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 April 28, 2006, 70,235,778 shares of the registrant's Class A common stock, $.001 par value per share were outstanding.
Pursuant to Rule 12b(25), Item 4 of Part I and the certifications of our chief exectuive officer and chief financial officer pursuant to Sections 902 and 306 of the Sarbanes Oxley Act of 2002 are omitted.
Nu Skin, Pharmanex and Big Planet are trademarks of Nu Skin Enterprises, Inc. or its subsidiaries.
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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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Option activity under the plans as of March 31, 2006 and changes during the three months ended March 31, 2006 were as follows:
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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/A for the year ended December 31, 2005, filed with the Securities and Exchange Commission (“SEC”) on March 17, 2006, 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-month period ended March 31, 2006 decreased 8% to $265.8 million compared to the same period in 2005. The decrease in revenue was primarily attributable to local currency declines in Japan and China and a 3% negative impact of foreign currency exchange rate fluctuations, particularly as a result of weakening of the Japanese yen. Revenue was positively impacted by growth in South Korea, the United States and Europe, and expansion into Indonesia during 2005.
During the first quarter of 2006, we recorded a loss per share of $.15, compared to earnings per share of $.25 for the same period in 2005. Earnings were negatively impacted by restructuring charges and impairment and other charges totaling $32.0 million, or $.29 per share, relating to a business transformation initiative that we implemented during the first quarter. These charges are more fully described in the sections below entitled “Impairment of assets and other” and “Restructuring and other charges.” Earnings for the first quarter of 2006 were also negatively impacted by foreign currency exchange fluctuations, lower revenue in Japan and China, and a $5.0 million convention expense in Japan that was not incurred in the prior year period. Earnings for the first quarter also include $1.9 million in stock option expense as a result of the implementation of a new accounting standard requiring the expensing of stock options beginning in the first quarter of 2006.
Revenue
North Asia. The following table sets forth revenue for the three-month periods ended March 31, 2006 and 2005 for the North Asia region and its principal markets (in millions):
Foreign currency exchange rate fluctuations, particularly a significant weakening of the Japanese yen, negatively impacted revenue in North Asia by 6%. Revenue in this region was also negatively impacted by an 11% local currency decline in Japan in the first quarter of 2006 compared to the same prior year period. The executive distributor count in Japan decreased 8% compared to the prior year period.
We have experienced declines in revenue and executive and active distributor counts during the last several quarters, due to several factors that continued to negatively impact year-over-year comparisons in Japan during the first quarter of 2006, including:
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Effective April 1, 2006, we implemented enhancements to distributor incentives in Japan in order to address the negative impact of the previous changes, although we anticipate that it could take a couple of quarters before we begin to see a positive impact on revenue as a result of these changes. In addition, in March of 2006 we launched the S2 Scanner in Japan, and we plan to launch our g3 nutrition drink in June, subject to necessary regulatory clearances. In our personal care category, we continue to work through the regulatory process in preparation for the launch of our Nu Skin® ProDerm™ Skin Analyzer (the “ProDerm Skin Analyzer”), a handheld skin analysis tool, scheduled to begin later this year. We are also implementing a corporate image enhancement campaign that will include facility upgrades, media campaigns and various other initiatives.
Our South Korea market continued its strong growth in the first quarter of 2006 in both our personal care and nutrition businesses, becoming our third largest market and increasing 24% on a local currency basis compared to the same period in 2005. Executive and active distributor counts continued to grow significantly as well. We believe that these results are due to strong product and other initiatives and alignment of our distributor leaders behind these initiatives.
Greater China. The following table sets forth revenue for the three-month periods ended March 31, 2006 and 2005 for the Greater China region and its principal markets (in millions):
Foreign currency exchange rate fluctuations did not significantly impact reported revenue in the Greater China region in the first quarter of 2006. China revenue decreased by 28% on a local currency basis in the first quarter of 2006 compared to the same period in 2005. We believe that continued consumer uncertainty in China regarding the impact of recently enacted direct selling regulations and uncertainty regarding the timing of the direct selling application process negatively impacted sales, and contributed to a 25% and 14% decline in our executive and active distributor counts, respectively, on a year-over-year basis in that market. In addition, we have experienced increased government and media scrutiny in China due to our status as a leading, global direct selling company and the increased focus on the direct selling industry, particularly following last year’s publication of the new direct selling regulations. We are also facing increasing instances of certain sales employees making product sales through unauthorized channels at discounted prices. As a result of these and certain other activities of some of our sales representatives, we have focused on training our sales employees and enforcing our employee policies. We also made certain changes to our compensation plan last year in preparation for the anticipated addition of direct selling to our business model. These changes negatively impacted revenue as our sales representatives adapted to them. We continue to work through the direct selling application process and we look forward to being able to begin augmenting our current business model with a direct selling component after receiving a direct selling license. During the last couple of quarters, we have also experienced some increased product supply challenges in China as well as Taiwan and Hong Kong that have resulted in stock outages and delayed product launches.
