Thursday, October 2, 2014

Assessing the state of Nu Skin's China business - Part 1

Nu Skin's stock for the past few years has been driven by its business in China. That business grew from a very small base to a (claimed) billion dollars of sales very rapidly. The stock followed - and the company in exuberance bought back stock at high prices with those prices supported by the Chinese business.

Nu Skin funded that buyback with debt.

This year the Chinese business was put into recruiting stasis because of regulatory action. The company claimed the decision to stop recruiting was voluntary - however it was clearly made under some regulatory duress.

Whilst the business has restarted sales are not what they used to be. The company has been less than clear about the number of sales leaders and sales made in china.

Moreover the company has been hugely cash consumptive - burning through roughly $240 million of cash in the first half as per the accounts. That cash burn is explained as a function of activities in China - the payments of commissions for past sales and - more recently - the build-up of excess inventory.

This cash burn has been brutal enough that the company breached its debt covenants for which it needed and received very short term extensions.

It is likely the company will need to renegotiate their debt covenants.

The range of potential outcomes is enormous. If China sales do not restart and the cash burn continues then renegotiation of the debt seems unlikely and the stock will go to zero.

If the China business restarts and grows beyond original sales the stock is very cheap and should go above its past peak of $140 per share.

A range of zero to say $170 a share for a share trading at $44 is wide enough to be worth a lot of analysis. Get the trade right and you could make a lot of money. Get the trade wrong and...

Disclosure: I am predisposed to believe that multi-level-marketing schemes like Avon, Herbalife or Nu Skin are likely to be good cash generative businesses. I have done much looking at Herbalife and got very long. I do not think a negative interpretation of Herbalife is sustainable. Herbalife's business is legal, sustainable and will generate vastly more cash in five years. Nu Skin does not lend itself to such definitive opinions. History is littered with MLMs that no longer exist - and a few like Avon, Nu Skin, Herbalife, Amway and Mary Kay which have lasted decades.

Trying to understand Nu Skin's China business

There are two posts in this series with the purpose is to work out what is really happening in China.

This post parses the statements of management and the financial statements to see if we can get a clear picture.

The follow up post employs investigators on the ground in China to visit Nu Skin facilities and take photographs and videos.

Neither of these gives a complete picture and the second post is unfortunately indecisive.

Whatever: I lay out what I have found in excruciating detail.

At the end I raise some interpretations of what I have found varying from the reasonable to the seemingly crazy. None of these can be dismissed on the evidence I have found.

Parsing the statements of Nu Skin's management

Several years ago Nu Skin gave its Chinese management a $30 million cash incentive to do a billion dollars of annual sales in a calendar year. To quote the Q1 2011 conference call:
Our 30th corporate anniversary will be in the year 2014. And because our pay-out to our sales force in China has been slightly below our global averages, we actually put an incentive in place to pay-out $30 million in conjunction with our 30th anniversary, if sales leaders in the Greater China region reach the $1 billion sales mark by the end of the year 2014. That’s how bullish they are. And essentially, our business there is just in good momentum right now.
Nu Skin claimed a billion dollars in China sales by the fourth quarter of 2013 - and the cash incentive was presumably paid.

In early January there were articles in the Peoples' Daily [the official newspaper] which criticized Nu Skin's selling practices. The company's initial response was to dismiss the importance of those articles:

"The article that appeared in today's People's Daily contains inaccuracies and exaggerations that are not representative of Nu Skin's business in China.  The reporters did not attempt to verify any information with Nu Skin. We do not believe that the article was the result of any particular government inquiry. 
"We are dedicated to operating in full compliance with applicable regulations as interpreted and enforced by the government of China. Nu Skin has an 11-year history of doing business in China under these regulations. Our business activities are regularly monitored by the government in this rapidly growing marketplace. As is our practice, we will communicate openly with regulators to address questions arising from this article. 
"Nu Skin has government-approved direct selling licenses to operate in a majority of provinces in China. The most recent government licensure in July further expanded our direct selling footprint to include 19 of the country's 32 provinces. 
"We actively educate our sales force to follow all regulations as well as company policies and procedures, and any member of our sales force not operating in accordance with local law or with our company policies is subject to discipline."

There was an admission in the initial response: whilst they denied the tenor of the Peoples' Daily article they stated [highlighted] that any member of the sales force that did not operate in accordance with local law and might be subject to discipline perhaps implying they might have had some problems with sales force compliance with their rules. It is a small admission to which the company added later.

As far as I can tell the initial response was never filed with the SEC.

The follow up letter released a couple of days later was filed with the SEC.

