Earnings Call Transcript - USNA Q2 2023

Operator, Operator

Good day, everyone, and welcome to USANA Health Sciences Second Quarter Earnings Call. Today's call is being recorded. And now at this time, I'd like to turn the call over to Andrew Masuda. Please go ahead.

Andrew Masuda, Corporate Secretary

Thank you, and good morning, everyone. We appreciate you joining us to review our second quarter results. Today's conference call is being broadcast live via webcast and can be accessed directly from our website at ir.usana.com. Shortly following the call, a replay will be available on our website. As a reminder, during the course of this conference call, management will make forward-looking statements regarding future events or the future financial performance of our company. Those statements involve risks and uncertainties that could cause actual results to differ materially from the results projected in such forward-looking statements. Examples of these statements include those regarding our strategies and outlook for fiscal year 2023 as well as uncertainty related to the economic and operating environment around the world, our operations and financial results. We caution you that these statements should be considered in conjunction with disclosures, including specific risk factors and financial data contained in our most recent filings with the SEC. I'm joined by our President and CEO, Jim Brown; our Chief Financial Officer, Doug Hekking, our Executive Chairman, Kevin Guest; as well as other executives. Yesterday, after the market closed, we announced our second quarter results and posted our management commentary document on the company's website. We'll now hear brief remarks from Jim before opening the call for questions.

Jim Brown, CEO

Thank you, Andrew, and good morning, everyone. We appreciate you joining us. We're pleased to report second quarter operating results that were better than our expectations. During the quarter, we saw further stabilization in our active customer counts, stronger-than-anticipated net sales in Mainland China and continued progress on several of our long-term strategic initiatives. As we mentioned in our first quarter call, first quarter net sales included approximately $12 million related to purchasing in Mainland China for our immunity products following the lifting of COVID restrictions, and approximately $13 million related to buying ahead of announced price increases in several markets. Both of these first quarter events created a tough sequential quarter comparison for the second quarter. We also had a challenging year-over-year comparison due to a large global promotion in the second quarter of 2022, which did not recur in 2023. Given the challenging comparable periods, we were pleased with the performance of the business during the quarter. Before opening the call up for questions, I'd like to spend a few minutes reviewing some of the progress we made during the quarter. If you recall at the beginning of the year, we made the strategic decision to move away from the large global incentives that we offered throughout different quarters in each of the previous three years. While these promotions resulted in strong sales activity during the quarter in which the promotion was offered, we realized that it was difficult to retain these customers at desired levels in subsequent periods. And it ultimately creates variability and fatigue with many of our leaders. Our 2023 strategy entails offering smaller market-specific incentives at various times throughout the year to generate sustainable sales and active customer growth. As I commented a few minutes ago, this change in approach has created difficult year-over-year comparisons in the first half of 2023. Although we remain in a fluid operating environment that is being influenced by inflationary pressures, we are generally pleased with the net sales and active customer counts and recognize that there is far more work to do to generate growth. Moving on, our team in China did an excellent job of executing the strategy in this key market during the second quarter. Local currency sales in the market grew 10% sequentially and exceeded our expectations, driven by strong demand from a small market-specific promotion offered during the quarter. We are pleased with our performance in this market, particularly given the macroeconomic environment. The country continues to reopen, allowing us to hold more in-person meetings and reengage with our customers in our single largest market. We are, however, continuing to see an impact on consumer spending from broader inflationary pressures, which are affecting customer purchasing decisions. Nevertheless, our team remains optimistic that we'll continue to see improvements in the market as China continues to operate more freely, and we'll execute our strategies in this market that still presents enormous opportunity for growth. In May, we announced our plan to expand into India and officially launch operations in late 2023. This new market expansion is several years in the making and wouldn't be possible without the diligent work and effort that our team has spent preparing for the launch. India is an exciting and compelling market opportunity. And we believe that our world-class health and wellness products and our business model are ideally suited for this market. That said, I have the utmost confidence in our local leadership team, and I would like to stress that our approach to expanding and growing this market will be intentional and will focus on long-term sustainable growth. We anticipate sales contribution to be modest on the onset and look forward to providing future updates on this market once we officially launch operations. In closing, our year-to-date performance and our current visibility into the remainder of the year is allowing us to raise the low end of our fiscal 2023 guidance range. We remain confident in our abilities to execute our strategies, which we believe will position USANA for sustainable long-term growth. With that, I'll now ask April, our operator to please open the lines for questions.

Operator, Operator

And we'll first hear from Linda Bolton-Weiser of D.A. Davidson.

