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NU SKIN ENTERPRISES INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) This quarterly report on Form 10-Q (this "Quarterly Report") contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended that represent our current expectations and beliefs. All statements other than statements of historical fact are "forward-looking statements" for purposes of federal and state securities laws and include, but are not limited to, statements of management's expectations regarding our performance, initiatives, strategies, product offerings, opportunities and risks; statements of projections regarding future sales, expenses, operating results, taxes and duties, capital expenditures, sources and uses of cash, foreign currency fluctuations and other financial items; statements of management's expectations and beliefs regarding China and other markets; statements regarding the payment of future dividends and stock repurchases; statements regarding the outcome of litigation; accounting estimates and assumptions; statements of belief; and statements of assumptions underlying any of the foregoing. In some cases, you can identify these statements by forward-looking words such as "believe," "expect," "project," "anticipate," "estimate," "intend," "plan," "targets," "likely," "will," "would," "could," "may," "might," the negative of these words and other similar words. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise, except as required by law. We caution and advise readers that these statements are based on assumptions that may not be realized and involve risks and uncertainties that could cause actual results to differ materially from the expectations and beliefs contained herein. For a summary of these risks, see the risk factors included in our Annual Report on Form 10-K for the year ended December 31, 2013, subsequent Quarterly Reports on Form 10-Q and any amendments thereto (our "Periodic Reports"). The following Management's Discussion and Analysis should be read in conjunction with our consolidated financial statements and related notes and Management's Discussion and Analysis included in our Periodic Reports, and our other filings, including Current Reports on Form 8-K, filed with the Securities and Exchange Commission through the date of this report. Overview Revenue for the three-month period ended September 30, 2014 decreased 30% to $638.8 million, when compared to the same prior-year period, with foreign currency fluctuations negatively impacting revenue 3%. Our revenue for the nine-month period ended September 30, 2014 decreased 8% to $2.0 billion, when compared to the same period in 2013, with foreign currency fluctuations negatively impacting revenue 1%. Sales Leaders and Actives were down 37% and 17%, respectively, compared to the prior year. When compared sequentially to results for the second quarter of 2014, our revenue in the third quarter of 2014 decreased 2%, and Sales Leaders and Actives decreased 3% and 2%, respectively. These declines reflect difficult comparisons with the prior year, which included significant sales leader activity and revenue related to the global limited-time offer of ageLOC TR90. Sales of ageLOC TR90 in the second half of 2013 were substantial, with $550 million of sales generated during this period, with $203 million generated in the third quarter of 2013. This product was sold in a kit containing a three-month supply, and we believe the significant 2013 sales and the three-month supply kit configuration decreased demand in subsequent regional limited-time offers of this product. In addition, TR90 was developed to decrease fat without sacrificing lean muscle. The result is a healthier body composition but not necessarily maximum weight loss. Our research shows that some consumers of TR90 were dissatisfied with the extent of their weight loss. In some markets, we have elected to make TR90 generally available shortly following a regional limited-time offer, rather than waiting a longer period as in previous limited-time offers for other products. We believe these issues combined to result in regional limited-time offer sales in 2014 being significantly lower than global limited-time offer sales in the prior year. Limited-time offers of ageLOC Tru Face Essence Ultra and TR90 generated $81.4 million of sales in the third quarter and $190.6 million in the first nine months of 2014. We anticipate that substantial limited-time offer sales in the fourth quarter of 2013 will present difficult year-over-year comparisons for the fourth quarter of 2014, as we estimate $20 million of limited-time offer sales in the fourth quarter of 2014. -17- -------------------------------------------------------------------------------- The year-over-year comparisons were also impacted by the disruption in our business in Mainland China and softness in some of our other markets such as Japan, the United States, Taiwan, and Hong Kong. As previously disclosed, our business in Mainland China was significantly disrupted following our voluntary suspension of business meetings and the acceptance of applications for new sales representatives in response to media and regulatory scrutiny of our business in January 2014. In May, we resumed business meetings and acceptance of applications for new sales representatives in Mainland China. In the third quarter we continued to expand our business meetings. As discussed in "-Revenue-Greater China" below, we believe our business in Mainland China showed signs of stabilization during the third quarter. Earnings per share for the third quarter of 2014 were $1.12, compared to $1.80 for the third quarter of 2013. Earnings