Wednesday, May 03, 2006

Nu Skin Enterprises- Brutal Honesty and Corporate Governance

Nu Skin Enterprises (NUS) is essentially a publicly traded version of Amway selling through a multi-level sales organization. The company does most of its sales globally rather than in the U.S. but is based in Provo, Utah. The company sells directly to consumers through a network of distributors. The company operates through three divisions: Nu Skin which offers daily skin-care products, advanced skin treatments, and other personal-care products; Pharmanex, which offers nutritional supplements; and Big Planet, which offers high-technology products and services.

NUS has tested investors patience since last year's third quarter when they started to see a decline in Japan and China. Poor earnings results, in fact a loss was reported for the first quarter this morning. The stock is down more than 13% as I write.

The press release speaks to the necessary business transformation in the usual sort of hollow happy speak that we expect from companies when they run into trouble:

"During the quarter we made great progress in the development and implementation of our business transformation initiative, which is designed to achieve three objectives: first, aligning our efforts and resources to better support our sales leaders; second, simplifying and clarifying our growth drivers in each geographic market; and, third, streamlining our organization to invest in growth initiatives."

But brutal honesty and frankness came from the CEO, Truman Hunt which is rarely heard inside most corporations let alone outside. The tough message rang out during the conference call:

"The first question being asked by many is whether our decline in Japan is related to external market factors....industry trends or the economic environment. The reality is that some of our industry peers have declined, but others have fared well...the environment in Japan is not the definitive factor in determining success or failure."

"Our field leaders identify this (the negative impact of last year's compensation plan changes) as the number one reason for their struggle over the past year..."

"The issues...have to do with simple execution issues...we have had simply too many fundamental execution failures, issues such as product formulation problems, stockouts, miscalculations in the impact of promotions that have hurt us in Japan. These blocking and tackling issues are not just a Japan management issue. On both sides of the water we have not been as attentive to Japan's needs as we need to be."

"Over the years we have had the tendency to overwhelm our sales leaders with too many products and programs emanating from each of our three product divisions."

I applaud the refreshing honesty and laying of blame on senior management, himself included.

Speaking of honesty and frankness, check out the proxy statement:

Under the CEO's new employment agreement, he is to be paid $650,000 as a base salary. Mr. Hunt elected last month to maintain it at his previous $550,000, where it has been for 3 years. The compensation committee offered him 200,000 options as his annual grant. Mr. Hunt accepted only 50,000 options.

In addition, no bonuses were paid to executive officers with respect to third or fourth quarter or second half incentive targets.

The mistakes and miscues will hinder results for a couple of quarters. But the seeds of recovery have been sown. The first and toughest step is recognizing the mistake. This management has clearly done so. Cost savings and a more strategically aligned organization will ensue. The focus on accountability and ownership of the core processes will address many issues. Simple advertising programs in Japan to increase brand awareness are being undertaken. The approvals of the right authorities in Beijing are frustratingly slow, but Avon (AVP) recently was issued the first licence for direct selling. It is possible...I wish I could say likely.

A simple fix in South Korea resulted in a 24% improvement in revenues in the quarter. But Japanese revenues declined 11% in local currency, Mainland China down 12%. The distributor count in mainland China was off by 14%.

Operationally, the business does earn great gross margins, still above 82% both this quarter and a year ago. G&A expenses went up by roughly $3 million despite the $24 million fall in total revenues. However, adjusting for stock option expenses and the formerly every 18 month distributor convention expenses (now going to every 2 years), G&A expenses as a percentage of sales were at 31.27% versus the previous year's 30.13%...not too bad given the dramatic fall in revenues.

On the operating line is where we saw the worst damage, coming in at 6.2% (before non-recurring) versus last year's almost 10%.

The balance sheet looks fine with merely $150 million in long term debt including current portion of LT debt. Cash position is still strong. On an EV/EBIT basis, the company is trading at 9.44 times TTM EBIT. ROIC has been in the 17-18% range before the Asian issues, and had trailed down to 12% prior to this quarter.

Given its valuation, and the honest assessment of blame, as well as the fairness of its management with respect to their own compensation, the company does deserve some consideration as an investment. A positive announcement from China would shed a totally different light on the valuation. Similarly, potential success in Russia could become the next anecdotal evidence to bolster its valuation.

In the interim, likely management will have to demonstrate the credibility and effectiveness of these restructuring moves.

Disclaimer: Neither I, nor my family have a position currently in NUS. However, certain clients do maintain a current position in NUS.


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