USANA Health Sciences, Inc. (USNA) Q3 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the USANA Health Sciences Third Quarter Earnings Conference Call. [Operator Instructions] This conference is being recorded today, October 23, 2013. I'd now like to turn the conference over to our host, Mr. Patrique Richards. Please go ahead, sir.

Good morning, everyone. We appreciate you joining us this morning to review our third quarter results. Today's conference call is being broadcast live via webcast and can be accessed directly from our website at www.usanahealthsciences.com. Shortly following the call, a replay will be available in our website. As a reminder, during the course of this conference call, management will make forward-looking statements regarding future events or the future financial performance of our company. Those statements involve risks and uncertainties that could cause actual results to differ perhaps materially from the results projected in such forward-looking statements. Examples of these statements include those regarding our strategic initiatives, our strategies for each of our regions and our outlook for 2013. We caution you that these statements should be considered in conjunction with the disclosures, including specific risk factors and financial data contained in our most recent filings with the SEC. I'm joined this morning by Dave Wentz, our Chief Executive Officer; and Paul Jones, our Chief Financial Officer. Dave will begin with a review of our operational progress and highlights during the quarter. Paul will follow with a more detailed look at our third quarter financial results and updated financial guidance. I'll now turn the call over to Dave.

Thanks, Pat. Good morning, everyone. Yesterday, we reported another successful quarter for USANA. When we last talked with you in July, we reviewed the worldwide policy changes implemented in June, which focus on customers' purchasing product in their home market and we also touched on the strategic changes we plan to launch at our International Convention in August. At that time, we noted that the implementation of these essential initiatives would benefit our financial performance long-term, but impact our results over the next few quarters. That is what we experienced during the third quarter. While net sales for the quarter increased 5.2% year-over-year to nearly $174 million, we estimate that the initiatives I just mentioned reduced sales by nearly $11 million for the quarter. The total reduction was comprised of: An estimated $5.9 million attributable to the worldwide policy changes and $4.6 million attributable to the pricing discounts that we announced at our International Convention earlier this year. Sales for the quarter were also reduced by $2 million due to changes in currency exchange rates. These initiatives also had an impact on our bottom line results, as net earnings declined by 4.2% to $16.8 million and earnings per share for the quarter declined by 1.7% to $1.16 compared with the prior year period. The estimated bottom line impact of these initiatives was $6 million or $0.43 per share with an estimated $0.10 attributable to the worldwide policy changes and $0.33 attributable to the initiatives we announced at our convention. Our operating margins were able to absorb these changes and remain relatively healthy at 14.2% for the quarter. As I mentioned a moment ago, we anticipated the short-term impact of these initiatives in our guidance and our results for the quarter were in line with our expectations. Our team has shown that they will implement strategies that are in the best long-term interest of our business, even if they may cause a short-term disruption in our operating results. We believe that the worldwide policy changes and initiatives we launched at our convention are the best strategies to drive USANA's future growth. Last quarter, we discussed the importance of the worldwide policy changes to our global business. This policy was designed to eliminate the incentive to purchase our products outside of a customer's home market. I won't spend much time addressing those changes again this morning. Instead, I would like to take you through each of the changes we implemented at our International Convention. Our rationale behind these changes was to simplify the business for our customers, making it easier for them to operate a successful business with USANA, to reward our loyal product users and making our comp stage plan more rewarding for everyone involved with USANA. Overall, these changes are designed to drive long-term and sustainable customer growth around the world. In terms of simplification, we simplified our product pricing by creating one price for all of our customers. These change is significant because it eliminates confusion that have come associated with buying our products, especially among new customers. Now, all of our