per share for the first nine months of 2014 were $2.34 compared to $3.91 for the same prior-year period. The decrease in earnings per share in the nine-month period ended September 30, 2014 includes a $46.3 million foreign currency charge taken in the first half of 2014, related to the impact of the devaluation of the Venezuela currency on monetary assets and liabilities of our Venezuela entity, and reflects the increased tax rate related to this foreign currency charge. The decrease in earnings per share in the nine-month period ended September 30, 2014 also includes a $50 million charge taken in the second quarter of 2014 for the write-down of inventory primarily in Mainland China. For more information regarding these items, please see "-Gross profit", "-Other income (expense), net" and "-Provision for income taxes." Revenue Greater China. The following table sets forth revenue for the three- and nine-month periods ended September 30, 2014 and 2013 for the Greater China region and its principal markets (U.S. dollars in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change Mainland China $ 153.0 $ 332.3 (54%) $ 519.0 $ 642.4 (19%) Taiwan 41.6 64.6 (36%) 119.0 134.5 (12%) Hong Kong 32.1 52.7 (39%) 97.5 104.7 (7%) Greater China total $ 226.7 $ 449.6 (50%) $ 735.5 $ 881.6 (17%) Foreign currency exchange rate fluctuations did not impact revenue in this region during the three- or nine-month periods ended September 30, 2014. Sales Leaders and Actives in Mainland China decreased 63% and 55%, respectively, compared to the prior-year quarter. Sales Leaders and Actives in Taiwan were down 31% and 16%, respectively, compared to the prior-year quarter. Sales Leaders in Hong Kong were down 31% and Actives were up 2%, compared to the prior-year quarter. The year-over-year comparisons were impacted by significant sales leader activity and revenue related to the global limited-time offer of ageLOC TR90 in the second half of 2013. This global limited-time offer generated $153.6 million in sales in the Greater China region during the third quarter of 2013. Regional limited-time offers of ageLOC Tru Face Essence Ultra and TR90 in 2014 generated revenue of $59.3 million in the third quarter. We currently anticipate that substantial limited-time offer sales in the fourth quarter of 2013 will similarly present difficult year-over-year comparisons for the fourth quarter of 2014. When compared sequentially to results for the second quarter of 2014, revenue for the Greater China region in the third quarter of 2014 decreased 1%, and Sales Leaders and Actives decreased 5% and 7%, respectively. -18- -------------------------------------------------------------------------------- Our revenue and number of Sales Leaders and Actives in this region during the first nine months of 2014 were also negatively impacted by our voluntary suspension of business meetings and applications for new sales representatives in Mainland China in response to adverse media reports and government investigations in the first part of the year. In May, we resumed business meetings and acceptance of applications for new sales representatives in Mainland China. In the third quarter, we continued to expand our business meetings. As we expand the number of meetings, we continue to act cautiously to properly educate and train our sales force. We may encounter unanticipated complications or other difficulties in rebuilding our business in Mainland China, which could further impact our business negatively. In addition, as we had not previously undertaken such a lengthy suspension of business meetings and applications for new sales representatives, there is uncertainty regarding the full impact the voluntary actions we took during the first part of 2014 could have on our sales force and business going forward. Significant limited-time offer sales in the third quarter of 2013 created difficult year-over-year comparisons for the three- and nine-month periods of 2014 in Taiwan and Hong Kong. Revenue in these markets was also impacted by a year-over-year decline in Sales Leaders. We also believe that the negative publicity and regulatory uncertainty in Mainland China caused some distraction among our Sales Leaders in Taiwan and Hong Kong, given the proximity of the markets. North Asia. The following table sets forth revenue for the three- and nine-month periods ended September 30, 2014 and 2013 for the North Asia region and its principal markets (U.S. dollars in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change South Korea $ 127.1 $ 111.5 14% $ 359.9 $ 290.0 24% Japan 78.4 90.9 (14%) 237.0 293.1 (19%) North Asia total $ 205.5 $ 202.4 2% $ 596.9 $ 583.1 2% Revenue in the region was positively impacted approximately 2% and 1% by currency exchange rate fluctuations for the three- and nine-month periods ended September 30, 2014. Local currency revenue increased 6% and 21% in South Korea for the three- and nine-month periods ended September 30, 2014, compared to the same prior-year periods. Revenue in the third quarter was positively impacted by a limited-time offer of ageLOC Tru Face Essence Ultra in South Korea during the third quarter of 2014, which generated $22.0 million in revenue. We currently anticipate that substantial limited-time offer sales in the fourth quarter of 2013 will present difficult year-over-year comparisons for the fourth quarter of 2014. Sales Leaders in South Korea were up 1% and Actives were down 8%, compared to the prior-year quarter. Local currency revenue decreased 9% and 18% in Japan for the three- and nine-month periods ended September 30, 2014, compared to the same prior-year periods. In the third quarter of 2014, Sales Leaders