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We recently launched the S2 Scanner and g3 nutrition drink in China. We also plan to launch the ProDerm Skin Analyzer in early 2007, which we anticipate will help reinvigorate enthusiasm for our Nu Skin products following declines in Nu Skin sales during the past year as sales leaders shifted their focus towards Pharmanex products. We also plan to continue to invest resources in continued expansion and build-out of our infrastructure in China.
Revenue in Taiwan grew 2% on a local currency basis in the first quarter of 2006 compared to the same prior year period, driven by continued success with the Scanner and new products such as g3 and relaunched Nu Skin 180°™, as well as other initiatives. Hong Kong revenue was down 2% in local currency on a year-over-year basis in the first quarter. Sales to Chinese sales representatives purchasing in Hong Kong declined substantially compared to the same prior year period as additional Pharmanex products were introduced in China throughout 2005. Sales to Hong Kong distributors, however, increased on a year-over-year basis. Sales in both Taiwan and Hong Kong were bolstered by purchasing in advance of an April 1 price increase in these markets. Our executive distributor counts in Taiwan and Hong Kong remained strong, growing 3% and 12%, respectively, in the first quarter of 2006 compared to the same prior year period.
North America. The following table sets forth revenue for the three-month periods ended March 31, 2006 and 2005 for the North America region and its principal markets (in millions):
The increase in revenue in the United States was primarily related to growth in our digital imaging service and the positive response to the introduction of a number of new, innovative products and initiatives during the past year. In addition, subscription order revenue represented 61% of revenue in the first quarter of 2006, a 17% increase compared to the prior year period. These initiatives, as well as the recent launch of the S2 Scanner in the United States, have enhanced distributor enthusiasm and sponsorship. Our executive and active distributor counts grew 18% and 3%, respectively, in the first quarter of 2006 compared to the same prior year period. We also look forward to the upcoming launch of the ProDerm Skin Analyzer. We plan to introduce a limited number of initial units of this tool in the United States during the second quarter of 2006. This first version will enable distributors to demonstrate the effectiveness of our skin care products by providing close up skin images, while we continue to work on developing a model that will quantify skin conditions and attributes.
South Asia/Pacific. The following table sets forth revenue for the three-month periods ended March 31, 2006 and 2005 for the South Asia/Pacific region and its principal markets (in millions):
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Foreign currency exchange rate fluctuations negatively impacted revenue in South Asia/Pacific by 1% during the first quarter of 2006 compared to the same period in 2005. This region benefited from $2.5 million in revenue during the first quarter from Indonesia, which we opened for business in August of 2005. Year-over-year revenue comparisons in Singapore/Malaysia/Brunei were negatively impacted by continued declines following the opening of Indonesia as some of our distributor leaders in these markets have focused their attention on business opportunities in Indonesia and away from their home markets, as well as negative impacts from modifications to distributor incentives implemented in September of 2005. In the first quarter we also experienced declines in executive and active distributor counts in Singapore/Malaysia/Brunei as excitement surrounding the Indonesia opening faded to some degree.
Other Markets. The following table sets forth revenue for the three-month periods ended March 31, 2006 and 2005 for our Other Markets (in millions):
Revenue growth in Europe resulted from continued success with the Scanner, the recent introduction of the S2 Scanner, our product subscription program, and continued expansion into Eastern Europe. Distributor sponsorship and leadership also remained strong, and we believe that our success in Europe is in part attributable to the strong alignment of distributor leaders behind certain initiatives in the various local markets. In April 2006, we opened operations in Russia, and we expect this market to contribute positively to our business in the Europe region.
