Friday, March 30, 2007

USANA & MLM Schemes -- Pyramid Scheme Alert Speaks Out

The 10Q Detective is publishing in its entirety an articulate and educational letter that we just received on Usana Health Sciences & MLM schemes by Pyramid Scheme Alert, a non-profit consumer organization dedicated to exposing and rooting out the (alleged) abuses and chicanery of pyramid scheme perpetrators.

I read your blog yesterday on Yahoo finance. Thanks for alerting me about it.

Since I have worked in this area of multi-level marketing for some time, I might add a thought to your analysis. I believe you have grabbed only the tip of a much larger issue that extends well beyond Usana.

Multi-level marketing, as practiced by Usana and most of the largest MLMs like Nuskin and Mannatech, is largely not understood in the financial markets. The analyst reports on Usana that I examined revealed that the analysts thought Usana was something like the Fuller Bush Company of 50 years ago, selling "through" distributors. Strangely none wondered why one of Usana's hundreds of thousands of reps had never knocked on their door.

Regarding reactions to the FDI report, as Thomas Paine, wrote, "Perhaps the sentiments contained in the following pages, are not YET sufficiently fashionable to procure them general favour; a long habit of not thinking a thing WRONG, gives it a superficial appearance of being RIGHT, and raises at first a formidable outcry in defense of custom. But the tumult soon subsides. Time makes more converts than reason."

Paine referred to the habit of accepting the domination of a foreign monarch. I am referring to the habit of viewing pyramid recruitment schemes as legitimate businesses, as we have largely done in the US for the last 20 years or so.

Since the 1980's when Pres. Reagan came to office, the US government has mostly allowed these blatant pyramid scams to operate. We did have a brief period between 1996 and 2000 when the FTC began to enforce the law and brought down some large MLMs. The largest and best known, Equinox International, was specifically prosecuted for building an endless chain business based on sales to distributors, with little or no retail sales. This was deemed an “unfair and deceptive trade practice.” Others would likely have been brought down too, including, I believe, Usana, had proper law enforcement continued. Cases were building and consumer awareness was rising. Then, Pres. Bush was elected, having received millions in contributions from Amway, and he appointed Timothy Muris to head the FTC in 2001. Muris' law firm represented Amway. For the next six years, the FTC was muzzled with also no congressional oversight. Schemes like Usana's went wild.

Their ability to generate enormous cash quickly which translates to sales tax revenues and political contributions; their ability to build up followings of cult-like adherents (Approximately 70% quit within the year after suffering financial losses, despite their early enthusiasm and credulous support); and their ability to quash, deceive or bully critics and victims have enabled them to evade law enforcement and the eyes of journalists for the most part. Only class action suits and a few private lawsuits indicted them for what they are and shed light on the large-scale harm they cause.

In more recent years, blogs, books, email networks, MLM-exposé websites, the formation of the consumer group, Pyramid Scheme Alert, and China's extraordinary decision take a stand against MLMs indicate a shift toward consumer awareness and, we think, a coming renewal of law enforcement in the USA.

Most MLMs—like Usana—operate in obvious violation of state laws – the CA Penal Code 327 is an excellent example, and ironically was signed by then Governor Ronald Reagan.

CA Penal Code 327. "Endless chain" schemes:

Every person who contrives, prepares, sets up, proposes, or operates any endless chain is guilty of a public offense, and is punishable by imprisonment in the county jail not exceeding one year or in state prison for 16 months, two, or three years.

As used in this section, an "endless chain" means any scheme for the disposal or distribution of property whereby a participant pays a valuable consideration for the chance to receive compensation for introducing one or more additional persons into participation in the scheme or for the chance to receive compensation when a person introduced by the participant introduces a new participant. Compensation, as used in this section, does not mean or include payment based upon sales made to persons who are not participants in the scheme and who are not purchasing in order to participate in the scheme.

In short, a sales scheme based on rewards tied to recruiting other participants who are similarly rewarded – and “endlessly” recruited – is illegal. The law does not restrict legitimate sales programs in which the rewards are tied to purchases made by non-participants (retail customers).

A the time most of these laws were passed in the states it was widely understood that endless chains were inherent frauds and could only reward a few at the top. The employment of the endless chain trick to sell products was seen as fraudulent. Deception was understood to be their MO. They were viewed as a corruption of the legitimate marketplace and unfair competition. That understanding has greatly diminished in recent years, especially inside the financial community.

For the reasons cited earlier, the state laws are seldom enforced, except on small-time operations. And, these types of schemes now even claim to be ambassadors of American business and American values. They are spreading worldwide, sometimes with the aid of the US Dept. of Commerce and Trade Representatives.

The political force and insider influence behind the MLM industry is Amway, which is now the target of a class action lawsuit that alleges the very same facts as Fraud Discovery Institute's report on Usana.

California’s—and most—other state’s anti-pyramid statutes, all past FTC and SEC prosecutions of Usana-type MLMs and several very explicit federal court rulings use the levels of retail selling as the dividing line between legitimate direct selling and MLM recruitment fraud.

The plain fact is that there is no retail sales opportunity in Usana-type recruitment MLMs. “Direct selling” is the official disguise, a ruse. The business is entirely based upon endless chain recruiting of "Associates" (distributors), a model that must cause 90+% loss rates among all distributors, even if the entire sales force were the equals of Donald Trump and Warren Buffet. It is a money trap, utterly based upon deception. For a full picture and a statistical analysis of the loss rates these endless chain recruitment schemes inflict on their revolving door groups of "associates" see: a clinical study by Pyramid Scheme Alert released in January 2006.

That these schemes generate profit and can manipulate their stocks upwards, through false, incomplete or misleading reporting, has caused some analysts to take them seriously as publicly traded businesses. This is a delusion and an error.

Though you clearly grasped the essence of the facts enough to say you were "skeptical", I would urge you to look more closely. I believe the proper response is outrage and amazement.

I leave you with a quote that I think captures the right view of a Usana-type enterprise. It was written by New York Supreme Court in 1966 in the State v. ITM Inc. case (a similar pyramid scheme), before these types of scams gained their political clout, built up their aura of legitimacy and gained the power and guile to face down regulators and intimidate critics in gang-like fashion as they do today.

"It is difficult to conceive of a more deliberately fraudulent and maliciously dishonest pattern of doing business with the public. [The defendants] gorged themselves on their ill-gotten gains from highly credulous consumers. They engaged in practices in which duplicity was the keynote and fraud the keystone of a commercial enterprise designed to pillage the public. None has the right to earn his livelihood in this fashion"

The employment of a pyramid reward plan to induce purchases by distributors, who cannot resell them on a retail basis—and then to report them to shareholders as "sales"—and to annually replace the 70% of distributors who quit the recruitment scheme after losing money—while withholding the huge failure and collapse rates from shareholders—have no place in the legitimate marketplace.

Usana's is the face of an "unfair and deceptive trade practice," based on my knowledge of FTC and SEC prosecutions of the past, state laws prohibiting pyramid schemes, and federal court rulings on distinguishing a legitimate direct selling business from a pyramid scheme.

Thanks again for your interest and your fine reporting to your readers.
-- Robert L. FitzPatrick, President



The 10Q Detective has a Full Disclosure Policy and holds no political or financial ties in Pyramid Scheme Alert.

Tuesday, March 27, 2007

Long Live the AFLAC Duck!

Aflac Inc. (AFL-$47.64), the largest provider of guaranteed-renewable insurance in the United States and Japan, rewarded Chairman and CEO Daniel Amos about $14.1 million in total compensation in 2006, according to a March 23 proxy filing with the Securities and Exchange Commission.

The Total Compensation paid to Amos was in direct alignment with the Company’s percentile performance results—including asset and EPS growth, ROA, and ROE—among 16 peer companies. On this basis, the Company received an overall composite performance rank of sixth in 2006, which equated to the 69 th percentile on a performance basis.

The Columbus, Ga.-based disability insurer said Daniel Amos' total pay compensation included a $1.2 million salary, $1.7 million in stock awards, $8.6 million in stock option awards, $2.2 million in non-equity incentive plan compensation, $229,543 for personal security services and $53,485 for personal use of company aircraft.

What we often find amusing in the headlines is how business columnists—out of sheer laziness or apathy—do not even bother to dig deeper in the regulatory filings to unearth the juicy stuff:

  1. As of February 28, 2007, Daniel Amos, 55, beneficially owned 11.7 million, or 2.4%, of the outstanding shares of common stock, worth an estimated $557.4 million;
  2. Included in the 11.7 million shares are option awards to purchase shares at strike prices between $15.05 to $30.57 per share, with option expiration dates from June 2008 to August 2012;
  3. In accordance with IRS guidelines, Messer. Amos is fully vested for his retirement benefits (based on his age, 55, and years of service, 33). The benefits payable per annum under Aflac’s U.S. Qualified Defined Benefit Pension Plan are $220,000 (indexed for cost-of-living adjustments);
  4. Messer. Amos also has a separate ‘Retirement Plan for Senior Officers’ account, with an estimated PV worth $48.5 million in accrued benefits;
  5. That plan differs, too, from the nonqualified deferred compensation plan, which at the close of fiscal 2006 had an aggregate balance of $770,000; and,
  6. Pursuant to his Employment Agreement, Amos has protection from a hostile ‘Change in Control’—a golden parachute worth about $18.3 million!

