UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
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þ |
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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934 |
For the quarterly period ended September 30, 2005
OR
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o |
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TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934 |
For the transition period from ___to ___
Commission File Number: 0-26272
NATURAL HEALTH TRENDS CORP.
(Exact name of registrant as specified in its charter)
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Delaware
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59-2705336 |
(State or other jurisdiction of
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(I.R.S. Employer |
incorporation or organization)
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Identification No.) |
2050 Diplomat Drive
Dallas, Texas 75234
(Address of principal executive offices)
(Zip code)
(972) 241-4080
(Registrants telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of
the Exchange Act). Yes o No þ
Indicate by check mark whether the registrant is a shell company
(as defined in Rule 12b-2 of the Exchange Act). Yes
o No
þ
At November 7, 2005, the number of shares outstanding of the registrants common stock was
7,108,867 shares.
NATURAL HEALTH TRENDS CORP. AND SUBSIDIARIES
Quarterly Report on Form 10-Q
September 30, 2005
INDEX
PART I FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
NATURAL HEALTH TRENDS CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In Thousands, Except Share Data)
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December |
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September |
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31, 2004 |
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30, 2005 |
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(Unaudited) |
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ASSETS |
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Current assets: |
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Cash and cash equivalents |
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$ |
22,324 |
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$ |
28,324 |
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Restricted cash |
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2,395 |
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2,127 |
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Accounts receivable |
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209 |
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524 |
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Inventories, net |
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13,991 |
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16,918 |
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Other current assets |
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2,096 |
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6,352 |
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Total current assets |
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41,015 |
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54,245 |
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Property and equipment, net |
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579 |
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2,171 |
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Goodwill |
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14,145 |
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14,145 |
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Intangible assets, net |
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5,474 |
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4,769 |
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Deferred tax assets |
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434 |
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430 |
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Other assets |
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458 |
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1,050 |
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Total assets |
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$ |
62,105 |
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$ |
76,810 |
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LIABILITIES AND STOCKHOLDERS EQUITY |
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Current liabilities: |
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Accounts payable |
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$ |
1,344 |
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$ |
2,418 |
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Income taxes payable |
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1,797 |
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2,370 |
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Accrued distributor commissions |
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4,259 |
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5,794 |
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Other accrued expenses |
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4,154 |
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7,080 |
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Deferred revenue |
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9,551 |
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13,511 |
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Current portion of debt |
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796 |
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278 |
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Other current liabilities |
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1,595 |
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2,189 |
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Total current liabilities |
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23,496 |
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33,640 |
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Debt |
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22 |
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11 |
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Total liabilities |
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23,518 |
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33,651 |
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Commitments and contingencies
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Minority interest |
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598 |
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736 |
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Mezzanine common stock |
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960 |
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Stockholders equity: |
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Preferred stock, $0.001 par value; 5,000,000 shares authorized; none issued and outstanding |
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Common stock, $0.001 par value; 50,000,000 shares authorized, 6,819,667 and 7,108,867
shares issued and outstanding at December 31, 2004 and September 30, 2005, respectively |
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7 |
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7 |
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Additional paid-in capital |
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64,933 |
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69,428 |
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Accumulated deficit |
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(27,799 |
) |
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(27,044 |
) |
Accumulated other comprehensive income (loss): |
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Foreign currency translation adjustment |
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(112 |
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32 |
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Total stockholders equity |
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37,029 |
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42,423 |
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Total liabilities and stockholders equity |
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$ |
62,105 |
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$ |
76,810 |
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The accompanying notes are an integral part of these consolidated financial statements.
1
NATURAL HEALTH TRENDS CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(In Thousands, Except Per Share Data)
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Three Months Ended |
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Nine Months Ended |
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September 30, |
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September 30, |
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2004 |
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2005 |
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2004 |
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2005 |
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As Restated |
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Net sales |
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$ |
40,482 |
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$ |
58,071 |
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$ |
96,913 |
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$ |
150,789 |
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Cost of sales |
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8,870 |
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12,984 |
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21,987 |
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33,590 |
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Gross profit |
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31,612 |
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45,087 |
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74,926 |
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117,199 |
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Operating expenses: |
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Distributor commissions |
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17,422 |
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29,087 |
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49,745 |
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77,959 |
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Selling, general and administrative expenses |
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8,288 |
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15,108 |
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22,450 |
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36,662 |
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Total operating expenses |
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25,710 |
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44,195 |
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72,195 |
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114,621 |
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Income from operations |
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5,902 |
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892 |
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2,731 |
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2,578 |
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Other expense, net |
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(91 |
) |
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(88 |
) |
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(121 |
) |
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(761 |
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Income before income taxes and minority interest |
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5,811 |
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804 |
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2,610 |
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1,817 |
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Income tax provision |
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(857 |
) |
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(610 |
) |
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(110 |
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(924 |
) |
Minority interest |
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74 |
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(75 |
) |
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(457 |
) |
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(138 |
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Net income |
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$ |
5,028 |
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$ |
119 |
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$ |
2,043 |
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$ |
755 |
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Income per share: |
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Basic |
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$ |
0.92 |
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$ |
0.02 |
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$ |
0.39 |
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$ |
0.11 |
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Diluted |
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$ |
0.75 |
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$ |
0.01 |
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$ |
0.32 |
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$ |
0.09 |
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Weighted-average number of shares outstanding: |
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Basic |
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5,450 |
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6,951 |
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5,189 |
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6,875 |
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Diluted |
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6,692 |
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8,418 |
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6,439 |
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8,267 |
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The accompanying notes are an integral part of these consolidated financial statements.
2
NATURAL HEALTH TRENDS CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In Thousands)
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Nine Months Ended |
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September 30, |
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2004 |
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2005 |
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As Restated |
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CASH FLOWS FROM OPERATING ACTIVITIES: |
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Net income |
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$ |
2,043 |
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$ |
755 |
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Adjustments to reconcile net income to net cash provided by (used in) operating activities: |
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Depreciation and amortization of property and equipment |
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309 |
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290 |
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Amortization of intangibles |
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562 |
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|
705 |
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Minority interest |
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457 |
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|
138 |
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Deferred income taxes |
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(1,403 |
) |
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Imputed compensation |
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99 |
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33 |
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Common stock issued for services |
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13 |
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Changes in assets and liabilities, excluding acquisitions: |
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Accounts receivable |
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(191 |
) |
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(328 |
) |
Inventories, net |
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(8,210 |
) |
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(3,353 |
) |
Other current assets |
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(655 |
) |
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(4,423 |
) |
Other assets |
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(40 |
) |
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(604 |
) |
Accounts payable |
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1,870 |
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|
1,107 |
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Income taxes payable |
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|
978 |
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|
579 |
|
Accrued distributor commissions |
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|
645 |
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|
1,686 |
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Other accrued expenses |
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2,224 |
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|
2,987 |
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Deferred revenue |
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(337 |
) |
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|
4,283 |
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Other current liabilities |
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(186 |
) |
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641 |
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Net cash provided by (used in) operating activities |
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(1,822 |
) |
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4,496 |
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CASH FLOWS FROM INVESTING ACTIVITIES: |
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Business acquired |
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(1,337 |
) |
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Purchase of minority interest |
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(141 |
) |
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Purchases of property and equipment |
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(180 |
) |
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(1,885 |
) |
Decrease (increase) in restricted cash |
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(953 |
) |
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255 |
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Net cash used in investing activities |
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(2,611 |
) |
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(1,630 |
) |
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CASH FLOWS FROM FINANCING ACTIVITIES: |
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Payments on debt |
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(892 |
) |
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(529 |
) |
Proceeds from issuance of common stock |
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12 |
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|
3,606 |
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Offering costs |
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(104 |
) |
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Net cash provided by (used in) financing activities |
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(880 |
) |
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2,973 |
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Effect of exchange rates on cash and cash equivalents |
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(401 |
) |
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161 |
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Net increase (decrease) in cash and cash equivalents |
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(5,714 |
) |
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6,000 |
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CASH AND CASH EQUIVALENTS, beginning of period |
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11,133 |
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22,324 |
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CASH AND CASH EQUIVALENTS, end of period |
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$ |
5,419 |
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$ |
28,324 |
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The accompanying notes are an integral part of these consolidated financial statements.
3
NATURAL HEALTH TRENDS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. NATURE OF OPERATIONS AND BASIS OF PRESENTATION
Nature of Operations
Natural Health Trends Corp. (the Company) is an international direct selling organization
headquartered in Dallas, Texas. The Company was originally incorporated as a Florida corporation in
1988. The Company re-incorporated in the state of Delaware effective June 29, 2005. Subsidiaries
controlled by the Company sell products to a distributor network that either uses the products
themselves or resells them to consumers. The Companys products promote health, wellness and
vitality and are sold under the Lexxus and Kaire brands (see Note 6).
The Companys majority-owned subsidiaries have an active physical presence in the following
markets: North America, which consists of the United States and Canada; Greater China, which
consists of Hong Kong, Macau, Taiwan and China; Southeast Asia, which consists of Singapore,
Malaysia, the Philippines, Thailand and Indonesia; Eastern Europe, which consists of Russia,
Mongolia and other former Soviet Union Republics; Australia and New Zealand, South Korea, Japan,
and Latin America (primarily Mexico).
Basis of Presentation
The unaudited interim consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America for interim financial
information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. As a result,
certain information and footnote disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United States have been condensed
or omitted. In the opinion of management, the accompanying unaudited interim consolidated financial
statements contain all adjustments, consisting of normal recurring adjustments, considered
necessary for a fair statement of the Companys financial information as of September 30, 2005. The
results of operations of any interim period are not necessarily indicative of the results of
operations to be expected for the fiscal year. These consolidated financial statements should be
read in conjunction with the consolidated financial statements and related notes included in our
2004 Annual Report on Form 10-K filed with the United States Securities and Exchange Commission
(SEC) on March 31, 2005.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and all of its
majority-owned subsidiaries. All significant intercompany balances and transactions have been
eliminated in consolidation.
Use of Estimates
The preparation of financial statements in accordance with accounting principles generally
accepted in the United States of America requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and the disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the reported amounts of
revenues and expenses during the reported period. Actual results may differ from these estimates.
The most significant accounting estimates inherent in the preparation of the Companys
financial statements include estimates associated with obsolete inventory and the fair value of
acquired intangible assets and goodwill, as well as those used in the determination of liabilities
related to sales returns, distributor commissions, and income taxes. Various assumptions and other
factors prompt the determination of these significant estimates. The process of determining
significant estimates is fact specific and takes into account historical experience and current and
expected economic conditions. Historically, actual results have not significantly deviated from
those determined using the estimates described above.
Reclassification
Certain balances have been reclassified in the prior year consolidated financial statements to
conform to current year presentation.
4
Revenue Recognition
Product sales are recorded when the products are shipped and title passes to independent
distributors. Product sales to distributors are made pursuant to a distributor agreement that
provides for transfer of both title and risk of loss upon our delivery to the carrier, which is
commonly referred to as F.O.B. Shipping Point. The Company primarily receives payment by credit
card at the time distributors place orders. Amounts received for unshipped product are recorded as
deferred revenue. The Companys sales arrangements do not contain right of inspection or customer
acceptance provisions other than general rights of return.
Actual product returns are recorded as a reduction to net sales. The Company estimates and
accrues a reserve for product returns based on its return policies and historical experience.
During April 2005, the Company launched a new product line, Gourmet Coffee Café, which
consists of coffee machines and the related coffee and tea pods, in the North American market. As
the Gourmet Coffee Café is a very different product than the Companys other products and there is
no reliable information on the Companys sales returns or warranty obligation, the Company has
deferred all revenue generated from the sale of coffee machines and the related coffee and tea pods
until sufficient return and warranty experience on the product can be established. The deferral
totaled approximately $1,464,000 and $1,131,000 in revenue and related costs, respectively, for
product shipped through September 30, 2005. The deferred costs are recorded in other
current assets.
Enrollment package revenue, including any nonrefundable set-up fees, is deferred and
recognized over the term of the arrangement, generally twelve months. During the third quarter of
2004, the Company changed its amortization methodology from a monthly method to the preferred daily
method whereby revenues for each enrollment package start the day of enrollment. The change in
methodology resulted in additional deferred revenue of approximately $280,000 during 2004.
Enrollment packages provide distributors access to both a personalized marketing website and a
business management system. Prior to the acquisition of MarketVision Communications Corp.
