如新 (NUS) 2005 Q2 法說會逐字稿

Good afternoon. My name is Elizabeth and I will be your conference facilitator. At this time I would like to welcome everyone to the second quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. [OPERATOR INSTRUCTIONS] Thank you.

I would now like to turn the call over to Charlie Allen, Vice President of Investor Relations. You may begin your conference, sir.

Thank you.

We appreciate all those joining us today on this conference call and listening over the Internet. With us on the call this afternoon are Truman Hunt, the President and Chief Executive Officer, and Ritch Wood, Chief Financial Officer. Following management's discussion of the Company's operations, the call will be opened for questions.

As a reminder, during this conference call comments may be made which include some forward-looking statements. These statements involve risks and uncertainties and as you know, actual results may differ materially from those discussed or anticipated. We encourage you to refer to today's earnings release and our SEC filings for a complete discussion of risks associated with these forward-looking statements and our business.

I'll now turn the time over to Truman.

Thanks Charlie. Good afternoon, everyone. Thanks for joining us today.

Today we reported earnings per share of $0.32, which represents a 14% increase over last year and is slightly ahead of our guidance. We also generated revenue of $310.1 million, which is the largest revenue quarter in our history and a 9% improvement over last year's results.

The success in this quarter can be attributed to three factors. First, we delivered solid results in our top three geographic markets: Japan, the United States, and China. Second, we posted revenue growth in nearly all of our other markets; and finally, we continue to benefit from our commitment to innovation with the ongoing success of our scanner initiative, the introduction of key products, and the effective use of programs aimed at retaining and expanding our global sales force.

Looking at our key geographies for a minute. The second quarter showed continued steady improvement in Japan. Our customer, distributor, and qualifying executive trends in the quarter were all positive and bode well for a solid second half.

For those of you who may not know, when we refer to qualifying executives, we're referring to those who have submitted an application to become an executive level distributor. These people have to achieve certain sales benchmarks to satisfy the qualification requirements which generally drives revenue. So at the end of the second quarter we had more people in that qualification process in Japan than we've had in the past three years, so that's obviously an encouraging sign for us.

The Biophotonic scanner continues to play an integral part in generating positive momentum in Japan. The scanner has been a very effective tool in growing a loyal product subscriber base, which in turn is helping to positively drive distributor indicators, all of which, again, bode well for growth in the third and fourth quarters.

Now, turning to the United States, we posted a 9% sequential revenue increase and a year-over-year revenue increase of 10%. During the quarter, the U.S. generated a 14% year-over-year increase in executive level distributors and saw a positive impact from some of the new products launched in the market.

For example, our new Pharmanex health drink, called G3, has been a great addition to our nutrition line. This is a nutrient-dense drink with exceptionally high levels of antioxidants and in particular carotenoid antioxidants, making it a very scanner-friendly product. And because of its tie to the Scanner, we're seeing nice incremental sales for Pharmanex. G3 is broadening our consumer base by appealing to those people who prefer to supplement their diet with a juice rather than taking a capsule or tablet.

As you likely know, our Big Planet division has been a development platform for us. Big Planet recently launched a digital imaging initiative that is generating good results in the United States. Although small in relation to our overall operations, this is a profitable piece of the Big Planet business and is generating positive and profitable results here in the U.S. We're committing to use Big Planet as a platform for additional product categories that fit our business model and our margin requirements. So if you'd like to learn a bit more about our digital imaging service in particular, I would encourage you to visit our website at photomax.com.

Mainland China showed a 9% sequential increase in revenue and, as expected, revenue for the quarter was down slightly over the same quarter of last year, but as you'll recall, the second quarter of 2004 was our highest revenue quarter in China.

We've implemented a product subscription program in China which has contributed to a significant increase in our sales force retention rate during the quarter, which is very encouraging, and we remain focused on building a consumer base through our employed sales force and on laying a solid foundation in the market for long-term growth as a direct seller.

I'd like to note that I was in China last week and had a very productive meeting with the minister of an agency called SAIC. This is the regulatory agency that will enforce the new direct selling laws when they become effective. This was a very positive meeting. It was actually or highest level government meeting to date, and it gave me a great assurance for our prospects in China for a couple of reasons.

