UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, DC 20549
(Mark One)
Commission File Number: 001-12421
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer Accelerated filer Non-accelerated filer
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
As of October 31, 2007, 64,748,127 shares of the registrant’s Class A common stock, $.001 par value per share were outstanding.
Nu Skin, Pharmanex and Big Planet are trademarks of Nu Skin Enterprises, Inc. or its subsidiaries. The italicized product names used in this Quarterly Report on Form 10-Q are product names, and also, in certain cases, our trademarks.
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NU SKIN ENTERPRISES, INC. Consolidated Balance Sheets (Unaudited)(U.S. dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
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NU SKIN ENTERPRISES, INC. Consolidated Statements of Income (Unaudited)(U.S. dollars in thousands, except per share amounts)
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NU SKIN ENTERPRISES, INC. Consolidated Statements of Cash Flows (Unaudited)(U.S. dollars in thousands)
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NU SKIN ENTERPRISES, INC. Notes to Consolidated Financial Statements
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Revenue generated by each of the Company’s three product lines is set forth below (in thousands):
Additional information as to the Company’s operations in its most significant geographic areas is set forth below (in thousands):
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The following table summarizes the Company’s debt arrangements as of September 30, 2007:
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Each of the credit facilities and arrangements listed in the table are secured by guarantees issued by the Company's material domestic subsidiaries and by pledges of 65% of the outstanding stock of the Company's material foreign subsidiaries.
The current portion of the Company's long-term debt (i.e. becoming due in the next 12 months) includes $12.1 million of the balance on the Company's 2000 Japanese yen denominated notes, $15.0 million of the balance on the Company's U.S. dollar denominated debt under the 2003 multi-currency uncommitted shelf facility and all of the Korea line of credit.
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The following Management’s Discussion and Analysis should be read in conjunction with Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2006 filed with the Securities and Exchange Commission (“SEC”) on March 1, 2007, and our other filings, including Current Reports on Form 8-K, filed with the SEC through the date of this report.
Our revenue for the three- and nine-month periods ended September 30, 2007 increased 5% and 3%, respectively, to $290.7 million and $851.6 million compared to the same periods in 2006. Foreign currency exchange rate fluctuations positively impacted revenue approximately 1% for the three-month period ended September 30, 2007. Foreign currency exchange rate fluctuations did not have a material impact on revenue for the nine-month period ended September 30, 2007. The increase in revenue was primarily a result of year-over-year growth in South Korea, Europe, the United States, and our South Asia/Pacific region. The continued promotion of our sales tools, including the Nu Skin® Galvanic Spa™ System II (the “Galvanic Spa System”), the Pharmanex® BioPhotonic Scanner (the “S2 Scanner”), and the Nu Skin® ProDerm™ Skin Analyzer (the “Proderm Skin Analyzer”), as well as the strength of key product and distributor initiatives contributed to our revenue growth in these markets. The revenue increases in these markets were offset by revenue declines in Japan and China.
Net income for the third quarter of 2007 was $13.5 million, compared to $13.2 million for the same prior-year period, and for the nine-month period ended September 30, 2007 was $37.8 million compared to $17.0 million for the same prior-year period. Net income was impacted by restructuring and other impairment charges of approximately $32.0 million in 2006 and approximately $3.0 million in 2007.
Revenue
North Asia. The following table sets forth revenue for the three- and nine-month periods ended September 30, 2007 and 2006 for the North Asia region and its principal markets (in millions):
Foreign currency exchange rate fluctuations did not impact revenue in our North Asia region for the three-month period ended September 30, 2007 and negatively impacted revenue 1% for the nine-month period ended September 30, 2007. In local currency, revenue in Japan was down 7% and 5% for the three- and nine-month periods ended September 30, 2007, respectively. South Korea revenue in local currency for the three- and nine-month periods ended September 30, 2007, improved 13% and 18%, respectively, when compared to prior-year periods.
The revenue decline in Japan was largely a result of continued softness in our distributor numbers and sponsoring activity in this market, with the number of executive distributors and active distributors each decreasing 7% compared to the third quarter of 2006. In April 2006, we hired a new president for our Japan operations, who has been engaged with management in reviewing operations and developing and implementing a plan to renew growth in this market. Based on this review, management believes that past initiatives and promotions have not been focused sufficiently on distributor sponsorship and other core growth strategies. As a result, at the end of the third quarter of 2007 we began implementing aggressive initiatives focused on distributor recruitment and leadership development. The initial results of these initiatives have been positive and our management team continues to work on developing and implementing strategic plans for this market. For example, we also recently launched the same distributor incentive related to the Galvanic Spa that has been positively received by our distributors in the United States and Europe. Revenue for the quarter in Japan also was negatively impacted by convention product purchases by our Japanese distributors attending the International Convention in the United States, which were recorded as revenue in our US market rather than our Japan market.
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South Korea posted year-over-year local currency revenue growth of 13% in the third quarter. This growth was fueled by product and distributor initiatives that have maintained a strong sponsoring environment for our distributors. Compelling product opportunities for the market include the Galvanic Spa System II, our top-selling Nu Skin 180° Anti-Aging Skin Therapy System, as well as a continued focus on nutrition products includingLifePak and g3. We are also planning to launch TriPhasic White, a global top-seller, in this market. The number of active and executive distributors increased 24% and 23%, respectively, during the third quarter of 2007 compared to the same prior-year period.