Linda Bolton-Weiser, Analyst

I have a question about the North Asia region, specifically Korea. It seems to me that the performance has declined sequentially. However, I understand there may be some factors at play due to the pull forward of activities in the first quarter. Can you discuss the current state of the Korean market? Do you think it is improving or deteriorating?

Doug Hekking, CFO

Yes. Linda, this is Doug. I'll comment, and I'll let Jim jump in and add any comments on top of it. So I think some of the sequential progress or a sequential headwind that you saw with Korea was primarily related to the run-up due to the price increase and kind of buying in advance to that. But Korea has been an incredibly strong market for us for the last number of years, and we have seen that flattening out a little bit. The team is working hard. They're engaged. They're really working on customer engagement, but we have seen that market flattening out a little bit relative to what we've seen as far as year-over-year growth. Jim, anything to add on top of that?

Jim Brown, CEO

Yes. Just to add, we had our Asia Pacific convention, and it was in Korea during the quarter. Even though we have seen, like Doug talked about, a little flattening out, we see excitement in the field. We had the biggest group, which was the Korean group, and that was thousands of people. There was just excitement and commitment from that group of associates.

Linda Bolton-Weiser, Analyst

The gross margin this quarter was quite impressive, exceeding our expectations and showing improvement both sequentially and compared to last year, if I recall correctly. Do you expect that level of performance to continue? Was pricing a significant factor in this success? How do you see the margin we achieved in the second quarter influencing future results?

Doug Hekking, CFO

Yes. I mean as we talked about, we have some unique nuances in the first half of the year to just make sure we put things in context. One is what Jim talked about in his opening remarks in the first quarter. In the second quarter, as we mentioned, some of our publicly provided material, we had a promotion in China that we were expecting maybe to generate $10 million from during the period, and we probably were upwards of $15 million to $16 million in incremental sales generated from that promotion in China. And you see a little bit of lifting from our internal expectations because it outperformed a little bit. But some of those things in China, and Brent Neidig, who oversees the market, has a lot of incredible strategies and efforts going on to build really long-term sustainable growth in the market. But we don't have the same cadence of promotional activity or one-off events in the back half of the year. And so that's just a little bit of context and gives a little bit of color on what we provided.

Linda Bolton-Weiser, Analyst

So you're saying that the gross margin was helped by that incremental revenue and that is that high gross margin revenue?

Doug Hekking, CFO

No. I think we see a little bit of a switch when we have a greater proportion of revenue coming from China and kind of the mix of the line items in their income statement. They typically have a modestly better gross margin and a little bit higher incentive rate. Overall, the margins are strong, but it's a little bit of a different structure in China than what we see in other markets.

Linda Bolton-Weiser, Analyst

So I'm not sure I'm understanding. So the China promotion that was better than expected occurred in the second quarter, and that high gross margin business. So that helps the gross margin. Is that what you're trying to say?

Doug Hekking, CFO

Yes, that's what I'm saying.

Linda Bolton-Weiser, Analyst

Okay. So then maybe going forward, we should be a little lower in our expectation for gross margin?

Doug Hekking, CFO

Yes. Yes. I think you saw something is probably a little bit better than what we'd expect in the back half of the year. And I think just the mix by market is the primary catalyst there.

Linda Bolton-Weiser, Analyst

Okay. I got you. And then I was just examining your cash flow a little bit. And your operating cash flow, I mean, it was down year-over-year. I think there's a line in the cash flow statement called other liabilities or something like that. That seems to be the culprit in affecting your cash flow. What is that line item? And is there something we should be concerned about? Or why is that such a negative element of the cash flow statement?

Doug Hekking, CFO

I mean, typically, in the front half of the year when you're looking at that kind of six-month stuff and doing the other stuff, you see a lot of stuff that had been accrued throughout '22 that gets settled up in '23. For example, some of the employee bonuses, some different tax payments that would be in that other liabilities, some of those types of things that you typically get flushed out. And when you look year-on-year, it just kind of depends on how those things influence it. But obviously, the operating margin has been a little bit softer than what we've seen historically just because of a little bit of top line pressure, but I think we're committed to continue investing. And so we're still generating robust cash flow and solid cash flow. But I think comparison is going to somewhat mirror over some reasonable period of time our operating margins as well.

Linda Bolton-Weiser, Analyst

Okay. And then just one more question on the cash flow. You had a lot of cash on your balance sheet, and you've kind of paused share repurchase. Is that cash kind of stranded overseas? And do you need to repay before you take it? I'm just wondering why you feel like you can't access that cash on your balance sheet to do share repurchase. Is it inaccessible for some reason?