First, the meeting confirmed to us that the government is close to publishing regulations and that its intention to regulate the industry is consistent with the way the industry is regulated elsewhere throughout the world. This is obviously very good news to us as we've grown a bit weary of the delays in the announcement of the new regulations. I personally believe that the delays are primarily a result of continued lobbying from various bodies, but the lobbying is having a positive impact on the content of the regulations. So, continued patience for the regulations will be a good thing, as we hope to end up with the most favorable regulations possible.

Now, second, it was also comforting to confirm that Nu Skin Enterprises is in good standing with the government and that we're well-positioned to secure a direct selling license in this rapidly developing market. We continue to believe that China will very quickly become one of the top 3 markets in the world for direct selling and I believe that Nu Skin Enterprises is well positioned to be a market leader.

During the quarter we continued our store expansion process throughout China, which included the opening of a flagship store in Beijing. We've also been refining our operational infrastructure to manage our expanding sales force and geographic footprint to be able to move as quickly as possible once the new regulations are in place.

Now, as we previously discussed, there are many dynamics to doing business in China, as the consumer base there evolves and as more and more people become exposed to our method of free enterprise on a microscale, there will be an understandable learning curve for people who are looking to become independent small business owners. Our business in China was built with eventual direct selling in mind, but because we're aware of the potential transition challenges, we've been very proactive in educating our sales force in anticipation of becoming a direct seller. These efforts have included extensive training meetings in locations across China to train on a revised remuneration program that resembles, to the extent possible, our global compensation plan as well as undertaking several product education tours. So whenever changes are made, there's always an absorption period required as salespeople absorb the changes and modify their activities, but with our proactive training efforts, I believe that our transition in China will be considerably smoother than what some of our competitors will face.

So overall the news is good. We're well-positioned to successfully operate in the direct selling environment that the new regulations will create in China, and we continue to believe that the market's potential is enormous.

Now, the next key element that helped us realize a positive second quarter was consistent and strong performance across the rest of our markets. In fact, nearly all of our markets posted revenue gains this quarter, with many reporting double or triple digit increases. We continue to see great momentum in Asia, with strong gains in Hong Kong, Taiwan, South Korea, and throughout our Southeast Asia region. With 15% year-over-year revenue growth, our Hong Kong market is now twice the size it was just two years ago, which is remarkable, considering we've been in that market since 1991. And Taiwan, which is also one of our more mature markets, continues to post impressive gains with year-over-year revenue growth of 13%.

South Korea continues to be another great market for us. While many direct sellers have really struggled recently in South Korea, we were able to post 22% revenue growth in the second quarter because of the strength of our programs, largely surrounding the Pharmanex biophotonic scanner.

Southeast Asia also continues to perform solidly, with year-over-year revenue growth of 6%. Singapore and Malaysia remain standout markets in this region, achieving 4% and 6% growth, respectively. And the recent declines in Thailand have been stemmed with revenue down there just 4% in the quarter.

We remain on track to open Indonesia in August, and with the healthy level of attention that our sales leaders are giving to that market, we believe that the market will conservatively contribute around $15 million of revenue in its first year.

Other star markets for this period were Europe and Latin America. It's really quite rewarding to see the changes that we've made over the past two years result in accelerating revenue growth in these markets. In Europe, we saw a 39% year-over-year increase and Latin America posted an impressive 173% gain over the same period of last year, with Mexico in particular growing very rapidly. As these markets continue to improve, I see them playing an even more meaningful role for our company in the near future.

This leads me to our third growth factor for the quarter. We spent a lot of time and effort as a management team focusing our people and resources in innovating in both our product categories and within our business model. I believe that our growth over the past few years is due to successful invasion in a couple of areas. Of course, the BioPhotonic Scanner gets a great deal of attention as being a real breakthrough in the nutritional industry and in direct selling, but I think that our focus on recurring product subscriptions is also a very positive development for us. When you consider that our automatic delivery programs generated 42% of total revenue in the second quarter, which includes almost 450,000 subscription orders in June alone, you can see what a powerful mechanism subscriptions are. I don't think it's unreasonable for us to think that we'll generate even a million subscription orders per month within the next couple of years.