and Actives in Japan decreased 11% and 6%, respectively, compared to the prior-year period, reflecting challenges related to the difficult direct selling environment in Japan. We continue to be cautious in our promotional activities in Japan and continue to meet with regulatory agencies regarding our ongoing distributor education, training and compliance efforts. When compared sequentially to results for the second quarter of 2014, revenue in the third quarter of 2014 increased 7%, Sales Leaders decreased 3% and Actives increased 3%. We currently plan to introduce our ageLOC Tru Face Essence Ultra through a limited-time offer in Japan in the fourth quarter of 2014, in connection with our North Asia regional convention. -19- -------------------------------------------------------------------------------- South Asia/Pacific. The following table sets forth revenue for the three- and nine-month periods ended September 30, 2014 and 2013 for the South Asia/Pacific region (U.S. dollars in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change South Asia/Pacific $ 88.9 $ 127.0 (30%) $ 241.8 $ 279.5 (13%) Foreign currency exchange rate fluctuations in South Asia/Pacific negatively impacted revenue by 1% for both the three- and nine-month periods ended September 30, 2014, when compared to the same prior-year periods. Sales Leaders and Actives in the region decreased 15% and 3%, respectively, compared to the prior-year quarter. The year-over-year decline in South Asia/Pacific was due largely to difficult prior-year comparisons, which included significant sales leader activity and revenue related to the global limited-time offer of ageLOC TR90 in the second half of 2013. This global limited-time offer generated $45.7 million in sales in the region during the third quarter of 2013. Third-quarter revenue in 2014 was positively impacted by the launch of TR90. When compared sequentially to results for the second quarter of 2014, revenue for the South Asia/Pacific region in the third quarter of 2014 increased 9%, Sales Leaders increased 6% and Actives were unchanged. Americas. The following table sets forth revenue for the three- and nine-month periods ended September 30, 2014 and 2013 for the Americas region (U.S. dollars in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change Americas $ 76.7 $ 84.8 (10%) $ 246.6 $ 243.9 1% Revenue in the region for the three- and nine-month periods ended September 30, 2014 was negatively impacted approximately 29% and 10%, respectively, by fluctuations in foreign currencies, primarily in Venezuela. Sales Leaders in the Americas region decreased by 3% and Actives increased by 4%, when compared to the prior-year quarter. Results for the region were positively impacted by strong local currency growth in Latin America, offset by the devaluation of the Venezuelan currency. Results for the region were negatively impacted by softness in the United States, which declined 8% and 4% from the three- and nine-month periods of 2013, respectively. We currently anticipate that significant limited-time offer sales in the fourth quarter of 2013 will present difficult year-over-year comparisons for the fourth quarter of 2014. EMEA. The following table sets forth revenue for the three- and nine-month periods ended September 30, 2014 and 2013 for the Europe, Middle East and Africa ("EMEA") region (U.S. dollars in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change EMEA $ 40.9 $ 44.6 (8%) $ 139.1 $ 132.8 5% Foreign currency exchange rate fluctuations in the EMEA region negatively impacted revenue by 1% for the three-month period ended September 30, 2014, and had no effect on the nine-month period ended September 30, 2014 when compared with the same prior-year periods. Sales Leaders and Actives in our EMEA region decreased by 6% and 7%, respectively, when compared to the prior-year. Growth in Western Europe during the third quarter of 2014 was offset by softness in the rest of the region. We currently anticipate that significant limited-time offer sales in the fourth quarter of 2013 will present difficult year-over-year comparisons for the fourth quarter of 2014. -20- --------------------------------------------------------------------------------Gross profit Gross profit as a percentage of revenue was 82.9% and 81.0% for the three- and nine-month periods ended September 30, 2014 compared to 84.6% and 83.9% for the same prior-year periods. Gross profit as a percentage of revenue in 2014 continued to be negatively impacted by currency fluctuations, decreased utilization of our manufacturing operations in Mainland China and a decline in the percentage of global revenue represented by Mainland China, where our gross margin on a consolidated basis benefits from our self-manufactured products. Gross profit as a percentage of revenue in 2014 was also negatively impacted by increased product promotions, which we currently expect to continue through the first part of 2015. Gross profit as a percentage of revenue in the nine-month period ended September 30, 2014 was negatively impacted by a $50 million write-down of inventory primarily in Mainland China. Any additional write-down of inventory in Mainland China or any of our other markets would negatively impact our gross margins. Selling expenses Selling expenses as a percentage of revenue decreased to 41.2% and 43.9% for the three- and nine-month periods ended September 30, 2014 from 48.2% and 45.6% for the same periods in 2013. Selling expenses in the prior-year period were high as a percentage of revenue as a result of the significant growth in the number of Sales Leaders qualifying for increased sales compensation and promotional incentives as a result