And lest we forget, despite being a gigantic holding company that had net sales and total assets in fiscal 2006 of $14.6 billion and $59.8 billion, respectively, Aflac still finds time to be an ‘equal opportunity’ employee for relatives—just like a ‘mom & pop’ accident, life and casualty company. Many investors are too young to recall that the acronym AFLAC stands for “American Family Life Assurance Company.”

  • In 2006, Aflac paid $153,206 to a corporation of which Maria Theresa Land, the sister of Director John Shelby Amos II, is the sole shareholder. This amount was earned as renewal commissions before expenses by W. Donald Land, the deceased husband of Maria Theresa Land, who served as Florida State Sales Coordinator with Aflac from 1975 until May 1990;
  • In 2006, Aflac paid $261,513 to John William Amos, the son of Director John Shelby Amos II. This amount was earned as renewal and first-year commissions before expenses. John William Amos serves as an Alabama District Sales Coordinator (Daniel P. Amos and John Shelby Amos II are cousins);
  • In 2006, Aflac paid $228,126 to Joe Frank Harris Jr., the son of Director Joe Frank Harris (and the Chairman, Harris Georgia Corp. & the former Governor of the State of Georgia). This amount was earned as renewal and first-year commissions before expenses. Joe Frank Harris Jr. serves as a Georgia District Sales Coordinator;
  • In 2006, Aflac paid $386,389 to Michael S. Kirkland, the son of AFLAC’s Dir. Of Sales, Ronald E. Kirkland. Michael Kirkland serves as a Missouri Regional Sales Coordinator;
  • For services rendered in 2006, the Company paid $440,595 in salary and bonus to Kenneth S. Janke Jr., 48, the son of Director Kenneth S. Janke, Sr. Mr. Janke Jr. serves as Senior Vice President, Investor Relations;
  • For services rendered in 2006, Aflac paid $221,262 to Jonathan S. Kirkland, the son of Ronald E. Kirkland. Mr. Jonathan Kirkland serves as Sales Strategy Consultant; and,
  • Paul S. Amos II, 31, the son of Daniel P. Amos, and the President of Aflac, since January 2007, earned $1.65 million in salary and incentives in fiscal 2006 (which included $76,517 for his personal use of the Company aircraft and $90,699 in reimbursement for the real estate sales commission and other miscellaneous moving expenses on the sale of his previous home).

In 2005, the Company’s logo was changed to incorporate—the now all-too familiar—duck character, which is prominently featured in its advertising [see YouTube - The First Duck Commercial]. In addition, the official spelling of the company name became "Aflac."

Falling into the Grand Canyon, being the hero to a damsel in distress, or sliding off a snowy roof—the “Aaaa-Flack!” Duck (voice provided by comedian Gilbert Gottfried) is there for you.

According to Oz Magazine, before the duck-ad campaign was introduced in 2000 [in a commercial starring Ray Romano], only 10 percent of Americans recognized the company. By 2005, after the 25th installment of the fan-favorite commercial series, Aflac enjoyed 90 percent brand recognition.

Aflac has been mentioned in Fortune magazine's list of the 100 Best Companies to Work for in America for nine consecutive years—especially true if your last name happens to be Amos, Harris, Janke, or Kirkland!

In the last two fiscal years, Aflac earned share-net of $2.95 and $2.92, respectively. Fiscal 2006 and fiscal 2005 were helped by investment gains of ten cents and 33 cents, respectively.

Aflac’s objective for 2007 is to increase net earnings per diluted share by 15% to 16% over 2006 (share-net of $3.17 to $3.26)—which assumes an average exchange rate for the year of 120 – 125 yen/dollar. This guidance, however, does not include any other deviance in foreign currency translations or investment portfolio gains/(losses).

According to Reuters Estimates, analysts surveyed—on average—are expecting the Company to report 2007 operating net of $3.27 per share. Target share price is 52, or about 16 times forward 2007 earnings (which is about a 23 percent premium to its peers in the Insurance—accident & health—industry).

Aflac Japan, which operates as a branch of Aflac, is the principal contributor—about 75 percent—to consolidated net earnings. Ergo, income variability to the Japanese yen is a considerable risk exposure, partially offset by the use of cross-currency swaps and a dollar-denominated fixed-income securities portfolio.

The likely results for 2007 net earnings per diluted share, including the impact of foreign currency translation using various yen/dollar exchange rate scenarios, is as follows: weighted-average Yen/Dollar exchange rate of 105, 116 (the actual 2006 exchange rate), and 125 would impact share-net by 17 cents, nil, and a loss of 11 cents, respectively.

In June 2006, Aflac began selling a new cancer plan aimed at existing cancer insurance policyholders. Management believes that this new product, coupled with continued cost pressure on Japan’s (national) health care system, will positively impact future demand for Aflac Japan’s medical insurance products.

Nonetheless, the Company expects fiscal 2007 to be a “challenging year from a sales perspective” and looks for sales to decline in the first half of the year, followed by modest sales increases in the second half of 2007.

As investors cannot blame the aforementioned U.S.-based related sales parties for happenings a continent away—blame it on the duck!

Contrary to recent media reports, the Company has no intention of abandoning its use of the beloved Aflac Duck.

"Like all of America, we love the Aflac Duck," said Jeff Herbert, Aflac's Chief Marketing Officer. "It is as central to our marketing efforts today as it will continue to be going forward."

Editor David J Phillips does not hold financial interests in any of the companies mentioned in this posting and is not a member of United Poultry Concerns. The 10Q Detective has a Full Disclosure policy.

Thursday, March 22, 2007

USANA Health Sciences--How Healthy is its Business Model?

Last week, Barry Minkow (infamous for the 1980s ZZZ Best Scandal) and his Fraud Discovery Institute released a 500-page report on USANA Health Sciences, Inc. (USNA-$50.00), alleging that the nutritional supplements, personal care products, and vitamin network marketer’s business model was founded on an untenable multi-level marketing (MLM) scheme, whereby no less than 85% of current distributors were losing money and no less than 74% of distributors failed within the first year.

On March 15, 2006,
USANA filed a lawsuit against the Fraud Discovery Institute and Barry Minkow for defamation. In a public statement, the Company said, “USANA believes this is a campaign to manipulate USANA's stock price that is being orchestrated by an individual who served 7 years in prison for stock fraud…. According to reporting in the March 15, 2007 edition of The Wall Street Journal, Mr. Minkow bought 'put' options on USANA's shares in a bet the price will fall."

After doing our own due diligence, the 10Q Detective walked away skeptical, too—the dearth of transparency in the vitamin marketer’s regulatory filings raises serious concerns as to the legitimacy of USANA’s business model and the MLM ‘business’ opportunity itself:

Associate Compensation Plan and Benefits

According to USANA’s website, the only requirement necessary to become an ‘active’ Associate and “begin to earn a lucrative income through an innovative marketing program,” is either to (a) Complete an Associate Application form and purchase a Business Development System or (b) order USANA products that total 150 points.

According to the
Pay Plan, a minimum of 250 volume points (weekly) are necessary to earn $40 in commissions; 5,000 volume points would earn the Associate $1,000 in commissions. [Ed. note. Products are assigned a sales volume point value that is independent of the product’s price.]

Management says that it is “committed to providing a highly competitive compensation plan to attract and retain Associates who constitute [its] sales force. [We] believe the USANA Associate compensation plan is one of the most financially rewarding in the network marketing industry. Associate incentives totaled $146.3 million, or 40.1% of net sales for the Direct Selling segment in 2006.”

The Company might want to talk down this marketing point, for the promise of exponential income growth belies reality—the average income for North American Associates in 2005 was $802.62.

Which makes us curious as to what USANA’s quarterly churn—or dropout rate—was for Associates? Albeit material—as distributors account for 86% of annual sales—this turnover number was not disclosed in any regulatory filings.

“Operating results could be adversely affected if our existing and new business opportunities and products do not generate sufficient economic incentive or interest to retain existing Associates and to attract new Associates.” – 2006 10-K filing

The Company is quick to disclose, however, that in fiscal years 2005 and 2006, USANA experienced a 16.7% and 15.0% increase in active Associates during each year, respectively!

According to Robert L. FitzPatrick, founder and president of
Pyramid Scheme Alert: “To obscure their dismal numbers, some MLMs classify their distributors as "active" and "inactive." The Active group includes only recent participants and those still buying products or receiving rebates. Payout and retention statistics are then disclosed only on the "active" group.