I'm also pleased that we have a nice innovation pipeline. In fact, we'll be introducing some of our latest product invasions at our upcoming global distributor convention in October. Each of our product divisions is taking significant steps forward with their product offerings and will also be introducing some tools that will further enhance the effectiveness of our sales force.

Because we believe the Scanner will be useful for many years to come, we will be announcing some breakthroughs in October that will make the Scanner an even more effective tool.

Additionally, we're developing a proprietary sales tool in our Nu Skin division that will essentially be the equivalent of the Scanner for our skin care division. This is a tool we developed in-house that will enable us to very quickly assess a consumer's skin quality, customize a skin care regimen based on that person's needs, and then track the progress that's made when using our wonderful skin care products. So we're very excited about this tool, which will be unveiled at our convention this fall.

Okay. With that, let me turn the time over to Ritch.

Thank you, Truman. Good afternoon, everyone.

First I'll provide the local currency sales figures from our major geographies. Second quarter revenue in Japan was 16.0 billion yen versus 15.9 billion yen in the second quarter of 2004. Quarterly revenue in South Korea was 22.8 billion won versus 18.8 billion won in 2004. In the greater China region, revenue from Taiwan during the quarter was 768 million NT dollars versus 678 million NT dollars last year, while Hong Kong reached 83.0 million Hong Kong dollars versus $72.2 million Hong Kong dollars in the prior year.

In mainland China, revenue was 240 million During the quarter versus 245 ren min bi during the quarter versus 245 million ren min bi in the prior year quarter. In Southeast Asia and the Pacific, the U.S. dollar revenue from Malaysia, Singapore and Brunei totalled 11.0 million versus $9.9 million in the second quarter of 2004. Thailand posted quarterly revenue of 249 million baht compared 259 million baht in the last year. And the U.S. market generated 36.8 million in revenue during the second quarter compared to 33.5 million in 2004.

Second quarter revenue in Europe was $11.9 million. That's compared to $8.3 million for the same period of 2004. And finally, Latin America revenue hit $2.0 million for current quarter compared to $740,000 in the same quarter of 2004.

We remind you these numbers can be found on the investor portion of our nuskinenterprises.com website as well.

The Company's second quarter gross margin was 82.6%. That's a 70 basis point decline compared to the prior year results, and this decrease in gross margin is due to the amortization of the Scanner, which you know is recorded in cost of sales. We currently have approximately 3,400 scanners leased around the globe in the current quarter and that's compared to approximately 1200 scanners in the prior year.

Selling expenses as a percent of revenue declined to 41.7% compared to 42.7% for the second quarter of 2004. The improvements can be attributed to three primary items: first, improvements in sales employee retention rates in China have reduced employee turnover and therefore reduced unemployment and other labor-related expenses recorded in selling incentives. Secondly, the increase in Scanner lease revenue, which is revenue upon which we do not pay commissions, is having a beneficial impact. And finally, the change in our distributor compensation plan which took place in the first quarter in 2005 in Japan also benefited the rate in the current quarter.

General and administrative expenses as a percent of revenue increased 70 basis points over the prior year results to 29.0%. This increase in expenses results largely from investment in growth initiatives. This includes upcoming market openings of Indonesia and Russia, globalization of the Pharmanex Biophotonic Scanner program, further development of our China, Latin America and European markets.

Operating margin for the quarter was 11.9%, down from 12.3% in the prior year, and then for modeling purposes we remind you that in the fourth quarter of this year we'll have our global convention, held October 6 through 8, and we will spend approximately $5 million on that initiative.

During the second quarter, interest expense was $1.7 million. We paid dividends of 6.3 million and invested $8.6 million in capital expenditures. And during the quarter the Company repurchased $6.5 million of its stock.

Cash flow from operations was 37.0 million during the second quarter. The Company's tax rate came in at 36.4%.

