Great on the outside, but beware of skeletons in the closet

Recommendation: NO BUY or SELL.

What does it do? USANA Health Sciences Inc. (USNA) develops and markets high-quality, science-based nutritional and personal care products that are distributed internationally through a network marketing system – a type of direct selling. The Company sells to two type of customers – ‘Associates’ and ‘Preferred Customers’. The former buy the product for personal use while doubling up as independent distributors. The latter involve users only without permission to distribute. USNA makes world-class health supplements to enhance well-being, performance, and to aid in protection from diseases. Its customers include professional athletes.

A note about Direct Selling: This type of distribution has been under scrutiny by governments since the 90s. Many governments, including the US and China, impose strict regulations and licensing for Direct Selling companies – monitoring them for fraudulent practices. One example of such a threat is the ‘Pyramid Scheme’ – where a Direct-Selling license is used by a company to scam individual distributors by incentivizing them to simply find new distributors to sign-up for a fee. When successful, the fees generated by this model are exponential, flowing up the cascade to the few at the helm of the company. Sometimes there isn’t even a viable product in the picture. USNA and its competitors are thus faced with a strict regulatory environment.

How has it done? (2011-2016 period)

• $1 of equity invested into USNA in 2011 would have doubled to $2.1 – a CAGR of 16%. A majority of this per share value creation has been created through growth in total Book Value, augmented by consistent buybacks. It is noteworthy that this growth is unleveraged i.e. USNA has not employed any bank debt since 2011.Note: I calculate ‘per-share value creation’ by adding the growth in BV/sh with the per-share dividends issued during 2011-2016. USNA’s BV/sh grew from ~$5.7 to ~$13.5, and no dividends were distributed during this period.
• USNA’s margins (Gross & EBIT) grew by lowering Costs of Goods Sold over the past 5 years. This along with a shrinking Tax Rate (more business shifted overseas) and a steady Capital Velocity (Sales/ InvestedCap) – has led to an expanding ROIC, ranging from 50-60%. Note: This ROIC assumes an InvestedCap with Excess Cash removed; in USNA’s case, 60% of this cash is held in China.
• Half of net sales are now through its operations in China. Since 2012, its Asia-Pacific – (particularly Great China) segment has expanded quickly. Greater China accounted for 30% of USNA’s business in 2010. Today it accounts for 50%. Only 25% of USNA’s business is now in the Americas & Europe.

Does it stand out? (2011-2016 period) I analyzed eight of USNA’s competitors in the Personal Products space, with a focus on nutrition supplements, skin care and other ‘well-being’ products. In order of Market Cap including USNA, these include HLF, NUS, AVP, USNA, MED, NHTC, NATR, LFVN, MTEX.
The average EBIT margin of the group (past 5 years) is 10%, with USNA’s being the widest at 15%. After accounting for other key metrics such as Tax Rate and CapitalVelocity, we find that USNA’s ROIC ranks second at 58% – with the first being MED. According to the value creation model described above, USNA’s ranks third in the group.

While these metrics indicate superior performance, I want to be careful not to make the comparisons too simplistic. The companies in this selection differ hugely in their size, the number of international markets they operate in, which in turn affects their tax rates, their risk profile (Cost-of-Capital and Debt levels) and their product portfolio. Most importantly, they differ in their ability to grow cash flows in the future while being able to reinvest this cash while maintaining profitability (ROIC).

(Find the full comparison table of the nine businesses in Appendix A)

What does the future have in store? Here is where things get problematic for USNA. On April 27, 2017, an anonymous whistle-blower published a long report on seekingalpha.com presenting evidence of illegal activities taking place in the key Chinese subsidiary of USNA – BabyCare Ltd. What makes this doubly important is that a majority of USNA’s impressive growth in the past five years (discussed under earlier headings) is owed to its business in China – namely the growth of BabyCare Ltd. The anonymous analyst points to arrests of BabyCare employees, the mysterious disappearance of BabyCare’s President, misreporting of BabyCare licenses and Chinese authorities having frozen the company’s assets. Even if these allegations are false, the analyst vehemently points to the fact that USNA has failed to inform investors of these ongoings in recent SEC filings.

This report created enough of a stir so that USNA management responded to it in a recent 8-K in words that I thought were vague and without any substantial counter-argument.
In light of the above issues, I have decided to cease writing a complete analysis of USNA for the simple reason that these allegations may be true, which puts its historic data into question, consequently throwing doubt on upon any inference I could draw about its past. As Buffett warns, “There’s never just one cockroach in the kitchen.”

I have put USNA in the ‘too-hard’ pile and decided against a DCF valuation.

Price Implied Expectations (PIE): The idea behind PIE is to start with the current stock price and use the discounted cash-flow model to ‘read’ what the market implies about a company’s future performance. In USNA’s case, the implied expectations seem somewhat pessimistic given the company’s recent history and potential growth in China. Though in the negative light of misinformation and possible legal trouble in China, the current $64 may be far too optimistic in the longer term.