Natural Health Trends Corp. — Q2 2018 Form 10-Q
Business context and reporting period. The company sells NHT Global personal care, wellness and “quality of life” products through direct selling and e-commerce. This report covers the quarter and six months ended June 30, 2018. Hong Kong generated 87.7% of Q2 sales; substantially all Hong Kong revenue came from products delivered to members in China. Active members totaled 93,000, down from 107,290 a year earlier.
Key financial metrics
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Net sales | $50.9 million | $51.5 million | $103.3 million | $111.3 million |
| Gross profit / margin | $40.5 million / 79.6% | $41.7 million / 81.0% | $82.7 million / 80.0% | $90.3 million / 81.1% |
| Income from operations | $10.1 million | $12.9 million | $20.2 million | $25.9 million |
| Net income | $9.0 million | $10.3 million | $17.8 million | $20.7 million |
| Diluted EPS | $0.80 | $0.91 | $1.58 | $1.84 |
| Operating cash flow | Not presented by quarter | $16.5 million | $20.6 million |
Liquidity and capital. At June 30, cash and cash equivalents were $128.3 million, restricted cash was $3.1 million, and working capital was $102.2 million; the current ratio was 3.43. The filing reports no debt balance. Cash and cash equivalents declined $7.0 million from year-end, chiefly reflecting $23.1 million of dividends paid, including a $20.0 million special dividend. The company used $0.1 million in investing activities during the first half. It had $77.1 million of available-for-sale investments classified as cash equivalents and $10.1 million held in Chinese banks subject to foreign currency controls.
Material changes and management commentary
- Q2 sales decreased 1% year over year; first-half sales fell 7%. First-half Hong Kong sales declined $8.0 million, or 8%, alongside a 16% decline in Hong Kong active members. Outside Hong Kong, first-half sales were approximately flat.
- Q2 China e-commerce sales more than doubled, primarily due to a one-time Home product promotion and increased Wellness sales. Promotions in China and lower event revenue reduced first-half gross margin to 80.0% from 81.1%.
- Commissions increased to 43.8% of sales in both Q2 and the first half, compared with 42.9% and 43.2%, respectively, mainly due to higher estimated costs for ongoing cash and other incentives. Q2 SG&A rose 20%, primarily because of higher employee-related costs.
- First-half operating cash flow declined to $16.5 million from $20.6 million, which management attributed mainly to lower product orders and increased inventory and inventory-related deposits as the company built Greater China inventory amid trade uncertainty.
- The Tax Act lowered the U.S. federal corporate tax rate; the company reported a 12.4% projected effective tax rate for 2018. GILTI added approximately $1.6 million, or 8%, to the first-half effective tax rate, net of related foreign tax credits. Tax accounting remained provisional.
Outlook, risks and unusual items
- No sales or earnings guidance was provided. Management said existing liquidity and operating cash flows should fund normal operations and commitments for the foreseeable future, and plans continued investment in Greater China and selected other markets. It was pursuing a China direct-selling license but could not predict if or when one would be obtained or whether resulting operations would be profitable.
- Business is highly concentrated in Hong Kong-linked sales and exposed to China regulatory and operating risks, direct-selling regulation, member retention, foreign exchange movements and competition. The company had no direct-selling license in China and stated that substantially all Hong Kong sales were delivered to members in China.
- Disclosure controls were deemed ineffective as of June 30 because of a previously identified material weakness involving the proprietary web-based system. Remediation work was underway, with completion expected during 2018.
- The securities class action was settled for $1.75 million, funded by insurers. A derivative-action settlement received final approval on July 16, 2018; it requires governance reforms and $250,000 in plaintiffs’ attorneys’ fees, also funded by insurers. A vendor-related matter was described as indemnified by the vendor.
- After quarter-end, the board declared a $0.15 quarterly dividend and a $0.25 special dividend per share, payable August 24, 2018.
Investor verification points
- Track Hong Kong sales and member trends, given the market’s dominant share of revenue and the reported member decline.
- Assess whether China e-commerce growth can continue without one-time promotions and whether the company’s China operating model faces regulatory changes.
- Monitor gross margin, incentive-related commission costs, inventory buildup and conversion of earnings into operating cash flow.
- Review progress in remediating the internal-control material weakness and the completion of provisional Tax Act and GILTI accounting.
- Consider dividend sustainability against operating cash generation, cash balances and the company’s investment plans.