Unknown, too, is how many of the Associates are—in actuality—Preferred Customers: in other words, what percent of goods purchased by the Associates are truly sold to ‘non-distributor’ customers?

MLM are legal forms of business only under certain rigid conditions set forth by the FTC and state Attorneys General. Mr. FitzPatrick alleges, “Many MLMs are currently in gross violation of these guidelines and operate only because they have not been prosecuted. Recent court rulings are using a 70% rule to determine an MLM's legality. At least 70% of all goods sold by the MLM company must be purchased by non-distributors.”

As of December 30, 2006, USANA had 153,000 active, independent distributors, known as Associates, who accounted for 86% of the Company’s $374.2 million in net sales in fiscal 2006.

The retail sales business (Preferred Customers) accounted for 14% of purchases during fiscal year 2006.

Barry Minkow raises a legitimate query: Would not retailing to Preferred customers be the most desirable to USANA, in that they do not involve the expense of commissions or incentives to Associates? [Ed. note. Offset by advertising costs?]

The Company counts as active only those Associates and Preferred Customers who have purchased product from USANA at any time during the most recent three-month period.

Business Model

USANA’s networking sales model does offer scalable benefits, including:

  1. USANA’s business model does not require a company-employed sales force to sell its products;
  2. The Company experiences minimal incremental cost to add a new Associate in the markets where it operates;
  3. Commissions paid to Associates are tied to sales performance; and,
  4. Since payment is required at the time an Associate purchases product, the Company has virtually no receivables.

USANA has a monthly product subscription program known as “Autoship,” which provides a stream of recurring revenue. For the year ended December 30, 2006, approximately 52% of net sales in the Direct Selling segment came from the Autoship program.

The Company does permit new Associates a 30-day return policy only on their first order.

During fiscal years 2005 and 2006, returns as a percentage of net sales were 1.5% ($943,000) and 1.6% ($947,000), respectively. These product return numbers include both retail customer and new Associate returns. Undisclosed, however,
was what percent of these returns were related to new Associates and/or monthly autoships belonging to older Associates (engaged to USANA for more than 30-days)?

The 10Q Detective did not note any red flags here, however, for these product return numbers were in line with other leading companies in the nutritional network marketing and nutritional product industry, including Herbalife, Inc. (HLF- 1.0% of sales), NBTY, Inc. (NTY-1.7% of sales), and Schiff Nutrition International, Inc. (WNI-1.2% of sales)

Stability of USANA’s networking business model is debatable, too, for the bulk of top-dollar commissions are reserved for the 3% of distributors, called
directors, at the top of the pyramid. The earnings of these highly paid diamond and gold directors skew the average income of ALL Associates. The mean income of ALL distributors is probably less than $802 per annum.

[According to Minkow, this jeweled 3% earns 70% of aggregate commissions.]

Dr. Jon Taylor, Consumer Awareness Institute, says, “MLM—or Network Marketing Programs—are one of the most problematic of business models, in part, because the pyramid shape—or ‘relative vertical equality’—shape of the compensation system leads to extreme horizontal inequality in payout(s) over the entire network of distributors (i.e. huge payouts to a tiny percentage of participants, while the vast majority wind up losing the money and effort they invested over a period of time).”

At the 7th Annual
Fraud Conference of the Association of Certified Fraud Specialists in San Francisco (September 27, 2006), Robert L. FitzPatrick said: "Far from a direct selling company operating in an open market, the MLM is a closed system with fixed prices and a built-in ratio of losers to winners. 99% will always lose in this closed system.”

USANA, refutes such [Minkow’s] allegations, saying: “"The claim by Mr. Minkow that USANA will 'run out of distributors' is false, misleading, and without any basis. The fact is that many professionally-managed multi-level marketing and direct selling companies have operated for decades. USANA's business model is dependent on consumption of its nutritional products, not the recruitment of associates.”

While the recruitment of distributors is not sufficient—in of itself—to guarantee the future viability of USANA, distributors are necessary for the profitability of the vitamin maker—as they account for 86% of net sales.

Barry Minkow was more brusque in his comments: “Because 86% of USANA’s direct selling revenues come from distributors who ultimately buy into [their] “story,” it is both material and appears to constitute a significant misrepresentation [of the facts].”

Granted, this is a brash comment, but was it necessary for USANA management to engage in ‘ad hominem’ attacks on Minkow, calling him a “convicted felon….out for nothing more than personal profit.”

In our view, USANA’s mudslinging only lends credence to Minkow’s allegations of predatory sales tactics.

USANA says that its “USANA business associates are under no obligation to purchase any amount of products beyond a $20 starter kit.” (A starter kit includes a detailed manual, including company policies and procedures.) This statement is somewhat misleading, for it is only the electronic format of the kit that it sells for $20. The actual cost is approximately $49 per starter kit.

If Associates wish to “continue to distribute products,” they must pay an annual “renewal” fee. The Company recognizes the annual renewal fee as deferred revenue, and it is recorded in ‘other current liabilities,’ recording the fees as income on a straight-line basis over a twelve-month period. At year-end 2006, deferred revenue—including prepayments for unshipped goods—were $3.1 million, up $1.2 from fiscal 2005.

Excluding the positive impact of foreign currency fluctuations, consolidated net sales increased 14.8% to $374.2 million in fiscal 2006, attributed to an increase in the number of active Associates.

Research & Development Issues

“[USANA] scientists are continually reviewing the latest published research on nutrition, attending scientific conferences, and working in collaboration with a number of outside research institutions and researchers to identify new product possibilities and opportunities to reformulate existing products.”

In fiscal 2006, USANA expended less than one-percent, or $3.2 million, of net sales on R&D, up 0.10% from fiscal 2005!

USANA introduced just one new product (line extension) in fiscal 2006, an
Optimizer supplement, TenX Antioxidant Blast, which is a dietary supplement fruit bar fortified with important antioxidants, including quercetin and the Company’s patented olive-fruit extract, Olivol.

In addition, for all of USANA’s purported R&D efforts, the Company owns just two patents, issued in 2002! These patents are process patents and relate to the method of extracting an antioxidant from olives and the waste products of olive oil production.

Product Claims & Regulatory Issues

Numerous governmental agencies in the United States regulate the manufacturing, packaging, labeling, advertising, promoting, distributing, and the selling of nutrition, health, beauty, and weight management products. In the United States, the Federal Trade Commission (FTC) under the FTC Act regulates advertisement of USANA’s products, and where such advertising is considered to be product labeling by the FDA, under the Food, Drug, and Cosmetic Act (FDC) and regulations promulgated under that act.

USANA products are also subject to regulation by, among others, the Consumer Product Safety Commission, the US Department of Agriculture, and the Environmental Protection Agency.

Among other health claims made by USANA, the new TENX bar is advertised by the Company as being ten times more powerful than any other juice on the market. The Fraud Discovery Institute had this product tested by independent third-party labs to determine whether or not this potency claim was true in a replicable test.

[Ed. Note. Minkow publicly stated that the intention of this—and lab tests done on other products—was not to accuse USANA of deliberately not putting enough of the active ingredients in their products, but rather to test their products in order to corroborate or refute potency claims.]

The Company makes these potency claims at weekly ‘opportunity’ meetings to potential distributors.

The Fraud Discovery Institute reported—among other findings—that test results showed that TENX was just over two times stronger than eight ounces of Langers Grape Juice Plus—nowhere near ten times stronger.

In fairness to USANA, a review of FDA Enforcement Activities, including
Warning Letters sent to vitamin supplement makers, indicates that the Company has no history of regulatory problems with the FDA.

Nonetheless, an important consideration raised by Minkow and the Fraud Discovery Institute—if potency claims are called into doubt—what does this portend for USANA’s premium pricing strategy?

Other Investment Considerations

Currently, a significant portion of net segment sales are concentrated in the North America region, representing 67.5% of net sales in 2006; however, management believes that over time the Asia Pacific region will continue to account for an increasing proportion of total net segment sales.

On January 8, 2007, USANA commenced operations in Malaysia, and will include this country as part of its Asia Pacific region in 2007 (19.2% of sales in fiscal 2006).

China will not be part of this growth equation: On December 1, 2005, China announced the adoption of new regulations governing direct selling. Single-level compensation models are permissible under the new regulations; however, these regulations prohibit multi-level compensation models as practiced by USANA.

Valuation Analysis

Recent insider trading activity is neutral. Founder, Chairman & CEO Myron W. Wentz did sell 170,000 shares—at $60.98—back on February 12, 2007; however, given that Messer. Wentz beneficially owns about 46% of the company stock, or about 8.2 million shares, attaching any material significance to these two trades is meaningless.

For fiscal 2007, management expects net sales to increase 15% to 17% and share-net to climb 17% to 20%, or in the $2.57 -- $2.64 range, attributable to improved gross margins and a lower proportion of its net sales coming from the Contract Manufacturing segment.