customers pay the lowest price we have previously offered and we call that price our Preferred Price. We also simplified our compensation plan for all Associates by making it easier to understand, easier to explain to others and easier to earn compensation. These change is especially important for our new and up-and-coming associates as the investor is trying to learn about our products and our business. To reward our loyal product users, we introduced a 10% price discount off of the Preferred Price of what's our lowest price on products. And that 10% price discount comes part of their order to our monthly Auto Order program. Our experience is that customers who are on Auto Order use our products more consistently and longer than those who are not. As such, we thought it was essential to create a new financial incentive to promote Auto Order and product loyalty. Our team did an excellent job of successfully implementing these changes and the adoption rate for many of the changes has been better than we anticipated leading up to our convention about 30% of our total business to place on Auto Order. For the period following our convention, that percentage increased to just over 40%, which is a significant increase in such a short time period. Our Auto Order percentage is up in almost every market, including markets that are predominantly will-call markets. We believe that having a significant portion of our customers and sales on Auto Order will lead to a sustainable customer growth. We also introduced a 10% rewards for new customers. Under this incentive, 10% of the amount of a customer's initial order will be credited toward the customer's next 2 Auto Orders. Our experience is that a customer's first few months using our products and participating in our business is critical. This Initial Order Reward, along with Auto Order discount, is intended to offer new customers a significant discount on our products at a time when they're still learning about our products and business. To make our compensation plan more rewarding for everyone, we also adjusted our commissioning qualification requirements to make it easier for all Associates to have not only earn compensation at USANA, but to also advance in rank and increase their earnings. Under our old requirements, earnings commissions could be confusing and overwhelming for inexperienced Associates. Our objective was to simplify this process and our initial results have been encouraging. The number of weekly commission checks earned by Associates has increased by about 40%. The weekly number of first-time check earners has also increased nearly 30%. These increases are important to our strategy to drive customer growth. We also increased the payout under our compensation plans for new and up-and-coming Associates. This increase complements the compensation plan changes I just mentioned, as well as the Initial Order Reward and the Auto Order discount. All of these changes are designed to improve the customer's experience with USANA. Finally, to make our business more rewarding, we increased the payout under our compensation plan for our Associate leaders who grow their business to a certain level through our Auto Order program. This increase payout is another way we are investing more on our Associates and also promoting our Auto Order program. These announcements were obviously well-received by our Associates and have generated a great deal of excitement in our business following our convention. Over the last several weeks, we have focused on training our Associates on each of these changes. As our sales force continues to capitalize on these initiatives going forward, I believe that we will see steady improvement in our results. Going forward, we expect these initiatives to begin contributing to the growth of our worldwide customer counts. Before we hear from Paul, I'd like to report on one more accomplishment during the quarter. The official opening of our newest market in Columbia, this is our 19th market worldwide, and our Mexico leaders have been working hard to leverage their ties to Columbia to make this market launch a success. Columbia generated $1.4 million in sales in its initial quarter of operations and we believe its results will continue to improve with time. As I've commented before, we believe that Columbia will be a solid contributor to our North American region and an ideal entrance into South America. In summary, I am confident in the strength of our underlying business in all of our regions, although we anticipate pressure on our operating results for the next few quarters due to the initiatives I just reviewed, we expect to continue to grow during this period. More importantly, we believe that the strategies we have in place will generate long-term, sustainable growth for USANA. With that, I will turn the call over to Paul to review our regional and financial results.