(MarketVision) on March 31, 2004, the Company paid MarketVision a fixed amount in exchange for
MarketVision creating and maintaining individual web pages for such distributors. These payments to
MarketVision were deferred and recorded as a prepaid expense. The related amortization was recorded
to cost of sales over the term of the arrangement. The remaining unamortized costs were included in
the determination of the purchase price of MarketVision. Subsequent to the acquisition of
MarketVision, no upfront costs are deferred as the amount is nominal.
Shipping charges billed to distributors are included in net sales. Costs associated with
shipments are included in cost of sales.
Accounting for Stock-Based Compensation
The Company continues to account for stock-based compensation plans under the recognition and
measurement principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock
Issued to Employees, and related Interpretations. The following table illustrates the effect on
net income and income per share if the Company had applied the fair value recognition provisions of
Financial Accounting Standards Board (FASB) Statement No. 123, Accounting for Stock-Based
Compensation, to stock-based employee compensation (in thousands, except per share data):
|
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|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2004 |
|
|
2005 |
|
|
2004 |
|
|
2005 |
|
|
|
|
|
|
|
|
|
|
|
As Restated |
|
|
|
|
|
Net income, as reported |
|
$ |
5,028 |
|
|
$ |
119 |
|
|
$ |
2,043 |
|
|
$ |
755 |
|
Add: Stock-based employee
compensation expense included
in reported net income, net of
related tax effects |
|
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
Deduct: Stock-based employee
compensation expense determined
under fair value based method
for all awards, net of related
tax effects |
|
|
(31 |
) |
|
|
(20 |
) |
|
|
(3,874 |
) |
|
|
(60 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Pro forma net income (loss) |
|
$ |
4,997 |
|
|
$ |
99 |
|
|
$ |
(1,831 |
) |
|
$ |
695 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic income (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As reported |
|
$ |
0.92 |
|
|
$ |
0.02 |
|
|
$ |
0.39 |
|
|
$ |
0.11 |
|
Pro forma |
|
$ |
0.92 |
|
|
$ |
0.01 |
|
|
$ |
(0.35 |
) |
|
$ |
0.10 |
|
Diluted income (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As reported |
|
$ |
0.75 |
|
|
$ |
0.01 |
|
|
$ |
0.32 |
|
|
$ |
0.09 |
|
Pro forma |
|
$ |
0.75 |
|
|
$ |
0.01 |
|
|
$ |
(0.35 |
) |
|
$ |
0.08 |
|
5
The weighted-average fair value of options granted was $11.91 for the nine months ended
September 30, 2004. No options were granted during the three months ended September 30, 2004 and
the nine months ended September 30, 2005. The fair value of each option grant was estimated on the
date of grant using the Black-Scholes option pricing model with the following weighted-average
assumptions: expected life of 4 years, risk-free interest rate of 2.5%, expected volatility of
97%, and dividend yield of zero.
Income Per Share
Basic income per share is computed by dividing net income applicable to common stockholders by
the weighted-average number of common shares outstanding during the period. Diluted income per
share is determined using the weighted-average number of common shares outstanding during the
period, adjusted for the dilutive effect of common stock equivalents, consisting of shares that
might be issued upon the exercise of outstanding stock options and warrants. In periods where
losses are reported, the weighted-average number of common shares outstanding excludes common stock
equivalents because their inclusion would be anti-dilutive.
The dilutive effect of stock options and warrants is reflected by application of the treasury
stock method. The potential tax benefit derived from exercise of non-qualified stock options has
been excluded from the treasury stock calculation as the Company is uncertain that the benefit will
be realized.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2004 |
|
|
2005 |
|
|
2004 |
|
|
2005 |
|
|
|
|
|
|
|
|
|
|
|
As Restated |
|
|
|
|
|
|
|
(In Thousands, Except Per Share Data) |
|
Net income |
|
$ |
5,028 |
|
|
$ |
119 |
|
|
$ |
2,043 |
|
|
$ |
755 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic weighted-average number of shares outstanding |
|
|
5,450 |
|
|
|
6,951 |
|
|
|
5,189 |
|
|
|
6,875 |
|
Effect of dilutive stock options and warrants |
|
|
1,242 |
|
|
|
1,467 |
|
|
|
1,250 |
|
|
|
1,392 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted weighted-average number of shares outstanding |
|
|
6,692 |
|
|
|
8,418 |
|
|
|
6,439 |
|
|
|
8,267 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
$ |
0.92 |
|
|
$ |
0.02 |
|
|
$ |
0.39 |
|
|
$ |
0.11 |
|
Diluted |
|
$ |
0.75 |
|
|
$ |
0.01 |
|
|
$ |
0.32 |
|
|
$ |
0.09 |
|
A warrant to purchase 1,419 shares of common stock was outstanding during each of the three
and nine month periods ended September 30, 2004, but was not included in the computation of diluted
income per share because the exercise price was greater than the average market price of the common
shares. The warrant expired on March 31, 2005.
Options to purchase 310,000 shares of common stock were outstanding during each of the three
and nine month periods ended September 30, 2004 and 2005, but were not included in the computation
of diluted income per share because the exercise prices were greater than the average market price
of the common shares. The options, which expire on March 31, 2011, were still outstanding at
September 30, 2005.
Recent Accounting Pronouncements
In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151,
Inventory Costs. This statement requires that certain costs such as idle facility expense,
excessive spoilage, double freight, and re-handling costs be recognized as current-period charges
and that allocation of fixed production overheads to the costs of conversion be based on the normal
capacity of the production facilities. The provisions of the statement shall be effective for
inventory costs incurred during fiscal years beginning after June 15, 2005. Adoption of this
statement is not anticipated to have a significant impact on the Companys financial condition,
results of operations, or cash flows.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (Revised
2004), Share-Based Payment. This statement is a revision of FASB Statement No. 123, Accounting
for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to
Employees. This Statement requires that we record compensation expense for stock options issued,
based on the estimated fair value of the options at the date of grant. This statement is effective
at the beginning of the next fiscal year that begins after June 15, 2005. We currently are not
required to record stock-based compensation charges if the employees stock option exercise price
is equal to or exceeds the fair value of the stock at the date of grant. We have not yet determined
what impact, if any, the proposed pronouncement would have on our financial statements.
6
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, Accounting
Changes and Error Corrections a replacement of APB Opinion No. 20 and FASB Statement No. 3. The
statement requires retrospective application to prior periods financial statements of changes in
accounting principle, unless it is impracticable to determine either the period-specific effects or
the cumulative effect of the change. The statement is effective for accounting changes and
corrections of errors made in fiscal years beginning after December 15, 2005. Adoption of this
statement is not expected to have a material impact on the Companys financial condition, results
of operations, or cash flows.
3. RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS
On March 23, 2005, the Company filed a Current Report on Form 8-K to report, after
consultation with its audit committee, that an amendment to its financial statements for the year
ended December 31, 2003 and for the first quarter of 2004 is warranted as certain commission and
transportation-related expenses incurred as of December 31, 2003 were under-accrued and certain
revenues not earned until 2004 were improperly recorded as revenue by its Eastern European
business, KGC Networks Ptd. Ltd., for the year ended December 31, 2003. The restatement of the
financial statements for the year ended December 31, 2003 reduced the Companys net sales by
approximately $310,000, increased cost of sales by approximately $180,000, increased distributor
commission expense by approximately $460,000, reduced minority interest expense by approximately
$300,000, and reduced after-tax net income by approximately $650,000 for the quarter as well as the
year ended December 31, 2003.
For the quarter ended March 31, 2004, the restatement increased the Companys net sales by
approximately $310,000, reduced cost of sales by approximately $180,000, reduced distributor
commission expense by approximately $460,000, increased minority interest expense by approximately
$300,000, and increased after-tax net income by approximately $650,000 for the quarter ended March
31, 2004.
Although the financial statements for the three month periods ended June 30, 2004 and
September 30, 2004 are unaffected by this error, the consolidated financial statements for the
second and third quarters of 2004 include inaccurate information on a year to date basis because
they include the erroneous information from the first quarter of 2004 which financial statements
should not be relied upon. The Company also intends to file in the near future an amended annual
report on Form 10-KSB for the year ended December 31, 2003, and amended quarterly reports on Form
10-Q for the first three quarters of 2004.
A reconciliation of the amounts as previously reported and as restated for the nine months
ended September 30, 2004 is as follows (in thousands, except per share data):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As |
|
|
|
|
|
|
|
|
Previously |
|
|
|
|
|
As |
|
|
Reported |
|
Adjustments |
|
Restated |
Net sales |
|
$ |
96,603 |
|
|
$ |
310 |
1 |
|
$ |
96,913 |
|
Gross profit |
|
|
74,436 |
|
|
|
490 |
2 |
|
|
74,926 |
|
Distributor commissions |
|
|
50,204 |
|
|
|
(459 |
)3 |
|
|
49,745 |
|
Selling, general and administrative expenses |
|
|
22,450 |
|
|
|
|
|
|
|
22,450 |
|
Income from operations |
|
|
1,782 |
|
|
|
949 |
|
|
|
2,731 |
|
Net income |
|
$ |
1,393 |
|
|
|
650 |
4 |
|
$ |
2,043 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income per share: |
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
$ |
0.27 |
|
|
|
|
|
|
$ |
0.39 |
|
Diluted |
|
$ |
0.22 |
|
|
|
|
|
|
$ |
0.32 |
|
|
|
|
1 |
|
Revenues not earned until 2004 were improperly recorded as revenue by the Companys
Eastern European business, KGC Networks Ptd. Ltd., for the year ended December 31, 2003. |
|
2 |
|
Includes certain transportation-related expenses incurred but not accrued as of December 31, 2003. |
|
3 |
|
Reflects distributor commissions incurred but not accrued as of December 31, 2003. |
|
4 |
|
Includes minority interest related to the restatement adjustments. |
7
4. COMPREHENSIVE INCOME (In Thousands)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2004 |
|
|
2005 |
|
|
2004 |
|
|
2005 |
|
|
|
|
|
|
|
|
|
|
|
As Restated |
|
|
|
|
|
Net income |
|
$ |
5,028 |
|
|
$ |
119 |
|
|
$ |
2,043 |
|
|
$ |
755 |
|
Other comprehensive income (loss), net of tax: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Foreign currency translation adjustment |
|
|
51 |
|
|
|
60 |
|
|
|
(357 |
) |
|
|
144 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Comprehensive income |
|
$ |
5,079 |
|
|
$ |
179 |
|
|
$ |
1,686 |
|
|
$ |
899 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
5. BUSINESS COMBINATION
On March 31, 2004, the Company entered into a merger agreement with MarketVision. MarketVision
is the exclusive developer and service provider of direct selling internet technology used by the
Company since 2001. MarketVision hosts and maintains the internet technology for the Company and
charged an annual fee for this service based upon the number of enrolled distributors of the
Companys products. MarketVision earned revenues for this service of approximately $579,000 for the
three months ended March 31, 2004.
The shareholders agreement entered into upon the merger with MarketVision contained a one
time put right related to 240,000 shares issued to the former stockholders of MarketVision (other
than Mr. LaCore). The put right requires the Company, during the six month period commencing
following the earlier of (i) the first anniversary of the closing date, or (ii) the date on which
the shares are registered with the Securities and Exchange Commission for resale to the public, to
repurchase all or part of such shares still owned by the stockholders for $4.00 per share less any
amount previously received by such stockholders from the sale of their shares. As the put right
expired unexercised on September 30, 2005, the Company reclassified the put right obligation of
$960,000 to additional paid-in capital.
The results of operations of MarketVision have been included in the Companys consolidated
statements of operations since the completion of the acquisition on March 31, 2004. The following
unaudited pro forma information presents a summary of the results of operations of the Company
assuming the acquisition of MarketVision occurred on January 1, 2004 (in thousands, except per
share data):
|
|
|
|
|
|
|
|
|
|
|
Nine Months Ended |
|
|
September 30, 2004 |
|
|
Actual |
|
Pro Forma |
|
|
As Restated |
|
|
|
|
Net sales |
|
$ |
96,913 |
|
|
$ |
96,913 |
|
Net income |
|
$ |
2,043 |
|
|
$ |
2,144 |
|
Income per share: |
|
|
|
|
|
|
|
|
Basic |
|
$ |
0.39 |
|
|
$ |
0.40 |
|
Diluted |
|
$ |
0.32 |
|
|
$ |
0.32 |
|
6. CONTINGENCIES
During the fall of 2003, the customs agency of the government of South Korea brought a charge
against LXK, Ltd. (LXK), the Companys wholly-owned subsidiary operating in South Korea, with
respect to the importation of the Companys Alura product. The customs agency alleges that Alura is
not a cosmetic product, but rather should be categorized and imported as a pharmaceutical product.
