Spectrum valuation and a case for Verizon and against wannabe players like Sprint and desperado/promotes like GSAT

This post has been in the back of my mind for a long time. It is also talking my book - long Verizon - big, boring with a *lot* of very high value spectrum and short the spectrum wannabe players like GSAT.

As for timing, the post is prompted by the beginning of GSAT's collapse following the research report by Sahm Adrangi and Kerrisdale Capital.

We have another motivation. For 18 months or so Verizon has been one of our biggest (and sometimes our absolute biggest) long position and it has not worked. We haven't lost money - we just have not kept up with the bull market.

This might be (and I hope it is) just the symptom of a wild bull market where "grandmother-safe" stocks (like Verizon) get left behind. But it might also be because I am wrong.

I sincerely hope for some really knowledgeable spectrum engineers to tell me where I am wrong on this. Comments are appreciated either on the blog or by email.

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Spectrum usage - the basis for valuation

Imagine we are sitting in the room and I have a purple flashlight. I can transmit information to you using that flashlight - by flashing it.

In the old days I might have used morse-code to do it - and I could probably get this to work at something under typing pace.

As computers have improved - and the light flashes faster and faster - I have been able to get more and more information into my signal. With telephone signals you get about a 10X improvement by going from analog to (2G) digital and get another large lick between 2G and 3G and then 4G. By the time we get to LTE for everything (including voice) this will largely have played itself out.

The purple light is flashing nearly as fast and efficiently as it can now.

Now suppose I have a room full of people and I wanted to flash my purple light to send everyone some information.

One way is that I could "share the channel" by sending a bit of my signal to everyone in the room usually with some kind of program whereby they can pick out their bit of the signal and everything else gets discarded. One example of this was "code division" as in "Code Division Multiple Access" or CDMA.

The problem is that as I share the channel everyone's gets their information a bit slower. I need to wait whilst information is sent to everyone else.

And if I try to do it too much I just cram up the signal.

I could try a different approach - which is to use multiple purple flashlights and flash signal at full pace to everyone separately but I will have another problem.

The room will be flooded with purple light.

And that purple light will degrade everyone else's signal.

That degradation has a name: "interference". Too much interference and the speed at which I can get information slows down - often dramatically.

There are a few solutions to the interference problem.

One solution is that instead of having a big tower flashing purple light to everyone I have lots of tiny little towers that flash a low powered purple lights that has an effective transmission distance of a few metres. In an ideal world everyone has their localised purple light which gives them information and does not interfere with their neighbours.

Alas that idealised solution requires lots of capital expenditure (you have to build a tower every few metres).

Another solution is to make the purple light into a beam and beam it at every individual person - so they all get their own signal. This has a name - "beam forming" and it the basis of many proposed 5G phone systems.

Another solution is to use the mathematics of interference to my advantage - design my system so that only my signal survives - and everyone elses' is cancelled as white noise.  There are variants on that - but the most famous is MIMO and it winds up being very computer intensive. However you can reasonably get another half order of magnitude of wireless efficiency via this method. It is also the basis of Steve Perlman's wireless technology. I am deeply skeptical of Steve Perlman's project - but I am sure there are people out there more knowledgeable than me.

Another solution is to encase my purple light in glass and send it individually to each person. You can get a vast amount of information this way (fibre-optics) but you lose mobility.

By far the cheapest solution though is to just use another colour.

So I flash in red, violet, indigo, yellow and a bunch of colours you can't see (but are still really colours).

Flashing my signal in multiple colours is an alternative to building more towers. This is a pretty direct trade-off. If I am allowed to use many colours I can get much more information out of a single tower.

When somebody buys "spectrum" what they are really buying is the right to flash light in a different colour. These colours are radio frequencies (say 700 MHZ) rather than visible light (say 700 THZ for the colour purple).

The right to flash information in a different frequency (that is a different colour) is an alternative to the practical obligation to build more towers.

As towers have an identifiable capital and running cost (a cost structure well known to phone companies) spectrum has a definable value - defined by avoided cost.

The point here is that if you know the cost of the phone company and the amount of capital expenditure avoided you can work out the value of the spectrum to a phone company. The phone company can either buy more spectrum or build more towers. [To work this out accurately you would need a map of the US, demographic and phone usage data by small region and try to work out how you would serve them.]

If you have a lot of information to transmit you can save a lot of money buying spectrum rather than building towers - and hence your spectrum is worth a lot of money. It is worth more if (a) the people are difficult to serve or (b) there is a lot of people willing to pay for speed or reliability.

This is where the value of spectrum in billions of dollars comes from. It comes from avoided cost.