of the limited-time offer of TR90 in the prior-year period. Selling expenses as a percentage of revenue also decreased in the third quarter of 2014 due to a reduction in estimates of the number of sales leaders qualifying for incentive trips and other promotional incentives based on results through the third quarter. We currently expect selling expenses as a percentage of revenue to return to approximately 44% in the fourth quarter. General and administrative expenses As a percentage of revenue, general and administrative expenses increased to 25.3% and 23.8% for the three- and nine-month periods ended September 30, 2014, from 17.9% and 21.1% for the same periods in 2013, reflecting lower revenue and relatively stable general and administrative expenses. Other income (expense), net Other income (expense), net for the three- and nine-month periods ended September 30, 2014, was $1.1 million of income and $37.6 million of expense compared to $0.5 million of income and $0.6 million of expense for the same periods in 2013. The increase in expense in the nine-month period ended September 30, 2014, was largely due to a $46.3 million non-cash foreign currency charge related to the devaluation of the Venezuelan currency. For the fourth quarter, other income (expense) will include a charge of $7.4 million for a fee related to the prepayment of debt. Provision for income taxes Provision for income taxes for the three- and nine-month periods ended September 30, 2014 was $37.7 million and $80.7 million, compared to $57.9 million and $125.3 million for the same periods in 2013. The effective tax rate was 35.6% and 36.1%, respectively, of pre-tax income during the three- and nine-month periods ended September 30, 2014, compared to 34.3% in both of the same prior-year periods. The increase in the effective tax rate in 2014 was due largely to the impact of the foreign currency charge relating to Venezuela, for which a deductible tax expense is not allowed until profit is realized in this market. -21---------------------------------------------------------------------------------Net income As a result of the foregoing factors, net income for the third quarter and first nine months of 2014 was $68.3 million and $142.7 million, respectively, compared to $110.9 million and $239.6 million, respectively, for the same periods in 2013. Liquidity and Capital Resources Historically, our principal uses of cash have included operating expenses, particularly selling expenses, and working capital (principally inventory purchases), as well as capital expenditures, stock repurchases, dividends, debt repayment and the development of operations in new markets. We have at times incurred long-term debt in order to fund strategic transactions and stock repurchases. We typically generate positive cash flow from operations due to favorable margins and have generally relied on cash flow from operations to fund operating activities. However, during the first nine months of 2014 we used $151.3 million in cash for operations, compared to generating $484.1 million in cash from operations during the same period in 2013, due to three primary factors. First, we had a significant amount of accrued expenses at the end of December 2013, following record sales and a record number of sales representatives who qualified for incentive trips. The selling expenses and incentive trip expenses, although accrued in 2013, were paid in 2014. Second, we had significant accounts payable at the end of December 2013, as we built a large amount of inventory for planned product launches in 2014. Finally, the decrease in revenue due to disruption of our Mainland China business lowered our net income for the first nine months of 2014. We generated positive cash flow from operations in the third quarter of 2014 of $33.6 million. As of September 30, 2014, working capital was $355.2 million, compared to $341.5 million as of December 31, 2013. Cash and cash equivalents as of September 30, 2014 and December 31, 2013 were $194.9 million and $525.2 million, respectively. The decrease in cash and cash equivalents reflects decreased income, and cash payments for inventory and accrued taxes, selling and other expenses. Capital expenditures in the first nine months of 2014 were $80.6 million, and we anticipate additional capital expenditures of approximately $20 million for the remainder of 2014. Our 2014 capital expenditures are primarily related to: • expansion of our corporate facilities in the United States, Greater China and South Korea; • purchases of computer systems and software, including equipment and development costs; • purchase of tooling and manufacturing equipment related to the development of new products; and • build-out and upgrade of leasehold improvements in our various markets, including retail stores and service centers in Mainland China. -22--------------------------------------------------------------------------------- The following table summarizes our debt facilities as of December 31, 2013 and September 30, 2014. Our book value for both the individual and consolidated debt included in the table approximates fair value. The estimated fair value of our debt is based on interest rates available for debt with similar terms and remaining maturities. We have classified these instruments as Level 2 in the fair value hierarchy. Balance as Balance as Original of of Principal September December Interest Debt Facility Amount 30, 2014(1) 31, 2013 Rate Repayment terms Multi-currency uncommitted shelf facility(2): U.S. dollar $40.0 $11.4 $17.1 6.2% Notes due July 2016 denominated: million million million with annual principal payments that began in July 2010. Paid in full on October 10, 2014. $20.0 $8.6 $11.4 6.2% Notes due January million million million 2017 with annual principal payments that began in January 2011. Paid in full on October 10, 2014. Japanese yen 3.1 - 0.4 1.7% Notes paid in full denominated: billion billion on April 30, 2014. yen yen or $4.1 million 2.3 1.0 billion 1.3 2.6% Notes due September billion yen or $8.9 billion 2017 with annual yen million yen or principal payments $12.3 that began in million September 2011. Paid in full on October 10, 2014. 