Thanks, Dave, and good morning, everyone. I'll start by taking you through our regional results and will then turn to the income statement. Sales growth this quarter was led by our Asia-Pacific region where net sales increased by 4.6% to $107.4 million for the quarter. This improvement was due primarily to sales growth in the Southeast Asia-Pacific, which was driven by strong growth in Singapore and Malaysia. Our MyHealthPak product continues to be the main contributor in Singapore, which services our entire Asia-Pacific region with this product. We were also pleased with our results in Australia and New Zealand during the quarter where the number of Active Associates increased over 13% and the number of Preferred Customers increased 25%. We believe the momentum we are seeing in these markets is directly related to the pricing initiative we announced earlier this year. Sales in the Philippines this quarter increased only modestly. While our growth rate in this market has slowed a bit, our results this quarter were certainly impacted by the typhoon and political unrest that occurred there. In spite of these disruptions, we ultimately anticipate continued growth in the Philippines and expect it to remain a solid part of the region. Sales in the Greater China region were flat year-over-year with significant growth in China and double-digit growth in Taiwan. These results were however, offset by a large decline in Hong Kong. Our results in Greater China were essentially in line with our expectations, especially considering the acceleration of approximately $7 million in sales ahead of the policy changes that occurred during the second quarter of this year. As a reminder, we implemented this policy to minimize cross-border purchasing and to help make our products and business opportunity more equitable across all of our markets. This policy has had the largest impact in the Hong Kong and China regions. That said, we continue to make solid progress in Mainland China due to our significant offering of licensed USANA products available there and the emergence of new Associate leaders and customers in China as we continue to see a significant number of Associates in that market advance up to our leadership ranks. In our North Asia region, South Korea continued to gain ground with 14.7% growth in -- sales growth and a strong increase in active customers. Turning now to North -- to the Americas and Europe. Sales for this region continued to improve and increased 6.1%, which was largely the result of strong sales and customer growth in Mexico, as well as sales and customer growth in Canada and the addition of Columbia. Our sales growth in Mexico was driven by double-digit increases in both Associates and Preferred Customers, as well as price increases that were implemented during the first quarter. Finally, as Dave mentioned, Columbia made a nice initial contribution to the region during the quarter. We continue to see progress in the U.S. where our team continues their efforts to work with Associate leaders to generate growth. Specifically, we expect our Associate leaders in the U.S. to leverage the changes we made at our convention to drive both sales and customer growth. Let's now turn to the income statement. Gross margins improved 30 basis points year-over-year, due mostly to production efficiencies and the favorable change in product sales mix. These efficiencies were partially offset by the negative impact of changes in currency, price changes during 2013 and an unfavorable change in sales mix by market. Associate incentives expense for the quarter increased 140 basis points year-over-year to 44% of net sales compared to 42.6% in the prior year quarter. This increase can primarily be attributed to the price and compensation plan changes made at our convention, which Dave just discussed. In particular, the change in our commission qualification requirements resulted in a one-time payout of approximately $4.5 million. These increases were partially offset by the change to the Lifetime Matching Bonus program, which launched in the second quarter of last year and was not completely phased in until November 2012. We expect Associate incentives to be around 43.5% of net sales going forward. SG&A in the third quarter was 23.7% of net sales, a decrease of 70 basis points from the third quarter of 2012. This relative decrease is due to leverage gains from higher net sale and lower spending on our 2013 convention as the prior year was our 20th anniversary celebration. On an absolute basis, SG&A increased as a result of the cost associated with supporting a higher sales base and spending associated with the opening of Columbia. Our effective tax rate for the quarter was 32.4% of pretax earnings, compared to 28.2% in the prior year. Notably, in Q3 2012, we had a tax benefit from a prior year tax return true-up, which mostly explains the 420 basis points spread year-over-year. We expect our effective tax rate for the year to be approximately 33%. Net earnings for the third quarter were $16.8 million, a decline of 4.2% compared with the prior year period. This decrease was due to higher Associate incentive expense and the higher relative tax rate, partially offset by higher net sales, higher relative gross margins and lower relative SG&A expense for the quarter. Earnings per share for the quarter decreased 1.7% to $1.16 per diluted share. This decrease can be attributed to lower net earnings, partially offset by a lower number of shares outstanding from the repurchases over the last 12 months. We did not repurchase any shares during the quarter and there are still approximately $13.6 million remaining under the -- our board authorization repurchase program. Turning to the balance sheet. We continue to generate strong cash from operations and ended the quarter with $115 million in cash. Cash generated from operations in the third quarter totaled $17.3 million. With only 1 quarter remaining in the year, we are updating our guidance range for Q4 as follows: Net sales will be in the range of $705 million to $710 million for the year; diluted earnings per share for the year is now expected to be in the range of $5.35 and $5.40. Our guidance obviously includes the estimated impact from all of the initiatives we have discussed this morning. Accordingly, we are estimating the following for the full year 2013: Gross margins of 82%; Associate incentive expense of 42.5%; operating margin of just over 16%; and effective tax rate of 33%. In conclusion, I am confident in the financial strength of USANA's business and believe that we have the right strategies in place to drive long-term growth. With that, I will now ask the operator to facilitate the question-and-answer session.