PROVO, Utah, Jan. 16, 2014 – Nu Skin Enterprises, Inc. (NYSE: NUS) today issued the following statement in regards to its China business. 
"We are aware that Chinese regulators have now initiated investigations to review issues raised by recent news reports. The government regularly monitors all businesses in this rapidly growing marketplace, and as is our practice, we will continue to communicate openly with regulators to address any questions they may have. 
"As part of our ongoing commitment to comply with all applicable Chinese regulations, we have initiated our own province-by-province business review and will invite relevant regulators to provide guidance. Given the substantial growth in our China salesforce over the last year, we are also taking additional steps to reinforce our training and education efforts. As we work through this evolving situation and remain focused on long-term growth, there will likely be a negative impact on China revenue, but it is too early to know whether our previous guidance will be affected. 
"We remain committed to working cooperatively with the government to ensure long-term, sustainable growth in this important market. Nu Skin has an 11-year history of doing business in China. We are dedicated to operating in full compliance with all applicable regulations as interpreted and enforced by the government of China."

Several days later (21 January) they filed a letter to their distributors and stated clearly that they had found violations:
As part of our initial review, we were disappointed to learn that during our recent rapid growth, there were instances where some of our sales people failed to adequately follow and enforce our policies and regulations. We sincerely apologize for these unfortunate and unauthorized activities. We are undertaking an internal review of the practices of our employees and sales force, and fully intend to take corrective actions.
As they said people who failed to follow the rules were subject to discipline I am interested to learn how many were disciplined by the company and in what manner.

That said - this press release also included a "voluntary" measures including temporarily suspending all business promotional meetings, acceptance of applications for any new sales people and direct sellers, and a strengthening of the refund policy to cover both direct selling and non-direct selling products sold through the company's retail channel. All multi-level-marketing (MLM) companies are dependent on regular promotion meetings partly to promote product to new customers and partly to find new distributors. Turnover amongst distributors is high - so these voluntary measures were likely to be sharply negative for sales.

It also included the following gem of a statement:
After reflection and self-examination, we recognize the importance of maintaining the trust and confidence of relevant authorities and the public. 
It is a strange reflection on Nu Skin that the importance of maintaining the trust and confidence of relevant authorities were not obvious before reflection and self-examination. The statement indicates that prior to the Government action the attitude was cavalier. A company that has a cavalier attitude to having mass community meetings in China might normally expect trouble with government.

The next we heard from Nu Skin about their China business was in the 2013 Q4 conference call (3 March 2014). In that they reaffirmed their strong balance sheet and 20-24 percent revenue growth despite the problems in China.

Note that this projection was made two thirds of the way through the quarter - when they might have had a fairly good idea of how the quarter would shape up.
Our balance sheet continues to be strong as we completed the year with $547 million in cash and $182 million of debt. We believe global revenue for the first quarter will be between $650 million and $670 million. So despite recent events impacting our business in China, we're projecting global revenue growth of 20% to 24% for the first quarter. At this level of revenue, we would expect earnings per share in the $0.90 to $0.94 range.
Moreover they explicitly stated that this guidance included allowances for the cost of the regulatory review in China.

This was - if the results are to be believed - an accurate enough projection: they met this guidance on revenue and beat it on earnings. To quote the first quarter conference call (6 May 2014):
For the quarter, we posted revenue of $671 million, a 24% increase over the first quarter of 2013. Our earnings per share for the quarter increased 17%, finishing at $1.05. And we also grew year-over-year in both the number of sales leaders as well as our active accounts.
The main issue was that there was a very large divergence between the stated earnings (large) and the cash flow (large and negative). Operating cash flow was negative $160 million for the quarter. Capital expenditures burned another $30 million. [You can find quarterly cash flow statements here.]

One of the reasons for this negative cash flow was an inventory build up. They stated explicitly they expected that to turn into cash over time.

By the time of the first quarter conference call they were still explicitly bullish about China. To quote:
As you know, as of May 1, we're allowing new sign-ups in China and have recommenced company-hosted meetings. But the first few days of May are holidays in China. So the reality is that our second quarter forecast, and really our forecast for the remainder of the year, is highly dependent on how quickly the China business recovers. Ideally, we'd be further into normalized operations in China before we provide guidance, as it's frankly just difficult to project how the business will respond. But for purposes of modeling today, we believe that a conservative projection for the quarter would be $700 million on the top line, which will yield $1.25 on the bottom

They were only a third of the way through the quarter - so I guess there is an excuse for getting the quarterly estimates wrong. Here is what happened (this time the quote is from the second quarter conference call).