2.2 0.9 billion 1.2 3.3% Notes due January billion yen or $8.5 billion 2017 with annual yen million yen or principal payments $11.8 that began in million January 2011. Paid in full on October 10, 2014. 8.0 8.0 billion 8.0 1.7% Notes due May 2022 billion yen or billion with annual yen $72.2 yen or principal payments million $75.8 that begin in May million 2016. Paid in full on October 10, 2014. Korean $20.0 $20.0 - 2.5% Notes due December subsidiary million million 2014, with a right loan(3): to extend the term for an additional six months. Revolving credit facilities: 2010(4) - $35.0 N/A Paid in full. million 2013(5) $50.0 $14.0 Variable Revolving line of million million 30 day: credit. Paid in 1.1035% full on October 10, 2014. 2014 - - N/A Revolving line of credit. Terminated on October 10, 2014. Japanese subsidiary loan(6): 2014 1 billion - 1.475% Paid in full as of yen or $9.1 October 15, 2014. million -23--------------------------------------------------------------------------------- _______________ (1) As of September 30, 2014, the current portion of our debt (i.e. becoming due in the next 12 months) included $5.2 million of the balance of our Japanese yen-denominated debt under the multi-currency uncommitted shelf facility, $8.6 million of the balance on our U.S. dollar denominated debt under the multi-currency uncommitted shelf facility, $50.0 million of our revolving loans, $20.0 million borrowed at our Korean subsidiary and $9.1 million borrowed at its Japanese subsidiary. (2) On August 8, 2014, we entered into an amendment of the amended and restated note purchase and private shelf agreement (multi-currency), dated as of May 25, 2012, among us, Prudential Investment Management, Inc. and certain other purchasers. On October 10, 2014, we repaid all the amounts outstanding under the notes and also paid a $7.4 million fee related to the prepayment of debt. (3) In July 2014, our subsidiary in South Korea borrowed $20.0 million through a U.S. dollar-denominated term loan. (4) We paid the outstanding balance in full prior to the August 8, 2014 expiration of the amended and restated credit agreement, dated as of May 25, 2012, among us, various financial institutions, and JPMorgan Chase Bank, N.A. as administrative agent. (5) On August 15, 2014, we entered into an amendment of the loan agreement, dated as of September 5, 2013, with Bank of America, N.A. The amendment extended the term of the agreement from September 4, 2014 to December 3, 2014, and changed the applicable interest rate from LIBOR plus 0.425% to LIBOR plus 0.95%. On October 10, 2014, we paid the outstanding balance of the revolving credit facility. (6) In July 2014, our subsidiary in Japan borrowed 3 billion Japanese yen ($29.5 million) through a yen-denominated revolving credit facility. Effective October 1, 2014, the interest rate on this credit facility was reduced to 0.74%. On October 15, 2014, we paid the outstanding balance of the revolving credit facility. On October 9, 2014, we entered into a Credit Agreement (the "Credit Agreement") with various financial institutions, and Bank of America, N.A. as administrative agent. The Credit Agreement provides for a $127.5 million term loan facility, a 6.6 billion Japanese yen term loan facility and a $187.5 million revolving credit facility, each with a term of five years. On October 10, 2014, the Company drew the full amount of the term loan facilities, which bear interest at 2.9018% on U.S. dollar borrowings and 2.835% on Japanese yen borrowings, and $112.5 million of the revolving credit facility, which bears interest at 2.9018%. Any additional amounts drawn under the revolving credit facility will bear interest at rates that will be determined in accordance with the Credit Agreement. Half of the principal amount of the term loan facilities will be payable in increasing quarterly installments over a five-year period, with the remainder payable at the end of the five-year term. The Credit Agreement requires that we maintain a consolidated leverage ratio not exceeding 2.25 to 1.00 and a consolidated interest coverage ratio of no less than 3.00 to 1.00. We believe these covenants provide us with greater flexibility to pay dividends and repurchase stock. -24--------------------------------------------------------------------------------- As set forth in the table above, on October 10, 2014, we repaid debt that was outstanding under our credit agreements with Bank of America, N.A. and the notes with Prudential Investment Management, Inc. and affiliates. We also paid a $7.4 million fee related to the prepayment of debt. On October 15, 2014 we repaid all amounts outstanding under our Japan subsidiary's revolving line of credit. Our board of directors has approved a stock repurchase program authorizing us to repurchase our outstanding shares of Class A common stock on the open market or in private transactions. The repurchases are used primarily to offset dilution from our equity incentive plans and for strategic initiatives. During the first nine months of 2014, we repurchased 0.3 million shares of Class A common stock under this program for $25.0 million. As of September 30, 2014, $369.5 million was available