Gross profit
Gross profit as a percentage of revenue decreased to 82.3% for the three-month period ended March 31, 2006, from 82.8% for the same period in 2005. Lower gross margins resulted from a strengthening of the U.S. dollar, particularly against the Japanese yen.
Selling expenses
Selling expenses as a percentage of revenue decreased to 42.3% for the three-month period ended March 31, 2006 from 42.8% for the same period in 2005. This decrease is attributable primarily to lower revenue in China, where selling expenses are generally higher as a percent of revenue compared to other markets, as well as short-term incentives paid in Japan in the prior year period. With the implementation of some additional enhancements to our compensation plan in Japan, we anticipate this could slightly increase selling expenses as a percentage of revenue going forward.
General and administrative expenses
General and administrative expenses as a percentage of revenue for the three-month period ended March 31, 2006 increased to 33.9% from 30.1% for the same period in 2005. In U.S. dollars, general and administrative expenses for the three-month period ended March 31, 2006 increased to $90.0 million from $87.2 million for the same period in 2005. General and administrative expenses as a percentage of revenue for the first quarter of 2006 were impacted by:
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Impairment of assets and other
During the first quarter of 2006, we recorded impairment charges of $20.8 million, primarily relating to our first generation BioPhotonic Scanners. In February 2006, as a result of our launch of and transition to the second generation BioPhotonic Scanner, we determined it was necessary to write down the book value of the existing inventory of the prior model of the Scanner. The impairment charges relating to the Scanner recorded during the quarter ended March 31, 2006 totaled $19.0 million.
In addition, during the first quarter of 2006 we completed a settlement agreement with a Big Planet vendor to terminate our purchase commitments for video technology for approximately $1.8 million as we looked to change direction with our Big Planet business.
Restructuring and other charges
During the first quarter of 2006, we recorded restructuring and other charges of $11.1 million, primarily relating to our business transformation initiative designed to (i) eliminate organizational redundancies, (ii) revamp administrative support functions, (iii) prioritize investments to favor profitable initiatives and markets, and (iv) increase efficiencies in the supply chain process. As a result, our overall headcount was reduced by approximately 225 employees, the majority of which related to the elimination of positions at our U.S. headquarters. These expenses consisted primarily of severance and other compensation charges.
Although our business transformation initiative will be an ongoing process, nearly all of the restructuring expenses related to the transformation were incurred during the first quarter of 2006. We believe that these initiatives will generate savings of approximately $14 million in 2006 and approximately $30 million in 2007. We plan to reinvest a portion of these savings towards various growth initiatives, particularly in Japan and the roll-out of the S2 Scanner.
Other income (expense), net
Other income (expense), net for the three-month period ended March 31, 2006 was approximately $1.1 million of expense compared to $0.7 million of expense for the same period in 2005. Fluctuations in other income (expense), net are impacted by interest expense and 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. The increase in other expense in 2005 was primarily a result of the effect of foreign exchange fluctuation on our yen-based bank debt.
Provision for income taxes
Provision for income taxes for the three-month period ended March 31, 2006 was a $6.2 million benefit compared to a $10.4 million expense for the same period in 2005. The effective tax rate was 37.5% of pre-tax income during the three-month period ended March 31, 2006, compared to the rate of 37.0% in the same prior-year period.
Net income (loss)
As a result of the foregoing factors, net income (loss) for the three-month period ended March 31, 2006 decreased to a loss of $10.3 million from income of $17.7 million for the same period in 2005.
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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 and dividends, 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 $11.6 million in cash from operations during the three-month period ended March 31, 2006, compared to $29.1 million during the same period in 2005. This decrease in cash generated from operations is due to lower revenue and profitability in 2006 as well as the increased payment of taxes during the first quarter of 2006.
As of March 31, 2006, working capital was $143.8 million, compared to $149.1 million as of December 31, 2005. Cash and cash equivalents at March 31, 2006 and December 31, 2005 were $129.8 million and $155.4 million, respectively. The decrease in cash balances and working capital was primarily due to the shift at March 31, 2006 in cash and cash equivalents to short-term investments as well as the payment of consumption taxes in Japan during the first quarter of 2006.