[Operator Instructions] Our first question comes from the line of Tim Ramey from Davidson. Timothy S. Ramey - D.A. Davidson & Co., Research Division: Just a few questions about the policy's changes. #1, how do you -- how are you actually accomplishing that and how do you know it's being implemented, sort of Hong Kong vis-à-vis Mainland China?

The way we're looking at is just a person is registered in Hong Kong and has a Hong Kong ID, they are allowed to buy products unrestricted. If a person is coming to buy products for personal use only, to take that somewhere, then we restrict them to just a small amount of products that they would personally use in that time period. And so we're just reducing the amount of products they can buy to a reasonable amount that we don't want them buying 10, taking it back using 1 and selling 9. We want them to buy 2, use them for the next 2 months, come back by 2 more and use for the next 2 months type of a scenario. Timothy S. Ramey - D.A. Davidson & Co., Research Division: Got it. Okay. And you said, I think you're very first statement, Dave, might have been that this is going to be a few quarters or a period of time but it's the right thing to do, and I agree it is obviously the right thing to do. Is this period going to be 2 or 3 more quarters or 1 or 2 more quarters, or is it hard to say?

I'm very optimistic. But that's my nature. I think we'll start to see things looking better in the fourth quarter. In the first quarter, hopefully, we're rolling because they understand the changes there now. I mean, we mentioned a lot of changes, 6 large changes, and it's a lot to wrap your arms around but they're all positive changes and so people are reacting well to them and jumping on quickly versus if they were just changes where they were more confused and some up, some down. And so we're starting to see, I mean, huge strides in Auto Order right away. We're looking forward to seeing customers staying longer and buying more. And we can't judge that right now, because we're just so close to the announcement. But I'm hopeful we'll see some great things in the fourth quarter and continuing on into the following year. I mean it's going to be a trending thing and it's not going to -- sales are not going to double overnight in the quarter or anything but it should trend in the right direction and keep us growing worldwide, which is another important thing to me and not just seeing growth in certain regions. I think we're going to see growth around the world and that's what excites me a lot. Timothy S. Ramey - D.A. Davidson & Co., Research Division: Sure. And then relative to Associate growth, would that be sort of tracking your top line comments on the various regions, I mean I think you said meaningful but not double-digit growth in Mainland China, double-digit growth in Taiwan and then some decline in Hong Kong or are we seeing Associates behave in line with that?

We're seeing good Associate growth definitely in Mainland China. We're also seeing a lot more preferred growth -- Preferred Customer growth not preferred growth, Preferred Customer growth, than we even expected. And so we're getting more and more customers, which is exciting for us to see and I think some of these changes are influencing that. So hopefully we'll see our Preferred Customer growth grow even faster.

Our next question comes from the line of Rommel Dionisio from Wedbush Securities.

It's a great number to hear that Auto Order numbers climbed to 40%. Dave, I'm wondering if you could just talk about how that dovetails with the initiatives you're focusing on with personalization, and if you're seeing that as the Auto Order number grows if you're seeing some progress in terms of Preferred Customers using that to personalize their own sort of model?

Well, one of the -- one of our initiatives was to really incent people's initial orders to be personalized. Over the year, they've been easier to make packs for their initial orders, so that they only had 1 item number to order because they didn't know their products that well, they didn't know which one were right for them. With our True Health Assessment, we give them a tool for them to input their own information so they can find the products that are most valuable to them and we're hoping to see a shift away from pack orders for their initial order to a personalized order that meets their need. So they have a higher beliefs level and value with the products. They aren't getting products in their pack that don't apply to them. For instance, if you put the kid's vitamin in a pack and they didn't initially know how many kids, it doesn't make quite as much sense for them. And so we're hoping to -- I haven't gotten a report yet, but I'm looking forward to see the shift toward personalized. But that then leads to personalized auto orders and we're looking to get rid of Auto Order packs as well so that they are -- we're spend -- we want our distributors to spend more time with the new customers and find out what the right products are for them, rather than going to easier route of a pack, that's 1 item number, easy to order and get them rolling with the basics. We don't want them to just have the basics. We want them to customize it to meet their health needs, create the value for them, which we believe will give them better results and keep them long-term. So we're seeing switchboard personalization both initial and in Auto Order and in the incentives for Auto Order. Everyone likes to save money and they see savings continually now, both when they first get started but then the ongoing Auto Order savings is exciting for people to save money and they tend to buy more when they're saving more.

[Operator Instructions] Our next question comes from the line of Frank Camma from Sidoti. Frank A. Camma - Sidoti & Company, LLC: Just a couple of quick questions. First is the sales that you achieved in Columbia. I could be wrong, but it seems like that number is actually higher than some of the other new markets that you recently opened or you reached that level quicker. I'm just wondering if you could speak to that. Is that basically because the opportunity is greater there or the execution was better or is that kind of in line with your expectations?

Yes. I mean, they're -- it was -- I think we've rated it internally as our smoothest opening ever possibly in USANA. We keep learning and I think we've rated it one of our smoothest with the fewest technical glitches or computer things or banking things or this or that, so it's very... Frank A. Camma - Sidoti & Company, LLC: Because you generally don't achieve really that much revenue incrementally that quickly, correct? Am I correct?