for repurchases under the stock repurchase program. In March, May and August 2014, our board of directors declared a quarterly cash dividend of $0.345 per share. These quarterly cash dividends were $20.1 million, $20.4 million and $20.5 million, respectively, and were paid on March 26, 2014, June 11, 2014 and September 26, 2014, to stockholders of record on March 14, 2014, May 23, 2014 and September 12, 2014. In November 2014, our board of directors declared a quarterly cash dividend of $0.345 per share to be paid December 3, 2014 to stockholders of record on November 21, 2014. Currently, we anticipate that our board of directors will continue to declare quarterly cash dividends and that the cash flows from operations will be sufficient to fund our future dividend payments. However, the continued declaration of dividends is subject to the discretion of our board of directors and will depend upon various factors, including our net earnings, financial condition, cash requirements, future prospects and other relevant factors. As of September 30, 2014 and December 31, 2013, we held $194.9 million and $525.2 million, respectively, in cash and cash equivalents, including $173.2 million and $493.9 million, respectively, held in our operations outside of the U.S. Substantially all of our non-U.S. cash and cash equivalents are readily convertible into U.S. dollars or other currencies, with the exception of cash in Venezuela which is subject to currency exchange restrictions by the government of Venezuela. Currency exchange restrictions in Venezuela require approval from the government's currency control organization for our subsidiary in Venezuela to obtain U.S. dollars at an official exchange rate to pay for imported products or to repatriate dividends to the United States. We have been unsuccessful in obtaining U.S. dollars at the official exchange rates and under alternative exchange mechanisms described below. As a result, these foreign exchange controls in Venezuela have limited our ability to repatriate earnings and settle our intercompany obligations, which has resulted in the accumulation of bolivar denominated cash and cash equivalents in Venezuela. During the first quarter of 2014, two new foreign exchange mechanisms ("SICAD I" and "SICAD II") became available in Venezuela. Accordingly, there are three legal mechanisms in Venezuela to exchange currency. As of March 31, 2014, we determined it would be most appropriate to utilize the SICAD I rate, which was approximately 10.7 bolivars per U.S. dollar. As a result of this determination, we incurred a $14.7 million charge related to the translation of our monetary assets in Venezuela. During the second quarter, we determined that it would most appropriate to use the SICAD II rate, which is approximately 50 bolivars per U.S. dollar, as we had still not received any approvals under SICAD I. The remeasurement of our net monetary assets and liabilities denominated in bolivars as a result of this change resulted in a foreign exchange loss of $25.3 million during the three months ended June 30, 2014. As of September 30, 2014, cash and cash equivalents in Venezuela were $6.8 million. We typically fund the cash requirements of our operations in the U.S. through intercompany charges for products, license fees and corporate services. However, in some markets such as Mainland China, where we have lower intercompany charges, we may be unable to repatriate cash from current operations in the form of dividends until we file the necessary statutory financial statements for the relevant period. We currently have in place an intercompany loan arrangement, which allows us to access a portion of available cash in Mainland China pending our repatriation of dividends. As of September 30, 2014, we had approximately $49.1 million in cash denominated in Chinese yuan. We currently plan to repatriate undistributed earnings from our non-U.S. operations as necessary, considering the cash needs of our non-U.S. operations and the cash needs of our U.S. operations for dividends, stock repurchases, capital investments, debt repayment and strategic transactions. In all but two jurisdictions, we have not designated our investments as indefinitely reinvested, but rather have these funds available for our operations in the U.S. as needed. Any repatriation of non-U.S. earnings requires payment of U.S. taxes in accordance with the applicable U.S. tax rules and regulations. Accordingly, we have accrued the necessary U.S. taxes related to the funds that are not indefinitely reinvested. -25--------------------------------------------------------------------------------- We currently believe that existing cash balances, future cash flows from operations and existing lines of credit will be adequate to fund our cash needs on both a short- and long-term basis. The majority of our historical expenses have been variable in nature and as such, a potential reduction in the level of revenue would reduce our cash flow needs. In the event that our current cash balances, future cash flow from operations and current lines of credit are not sufficient to meet our obligations or strategic needs, we would consider raising additional funds in the debt or equity markets or restructuring our current debt obligations. Additionally, we would consider realigning our strategic plans, including a reduction in capital spending, stock repurchases or dividend payments. Contingent Liabilities We are currently involved in a dispute related to customs assessments by Yokohama Customs on several of our products for the period of October 2006 through September 2009 in connection with post-importation audits, as well as the disputed