Greater China. The following table sets forth revenue for the three- and nine-month periods ended September 30, 2007 and 2006 for the Greater China region and its principal markets (in millions):
Foreign currency exchange rate fluctuations positively impacted revenue in our Greater China region by approximately 1% for the three-month period ended September 30, 2007 and less than 1% for the nine-month period ended September 30, 2007.
In local currency, revenue in Taiwan was up 3% and 1%, respectively, for the three- and nine-month periods ended September 30, 2007. The revenue growth in Taiwan is largely attributed to strong sales in our weight management products. Executive distributors in Taiwan increased 3%, and active distributors declined 3% during the quarter compared to the same prior-year period.
In China, our business remained soft as we continue to transition our business model in this market. Revenue, on a local currency basis, was down 7% on a year-over-year basis, and 9% on a sequential basis. In the second quarter, we replaced our management team in this market. As the direct selling and regulatory environment continues to evolve and develop in this market, our new management team is in the process of making changes to our business model in this market to take advantage of these developments, to better align our direct selling business model and employee sales model, and to help reduce our overhead and improve profitability. These business model changes will allow us to engage independent direct sales representatives as well as offer part-time employment for sales representatives, which will provide a smoother integration between our direct selling model and our employee model. This will allow us to provide a supplemental income opportunity to individuals who may not be interested in working full-time in this business as well as reduce our selling expenses, as the amount of social benefits and taxes would be lower under this model. We anticipate the changes will be fully implemented by April 2008.
We also plan to streamline our operations in this market by altering our current store strategy. We will open new flagship stores in key cities within China, while closing small retail outlets and branch offices in secondary cities. We believe we can operate more effectively and efficiently by focusing our business around our larger flagship stores, complemented with stores which have an improved image. As a result, we plan to open 5 flagship stores in Shanghai, Beijing, Guangzhou, Shenzen and Xian and close approximately 67 of our current 115 retail stores in China. With fewer stores in operation and more efficiently running stores in place, we will be able to reduce our overhead expenses in China, through a reduction in labor and occupancy costs. Our strategic focus in the near-term will be on implementing our growth initiatives in our key provinces and municipalities, Shanghai, Beijing and Guongdong, which account for more than 50% of our revenue.
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In Hong Kong, revenue in local currency for the three-month period ended September 30, 2007, improved 7% compared to the prior-year period, while revenue for the nine-month period ended September 30, 2007 was relatively level with the prior-year period. Revenue for the nine-month period in 2006 included sales to non-Hong Kong distributors attending the regional convention held in this market. In Hong Kong, executive distributors were up 6% and active distributors were down 1% for the quarter compared to the third quarter of 2006.
Americas. The following table sets forth revenue for the three- and nine-month periods ended September 30, 2007 and 2006 for the Americas region and its principal markets (in millions):
Revenue in the United States continued to be positively impacted by several key initiatives implemented in each of our product categories during the past year. In particular, the Galvanic Spa System II has been a primary focus of many of our distributor leaders and has helped drive significant growth in our personal care revenue. We have implemented distributor incentives around the Galvanic Spa System II to increase the initial earnings opportunity for new distributors, which we believe has contributed to the revenue growth. Additionally, during the quarter, the United States hosted our global convention, which positively impacted revenue in the market by approximately $5.0 million as a result of product and convention fee revenue from foreign distributors attending the convention.
At our global convention held in September, we introduced an array of new products and distributor tools which we believe helped contribute to the growth in revenue. These products and tools include, myVictory weight control plan, a new version of the Galvanic Spa System II, an S2 Scanner upgrade, which eliminates the need for calibration, and TruFace Essence Ultra. These new products will initially be launched only in the United States market with plans to introduce globally in the future.
We announced that we would be restructuring our Brazil operations after many years of disappointing results. We have closed our offices in Sao Paulo, narrowed our product offering and moved our call center operations to our U.S. headquarters. We continue to provide products for personal use consumption and distributor support for this market from other regional markets.
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South Asia/Pacific. The following table sets forth revenue for the three- and nine-month periods ended September 30, 2007 and 2006 for the South Asia/Pacific region and its principal markets (in millions):
Foreign currency exchange rate fluctuations positively impacted revenue in South Asia/Pacific by 10% in the third quarter of 2007 and for the nine-month period ended September 30, 2007 compared to the same prior-year period. The majority of the markets within this region experienced revenue growth during the quarter. The growth was fueled in part by continued success of our TRA family of weight loss products. Active distributors in the region decreased 11% while executive distributors increased 4% in the third quarter compared to the same prior-year period.
Europe. The following table sets forth revenue for the three- and nine-month periods ended September 30, 2007 and 2006 for Europe (in millions):
We experienced growth throughout our European markets in the third quarter driven by continued growth in our personal care division. We believe that our success in Europe is attributable to enthusiasm and strong alignment of our distributor leaders behind key initiatives, including the Galvanic Spa System, the Scanner, and the ProDerm Skin Analyzer. Active distributors in the region improved 15%, while the number of executive distributors improved 20% when compared to the prior-year period.