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A phone company with a good spectrum position will be able to avoid a lot of costs and still provide a very good service. This will make it profitable. It will be able to charge more (as it has reliable coverage) and will not have to build a lot of towers.

A company with a bad spectrum position will have a cost structure that - well frankly - sucks. It will be competed away.

When we think about the value of spectrum we have to think about the amount of cost that it avoids.

If it avoids lots of costs it is worth a lot.

If it avoids very little cost it is worth very little.

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The rise of smart phones has increased demand for information a lot. Okay a huge amount. We all have the internet in our pocket these days.

And that has obliged phone companies to spend lots of money to keep up with demand. If they don't spend all that money their phone system will break down. [Lots of readers will remember AT&Ts problems in 2009 and if you do not here is Jon Stewart to remind you.] After the iPhone was introduced demand for data went through the roof (especially at AT&T who had a monopoly on iPhones). AT&T capital expenditure in the last five years has been roughly $100 billion - mostly on fixing this problem. These are not small sums and as spectrum is an alternative to capital expenditure AT&T most certainly wishes they had more of it.

The rise of smart-phones has driven up the capital expenditure requirements of the carriers - and as spectrum is an alternative to capital expenditure it has driven up the value of spectrum.

That rise in the value of spectrum (which really has been quite extreme) is the main reason for owning Verizon. They have lots of good spectrum which means good coverage at low costs and that means big profits. My view is simple here. The trend will continue and is Verizon's friend. Profits will be *much* higher in five years. The stock starts at a low teens PE ratio with a 4.4 percent yield and it is only going to get better.

Verizon wireless grows revenue at about 7 percent and will grow earnings faster.

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What sort of spectrum avoids costs?

Spectrum has value because it allows you coverage and capacity at lower costs.

But not all spectrum is equal.

There is really good spectrum. That comes at low frequency and with very few restrictions as to the power output.

And there is poor spectrum which is either very high frequency or has restrictions as to the power output or both.

Low frequency spectrum is good because it propagates really well. It can go through buildings so you can use your iPhone whilst sitting on the toilet in the centre of your concrete office block. It can travel decent distances with limited regard to obstacles. In the wireless world low frequency tends to mean 600-900 MHZ.

In every country in the world there was a big block of this "beach front real estate" taken by the TV channels. Why? Because when they were allocating spectrum in the 1950s there were not many demands and the TV stations asked for and got the best bit.

In every country in the Western World the TV channels are being forced to go digital and their extra spectrum is being sold off. That sell-off has been the basis of most of the big spectrum auctions that have taken place.

In the last auction AT&T and Verizon were the big purchasers - and those blocks are where the LTE/4G networks have been rolled out.

However this is not just "low frequency" spectrum but it also has very few restrictions as to the power of transmitter allowed. Typically Verizon is allowed a tower hundreds of feet high on which they can put a 1000 watt transmitter. This allows Verizon the ability to cover a large amount of area (often hundreds of square kilometres) from a single transmitter. The most valuable spectrum at the last big auction covered the affluent suburbs of Chicago - middling population density and thick insulating walls meant that low frequency spectrum was required. Affluence meant that people would pay for the premium service.

You would never use the spectrum that way in Manhattan. There is simply too much demand for it. However you can still use smaller, lower towers and get good coverage inside buildings.

The two things that make this spectrum value is frequency (low) and power restrictions (very few).

High frequency spectrum is less good generally. It doesn't propagate as well. At very high frequencies (say 2500 MHZ) it can't get into a building and so you lose coverage as you go into elevators or behind trees. You certainly lose coverage when you go into the concrete core of your building (ie the toilet) and try to use the phone.

High frequency spectrum does however have one big advantage.

There is more of it. Much more of it.

And so it gets extensively used for capacity when you really need to move a lot of data.

If you are going to build a wireless network in Tokyo or Seoul or New York you are going to need a lot of spectrum (because the density of use is high) and some of that will need to be high frequency (simply because there is not much low-frequency spectrum and there is a lot of high frequency spectrum).

The poor propagation of high frequency spectrum can be used to your advantage. High frequency spectrum has a hard time getting into a building resulting in poor indoor coverage. A solution is to "light" the building from the inside - putting a transmitter say in the air conditioning duct. This makes for very good internal coverage.

Moreover as the high frequency spectrum can't normally get into the building in this case it can't get out of the building. This means the spectrum used in the building does not interfere (much) with the spectrum used outside the building allowing reuse of spectrum.