On February 18, 2005, the Seoul Central District Court ruled against LXK and fined it a total of
approximately $200,000. LXK also incurred related costs of approximately $40,000 as a result of the
judgment. The Company recorded a reserve for the entire $240,000 at December 31, 2004 and is
appealing the ruling. The failure to sell Alura in South Korea is not anticipated to have a
material adverse effect on the financial condition, results of operations, cash flow or business
prospects of LXK.
On or around March 31, 2004, Lexxus International, Inc. (Lexxus U.S.) received a letter from
John Loghry, a former Lexxus distributor, alleging that Lexxus U.S. had wrongfully terminated an
alleged oral distributorship agreement with Mr. Loghry and that the Company had breached an alleged
oral agreement to issue shares of the Companys common stock to Mr. Loghry. After Mr. Loghry
threatened to commence suit against Lexxus U.S. and the Company in Nebraska, on May 13, 2004,
Lexxus U.S. and the
8
Company filed an action for declaratory relief against Mr. Loghry in the United States
District Court for the Northern District of Texas seeking, inter alia, a declaration that Mr.
Loghry was not wrongfully terminated and is not entitled to recover anything from Lexxus U.S. or
the Company. Mr. Loghry has filed counterclaims against the Company and Lexxus U.S. asserting his
previously articulated claims. In September 2004, Mr. Loghry filed third party claims against
certain officers of the Company and Lexxus U.S., including against Terry LaCore, former Chief
Executive Officer of Lexxus U.S. and former director of the Company, and Mark Woodburn, former
President and director of the Company, for fraud, Messrs. LaCore, Woodburn, and a certain Lexxus
distributor for conspiracy to commit fraud and tortuous interference with contract. In February
2005, the court dismissed all of Mr. Loghrys claims against the individual defendants, except the
claims for fraud and conspiracy to commit fraud. On June 2, 2005, after Mr. Loghry had filed
amended counterclaims, Lexxus U.S., the Company, and the individual defendants moved to dismiss the
counterclaims on the grounds that the claims were barred because Mr. Loghry had failed to disclose
the existence of the alleged claims when he filed for personal bankruptcy in September 2002. On
June 23, 2005, the court stayed discovery pending resolution of the pending motion to dismiss. On
June 30, 2005, at the request of Mr. Loghry, the U.S. Bankruptcy Court for the District of Nebraska
reopened Mr. Loghrys previously closed Chapter 7 bankruptcy case. On September 6, 2005, the
trustee commenced an action in the U.S. District Court for the District of Nebraska against the
Company; Lexxus U.S.; Messrs. LaCore and Woodburn; Curtis Broome, President of Greater China and
Southeast Asia; and Lisa Grossman, an independent distributor of Lexxus U.S., alleging (i) breaches
of contracts by the Company and Lexxus U.S., (ii) fraudulent inducement by the Company, Lexxus
U.S., and Messrs. LaCore and Woodburn, (iii) civil conspiracy among all defendants, and (iv)
tortuous interference with existing contractual relations by Mr. Broome and Ms. Grossman. The
Company denies the allegations and intends to contest the claims.
On November 1, 2004, Toyota Jidosha Kabushiki Kaisha (d/b/a Toyota Motor Corporation) and
Toyota Motor Sales, U.S.A. (the Toyota Entities) filed a complaint against the Company and Lexxus
U.S. in United States District Court for the Central District of California (CV04-9028). The
complaint alleges trademark and service mark dilution, unfair competition, trademark and service
mark infringement, and trade name infringement, each with respect to Toyotas Lexus trademark.
Toyota seeks to enjoin the Company and Lexxus U.S. from using the Lexxus mark and otherwise
competing unfairly with Toyota, to transfer the ownership of the mylexxus.com and
lexxusinternational.com internet sites to Toyota, and reimbursement of costs and reasonable
attorney fees incurred by Toyota in connection with this matter. The Company has reached a
settlement agreement, dated August 31, 2005, under which the Toyota Entities have agreed to
terminate their claims against the Company, and the Company has agreed to, on or before June 1,
2006, discontinue use of the Lexxus name and mark, and change the name of its Lexxus operations and
domain names, which could have a material adverse effect on the financial condition, results of
operations, cash flow or business prospects of the Company.
On November 12, 2004, Dorothy Porter filed a complaint against the Company in the United
States District Court for the Southern District of Illinois alleging that she sustained a brain
hemorrhage after taking Formula One, an ephedra-containing product marketed by Kaire
Nutraceuticals, Inc., a former subsidiary of the Company, and, thereafter, eKaire.com, Inc., a
wholly-owned subsidiary of the Company. Ms. Porter has sued the Company for strict liability,
breach of warranty and negligence. The Company intends to defend this case vigorously and on
December 27, 2004 filed an answer denying the allegations contained in the complaint. The plaintiff
demanded $2 million in damages to settle the case. On March 7, 2005, a Notice of Tag-Along Action
was filed by Ms. Porter with the Judicial Panel on Multidistrict Litigation. It is anticipated that
this case will be placed on the next Conditional Transfer Order and, ultimately, transferred to the
consolidated Ephedra Products Liability proceedings in the United States District Court for the
Southern District of New York. The Company does not believe that the plaintiff can demonstrate that
its products caused the alleged injury and intends to vigorously defend this action.
On January 13, 2005, Natures Sunshine Products, Inc. and Natures Sunshine Products de Mexico
S.A. de C.V. (collectively Natures Sunshine) filed suit against the Company in the Fourth
Judicial District Court, Utah County, State of Utah seeking injunctive relief and unspecified
damages against the Company, Lexxus U.S., the Companys Mexican subsidiary, and the Companys
Mexico management team, Oscar de la Mora and Jose Villarreal Patino, alleging among other things
that the Companys employment of Messrs. De la Mora and Villarreal violated or could lead to the
violation of certain non-compete, non-solicitation, and confidentiality agreements allegedly in
effect between Messrs. De la Mora and Villarreal and Natures Sunshine. Following repeated
unsuccessful attempts by Natures Sunshine to remand the case to state court, Natures Sunshine
voluntarily dismissed its lawsuit on May 5, 2005 and subsequently filed a new lawsuit in the Fourth
Judicial District Court in Utah County, Utah. On August 22, 2005, a hearing was conducted on
Natures Sunshiness request for preliminary injunction, after which the court announced its
intention to enjoin Messrs. De la Mora and Villarreal from disclosing any confidential information
of Natures Sunshine or soliciting any employee or distributor of Natures Sunshine or inducing
them to terminate their relationship with Natures Sunshine. The court, however, did not enjoin
Messrs. De la Mora or Villarreal from competing with Natures Sunshine. The case remains pending.
If the Company or Messrs. De la Mora and Villarreal are unsuccessful in defending this action, the
Company may be required to change its Mexico management team, at least during the unexpired term of
any enforceable non-compete period, and pay any damages and attorneys fees that may be assessed
against it.
9
Currently, there is no other significant litigation pending against the Company other than as
disclosed in the paragraphs above. From time to time, the Company may become a party to litigation
and subject to claims incident to the ordinary course of the Companys business. Although the
results of such litigation and claims in the ordinary course of business cannot be predicted with
certainty, the Company believes that the final outcome of such matters will not have a material
adverse effect on the Companys business, results of operations or financial condition. Regardless
of outcome, litigation can have an adverse impact on the Company because of defense costs,
diversion of management resources and other factors.
7. RELATED PARTY TRANSACTIONS
In August 2001, the Company entered into a written lease agreement and an oral management
agreement with S&B Business Services, an affiliate of Brad LaCore, the brother of Terry LaCore,
former Chief Executive Officer of Lexxus U.S. and former director of the Company, and Sherry
LaCore, Brad LaCores spouse. Under the terms of the two agreements, S&B Business Services provides
warehouse facilities and certain equipment, manages and ships inventory, provides independent
distributor support services and disburses payments to independent distributors. In exchange for
these services, the Company pays $18,000 annually for leasing the warehouse, $3,600 annually for
the lease of warehouse equipment and $120,000 annually for the management services provided, plus
an annual average of approximately $12,000 for business related services. The Company paid S&B
Business Services approximately $38,500 and $41,000 for the three month periods ended September 30,
2004 and 2005, respectively, and approximately $116,500 and $119,000 for the nine month periods
ended September 30, 2004 and 2005, respectively.
In September 2001, the Company entered into an oral consulting agreement with William
Woodburn, the father of Mark Woodburn, former President and director of the Company, pursuant to
which William Woodburn provided the Company with management advice and other advisory assistance.
In exchange for such services, the Company starting June 8, 2001 paid to Ohio Valley Welding, Inc.,
an affiliate of William Woodburn, $6,250 on a bi-weekly basis. The Company paid $43,750 and
$118,750 for the three and nine month periods ended September 30, 2004, respectively, to Ohio
Valley Welding, Inc. The consulting agreement between the Company and William Woodburn was
terminated as of September 30, 2004.
The Companys former controller is married to Mark Woodburn, former President and director of
the Company. Her employment with the Company ended in August 2004. The Company paid her
approximately $27,000 and $73,000 for the three and nine month periods ended September 30, 2004,
respectively.
On March 31, 2004, the Company entered into a merger agreement with MarketVision, pursuant to
which the Company acquired all of the outstanding capital stock of MarketVision (see Note 5). As a
founding stockholder of MarketVision, Terry LaCore, former Chief Executive Officer of Lexxus U.S.
and former director of the Company, received 450,000 shares of the Companys common stock and is
entitled to receive approximately $840,000 plus interest from promissory notes issued by the
Company. As of September 30, 2005, the outstanding balance due Mr. LaCore was approximately
$52,000.
See Note 8 for additional related party transactions.
8. SUBSEQUENT EVENTS
During September 2005, the Company reorganized its senior management team in connection
with an investigation conducted by the Companys Audit Committee. Effective October 3, 2005, the
Board of Directors of the Company appointed Robert H. Hesse, a member of the Companys Board of
Directors since July 2004, as the Companys Interim Chief Executive Officer. Each of Mark Woodburn
and Terry LaCore resigned as officers and members of the Companys Board of Directors due to their
failure to cooperate with the Audit Committees investigation. The investigation was initiated in
August 2005 and includes allegations of misconduct by Messrs. Woodburn and LaCore asserted by an
unrelated third party arising out of a lawsuit involving Mr. LaCore and such unrelated third party.
From October 3, 2005 through November 13, 2005, Messrs. Woodburn and LaCore were employed as the
Companys Global Managing Director Operations and Global Managing Director Business
Development, respectively.
The Company also created the Office of the Chief Executive, which is comprised of Mr. Hesse,
Chris Sharng, the Companys Executive Vice President and Chief Financial Officer, and Richard S.
Johnson, President of Natural Health Trends Japan. The Office of the Chief Executive is
responsible for managing the day-to-day operations of the Company. Since Mr. Hesse is no longer
considered to be an independent director, he resigned from the Companys Audit Committee in
September 2005. The Companys Nominating Committee is in the process of identifying, reviewing and
evaluating appropriate candidates for appointment to the Board of Directors as independent
directors. The Company intends to appoint two of the anticipated new independent directors to its
Audit Committee.
The Company has formed a search committee to identify and consider appropriate candidates to
serve as the Companys Chief Executive Officer. While serving as the Companys Interim Chief
Executive Officer, the Company pays Mr. Hesse $2,000 per day plus reimbursement of out-of-pocket
expenses.
10
On November 10, 2005, an independent investigator retained by the Companys Audit Committee
learned that an entity controlled by Messrs. Woodburn and LaCore received payments from an
independent distributor of the Companys products during 2001 through August 2005. The Company
believes that Messrs. Woodburn and LaCore received from such independent distributor a total of
approximately $1.4 million and $1.1 million, respectively. The Company believes that the fees paid
by the Company to such independent distributor were not in excess of the amounts due under the
Companys regular distributor compensation plan.
Approximately $2.4 million of the funds paid by the independent distributor to Messrs.
Woodburn and LaCore were paid at the direction of Messrs. Woodburn and LaCore to an entity that is
partially owned by Mr. Woodburns father and Randall A. Mason, a member of the Companys Board of
Directors and Chairman of the Companys Audit Committee. The funds were subsequently paid to an
entity controlled by Messrs. Woodburn and LaCore at their direction. The Company believes that Mr.