A bewilderment of lied and half-truths? The Contract Manufacturing Segment contributed only $9.3 million, or 2.5%, to consolidated net sales during the year ended December 30, 2006. How much in future savings can possibly be wrung out from this segment?

At the current share price, USANA is selling for about 19 times forward 2007 earnings’ estimate, which is near the lower-end of its three-year historic P/E multiple (16x – 24x).

Any good news could panic the short-sellers to cover their open positions, causing a short-squeeze. According to, as of late February 2007, short interest was currently about 24% of the float, and would take almost 11 days to cover.

Given USANA’s fundamental outlook, the current 20 percent pullback in its share price might be a good inflection point—if one believes that the Company’s MLM business model is sound.

To the contrary, Barry Minkow’s asserts that “if new distributors knew about failure and collapse rates, the inability to resell hopelessly overpriced products and that most of the money paid in commissions goes to the top 3% of the Usana distributors, Usana's ability to attract new distributors would be materially adversely affected.

The 10Q Detective agrees that any changes to its business model—such as more retail sales exposure—would be disastrous to margins and earnings momentum.

In our view, however, Barry Minkow’s tenet that people’s ability to interpret ‘failure and collapse rates’ is well-intentioned, but based on a faulty premise—that we can learn from others’ mistakes. To wit: MLM, network marketing, dinner party—or whatever you want to coin the phrase—schemes and scams has been around for decades. Why?

“Work is a necessary evil to be avoided” – Mark Twain.

There is a catalyst that has the shorts salivating. Just aired from the Company’s ditty bag: The Company disclosed on March 19 that the
SEC has begun an informal inquiry over the recent allegations on possible fraud and the legitimacy of the company's business model.

The 10Q Detective is neutral on the prospects of USANA, with a slight downside bias.

In our view, however, the options market has already discounted any profit potential in the downward bias in the share price. The asking price for July 50 puts is $5.50—representing all time premium.

Editor David J Phillips does not hold financial interests in any of the companies mentioned in this posting. The 10Q Detective has a Full Disclosure policy.

Tuesday, March 20, 2007

Something Smells at Bodisen Biotech--and it ain't Manure!

In January, China-based Bodisen Biotech Inc. (BBC-$3.36), which produces fertilizers and pesticides, announced it expected to post a 74 percent increase in 2006 earnings, as sales allegedly climbed an estimated 39 percent last year.

Bodisen said it expected 2006 revenue of $43 million and net income of $12.9 million, excluding one-time legal and other expenses related to deficiencies with the American Stock Exchange.

In 2005, the company reported $31 million in revenue and net income of $7.4 million.

Given today’s
announcement that the Company will delay the filing of its annual report—due to previously undisclosed ownership issues and other potential liabilities—in our view, shareholders should not take any previous earnings guidance seriously.

Money is like manure. You have to spread it around or it smells. – Industrialist Jean Paul Getty (1892 – 1976)

Unfortunately, something smells foul at Bodisen these days—and it's not money or manure.


The 10Q Detective--sadly--holds shares in Bodisen Biotech. The 10Q Detective has a Full Disclosure policy.

"Taking Stock with Derek Simon" Podcast

Last week, the 10Q Detective guested on, a virtual investment educational site and collection of tools to assist individual investors.

Taking Stock with Derek Simon, an insightful show focused on looking behind some of the Wall Street babble concerning financial reporting, the 10Q Detective shared our insights into the accounting process and offered investors some suggestions on how to spot accounting irregularities in reported earnings.

The show also featured commentary from David Malpass, chief economist at Bear Stearns & Co.; Jim Jubak, Senior Markets Editor of MSN Money; and Bertha Coombs of CNBC. Companies mentioned include Hollis-Eden Pharmaceuticals Inc. (Nasdaq: HEPH) and Gap (NYSE: GPS).

Friday, March 16, 2007

Looking for Profitable Ideas? Follow the "CalPERS' Effect."

Responding to dismal stock performance and poor governance practices, the California Public Employees’ Retirement System (CalPERS), the nation's largest public pension fund with assets totaling more than $230 billion, released its annual Focus List yesterday –naming 11 underperforming companies in such sectors as retail, electronics, pharmaceuticals, and media.

CalPERS Focus List Process begins by screening underperforming companies in the pension fund's largest equity portfolio – the CalPERS 2500 Index Fund.

Its objective is to engage publicly traded companies to improve their business models and governance practices to gain positive investment returns. The Focus List is used to call attention to companies that ignore CalPERS' suggestions for change.

"The long term performance of all 11 companies is at least 20 percent behind their peers, and they have resisted appeals to change corporate practices that make their boards unresponsive to shareowner interests," said Rob Feckner, CalPERS Board President. "In several cases, their entrenched boards refuse to discuss our grievances.”

  • Shares in Corinthian Colleges, Inc. (COCO-13.59) have underperformed relative to the S&P 500 Index and its industry peer index over the three period by (85.23)% and (77.23)%, respectively, and five year time period by (21.64)% and (13.89)%, respectively.

    Despite 60% and 18% increases in 3Q:04 sales and earnings (Y-oY), respectively, investors focused their worries on revelations that operating margins at the for-profit operator of post-secondary educational programs tumbled 5.8% to 16.4%, hurt by higher overhead costs at 71 campuses acquired in August 2003. Prescient investors dumped their shares: the share price peaked on April 22, 2004 at $35.81 per share (adjusted for a 2:1 Stock Split on March 24, 2004). In August 2004, management guided share-net lower, blaming increases in marketing and advertising expenses needed to mitigate
    student lawsuits at the company's Florida Metropolitan University system.

    An SEC options investigation (now closed) and ongoing student enrollment problems continue to hamper earnings—and investor enthusiasm for Corinthian.

    CalPERS is seeking shareowner approval to remove the Company’s classified or ‘staggered’ board structure, too.

  • Hurt by erratic earnings performance, the shares in Dollar Tree Stores, Inc. (DLTR-$35.98) have underperformed relative to the S&P 500 Index and its industry peer index over the three period by (21.23)% and (42.85)%, respectively, and five year time period by (36.96)% and (75.18)%, respectively.

    Among other board accountability issues, CalPERS contends that the operator of discount variety stores refuses to seek shareowner approval to remove the Company’s classified or ‘staggered’ board structure; would not agree to seek stockholder approval to remove the supermajority requirements that pertain to the articles of incorporation; and, ignored a petition to implement “double-triggers” on equity payouts so that during a change in control, unvested equity would convert to the new company.

  • Shares in Eli Lilly & Company (LLY-$52.05) have underperformed relative to the S&P 500 Index and its industry peer index over the three period by (52.63)% and (23.10)%, respectively, and five year time period by (60.48)% and (10.78)%, respectively.

    In fiscal 2002, the drugmaker reported share-net of $2.50—in fiscal 2006, the company reported earnings of $2.45 per share. Prior uncertainties over pricing power and generic intrusions, coupled with recent press disclosures that Lilly deliberately withheld risk information from the medical community about its schizophrenia drug Zyprexa’s links to elevated blood sugar levels and obesity have offset recent positives, including limited patent expiration exposure, increased market penetration of franchise drugs, and an exciting pipeline (e.g. Prasrugel, an oral anti-platelet inhibitor and Ruboxistaurin, for diabetic retinopathy).

    Among other lack of board accountability issues, CalPERS cited the drugmaker for not allowing shareholders the opportunity to amend bylaws—by employing restrictions used by only 4 percent of S&P 500 companies.

    Lilly also would not agree to grant shareowners the right to call special meetings or act by written consent; and, ignored a petition that stockholder approval be sought for existing or future poison pills.

  • Shares in EMC Corporation (EMC-$12.93) have underperformed relative to the S&P 500 Index and its industry peer index over the three period by (32.34)% and (25.10)%, respectively, and five year time period by (11.21)% and (7.67)%, respectively, due to concerns that EMC's growth is being fueled more from acquisitions than from its core data hardware business (a highly competitive market—think IBM or HP—prone to short maturity cycles and related declines in average selling prices).

    Another CalPER grievance is that the data storage device maker refuses to seek shareowner approval when the present value of an officer’s severance exceeds 2.99 times base plus bonus.

  • Shares in International Paper Corporation (IP-$35.39) have underperformed relative to its industry peer index over the three and five year time period by (35.00)% and (43.84)%, respectively.

    Weak demand for—and substitution of cheaper grades of—paper, coupled with rising energy costs have hurt sales volume and net income in the last five years. During this time period—adjusted for dividends, the stock of the forest products company has lost $3.49 per share.

    Characteristic of an entrenched board, directors at the world's largest pulp and paper producer are allegedly unresponsive to shareholders: (i) ignored a request that stockholder approval be sought for any future poison pills; (ii) refused to remove the staggered or “classified” board structure; and, would not agree to remove supermajority voting requirements that pertain to the articles of incorporation.