Very high frequency spectrum (say upper-band WiFi at frequencies of around 5000 MHZ) can stay inside individual rooms of a home. Low interference is good and means the WiFi never gets congested. The downside is low propagation even within your home. [If you try using your iPad in bed on the other side of the house you will understand the problem.]

Verizon's spectrum mix (unequivocally the best in America) consists mostly of low frequency 700 MHZ "beach front" property with another amount of high-frequency spectrum (the so-called AWS bands) which are used primarily for urban infill. They have some frequency at higher levels too however they have not traditionally had any interest in very high frequency spectrum (eg 2500 MHZ).

Power restrictions

Driving in the country at night you know that a big city radio station (even one a very long way away) can drown out a country station. Radio - especially AM radio - is very low frequency (say 0.6 MHZ) and can propagate a long way (hundreds or sometimes thousands of kilometres).

There is not much spectrum this far down the dial so you can't have a lot of stations. And they interfere with each other a great deal. The big city station has a power output that will simply dwarf a regional station.

Not everyone will be allowed to broadcast with high power because something with high power will (badly) interfere with something at lower power a little way up or down the dial.

All rights to use spectrum come with a power restriction. That power restriction can be for a trivial amount of power or can allow you to use 1600 watts from a 300 metre high antenna.

Obviously being able to pump out a large amount of power from a high tower with a great line of sight will be cheaper than putting a smaller transmitter every 50 meters.

The higher the amount of power you can pump out the higher the value of spectrum.

Lightsquared and power restrictions

Power restrictions can completely neuter the value of your spectrum. LightSquared had some spectrum that was originally designated for satellites. Phil Falcone bet his hedge fund and his reputation on the possibility of getting that spectrum approved for terrestrial use. If he could it was very valuable.

The only problem: that spectrum was near (in frequency) to the spectrum used for the economically important GPS satellite system.

The Federal Communications Commission (FCC) said that was fine so long as independent tests verified that there was no interference.

Phil Falcone took that as the go-ahead - the right to use the spectrum.

Alas the independent tests came back nasty - a phone tower interfered with an aircraft navigation system 20 kilometres away. Approval was denied.

Now I am going to make the obvious point. GPS signal is broadcast by a satellite running on solar energy and batteries hundreds of kilometres away. A phone signal comes from a large tower hooked to mains power.

There are 11 orders of magnitude difference of power between the GPS signal and the phone signal. If the colours were not very different (say a slightly different shade of purple) then there is simply no way that the GPS signal could be seen. The way to think about it: try spotting a 1 watt LED versus the entire power load of a nuclear power station converted to light when the light is a similar colour. It can't be done.

LightSquared demonstrated one thing: Phil Falcone is so egotistical he thought his will could out override the laws of physics. It cost him his fund and his reputation. It cost his clients an awful lot of money.

Alas this seems common enough on Wall Street. I have seen the most absurd things being said about spectrum as if power restrictions do not matter. Power restrictions absolutely determine the value of the spectrum holding.

Quick summary as to what is valuable and what is not

Low frequency spectrum with limited power restrictions is hugely valuable.

High frequency spectrum with only modest power restrictions is less valuable - but is very good for urban infill. Once you have covered most the nation with low frequency spectrum you need to do mid-range or high frequency infill. This is the stage Verizon is now at - using AWS spectrum for infill.

High frequency spectrum with dramatic power restrictions is worthless. A high frequency spectrum with a binding power restriction can't get into a building and can't go very far and you simply can't cost-effectively build a network using that stuff. Besides it competes with WiFi - and WiFi is free - and competing against free is difficult.

WiFi

 There is a lot of WiFi spectrum, some at 2400 MHZ but most around 5000 MHZ. It is unlicensed and anyone can use it. It is high frequency spectrum which makes transmission through the walls of your home difficult (as anyone who has tried can attest).

There are some rules for using it - concerning how you are meant to share channels. The most important rule however is a power restriction. Power restrictions on WiFi are binding and a WiFi signal has an effective range of about 70 meters. [The range will depend on how many walls you have and also on other WiFi signals and how good your antenna is.] Whatever - it is useless over long ranges.

The power restriction is absolutely critical to WiFi. The reason why everyone in a street manages to use WiFi in their home without causing critical interference is that everyone abides by a power-restriction. [You cannot legally sell a WiFi access point that does not abide by the power restriction.]

WiFi carries a lot of data and it carries it by the mechanism of giving everyone a very low powered purple light which they put right next to them. But instead of just purple it has about twenty colours (known as channels). You can carry a *lot* of information by WiFi - multiple high-definition TV channels even - but you can't carry it very far. And for the most part the consumer pays for the infrastructure [ie the little purple light] which is nice for the carriers.