Mason was unaware that these payments were directed by Messrs. Woodburn and LaCore to an entity
partially owned by him until uncovered by the Audits Committees independent investigator on
November 10, 2005. Further, the Company believes that Mr. Mason received no pecuniary benefit from
the payments made by the independent distributor. Since payments were directed into an entity that
is partially owned by Mr. Mason, he no longer can be considered independent in accordance with
the rules of The Nasdaq Stock Market and under the federal securities laws. Therefore, effective
November 11, 2005, Mr. Mason resigned as Chairman and a member of the Companys Audit Committee.
Mr. Mason remains as a director.
On November 14, 2005, in light of the information learned by the Companys Audit Committee on
November 10, 2005, the Company has terminated the employment of each of Messrs. Woodburn and
LaCore. No severance has been paid by the Company to Messrs. Woodburn and LaCore and the Company
is investigating claims of action against them.
In addition, a loan made by the Company under the direction of Mr. Woodburn in the aggregate
principal amount of $256,000 in February 2004 was previously
recorded as a loan to a third party.
On November 10, 2005, the Audit Committee investigator learned that the Company actually loaned the
funds to an entity owned and controlled by the parents of Mr. Woodburn. The loan was repaid in
full, partially by an entity controlled by a third party and partially by an entity controlled by
Mr. Woodburn in December 2004.
The Audit Committees
investigation is ongoing, and among other procedures the Company is attempting to interview additional top
distributors. The outcome of the interviews could have an adverse effect on
disclosures related to funds paid to Messrs. Woodburn and LaCore
and potentially other members of management. The Company is seeking additional
independent directors for its Board of Directors and the committees thereof. The Company intends
to amend certain disclosures in previous filings with the Securities and Exchange
Commission related to payments
made by the independent distributor to Messrs. Woodburn and LaCore and to re-characterize the loan
made by the Company to the entity controlled by Mr. Woodburns parents.
Although we are currently unable to predict the effect of the outcome of the termination of
Messrs. Woodburn and LaCore as well as the Audit Committees investigation on our business, we
anticipate that, among other things, the number of active independent distributors and sales
revenue could be materially and adversely effected.
On October 12, 2005, the Company received a letter from The Nasdaq Stock Market stating that
the Company is not in compliance with Marketplace Rule 4350. Specifically, due to the resignation
of Mr. Hesse from the Companys Audit Committee, the Companys Audit Committee is not comprised of
three independent directors. Pursuant to Marketplace Rule 4350(d)(4), the Company has been provided
with the opportunity to cure such non-compliance until the earlier of its next annual stockholders
meeting or September 28, 2006.
On October 31, 2005, the Companys Board of Directors authorized the issuance of options to
purchase a total of 130,000 shares of the Companys common stock at an exercise price of $10.01 per
share (the closing price on the date of issuance). Options to purchase 7,500 shares of the
Companys common stock issued to each of the three members of the Companys Board of Directors vest
immediately. The remaining options issued to management and certain other employees vest over a
three year period.
Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following Managements Discussion and Analysis should be read in conjunction with
Managements Discussion and Analysis included in our 2004 Annual Report on Form 10-K filed with the
United States Securities and Exchange Commission (SEC) on March 31, 2005, and our other filings,
including Current Reports on Form 8-K, filed with the SEC through the date of this report.
11
Company Overview
Natural Health Trends Corp. (the Company) is an international direct selling organization.
We control subsidiaries that distribute products through two separate direct selling businesses
that promote health, wellness and vitality. Lexxus International, Inc., our wholly-owned subsidiary
(Lexxus U.S.), and other Lexxus subsidiaries (collectively, Lexxus), sell certain cosmetic
products as well as quality of life products, which accounted for approximately 99% of our
consolidated net revenues in 2004 as well as in the nine months ended September 30, 2005.
eKaire.com, Inc. (eKaire), our wholly-owned subsidiary, distributes nutritional supplements aimed
at general health and wellness.
Lexxus commenced operations in January 2001 and has experienced tremendous growth, as we are
currently conducting business in at least 30 countries through approximately 166,000 active
distributors as of September 30, 2005. (We consider a distributor active if he or she has placed
at least one product order with us during the preceding year). The Lexxus business includes KGC
Networks Pte. Ltd. (KGC), a Singapore company owned 51% by the Company and 49% by a European
private investor. KGC sells Lexxus products into a separate network with distributors primarily in
Russia and other Eastern European countries. eKaire has been in business since 2000 and is
operating in four countries through approximately 3,000 active distributors.
We have experienced significant revenue growth over the last few years due in part to our
efforts to expand into new markets. We intend to pursue additional foreign markets in 2005. We
began accepting orders in Mexico the week of July 18, 2005 and anticipate commencing revenue
generation in Japan in the fourth quarter of 2005. We also opened our first of up to four
experience centers in Guangzhou, China the week of July 18, 2005.
In the quarter ended September 30, 2005, we generated approximately 93% of our revenue from
outside North America, with sales in Hong Kong representing approximately 65% of revenue. Because
of the size of our foreign operations, operating results can be impacted negatively or positively
by factors such as foreign currency fluctuations, and economic, political and business conditions
around the world. In addition, our business is subject to various laws and regulations, in
particular regulations related to direct selling activities that create certain risks for our
business, including improper claims or activities by our distributors and potential inability to
obtain necessary product registrations.
Recent Developments
During September 2005, the Company reorganized its senior management team in connection with
an investigation conducted by the Companys Audit Committee. Effective October 3, 2005, the Board
of Directors of the Company appointed Robert H. Hesse, a member of the Companys Board of Directors
since July 2004, as the Companys Interim Chief Executive Officer. Each of Mark Woodburn and Terry
LaCore resigned as officers and members of the Companys Board of Directors due to their failure to
cooperate with the Audit Committees investigation. The investigation was initiated in August 2005
and includes allegations of misconduct by Messrs. Woodburn and LaCore asserted by an unrelated
third party arising out of a lawsuit involving Mr. LaCore and such unrelated third party. From
October 3, 2005 through November 13, 2005, Messrs. Woodburn and LaCore were employed as the
Companys Global Managing Director Operations and Global Managing Director Business
Development, respectively.
The Company also created the Office of the Chief Executive, which is comprised of Mr. Hesse,
Chris Sharng, the Companys Executive Vice President and Chief Financial Officer, and Richard S.
Johnson, President of Natural Health Trends Japan. The Office of the Chief Executive is
responsible for managing the day-to-day operations of the Company. Since Mr. Hesse is no longer
considered to be an independent director, he resigned from the Companys Audit Committee in
September 2005. The Companys Nominating Committee is in the process of identifying, reviewing and
evaluating appropriate candidates for appointment to the Board of Directors as independent
directors. The Company intends to appoint two of the anticipated new independent directors to its
Audit Committee.
The Company has formed a search committee to identify and consider appropriate candidates to
serve as the Companys Chief Executive Officer. While serving as the Companys Interim Chief
Executive Officer, the Company pays Mr. Hesse $2,000 per day plus reimbursement of out-of-pocket
expenses.
On November 10, 2005, an independent investigator retained by the Companys Audit Committee
learned that an entity controlled by Messrs. Woodburn and LaCore received payments from an
independent distributor of the Companys products during 2001 through August 2005. The Company
believes that Messrs. Woodburn and LaCore received from such independent distributor a total of
approximately $1.4 million and $1.1 million, respectively. The Company believes that the fees paid
by the Company to such independent distributor were not in excess of the amounts due under the
Companys regular distributor compensation plan.
12
Approximately $2.4 million of the funds paid by the independent distributor to Messrs.
Woodburn and LaCore were paid at the direction of Messrs. Woodburn and LaCore to an entity that is
partially owned by Mr. Woodburns father and Randall A. Mason, a member of the Companys Board of
Directors and Chairman of the Companys Audit Committee. The funds were subsequently paid to an
entity controlled by Messrs. Woodburn and LaCore at their direction. The Company believes that Mr.
Mason was unaware that these payments were directed by Messrs. Woodburn and LaCore to an entity
partially owned by him until uncovered by the Audits Committees independent investigator on
November 10, 2005. Further, the Company believes that Mr. Mason received no pecuniary benefit from
the payments made by the independent distributor. Since payments were directed into an entity that
is partially owned by Mr. Mason, he no longer can be considered independent in accordance with
the rules of The Nasdaq Stock Market and under the federal securities laws. Therefore, effective
November 11, 2005, Mr. Mason resigned as Chairman and a member of the Companys Audit Committee.
Mr. Mason remains as a director.
On November 14, 2005, in light of the information learned by the Companys Audit Committee on
November 10, 2005, the Company has terminated the employment of each of Messrs. Woodburn and
LaCore. No severance has been paid by the Company to Messrs. Woodburn and LaCore and the Company
is investigating claims of action against them.
In addition, a loan made by the Company under the direction of Mr. Woodburn in the aggregate
principal amount of $256,000 in February 2004 was previously
recorded as a loan to a third party.
On November 10, 2005, the Audit Committee investigator learned that the Company actually loaned the
funds to an entity owned and controlled by the parents of Mr. Woodburn. The loan was repaid in
full, partially by an entity controlled by a third party and partially by an entity controlled by Mr. Woodburn in
December 2004.
The Audit Committees investigation
is ongoing, and among other procedures the Company is attempting to interview additional top
distributors. The outcome of the interviews could have an adverse effect on
disclosures related to funds paid to Messrs. Woodburn and LaCore
and potentially other members of management. The Company is seeking additional
independent directors for its Board of Directors and the committees thereof. The Company intends
to amend certain disclosures in previous filings with the Securities
and Exchange Commission related to payments
made by the independent distributor to Messrs. Woodburn and LaCore and to re-characterize the loan
made by the Company to the entity controlled by Mr. Woodburns parents.
Although we are currently unable to predict the effect of the outcome of the termination of
Messrs. Woodburn and LaCore as well as the Audit Committees investigation on our business, we
anticipate that, among other things, the number of active independent distributors and sales
revenue could be materially and adversely effected.
13
Income Statement Presentation
Net Sales. The Company derives its revenue from sales of its products, sales of its enrollment
packages, and from shipping charges. Substantially all of its product sales are to independent
distributors at published wholesale prices. We translate revenue from each markets local currency
into U.S. dollars using average rates of exchange during the period.
The following table sets forth revenue by market and product line for the time periods
indicated (in thousands).
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2004 |
|
|
2005 |
|
|
2004 |
|
|
2005 |
|
|
|
|
|
|
|
|
|
|
|
As Restated |
|
|
|
|
|
North America |
|
$ |
4,073 |
|
|
$ |
3,534 |
|
|
$ |
10,898 |
|
|
$ |
12,486 |
|
Hong Kong |
|
|
23,751 |
|
|
|
37,653 |
|
|
|
52,798 |
|
|
|
94,902 |
|
Taiwan |
|
|
821 |
|
|
|
1,082 |
|
|
|
2,368 |
|
|
|
2,895 |
|
Southeast Asia |
|
|
631 |
|
|
|
2,687 |
|
|
|
937 |
|
|
|
5,493 |
|
Eastern Europe |
|
|
8,863 |
|
|
|
9,840 |
|
|
|
23,883 |
|
|
|
26,474 |
|
South Korea |
|
|
1,787 |
|
|
|
2,453 |
|
|
|
4,169 |
|
|
|
6,066 |
|
Australia/New Zealand |
|
|
156 |
|
|
|
382 |
|
|
|
408 |
|
|
|
1,120 |
|
Latin America |
|
|
|
|
|
|
65 |
|
|
|
|
|
|
|
65 |
|
Other |
|
|
|
|
|
|
|
|
|
|
85 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Lexxus |
|
|
40,082 |
|
|
|
57,696 |
|
|
|
95,546 |
|
|
|
149,501 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
North America |
|
|
271 |
|
|
|
267 |
|
|
|
985 |
|
|
|
956 |
|
Australia/New Zealand |
|
|
129 |
|
|
|
108 |
|
|
|
382 |
|
|
|
332 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Kaire |
|
|
400 |
|
|
|
375 |
|
|
|
1,367 |
|
|
|
1,288 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
40,482 |
|
|
$ |
58,071 |
|
|
$ |
96,913 |
|
|
$ |
150,789 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost of Sales. Cost of sales consist primarily of products purchased from third-party
manufacturers, freight cost of shipping products to distributors and import duties for the
products, costs of promotional materials sold to the Companys distributors at or near cost,
provisions for slow moving or obsolete inventories and, prior to the closing of the merger with
MarketVision Communications
14
Corp. (MarketVision) as of March 31, 2004, the amortization of fees charged by the Companys
third party software service provider. Cost of sales also includes purchasing costs, receiving
costs, inspection costs and warehousing costs. Certain prior year amounts have been re-classified
into cost of sales so that the financial statements are comparable between periods.
