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

Follow up to the Pershing Square insider trading post

There was one major error in the Pershing Square post - which is I suggested that an analyst at PS was charged. No such event happened.

The analyst was not charged. It was the room mate as tipper and a friend as tipee.

Whatever. Bill Ackman's presentation was as far as I know sourced entirely from public information. It is in my opinion wrong - but that is beside the point.

All the room mate knew is that Bill Ackman was going to publicize public information and his analysis of it.

It is a stretch of insider trading rules to deem as insider trading the future publication of already public information.

It is a stretch that I would rather have seen challenged in court. My view remains: SEC over-reach.




John

In defense of the Pershing Square analysts

I can't quite believe I am doing this - because I loathe Bill Ackman with a passion. Mr Ackman in the presence of one of my clients told the world that Bronte would blow up. I had the temerity to disagree with him on two stocks (Herbalife, Valeant). However my positions were much smaller than his in both stocks - so it was rich for him to suggest that I was risky.

Whatever: I think today's charging of one of his former analysts and his room mate for insider trading in Herbalife is a bad case of SEC over-reach.

US insider trading rules first require that someone breach a position of trust regarding the company that is being traded. In the Mark Cuban case - which the SEC ultimately lost on appeal - Mark Cuban was told by the CEO of Mamma.com that the company was going to need to do a secondary offer. Mark Cuban sold his stock and was charged with insider trading.

The whole case swung on whether Mark Cuban had agreed to be bound by the CEO into not trading the information he was given. The SEC could not prove that he had so agreed and so Mark Cuban had not breached any position of trust he had been put in by the company and hence was not guilty of insider trading. I blogged extensively about the Mark Cuban case here and again when the SEC lost the case here.

In the recent Herbalife an analyst at Pershing Square knew in advance that Pershing was going to do its "hit piece" on Herbalife. The analyst had a duty to Pershing Square but did not have any duty to Herbalife and was not an insider in Herbalife.

The analyst tipped his room mate who traded the stock. The room mate made about fifty grand.

Both were charged with insider trading - but neither was in a position of trust with respect to Herbalife and neither had inside company information.

As stated the analyst clearly had a duty to Pershing Square - and I think it is incumbent on Bill Ackman to sue his analyst if the analyst acted contrary to his obligations to Pershing. But it is not a case which should involve the SEC. It is not insider trading.

My guess is that the SEC put Bill Ackman through hell on this one.

For once - and I suspect it is only once - I am on his side.





John

Post script: I did not read the source material accurately. The analyst was not charged. It was the roommate as tipper and a friend as tippee. However either way I find it extremely hard to work out what duty was breached.

The only person here with a written duty was probably the analyst at Pershing.

Roddy Boyd has more patience than me in chasing down stock hucksters

Roddy Boyd has a story about the wondrous life of yet another stock huckster with a couple of fake PhDs.

http://sirf-online.org/2014/09/16/the-manufacturing-of-professor-dr-anthony-nobles/

I maintain it is better to be a stock-promoter than a short-seller. Stock promoters tend to live very well. Right up there with the biggest hedge fund managers.




John

Nouvelle Vague live in Cologne

Very sick in bed, so looking for (very light) YouTube entertainment to see me through the fever...

The cover of Blondie's Rapture is worth the price of admission. It starts at 7 minutes 11 seconds.

In 2014 the New York Times has gone off line becoming a print-only newsletter for the elite and the elderly

A decade ago Robin Sloan and Matt Thomson made a cheap flash movie on a simple premise. The movie was a production of the Museum of Media History, was made in 2014 and had dropped to the year 2004 through a wormhole in time.

I guess you could think of it as predictive (though Robin Sloan specifically disavowed that).

Some of it is surprisingly good. Some less so. They seem to think that Friendster and not Facebook was what would matter. Enjoy.

http://idorosen.com/mirrors/robinsloan.com/epic/ols-master.html




John

The Gobi Desert people like their Nu Skin, so do Wild Yaks, Donkeys and Bears

Not all of Western China is thinly populated. Chongquing is big modern city (though I have not been there since 1981 when it felt medieval).