Point here: low-powered high-frequency spectrum competes with WiFi and you can't do that very effectively because WiFi spectrum is fairly abundant (caveat in the next section) and free.

The caveat: WiFi in the Superbowl Stadium versus WiFi in Times Square

There are about twenty useable WiFi channels and it is not often that twenty people want to be downloading something simultaneously within say a 100 foot radius.

When this happens you run the risk of WiFi congestion.

There are prominent places when far more than twenty people want to use the same spectrum simultaneously. The Superbowl stadium at half time has 70 thousand people in it all wanting to film, take pictures and upload the stuff to the internet. The Superbowl stadium at half-time is probably the most congested spectrum in the world.

The WiFi (and phone systems) in the last Superbowl worked. [It had to work - it was sponsored by Verizon. Verizon would have had very bad press if it had not worked.]

In Times Square at the queue for half-priced tickets everyone seems to want to download theatre reviews (as much as anything to see what to see).

WiFi does not work. I know. I have tried it.

It is worth explaining why.

Even though there are rules unlicensed spectrum suffers from the problem of the commons. Too many people in an uncontrolled fashion want to get onto it. The commons however are not very big (a couple of hundred feet radius mostly) and most commons (say the one in my suburban street) have a limited number of people who want to share. So "commons" is not a big problem.

In Times Square "commons" is a big problem. Way too many people fit into my small radius and the network is congested.

At the Superbowl that is also true - but for one thing. There is only one party managing the network in the Superbowl stadium. Signal from outside the stadium can't get in. (The walls are too thick!)

So within the stadium the unlicensed spectrum behaves as if it were licensed spectrum. Sophsiticated WiFi equipment (such as Meraki) include "rogue network detection" as as standard feature. If you were setting up a wireless network for (say) Stanford University where there were a gazillion devices you would want to ensure that rogue networks were prohibited and to ensure you own the spectrum in those places. Rogue devices are jammed and "deauthorized".

The FCC has recently pronounced against jamming rogue networks - at least if you want to charge for an alternative network. The FCC recently fined Marriott Hotels $600 thousand for jamming a rogue WiFi hotspot and then forcing people to pay for hotel-provided WiFi.

My guess is that jamming remains legal (it is certainly supported by equipment manufacturers) but it is only legal if you give away the WiFi signal on your controlled network.

GSAT

GSAT - the latest victim of Sahm Adrangi's precision analysis - is the owner of two blocks of spectrum - both originally allocated as satellite spectrum.

One lot is clearly worthless as it even closer to GPS spectrum than the Lightsquared spectrum. Interference is a given. There is no way they will be allowed to operate at any meaningful power level.

The other lot of spectrum is adjacent WiFi and will never be allowed by the FCC to be substantially more powerful than WiFi spectrum for fear of drowning out WiFi. GSAT proposes using their spectrum with a 4 watt power limit. [Verizon spectrum is low frequency and often has a 1000 watt power limit.] This will mean it has a range commensurate with WiFi.

What GSAT are proposing is a private WiFi channel.

But for the most part there is enough WiFi channels.

In football stadiums or Grand Central where rogue networks can be removed there is plenty of WiFi capacity. [This was demonstrated by the fact that your phone worked during the last Superbowl.]

This applies in hotels too (provided hotels give up charging for WiFi and hence don't fall foul of the Marriott ruling).

In places where rogue networks can't be excluded like Times Square another WiFi channel will be nice. But there are not that many such places. Moreover one channel will get congested for sure in those places... after all if just two people want it you have a difficulty...

Simple summary: GSAT has nothing in the spectrum game. High frequency spectrum with a binding power restriction is worth something near zero. It is a non-starter.

It is hard to see what capital costs GSAT's spectrum helps a carrier avoid. And if it doesn't help them avoid costs then the spectrum is worthless. [Sorry guys.]

That said there are plenty of hedge fund managers who hold GSAT on some vague notion that spectrum is scarce and hence valuable.

I know you read this blog. I suggest you start your next letter as follows:

Dear Limited Partner 

As you know we hold GSAT even though their spectrum is restricted to low power output and is of a high frequency and hence will not have a range of more than a few hundred feet. It also competes with WiFi spectrum within that range. 

We however think that the laws of physics do not apply to us because...

Low frequency spectrum - and the incredible value it offers

AT&T and Verizon have the lion's share of low frequency spectrum in the US. [Both Sprint and T-Mobile have narrow slices.]

These large holdings of low-frequency spectrum mean that Verizon and AT&T can offer better coverage at lower capital cost than their competitors.