Distributor Commissions. Distributor commissions are our most significant expense and are
classified as operating expenses. Under our compensation plan, distributors are paid weekly
commissions in the distributors home country, in their local currency, for product sold by that
distributors down-line distributor network across all geographic markets. Distributors are not
paid commissions on purchases or sales of our products made directly by them. This seamless
compensation plan enables a distributor located in one country to sponsor other distributors
located in other countries where we are authorized to do business.
Currently, there are two fundamental ways in which our distributors can earn income:
|
|
|
Through retail markups on sales of products purchased by distributors at wholesale prices; and |
|
|
|
|
Through a series of commissions paid on product purchases made by their down-line distributors. |
Each of our products carries a specified number of sales volume points. Commissions are based
on total personal and group sales volume points per sales period. Sales volume points are
essentially based upon a percentage of a products wholesale cost. To be eligible to receive
commissions, a distributor may be required to make nominal monthly purchases of our products.
Certain of our subsidiaries do not require these nominal purchases for a distributor to be eligible
to receive commissions.
In determining commissions, the number of levels of down-line distributors included within the
distributors commissionable group increases as the number of distributorships directly below the
distributor increases. Distributor commissions are dependent on the sales mix and, for 2004,
typically ranged between 42% and 55% of net sales. From time to time we make modifications and
enhancements to our compensation plan to help motivate distributors, which can have an impact on
distributor commissions. In January 2005, we implemented a 5% price increase across all product
lines without changing the sales volume points assigned to them. Effectively the price increase is
expected to reduce the distributor commissions as a percentage of revenue.
Selling, General and Administrative Expenses (SG&A). Selling, general and administrative
expenses consist of administrative compensation and benefits, travel, credit card fees and
assessments, professional fees, certain occupancy costs, depreciation and amortization, and other
corporate administrative expenses. In addition, this category includes selling, marketing, and
promotion expenses including costs of distributor conventions which are designed to increase both
product awareness and distributor recruitment. Because our various distributor conventions are not
always held at the same time each year, interim period comparisons will be impacted accordingly.
Income Tax Provision. Provision for income taxes depends on the statutory tax rates in each of
the jurisdictions in which we operate. We expect to complete by the end of 2005 the implementation
of a foreign holding and operating company structure for our non-United States businesses. This new
structure will re-organize our non-United States subsidiaries in the Cayman Islands. Though our
goal is to improve the overall tax rate, there is no assurance that the new tax structure could be
successful. If the United States Internal Revenue Service or the taxing authorities of any other
jurisdiction were to successfully challenge these agreements, plans, or arrangements, or require
changes in our transfer pricing practices, we could be required to pay higher taxes, interest and
penalties, and our earnings would be adversely affected.
Critical Accounting Policies and Estimates
In response to SEC Release No. 33-8040, Cautionary Advice Regarding Disclosure about Critical
Accounting Policies and SEC Release Number 33-8056, Commission Statement about Managements
Discussion and Analysis of Financial Condition and Results of Operations, the Company has
identified certain policies that are important to the portrayal of its consolidated financial
condition and consolidated results of operations. These policies require the application of
significant judgment by the Companys management.
The most significant accounting estimates inherent in the preparation of the Companys
financial statements include estimates associated with obsolete inventory and the fair value of
acquired intangible assets and goodwill, as well as those used in the determination of liabilities
related to sales returns, distributor commissions, and income taxes. Various assumptions and other
factors prompt the determination of these significant estimates. The process of determining
significant estimates is fact specific and takes into account historical experience and current and
expected economic conditions. Historically, actual results have not significantly deviated from
those determined using the estimates described above. If circumstances change relating to the
various assumptions or other factors used in such estimates the Company could experience an adverse
effect on its consolidated financial condition, changes in financial condition, and results of
operations. The Companys critical accounting policies at September 30, 2005 include the following:
15
Inventory Valuation. The Company reviews its inventory carrying value and compares it to the
net realizable value of its inventory and any inventory value in excess of net realizable value is
written down. In addition, the Company reviews its inventory for obsolescence and any inventory
identified as obsolete is reserved or written off. The Companys determination of obsolescence is
based on assumptions about the demand for its products, product expiration dates, estimated future
sales, and managements future plans. Also, if actual sales or management plans are less favorable
than those originally projected by management, additional inventory reserves or write-downs may be
required. The Companys inventory value at September 30, 2005 was approximately $16.9 million.
Inventory write-downs for the three and nine months ended September 30, 2005 were not significant.
Asset Impairment. The Company reviews the book value of its property and equipment and
intangible assets whenever an event or change in circumstances indicates that the net book value of
an asset or group of assets may be unrecoverable. The Companys impairment review includes a
comparison of future projected cash flows (undiscounted and without interest charges) generated by
the asset or group of assets with its associated carrying value. The Company believes its expected
future cash flows approximate or exceed its net book value. However, if circumstances change and
the net book value of the asset or group of assets exceeds expected cash flows, the Company would
have to recognize an impairment loss to the extent the net book value of the asset exceeds its fair
value. At September 30, 2005, the net book value of the Companys property and equipment and
intangible assets were approximately $2.2 million and $4.8 million, respectively. No such
impairment losses were recognized for the three and nine months ended September 30, 2005.
Allowance for Sales Returns. An allowance for sales returns is provided as Lexxus and Kaire
product is shipped. The allowance is based upon the return policy of each country, which varies
from 14 days to one year, and their historical return rates, which range from approximately 1% to
approximately 18% of product sales. Sales returns are approximately 4% of product sales for the
three and nine months ended September 30, 2004 and 2005. The allowance for sales returns was
approximately $1.5 million and $3.1 million at December 31, 2004 and September 30, 2005,
respectively. No material changes in estimates have been recognized for the three and nine months
ended September 30, 2005.
Revenue Recognition. Product sales are recorded when the products are shipped and title passes
to independent distributors. Product sales to distributors are made pursuant to a distributor
agreement that provides for transfer of both title and risk of loss upon our delivery to the
carrier, which is commonly referred to as F.O.B. Shipping Point. The Company primarily receives
payment by credit card at the time distributors place orders. The Companys sales arrangements do
not contain right of inspection or customer acceptance provisions other than general rights of
return. Amounts received for unshipped product are recorded as deferred revenue. Such amounts
totaled $4.9 million at December 31, 2004 and September 30, 2005.
Enrollment package revenue, including any nonrefundable set-up fees, is deferred and
recognized over the term of the arrangement, generally twelve months. Enrollment packages provide
distributors access to both a personalized marketing website and a business management system.
Prior to the merger with MarketVision on March 31, 2004, the Company paid MarketVision a fixed
amount in exchange for MarketVision creating and maintaining individual web pages for such
distributors. These payments to MarketVision were deferred and recorded as a prepaid expense. The
related amortization was recorded to cost of sales over the term of the arrangement. The remaining
unamortized costs were included in the determination of the purchase price of MarketVision.
Subsequent to the acquisition of MarketVision, no upfront costs are deferred as the amount is
nominal. Deferred enrollment package revenue totaled $4.7 million at December 31, 2004 and $7.1
million at September 30, 2005. Although the Company has no immediate plans to significantly change
the terms or conditions of enrollment packages, any changes in the future could result in
additional revenue deferrals or could cause us to recognize its deferred revenue over a longer
period of time.
During April 2005, the Company launched a new product line, Gourmet Coffee Café, which
consists of coffee machines and the related coffee and tea pods, in the North American market. As
the Gourmet Coffee Café is a very different product than the Companys other products and there is
no reliable information on the Companys sales returns or warranty obligation, the Company has
deferred all revenue generated from the sale of coffee machines and the related coffee and tea pods
until sufficient return and warranty experience on the product can be established. The deferral
totaled approximately $1.5 million for product shipped through September 30, 2005.
Tax Valuation Allowance. The Company evaluates the probability of realizing the future
benefits of any of its deferred tax assets and records a valuation allowance when it believes a
portion or all of its deferred tax assets may not be realized. At December 31, 2004, the Company
recognized net deferred tax assets of approximately $515 thousand as it expects to utilize a
portion of its net operating loss carry-forward in connection with the implementation of a foreign
holding and operating company restructure. A valuation allowance of $1.5 million was established
for the remainder of its net deferred tax assets. If the Company is unable to realize the expected
future benefits of its deferred tax assets, it would be required to provide an additional valuation
allowance.
16
Results of Operations
The following table sets forth our operating results as a percentage of net sales for the periods
indicated.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2004 |
|
|
2005 |
|
|
2004 |
|
|
2005 |
|
|
|
|
|
|
|
|
|
|
|
As Restated |
|
|
|
|
|
Net sales |
|
|
100.0 |
% |
|
|
100.0 |
% |
|
|
100.0 |
% |
|
|
100.0 |
% |
Cost of sales |
|
|
21.9 |
|
|
|
22.4 |
|
|
|
22.7 |
|
|
|
22.3 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross profit |
|
|
78.1 |
|
|
|
77.6 |
|
|
|
77.3 |
|
|
|
77.7 |
|
Operating expenses: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Distributor commissions |
|
|
43.0 |
|
|
|
50.1 |
|
|
|
51.3 |
|
|
|
51.7 |
|
Selling, general and administrative expenses |
|
|
20.5 |
|
|
|
26.0 |
|
|
|
23.2 |
|
|
|
24.3 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total operating expenses |
|
|
63.5 |
|
|
|
76.1 |
|
|
|
74.5 |
|
|
|
76.0 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income from operations |
|
|
14.6 |
|
|
|
1.5 |
|
|
|
2.8 |
|
|
|
1.7 |
|
Other expense, net |
|
|
(0.2 |
) |
|
|
(0.1 |
) |
|
|
(0.1 |
) |
|
|
(0.5 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Income before income taxes and minority interest |
|
|
14.4 |
|
|
|
1.4 |
|
|
|
2.7 |
|
|
|
1.2 |
|
Income tax provision |
|
|
(2.1 |
) |
|
|
(1.1 |
) |
|
|
(0.1 |
) |
|
|
(0.6 |
) |
Minority interest |
|
|
0.1 |
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(0.1 |
) |
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(0.5 |
) |
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(0.1 |
) |
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Net income |
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12.4 |
% |
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0.2 |
% |
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2.1 |
% |
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0.5 |
% |
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Net Sales. Net sales were approximately $58.1 million for the three months ended September 30,
2005 compared to $40.5 million for the same period in the prior year, an increase of $17.6 million
or 43 percent. This increase was largely due to the significant growth in the business based in
Hong Kong. In the third quarter of 2005, the Companys Hong Kong business recorded approximately
$37.7 million of net sales compared with approximately $23.8 million a year ago. Furthermore, in
the third quarter of 2005, approximately $2.0 million of the net sales increase could be attributed
to distributors purchasing products in anticipation of our opening in the Japanese market. The
remainder of the net sales increase for the third quarter over a year ago was due to Eastern Europe
($1.0 million) and South Korea ($0.7 million).
Net sales were approximately $150.8 million for the nine months ended September 30, 2005
compared to $96.9 million for the same period in the prior year, an increase of $53.9 million or 56
percent. The net sales increase was primarily due to Hong Kong (approximately $42.1 million), Japan
($4.6 million), Eastern Europe ($2.6 million) and South Korea ($1.9 million).
The growth in net sales could also be attributable to a 5% product price increase implemented
in January 2005 and an increase in the number of active independent distributors. As of September
30, 2005, the operating subsidiaries of the Company had approximately 169,000 active distributors,
compared to 133,000 active independent distributors at the end of 2004, and 118,000 at the end of
the third quarter of 2004. As of September 30, 2005, the Company had deferred revenue of
approximately $13.5 million, of which $4.9 million pertained to product sales. Additionally,
deferred revenue included $1.5 million of Gourmet Coffee Café product shipped but unrecognized as
of September 30, 2005.