portion of our import duties from October 2009 to the present, which we have or will hold in bond or pay under protest. Additional assessments related to any prior period are barred by applicable statutes of limitations. The aggregate amount of these assessments and disputed duties was approximately 4.4 billion Japanese yen as of September 30, 2014 (approximately $39.7 million), net of any recovery of consumption taxes. The issue in this case is whether a United States entity utilizing a commissionaire agent in Japan to import its products can use the manufacturer's invoice or must use another valuation method, and, if an alternative method must be used, what the allowable deductions would be in determining the proper valuation. Following our review of the assessments and after consulting with our legal and customs advisors, we believe that the additional assessments are improper and are not supported by applicable customs laws. We filed letters of protest with the applicable Customs authorities, which were rejected. We then appealed the matter to the Ministry of Finance in Japan. In the second quarter of 2011, the Ministry of Finance in Japan denied our administrative appeal. We disagree with the Ministry of Finance's administrative decision. We are now pursuing the matter in Tokyo District Court, which we believe will provide a more independent determination of the matter. In addition, we are currently being required to post a bond or make a deposit to secure any additional duties that may be due and payable on current imports. Because we believe that the assessment of higher duties by the customs authorities is an improper application of the regulations, we are currently expensing the portion of the duties we believe is supported under applicable customs law, and recording the additional deposit or payment as a receivable within long-term assets on its consolidated financial statements. If we are unsuccessful in recovering the amounts assessed and paid, we will record a non-cash expense for the full amount of the disputed assessments. We anticipate that additional disputed duties will be limited going forward as we purchase a majority of the affected products in Japan from a Japanese company that purchases and imports the products from the manufacturers. We are also currently being sued in a purported class action lawsuit and derivative claim relating to negative media and regulatory scrutiny regarding our business in Mainland China and the associated decline in our stock price. Beginning in January 2014, six purported class action complaints were filed in the United States District Court for the District of Utah. On April 10, 2014, the plaintiffs filed a stipulated motion requesting that the court consolidate the various purported class actions, appoint State-Boston Retirement System as lead plaintiff in the consolidated action, and appoint the law firm Labaton Sucharow as lead counsel for the purported class in the consolidated action. On May 1, 2014, that stipulated motion was granted and on June 30, 2014, a consolidated class action complaint was filed. On August 29, 2014, we filed a motion to dismiss the case and on October 28, 2014, the plaintiffs filed their opposition to our motion to dismiss. The consolidated class action complaint purports to assert claims on behalf of certain of our stockholders under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder against Nu Skin Enterprises, Ritch N. Wood, and M. Truman Hunt and to assert claims under Section 20(a) of the Securities Exchange Act of 1934 against Messrs. Wood and Hunt. The consolidated class action complaint alleges that, inter alia, we made materially false and misleading statements regarding our sales operations in and financial results derived from Mainland China, including purportedly operating a pyramid scheme based on illegal multi-level marketing activities. We believe that the claims asserted in the consolidated class action complaint are without merit and intend to vigorously defend ourselves. -26- -------------------------------------------------------------------------------- In addition, beginning in February 2014, five purported shareholder derivative complaints were filed in the United States District Court for the District of Utah. On April 17, 2014, the plaintiffs filed a joint motion to consolidate the derivative actions, to appoint plaintiffs Amos. C. Acoff and Analisa Suderov as co-lead plaintiffs in the consolidated action, and to appoint the law firms Bernstein Litowitz Berger & Grossmann LLP and The Weiser Law Firm, P.C. as co-lead counsel for the plaintiffs in the consolidated action. On May 1, 2014, that joint motion was granted. On July 25, 2014, a consolidated derivative complaint was filed. On September 25, 2014, we filed a motion to dismiss or stay the case. The consolidated derivative complaint purports to assert claims on behalf of Nu Skin Enterprises for, inter alia, breach of fiduciary duties for disseminating false and misleading information, failing to maintain adequate internal controls, unjust enrichment, abuse of control, and gross mismanagement against M. Truman Hunt, Ritch N. Wood, Steven J. Lund, Nevin N. Andersen, Neil Offen, Daniel W. Campbell, Andrew W. Lipman, Patricia A. Negrón, Thomas R. Pisano, and nominally against Nu Skin Enterprises. The consolidated derivative complaint also purports to assert claims on behalf of Nu Skin Enterprises for breach of fiduciary duty for insider selling and misappropriation of information against Messrs. Wood, Lund, and Campbell. The consolidated derivative complaint alleges that, inter alia, the defendants allowed materially false and misleading statements to be