Last week, in a Fortune funded survey of more than 3,000 executives, directors and securities analysts queried about the 10 largest companies by revenue in 63 industries, IP was ironically named the most admired paper company in the magazine’s annual report of "America's Most Admired Companies."

  • Shares in Kellwood Corporation (KWD-$31.65) have underperformed relative to its industry peer index over the three and five year time period by (51.59)% and (82.12)%, respectively, due to continuing decreases in orders for certain legacy brands.

    CalPERS cites its concern over shareholder rights, for the apparel marketer requires a supermajority vote for issues that pertain to the articles of incorporation and bylaws.

  • Shares in Sara Lee Corp. (SLE-$16.47) have underperformed relative to its industry peer index over the three and five year time period by (33.55)% and (44.26)%, respectively.

    Earnings results in the last two years have been adversely affected by higher commodity costs (coffee, fuel, packaging) and distractions caused by owning too diverse product lines, from apparel to Kiwi shoe polish to baked goods.

    In the past two years, the food and beverage purveyor has been exiting non-core businesses, including the spin-off of
    Hanesbrands and the sale of sale of its European meats business to Smithfield Foods, Inc., the world’s largest pork processor and hog producer.

    Nonetheless, CalPERS believes the board is too insulated and lacks accountability during this restructuring: (i) Shareholders may not amend the bylaws and (ii) the board refuses to seek shareholder approval to remove the supermajority voting requirements that pertain to business combinations, director removal, and shareowner’s ability to act by written consent.

Other Companies called out this year for lackluster efforts media giant Tribune Company (TRB-$29.62), the Marsh & McLennan insurance firm (MMC-$28.85), integrated electronics manufacturer Sanmina-SCI (SANM-$3.72), and hospital operator Tenet Healthcare (THC-$6.31).

The fund warned it would start or step up existing efforts to push for changes if the companies do not act quickly themselves. Calpers is already pursuing shareholder proposals at four of the 11 companies.

CalPERS 2007 Shareowner Proposals:

  1. Dollar Tree Stores: “seeks to remove the company’s supermajority voting (usually 80%) requirements that pertain to the articles and bylaws.”
  2. Eli Lilly & Company: “seeks to allow a simple majority of shareowners (51%) the right to amend the bylaws.”
  3. Kellwood Corporation: Believing that annual elections for directions provide greater accountability to shareowners, in 2007, activist stockholder, CalPERS, is “seeking to remove the apparel marketer’s classified or “staggered” board structure.”
  4. Marsh & McLennan Companies: “seeks shareowner ratification of any severance agreement that provides severance benefits with a total present value exceeding 2.99 times the sum of the officer’s base salary plus target bonus.”

The success of the program is measured on the basis of excess shareowner returns to the internal portfolio and improved governance practices market-wide.

Research indicates that naming the companies helps change practices and improves performance over the longer term. One study of
The "CalPERS' Effect" found that the stocks of companies named to the list went on to outperform the S&P 500 Index by 3.1% on an annualized basis over five years.

Editor David J Phillips does not hold financial interests in any of the companies mentioned in this posting. The 10Q Detective has a Full Disclosure policy.

Wednesday, March 14, 2007

Washing Machines, Cruises, and Tax Gross-ups -- Handouts Live On in Corporate Boardrooms.

Despite recently enacted SEC regulations that made reporting of executive compensation more transparent—and allegedly easier to read and digest, a key issue still unaddressed was the continued excessive pay packages being granted for poor performance (both financial and shareholder return).

Christian E. Weller and Kate Sabatini of the Center for American Progress detailed what is largely a non-relationship between share prices and executive compensation in a study released in July last year. The report, “The Great CEO Guarantee: Getting Really Well-Paid Regardless of Your Performance,” shows that many companies increased the pay of their CEOs from 2001 to 2005 even when these companies’ stocks fell short of basic benchmarks such as the S&P 500 stock price index, and even when these companies' stocks failed to outperform staid U.S. Treasury bonds.

Under pressure from activist investors, Representative Barney Frank (D-Mass.), the new chair of the House Financial Services Committee, has pledged to hold Congressional hearings on runaway CEO pay packages; ancillary legislation to be discussed, too, is how to bring shareholders into the decision-making process on executive pay.

In our view, the oversight hearings need to transcend disclosure reforms and open up floor debate on the egregious perquisites showered on board members, too. Unfortunately, the 10Q Detective feels like we are yodeling in the Swiss Alps—and the only ones hearing our echoes of distress are ourselves.

No matter how cogent their populist arguments—activist hedge funds, labor unions, and reformers alike--are remiss in failing to open up their eyes to lavish board compensation. No matter how small the additional perks granted to directors, it is the other stakeholders, including workers and shareholders, who will foot the bills.

To the methods of persuasion,
turn a blind eye
To the masters of evasion,
turn a blind eye
To the science of control,
turn a blind eye
To the sellers of illusion,
turn a blind eye
To masters of confusion,
turn a blind eye
-- Call, album Turn a Blind Eye

Granted, there is an absence of conclusive empirical data in the executive compensation debate that boards' abdication of their fiduciary duties, such as ceding responsibility to CEO pay demands, is related to their own posh pay packages. Nevertheless, is it not human nature that those non-employee directors who serve on the Compensation Committee would be more inclined to co-opt the contract process to the CEO if they were treated to similar largesse?

One hand washes the other. – Roman philosopher & politician Seneca (5 BC - 65 AD)

This being Proxy season, the 10Q Detective wanted to share some board perquisites discovered—to date—in our diurnal readings--not unavailable to Common stockholders:

  • Whirlpool Corporation (WHR-$84.79): “For evaluative purposes, we permit non-employee directors to test Whirlpool products for home use, and [we] reimburse the directors for any income tax payment resulting from any additional tax obligation of this policy.”

10Q Detective: A federal lawsuit is filed against Whirlpool in Arkansas, claiming the company has done nothing to fix or warn customers of leaky icemakers in some of its side-by-side refrigerators. We wonder if any directors found problems in their ‘testing’ of these or other appliances, like dishwashers or room air-conditioning equipment?

  • Life Time Fitness, Inc. (LTM-$49.43): The upscale urban fitness centers operator “will reimburse all non-employee directors for the cost of purchasing a “family” Athletic membership to our health and fitness centers.”

10Q Detective: Do the memberships include FREE amenities, such as the full-service spas and dining services?

  • Anheuser-Busch Companies (BUD-$50.05): “As part of their continuing education, directors are encouraged to visit the beer king’s facilities—and the Company pays their expenses related to such visits.
  • Directors using the corporate aircraft and corporate residences for board purposes may be permitted to invite family members or other guests to accompany them on the aircraft or to join them in the use of the corporate residences for the limited period the director is on board business.”

10Q Detective: BUD adds to life's enjoyment not only through the responsible consumption of beer by adults, but through theme park entertainment, too. One of the largest U.S. theme park operators, Anheuser-Busch’s adventure parks include SeaWorld, Busch Gardens, Water Country, and the water park Adventure Island. Now what is the probability that much of the ‘continuing education’ is conducted during the spring/summer months, when the theme parks—oops! — learning facilities are open for business?

  • The Goodyear Tire & Rubber Co. (GT-$28.25): Each director is entitled to receive “up to two sets of automobile tires per year—as well as the reimbursement of taxes in respect of income (value of tires).”

10Q Detective: Goodyear, the largest U.S. tire maker, said last month that it would freeze pensions and require salaried retirees in the United States to contribute more for health coverage to cut costs. How about easing the pain of its restructuring angst by throwing in some free tires for employees, too?

  • Hewlett Packard Company (HPQ-$39.55): “non-employee directors may use the company aircraft for travel to and from HP events. Each non-employee director also may receive up to $2,500 worth of HP equipment each year.”

10Q Detective: Compensation for non-employee directors who served during fiscal 2006 exceeded $200,000 (cash/stock).

Last year, before the Hewlett Packard scandal broke, board chair, Patricia Dunn, hired an investigative firm to ferret out the board-level source of media leaks. The gumshoes used pretexting to obtain information on the residential call records of the directors. HP's investigation found that Dr. George Keyworth II was the source of several leaks. [We trust he was prudent enough not to use HP e-mail to transmit those media leaks?]

  • The Steak n’ Shake Company ($16.70): “All non-employee directors are also eligible to participate in the Company’s medical reimbursement plan, which provides reimbursement up to $3,500 per year for otherwise unreimbursed medical costs. Finally, all non-employee directors are entitled to reimbursement of 75% of the cost of their personal tax preparation, up to a maximum reimbursable amount of $1,250.”

10Q Detective: During fiscal 2006, the board met five times.

  • Starwood Hotels & Resorts Worldwide (HOT-$63.17): “Each non-employee director receives “the annual grant of 250,000 Starwood Preferred Guest Points and eighteen free nights per year in the Company’s hotels.”