Cost of Sales. Cost of sales was approximately $13.0 million or 22.4% of net sales for the
three months ended September 30, 2005 compared with approximately $8.9 million or 21.9% of net
sales for the same period in the prior year. Cost of sales was approximately $33.6 million or
22.3% of net sales for the nine months ended September 30, 2005 compared with approximately $22.0
million or 22.7% of net sales for the same period in the prior year. This quarterly increase in
cost of sales of approximately $4.1 million or 46% was primarily driven by the significant increase
in net sales. For the nine month period, cost of sales as a percentage of net sales decreased over
a year ago mainly due to a 5% price increase instituted in January 2005, as well as the elimination
of the commissions paid to MarketVision (approximately $579,000) after its acquisition by the
Company on March 31, 2004.
Gross Profit. Gross profit was approximately $45.1 million or 77.6% of net sales for the three
months ended September 30, 2005 compared with approximately $31.6 million or 78.1% of net sales for
the same period in the prior year. Gross profit was approximately $117.2 million or 77.7% of net
sales for the nine months ended September 30, 2005 compared with approximately $74.9 million or
77.3% of net sales for the same period in the prior year. This increase in the dollar amount of
gross profit was primarily driven by increased sales, a 5% price increase instituted in January
2005, as well as the elimination of the commissions paid to MarketVision after its acquisition by
the Company on March 31, 2004.
Distributor Commissions. Distributor commissions were approximately $29.1 million or 50.1% of
net sales for the three months ended September 30, 2005 compared with approximately $17.4 million
or 43.0% of net sales for the same period in the prior year. The increase in distributor
commissions as a percentage of sales over a year ago primarily related to commissions recorded in
the second
17
quarter of 2004 totaling approximately $2.7 million for which the associated net sales of
approximately $5.4 million was recognized in the third quarter of 2004. These commissions
pertained to products that potentially could be returned under the special return policy the
Company implemented in April 2004. As a special measure to establish long-term relationships with
the distributors doing business with our Hong Kong office, the Company did not seek to recover
commissions associated with the products returned.
Distributor commissions were approximately $78.0 million or 51.7% of net sales for the nine
months ended September 30, 2005 compared with approximately $49.7 million or 51.3% of net sales for
the same period in the prior year. This increase in the dollar amount of commission expense was
mainly due to the increase in net sales. The increase in distributor commissions as a percentage
of sales over a year ago primarily relates an increase in local market programs, offset by a 5%
price increase implemented in January 2005 without changing the commission calculation formula.
Selling, General and Administrative Expenses (SG&A). SG&A costs were approximately $15.1
million or 26.0% of net sales for the three months ended September 30, 2005 compared with
approximately $8.3 million or 20.5% of net sales for the same period in the prior year. In the
third quarter, this increase of approximately $6.8 million or 82% was mainly attributable to
additional marketing-related expenses primarily in Eastern Europe ($1.6 million) and Hong
Kong/China ($2.3 million), preparing the opening of new markets in Mexico and Japan ($1.6 million),
and higher professional fees and personnel cost in North America ($1.3 million). SG&A costs are
expected to continue to increase for the balance of the year as spending on new markets and
marketing events increase.
SG&A costs were approximately $36.7 million or 24.3% of net sales for the nine months ended
September 30, 2005 compared with approximately $22.5 million or 23.2% of net sales for the same
period in the prior year. The increase was due to increased marketing spending in Eastern Europe
($4.1 million) and Hong Kong/China ($3.0 million), preparing the opening of new markets in Mexico
and Japan ($3.0 million), and higher professional fees and personnel cost in North America ($2.5
million).
Other Expense, Net. Other expense was approximately $88 thousand for the three months ended
September 30, 2005 compared to approximately $91 thousand for the same period in the prior year.
For the first nine months of the year, other expense was approximately $761 thousand for 2005,
versus $121 thousand a year ago. This unfavorable variance was mainly due to exchange losses caused
by a strengthening of the U.S. dollar since December 31, 2004, particularly against the euro.
Income Taxes. Income tax expense was approximately $924 thousand or 51% of income before
income taxes and minority interest for the nine months ended September 30, 2005, compared to
approximately $110 thousand or 4.2% of income before income taxes and minority interest for the
same period in the prior year. The increase in the effective tax rate is primarily attributable to
lower taxable earnings in the United States and its corresponding effect on the realization of net
operating loss carryforwards and the associated deferred tax benefits.
Minority Interest. Minority interest expense was approximately $75 thousand for the three
months ended September 30, 2005, compared to a benefit of approximately $74 thousand for the same
period in the prior year. Minority interest expense was approximately $138 thousand for the nine
months ended September 30, 2005, compared to approximately $457 thousand for the same period in the
prior year. The change relates primarily to the decreased profitability of our 51%-owned
subsidiary, KGC Networks Pte. Ltd.
Net Income. Net income was approximately $119 thousand or 0.2% of net sales for the three
months ended September 30, 2005, compared to approximately $5.0 million or 12.4% of net sales for
the same period in the prior year. Net income was approximately $755 thousand or 0.5% of net sales
for the nine months ended September 30, 2005, compared to approximately $2.0 million or 2.1% of net
sales for the same period in the prior year. The reduction in profitability was primarily due to
an increase in distributor commissions and SG&A as a percent of sales.
Liquidity and Capital Resources
Cash generated from operations is the main funding source for the Companys working capital
and capital expenditure. In the past, the Company also borrowed from institutions and individuals
and issued preferred stock. In October 2004, the Company raised approximately $16 million, net of
transaction fees, through a private equity placement.
At September 30, 2005, the ratio of current assets to current liabilities was 1.61 to 1.00 and
the Company had working capital of approximately $20.6 million.
Cash provided by operations for the nine months ended September 30, 2005 was approximately
$4.5 million. The sales increase and the Companys anticipation of continued sales increase in the
near future was the most significant underlying trend for cash flows from operating activities and
the change in the Companys working capital. Cash was mainly generated from earnings, increases in
accrued distributor commissions and deferred revenue, all driven by sales increase, partly offset
by an increase in inventories and deposits to acquire additional inventories. But there is no
assurance that the expected sales increase in the near term will be realized.
18
Cash used in investing activities during the period was approximately $1.6 million, which
primarily relates to the purchase of property and equipment for our Mexican operations, the build
out of new offices in Hong Kong, and a manufacturing facility in China. Cash provided by financing
activities during the period was approximately $3.0 million as of the Company received proceeds
totaling approximately $3.6 million from the exercise of warrants for 289,200 shares of common
stock, partly offset by the continued repayment of MarketVision acquisition-related promissory
notes. In connection with the MarketVision acquisition, the Company issued three different
promissory notes in the aggregate principal amount of approximately $3.2 million. As of September
30, 2005, approximately $173 thousand remained to be paid over the rest of the year.
Total cash increased by approximately $6.0 million during the period.
With cash generated from profitable business operations and the net proceeds from the private
placement closed in October 2004, the Company believes that its existing liquidity and cash flows
from operations, including its cash and cash equivalents, should be adequate to fund normal
business operations expected in the future.
The Company intends to open additional operations in new foreign markets. The Company
continues to incur expenses to develop the Mexican and Japanese markets in 2005. The estimated
initial cost for entering into the Mexican market is $2 million to $3 million, and $5 million to $7
million for the Japanese market. Actual cost incurred through September 30, 2005 total
approximately $2.6 million and $3.5 million for the Mexican and Japanese markets, respectively.
China is currently the Companys most important business development project. Direct selling,
or multi-level marketing, is currently prohibited in China. The Chinese government has agreed to
open the direct selling market and has published drafts of pertinent legislation. The latest draft
of the legislation earmarked December 1, 2005 as the day the laws are to be officially adopted. The
drafted laws, among other requirements, also require a capital formulation of approximately $10
million. Before the formal adoption of direct selling laws, many of the international direct
selling companies have started to operate in China by employing a retail format.
In June 2004, the Company obtained a business license in China. The license stipulates a
capital requirement of $12 million over a three-year period, including a $1.8 million initial
payment that the Company made in January 2005. In planning for retail operations, the Company
estimates that each experience center, where prospective distributors or consumers could sample
the Companys products, will cost approximately $50,000 to $100,000 to build out, plus
approximately $100,000 to $250,000 of annual lease costs. The Company opened its first experience
center in Guangzhou in July 2005 and is evaluating the number, location, timing and
format of up to three additional experience centers.
As part of the Companys plan to expand business in China, we are preparing for a
manufacturing facility in China to supply the demand in China once the Company obtains a direct
selling license. The Company has leased a factory building and a warehouse as well as purchased
machinery in the second quarter. Our current intention is to start with the finishing stage of the
manufacturing process needed to produce our products in China. In the future, we expect to add
more early-stage manufacturing processes. However, this is dependent upon the progress of our
manufacturing facility and the regulatory environment.
On April 12, 2004, an independent TV documentary show was aired on Chinese television, which
made allegations that the Company engaged in illegal acts and the distributors made false claims.
The show had adversely impacted the Companys Hong Kong based business in 2004. Since the airing of
the program, to the knowledge of the Company, the Chinese government has not initiated any
investigation of the Company or its independent distributors. Nevertheless the Company is also
unable to predict whether it will be successful in obtaining a direct selling license to operate in
China, and if it is successful, when it will be permitted to commence direct selling operations
there. Further, if the Company is successful in obtaining a direct selling license to do business
in China, it is uncertain as to whether the Company will generate profits from such operations.
The Company launched a new product line, Gourmet Coffee Café, in the North American market in
the second quarter. The Company received approximately $1.5 million of orders as of September 30,
2005.
The Company has begun an evaluation of implementing an enterprise resources planning (ERP)
system. Internal business processes are mostly manual and do not link to the MarketVision system,
the Companys Internet-based distributor interface. At this point, the Company does not know how
much the ERP project might cost or when the implementation may start.
19
Off Balance Sheet Arrangements
The Company does not utilize off-balance sheet financing arrangements other than in the normal
course of business. The Company finances the use of certain facilities, office and computer
equipment, and automobiles under various operating lease agreements.
Forward Looking Statements
Certain statements contained in this report constitute forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. All statements included in this report, other than statements of
historical facts, regarding our strategy, future operations, financial position, estimated
revenues, projected costs, prospects, plans and objectives are forward-looking statements. When
used in this report, the words believe, anticipate, intend, estimate, expect, project,
could, would, may, plan, predict, pursue, continue, feel and similar expressions
are intended to identify forward-looking statements, although not all forward-looking statements
contain these identifying words.
We cannot guarantee future results, levels of activity, performance or achievements, and you
should not place undue reliance on our forward-looking statements. Our actual results could differ
materially from those anticipated in these forward-looking statements as a result of various
factors. Our forward-looking statements do not reflect the potential impact of any future
acquisitions, mergers, dispositions, joint ventures or strategic investments. In addition, any
forward-looking statements represent our expectation only as of the date of this report and should
not be relied on as representing our expectations as of any subsequent date. While we may elect to
update forward-looking statements at some point in the future, we specifically disclaim any
obligation to do so, even if our expectations change.
Although we believe that the expectations reflected in any of our forward-looking statements
are reasonable, actual results could differ materially from those projected or assumed in any of
our forward-looking statements. Our future financial condition and results of operations, as well
as any forward-looking statements, are subject to change and to inherent risks and uncertainties,
such as those disclosed in this report. Important factors that could cause our actual results,
performance and achievements, or industry results to differ materially from estimates or
projections contained in forward-looking statements include, among others, the following:
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our relationship with our distributors; |
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our need to continually recruit new distributors; |
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our internal controls and accounting methods may require further modification; |
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regulatory matters governing our products and network marketing system; |
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our relationship with our majority owned subsidiary operating in Russia and other Eastern European countries; |
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our ability to recruit and maintain key management; |
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adverse publicity associated with our products or direct selling organizations; |
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product liability claims; our reliance on outside manufacturers; |
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risks associated with operating internationally, including foreign exchange risks; |
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product concentration; |
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dependence on increased penetration of existing markets; |
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adverse consequences from audit committee investigation and/or management reorganization; |
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the competitive nature of our business; and |
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our ability to generate sufficient cash to operate and expand our business. |
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency Risk
In the first nine months of 2005, approximately 9% of our revenue was recorded in United
States dollars. The Hong Kong dollar is pegged to the U.S. dollar and we purchase nearly all
inventories in U.S. dollars. Therefore, our currency exposure, mainly to European euro, Korean won,
Singapore dollar, New Taiwan dollar and Australia dollar, represented approximately 28% of our
revenue (18% of that for euro) in the first nine months of 2005.
In preparing our consolidated financial statements, we translate revenue and expenses in
foreign countries from their local currencies into U.S. dollars using the average exchange rates
for the period. The local currency of each subsidiarys primary markets is considered the
functional currency. The effect of the translation of the Companys foreign operations is included
in accumulated other comprehensive income within stockholders equity and does not impact the
statement of operations.