Gross profit
Gross profit as a percentage of revenue decreased to 82.0% and 81.9% for the three- and nine-month periods ended September 30, 2007 from 82.5% and 82.6% for the same periods in 2006. The decrease is due in part to a shift in our product mix as our Japan business, which historically has our strongest gross margins, now represents a smaller percentage of our overall business. Gross margins have also been impacted by the increase in sales of tools that have lower margins such as the Galvanic Spa.
Selling expenses
Selling expenses as a percentage of revenue decreased to 43.1% and 42.9% for the three and nine-month periods ended September 30, 2007 from 43.7% and 43.1% for the same periods in 2006. The improvement for the third quarter of 2007 compared to the prior-year is largely related to the phase-in of some compensation plan changes in Japan in the second quarter of last year, which resulted in us paying additional compensation during the transition period. We have introduced a temporary distributor incentive in Japan at the end of the third quarter of 2007, which we expect will result in a slight increase in selling incentives, as a percent of revenue, in the fourth quarter of 2007.
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General and administrative expenses
General and administrative expenses as a percentage of revenue increased to 32.3% for the three- and nine-month periods ended September 30, 2007 from 31.2% and 32.1% for the same prior-year periods, respectively. In U.S. dollars, general and administrative expenses increased for the three- and nine-month periods to $94.0 million and $274.7 million from $86.3 million and $265.1 million for the same periods in 2006. The increase is primarily attributable to the company’s global distributor convention, which was not held in the prior-year.
During the fourth quarter, we plan to take steps to reduce our overall general and administrative expenses by reducing labor and occupancy costs. We anticipate that we will incur approximately $10 million to $14 million in restructuring charges in the fourth quarter in connection with implementing these changes, primarily consisting of severance and other compensation charges and the costs related to termination of leasehold interests. We anticipate that our 2008 general and administrative expenses will be approximately $15 million lower than 2007.
Other income (expense), net
Other income (expense), net for the three- and nine-month periods ended September 30, 2007 was approximately zero and $0.1 million of income compared to $0.2 million of income and $2.2 million of expense for the same periods in 2006. Fluctuations in other income (expense) net are due to foreign exchange fluctuations to the U.S. dollar on the translation of yen-based bank debt and other foreign denominated intercompany balances into U.S. dollars for financial reporting purposes.
Provision for income taxes
Provision for income taxes for the three- and nine-month periods ended September 30, 2007 was $5.7 million and $20.1 million of expense compared to $8.0 million and $10.3 million of expense for the same periods in 2006. The effective tax rate was 29.6% and 34.7% of pre-tax income during the three- and nine-month periods ended September 30, 2007, respectively, compared to a rate of 37.7% in the same prior-year periods. This lower tax rate in the third quarter of 2007 resulted from the impact of the closure of tax years by expiration of the statute of limitations under the provisions of FIN 48. We expect our tax rate for the year to be between 35% and 36%, excluding any impact from fourth quarter restructuring charges. Under the provisions of FAS 109, we continue to evaluate our ability to utilize net operating losses and corresponding deferred tax assets on an on-going basis with particular attention to deferred tax assets associated with losses sustained in China. If we determine we won't be able to utilize a loss, it may result in a valuation allowance, resulting in a charge to earnings.
Net income
Net income for the three-month period ended September 30, 2007 increased to $13.5 million compared to $13.2 million for the prior year period, and increased to $37.8 million for the first-nine months of the year compared to $17.0 million for the same period in 2006. The nine-month comparisons were impacted by pre-tax impairment and restructuring charges of $20.8 million and $11.1 million, respectively, in 2006.
Historically, our principal uses of cash have included operating expenses, particularly selling expenses, and working capital (principally inventory purchases), as well as capital expenditures, stock repurchases, dividends, debt repayment and the development of operations in new markets. We have generally relied on cash flow from operations to fund operating activities, and we have at times incurred long-term debt in order to fund strategic transactions and stock repurchases.
We typically generate positive cash flow from operations due to favorable gross margins and the variable nature of selling expenses, which constitute a significant percentage of operating expenses. We generated $31.4 million in cash from operations during the nine-month period ended September 30, 2007, compared to $48.4 million during the same period in 2006. The decrease in cash generated from operations is primarily due to fluctuations in receivables and inventory as well as the increase in taxes as a result of higher taxable income in 2007.
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As of September 30, 2007, working capital was $123.2 million, compared to $109.4 million as of December 31, 2006. Cash and cash equivalents, plus short-term investments, at September 30, 2007 and December 31, 2006 were $125.7 million and $121.4 million, respectively.
Capital expenditures in the first nine months of 2007 were $16.9 million. We anticipate additional capital expenditures of approximately $5 to $10 million through the remainder of 2007. These capital expenditures are primarily related to:
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We currently have debt pursuant to various credit facilities and other borrowings. The following table summarizes these debt arrangements as of September 30, 2007:
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Each of the credit facilities and arrangements listed in the table are secured by guarantees issued by our material domestic subsidiaries and by pledges of 65% of the outstanding stock of our material foreign subsidiaries.
The current portion of our long-term debt (i.e. becoming due in the next 12 months) includes $12.1 million of the balance on our 2000 Japanese yen denominated notes, $15.0 million of the balance on our U.S. dollar denominated debt under the 2003 multi-currency uncommitted shelf facility and all of the Korea line of credit.