We anticipate capital expenditures of approximately $40 million to $45 million for 2006, of which we incurred $13.6 million in the first quarter. These capital expenditures are primarily related to:
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We currently have long-term debt pursuant to various credit facilities and other borrowings. The following table summarizes these long-term debt arrangements as of March 31, 2006:
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% to 100% 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 $11.8 million of the balance on our 2000 Japanese yen denominated notes and $15.0 million of the balance on our U.S. dollar denominated debt under the 2003 multi-currency uncommitted shelf facility.
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 quarter of 2006, we repurchased approximately 10,000 shares of Class A common stock under this program for an aggregate amount of approximately $0.2 million. Currently, approximately $52.3 million is available under the stock repurchase program for repurchases.
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In February 2006, our board of directors declared a quarterly cash dividend of $0.10 per share for all shares of Class A common stock. This quarterly cash dividend of $7.0 million was paid on March 22, 2006 to stockholders of record on March 3, 2006. 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 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. The Valuation Department of the Yokohama customs authorities reviewed and approved this methodology at that time, and it has been reviewed on several occasions by the audit division of the Japan customs authorities since then. In connection with recent audits, the Yokohama customs authorities have 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. We have also disputed the amount of duties we were required to pay on products imported from November of 2004 to June of 2005. 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 with respect to product imports in Japan after that time.
Because 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 have filed letters of protest with Yokohama customs with respect to most of this amount, and intend to file letters of protest with respect to the rest. Yokohama customs has not accepted our letters of protest to date, and to follow proper administrative procedures we have filed appeals with the Japan Ministry of Finance. To the extent necessary, we plan to continue to file protests and appeals within the appropriate governmental channels concerning this issue. We may also choose to use the judicial court system in Japan if necessary to bring this issue to a resolution. In order to file our letters of protest, we were required to pay the $25.0 million in customs duties and assessments, 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 and 2000 tax years, the Taiwan tax authorities have disallowed our commission expense deductions for those years and assessed us a total of approximately $18.7 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.
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Stock-Based Compensation Expense
Effective January 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”) using the modified prospective transition method and therefore have not restated results for prior periods. Our results of operations for the first quarter of 2006 were impacted by the recognition of non-cash expense related to the fair value of our stock-based compensation awards. During the first quarter of 2006, we recorded $1.9 million in pre-tax stock-based compensation expense. Total stock-based compensation expense, net of tax, for the three months ended March 31, 2006 was $1.2 million.
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 upon the selling efforts of the distributors and their downlines, and not their personal purchases.
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 March 31, 2006, we had net deferred tax assets of $28.3 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.
Our foreign taxes paid are high relative to foreign operating income and our U.S. taxes paid are low relative to U.S. operating income due largely to the flow of funds among our Subsidiaries around the world. As payments for services, management fees, license arrangements and royalties are made from our foreign affiliates to our U.S. corporate headquarters, these payments often incur withholding and other forms of tax that are generally creditable for U.S. tax purposes. Therefore, these payments lead to increased foreign effective tax rates and lower U.S. effective tax rates. Variations (or shifts) occur in our foreign and U.S. effective tax rates from year to year depending on several factors, including the impact of global transfer prices and the timing and level of remittances from foreign affiliates.
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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 SFAS No. 5, “Accounting for Contingencies,” 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 definite 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.” For example, with the recent completion of the earnout payments in connection with the acquisition of Scanner-related technology, we have recorded an intangible asset of approximately $42.0 million, which we are amortizing over the life of the patent related to the technology. We are required to make judgments regarding the useful life 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-month periods ended March 31, 2006 or 2005. 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.
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, and therefore have not restated prior periods’ results. 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 forfeiture rate and only recognize compensation cost for those shares expected to vest 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 a combination of historical and implied volatility of the Company’s common stock.
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 short 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.
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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.
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 would benefit our reported revenue and profits and a weakening of the yuan would negatively impact reported revenue and profits. In addition, in recent months we have seen a weakening of the Japanese yen against the U.S. dollar. Any further weakening of the yen would negatively impact 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 March 31, 2006, we had $19.5 million of these contracts with expiration dates through March 2007. All of these contracts were denominated in Japanese yen. For the three-month period ended March 31, 2006, we recorded pre-tax gains of $2.2 million, which were offset against our revenue in Japan, and gains of $0.3 million as of March 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 March 31, 2006, 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.
