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 short-squeeze.com, 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.