We appreciate you joining us today. While our business generally performed in line with our guidance for the second quarter, lower-than-expected results from the China LTO in June resulted in second quarter revenue of $650 million, which was obviously lower than our guidance. When we guided the quarter at the beginning of May, we were just a few days in the resumption of corporate promotional activities in China, which included accepting new sales leader applications and holding corporate-sponsored promotional meetings. 
At the time, our China team felt that a $100 million estimate was a conservative forecast for the June limited time offer of our Tru Face Essence Ultra skincare serum. We were disappointed with the results for the LTO that came in at about 50% of our expectations. We believe this was largely due to the lack of business promotional mediums and the suspension of applications, which impacted the ability of our sales force to build momentum in the months leading up to the LTO. 
Otherwise, our local-currency revenue results were largely in line with guidance, with the Americas performing well, up 18% in local currency, EMEA up 14% in local currency, SCA up slightly against the tough comp and North Asia in line, although Korea's continued strength was offset obviously by a soft quarter in Japan, where we were going up against a tough comp in the previous

I have puzzled over this. The guidance was originally $700 million revenue in the quarter and they came in at $650 million. They had a single program - the Tru Face Essence Ultra skincare serum limited time offer which they thought would do $100 million but only did $50 million. Everything else came in in-line. [Well except that weakness in Japan was offset by strength in Korea.]

In other words only one product in one market accounted for the miss.

Indeed reading through this every product that they had in China was in line with expectations except the June limited time offer of Tru Face Essence Ultra skincare serum.

I was trying to work out what that meant in terms of actual sales. 60 capsules of this stuff has a list price of about $200. At $200 per pack $50 million in sales of this would be a quarter of a million packs. The shortfall is another quarter of a million packs. They sure expected to sell (and for that matter supposedly did sell) a vast number of packs of $200 capsules.

Indeed on the numbers they sold roughly a quarter of a million $200 packs of Tru Face Essence Ultra. If they sold that to 200 thousand customers they clearly have a lot of customers in China. Moreover if each "sales leader" sold 15 packs (quite a lot of expensive cosmetics I would think) they have something like 13500 sales leaders. It is a long way down from the 60 thousand sales leaders they claimed in China - but it still implies a very vibrant Chinese business.

Moreover there was no weakness in any product except Tru Face Essence. Those sales leaders must - by implication have sold a lot of other product.

The Wedbush Conference Presentation

On 23 September 2014 Nu Skin presented at Wedbush's  "California Dreamin Consumer Conference" in New York. This was the first time they had given us specific numbers as to the new sign-ups for the distribution force in China. It was really bleak. Here is a direct quote from when the CFO (Ritch Wood) was asked how they were going in China.

It's a great question and I'll repeat it so the webcast – those on the webcast will be able to hear. But really, how are we recruiting people back in China and are we looking to recruit some of those who were sales reps. So our sales rep count went from 30,000 in Greater China to 60,000 from June 30 of last year to the end of the year. We had significant growth as we launched our weight-loss product and a whole bunch of brand new people came into the business. 
As we stopped the activities in January, in other words, they couldn't hold any business meetings and they couldn't bring in any new salespeople, it really made it difficult for our new salespeople, those who are brand new, who didn't have significant build-out consumer basis to be able to stick with the business. In May we allowed those who had fallen out an opportunity to rejoin in one month and basically take over the same spot. However, they had to come back in at the full qualified sales employee level, which is about $2,000 in sales volume per month, which was a pretty high hurdle. 
We didn't have a lot of salespeople actually accept that invitation. There were about 1,500, I believe, that came back to that program. So the rest of those who have fallen out, we certainly go back and try and invite them to come back. They have to go through the four-month qualification process. 
The implications of this are that most of the new sales reps in China (which is most of the sales leaders in China) fell out when they stopped promotional meetings. And then only 1500 of them came back. They "didn't have a lot of salespeople actually accept that invitation".
I would say we're quite restrictive still on what we're doing to recruit new people. We're still only allowing meetings inside our offices, generally speaking.
The fact that they are only allowing sales meetings inside their offices is a very important disclosure. Firstly it means that they cannot possibly be spreading over all of China - but only within reasonable transport distance of where they have an office (which is admittedly a lot of locations).

Also it means that you can scope the size of the business simply by scoping the offices. Avon - a large and reputable MLM - has 6.4 million reps and does roughly ten billion in sales. The average rep sells $1500 worth a year. To do a billion in sales at this intensity you would need something like 660 thousand sellers (only a minority of whom would sell enough product to qualify as "sales rep"). And you need to present to and train all these people. Unless the offices are crawling with people or unless the average sales person is doing great than $100 thousand then the business is not doing a billion in sales.