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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:
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 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. 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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Because a substantial majority of our sales are generated in Asia, particularly Japan, significant variations in operating results including revenue, gross margin and earnings from those expected could be caused by:
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 minor fines being paid in some cases. Because of current restrictions on direct selling, government regulators in China scrutinize very closely activities of direct selling companies or activities that resemble direct selling. Although China has recently adopted new direct selling regulations, we have not yet received a direct selling license, and we continue to operate using our retail store/employed sales representative model. Government scrutiny has increased following the adoption of new direct selling and anti-pyramiding regulations, and we continue to be subject to various investigations and inquiries by regulators regarding our business model. In addition, we could face risks that any improper actions by our local sales employees, or any overseas distributors, in violation of local laws or our policies could result in regulatory investigations and penalties that could harm our business. The regulatory environment in China is rapidly evolving, and government officials in China often exercise significant discretion in deciding how to interpret and apply applicable regulations. Any determination that our operations or activities, or the activities of our employed sales representatives or distributors living outside China, are not in compliance with applicable regulations, could result in the imposition of substantial fines, extended interruptions of business, restrictions on our ability to obtain a direct selling license, open new stores or obtain approvals for service centers or expand into new locations, changes to our business model, the termination of required licenses to conduct business, limitations on the number of sales persons we can employ, all of which could harm our business.
Towards the end of 2005, Chinese regulators adopted anti-pyramiding and new direct selling regulations that will allow direct selling but contain significant restrictions and limitations, including a restriction on multi-level compensation. Although we have applied for a direct selling license and anticipate that we will be able to obtain a direct selling license under these regulations, the timing and application process are not clear, and there can be no assurance that we will be able to obtain such a license. Our future growth in China could be harmed if we do not receive a direct selling license or if the direct selling application process is delayed further than anticipated. Also, we may face increased competition or competitive disadvantages if other companies begin receiving direct selling licenses before we do. In addition, these new regulations are not yet well understood, and there continues to be some confusion and uncertainty as to the meaning of the new regulations and the specific types of restrictions and requirements imposed under them. It is also difficult to predict how regulators will interpret and enforce these new regulations and the impact of these new regulations on pending regulatory reviews and investigations. 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 planned direct selling business. In addition, there can be no assurance that we will be able to successfully grow our business through direct selling activities given the restrictive nature of the new direct selling regulations.
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Our ability to retain key and executive level distributors or to sponsor new executive distributors is critical to our success. 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 or to sponsor new distributors on a sustained basis. In addition, in our more mature markets, one of the challenges we face is keeping distributor leaders with established businesses and high income 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 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, during the past year certain modifications were made to compensation incentives in China, Japan, and Singapore that appear not to have been as well received by some distributors as expected, contributing to declines in distributor numbers and revenue results. We have recently implemented compensation plan enhancements in Japan designed to address the negative impacts of previous changes, but there can be no assurance that these measures will be successful in generating distributor excitement.
Our use of the Scanner is 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 its status 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 the Scanner is a medical device, including the claims that we or our distributors make about it. We face similar regulatory issues in other markets with respect to the status of the Scanner as a non-medical device and the claims that can be made in using it. For example, during the past year 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 the Scanner. A determination in any market that the Scanner is a medical device or that distributors are using it to make medical claims could negatively impact our ability to use the Scanner in such market. In addition, if distributors make claims regarding the Scanner 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.
Our current and planned initiatives surrounding the introduction of 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 is a newly developed tool and we cannot be certain that it will consistently meet performance expectations. In addition, we are currently in the process of finalizing the hardware and software design specifications for our ProDerm unit. We have experienced delays and challenges in completion of the design that will quantify skin conditions and attributes. 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 we are currently working through the regulatory process for the planned introduction of the ProDerm™ tool in that market. There is a risk that regulatory authorities in Japan may 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 this tool in building their businesses, and could dampen distributor enthusiasm surrounding it.
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As we begin operations in Russia, prepare for the implementation of direct selling regulations 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 two 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 Russia and China are not as successful as the distributor leaders from these other markets anticipate, this can also dampen distributor enthusiasm.
As we implement our business transformation initiative, there could be unintended negative consequences, including business disruptions 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 this realignment.