As we look to the balance of 2005, we would expect Japan to generate local currency growth of 2 to 3% in the third quarter and then slightly improving in the fourth quarter to 3 to 4% local currency growth in that quarter.

As we mentioned in the earnings release, with the changes happening in China, we feel it prudent to guide to no sequential growth in the third quarter in China and returning to sequential growth in the fourth quarter. This all accounts for our model in China to finish the year with revenue between 115 and $120 million.

Gross margins are expected to be in the 82.2 to 82.5% range for the balance of the year, and we expect selling expenses to be in the 41.5 to 42% range. Company's tax rate should be in the 36 to 36.5% range for the balance of the year.

The currency markets have experienced some interesting movements during the last several weeks. The yen has weakened from its second quarter trading range of 105 to 108 against the dollar to approximately 112 to the dollar during July. And as you're aware, we previously guided our revenue and operating results based on an estimated average yen rate of 108 for the balance of the year. Given the current position of the yen, we've adjusted our forecast assuming a yen rate of 112 for the balance of the year. And this movement from 108 to 112 negatively impacts our estimated Japan revenue in the second half of the year by approximately $11 million and therefore our overall earnings per share by $0.03 to $0.04 .

Also for the first time in ten years the Chinese yuan moved from it's previous tag of approximately 8.3 to the dollar to 8.11, about a 2% movement. This is very small movement and will not have a material impact on our results, although further strengthening of the yuan could be very beneficial, not just to our China operations, but possibly have a good impact on the yen and other Asian currencies.

Although we have adjusted our forecast to include a yen rate of 112, we remain comfortable that we will finish the 2005 year within our previous guidance, modeling the yen-to-dollar rate at 112, we estimate 3rd quarter revenue of 298 to 303 million and earnings per share of $0.29 to $0.30. And then fourth quarter revenue, again modeled at a yen rate of 112, would come in and -- we project at 320 to 325 million. That would generate earnings per share of $0.32 to $0.34.

So with that, we'll open the call up for questions .

[OPERATOR INSTRUCTIONS] We will pause for questions.

Your first question comes from Kathleen Reed.

Good afternoon. A couple quick questions.

First, on China, can you just give us a little more detail on -- I know you said you're -- it's going to take a lot of training to communicate to your distributors there the plans you're making for the implementation of direct selling, but just why you think, considering -- I guess, is it partly that you're projecting direct selling to change, for the regs to be implemented in the third quarter? Which is why you're projecting flat sequential revenue growth. I guess I'm just trying to figure out if you're projecting the regs to kick in in the third quarter and therefore your flat sequential revenue number is part retail or part direct selling? Or -- just what -- I'm trying to get more detail there.

Sure. We are projecting that the regulations will be published in the third quarter and will be close to being implemented if not actually implemented by the end of the third quarter. The issue is that we have wanted to migrate our compensation plan there towards our global model to the extent we can, given the structure of the new regulations. And so we're in the process of doing that migration, which is very -- a very positive thing for our sales leaders because they will have the opportunity to make more money than what the current plan provides. But whenever there's change, you know, there's always just temporary -- a temporary period where people absorb the changes, figure out how they need to adjust their sales pitch and their recruiting pitch, and they -- and then life goes on.

But, you know, we're finding, Kathy, that this is an environment where consumers and sales force is a little bit more sensitive to change. So we felt that to be prudent we should not have people plan on sequential growth in Q3 as we go through this process.

Also, if you're expecting the regs to be out and implemented in the third quarter, I guess is that timetable still accurate where it takes about three months for you to get your own direct selling license? Or has that time frame been changed?

There will be a time frame -- a licensing time frame, and it probably is two to three months. But we are going ahead with changes to our compensation plan even in advance of the license -- of getting the license. And we actually implemented most of the changes we're going to be making on July 1st.

Okay. But then, is it fair to say that most of your revenue in your third quarter would still be just through your retail stores?

That's correct.