The low frequency spectrum however still has limited capacity. If you want lots of capacity you have to use high frequency spectrum (simply because there is much more of it).

If you have low frequency spectrum you advertise yourself on network reliability ("Can you hear me now") but you offer limited and often small data plans.

If you have a high-frequency network your reliability is going to suck (sorry Sprint) but you can offer very large (even unlimited) data plans.

To the extent that you can charge for reliability and you do not have to carry huge amounts of data you should have pricing power AND more modest capital expenditures. You should make pots of money.

We have almost pure comparison between a high-frequency player and a low frequency player in the US - an that is between Verizon Wireless and Sprint.

Verizon Wireless was a separately reporting subsidiary until the end of 2012 and reported its data (courtesy CapitalIQ) can be found here. You can see it did something like $76 billion in revenue in 2012 and the capital expenditure was 8.8 billion (which was its all time high). The capital expenditure was the all-time-high because of the roll-out of the LTE network. Since then Verizon Wireless revenue has risen. Here is wireless revenue by quarter:

								(dollars in millions)
	2012		2013				2014
Unaudited	3Q	4Q	1Q	2Q	3Q	4Q	1Q	2Q
Operating Revenues
Retail service	$ 15,538	$ 15,786	$ 16,169	$ 16,422	$ 16,776	$ 16,967	$ 17,246	$ 17,288
Other service	616	607	559	656	740	744	741	790
Service	16,154	16,393	16,728	17,078	17,516	17,711	17,987	18,078
Equipment	1,858	2,559	1,813	1,953	1,924	2,421	1,870	2,387
Other	1,012	1,042	982	945	959	993	1,022	1,018
Total Operating Revenues	19,024	19,994	19,523	19,976	20,399	21,125	20,879	21,483

You can find the original here.

The growth rate is about 7 percent. It is pretty good.

Operating income for wireless is growing faster because there is relatively fixed costs - and thus operational leverage. Operating income for wireless is now running over 7 billion per quarter and the growth rate was 14 percent in the first quarter but only 7 percent in the second quarter. [There were some unusual expense shifts - my guess is the growth rate is about 10 percent.]

Capital expenditure for wireless is currently running a little over 10 billion per year (it has gone up - all that urban infill is not cheap). They are guiding it down in a couple of years which makes sense (but I guess has to be seen to be utterly believed).

By contrast here are Sprint's numbers. [Again you can find the original courtesy of CapitalIQ.]

Revenue is only 35 billion per year - less than half Verizon - and it does not grow very much.

More importantly capital expenditure is running at roughly 6 billion per year. Again they are guiding for it to fall somewhat - but it can't fall much because of the lack of coverage. What we have is less than half the revenue, roughly 60 percent of the capital expenditure and a lack of growth. It is not pretty.

Capital expenditure has been SUBSTANTIALLY larger than operating cash flow for many years. By contrast Verizon Wireless has substantial operating cash flow after capital expenditure. The spectrum holdings of Verizon have avoided vast capital expenditures and provided better service and pricing power.

Sprint by contrast has large and increasing funding needs. They needed a huge capital injection from Softbank. My guess is that they will need another one.

T-Mobile whose spectrum position is similar to Srpint also has capital expenditure substantially larger than operating cash flow. Alas their parent is not as rich. My guess is that contrary to the popular perception Sprint and not T-Mobile is the ultimate survivor - but only because Sprint is controlled by Softbank and Masa Son will decide at some point he prefers owning a solvent number three phone company than owning a large stake in Alibaba.

Some people (and guidance) think that T-Mobile becomes cash flow positive (after capital expenditure) when it finally turns off old 2G networks. I do not believe it as I think their unlimited buckets now will force them to infill for a very long time. [The 2G network thing will also apply to Verizon.]

The Verizon question

Verizon wireless grows revenue at about 7 percent, income at about 10 percent and according to management is likely to drop its capital expenditure.

It is priced at a teens PE ratio.

Of course it includes a wireline business but that is no longer shrinking. Why? Mainly because it is the opposite end of all those WiFi access points.

What is is worth?

My guess is a *lot* more than the current price. I can't see any reason why the demand for bandwidth will not be a lot higher in a decade and the ability to solve problems by digital compression (ie 4G over analog) is nearing an end. There is likely going to be a true crunch and that crunch will provide pricing power.

But bluntly you don't need that. All you need is the revenue growth to continue at 4-7 percent for half a dozen years, profit growth is thus 8-14 percent and the free cash is overwhelming. Verizon is very cheap it continues. It starts with an almost 4.5 percent dividend. If it gets better at that rate for half a dozen years (still an open question) Verizon is really cheap. In order for Verizon not to be good value that revenue growth needs to stop or the capital expenditure requirements need to blow out.