made regarding our sales operations in and financial results derived from Mainland China, including purportedly operating a pyramid scheme based on illegal multi-level marketing activities, and that certain defendants sold common stock on the basis of material, adverse non-public information. The purported class action lawsuit and derivative claim, or others filed alleging similar facts, could result in monetary or other penalties that may affect our operating results and financial condition. Critical Accounting Policies There were no significant changes in our critical accounting policies during the quarter ended September 30, 2014. Seasonality and Cyclicality In addition to general economic factors, we are impacted by seasonal factors and trends such as major cultural events and vacation patterns. For example, most Asian markets celebrate their respective local New Year in the first quarter, which generally has a negative impact on that quarter. We believe that direct selling is also generally negatively impacted during the third quarter, when many individuals, including our sales force, traditionally take vacations. Although our product launch process may vary by market, we generally introduce new products to our sales force and consumers in all markets where the products are registered, through limited-time offers. The limited-time offers typically generate significant activity and a high level of purchasing, which may result in a higher than normal increase in revenue during the quarter of the limited-time offer and skew year-over-year and sequential comparisons. -27- --------------------------------------------------------------------------------Actives and Sales Leaders The following table provides information concerning the number of Actives and Sales Leaders as of the dates indicated. "Actives" are persons who have purchased products directly from the Company during the three months ended as of the date indicated. "Sales Leaders" include our independent distributors who have completed and who maintain specified sales requirements, and our sales employees and contractual sales promoters in Mainland China, who have completed certain qualification requirements. As of September 30, 2014 As of September 30, 2013 Region: Actives Sales Leaders Actives Sales Leaders Greater China 238,000 24,823 418,000 57,780 North Asia 398,000 17,153 430,000 17,994 South Asia/Pacific 121,000 7,881 125,000 9,280 Americas 186,000 7,244 179,000 7,461 EMEA 113,000 4,103 121,000 4,375 Total 1,056,000 61,204 1,273,000 96,890 Currency Risk and Exchange Rate Information A majority of our revenue and many of our expenses are recognized outside of the United States, except for inventory purchases, a significant portion of which are transacted in U.S. dollars from vendors in the United States. The local currency of each of our subsidiaries' primary markets is considered the functional currency with the exception of Venezuela. All revenue and expenses are translated at weighted-average exchange rates for the periods reported. Therefore, our reported revenue and earnings will be positively impacted by a weakening of the U.S. dollar and will be negatively impacted by a strengthening of the U.S. dollar. Given the large portion of our business derived from Mainland China, South Korea and Japan, any weakening of these currencies negatively impacts reported revenue and profits, whereas a strengthening of these currencies positively impacts our reported revenue and profits. Given the uncertainty of exchange rate fluctuations, it is difficult to predict the effect of these fluctuations on our future business, product pricing and results of operations or financial condition. Foreign exchange risk is managed in certain jurisdictions through the use of foreign currency debt. Portions of our Japanese yen borrowings have been designated, and are effective as, economic hedges of the net investment in a foreign operation. Accordingly, foreign currency transaction gains or losses due to spot rate fluctuations on these debt instruments are included in foreign currency translation adjustment within other comprehensive income. Included in the cumulative translation adjustment are $16.9 million and $19.8 million of pretax net gains for the periods ended September 30, 2014 and 2013, respectively from Japanese yen borrowings. Additionally, we may seek to reduce our exposure to fluctuations in foreign currency exchange rates through the use of foreign currency exchange contracts and through intercompany loans of foreign currency. We do not use derivative financial instruments for trading or speculative purposes. We regularly monitor our foreign currency risks and periodically take measures to reduce the impact of foreign exchange fluctuations on our operating results. As of September 30, 2014, we held forward contracts designated as foreign currency cash flow hedges with notional amounts of approximately 800 million Japanese yen ($7.3 million) and 7.0 million euros ($8.8 million) to hedge forecasted foreign-currency-denominated intercompany transactions; and as of September 30, 2013, we held 3.0 billion Japanese yen ($30.5 million based on the September 30, 2013, exchange rate) and 6.0 million euros ($8.1 million based on the September 30, 2013, exchange rate). Because of our foreign exchange contracts as of September 30, 2014, the impact of a 10% appreciation or 10% depreciation of the U.S. dollar against the Japanese yen would not represent a material potential loss in fair value, earnings or cash flows against these contracts. This potential loss does not consider the underlying foreign currency transaction or translation exposures to which we are subject. |