The network marketing and nutritional supplement industries are 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. Recent negative publicity concerning certain supplements with controversial ingredients has spurred efforts to change existing regulations or adopt new regulations in order to impose further restrictions and regulatory control over the nutritional supplement industry. If our existing business practices or products, or any new initiatives or products, are challenged or found to contravene any of these laws by any governmental agency or other third party, or if there are any changes in regulations applicable to our business or any of our nutritional products that limit our ability to market such products, our revenue and profitability may be harmed.
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 were recently 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.
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 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 5 to the Financial Statements contained in Item 1 of Part I.
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OMITTED
No updates to report. Please refer to our recent SEC filings, including our Annual Report on Form 10-K for the 2005 fiscal year, and amendments thereto for information regarding the status of certain legal proceedings.
Our 2005 Annual Report on Form 10-K, and amendments thereto, includes a detailed discussion of our risk factors. The information presented below updates four of those risk factors and should be read in conjunction with the risk factors and information disclosed in that Form 10-K.
Because our Japanese operations account for a majority of our business, adverse changes in our business operations in Japan would harm our business.
Approximately 48% of our 2005 revenue was generated in Japan. We have experienced declines in our business in this market during the past several quarters, and many of our competitors have seen their businesses in this market contract in the last few years. We believe our operating results have been negatively impacted by a variety of factors, including the unanticipated impact of compensation plan changes, regulatory issues, and production difficulties. In addition, we continue to face increasing competition from existing and new competitors in Japan. Our financial results would be harmed and our business could continue to decline if our products, business opportunity or planned growth initiatives do not retain and generate continued interest and enthusiasm among our distributors and consumers in this market. Current and planned initiatives in this market include the introduction of the second-generation BioPhotonic Scanner, the Nu Skin® ProDerm™ Skin Analyzer and g3 nutrition drink. We have also recently introduced compensation plan enhancements in Japan designed to address the negative impacts of previous compensation plan changes. If these and other planned initiatives are delayed, are impacted by regulatory constraints or do not generate distributor excitement or attract new distributors or customers in Japan, it may limit our prospects for renewed growth in that market and harm our financial results. Our plans to launchg3 nutrition drink in June, for example, is subject to certain regulatory risks. The Gak fruit ingredient in g3 has not yet been recognized as an approved food. Although we are working with the regulatory authorities on this issue, any delay or failure of the government to list this ingredient as an approved food could negatively impact our plans to launch g3 in Japan.
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Technical and regulatory issues associated with the second generation BioPhotonic Scanner and the Nu Skin® ProDerm™ Skin Analyzer could negatively impact the success of these programs, which could harm our business.
Our current and planned initiatives surrounding the introduction of the S2 Scanner and the Nu Skin® ProDerm™ Skin Analyzer in our various markets are subject to technical and regulatory risks and uncertainties. The S2 is smaller, more portable, and faster than its predecessor in terms of calibration and scan time. However, the S2 is a newly developed tool and we cannot be certain that the units we introduce in the field will consistently perform according to expectation in terms of speed, accuracy and other factors. If the S2 does not perform as expected, distributors may be limited in their ability to utilize this tool, and distributor enthusiasm may be dampened with respect to this tool. As with any new, innovative technology, we have also experienced challenges in our development of the ProDerm™ tool. As we continue to work through these technical issues, we have elected to introduce a limited number of an initial version that has fewer features than we initially anticipated, while we continue to refine the technology. The initial version of this tool that we plan to launch during the next couple of quarters will provide close-up skin images that will enable distributors to demonstrate the effectiveness of our skin care products. We plan to aggressively continue to work on the development of an updated version that will provide a quantifiable assessment of skin conditions and attributes. There can be no assurance, however, that we will be successful in achieving this result. Our plans with respect to the launch of the ProDerm™ are also subject to regulatory risks, particularly in Japan, where we are currently working through the regulatory process for the planned introduction of the ProDerm™ Skin Analyzer in that market. It appears that regulatory restrictions in Japan may 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 this tool in building their businesses, and could dampen distributor enthusiasm surrounding it.
Laws and regulations may prohibit or severely restrict our direct sales efforts and cause our revenue and profitability to decline.