Okay. Next ,on the U.S. business: can you just -- I'll go to your website to get some more info on your digital imaging. Can you just give us a quick -- what exactly that is. I know you said it was small. I just was trying to see if -- how much of the revenue gain in North America was due to that versus just your other new products introductions, such as the G3.

Yes. Well, it definitely was a positive contributor to our revenue growth in the quarter. And basically, what Photomax is is a digital imaging site, somewhat like the sites that you hear like Snapfish and some of the other digital photography websites where people can download digital images, have them -- have the output be either prints or whatever over novelty they want to put their imagine on. Where we are differentiated a bit from some of those competitive sites is that we also offer a scanning service, where people can send us their images, we'll scan them into a digital form, put them on a -- and store them on a website for free where they can then access any kind of output they want from those digitized images. And it just happens to be a hot category in the United States and elsewhere, and it's growing rapidly.

But this is a direct selling opportunity?

It is. Yes. Our Big Planet distributor for it are the people who are out there marketing this service as they would any of our other products in any of other our other divisions. So, any of the output from the Photomax website is fully commissioned, just like our nutrition or skin care products would be.

Okay. And what is the -- are the margins accordingly somewhat lower than your Pharmanex?

Yes. We've been very sensitive to that issue because of the trauma in the past with low margins, Big Planet products and services, and so we're very focused on keeping margins in Big Planet consistent with other product divisions and that's what you'll see in Big Planet.

Great. And then just finally -- this is just a clarification question -- Ritch, when you just said you're keeping with your previous guidance. I think you raised guidance on your first quarter call to a range of $1.17 to $1.24. So, I just wanted to make sure that's what you were sticking with for the full year.

Yes, that's right. As we tighten it up for Q3 and Q4, our guidance was $1.17 to $1.24. We still feel confident we'll be in that range, even taking out $0.03 to $0.04 for currency fluctuation.

Okay. Great. Thanks very much.

You bet.

Your next question comes from Chris Ferrara.

Hey, good morning or good afternoon. I just wanted to -- Truman, I think in your comments you said something about the fact that you expected legislation in China would be consistent with the way direct selling is regulated in other places. And I know that's been a sticking point. Does that mean you guys have a greater degree of optimism that you could get multi-level through?

Yes, the meeting that we had last week was encouraging along those lines, and I actually tried to pin the minister down specifically on this point. And his response to me was that they're committed to regulating the industry as it's regulated elsewhere in the world. Now, we do not have confirmation from any other sources that they're reconsidering the issue of multi-level compensation, but we know that that issue is still in play. And we do believe that there are other aspects of the regulations that will be changed to the industry's favor. For example, they're modifying the storefront requirement. They are likely going to increase the commission cap. They are opening more product categories to the direct selling industry and they're not going to be as dogmatic on the issue of which products are locally produced versus imported. So all of that is very good movement and where they come out on the multi-level compensation issue is just still a question.

Got it. And then, on the compensation plan changes that you guys made on July 1st, can you give a little bit more detail specifically as to what's different now and how you're able to do that ahead of regs and how you're not risking stepping on anyone's toes by doing that.

Well, as you know, Chris, the -- what we call the back end of our compensation plan pays to our sales leaders 5% commissions on six levels of sales volume. And we have not implemented that full commission payout in China in the past. We have done, over time, a two-level -- the equivalent of a two-level, three-level, or four-level payout to our employed sales force, where their remuneration is essentially equivalent with what they would have been paid had we been paying commissions on that basis.

Well, what we did on July 1st, in advance of the regulations, was alter that structure so that we're essentially paying out the equivalent of a six-level 5% payout to employed sales people. So, the fact that we're doing it on an employed basis as opposed to through an independent sales force is really what enables us to do it and get away with it. It isn't calculated in exactly the same fashion as our global compensation plan is. We just try to get to an equivalent payout.

The fact that we are increasing payout to sales leaders has required us to make some adjustments to other aspects of the plan, just so that we can afford a more lucrative payout. And that's really the change that was made on July 1st.