10Q Detective: Last month, the hospitality concern announced joint venture plans with Morgan Stanley to buy the Sheraton Grand Tokyo Bay Hotel, which is located in the Tokyo Disney Resort area. Guess whose going to Disney World?

  • And speaking of The Walt Disney Company (DIS-$33.62): “To encourage Directors to experience the Company’s products, services and entertainment offerings personally, the Board has adopted a policy, that, subject to availability, entitles each non-employee Director (and his or her spouse, children and grandchildren) to use Company products, attend Company entertainment offerings and visit Company properties (including staying at resorts, visiting theme parks and participating in cruises) at the Company’s expense, up to a maximum of $15,000 in fair market value per calendar year plus reimbursement of associated tax liabilities.”

10Q Detective: Does the tax gross-up include the sales tax for purchase(s) of (i) Mickey Mouse ears and (ii) a picture with Pluto?

  • Carnival plc (CUK-$46.75): “All non-executive directors are encouraged to take a cruise for up to 14 days per year for product familiarization and pay a fare of $35 per day for such cruises. Guests traveling with the non-executive director in the same stateroom will each be charged a fare of $35 per day.”

10Q Detective: “All other charges associated with the cruise are the responsibility of the non-executive director.” God forbid! The directors might actually have to open up their own wallets and pay for gratuities and airfare out of their annual $40,000 retainers (does not include stock grants) received in remuneration.

Editor David J Phillips does not hold financial interests in any of the companies mentioned in this posting. The 10Q Detective has a Full Disclosure policy.

Monday, March 12, 2007

Amkor Tech Facing Bumps in the Road Ahead?

  • From looking at Amkor Technology’s (AMKR-$12.02) regulatory filings, an investor can see the muddy footprints—for better or worse?—of the Kim family in the operational scope of the Company’s semiconductor assembly and testing services.

    As of December 31, 2006, James J. Kim, 71, CEO and Chairman of the Board, and family beneficially owned 87.9 million shares, or approximately 46% of Amkor’s outstanding common stock:

    JooHo Kim, a brother of James J. Kim, is employed as the Corporate Vice President of Information Technology Services, making $270,000 per annum in salary.

    Mr. JooHo Kim, together with his wife and children, own 96.1% of Jesung C&M, a company that provides cafeteria services to Amkor Technology Korea, Inc. During 2006, 2005, and 2004, Jesung C&M provided $6.5 million, $6.5 million, and $6.4 million respectively, in catering services.

    Dongan Engineering Co., Ltd. was 100% owned by JooCheon Kim, another brother of James J. Kim, until the third quarter of 2005. There is no longer any related party ownership. Dongan Engineering Co., Ltd. provides construction and maintenance services to Amkor Technology Korea, Inc. and Amkor Technology Philippines, Inc., both subsidiaries of Amkor. Purchase services provided by Dongan Engineering were $0.5 million and $3.0 million, respectively, in 2005 and 2004.

    Amkor purchases lead frame inventory from Acqutek Semiconductor & Technology Co., Ltd. James J. Kim’s ownership in Acqutek Semiconductor & Technology Co., Ltd. is approximately 17.7 percent. During 2006, 2005 and 2004, purchases from Acqutek Semiconductor & Technology Co., Ltd. were $16.7 million, $11.8 million and $11.8 million, respectively.

    The Company also leases office space in West Chester, Pennsylvania from trusts related to James J. Kim. During 2006, 2005, and 2004 amounts paid for this lease were $0.1 million, $0.6 million, and $1.1 million, respectively.

    John T. Kim, 37, the son of James J. Kim, was formerly employed as Director of Corporate Development (and earned a base salary of $120,000 in 2005). In August 2005, he resigned upon being appointed to the Board of Directors. Mr. John T. Kim received an initial grant of 20,000 shares as a Board member. Annual compensation as a director includes an annual retainer of $25,000 and $2,000 per Board meeting that he attends.

Amkor’s business is highly dependent on the requirements of semiconductor companies for subcontracted packaging and test services.

Prices for assembling and test services have generally declined over time. To capture the growth in the scope and complexity of chip packaging and testing, and to offset product-growth cycle price declines, Amkor is constantly developing and marketing new packages with higher prices, such as advanced leadframe and laminate packages.

Amkor operates in a capital-intensive environment. In recent years, Amkor has invested heavily to service/capture the growing demand for outsourcing of packaging and test services by integrated device manufacturers. The Company spent $66.4 million (excluding performance earn-oyts) purchasing UST, a Taiwan-based provider of wafer level technologies and services for flip chip and wafer level packaging applications. Flip chip assembly has long been used in the automotive industry, and is now gaining popularity among telecom manufacturers (By using the entire surface of the die for establishing interconnect, the need for wire bond interconnect is eliminated and package size can be reduced).

The Company has also spent heavily to expand its geographical presence, by buying and building operational scale and scope in China, Singapore and Taiwan. For example, in 2004, Amkor paid IBM approximately $138.1 million to purchase its test operations in Singapore and Shanghai, China.

During 2006, the Company incurred capital additions of $299 million, commencing operations in a new Singapore 300mm wafer bumping factory (wafer bumping is the process of depositing tiny solder "bumps" onto fabricated semiconductor wafers); in 2007, Amkor anticipates making capital additions of approximately $250 to $300 million.

The source of cash to fund operations, including making capital expenditures and servicing principal and interest obligations with respect to its debt, are cash flows from operations, current cash, and borrowings under available debt facilities.

Growth does not come cheap. As of December 31, 2006, Amkor had cash of $244.7 million and $99.8 million available under revolving credit facility; but its total debt balance was about $2.0 billion.

Amkor’s substantial leverage comes with aggressive loan covenants, too. Any ‘technical’ violation (such as late filings of quarterly reports) could trigger a default—and a default and acceleration under one debt instrument may also trigger cross-acceleration under other debt instruments.

Granted, in a good year a highly leveraged company can trade on the equity at a gain. In fiscal 2006, Amkor’s ROE of 55.06% exceeded its ROA by some 47 percent! A prescient word of caution—trading on the equity is a two-way street: just as a company’s gains can be magnified, so, too, can losses be magnified!

Although Amkor achieved net income and positive operating cash flow in 2006, the Company has reported net losses in four of the previous five years and negative free cash flow in several previous years—about $(198.8) million and $(176.9) million, respectively, in fiscal 2005 and fiscal 2004.

Amkor’s fixed charge ratio was 2.48x, 0.18x, and 0.68x in fiscal 2006, 2005, and 2004, respectively. However, this alleged improvement in the Company’s ability to cover the interest payments on its debt does not weight the $185.4 million and $109.5 million in debt payments due in fiscal 2007 and fiscal 2008, respectively. [Nor the $15.3 million in lease obligations owed in the next two years or an under-funded pension plan owed about $27.2 million.]

The Kim family has bet heavily on a semiconductor turnaround, too. In November 2005, Amkor issued $100.0 million of 6.25% Convertible Subordinated Notes (due December 2013) in a private placement to James J. Kim, and certain Kim family members. The December 2013 Notes are convertible at any time prior to the maturity date into common stock at an initial price of $7.49 per share.

The Kim family has almost half of its $2.0 billion fortune invested in Amkor’s future. Among their other interests (not previously disclosed in this posting) is a 9.0% stake, or 4.12 million shares, in the world’s largest video-game retailer GameStop (GME-$54.71), worth an estimated $226.4 million, and a privately-held Sports-Collectible business (bought in 2002 for about $2.0 million from GameStop).

Investors might consider leaving this stock to the Kim family, for sales and share-net growth have been erratic in the last four years, with a net loss for 2005 of $(136.9) million, or ($0.78) per share and a net loss of $(37.5) million, or ($0.21) per share, in fiscal 2005 and fiscal 2004, respectively.

Guidance was recently cut for the 1Q:07, too, as CEO Kim cited a ‘seasonal’ slowdown. [Ed. note: Do not forget margins, too: high fixed costs and factory under-utilization issues.]

As mentioned, Amkor is highly leveraged, with five times as much debt as equity [buying binge of chipmakers’ in-house packaging operations].

The Company has taken steps to cut overhead costs. Recent examples include (i) October 2005, sale of Amkor Test Services, a specialty test operation based in Wichita, Kansas for $8.1 million; (ii) a 2005 deal to subcontract excess manufacturing labor force (in Japan) to one its customers; and (iii) 2006 early voluntary retirement program with special termination benefits to employees at its Korean subsidiary.

In July 2006, the SEC informed the Company that it is formally investigating Amkor’s historical stock option practices and certain trading activities with respect to Amkor securities, including alleged insider trading activities by or on behalf of certain current and former members of the Board of Directors and Amkor’s Chief Executive Officer.

Among Amkor Technology, Inc., The S&P 500 Index
And The Philadelphia Semiconductor Index

* $100 invested on 12/31/01 in stock or index-including reinvestment of dividends. Fiscal year ending December 31.
Copyright © 2007, Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved.

