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):
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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
As of July 29, 2006, 69,829,558 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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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- and six-month periods ended June 30, 2006 decreased 8% to $284.1 million and $549.9 million, respectively, compared to the same periods in 2005. The decrease in revenue for these periods was primarily attributable to revenue declines in Japan and China. In addition, foreign currency exchange rate fluctuations negatively impacted revenue by 2% for the three- and six-month periods ended June 30, 2006, particularly as a result of weakening of the Japanese yen. Revenue was positively impacted by growth in South Korea, Hong Kong, and Europe, and expansion into Indonesia in 2005.
Earnings per share for the second quarter of 2006 were $0.20 compared to $0.32 for the same prior year period, and for the six-month period ended June 30, 2006 were $0.05 compared to $0.57 for the same prior year period. In addition to the factors described above, earnings for these periods were negatively impacted by $1.2 million and $2.4 million in stock option expense, net of income taxes, respectively, as a result of the implementation of a new accounting standard requiring the expensing of stock options beginning in the first quarter of 2006. In addition, earnings per share for the first half of 2006 were negatively impacted by restructuring charges and impairment and other charges totaling $32.0 million, or $.28 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.”
Revenue
North Asia. The following table sets forth revenue for the three-month and six-month periods ended June 30, 2006 and 2005 for the North Asia region and its principal markets (in millions):
Foreign currency exchange rate fluctuations, particularly a weakening of the Japanese yen, negatively impacted revenue in North Asia by 3% and 5%, respectively, for the three- and six-month periods ended June 30, 2006. Revenue in this region was also negatively impacted by a 13% and 12% local currency decline in Japan in the second quarter and first half of 2006, respectively, compared to the same prior year periods. The executive distributor count in Japan decreased 9% in the second quarter compared to the prior year period.
Several factors contributed to the year-over-year revenue decline in Japan for the second quarter and first half of 2006, including:
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We believe that we are beginning to see some stabilization of our business in Japan as a result of various initiatives we have implemented during the last quarter designed to stem the declines and renew growth in this market. We began introducing S2 Scanners in the market during the second quarter, and we plan to continue the roll-out of this tool over the next couple of quarters. Other key second quarter initiatives included enhancements to distributor incentives that became effective April 1, 2006 designed to address the negative impact of the previous changes, the launch of our g3 nutrition drink, and the launch of a corporate image enhancement campaign that includes facility upgrades and media campaigns.
Our South Korea market continued its strong growth in both our personal care and nutrition businesses, and is now our third largest market. This market grew 27% on a local currency basis in the second quarter compared to the same period in 2005 and increased 19% sequentially over the first quarter of 2006. Executive and active distributor counts continued to grow significantly as well. We believe that these results are due to the success of our management team in launching strong product and other initiatives, particularly the recent launch of our g3 nutrition drink, and in achieving alignment of our distributor leaders behind these initiatives.
Greater China. The following table sets forth revenue for the three-month and six-month periods ended June 30, 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 second quarter and first half of 2006. China revenue decreased by 41% on a local currency basis in the second quarter of 2006 compared to the same period in 2005. We believe that sales in China were negatively impacted by several factors, including:
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In late July, our direct selling application was approved by the Chinese government, and we now plan to begin the process of augmenting our current business model with a direct selling component. This will allow us to engage an entry-level, non-employee sales force that will be able to sell certain products away from our fixed retail locations. The new direct selling regulations prohibit the use of multi-level compensation plans for direct selling, so we will compensate these independent contractors based on their personal selling efforts only. We plan to maintain our retail store/employed sales representative model because we believe it provides us with more flexibility in the manner in which we conduct business in China, including the manner in which we compensate our full-time sales representatives. In addition, products we market with a “general food” classification, including our LifePak supplements and certain other Pharmanex products, are not approved for direct selling, and will therefore continue to be sold only through our retail store channel until such time as we obtain a “health food” classification for these products.