Some people state the revenue growth will stop because there is a price war going on in US telephony. I have spent a lot of time looking at it and think it is mostly a phoney war (forgive the pun) but it is clearly impacting Sprint whose revenue is stationary but whose customers

I would love (off-the-blog) a decent conversation with anyone who has a decent idea on how to value Verizon's spectrum. I have a list by county of the US of their spectrum holdings (its a 25 megabyte file).

Is there any more spectrum?

It is worth asking whether this can be solved by making more spectrum available. Are there great "fallow fields" of spectrum?

The short answer is no.

The long answer is a little more complicated.

The available low-frequency spectrum has by-and-large come from freeing up the spectrum previously used for TV. In most countries (though not America) all the auctions have happened.

In America there are two major releases of that spectrum. The first was in January 2008 - and the second will be in 2015 (the so-called incentive auction).

The 2008 auction was bid just after the introduction of the iPhone (announced 29 June 2007, introduced a little later). The bidding prices were not high. Spectrum demand and prices have gone up massively since the introduction of smart-phones.

The 2015 auction will be the last auction of high-value low frequency spectrum in my lifetime. There are no more huge blocks to be had. The FCC has reserved 30 MHZ for minor players (not AT&T or Verizon). That reservation is a huge gift from taxpayers to the minor carriers and will allow at least one of Sprint or T-Mobile (or maybe Dish) to prosper. For the minor players the 2015 auction is their last chance to get some high-powered low-frequency spectrum. It is do-or-die.

Because Sprint has a richer parent (Softbank) my guess is the winner will be Sprint.

At high frequency there is not really a shortage of spectrum. There is a lot of WiFi spectrum if you want to build a very dense network (at very high cost). But more realistically Sprint owns (courtesy of Clearwire) huge swathes of very high frequency spectrum with much more realistic power limits than WiFi. Sprint is able to offer a lot of capacity - but as the spectrum is high frequency they might have trouble offering it over a broad market.

Future research

I am seeking anyone who can help me value Verizon's spectrum. I want to develop a physics-based model of Verizon's competitive advantage. Hope dear readers that you can help.



John

Identifying at least one Herbalife customer

One of those bizarre moments in Bill Ackman's first Herbalife presentation was when his former staff member Shane Dinneen stated that it was possible that there was not one legitimate Herbalife customer anywhere in the world.

I want you to remember that. No customers. Anywhere.

Okay - got that embedded in your memory.

Today Herbalife appointed Pamela Jones Harbour as Head of compliance.

Pamela Jones Harbour is a former Commissioner of the Federal Trade Commission. There are plenty of reasons why they might need such a high profile appointment - some good, some bad.

Whatever - I want to focus on PJH's statement:

"Herbalife has helped millions of consumers pursue healthy, active lives through its excellent nutrition products. I know first-hand how great the products are because I've been a customer for 10 years," said Harbour. "My understanding of the industry and familiarity with the products have given me great insight into what a beneficial company Herbalife is, and I am delighted to join such a talented team."

What do you know? One of the non-existent Herbalife customers was a customer for a decade including the time she was a Commissioner at the FTC.

She probably drank the shakes at work in front of her colleagues.

Shane Dinneen's assertion doesn't look good.





John

Assessing the state of Nu Skin's China business - Part 2

In the last post we noted that the swings in Nu Skin's stock were dependent on the state of their business in China. Nu Skin is currently burning considerable amounts of cash and will likely need to renegotiate their debt covenants.

There is a huge range of potential outcomes for the stock. If the cash burn does not stop it might be difficult to renegotiate covenants and Nu Skin could potentially go to zero.

By contrast if the Chinese business were to resume at a rate faster than last year the stock could easily go above its previous high (of roughly $140 per share).

As the stock is currently in the low 40s this range of outcomes makes Nu Skin a worthwhile target for investigation. If you get the stock right you can make a lot of money. Symmetrically if you get it wrong you might lose a lot of money. And China is the issue.

One useful disclosure

Quoted in the last post the CFO of Nu Skin noted that they are currently quite restrictive in what they can do in China. For recruiting he states "we're still only allowing meetings inside our offices, generally speaking."

This is a very important disclosure because we can get a view on how good or bad the business is by visiting the offices and stores. We did just that. In some instances sites were locked and our correspondents in China talked to the guards but were not allowed inside. In other situations our correspondents walked around with permission snapping photos and videos on the trusty iPhone.