And then maybe one other comment, Chris, if I can just jump in, is we've kind of moved more toward some subscription initiatives that will be more -- or better positioned for kind of part-time nonemployee sales people in the future as we expect to move to that sort of a position with the new regs. So, we're kind of transitioning the model a little bit so it will fit well with a nonemployee sales base at the time the regulations are fully implemented.

Got it. And then on growth in general in China, I know I guess last year you guys were trying to just watch where you were going with respect to putting up numbers, like 120% growth in a period where you were heading into getting -- applying for licenses. And now it seems like it's being moderated more because you're trying to make sure that sales people are getting the right training and it's a change of model.

Are you still in a mode where you're trying to regulate growth? Or is it really growing at a natural rate at this point, excluding any interruption in changing business model?

I would say that we're still in a mode of being very cautious, because we want to be in a good position to be licensed when the regulations are effective. You know, on this point, again, it was -- the minister with whom I met last week was very comforting to me because he indicated that he was aware that when we got started in China two years ago we were growing at a very rapid rate and there were some concerns about our activities in the market. But he was very impressed with the fact that we quickly addressed those concerns and, because of the fact that we were responsive, his statement to me was that he was confident that Nu Skin would be licensed as a direct seller.

Thank you very much.

Your next question comes from Scott Van Winkle.

Hi. A couple of questions. First, you gave the scanner total worldwide. I believe 3400. What was the number for Japan?

It was 1200 at the end of the quarter

That's a little ahead of your expectations. Wasn't it 1,000, I think, was your target?

Yes. That is right

Okay. And as far as the back half of the year, the same type of pace?

No, it will slow down just a little bit. We've got about 600 scanners that we would have planned to kind of release in the next six months, about 100 a month. So we should be somewhere around 1800 by the end of the year.

Okay. And another housekeeping. The number of stores in China at the end of the second quarter?

About 125. And you're still targeting, I think it was 180, by the end of the year? Yes, that's correct

Okay. If you look at the distributor count in China, greater China, in this quarter up from Q1, a significant leap. Around 20% or so, yet only 9% revenue growth. I think that was the greater China number. Any reason behind that while at the same time the executive count fell a little bit? Can you kind of explain all that?

Yes. Scott, the first thing to realize too, when you look at greater China, is last year was a bit an anomaly in the second quarter. We had kind of a big uptick in China. It was our largest quarter. There was a lot of sponsoring going. So, the dynamics have changed somewhat. We've been able to really make good improvements on our retention rate. It's made our active number improve at a faster rate, really, than our executive number, And that's really what's driving the primary change. We will see more, I think, year-over-year, apples-to-apples comparison as we go into the third and fourth quarters.

Okay. And on Japan: the growth in distributors on a sequential basis in Q2, wasn't that abnormal from prior sequential periods from Q1 to Q2? Do you still feel comfortable that you got a nice boost there from the Scanner, even though we really didn't see it in the revenue, sequentially?

Yes. It's interesting, the dynamics of our business, I think, with the scanner. We see a lot of new customers coming in, a lot of subscription customers. And that, again, has kind of preceded our executive growth. We see that number up 8%, our active distributors in Japan, 8% year-over-year, which is really running out ahead a little bit of our revenue growth. We do believe that really indicates stability. It indicates the fact that we've shifted a little bit of the focus of our distributors on bringing in new customers as well as driving new executives. And we think executives will follow. We see the trends in our distributor force and believe that executive growth will -- we'll see that going into the third quarter.

One final question is, it's obviously clear that Pharmanex is growing, somewhat to the detriment of the personal care side. Do you look at the sales of the Nu Skin brand and -- in a worry or get eager to push through some promotions or new incentives to kind of pick that business up while Pharmanex is still doing so well?

Right. Well, as you know, Scott, we're really most concerned about just our overall sales trend and the fact that Pharmanex is up 29% year-over-year is very positive. Sure, we would prefer not to decline in Nu Skin sales and we're undertaking -- undertaking measures to reverse the decline and stem the decline where that's happening. But the attention that our distributor force has placed on Pharmanex, in light of the Scanner launch, it really isn't surprising.