20
As currency rates change, translation of our foreign currency functional businesses into U.S.
dollars affects year-over-year comparability of equity. We do not plan to hedge translation risks
because cash flows from our international operations are generally reinvested locally. Changes in
the currency exchange rates that would have the largest impact on translating our international net
assets included European euro, Korean won, New Taiwan dollar and Australian dollar. Japanese yen
and Mexican peso are expected to be more significant as we enter those two markets in the second
half of 2005.
The Chinese government announced on July 21, 2005 that its currency will no longer be pegged
to the U.S. dollar. Instead, the exchange rates for the Chinese yuan, or RMB, will be determined by
a basket of foreign currencies. This change effected a de facto revaluation of the yuan to the U.S.
dollar from an 8.28 yuan to 8.11 yuan per U.S. dollar.
This change should have a very modest, potentially positive, effect on the Companys Hong Kong
business. The Company currently does not generate revenue in yuan. Revenue recorded in Hong Kong is
denominated in Hong Kong dollar, which is not impacted by the yuan revaluation and still pegged to
the U.S. dollar. But the Chinese consumers in purchasing the Companys products will now pay a
smaller amount of yuan to purchase our products, thus effectively a price decrease is implemented
for our Chinese consumers.
The Company does incur some expenses in yuan in China, and these expenses will be translated
into a greater amount of U.S. dollars in our financial statements. The exchange impact on the
expenses incurred in China, approximately $1.2 million in the second and third quarters, were, and
are expected to continue to be, immaterial.
If the Company determines to increase our capital formulation in China in the near future with
cash infusion, the yuan revaluation means that we will need to contribute a greater amount of U.S.
dollars. When the Company is ready to apply for a direct selling license in China, in accordance
with the pending direct selling legislation, we are expected to transfer approximately $8 million
of cash to capitalize our Chinese entity, in order to fulfill the capital requirement.
Hedging
Our exposure to foreign currency fluctuation is expected to increase when the Company opens
for business in Japan and Mexico. The Company currently has no specific plans but expects to
evaluate whether it should use forward or option contracts to hedge its foreign currency exposure.
Seasonality
In addition to general economic factors, the Companys revenue is slightly impacted by
seasonal factors and trends such as major cultural events and vacation patterns. For example, most
Asian markets celebrate their respective local New Year in the first quarter, which generally has a
negative impact on that quarter. We believe that direct selling in the United States and Europe is
also generally negatively impacted during the month of August, which is in our third quarter, when
many individuals, including our distributors, traditionally take time off for vacations.
The seasonality of the Companys spending in SG&A is significantly impacted by the timing of
major meetings, events, advertising, promotions and other marketing-related programs, which are
materially discretionary. For example, the marketing-related spending is generally less in the
first quarter when no major event is planned. The Company currently does not have a fixed calendar
for when these events are held.
Interest Rate Risk
As of September 30, 2005, we do not think the Company has any exposure to interest rate risk
as the Company has limited borrowings that are interest rate sensitive.
Item 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information
required to be disclosed in our Exchange Act reports is recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange Commissions rules and
forms and that such information is accumulated and communicated to our management, including our
President and Chief Financial Officer, as appropriate, to allow for timely decisions regarding
required disclosure. In designing and evaluating the disclosure controls and procedures, management
recognizes that any controls and procedures, no matter how well
21
designed and operated, can provide only reasonable assurance of achieving the desired control
objectives, and management is required to apply its judgment in evaluating the cost-benefit
relationship of possible controls and procedures.
During its review of its financial statements for the quarter ended March 31, 2004, the
Company learned that commission and transportation-related expenses incurred as of December 31,
2003 were under-accrued by approximately $640,000 (on a pre-tax basis) for the quarter and year
ended December 31, 2003. Adjusting entries of approximately $640,000 were included as expenses in
the financial statements for the quarter ended March 31, 2004.
At that time, the Company concluded that the error was not material, and therefore, did not
warrant a restatement of the 2003 financial statements. Based upon the Companys pre-tax income of
approximately $4.0 million for the first quarter of 2004 combined with the Companys historical
sales and net income growth rates, the Company believed that the recording of $640,000 of pre-tax
expenses during the first quarter of 2004 would not have a material effect on the Companys net
income for the 2004 fiscal year.
However, while sales continued to grow significantly, net income for the 2004 fiscal year
declined substantially. As a consequence, the adjusting entries made in the first quarter of 2004
are now considered by management to materially affect the Companys net income for fiscal 2004.
During its review of its financial statements for the year ended December, 31, 2004, the
Company discovered that certain revenues not earned until 2004 were improperly recorded as revenue
by its Eastern European business, KGC Networks Ptd. Ltd., for the year ended December 31, 2003. The
amount of revenues that was over-stated for the 2003 fiscal year was approximately $310,000.
On March 23, 2005, the Audit Committee of the Companys Board of Directors determined that the
inclusion of the aforementioned two items in the financial statements for the quarter ended March
31, 2004 would materially affect the Companys net income for the year ended December 31, 2004, and
the Company believes that an amendment to its financial statements for the year ended December 31,
2003 is warranted.
The restatement of the financial statements for the year ended December 31, 2003 reduced the
Companys net sales by approximately $310,000, increased cost of sales by approximately $180,000,
increased distributor commission expense by approximately $460,000, reduced the minority interest
expense by approximately $300,000, and reduced after-tax net income by approximately $650,000 for
the quarter as well as the year ended December 31, 2003.
For the quarter ended March 31, 2004, the restatement increased the Companys net sales by
approximately $310,000, reduced cost of sales by approximately $180,000, reduced distributor
commission expense by approximately $460,000, increased the minority interest expense by
approximately $300,000, and increased after-tax net income by approximately $650,000 for the
quarter ended March 31, 2004.
The Company, after consultation with its Audit Committee, concluded that the consolidated
financial statements for the quarter and the year ended December 31, 2003 as well as the first
quarter of 2004 should no longer be relied upon, including the consolidated financial statements
and other financial information in the Companys Annual Report on Form 10-KSB for the year ended
December 31, 2003 and the Quarterly Report on Form 10-Q for the first quarter ended March 31, 2004.
Although the financial statements for the three month periods ended June 30, 2004 and September 30,
2004 are unaffected by this error, the consolidated financial statements for the second and third
quarters of 2004 include inaccurate information on a year to date basis because they include the
erroneous information from the first quarter of 2004 which financial statements should not be
relied upon.
The Companys Audit Committee and management have discussed these matters with BDO Seidman LLP
(BDO), the Companys independent registered public accounting firm.
The Company recognizes that the improper accounting for commission and transportation-related
expenses and revenue recognition for the year ended December 31, 2003 reflected a material control
weakness in the Companys internal control over financial reporting that existed at December 31,
2003, such control weakness has been subsequently remedied during 2004.
At March 31, 2005, the Company determined a significant disclosure control weakness resulted
from an inaccurate tax provision calculation. Such control weakness was remedied during the second
quarter of 2005. The Company may elect to adopt additional procedures and controls related to the
tax provision calculation in the future if deemed necessary.
In December 2004, concerns were raised by management regarding certain of the Companys
controls and procedures involving related party transactions, personal expenses incurred by senior
management and inventory shipped to a Company subsidiary. The Companys Audit Committee had such
transactions, controls and procedures examined by a third party, and the Board of Directors of the
Company concluded in July 2005 that there was a lack of documentation with respect to certain
related party transactions,
22
subsidiary operations and expense reimbursement procedures. In addition, sufficient policies
regarding loans to employees and third parties had not been adopted or implemented. Further, an
investigation was initiated in August 2005 and includes allegations of misconduct by Messrs.
Woodburn and LaCore asserted by an unrelated third party arising out of a lawsuit involving Mr.
LaCore and such unrelated third party. As a result of this
investigation, the Company further determined policies related to
independent distributor relationships are inadequate. These control
weaknesses, taken in the aggregate, are considered by
management a material control weakness.
An evaluation of the Companys disclosure controls and procedures (as defined in Section
13(a)-14(c) of the Exchange Act) as of September 30, 2005 was carried out under the supervision and
with the participation of the Companys Interim Chief Executive Officer, Chief Financial Officer,
Chief Accounting Officer and other members of the Companys senior management. The Companys
Interim Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer concluded
that, because of the material control weakness identified in the preceding paragraph, the
Companys disclosure controls and procedures as currently in
effect are not effective in ensuring that
the information required to be disclosed by the Company in the reports it files or submits under
the Exchange Act is (i) accumulated and communicated to the Companys management (including the
Interim Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded,
processed, summarized and reported within the time periods specified in the Securities and Exchange
Commissions rules and forms.
Changes in Internal Controls
In 2004 and the first half of 2005, the Company made changes to improve its internal controls
over financial reporting with respect to (i) each of the Restatement Items, and (ii) monthly
financial reports provided to the Company by its subsidiaries. The Company hired a new Chief
Financial Officer in August 2004, a new Chief Accounting Officer in September 2004, a regional
Chief Financial Officer for Greater China and Southeast Asia in October 2004 and other additional
staff to upgrade our financial organization. In addition, the Company has commenced its
documentation required under the Sarbanes-Oxley Act of 2002 and is developing additional policies
and procedures to further strengthen its international reporting, including the areas of revenue
recognition, sales and expense cut-off and sales returns. The Company hired a reporting specialist
in November 2004 to coordinate the world-wide Sarbanes-Oxley compliance work. In December 2004, the
Company hired a general counsel, who subsequently was given additional responsibilities as the
Chief Operating Officer, to enhance compliance and control.
In June 2005, the Company engaged the national accounting firm Grant Thornton to assist its
effort in designing and documenting controls over business processes, working toward compliance
with Section 404 of the Sarbanes-Oxley Act of 2002. The Company is also evaluating whether to
implement additional controls and procedures, including but not limited to an enterprise resources
planning system to replace its present predominantly manual process, sufficient to accurately
report financial performance on a timely basis.
As a result of the examination concluded in July 2005, the Board of Directors formed a
Compliance Committee comprised of an independent director and several members of senior management
which are advised by outside, independent counsel. The purpose of the Compliance Committee is to
review the policies, programs and practices of the Company and its subsidiaries and to monitor the
adequacy of compliance systems with respect to foreign, federal and state laws. The Company also
appointed an Ethics and Compliance Officer (who is currently the Companys General Counsel).
During September 2005, the Company reorganized its senior management team in connection
with an investigation conducted by the Companys Audit Committee. Effective October 3, 2005, the
Board of Directors of the Company appointed Robert H. Hesse, a member of the Companys Board of
Directors since July 2004, as the Companys Interim Chief Executive Officer. Each of Mark Woodburn
and Terry LaCore resigned as officers and members of the Companys Board of Directors due to their
failure to cooperate with the Audit Committees investigation. The investigation was initiated in
August 2005 and includes allegations of misconduct by Messrs. Woodburn and LaCore asserted by an
unrelated third party arising out of a lawsuit involving Mr. LaCore and such unrelated third party.
From October 3, 2005 through November 13, 2005, Messrs. Woodburn and LaCore were employed as the
Companys Global Managing Director Operations and Global Managing Director Business
Development, respectively.
The Company also created the Office of the Chief Executive, which is comprised of Mr. Hesse,
Chris Sharng, the Companys Executive Vice President and Chief Financial Officer, and Richard S.
Johnson, President of Natural Health Trends Japan. The Office of the Chief Executive is
responsible for managing the day-to-day operations of the Company. Since Mr. Hesse is no longer
considered to be an independent director, he resigned from the Companys Audit Committee in
September 2005. The Companys Nominating Committee is in the process of identifying, reviewing and
evaluating appropriate candidates for appointment to the Board of Directors as independent
directors. The Company intends to appoint two of the anticipated new independent directors to its
Audit Committee.
The Company has formed a search committee to identify and consider appropriate candidates to
serve as the Companys Chief Executive Officer. While serving as the Companys Interim Chief
Executive Officer, the Company pays Mr. Hesse $2,000 per day plus reimbursement of out-of-pocket
expenses.
23
On November 10, 2005, an independent investigator retained by the Companys Audit Committee
learned that an entity controlled by Messrs. Woodburn and LaCore received payments from an
independent distributor of the Companys products during 2001 through August 2005. The Company
believes that Messrs. Woodburn and LaCore received from such independent distributor a total of
approximately $1.4 million and $1.1 million, respectively. The Company believes that the fees paid
by the Company to such independent distributor were not in excess of the amounts due under the
Companys regular distributor compensation plan.