Doug Hekking, CFO

No, there is a point in time when, due to our international operations, not all of our cash is readily available here. However, we could always utilize our credit facilities if necessary. This situation isn’t a short-term concern. Each quarter, we discuss capital allocation with the board, exploring different purposes and assessing our business priorities. This process is a key factor in our decisions. We've explored external business opportunities at a higher level than we ever have in the company's history. As we engage in discussions, we keep these considerations in mind along with other priorities. While there might be some timing issues in certain markets, this does not impede us, and we have not provided much clarity on our plans regarding share repurchase.

Linda Bolton-Weiser, Analyst

Okay. And then switching back to China. I mean your comments sounded pretty positive, and you pointed out the sequential improvement there. I know you don't want to get into specific guidance, but I'm thinking that maybe China in local currency revenue could be flat or up in the third quarter for you, flat or up year-over-year. Am I thinking correctly? Am I way kind of off on that?

Doug Hekking, CFO

We've been considering our approach more sequentially. Looking back, in the second quarter we had a promotion, and we won't have a comparable promotion in the third quarter, which makes it difficult to evaluate sequentially. Year-over-year, I'd need to check the specifics, as I don't have that information at the moment. However, I am optimistic based on feedback from Brent and the leadership team in China. They've had positive conversations and are making progress, although some aspects are more structural and aimed at the long term, which won't provide the same immediate impact as a short-term promotion would.

Linda Bolton-Weiser, Analyst

Do you find that the China customers are oriented toward immunity and health and wellness because of the COVID aftermath?

Doug Hekking, CFO

Yes, Brent is here. I'll let him share his insights as he has a better understanding of the China consumer than I do.

Brent Neidig, Manager, China Operations

We saw a very strong buy-up of our immune products in the fourth quarter and in the first quarter of this year when the zero-COVID policy lifted. After that, we started to see more of a tapering of sales from those products. So I think it's kind of returning back to a normal level of what we would expect to see. But long term, absolutely, the Chinese consumer is very health-conscious, health-focused and immune-focused. So I think those products will continue to be strong sellers for us into the future.

Linda Bolton-Weiser, Analyst

Okay. If I could please ask one other question regarding the SG&A expense, it was a bit higher than we anticipated this quarter, around $68 million if I recall correctly. Is that due to the conventions and meetings you held? Looking ahead, should I expect that amount to remain the same, or could it possibly decrease in the third and fourth quarters?

Doug Hekking, CFO

Yes. You're correct, Linda. I mean that's something just because of the whole environment surrounding COVID, we haven't had a great deal of those in-person engagements. It's definitely a priority from the sales structure. So we had a good chunk of change in SG&A expense, and that was the driver of having modest increases in SG&A year-over-year. And right now, even though we have some plans in the third quarter, for example, in our Americas and Europe, it's not the same magnitude of dollars that you would have seen there. So you probably should not see it at that absolute rate. And then circling back around real quick one, I look at the year-over-year, I think we would see some progress year-over-year with China. That would be the expectation, even after kind of taking out kind of the sequential change with not having the same promotion.

Operator, Operator

Next, we hear from Anthony Lebiedzinski of Sidoti.

Anthony Lebiedzinski, Analyst

So nice to see a sequential sales improvement in China. I know that was driven partly because of a local market promotion there. Just wondering if you could comment anything as far as you can share with us as far as how your trends have been so far in July?

Doug Hekking, CFO

Yes. I mean, I think it's the same thing as you come off promotions. I think we're still with kind of the activity we've had trying to see kind of what that level set area is that’s in kind of an unintended or not having a sales event or something right surrounding it. So I think we're seeing it absent the promotion, clicking on a good cadence. I think we're pleased with it. I think we obviously want to do better, and it's something we're pushing towards. But as Jim talked about in his comments, I think we've seen more of a stabilized customer base. And really what we need to do to get that inflection point and start getting that momentum and traction going forward. And that's obviously the intent of our long-term strategies and some of the things we augment on a short-term basis as well. But like I said, I think we're generally pleased, but we understand we have work to do as well.

Anthony Lebiedzinski, Analyst

Understood. And in your management commentary, you talked about new incentive opportunities for your sales force. So are you referring to your affiliate program in North America? Or is that something else? Maybe you could just expand on that, please?

Doug Hekking, CFO

Yes. That's primarily the reference, but we're looking in several markets. And I think it would be good for maybe Jim to comment on this from a strategic standpoint. But things that we think are going to really be relevant to be additive to what we're doing and engage the customer base at a higher level.

Jim Brown, CEO

Yes. When discussing a few points, we mentioned SG&A earlier. In the first and second quarters, we significantly increased travel and in-person meetings, including major conventions and smaller gatherings in various countries, to reconnect with the field. Additionally, as we've discussed, the affiliate program is a new revenue opportunity in North America, and we plan to explore expanding it into interested markets in 2024. We're also open to making minor adjustments to our business model by market. While we won't have the large promotions like last year, we have many specific local market promotions planned for the second half of the year.