Various government agencies throughout the world regulate direct sales practices. These laws and regulations are generally intended to prevent fraudulent or deceptive schemes, often referred to as “pyramid” schemes, that compensate participants for recruiting additional participants irrespective of product sales, use high pressure recruiting methods and/or do not involve legitimate products. The laws and regulations in our current markets often:
Complying with these widely varying and sometimes inconsistent rules and regulations can be difficult and require the devotion of significant resources on our part. If we are unable to continue business in existing markets or commence operations in new markets because of these laws, our revenue and profitability will decline. Countries where we currently do business could change their laws or regulations to negatively affect or prohibit completely direct sales efforts. In addition, government agencies and courts in the countries where we operate may use their powers and discretion in interpreting and applying laws in a manner that limits our ability to operate or otherwise harms our business or adopt new laws or regulations that could impose additional restrictions. For example, the FTC in the United States has recently proposed new regulations which would impose additional disclosure requirements and waiting periods that are more restrictive. If any governmental authority were to bring a regulatory enforcement action against us that interrupts our business, revenue and earnings would likely suffer.
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Although our distributors are independent contractors, improper distributor actions that violate laws or regulations could harm our business.
Distributor activities in our existing markets that violate governmental laws or regulations could result in governmental actions against us in markets where we operate. Except in China, our distributors are not employees and act independently of us. We implement strict policies and procedures to ensure our distributors will comply with legal requirements. However, given the size of our distributor force, we experience problems with distributors from time to time. For example, product claims made by some of our distributors in 1990 and 1991 led to an investigation by the FTC, which resulted in our entering into a consent decree with the FTC as described below. In addition, recent rulings by the Korean FTC and by judicial authorities against our company and other companies in Korea indicate that vicarious liability may be imposed on us for the criminal activity of our independent distributors.
If we are unable to retain our existing independent distributors and recruit additional distributors, our revenue will not increase and may even decline.
We distribute almost all of our products through our independent distributors (including China sales representatives) and we depend on them to generate virtually all of our revenue. Our distributors may terminate their services at any time, and, like most direct selling companies, we experience high turnover among distributors from year to year. As a result, in order to maintain sales and increase sales in the future, we need to continue to retain existing distributors and recruit additional distributors. To increase our revenue, we must increase the number of and/or the productivity of our distributors.
We have experienced periodic declines in both active distributors and executive distributors in the past. The number of our active and executive distributors may not increase and could decline again in the future. While we take many steps to help train, motivate and retain distributors, we cannot accurately predict how the number and productivity of distributors may fluctuate because we rely primarily upon our distributor leaders to recruit, train and motivate new distributors. Our operating results could be harmed if we and our distributor leaders do not generate sufficient interest in our business to retain existing distributors and attract new distributors.
The number and productivity of our distributors also depends on several additional factors, including:
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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 or to sponsor new distributors on a sustained basis. In addition, in our mature markets, one of the challenges we face is keeping distributor leaders with established businesses and high income levels motivated and actively engaged in business building activities and developing new distributor leaders. There can be no assurance that our initiatives such as the Scanner and others will 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, during the past year certain modifications we made to compensation incentives in China, Japan and Singapore were not received or understood well by some distributors, resulting in unanticipated negative impacts on distributor numbers and revenue in these markets. The introduction of a new product or key initiative such as the Scanner can also negatively impact other product lines to the extent our distributor leaders focus their efforts on the new product or initiative.
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 $160.0 million is currently authorized. As of March 31, 2006, we had repurchased approximately $107.7 million of shares under the plan. There has been no termination or expiration of the plan since the initial date of approval.
None.
In Item 9B of our Annual Report on Form 10-K for the year ended December 31, 2006, we described the material terms of a severance arrangement we agreed to in March of 2006 with Lori Bush, who had previously been serving as the President of our Nu Skin division. On April 20, 2006, we entered into a definitive settlement and release agreement with Ms. Bush, containing the terms previously agreed to. As a result of further analysis of tax implications, the definitive agreement provides for a lump sum severance payment instead of payments over time as previously agreed to. Reference is made to the complete text of the settlement and release agreement with Ms. Bush, attached as Exhibit 10.3 to this Report and incorporated by reference in this Item 5.
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*Omitted
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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.
May 10, 2006
By: /s/ Ritch N. Wood Ritch N. WoodIts: Chief Financial Officer (Duly Authorized Officer and Principal Financial and Accounting Officer)
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