There are always surprises and learning curves in a new country and we had a very smooth opening and I credit our great international team. In addition to that, we've had a lot of leaders excited, mainly from Mexico, we've had some move down from U.S. and Canada as well to work there for a period of time. But Mexico, I mean a lot of people move there for long periods of time to get their teams up and running, to get the leadership established. We just had a huge -- we had the largest grand opening and I think in USANA's history, especially only 12 weeks after opening the doors. We had a grand opening somewhere between 1,500 and 1,800 people, which is a huge grand opening, especially in 3 months. Sometimes we'll have them 6, 9, 12 months down the road and they'll be -- they won't even be that size. So good leaders, good energetic group of people, good response. They're seeing results. And they have a great benefit that they were only in the business, I think, it was 6 weeks or 4 weeks before we introduced all the new comp line enhancements. So they weren't kind of set in their ways or ingrained with habits of old when we changed it. So they're, I'm hoping they'll respond even quicker because they're not breaking old habits to adapt to the new composition enhancements. So they didn't have to wait 5 to 10 years like other countries to get these enhancements. They got them in 4 to 6 weeks. So we're very excited about that market. Frank A. Camma - Sidoti & Company, LLC: Right. Okay. The only other question I have was just on the level of cash you have now. I think in the past you were kind of targeting to build up to about $100 million and obviously now you're in excess of that and you don't really have much left on your share authorization, not that you can accrete that. But any new thoughts on what you're going to do with the cash?

We continue to -- as we look forward, I think we mentioned earlier this year, and this is Paul, that we anticipate some capital investment into the infrastructure in China, that's still on the books. It's a little slower than we anticipated, but we expect the fourth quarter and then we're starting more heavily into 2014 that we'll see some of those outlays of cash there. We also anticipate and are continually looking for opportunities to purchase or invest in situations that will help our core products and integrate into our supply chain to reduce margins and to help us there. And so between those, we'll continue to look. We also will anticipate, if the need -- or the situation occurs properly, we will continue to look at our share repurchase according to our guidelines that we use internally.

Our next question comes from the line of Tim Ramey from Davidson. Timothy S. Ramey - D.A. Davidson & Co., Research Division: As you're just chatting with Paul, I was writing down continuing to look at opportunities to backward integrate. Did I read that correctly as a potential use of cash buying production assets?

Yes. Continue looking at those kinds of opportunities, yes. Timothy S. Ramey - D.A. Davidson & Co., Research Division: And the anticipated use of cash in China, is there any kind of rough quantification on what that's going to be?

Well, we would anticipate that over the next couple of years, we would spend in excess -- or invest in excess of around $40 million in cash to upgrade and improve the infrastructure, make sure we have the production facilities necessary to handle the volume that we anticipate. Timothy S. Ramey - D.A. Davidson & Co., Research Division: Great. So should we be thinking of a more muted share repurchase profile over the next couple of years or is it -- you can do it all kind of thing?

I think it depends on where the -- whether we think the stock is undervalued and if we have the cash and we don't have it committed to something that's in a sense growing company in China where we're vertically integrating. We're always going to try to provide shareholder value by buying when we believe it's undervalued.

Our next question comes from the line of Jim Larkins.

Yes. I wonder if I missed this, but did you give out the number for Mainland China, what it was this quarter and if so, what it was last year as well?

The sales number?

Yes.

We did not give it out, but we were -- year-over-year, for the quarter, we were at $8.3 million in sales. A year ago just last quarter, we were at $29.8 million. That's it. The growth in sales of about 260%.

And that's just Mainland proper?

Yes. Typically, we looked at regions, we break it out regionally. But yes, that's a big area that we're looking at. So that's where we're at.

So highlights just how impactful that change in timing of revenue was in Hong Kong and for the region?

Yes. Absolutely.

I show no further questions in the queue. I'd like to turn it back to management for any closing remarks.

Thank you for your questions and for your participation on today's conference call. If you have any remaining questions, please feel free to contact Investor Relations at (801) 954-7961.

Ladies and gentlemen, that does conclude the USANA Health Sciences Third Quarter Earnings Conference Call. We would like to thank you for your participation and you may now disconnect.