The CFO continued:  
We're doing a lot of training. We had an expo. It was the first expo we've held this year. We normally have an expo where we open our sales offices and people can bring new people and introduce them to the company, and we do that every three months. And those have been very helpful and successful. 
We cancelled the one in February, we cancelled the one in May , but we did hold the one in August, the 1st and 2nd of August, and that was very effective. We had a lot of people, about 13,000 new customers who came in during those two days. That's the amazing thing about China. There's a lot of opportunity for a big influx of people, but we're still quite restrictive. We haven't provided really any significant new incentives to drive their recruiting. It'll be a slow build from here and really try and build that base strong, make sure people are well trained as they come in so that we'll have a solid base to build off of as we go forward.
Alas Nu Skin has still not given us a number for how many sales leaders they have in China. It is a hard number and Nu Skin knows it. They are just unwilling to share it.

They went from 30 thousand in June last year to 60 thousand by year end. However when they stopped it made it "really made it difficult for our new salespeople, those who are brand new, who didn't have significant build-out consumer basis to be able to stick with the business".
They gave those people who dropped out an opportunity to come back at the old sales people level but only if they could get $2000 worth of sales per month. They got only 1500 takers.

Now $1500 of sales per month times $2000 people is $36 million annually. This is a drop-in-the-ocean relative to the old sales run-rate of over a billion dollars annually.

They held their first expo of the year (the only substantial sales meeting they have held). They got 13000 new customers. Even if you sold $1000 worth of cosmetics to each of these people (an insanely large amount of cosmetics for a customer) it wouldn't make 2 percent of the old sales run-rate.

They might have meant 13000 new "distributors" even though they said "customers" in which case $1000 in inventory is not insane - but $5000 worth would be a very large amount. Inventory loading per distributor is well below that number in the relatively affluent United States. 13000 customers or even distributors does not get us close to a billion dollar annual sales rate.

On these comments it looks rather like the business has collapsed in China. Utterly collapsed. However if a very large number of last year's sales people stayed on then the business may have stopped growing but is otherwise fine. We really need to know the total number of sales leaders in China - not the inflows. Thirteen thousand might sound like a lot of new customers - but in the past there were 60 thousand sales leaders doing a billion in sales. If the average customer purchased $500 worth of cosmetics there were two million customers. On that scale 13,000 new customers is flatly a meaninglessly small number.

What we need to make the assessment is the data that they are not giving us: sales and sales leader numbers in China. Whatever we know the number of new customers is low. But we do not know the retention rate for old customers.

Just how bad is the cash flow?

It is worth quoting from the Wedbush conference call discussion to illustrate how bad the cash flow has become. This is a direct quote:
So in the first six months of the year, there was about a $450 million shift in working capital which caused our cash from operations to go negative, and that limited our ability to buy back shares and pay dividend. We received an exception. We went back and amended that covenant for this y ear so that we're able to pay dividend. But if we really want to be in the market, which we like doing. We're a cash flow business, we think that's a great use of cash, it requires us to refinance our debt. We're in the process of working on that today. Our commitment, as we talked on our last earnings call would be that we should be ready to announce that by the time we released our 3Q numbers at the end of October.
Bluntly I have never seen a business of this size have a $450 million shift in working capital. That is the sort of shift that happens in a business like Tesco which has enormous sales and payables.

This is very surprising. The company grew sales at an annual rate of 24 percent in the first quarter and did not miss earnings. It missed sales by only $50 million in the second quarter and it was massively cash consumptive. The only miss on revenue they had in the second quarter was $50 million in the Tru Face Essence Ultra LTO - and yet they burnt cash at a massive rate.

Sales of old product continued at the expected rate - which suggests the back-book does not generate much cash.

Unless there are some very peculiar and very lagged bonus structures in China it is very hard to explain how a cosmetic company can have a $450 million adverse shift in working capital. Certainly it is seemingly inconsistent with their bullishness about earnings (and subsequent beat) in the first quarter or their mere $50 million miss on revenue in the second quarter.

We were left confused as there is an apparent mismatch between statements in the first two quarters (China is good), statements in the Wedbush conference call (China is certainly not as good as it was) and cash flow (which is diabolically poor).

We have attempted to sort this out by visits to their sites in China. This is particularly valid as the company has stated that generally speaking they are "still only allowing meetings inside [their] offices." The number of people we see at the offices should then be reflective of the state of the business.

Till next time.



Peter Phan said...

If the outcome is binary within a wide range, why not express the trade with long dated put and call options?

Anonymous said...

Hey John,

Am I missing something? The Q1 and Q2 10-Qs clearly state the number of Sales Leaders in China: 31,118 in Q1 and 26,192 in Q2, both well down from 61,546 at YE 2013.

Kind regards.

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