Buoyed by bargain chip buyers looking through the lens of an alleged cyclical turnaround in the chip equipment market, the share price of Amkor is bumping up against its 52-week high.

Given the lack of share-net visibility, competitive forces in Asia [market share vs. margins], and the Kim family influence—if downturn lasts longer than anticipated, debtload [high leverage and restrictive loan covenants] could be problematic. In our view, risk-reward favors a cautious outlook.

Editor David J Phillips does not hold financial interests in any of the companies mentioned in this posting. The 10Q Detective has a Full Disclosure policy.

Friday, March 09, 2007

Shareholders in Hollis-Eden Sickened by Neumune Failure

Drug developer Hollis-Eden Pharmaceuticals Inc. (HEPH-$2.90) said Thursday the Department of Health and Human Services rejected the company's radiation sickness drug, Neumune.

Neumune is postulated to work by mitigating neutropenia (loss of white blood cells known as neutrophils), thrombocytopenia (loss of key clotting elements known as platelets), and anemia (loss of red blood cells).

The stock got nuked on the news, stumbling $1.38, or 32.2 percent, to $2.90 per share, on the Nasdaq Stock Market on heavy volume, after hitting a 52-week low of $2.81 earlier in the session.

There was a turtle by the name of Bert
and Bert the turtle was very alert;
when danger threatened him he never got hurt
he knew just what to do...
He ducked! And covered!
Ducked! And Covered!
He did what we all must learn to do'

[Click to Play Duck and Cover - Video]

“Given the nature and stage of our communications with HHS regarding our original ARS proposal and subsequent revisions, this decision by HHS to exclude our proposal and cancel the RFP is shocking and difficult to understand," stated Richard B. Hollis, Chairman and Chief Executive Officer of Hollis-Eden.

The 10Q Detective took an interest in Hollins-Eden for two reasons:

  1. To determine if the HSS denial of solicitation of Neumune could have been foreseen by an informed investor.
  2. Will plaintiffs in the expected securities fraud suits be able to “prove that the act or omission of the defendants (management/board)” caused the loss for which the shareholders will ultimately seek to recover [financial losses]?

After an extensive read of regulatory filings, clinical trials, and press clippings, we believe that an informed investor could have heard the Geiger counter clicking; however, the incessant promulgations from management made it more difficult to reliably ‘hear’ the “Danger, Will Robinson” warnings [Lost in Space, 1960s sci-fi television classic].

Sit back, watch the show, and make your own informed decision(s).

Let us start at the beginning:

In the aftermath of September 11, U.S. intelligence officials feared the risk of a terrorist attack with a biological, chemical, radiological or nuclear agent. On July 21, 2004, President Bush signed the Project BioShield Act, legislation that provided, among other components, a mechanism for speeding research in promising areas of medical countermeasures, including the development and stockpiling of next-generation drugs that act as medical countermeasures to weapons of mass destruction.

A total of $6 billion was allocated to purchase medical countermeasures under this legislation.

Project BioShield also contained provisions enabling the Department of Health and Human Services, or HHS, to begin purchasing new medical countermeasures for the Strategic National Stockpile, or SNS, in advance of any formal FDA approval.

October 4, 2004. [HEPH-$11.14] In lethal studies, initially reported on at the Annual Meeting of The American Society for Therapeutic Radiology and Oncology (ASTRO, Neumune demonstrated a reduction in both neutropenia and severe thrombocytopenia, as well as a survival benefit as compared to animals not receiving Neumune.

[Ed. note. Under the FDA ‘Animal Rule,’ because it is unethical to conduct radiation-induced efficacy trials in humans, results in animals are used as a surrogate for efficacy results in humans—sorry PETA.]

Dr. Dwight Stickney, VP-Medical Affairs: We believe the model we have developed is one that recognizes the reality of the effects of a mass casualty scenario following a nuclear event…. we believe we have both defined, and shown potential benefit in, a model of the most stringent and relevant endpoint for radiation injury protection—survivability of high-dose radiation exposure.

RED FLAG! Statistical concerns: (i) the trial was originally powered to study 100 – 200 Rhesus macaques. The actual pilot study sample size was 30 monkeys. Ten of the animals received no treatment, while 10 received placebos, and 10 received Neumune beginning several hours after radiation exposure. (ii) Contrary to press release, the results were not statistically significant (p = 0.07).

October 19, 2004. [HEPH-$8.81] The Department of Health and Human Services (HHS) formally issues a Request for Information (RFI) for therapeutics to treat neutropenia and thrombocytopenia associated with ARS.

December 21, 2004. [HEPH-$9.35] Hollis-Eden announces that the company has submitted a formal response to the RFI. This response included data generated with Neumune in pre-clinical models of ARS, as well as information relating to safety and manufacturing, and also included preliminary estimates of pricing that were volume dependent.

March 31, 2005. [HEPH-$7.05] During the first quarter of 2005, Hollis-Eden continues to advance its Neumune development program for Acute Radiation Syndrome.

In late March, the Company initiated the first in a series of Phase I safety and pharmacokinetic (PK) clinical trials with Neumune. This first study is being conducted in the Netherlands.

The purpose of the Phase 1 studies, in addition to analyzing safety, is to determine the concentration of Neumune that can be achieved in human blood. The PK data can then be used in selecting the final dose for the pivotal efficacy study in non-human primates. By comparing the concentration of Neumune that can be achieved in humans to that which has already been established in non-human primates, the Company expects to be able to match the dose most likely to achieve efficacy in the pivotal study with a dose that is achievable and tolerable in humans.

In addition, the Company continues to expect to file an Investigational New Drug (IND) with the FDA in the first half of 2005 to initiate U.S. clinical studies. Safety and PK results from these studies are expected to be available in a timeframe that enables the Company to initiate the pivotal efficacy study in non-human primates in the second half of 2005.

To date, Hollis-Eden has conducted and reported on both sub-lethal and lethal radiation studies in over 200 non-human primates.

May 31, 2005. [HEPH-$8.49] Hollis-Eden files an IND application with the FDA to begin Phase I clinical trials in human volunteers with Neumune in the United States.

The similar Phase I clinical trial for Neumune is still ongoing in the Netherlands.

“Filing our IND to commence human studies with NEUMUNE in the U.S. is another significant milestone for our ARS development program,” stated Richard Hollis, Chairman and CEO of Hollis-Eden Pharmaceuticals. “We believe Hollis-Eden is the first company to file an IND with the FDA for a compound designed to treat ARS.”

Management informs its stockholders, too, that HHS has recently indicated on its website that it anticipates releasing by July 2005 a draft RFP for therapeutics to treat ARS.

“Issuance of a draft RFP for ARS under Project BioShield will be a positive market signal that the government is moving to procure a drug therapy for this indication,” said John Clerici, a partner at McKenna Long & Aldridge LLP, recently retained by Hollis-Eden to assist in responding to the potential upcoming RFP for ARS therapies.

July 5, 2005. [HEPH-$7.64] Hollis-Eden announces FDA clearance to commence Phase 1 human clinical trials with Neumune in the United States.

August 2, 2005. [HEPH-$8.67] RED FLAG? “Given the advanced stage of Neumune’s development, we are rapidly reaching a point where specific input and a firm commitment from HHS is critical to conducting the final components of the program,” stated Chairman and CEO Richard B. Hollis. “Given the current uncertainty with respect to the timing of this input and commitment from HHS, we are unable to provide guidance at this time as to anticipated timelines for the remaining steps necessary to potentially begin supplying Neumune to the Strategic National Stockpile.”

October 18, 2005. [HEPH-$5.11] The Company presents positive data from a preliminary interim analysis of its ongoing Phase I human clinical trials at the 47th Annual Meeting of The American Society for Therapeutic Radiology and Oncology (ASTRO) in Denver, including data showing a five-day treatment course in Neumune--treated human volunteers experienced statistically significant increases in neutrophils and platelets versus placebo-treated animals.

Hollis-Eden also reported at ASTRO updated data from pre-clinical studies indicating that Neumune can provide protection and benefit in non-human primate models across a wide range of radiation exposures (including lethal exposures > 600 cGy) both in settings where no other medical support is administered as well as in settings where supportive care can be provided.

This data suggests that Neumune could possibly be administered on an outpatient basis, or be self-injected by those exposed if the compound were previously forward deployed to those at risk.

An important finding from these studies, too, was that the best predictor for survival in primates exposed to lethal doses of radiation was days of thrombocytopenia (loss of platelets) through day 14 after radiation exposure, highlighting the importance of protecting platelets in addition to neutrophils.

Representative data suggests that giving the compound once-per-day for 5 days by injection at a dose of 15 mg/kg reduced the number of days of severe neutropenia from 12 to three. Similarly, days of thrombocytopenia were reduced from 8 days to zero days. Both of these results were statistically significant [p value N/A].