Our board of directors has approved a stock repurchase program authorizing us to repurchase our outstanding shares of Class A common stock on the open market or in private transactions. The repurchases are used primarily for our equity incentive plans and strategic initiatives. During the first nine months of 2007, we repurchased approximately 2,659,000 shares of Class A common stock under this program for an aggregate amount of approximately $46.1 million. At September 30, 2007, approximately $14.6 million was available for repurchases under the stock repurchase program. On November 2, 2007, our board of directors authorized an increase of $100 million to our ongoing share repurchase authorization. We also entered into a $25 million accelerated repurchase transaction under this program on November 7, 2007.
In February, May and August 2007, our board of directors declared a quarterly cash dividend of $0.105 per share for all shares of Class A common stock. These quarterly cash dividends of $6.9 million, $6.8 million and $6.8 million were paid on March 21, 2007, June 20, 2007 and September 19, 2007 to stockholders of record on March 2, 2007, June 1, 2007 and August 31, 2007. Our board of directors recently approved payment of a dividend of $0.105 on December 12, 2007, to stockholders of record on November 30, 2007. Currently, we anticipate that our board of directors will continue to declare quarterly cash dividends and that the cash flows from operations will be sufficient to fund our future dividend payments. However, the continued declaration of dividends is subject to the discretion of our board of directors and will depend upon various factors, including our net earnings, financial condition, cash requirements, future prospects and other factors deemed relevant by our board of directors.
We believe we have sufficient liquidity to be able to meet our obligations on both a short- and long-term basis. We currently believe that existing cash balances, future cash flows from operations and existing lines of credit will be adequate to fund our cash needs on both a short- and long-term basis. The majority of our historical expenses have been variable in nature and as such, a potential reduction in the level of revenue would reduce our cash flow needs. In the event that our current cash balances, future cash flow from operations and current lines of credit are not sufficient to meet our obligations or strategic needs, we would consider raising additional funds in the debt or equity markets or restructuring our current debt obligations. Additionally, we would consider realigning our strategic plans, including a reduction in capital spending, stock repurchases or dividend payments.
Due to the international nature of our business, we are subject from time to time to reviews and audits by the foreign taxing authorities of the various jurisdictions in which we conduct business throughout the world. In 1999, we implemented a duty valuation methodology with respect to the importation of certain products into Japan. For purposes of the import transactions at issue, we had taken the position that, under applicable customs law, there was a sale between the manufacturer and our Japan subsidiary, and that customs duties should be assessed on the manufacturer’s invoice. The Valuation Department of the Yokohama customs authorities reviewed and approved this methodology at that time, and it had been reviewed on several occasions by the audit division of the Japan customs authorities since then. In connection with subsequent audits in 2004, the Yokohama customs authorities assessed us additional duties and penalties on these products imported into Japan from October 2002 to October 2004, based on a different valuation methodology than what was previously approved. With respect to the periods under audit, the customs authorities took the position that the relevant import transaction involved a sale between our U.S. affiliate and our Japan subsidiary and that duties should be assessed on the value of that transaction. We disputed this assessment. We also disputed the amount of duties we were required to pay on products imported from November of 2004 to June of 2005 for similar reasons. The total amount assessed or in dispute is approximately $25.0 million, net of any recovery of consumption taxes. Effective July 1, 2005, we implemented some modifications to our business structure in Japan and in the United States that we believe will eliminate any further customs valuation disputes on these issues with respect to product imports in Japan after that time.
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Because we believe the documentation and legal analysis supports our position and the valuation methodology we used with respect to the products in dispute had been reviewed and approved by the customs authorities in Japan, we believe the assessments are improper and we filed letters of protest with Yokohama customs with respect to this entire amount. Yokohama customs rejected our letters of protest, and to follow proper administrative procedures we filed appeals with the Japan Ministry of Finance. On June 26, 2006, we were advised that the Ministry of Finance had rejected the appeals filed with their office relating to the imports from October 2002 to October 2004. We decided to appeal this issue through the judicial court system in Japan, and on December 22, 2006 we filed a complaint with the Tokyo District Court Civil Action Section with respect to this period. In January 2007, we were advised that the Ministry of Finance also rejected our appeal with them for the imports from November 2004 to June 2005. We appealed this decision with the court system in Japan in July 2007. Currently, all appeals are pending with the Tokyo District Court Civil Action Section. One of the findings cited by the Ministry of Finance in its decisions was that we had treated the transactions as sales between our U.S. affiliate and our Japan subsidiary on our corporate income tax return under applicable income tax and transfer pricing laws. We have paid the $25.0 million in customs duties and assessments related to all of the amounts at issue, the amount of which we recorded in “Other Assets” in our Consolidated Balance Sheet. To the extent that we are unsuccessful in recovering the amounts assessed and paid, we will be required to take a corresponding charge to our earnings.
In Taiwan, we are currently subject to an audit by tax authorities with respect to the deductibility of distributor commission expenses in that market. In order to avoid the running of the statute of limitations with respect to the 1999, 2000 and 2001 tax years, the Taiwan tax authorities have disallowed our commission expense deductions for those years and assessed us a total of approximately $26.0 million. At this stage of the discussions, we are not required to pay the amount of tax under dispute. We are contesting this assessment and are in discussions with the tax authorities in an effort to resolve this matter. Based on our understanding of this matter, we do not believe that it is probable that we will incur a loss relating to this matter and accordingly have not provided any related reserves.