Approximately $2.4 million of the funds paid by the independent distributor to Messrs.
Woodburn and LaCore were paid at the direction of Messrs. Woodburn and LaCore to an entity that is
partially owned by Mr. Woodburns father and Randall A. Mason, a member of the Companys Board of
Directors and Chairman of the Companys Audit Committee. The funds were subsequently paid to an
entity controlled by Messrs. Woodburn and LaCore at their direction. The Company believes that Mr.
Mason was unaware that these payments were directed by Messrs. Woodburn and LaCore to an entity
partially owned by him until uncovered by the Audits Committees independent investigator on
November 10, 2005. Further, the Company believes that Mr. Mason received no pecuniary benefit from
the payments made by the independent distributor. Since payments were directed into an entity that
is partially owned by Mr. Mason, he no longer can be considered independent in accordance with
the rules of The Nasdaq Stock Market and under the federal securities laws. Therefore, effective
November 11, 2005, Mr. Mason resigned as Chairman and a member of the Companys Audit Committee.
Mr. Mason remains as a director.
On November 14, 2005, in light of the information learned by the Companys Audit Committee on
November 10, 2005, the Company has terminated the employment of each of Messrs. Woodburn and
LaCore. No severance has been paid by the Company to Messrs. Woodburn and LaCore and the Company
is investigating claims of action against them.
In addition, a loan made by the Company under the direction of Mr. Woodburn in the aggregate
principal amount of $256,000 in February 2004 was previously recorded as a loan to a third party.
On November 10, 2005, the Audit Committee investigator learned that the Company actually loaned the
funds to an entity owned and controlled by the parents of Mr. Woodburn. The loan was repaid in
full, partially by an entity controlled by a third party and partially by an entity controlled by
Mr. Woodburn in December 2004.
The Audit
Committees investigation
is ongoing, and among other procedures the Company is attempting to interview additional top
distributors. The outcome of the interviews could have an adverse effect on
disclosures related to funds paid to Messrs. Woodburn and LaCore
and potentially other members of management. The Company is seeking additional
independent directors for its Board of Directors and the committees thereof. The Company intends
to amend certain disclosures in previous filings with the Securities and Exchange Commission related to payments
made by the independent distributor to Messrs. Woodburn and LaCore and to re-characterize the loan
made by the Company to the entity controlled by Mr. Woodburns parents.
In light of the noted
material weakness, we have instituted, and will continue to institute,
control improvements that we believe will reduce the likelihood of
similar errors, such as developing policies related to distributor
compensation adjustments, employee loans, expense reimbursements, and
distributor relationships. If the remedial
policies and procedures we have implemented, and will continue to implement, are insufficient to
address the material weakness or if additional significant deficiencies or other conditions
relating to our internal controls are discovered in the future, we may fail to meet our future
reporting obligations, our financial statements may contain material misstatements and our
operating results may be adversely affected. Any such failure could also adversely affect the
results of the periodic management evaluations and annual auditor attestation reports regarding the
effectiveness of our internal controls over financial reporting, which will be required when the
SECs rules under Section 404 of the Sarbanes-Oxley Act of 2002 become applicable to us beginning
with the filing of our Annual Report on Form 10-K for the year ended December 31, 2006. Internal
control deficiencies could also cause investors to lose confidence in our reported financial
information. Although we believe that we have addressed, or will address in the near future, our
material weakness in internal controls, we cannot guarantee that the measures we have taken to date
or any future measures will remediate the material weakness identified or that any additional
material weakness or significant deficiencies will not arise in the future due to a failure to
implement and maintain adequate internal controls over financial reporting.
The Company intends to continually review and evaluate the design and effectiveness of its
disclosure controls and procedures and to improve its controls and procedures over time and to
correct any deficiencies that it may discover in the future. The goal is to ensure that senior
management has timely access to all material financial and non-financial information concerning the
Companys business. Future events affecting its business may cause the Company to modify its
disclosure controls and procedures.
24
PART II OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
During the fall of 2003, the customs agency of the government of South Korea brought a charge
against LXK, Ltd. (LXK), the Companys wholly-owned subsidiary operating in South Korea, with
respect to the importation of the Companys Alura product. The customs agency alleges that Alura is
not a cosmetic product, but rather should be categorized and imported as a pharmaceutical product.
On February 18, 2005, the Seoul Central District Court ruled against LXK and fined it a total of
approximately $200,000. LXK also incurred related costs of approximately $40,000 as a result of the
judgment. The Company recorded a reserve for the entire $240,000 at December 31, 2004 and is
appealing the ruling. The failure to sell Alura in South Korea is not anticipated to have a
material adverse effect on the financial condition, results of operations, cash flow or business
prospects of LXK.
On or around March 31, 2004, Lexxus International, Inc. (Lexxus U.S.) received a letter from
John Loghry, a former Lexxus distributor, alleging that Lexxus U.S. had wrongfully terminated an
alleged oral distributorship agreement with Mr. Loghry and that the Company had breached an alleged
oral agreement to issue shares of the Companys common stock to Mr. Loghry. After Mr. Loghry
threatened to commence suit against Lexxus U.S. and the Company in Nebraska, on May 13, 2004,
Lexxus U.S. and the Company filed an action for declaratory relief against Mr. Loghry in the United
States District Court for the Northern District of Texas seeking, inter alia, a declaration that
Mr. Loghry was not wrongfully terminated and is not entitled to recover anything from Lexxus U.S.
or the Company. Mr. Loghry has filed counterclaims against the Company and Lexxus U.S. asserting
his previously articulated claims. In September 2004, Mr. Loghry filed third party claims against
certain officers of the Company and Lexxus U.S., including against Terry LaCore, former Chief
Executive Officer of Lexxus U.S. and former director of the Company, and Mark Woodburn, former
President and director of the Company, for fraud, Messrs. LaCore, Woodburn, and a certain Lexxus
distributor for conspiracy to commit fraud and tortuous interference with contract. In February
2005, the court dismissed all of Mr. Loghrys claims against the individual defendants, except the
claims for fraud and conspiracy to commit fraud. On June 2, 2005, after Mr. Loghry had filed
amended counterclaims, Lexxus U.S., the Company, and the individual defendants moved to dismiss the
counterclaims on the grounds that the claims were barred because Mr. Loghry had failed to disclose
the existence of the alleged claims when he filed for personal bankruptcy in September 2002. On
June 23, 2005, the court stayed discovery pending resolution of the pending motion to dismiss. On
June 30, 2005, at the request of Mr. Loghry, the U.S. Bankruptcy Court for the District of Nebraska
reopened Mr. Loghrys previously closed Chapter 7 bankruptcy case. On September 6, 2005, the
trustee commenced an action in the U.S. District Court for the District of Nebraska against the
Company; Lexxus U.S.; Messrs. LaCore and Woodburn; Curtis Broome, President of Greater China and
Southeast Asia; and Lisa Grossman, an independent distributor of Lexxus U.S., alleging (i) breaches
of contracts by the Company and Lexxus U.S., (ii) fraudulent inducement by the Company, Lexxus
U.S., and Messrs. LaCore and Woodburn, (iii) civil conspiracy among all defendants, and (iv)
tortuous interference with existing contractual relations by Mr. Broome and Ms. Grossman. The
Company denies the allegations and intends to contest the claims.
On November 1, 2004, Toyota Jidosha Kabushiki Kaisha (d/b/a Toyota Motor Corporation) and
Toyota Motor Sales, U.S.A. (the Toyota Entities) filed a complaint against the Company and Lexxus
U.S. in United States District Court for the Central District of California (CV04-9028). The
complaint alleges trademark and service mark dilution, unfair competition, trademark and service
mark infringement, and trade name infringement, each with respect to Toyotas Lexus trademark.
Toyota seeks to enjoin the Company and Lexxus U.S. from using the Lexxus mark and otherwise
competing unfairly with Toyota, to transfer the ownership of the mylexxus.com and
lexxusinternational.com internet sites to Toyota, and reimbursement of costs and reasonable
attorney fees incurred by Toyota in connection with this matter. The Company has reached a
settlement agreement, dated August 31, 2005, under which the Toyota Entities have agreed to
terminate their claims against the Company, and the Company has agreed to, on or before June 1,
2006, discontinue use of the Lexxus name and mark, and change the name of its Lexxus operations and
domain names, which could have a material adverse effect on the financial condition, results of
operations, cash flow or business prospects of the Company.
On November 12, 2004, Dorothy Porter filed a complaint against the Company in the United
States District Court for the Southern District of Illinois alleging that she sustained a brain
hemorrhage after taking Formula One, an ephedra-containing product marketed by Kaire
Nutraceuticals, Inc., a former subsidiary of the Company, and, thereafter, eKaire.com, Inc., a
wholly-owned subsidiary of the Company. Ms. Porter has sued the Company for strict liability,
breach of warranty and negligence. The Company intends to defend this case vigorously and on
December 27, 2004 filed an answer denying the allegations contained in the complaint. The plaintiff
demanded $2 million in damages to settle the case. On March 7, 2005, a Notice of Tag-Along Action
was filed by Ms. Porter with the Judicial Panel on Multidistrict Litigation. It is anticipated that
this case will be placed on the next Conditional Transfer Order and, ultimately, transferred to the
consolidated Ephedra Products Liability proceedings in the United States District Court for the
Southern District of New York. The Company does not believe that the plaintiff can demonstrate that
its products caused the alleged injury and intends to vigorously defend this action.
25
On January 13, 2005, Natures Sunshine Products, Inc. and Natures Sunshine Products de Mexico
S.A. de C.V. (collectively Natures Sunshine) filed suit against the Company in the Fourth
Judicial District Court, Utah County, State of Utah seeking injunctive relief and unspecified
damages against the Company, Lexxus U.S., the Companys Mexican subsidiary, and the Companys
Mexico management team, Oscar de la Mora Romo and Jose Villarreal Patino, alleging among other
things that the Companys employment of Messrs. De la Mora and Villarreal violated or could lead to
the violation of certain non-compete, non-solicitation, and confidentiality agreements allegedly in
effect between Messrs. De la Mora and Villarreal and Natures Sunshine. Following repeated
unsuccessful attempts by Natures Sunshine to remand the case to state court, Natures Sunshine
voluntarily dismissed its lawsuit on May 5, 2005 and subsequently filed a new lawsuit in the Fourth
Judicial District Court in Utah County, Utah. On August 22, 2005, a hearing was conducted on
Natures Sunshiness request for preliminary injunction, after which the court announced its
intention to enjoin Messrs. De la Mora and Villarreal from disclosing any confidential information
of Natures Sunshine or soliciting any employee or distributor of Natures Sunshine or inducing
them to terminate their relationship with Natures Sunshine. The court, however, did not enjoin
Messrs. De la Mora or Villarreal from competing with Natures Sunshine. The case remains pending.
If the Company or Messrs. De la Mora and Villarreal are unsuccessful in defending this action, the
Company may be required to change its Mexico management team, at least during the unexpired term of
any enforceable non-compete period, and pay any damages and attorneys fees that may be assessed
against it.
Currently, there is no other significant litigation pending against the Company other than as
disclosed in the paragraphs above. From time to time, the Company may become a party to litigation
and subject to claims incident to the ordinary course of the Companys business. Although the
results of such litigation and claims in the ordinary course of business cannot be predicted with
certainty, the Company believes that the final outcome of such matters will not have a material
adverse effect on the Companys business, results of operations or financial condition. Regardless
of outcome, litigation can have an adverse impact on the Company because of defense costs,
diversion of management resources and other factors.
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
During the three months ended September 30, 2005, the Company issued 237,600 shares of common
stock in connection with the exercise of common stock purchase warrants that were issued to
investors in October 2004. The exercise price was $12.47 per share and the shares were issued
pursuant to Section 4(2) of the Securities Act of 1933, as amended.
Item 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
Item 5. OTHER INFORMATION
None.
Item 6. EXHIBITS
31.1 |
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Certification of the Interim Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
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31.2 |
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Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
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32.1 |
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Certification of the Interim Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002. |
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32.2 |
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Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002. |
26
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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NATURAL HEALTH TRENDS CORP.
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Date: November 18, 2005
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/s/ Robert H. Hesse |
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Robert H. Hesse
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Interim Chief Executive Officer
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(Principal Executive Officer) |
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Date: November 18, 2005
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/s/ Chris Sharng |
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Chris Sharng
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Executive Vice President and Chief Financial Officer
(Principal Financial Officer) |
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27