Mr. Broady's shares, we expect this sweetheart deal will be extended to his wife's trust; The Jane Elanor Broady 2012 irrevocable Trust. George, what happened to "women first?" Chivalry must truly be dead. Total insider holdings are valued in the market at ~$35 million and equate to 34% of the outstanding shares.
A Red Flag Wonderland
We were originally introduced to NHTC years ago as a long idea - if you haven't already noticed, the unit-level economics are amazing. Due to the trade war on the horizon and the company's China exposure, as well as other red flags, we passed, but put it on our watch list. After the drop in January, we revisited the name. We do a lot of work with Freedom of Information Act (FOIA) requests and through our own work (and others), we identified a potential ongoing SEC investigation into the company.
After making the SEC aware that the company had not disclosed the ongoing investigation, the company "voluntarily" disclosed the investigation in its 2018 10-K. The disclosure claims:
"Since August 2016, the SEC has been conducting a non-public investigation to determine whether there have been violations of the federal securities laws relating to the trading of the Company’s securities. The Company has fully cooperated with the SEC and has and continues to provide documents in response to subpoenas. The SEC has expressly stated that its document requests should not be construed as an indication that any violation of law has occurred, or as a reflection upon any person, entity, or security. The amount of time needed to resolve this matter is uncertain, and the Company cannot predict the outcome or whether it will face additional governmental inquiries or other actions."
In our experience, most SEC investigations don't take years to conclude. We find it odd that something as simple as an investigation into insider trading would require a multi-year investigation. We believe the scope of the SEC investigation is not limited to insider transactions.
Material Weakness in Internal Controls Over Financial Reporting:
The company claims that they could not identify any material misstatements of revenue, but have identified a material weakness related to revenue recognition (2018 10-K):
"Management identified a deficiency related to the design effectiveness of the Company’s controls surrounding the determination of the appropriate revenue recognition date. Specifically, the Company did not timely review and appropriately document shipping information provided by its third-party logistics (“3PL”) facilities. Furthermore, the Company did not test a sufficient sample of individual shipping documents, as provided by its 3PLs, to determine and conclude that the shipping date agreed with the date revenues were recognized...As a result, management concluded that our internal control over financial reporting was not effective at December 31, 2018."
Adverse Auditor Opinion on Internal Control over Financial Reporting:
From the 2018 10-K:
"We have audited Natural Health Trends Corp.’s (the "Company") internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, because of the effect of the material weakness described in the following paragraph on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have served as the Company’s auditor since 2017"
Marcum has a reputation for pushing boundaries.
Valuation - How Low Can You Go?:
The company burned through $13.84 million in the previous quarter, ending the quarter with $118 million in cash. Less the $32 million set aside for buybacks (which I wouldn't be surprised to see exhausted in the coming quarters), that leaves $86 million. Unlike the previous China selling ban in 2005, due to the US/China trade war, and the resolve to stem the degree of capital flight the country saw in 2015, we don't expect those China revenues to come back.
Look no further than the 2005 crackdown cycle for an indication as to how this story plays out. For five years, the company burned cash (cash down 96%). Over the same period, the share count increased by ~60%. Price to book value went from a multiple of book value of around 3x to a discount of 0.33x within a year of being banned from China.
We think the 2005 pattern repeats in a similar way this time around, but with no recovery in the China revenues. On the balance sheet side, the $32 million share buybacks above book value will only dilute an already rapidly declining book value. On the P&L side, the buybacks are going to magnify losses per share by distributing growing losses across a decreasing number of shares. As the cash balance grows smaller, operating losses will eat up an increasingly larger amount of cash on the balance sheet (on a percentage basis).
Management are poor custodians of shareholder value. In our opinion, this won't change. Broady's bold move to have the company purchase his shares while having the company buy shares in the open market should concern investors. Given the loss of the China revenues, the plethora of red flags, and management's unhelpful use of the company's cash, we believe this business should be trading at a 30% discount to book value ($5.53/~40% downside with a six month time horizon). Currently, the stock trades at 1.14x BV (1.16x TBV).
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Disclosure: I am/we are short NHTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.