The following critical accounting policies and estimates should be read in conjunction with our audited consolidated financial statements and related notes thereto, and our interim unaudited consolidated financial statements and related notes thereto. Management considers the most critical accounting policies to be the recognition of revenue, accounting for income taxes, accounting for intangible assets and accounting for stock-based compensation. In each of these areas, management makes estimates based on historical results, current trends and future projections.
Revenue. We recognize revenue when products are shipped, which is when title and risk of loss pass to our independent distributors. With some exceptions in various countries, we offer a return policy whereby distributors can return unopened and unused product for up to 12 months subject to a 10% restocking fee. Reported revenue is net of returns, which have historically been less than 5% of gross sales. A reserve for product returns is accrued based on historical experience. We classify selling discounts as a reduction of revenue. Our selling expenses are computed pursuant to our global compensation plan for our distributors, which is focused on remunerating distributors based primarily upon the selling efforts of the distributors and the volume of products purchased by their downlines, and not their personal purchases.
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Income Taxes. We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” This statement establishes financial accounting and reporting standards for the effects of income taxes that result from an enterprise’s activities during the current and preceding years. It requires an asset and liability approach for financial accounting and reporting of income taxes. We pay income taxes in many foreign jurisdictions based on the profits realized in those jurisdictions, which can be significantly impacted by terms of intercompany transactions among our affiliates around the world. Deferred tax assets and liabilities are created in this process. As of September 30, 2007, we had net deferred tax assets of $53.7 million. These net deferred tax assets assume sufficient future earnings will exist for their realization, as well as the continued application of current tax rates. We have considered projected future taxable income and ongoing tax planning strategies in determining that no valuation allowance is required. In the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to earnings in the period such determination was made.
In June 2006, the FASB issued FASB Interpretation Number 48, Accounting for Uncertainty in Income Taxes – an Interpretation of SFAS 109, (“FIN 48”). We adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, we recognized a $2.6 million increase in the liability for unrecognized tax benefits, which was accounted for as a reduction to the January 1, 2007 balances of retained earnings and additional paid in capital.
We and our subsidiaries file income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. With a few exceptions, we are no longer subject to U.S. federal, state and local income tax examination by tax authorities for years before 2002. In major foreign jurisdictions, we are no longer subject to income tax examinations for years before 2000. We are currently under examination in a few foreign jurisdictions; however, the final outcomes of these reviews are not yet determinable.
At January 1, 2007, we had $13.8 million in unrecognized tax benefits of which $12.7 million, if recognized, would affect the effective tax rate. At the date of adoption, we had approximately $2.2 million of accrued interest and penalties related to uncertain tax positions. Interest and penalties related to uncertain tax positions are recognized as a component of income tax expense. The amount of unrecognized tax benefits decreased by a net amount of $1.2 million, during the three months ended September 30, 2007.
We are subject to regular audits by federal, state and foreign tax authorities. These audits may result in additional tax liabilities. We account for such contingent liabilities in accordance with FIN 48, and believe we have appropriately provided for income taxes for all years. Several factors drive the calculation of our tax reserves. Some of these factors include: (i) the expiration of various statutes of limitations; (ii) changes in tax law and regulations; (iii) issuance of tax rulings; and (iv) settlements with tax authorities. Changes in any of these factors may result in adjustments to our reserves, which would impact our reported financial results.
Intangible Assets. Under the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), our goodwill and intangible assets with indefinite useful lives are not amortized. Our intangible assets with finite lives are recorded at cost and amortized over their respective estimated useful lives and are reviewed for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We are required to make judgments regarding the useful lives of our intangible assets. With the implementation of SFAS 142, we determined certain intangible assets to have indefinite lives based upon our analysis of the requirements of SFAS No. 141, “Business Combinations” (“SFAS 141”) and SFAS 142. Under the provisions of SFAS 142, we are required to test these assets for impairment at least annually. No impairment charges related to intangible assets were recognized during the three- and nine-month periods ended September 30, 2007 or 2006. To the extent an impairment is identified in the future, we will record the amount of the impairment as an operating expense in the period in which it is identified.
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Stock-Based Compensation Expense. Effective January 1, 2006, we adopted the fair value recognition provisions of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), using the modified prospective transition method. Under this method we recognize compensation expense for all share-based payments granted after January 1, 2006 and prior to but not yet vested as of January 1, 2006, in accordance with SFAS 123R. Under the fair value recognition provisions of SFAS 123R, we recognize stock-based compensation net of any estimated forfeitures on a straight-line basis over the requisite service period of the award. The fair value of our stock-based compensation expense is based on estimates using the Black-Scholes option pricing model. This option-pricing model requires the input of highly subjective assumptions including the option’s expected life, risk-free interest rate, expected dividends and price volatility of the underlying stock. The stock price volatility assumption was determined using the historical volatility of our common stock. The compensation committee has made a determination that it will be transitioning to performance-based options rather than time-based options for members of the senior management team.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective January 1, 2008. We are currently evaluating the impact of SFAS 157 on our consolidated financial statements.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – including an amendment to FASB Statement No. 115, (“SFAS 159”), which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS 159 is effective January 1, 2008. We are currently evaluating the impact of SFAS 159 on our consolidated financial statements.