We plan to begin conducting direct selling activities in Shanghai in late 2006, and we will then proceed to expand our direct selling model throughout China. The direct selling regulations require us to establish service centers and secure licenses in each of the provinces in which we wish to implement direct selling. This provincial licensing process will include a requirement that we establish “service centers” that will primarily be used to provide a product return location and will not require a large capital investment. Although it will likely take some time to integrate direct selling into our business model, expand throughout the market and train our sales force to work successfully within the new direct selling guidelines, we believe that this will positively impact our business in China as this process unfolds.
Although revenue in Taiwan was slightly down on a local currency basis in the second quarter and first half of 2006 compared to the same prior year periods, we believe that this market continues to be healthy. Revenue in this market was negatively impacted in the second quarter by Taiwanese distributors purchasing products in Hong Kong as they attended the Greater China Convention held there in May. However, we continue to see success with the Scanner and new products, and our second quarter launch of the S2 Scanner should help bolster further growth in this market. In addition, in late June we completed the build-out of a “gym spa” in this market in an effort to generate additional brand awareness. The gym spa consists of a product showcase combined with a fitness center and spa. Hong Kong revenue was up 19% in local currency on a year-over-year basis in the second quarter largely due to sales to distributors from China and Taiwan attending the Greater China Convention held in May. In addition, sales to local Hong Kong distributors increased on a year-over-year basis. Our executive distributor counts in Taiwan and Hong Kong were up 1% and 17%, respectively, in the second quarter of 2006 compared to the same prior year period.
North America. The following table sets forth revenue for the three-month and six-month periods ended June 30, 2006 and 2005 for the North America region and its principal markets (in millions):
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Revenue in the United States remained relatively flat, while executive and active distributor counts in the North America region grew 3% and 4%, respectively, in the second quarter of 2006 compared to the same prior year period. During the second quarter we began to implement key growth initiatives in the United States. We introduced a limited number of S2 Scanners and Nu Skin® ProDerm™ Skin Analyzer (the “ProDerm Skin Analyzer”) units into this market, and we plan to implement a more aggressive roll-out of these tools during the next couple of quarters. The initial version of the ProDerm Skin Analyzer 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. Our global strategy with respect to the ProDerm Skin Analyzer will be to focus this tool initially on the United States, and then over time consider the launch of this tool in our other global markets as we assess its success in the United States and as we work to develop a tool with enhanced functionality.
South Asia/Pacific. The following table sets forth revenue for the three-month and six-month periods ended June 30, 2006 and 2005 for the South Asia/Pacific region and its principal markets (in millions):
Foreign currency exchange rate fluctuations negatively impacted revenue in South Asia/Pacific by 3% and 1% during the three- and six-month periods ended June 30, 2006 compared to the same periods in 2005. This region benefited from $2.5 million in revenue during the second quarter and $5.1 million during the first half from Indonesia, which we opened for business in August of 2005. Year-over-year comparisons in Singapore/Malaysia/Brunei were negatively impacted by revenue declines in the latter part of 2005 that were a result of some of our distributor leaders in these markets focusing their attention on the newly opened Indonesia market and away from their home markets, and by compensation plan changes made in 2005. Executive and active distributor counts in the region declined by 5% and 4%, respectively when compared with the second quarter of 2005.
Other Markets. The following table sets forth revenue for the three-month and six-month periods ended June 30, 2006 and 2005 for our Other Markets (in millions):
Revenue growth in Europe resulted from growth in Germany and France and the expansion into Israel and Russia. 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.
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Gross profit
Gross profit as a percentage of revenue increased to 83.0% for the second quarter of 2006 from 82.6% for the same period in 2005, due to a decrease in Scanner amortization following our write-down of first generation Scanner units in the first quarter. For the first half of 2006, however, gross profit as a percentage of revenue decreased slightly to 82.6% from 82.7% for the same period in 2005, due to a strengthening of the U.S. dollar, particularly against the Japanese yen.
Selling expenses
Selling expenses as a percentage of revenue increased to 43.3% and 42.8% for the three- and six-month periods ended June 30, 2006 from 41.7% and 42.2% for the same periods in 2005. This increase was due to enhancements to our compensation plan in Japan that took effect April 1, 2006. The modified plan pays out at a slightly higher rate, and as a result we anticipate selling expenses as a percentage of revenue to be approximately 43% over the next couple of quarters.