Anthony Lebiedzinski, Analyst

Understood. Okay. And then you also talked about expanded digital commerce capabilities. So if you could maybe just also share with us maybe some examples of what you're planning to do? And which markets do you think have the most opportunity to benefit from that initiative?

Jim Brown, CEO

Yes. I mean when we talk about our digital footprint, what we're mainly trying to do is make our business easier for our associates, affiliates and just anyone who wants to order products and consume products. There are some hotspots. We are working a lot in China. You got the WeChat platform that basically is how commerce is done in China. So we're working to make sure that we stay relevant in that market. We're pushing stuff out in the Americas, a lot of it to do with the affiliate program to make sure that the digital assets are enough to have that be successful. And then we look at it from market to market. Some of our bigger markets are always wanting some digital platform or something new, and we have to, as a company, sit back and see which ones will make an impact. But that mobile-first for our IT systems is kind of where we're at throughout all 25 markets.

Doug Hekking, CFO

I would say also, Anthony, as we've talked about a lot of the shareable content that makes it easier for our sales force to do stuff really across the board and engage the customers. And yes, really the main catalyst here is finding ways to interact at an enhanced and more relevant kind of level to go back and kind of get more and more traction going forward. And I think feedback we've had has been positive, which you got to get more users of some of that technology, and there's definitely more work to be done on the horizon.

Anthony Lebiedzinski, Analyst

Got it. Okay. Given the timing of your entry into India later this year, you will incur some upfront costs. Have you discussed how much this might affect EPS this year?

Doug Hekking, CFO

Yes. From an operating margin standpoint, you're probably in that $2.5 million to $3 million range is kind of what we're expecting as far as kind of a net expense just from what's happening. And the opening or nonopening and timing of that really doesn't factor in there. It was really trying to go back and get the best talent we can and get everything done in an appropriate way. And there's just there's kind of a period expense aspect to that, that we think is a worthwhile investment.

Jim Brown, CEO

Yes. We began hiring the management team around this time last year, but we significantly ramped up in the second half of the year. Therefore, we will incur some costs this year without seeing the corresponding revenue until later in 2023.

Anthony Lebiedzinski, Analyst

Got it. Okay. And lastly, just to follow up on Linda's question about the cash position. Obviously, a very strong balance sheet that you guys have. Maybe if you could just rank if you could just kind of go over your priorities for your capital allocation between the different usages of that cash. And I know you talked about acquisition opportunities. Maybe if you can also touch on as far as what you're looking for to do as far as acquisitions? If you could share any details about your strategy, that would be very helpful.

Doug Hekking, CFO

Yes. I'll give you the kind of high-level way that we go back and approach. And Walter, who heads up our business development, is in the room. I'll let him maybe talk a little bit about some of the aspects. But first priority is really investing in things that are going to stimulate and grow the organic business. As we go back and have things that we think are going to get traction and build either short term or long term, those are some areas of investment that we think we have. And then also, second would really be looking at things that aren't confined to our business, some of these inorganic type of opportunities that Walter will touch on a little bit. And then following that, when we don't have some immediate use in evaluating the environment, what we've done historically is really seek to go back and return that value through a share repurchase program. And those are kind of big picture, the levels we have. We're debt-free. So debt repayment really isn't on the capital allocation. But that's high level. And then maybe I'll have Walter give a little bit of color on the business development and some of the focal areas.

Walter Noot, Head of Business Development

Yes. Last year, we invested in a company called Rise Bar as an example. Rise is a small company that we allow to operate independently. We have strong synergies since we can produce their products, which lowers their costs of goods sold, while still allowing them to function autonomously. We are exploring brands that have diverse sales channels, such as direct-to-consumer, Amazon, and retail, as these present excellent opportunities for us. We are actively searching for businesses and companies that we believe will yield a good return. I believe there are many opportunities available right now.

Doug Hekking, CFO

And I think the sweet spot is typically a company that is a little bit smaller where we think we can go back and provide a great service or vice versa. And really kind of building some core competencies that maybe aren't currently in our sweet spot seems to be a pretty big area of focus for us.

Operator, Operator

It seems there are no further questions at this time. I will now hand the call back to our presenters for any additional or closing comments.

Andrew Masuda, Corporate Secretary

Thanks, April, and thank you, everyone, for your questions and for your participation on today's conference call. If you have any remaining questions, please feel free to contact Investor Relations at (801) 954-7210.

Operator, Operator

That does conclude today's call. Thank you all for your participation. You may now disconnect.