Retail stores are more easily open to the public.

Below we present what we have found so you, dear readers, can scale the business. Again alas there may be a large number of old sales leaders who are selling product and not visiting the offices. We have not seen these people but we cannot judge the likelihood (or otherwise) of their existence.

We may have also visited the offices on a bad day (though some places we visited more than once). The date and time of our visit may distort our observations.

Whilst we have an idea how many people are at the offices (very few relative to the scale of the facilities) we cannot tell how much these people are selling.

Below we present what we found with our on-the-ground checks. You can make your own estimates as to the sales this infrastructure supports.

No. 3000 West Huancheng Road

No. 3000 West Huancheng Road is the headquarters of Nu Skin in China, with the company logo prominent and dozens of people (some wearing Nu Skin apparel) onsite and within the building. There was also what appeared to be sales meeting with more than 100 people on the second floor.

However, large tracts of the building inside were devoid of people, particularly the third floor (apparently the Pharmanex area). Our visit took place on the afternoon of a weekday.

More detailed notes from our observer are as follows:

Nu Skin headquarters consists of three buildings connected together in a large “U” formation. Our observer toured the inside of these buildings and made the following comments:

• On the First Floor Nu Skin logos, posters, promotional material and similar are widely in evidence. This floor appears to be mainly used as a canteen and staff leisure center. Dozens of people (many wearing Nu Skin signage) were eating at tables, playing table tennis, snooker or using nearby exercise bikes.
• The Second Floor is comprised of several operational areas and meeting rooms. Our observer saw more than one hundred people on this floor, including what appeared to be both visitors and staff from Nu Skin.
• The Third Floor was not widely populated at all and looks to be dedicated to R&D / similar. No signage was seen mentioning either Shanghai Pharmenex Research & Development Center or its Chinese equivalent (上海华茂研发中心).

This is clearly not devoid of people with more than 100 people probably attending a sales-training program upstairs. However this is a small number compared to the size of the building. According to the Wedbush Presentation the building cost about $65 million to complete last December. That is a lot of building for that number of people.

The campus is huge. Here are two videos taken about 1pm on a weekday afternoon. The first video is almost entirely devoid of people. Photos taken by friends who visited on a separate day are also almost entirely devoid of people.

The second video has people appear at about three minutes and there are about 100 people in total mostly seen at the end of the second video.

You cannot alas tell what sales are from these videos but you can tell one thing for sure. The campus was built at a scale much bigger than the scale of the business on these days.

In other words from these videos you can't tell whether the campus was built in anticipation of a business with three billion in sales functioning at say $600 million or whether it was built in anticipation of a business with one billion in sales functioning at (say) $200 million or even $50 million.

Whatever the site does not appear to be buzzing and was not buzzing on other days on which my friends visited. Indeed some people might find the empty space depressing.




And the second video:



Given that Nu Skin said in the Wedbush conference call quoted above that "still only allowing meetings inside our offices" this does not indicate a lot happening when the observer visited or on the other day at which my friend visited.

Part of what all successful multi-level-marketing companies do is create the "rah-rah" atmosphere that something important is happening and you want to be part of it. They create that with a feeling extravaganza (which other people interpret as cultish). We have - in two visits - seen no sign of the "rah-rah".

We have a lot of photographs of this facility taken on more than one day and mostly devoid of people. The most people we saw appear in the second video starting at about 3:40. If you wish to take the bullish side of the debate you should start there.

No. 29 Workshop, Longyang Industrial Park, Fengxian District, Shanghai

According to the form 10-K, Nu Skin does most of its Chinese manufacturing in China. Our on-the-ground gossip seems to indicate that they import their proprietary formulas in bulk and bottle/package them in China. This makes sense if the proprietary formulas actually contain anything proprietary as their are risks of intellectual property being misappropriated.

The facility at Longyang Industrial Park was not very active. As our observer visited midweek from 9.30 am to 10.30 am. Their notes:

The signage of Nu Skin (China) Daily-Use & Health Products Co Ltd was located at the entrance to an area which was comprised of two buildings. During our time onsite we saw a handful of staff – apparently wearing Nu Skin branded clothing, although it was hard to definitively ascertain this – enter one of the buildings. The other building appeared empty and we saw no one come in or out. Unfortunately, given that there was virtually no one else on site, it was not possible to make inquiries with regard to the current status of operations, and for how long it may have not been fully operational. It appears unlikely however that much activity takes place here.

Again we have no idea as to whether this facility was designed to start up in scale in anticipation of say $3 billion sales or this facility was highly active say eight months ago and was closed as a result of falling sales.