However some of China is very thinly populated indeed. Parts of the Tibetan Plateau are almost as thinly populated as Antarctica. I was flattering when I described them as being for nomadic herdsmen (though Nu Skin is also opening stores for them too).

Here again is the map of Nu Skin's store openings - but this time I have marked a few stores.

Note the several stores planned for the Gobi Desert. This area is thinly populated - but they are planning multiple stores.

The map shows an existing store in Hohhot (a reasonable sized city). That store is marked in red. The proposed stores do not correspond to any reasonable looking population centres. However as China hands observe - the area has a surprising population density given how infertile it is.

The store that stands out though is the one marked in Hoh Xil. Hoh Xil is an elevated part of the Tibetan Plateau and the whole area is above the altitude at which sustained human existence is possible. According to Wikipedia Hoh Xil is the least populated part of China and the third least populated part of the world. The population density is comparable to the Greenland Ice Cap.

But it warrants a Nu Skin store and a couple more on the periphery of the wilderness.

There are no people in Hoh Xil, so I guess the Wild Yaks, Donkeys and Bears like their multi-level marketing schemes.

Speculations

There is little chance they will ever open a store in Hoh Xil. A store on Baffin Island is more likely. Indeed many of these marked stores are implausible.

The question arises how did this slide get into a Nu Skin presentation?

There are lots of possibilities. Perhaps it is a mistake as per Richard M. Nixon signing the debt covenant.

Perhaps the Chinese management are having the Provo Utah head-office on. After all if they "build" this store the management could just steal the money. It would be a long time before the Provo Utah team get to visit all these Chinese facilities. This is a company that bought back shares only to breach its debt covenants. That does not speak to good financial controls. This map speaks to further poor financial controls.

At this point I am just speculating. The company issued an 8-K to correct the Richard M. Nixon signature. Perhaps they could also give more accurate store opening plans for China.





John

Nu Skin's remarkable store opening plans in China

Several people did not get the significance of my last post. This post showed a remarkable lack of correlation between the location of the Chinese population and the sales of Nu Skin in China.

Western China - even if you include the populous provinces of Sichuan and Yunnan is still only a small percentage of the Chinese population - and it is a smaller percentage of Chinese disposable income.

But Western China looms large in Nu Skin's China sales. China hands I talk to know no other consumer company that has sales so weighted to the West.

For most companies (and over the whole industry) almost all Chinese retail sales come from populous and relatively rich Eastern Provinces. China Business Review published a reasonable summary. To quote:

Because of the wide disparities among China’s regions and the country’s rural-urban income gap, purchasing power and retail demand vary greatly. According to the PRC National Bureau of Statistics, 42 percent of China’s total retail sales in 2008 came from (by rank) Guangdong, Shandong, Jiangsu, Zhejiang, and Henan—most of which are prosperous eastern provinces. In comparison, Tibet, Qinghai, Ningxia, Hainan, and Gansu had the lowest retail sales that year.

The old-hands think Nu Skin's sales distribution is very unlikely. But according to Nu Skin's auditor it is profitable in China.

Nu Skin is - at least according to their presentations - actively opening stores in the most unlikely places in Western China. Here - from November last year is a store-opening plan:

There are no stores planned in Tibet, but plenty in other poor and thinly populated provinces. Indeed there are several in Chinese high-altitude desert where there are no permanent settlements, only pastoral nomads.

Nu Skin's sales distribution figures in China seem implausible but the aggregate sales are audited - so they should be believed.

Moreover the company's plans are indicative of their past-success in Western China. They are (proudly) setting up shops where nobody lives.

Not only are they good at selling to Uyghur women, but they also appear to have big plans to introduce network marketing to pastoral nomads.





John