In addition to general economic factors, we are impacted by seasonal factors and trends such as major cultural events and vacation patterns. For example, most Asian markets celebrate their respective local New Year in the first quarter, which generally has a negative impact on that quarter. We believe that direct selling in Japan, the United States and Europe is also generally negatively impacted during the third quarter, when many individuals, including our distributors, traditionally take vacations.
We have experienced rapid revenue growth in certain new markets following commencement of operations. This initial rapid growth has often been followed by a period of stable or declining revenue, then followed by renewed growth fueled by product introductions, an increase in the number of active distributors and increased distributor productivity. The contraction following initial rapid growth has been more pronounced in certain new markets, due to other factors such as business or economic conditions or distributor distractions outside the market.
The following table provides information concerning the number of active and executive distributors as of the dates indicated. Active distributors are those distributors and preferred customers who were resident in the countries in which we operated and purchased products for resale or personal consumption directly from us during the three months ended as of the date indicated. Executive distributors are active distributors who have achieved required monthly personal and group sales volumes as well as employed full-time sales representatives in China who have completed a qualification process and receive a salary, labor benefits and bonuses based on their personal sales efforts.
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A majority of our revenue and many of our expenses are recognized outside of the United States, except for inventory purchases, which are primarily transacted in U.S. dollars from vendors in the United States. The local currency of each of our Subsidiaries’ primary markets is considered the functional currency. All revenue and expenses are translated at weighted-average exchange rates for the periods reported. Therefore, our reported revenue and earnings will be positively impacted by a weakening of the U.S. dollar and will be negatively impacted by a strengthening of the U.S. dollar. The Chinese government is beginning to allow the yuan to float more freely against the U.S. dollar and other major currencies. A strengthening of the yuan benefits our reported revenue and profits and a weakening of the yuan negatively impacts reported revenue and profits. Similarly, given the large portion of our business derived from Japan, any weakening of the yen negatively impacts reported revenue and profits, whereas a strengthening of the yen positively impacts our reported revenue and profits. Given the uncertainty of exchange rate fluctuations, we cannot estimate the effect of these fluctuations on our future business, product pricing and results of operations or financial condition.
We seek to reduce our exposure to fluctuations in foreign currency exchange rates through the use of foreign currency exchange contracts, through intercompany loans of foreign currency and through our Japanese yen-denominated debt. We do not use derivative financial instruments for trading or speculative purposes. We regularly monitor our foreign currency risks and periodically take measures to reduce the impact of foreign exchange fluctuations on our operating results.
Our foreign currency derivatives are comprised of over-the-counter forward contracts with major international financial institutions. As of September 30, 2007, we had $0.9 million of these contracts with expiration dates through September 2008. All of these contracts were denominated in Japanese yen. For the three- and nine-month periods ended September 30, 2007, we recorded pre-tax gains of approximately zero and $0.4 million, which were included in our revenue in Japan, and gains/(losses) of $(0.1) million and $0.2 million as of September 30, 2007 and December 31, 2006, net of tax, in other comprehensive income related to the fair market valuation of our outstanding forward contracts. Based on our foreign exchange contracts at September 30, 2007, the impact of a 10% appreciation or 10% depreciation of the U.S. dollar against the Japanese yen would not represent a material potential loss in fair value, earnings or cash flows against these contracts. This potential loss does not consider the underlying foreign currency transaction or translation exposures to which we are subject.
With the exception of historical facts, the statements contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 that reflect our current expectations and beliefs regarding our future results of operations, performance and achievements. These statements are subject to risks and uncertainties and are based upon assumptions and beliefs that may not materialize. These forward-looking statements include, but are not limited to, statements concerning:
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In addition, when used in this report, the words or phrases “will likely result,” “expect,” “anticipate,” “will continue,” “intend,” “plan,” “believe” and similar expressions are intended to help identify forward-looking statements.
We wish to caution readers that our operating results are subject to various risks and uncertainties that could cause our actual results and outcomes to differ materially from those discussed or anticipated. Reference is made to the risks and uncertainties described below and in our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and amendments thereto (which contains a more detailed discussion of the risks and uncertainties related to our business). We also wish to advise readers not to place any undue reliance on the forward-looking statements contained in this report, which reflect our beliefs and expectations only as of the date of this report. We assume no obligation to update or revise these forward-looking statements to reflect new events or circumstances or any changes in our beliefs or expectations, except as required by law. Some of the risks and uncertainties that might cause actual results to differ from those anticipated include, but are not limited to, the following:
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(a) Because a substantial majority of our sales are generated in Asia, particularly Japan, significant variations in operating results including revenue, gross margin and net income from those expected could be caused by:
(b) Our operations in China are subject to significant regulatory scrutiny, and we have experienced challenges in the past, including interruption of sales activities at certain stores and fines being paid in some cases. Because of the government’s significant concerns about direct selling activities, government regulators in China scrutinize very closely activities of direct selling companies. Even though we have now obtained a direct selling license, we anticipate that government regulators will continue to scrutinize our activities and the activities of our distributors and sales employees to monitor our compliance with the new regulations and other applicable regulations as we integrate direct selling into our business model. We continue to be subject to current governmental reviews and investigations. Any determination that our operations or activities, or the activities of our employed sales representatives or distributors, are not in compliance with applicable regulations, could result in the imposition of substantial fines, extended interruptions of business, termination of necessary licenses and permits, including our direct selling licenses, or restrictions on our ability to open new stores or obtain approvals for service centers or expand into new locations, all of which could harm our business.