Here is a picture of the entrance to the industrial park.

And here is the entrance to the Nu Skin part of the industrial park:

And here is the other Nu Skin building:

We have a video here as well:

 

No. 12 Fengpu Avenue, Fengpu Town, Fengxian District, Shanghai

This is another Nu Skin facility that is seemingly devoid of people.

Here is some signage outside:

And here is the main entrance which was open:

Various photos of this building clearly show Nu Skin labelled but the photos in Baidu Maps (taken in October last year according to Baidu) do not have the Nu Skin logos on the building. So we figure it is a recent addition to the Nu Skin portfolio.

Our observer came to a similar conclusion:

Our observer confirmed that No. 12 Fengpu Avenue, Shanghai is indeed a Nu Skin facility. The signature board at the site entrance reads only “NU SKIN”, and note that no Chinese version of the name was included.  

Interestingly, the outside wall of the main building inside the facility has the sign “Dexin Building” (德昕大厦). This was explained via inquires with the entrance security guard, who told us that the old owners were Dexin Daily Chemical Co Ltd (德昕日化有限公司). Nu Skin apparently purchased this site “last year.” The security guard at the gate claimed that the Facility was operational, although during our visit [we] did not see any obvious evidence of activity from outside. Note we were not allowed into the site and no one walked in or out that we could interview.

Another friend of mine visited this facility on another date and was apparently told by the guard that the facility had never been opened. The guard had only had their position for a couple of months - so that information may have been faulty.

One manufacturing facility with activity: 819 Xinzhu Road, Economic Development Zone, Huzhou City

In fairness to Nu Skin we did find one facility with considerable signs of activity. It was a smaller facility (address above). Alas they were not permitted by security to enter the facility so all photos are taken from outside.

To quote:

[Our observer] confirmed that there is a Nu Skin facility at this address. Signage of both “Huzhou Branch of Nu Skin (China) Daily-Use & Health Products Co Ltd” (如新(中国)日用保健品有限公司湖州分公司)” and “Pharmanex (Huzhou) Health Products Co Ltd” (华茂(湖州)保健品有限公司) were visible at the entrance.
Although our observer did not see much human traffic during the working hours we were present on site, we noted that there are numerous private cars, motorcycles, and electric bicycles parked inside the facility. We were prevented from entering with facility by the security guard at the main gate. 

Here are the photos:

Main entrance gate:

Main entrance sign:

And peering through the gate - note the cars which were the main evidence of activity:

Photos of stores

Friends of mine have visited many Nu Skin stores. These photos of the main Beijing premises on a Saturday afternoon are typical. There were no customers, only staff:

and

Other stores were similarly devoid of customers. Visits were made to several stores at different times of day.

I did a comparison by visiting the only mock-up store in Sydney - which is at their Australian headquarters. It was in an industrial park with only modest access to public transport. The internal presentation was similar (though the Australian store was smaller). On a weekday morning a handful of distributors came through the Australian store.

Scale of Nu Skin's China business - time for a guess

Given what we have been told about the size of the business, it seems to have facilities that are
rather large relative to its current operations. It seems fair to say that the facilities weren’t bursting
with activity on the days our observers visited.

There are three obvious hypotheses: either (a) the business was built in anticipation of a much larger scale than it had at the end of 2013 when most of these buildings were commissioned or (b) the business which once required facilities of this size has collapsed or (c) the substantive activity happens outside the limited (though sometimes multiple) times we visited.

Alas I can't tell which - but it would be very nice if Nu Skin were to give us more accurate data about the month-by-month sales and month by month numbers of sales leaders.

But other explanations are possible. The factories could be very idle because as Nu Skin has admitted they built up an enormous pile of excess inventory in China and it would make sense to idle factories whilst that excess inventory is worked off.

I have another hypothesis - and it is a hypothesis born of the cynicism of someone who has spent a lot of time looking at Chinese companies. In this hypothesis there never was a billion dollars in sales in China - and the Chinese management just lied to the US management to get a $30 million cash incentive they were promised if they could get sales to a billion dollars. In any country other than China I would dismiss this as impossible a fraud that audacious. But in China I am not sure. Financial controls in China are seldom up to Western standards. In this scenario, the cash burn this year is also not real - the negative cash flow in China just squares the cash balances to reality. [In this hypothesis management in the US are victims of any misstatement in China.]

Whatever: all these hypotheses are just guesses. Even after having spent some money visiting multiple Nu Skin facilities I really do not know.

I for one am looking forward to Nu Skin management giving a clearer explanation of the state of their Chinese business.






John

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.





John