General and administrative expenses
General and administrative expenses as a percentage of revenue for the three- and six-month periods ended June 30, 2006 increased to 31.3% and 32.5% from 29.0% and 29.5% for the same periods in 2005. In U.S. dollars, general and administrative expenses decreased in the second quarter to $88.8 million from $90.0 million for the same period in 2005 and increased in the first half of 2006 to $178.8 million from $177.1 million for the same period in 2005. The increase in general and administrative expenses as a percentage of revenue for the second quarter and second half of 2006 were impacted by:
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.
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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 $15 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.
Other income (expense), net
Other income (expense), net for the three- and six-month periods ended June 30, 2006 was approximately $1.4 million and $2.5 million of expense compared to $1.2 million and $1.8 million of expense for the same periods 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.
Provision for income taxes
Provision for income taxes for the three- and six-month periods ended June 30, 2006 was an $8.4 million and a $2.2 million expense compared to a $13.1 million and $23.5 million expense for the same periods in 2005. The effective tax rate was 37.5% of pre-tax income during the three- and six-month periods ended June 30, 2006, compared to rates of 36.4% and 36.7% in the same prior-year periods.
Net income
As a result of the foregoing factors, net income for the three- and six-month periods ended June 30, 2006 decreased to $14.1 million and $3.7 million from $22.8 million and $40.5 million for the same periods in 2005.
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 $21.8 million in cash from operations during the six-month period ended June 30, 2006, compared to $66.1 million during the same period in 2005. This decrease in cash generated from operations is due to lower revenue and lower profitability in the first half of 2006 resulting from the severance payments and other restructuring charges as well as the increased payment of taxes in 2006.
As of June 30, 2006, working capital was $130.4 million, compared to $149.1 million as of December 31, 2005. Cash and cash equivalents at June 30, 2006 and December 31, 2005 were $121.6 million and $155.4 million, respectively. The decrease in cash balances was primarily due to the increase in the payment of debt in 2006 compared to 2005 as well as the proceeds from debt in 2005. The decrease in working capital was due primarily to the decrease in cash balances.
We anticipate capital expenditures of approximately $40 million to $45 million for 2006, of which we incurred $21.5 million in the first half of 2006. 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 June 30, 2006:
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 second quarter of 2006, we repurchased approximately 331,000 shares of Class A common stock under this program for an aggregate amount of approximately $5.2 million. Currently, approximately $47.1 million is available under the stock repurchase program for repurchases.
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In February and May 2006, our board of directors declared quarterly cash dividends of $0.10 per share for all shares of Class A common stock. These quarterly cash dividends of $7.0 million each were paid on March 22, 2006 and June 21, 2006 to stockholders of record on March 3, 2006 and June 2, 2006, respectively. In July 2006, the board of directors declared a quarterly cash dividend of $0.10 per share for all shares of Class A common stock to be paid in September 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 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 we filed letters of protest with Yokohama customs with respect to this entire amount. Yokohama customs has rejected our letters of protest to date, and to follow proper administrative procedures we filed appeals with the Japan Ministry of Finance. On June 26, 2006, we were also advised that the Ministry of Finance has rejected the appeals filed with their office. We currently plan to appeal the decision of the Ministry of Finance through the judicial court system in Japan. We paid the $25 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 $19 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 and second quarters of 2006 were impacted by the recognition of non-cash expense related to the fair value of our stock-based compensation awards. During the three- and six- month periods ended June 30, 2006, we recorded $2.0 million and $3.9 million in pre-tax stock-based compensation expense. Total stock-based compensation expense, net of tax, for the three- and six-month periods ended June 30, 2006 was $1.2 million and $2.4 million, respectively.
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 June 30, 2006, we had net deferred tax assets of $35.2 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 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.” 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- and six-month periods ended June 30, 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 volatility of the Company’s common stock.
In June 2006, the Financial Accounting Standards Board issued FASB Interpretation Number 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109. The interpretation contains a two step approach to recognizing and measuring uncertain tax positions accounted for in accordance with SFAS No. 109. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. The provisions are effective for us beginning in the first quarter of 2007. We are evaluating the impact this statement will have 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.