(c) China’s anti-pyramiding and direct selling regulations allow direct selling but contain significant restrictions and limitations, including a restriction on multi-level compensation. Government regulators, both on a national and local level, have significant discretion in interpreting and applying these regulations. As a result, the development of direct selling in this market continues to evolve and there continues to be a high level of uncertainty and ambiguity regarding the interpretation and enforcement of these regulations. Our business and our growth prospects may be harmed if Chinese regulators interpret the anti-pyramiding regulations or direct selling regulations in such a manner that our current method of conducting business through the use of employed sales representatives violates these regulations. In particular, our business would be harmed by any determination that our current method of compensating our sales employees, including our use of the sales productivity of a sales employee and the group of sales employees whom he or she trains and supervises as one of the factors in establishing such sales employee’s salary and compensation, violates the restriction on multi-level compensation under the new rules. Our business could also be harmed if regulators inhibit our ability to concurrently operate our retail store/employed sales representative business model and our direct selling business. Although we have obtained a direct selling license in China, our current license only allows us to conduct direct selling in a limited area in Shanghai. If we are unable to establish required service centers or obtain additional necessary national and local licensing as quickly as we would like, or if we are not able to offer a direct selling opportunity that is attractive to distributors as a result of the limitations under the direct selling regulations, our ability to grow our business there could be negatively impacted.
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(d) Our ability to retain key and executive level distributors or to sponsor new executive distributors is critical to our success. Like most direct selling companies, we experience high turnover among distributors from year to year. Because our products are distributed exclusively through our distributors and we compete with other direct selling companies in attracting distributors, our operating results could be adversely affected if our existing and new business opportunities and incentives, products, business tools and other initiatives do not generate sufficient enthusiasm and economic incentive to retain our existing distributors and increase sponsorship of new distributors and preferred customers on a sustained basis. In addition, in our more mature markets, one of the challenges we face is keeping distributor leaders, who have large, established sales networks generating high commission levels, motivated and actively engaged in business building activities and in developing new distributor leaders. There can be no assurance that our initiatives such as the Scanner, Galvanic II, and others will continue to generate excitement among our distributors in the long-term or that planned initiatives will be successful in maintaining distributor activity and productivity or in motivating distributor leaders to remain engaged in business building and developing new distributor leaders. In addition, some initiatives may have unanticipated negative impacts on our markets. For example, modifications made to compensation incentives, at times, have not been well received and contributed to declines in distributor numbers and revenue results.
(e) Our use of the Scanner, ProDerm and the Galvanic Spa II are subject to regulatory risks and uncertainties in our various markets. For example, in March 2003 the United States Food and Drug Administration (the “FDA”) questioned the status of the Scanner as a non-medical device and we subsequently filed an application with the FDA to have the Scanner classified as a non-medical device. The FDA has not yet acted on our application. There are various factors that could determine whether a tool is a medical device, including the claims that we or our distributors make about it. We face similar regulatory issues in other markets. For example, we faced regulatory inquiries in Singapore, Korea and Japan regarding distributor claims with respect to the Scanner. Although these matters have not resulted in any adverse action against us, our revenue in any market going forward could be negatively impacted if we face similar issues in the future or if such inquiries weaken distributor enthusiasm surrounding a tool. A determination in any market that a tool is a medical device or that distributors are using it to make medical claims could negatively impact our ability to use a tool in such market. In addition, if distributors make claims regarding a tool outside of claims approved by us, or use it in a manner not authorized by us, this could result in regulatory actions against our business.
(f) Our current and planned initiatives surrounding the S2 Scanner and the Nu Skin® ProDerm™ skin analysis tool in our various markets are subject to technical and regulatory risks and uncertainties. The S2 Scanner and ProDerm are newly developed tools and we cannot be certain that they will consistently meet performance expectations. If we continue to experience difficulties or delays in completing this process that prevent us from meeting our launch schedules or developing a tool that performs the desired functions, our business may be harmed. Our plans are also subject to regulatory risks, particularly in Japan, where regulatory requirements impose limitations on the use of this tool and on claims that may be made in connection with its use. Such limitations in Japan or any other markets could weaken the ability of our distributors to utilize our tools in building their businesses, and could dampen distributor enthusiasm surrounding it.
(g) As we work to grow operations in developing markets, work through the approval processes for expansion of direct selling in China and look to develop other new markets, we anticipate that some distributor leaders in other markets will shift their focus away from their home markets and towards business prospects in these markets. This shift of focus of distributor leaders can negatively impact distributor leadership and growth in these other markets and consequently negatively impact revenue. In addition, if China or other markets are not as successful as the distributor leaders from these other markets anticipate, this can also dampen distributor enthusiasm.
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(h) As we take steps to improve gross margins and reduce overhead, there could be unintended negative consequences, including business disruptions, revenue declines and/or a loss of employees. Further, we may not realize the cost improvements and greater efficiencies as we hope for as a result of unanticipated expenses or business developments or the inability to effectively implement our strategic plans. In addition, as we continually evaluate strategic reinvestment of any savings generated as a result of our restructuring efforts, we may not ultimately achieve the amount of savings that we currently anticipate.