Human Clinical Trials: To date, a total of 95 volunteers have been enrolled in safety/dosing trials. Interim results indicate the compound is generally well tolerated, with pain and swelling at the injection site being the most commonly reported adverse event [to be expected].

September 30, 2005. [HEPH-$6.39] On the ARS procurement front, the Department of Health and Human Services issues a draft RFP for therapeutics to treat neutropenia associated with ARS.

October 31, 2005. [HEPH-$4.75] Management announces that included in its formal response to the draft RFP is a memo addressing its concern that the number of treatment regimens of a countermeasure for ARS is insufficient to protect the U.S. population at-risk called for in the draft RFP. The Company recommends increasing the targeted stockpile volume from 100,000 to 12—24 million treatment courses!

Furthermore, the Company categorically says that focusing solely on neutropenia, which is a change from the original Request for Information, runs counter to data indicating thrombocytopenia is a significant source of morbidity and mortality from ARS.

[Ed. note. Never contradict Big Brother!]

December 9, 2005. [HEPH-$5.25] The U.S. Department of Health and Human Services issues a Request for Proposal, specifying an initial potential stockpiling order of up to 100,000 treatment regimens, which is substantially lower than Hollis-Eden had anticipated.

December 30, 2005. [HEPH-$4.84] 39 –out of—111 volunteers have completed the 5-day treatment course in the Phase 1 human clinical trials. As expected, these healthy volunteers experienced a dose dependent, increase in neutrophils and platelets during the study. The magnitude of the increase in platelets and neutrophils in healthy volunteers was generally consistent with that seen in un-irradiated monkeys when given doses of Neumune that led to protection in radiation studies.

[Ed. note. Monkey see = Monkey do. Translation: Validation of ‘Animal Rule’ model. RED FLAG! SAMPLE SIZE STILL TOO SMALL.]

Stewart Simonson, is the man who oversees Project Bioshield. Simonson is a Republican political appointee who, before running Project Bioshield, was a lawyer for Amtrak. Republicans as well as Democrats have criticized his management of the program.

[Ed. note. Simonson--who has no scientific background--steered more than $1.0 billion in R&D monies to a still useless Anthrax vaccine program, and reminds many in Washington of Michael "FEMA" Brown--someone who is in way over his head.]

In January 2006, correspondent Ed Bradley did a 60 Minutes’ story on Project BioShield.

Simonson declined 60 Minutes' request for an interview, but his deputy, Dr. William Raub, was made available. Raub defended his boss. "When he worked for Amtrak, one of his major responsibilities was terrorist threats against the rail industry. He’s brought a considerable background and expertise and he’s provided strong leadership," he said.

Ed Bradley: “Why did the government decide to buy only 100,000 does to treat acute radiation syndrome?”

"Well this is the place to start and we don’t see 100,000 as the end, we see 100,000 as the beginning," says Raub.

The truth, according to 60 Minutes, is that [political hack] Simonson seems to be going in a different direction. He wrote a letter to Congress emphasizing that nuclear victims bleeding to death could be treated in hospitals. [Huh? Has he ever been to an ER during a flu outbreak—never mind radiation fallout.]

March 16, 2006. [HEPH-$6.17]

10-K filing: “In addition to a possible BioShield procurement under the initial ARS RFP issued by HHS, we believe there are multiple other significant market opportunities for Neumune. Among these is a potential procurement of a countermeasure such as Neumune by the Department of Defense, which has been seeking an ARS therapy since the 1960s and considers Neumune its lead product candidate for ARS. The Department of Defense has issued a Sources Sought Notice, or SSN, for an ARS therapy for use by U.S. forces, and we responded to that SSN in January 2006.

The Department of Defense also indicated in a letter to us that it would be issuing by mid-year 2006 its own RFP for an ARS therapy for the military. In that letter, we were highly encouraged by the Defense Department to respond to this RFP.”

April 27, 2006. [HEPH-$5.70] Hollis-Eden files its annual Proxy statement. 10Q Detective Due Diligence reveals that of the seven members on the Board of Directors, just one director, Thomas C. Merigan, Jr., MD, 72, has a science/research background.

Chairman and CEO Richard B. Hollis, 53, has a sales and marketing background, and a B.A. in Psychology from San Francisco State University. Despite the fact the Company is bleeding red, his salary/bonus in each of the last three fiscal years was $750,000, $810,000, and $798,000, respectively.

[Ed. note. RED FLAG! Hollis-Eden has been unprofitable since our inception [March 1997]. As of March 31, 2006, the Company had an accumulated deficit of approximately $168.2 million.

Further, as of December 31, 2005, the aggregate revenue [contract] earned by Hollis-Eden was an anemic $119,000—less than Messer. Hollis makes in just two months!]

June 26, 2006. [HEPH-$4.89] Hollis-Eden provides its shareholders with the anticipated update of Neumune RFP: The Department of Health and Human Services in a letter says that Hollis-Eden “is within the competitive range for discussion and further evaluation” with respect to Hollis-Eden’s response to HHS’ Request for Proposal entitled “Medical Countermeasures to Mitigate or Treat Neutropenia Alone or in Combination with Co-Morbidities Associated with Acute Radiation Syndrome (ARS).”

After two years of false starts, the negotiation process for a potential procurement is formally underway. HHS indicates in their letter that the new estimated date of award is September 15, 2006.

August 18, 2006. [HEPH-$6.93] RED FLAG! Richard Hollis and other members of Hollis-Eden's senior management team, announce their intent to sell a portion of their Hollis-Eden stock over time as part of “individual long-term strategy for estate planning, asset diversification and liquidity” via pre-arranged stock trading plans (SEC Rule 10b5-1).

[Ed. note. Insiders who invoke Rule 10b5-1 have successfully refuted—in court—allegations that the trading was done pursuant to previously established trading plans—and not because of possession of material non-public information. RED FLAG! Nonetheless, this begs the question: Why sell before the big day?]

September 27, 2006. [HEPH-$5.57] RED FLAG! The announcement of first procurement of Neumune by the HHS is delayed, and while “HHS has not provided Hollis-Eden with a new estimated contract award date, based on this extension an award could be made under this RFP at any time prior to the end of November 2006.”

October 13, 2006. [HEPH-$6.34] RED FLAG! Companies with nothing new to report often fill the void with noise: “Hollis-Eden presents new clinical data—in a study that enrolled 18 patients! —supports the use of Neumune in mitigating ARS.”

November 13, 2006. [HEPH-$6.11] Hollis-Eden announces 3Q:06 fiscal results: “From inception through September 30, 2006, the Company has generated approximately $323,600 in revenues [still less than one-year ‘s salary of its co-founder, Richard Hollis] and the aggregate net loss was approximately $183.6 million for this period.”

RED FLAG! General and administrative expenses were $1.9 million and $7.1 million for the three-month and nine-month periods ended September 30, 2006, respectively, compared to $1.9 million and $6.5 million for the same periods in 2005.

The 10Q Detective notes that in calculating its option expense for 2006, expected volatility fell year-over-year from 136% to 91 percent! (Such a material decline in implied stock price volatility tends to lower option expenses.)

December 29, 2006. [HEPH-$5.26] Still no news from HHS….

February 1, 2007. [HEPH-$5.47] Hollis-Eden Gets New HHS Date on Award

RED FLAG! The Department of HHS revised its award date to March 7. Previously, Hollis-Eden expected a decision by Jan. 31, and prior to that, by the end of September.

February 26, 2007. [HEPH-$5.46] Blah! Blah! Company posts new monkey data demonstrating the ability of Neumune to increase survival in a primate model of lethal radiation injury.

Of note, in its press releases, the Company is getting more novel in describing its proprietary class of adrenal steroid hormones: “Hormonal Signaling Technology Platform” has replaced “Immune Regulating Hormones” in the Company’s lexicon.

March 8, 2007 (7:51 A.M.) HHS considers Hollis-Eden's Neumune “technically unacceptable” and no longer in the competitive range. Closing price: [HEPH-$2.90]

Circumstantial evidence? Yeah--but in our view, starting in October 2005, the Company was conjuring away doubts as to Neumune's eventual fate with hollow press releases and smoke and mirror promises of riches just over the next mushroom cloud.

Sadly, any drug to treat acute radiation sickness will probably never see the light of day.

Farewell the neighing steed, and the shrill trump,/ The spirit-stirring drum, the ear-piercing fife,/ The royal banner, and all quality,/ Pride, pomp, and circumstance.... -- Shakespeare's Othello

Save for some 300 million doses of mallpox vaccine stockpiles, biodefense countermeasure initiatives are nonexistent--mired in bureaucratic muck. Knowing this--and given Hollis-Eden's constant assurances that its RFP was tracking on schedule, we look for investors to charge the company with issuing false statements about Neumune's prospects.

The 10Q Detective predicts that the first shareholder class-action lawsuit will be filed by the close of trading today.

Editor David J Phillips does not hold financial interests in any of the companies mentioned in this posting. The 10Q Detective has a Full Disclosure policy.