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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.
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. Given the large portion of our business derived from Japan, any 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 June 30, 2006, we had $21.8 million of these contracts with expiration dates through June 2007. All of these contracts were denominated in Japanese yen. For the three- and six-month periods ended June 30, 2006, we recorded pre-tax gains of $0.1 million and $2.7 million, which were included in our revenue in Japan, and gains of $0.1 million and $1.4 million as of June 30, 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 June 30, 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.
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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, 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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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 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 defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as the result of the on-going remediation of a material weakness identified in the prior quarter and discussed below, our disclosure controls and procedures were not effective as of June 30, 2006.
Notwithstanding the material weakness discussed below, our management has concluded that the consolidated financial statements included in this Quarterly Report on Form 10-Q fairly state, in all material respects, our financial position, results of operations and cash flows for the periods presented in conformity with accounting principles generally accepted in the United States of America.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. As of March 31, 2006, we did not maintain effective controls related to the accuracy of our impairment evaluation of long-lived assets, as required under Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-lived Assets (“SFAS 144”). Specifically, management’s review of the impairment analysis and computation failed to detect an error in the application of the discount rate used to estimate the fair value of the first generation BioPhotonic (“S1”) Scanners. This control deficiency resulted in a material adjustment to the impairment charge that we had initially recorded relating to our S1 Scanners in our first quarter financial statements. This control deficiency could result in a misstatement of our long-lived assets and related impairment charges that would result in a material misstatement to the annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management has determined that this control deficiency constitutes a material weakness.
Our remediation plan outlined in last quarter’s report included the implementation by management of the following controls and procedures:
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We have begun implementation of controls and procedures to remediate this control deficiency. However, as of June 30, 2006, we have not completed our remediation efforts, including subsequent testing and evaluation of the revised controls for operating effectiveness. Accordingly, we have determined that this control deficiency remains a material weakness as of June 30, 2006.
Other than described above, there has been no change 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 has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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 six 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. 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. We have implemented several initiatives, including the launch of the second generation of the BioPhotonic Scanner and compensation plan changes, and have other initiatives planned to help renew growth in these markets. 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. For example, we have elected to wait until we have completed an updated version of the Nu Skin® ProDerm™Skin Anlayzer before implementing this initiative in Japan, which likely will not occur until sometime in 2007. In addition, there are regulatory issues that may prevent us from quantifying skin attributes in a score for this market.
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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, including some software glitches in beta units that were tested in some Asia markets. As we continue to work through these technical issues, we have elected to introduce the 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 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.
Our operations in China are subject to significant governmental scrutiny, and our operations in China may be harmed by the results of such scrutiny.
Because of the government’s significant concerns about direct selling activities, government regulators in China scrutinize very closely activities of direct selling companies or activities that resemble direct selling. This scrutiny has increased following adoption of the new direct selling and anti-pyramiding regulations. The regulatory environment in China with regards to direct selling is evolving, and officials in the Chinese government often exercise significant discretion in deciding how to interpret and apply applicable regulations. In the past, the government has taken significant actions against companies that the government found were engaging in direct selling activities in violation of applicable law, including shutting down their businesses and imposing substantial fines.
Our business has been subject to significant governmental scrutiny over the last few years, and reviews and investigations by government regulators have at times obstructed our ability to conduct business and have resulted in several cases in fines being paid by us, which in the aggregate have been less than 1% of our revenue in China. We may incur similar or more severe sanctions in the future. Occasionally, we have also been asked to cease sales activity in some stores while the regulators review our operations. While, in each of these cases, we have been allowed to recommence operations after the government’s review without material changes to our operations, there is no assurance that this will always be the case. 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 implement direct selling into our business model. 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, or other actions, all of which would harm our business.
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If recently adopted direct selling regulations in China are interpreted or enforced by governmental authorities in a manner that negatively impacts our current business model or our planned dual business model there, our business in China would be harmed.