(i) The network marketing industry is subject to various laws and regulations throughout our markets, many of which involve a high level of subjectivity and are inherently fact-based and subject to interpretation. Our business could be harmed if our distributors engage in activities that are found to be in violation of these laws. In Japan, we have experienced an increase in complaints to consumer protection agencies related to distributor activities over the last year. As a result, we have performed additional training for distributors in this market to try to resolve these issues. If the level of complaints further increases or does not improve, regulators could take action against us or we may need to take more aggressive measures, either of which could harm our business. The FTC in the United States is also proposing new regulations that would impose new requirements that could be burdensome and harm our business in this market, including the requirement that new distributors would have to wait for a period of time before they could sign a distributor agreement. Our business could be harmed if we are found to be in violation of these laws related to network marketing or if any of our distributors engage in activities that violate applicable laws.
(j) The nutritional supplement industry is subject to various laws and regulations throughout our markets. If our existing products, or any new products, are challenged or found to contravene any of these laws by any governmental agency, our revenue and profitability may be harmed. There has been increased regulatory scrutiny of supplements, particularly in Europe where we have been asked to stop selling a few products. In Denmark, the local authorities ruled that our G3 product contained a “novel” food (an ingredient they felt had not been previously marketed in such market), which would require a lengthier registration process before we could begin selling it again in this market. In addition, we recently have been prevented from selling our IGG Boost product in Denmark and our Cholestin product in the Netherlands for various regulatory reasons. New laws and regulations governing the sale and distribution of nutritional supplements have been proposed or enacted in various markets, including Europe, South Korea and Hong Kong and may require us to reformulate some products, seek new registration of such products, or limit the claims we can make with respect to products. In addition the FDA recently enacted new GMPs for supplement companies that will go into effect in the next year. These new regulations and any increased governmental scrutiny could harm our sales of these products if regulators take positions that impact our ability to sell current products, if new regulations require us to reformulate products or effect new product registrations, or if we are not able to effect necessary changes in a timely and efficient manner to respond to new regulations including the GMPs.
(k) Due to the international nature of our business, we are subject from time to time to reviews and audits by the foreign taxing authorities of the various jurisdictions in which we conduct business throughout the world. These audits sometimes result in challenges by such taxing authorities as to our methodologies used in determining our income tax, duties, customs, and other amounts owed in connection with the importation and distribution of our products. For example, we have been assessed by the Japan customs authorities for additional duties on products imported into Japan, and we are currently contesting this assessment. Audits are also often focused on whether or not certain expenses are deductible for tax purposes in a given country. Currently, audits are underway with respect to this issue in a number of our markets, including Taiwan. To the extent we are unable to successfully defend ourselves against such audits and reviews, we may be required to pay assessments and penalties and increased duties, which may, individually or in the aggregate, negatively impact our gross margins and operating results.
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(l) Production difficulties and quality control problems could harm our business, in particular our reliance on third party suppliers to deliver quality products in a timely manner. Occasionally, we have experienced production difficulties with respect to our products, including the delivery of products that do not meet our quality control standards. These quality problems have resulted in the past, and could result in the future, in stock outages or shortages in our markets with respect to such products, harming our sales and creating inventory write-offs for unusable products.
The information required by Item 3 of Part I of this Form 10-Q is incorporated herein by reference from the section entitled “Currency Risk and Exchange Rate Information” in “Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations” of Part I and also in Note 6 to the Financial Statements contained in Item 1 of Part I.
As of the end of the period covered by this report, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, our disclosure controls and procedures were effective as of September 30, 2007.
There have been no changes in our internal control over financial reporting (as defined in Rule 13a-15 (f) under the Exchange Act) during the most recent fiscal quarter covered by this report, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Please refer to our recent SEC filings, including our Annual Report on Form 10-K for the 2006 fiscal year and our Quarterly Reports on Form 10-Q, for information regarding the status of certain legal proceedings that have been previously reported.
Please refer to our recent SEC filings, including our Annual Report on Form 10-K for the 2006 fiscal year and our Quarterly Reports on Form 10-Q, for information on risks associated with our business.
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In August 1998, our board of directors approved a plan to repurchase $10.0 million of our Class A common stock on the open market or in private transactions. Our board has from time to time increased the amount authorized under the plan and a total amount of $235.0 million was authorized as of September 30, 2007. As of September 30, 2007, we had repurchased approximately $220.4 million of shares under the plan. There has been no termination or expiration of the plan since the initial date of approval. Our board has recently authorized an increase of $100 million to our share repurchase program. In addition, we entered into a $25 million accelerated repurchase transaction under this program.
We have authorized the repurchase of shares acquired by our distributors and employees in foreign markets because of regulatory and other issues that make it difficult and costly for these persons to sell such shares in the open market. These shares were awarded or acquired in connection with our initial public offering in 1996. Of the shares listed in this column, 214 shares for August relate to repurchases from such distributors/employees at an average per share price of $16.97.
None.
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
November 9, 2007
By: /s/ Ritch N. Wood Ritch N. WoodIts: Chief Financial Officer (Duly Authorized Officer and Principal Financial and Accounting Officer)
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