Towards the end of 2005, Chinese regulators adopted anti-pyramiding and new direct selling regulations. These regulations contain significant restrictions and limitations, including a restriction on multi-level compensation for independent distributors selling away from a fixed location. 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 their scope, 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 would be harmed if Chinese regulators interpret the anti-pyramiding regulations or direct selling regulations as applying to our retail store/employed sales representative business model, or if regulations are interpreted in such a manner that our current method of conducting business through the use of employed sales representatives or our planned implementation of direct selling is found to violate applicable 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 in the new regulations. 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.
Although we have obtained a direct selling license in China, if we are unable to establish required service centers in China 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.
The new direct selling regulations and supplemental rules recently adopted in China require us to establish a service center in each area where we conduct direct selling activities. We will be required to obtain approval from local governmental authorities for each service center we intend to establish. The local approval processes vary and remain uncertain in some areas. The local governmental officials also have broad discretion in approving these service centers. If regulators fail to approve licenses for service centers at a rate that meets our growth demands, this could limit our ability to obtain direct selling licenses in some provinces and harm our business. In addition, the direct selling regulations impose various limitations and requirements, including a prohibition on multi-level compensation and a requirement that all distributors pass a required examination before becoming a distributor. In addition, the regulations do not allow the sale of general foods through a direct selling business model. As some of our supplements are being marketed as general foods until we obtain health food status for these products, including LifePak, we will only be able to sell these products at our stores and not away from the stores until they receive health food status. There can be no assurance that these restrictions will not negatively impact our ability to provide an attractive business opportunity to distributors in this market and limit our ability to grow our business in this market.
Laws and regulations may prohibit or severely restrict our direct sales efforts and cause our revenue and profitability to decline, and regulators could adopt new regulations that harm our business
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:
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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 before a distributor could sign up to become a distributor that are restrictive and burdensome. The direct selling industry has filed comments objecting to many of these requirements and are working to get the FTC to change their proposal for new regulations. If these regulations were adopted in there current form, it could have a negative impact on direct selling businesses in the United States including our business. 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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None.
Our Annual Meeting of Stockholders was held on May 25, 2006. At the Annual Meeting of Stockholders Blake M. Roney, M. Truman Hunt, Sandra N. Tillotson, Jake Garn, Paula F. Hawkins, Daniel W. Campbell, Andrew D. Lipman, Jose Ferreira, Jr., Dee Allen Andersen and Patricia Negrón were elected to serve as our directors until the next annual meeting of stockholders or until their successors are duly elected. Each director was elected by a plurality of votes in accordance with the Delaware General Corporation Law. There was no solicitation in opposition to management’s director nominees. The following chart reflects the vote tabulation with respect to each director nominee. The figures reported reflect votes cast by holders of our Class A common stock. Each share of Class A common stock entitles its holder to one vote.
The stockholders ratified Proposal 2, The 2006 Stock Incentive Plan, with 52,062,595 votes being cast for, 5,719,052 votes being cast against and 5,247,356 abstentions and broker non-votes.
The stockholders ratified Proposal 3, The 2006 Senior Executive Incentive Plan, with 57,419,097 votes being cast for, 349,623 votes being cast against and 5,260,283 abstentions and broker non-votes.
The stockholders also ratified the appointment of PricewaterhouseCoopers LLP as our independent registered public accounting firm, with 42,857,210 votes being cast for, 15,054,709 votes being cast against and 6,914 abstentions.
On August 9, 2006, our Board of Directors approved a Change of Control Severance Plan that we currently anticipate to enter into with our executive officers who do not already have an existing change in control arrangement, and certain other senior corporate officers. This plan provides that if the executive officer or other senior corporate officer is terminated by us without cause within 2 years after a change of control, then such person is entitled to a severance payment equal to 1.5 times the then applicable annual compensation (salary plus target bonus), and is also entitled to be paid a pro rata portion of such person’s target bonus for that period that would have been earned had the employment not been terminated.
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The foregoing does not constitute a complete summary of the terms of the Change of Control Severance Agreement, and reference is made to the complete text of the form of agreement, which is attached as Exhibit 10.8 to this report and incorporated by reference in this Item 5.
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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.
August 9, 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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