Let me note, by the way, one other point on the Scanner deployment for the rest of the year. We will be revealing at our convention in the fall some significant improvements to the Scanner functionality and the Scanner format. So we've actually been quite anxious to slow down deployment a little bit of the current model, because the new model of the Scanner will enjoy benefits that are considerable. So we likely won't be in production of the new model, though, until the first of next year. That's one of the reasons why you'll see Scanner deployment slow down a bit.

Okay. Oh -- I'm sorry -- Ritch, one more question. What percentage of your SG&A is denominated in the yen?

That's a good question. Let me think. It's probably about 10%. I think it's about 10% of our SG&A.

Okay. Thank you.

You bet.

Your next question coming from Doug Lane.

Hi. Good morning, everybody.

Hi, Doug.

Back on China here, just so I can get a feel for the leads and lags here. It sounds like the transition of the model that we were looking for has kind of now been front-loaded to the approval of the regulations and your approvals, once the direct selling regulations are adopted, as opposed to back-end loaded. So is there anything additional that we should worry about? Let's say the regulations don't get passed until September and you don't get approval until November. Is there then going to be something between November and March that is going to be transitory, or are you good to go after this new program you just put in July 1st is up and running?

You know, Doug, I don't anticipate any further major modifications. I mean, we will have the licensing process, obviously. We will also have province by province approvals that will need to be secured, and the extent to which we have retail store requirements in each province will also be a factor in how quickly we can grow throughout the country.

But with respect to the model as it exists for our sales force, I don't anticipate much more transition trauma, apart from what we're already doing.

And, Doug, just to clarify, too, as kind of our theory with guidance here, we have not dealt in any benefit into the numbers we've given for China from change in regulations in 2005.

So, I mean, the -- I understand that -- it sounds like a pretty significant change to your compensation, and that's an education process. Then once that's done, obviously, in anticipation of the new regulations, which sounds like, Truman, you've got a pretty good bead on, although they are still fluid. But approvals and things like that shouldn't affect the sales force, right? I mean, that's more back office. There's nothing, once this new comp plan is implemented, that should be impacting the sales force's ability to go out and build a business?

Yes. That's a good question, Doug, and as I think about it there is one other factor that potentially comes into play, and that is that there continues to be a lot of misinformation in the market and even in the media about what the state is of the anticipated regulations and where direct selling is headed, and this was another point that was addressed in our meetings last week in China, and I was actually, again, very pleased to hear from the minister's own lips their recognition of the need to be proactive in telling consumers what the rules are with respect to direct selling and just clarifying that through media channels.

And I suppose that there might continue to be some confusion in the marketplace about how the state of direct selling -- until that process is complete as well, but that's something they recognize and is an issue that they're prepare to do address.

And is that more confusion among potential consumers or potential entrepreneurs in this system?

Well, it's confusion among consumers, but those consumers are potential salespeople, and so, you know, it impacts our ability to enjoy as robust a recruiting environment as we would like to. But, again, it's an issue that he actually raised himself. So the fact that they recognize it and are prepared to address is encouraging.

Do you anticipate any disruption from the ability to hire independent agents and sell away from the store? I mean, it sounds like the compensation plan will be geared to plug that in once it's allowed, assuming it is allowed. But is that a source of another delay, or is that something that's just insignificant as far as practical execution is concerned?

I don't think that that's going to be the big hurdle. You know, there might be factors that come into play that we just frankly can't foresee today, Doug. But I really think that just the business model, transition, education of our sales force, and just public awareness of the new direct selling regulations are the biggest issues.

Just one last thing. The education and the change in the rules, should they occur, will apply uniformly across your sales force in China, right? There's no group that does or does not get implemented by the changes that you're implementing and that you expect to be implemented in the regulations from the government?

Yes, that's correct.

Okay. Shifting to Japan, with -- I mean, you had, what, maybe 300 Scanners at the end of the first quarter and 1200 at the end of the second quarter, and yet in both quarters the internal growth was 1%. It seems to me that you didn't get much bang for the buck for the incremental scanners. I wondered if you could give us some more color on that dichotomy, where we saw scanners go into the market, you had probably an average of 200 in the first quarter, multiples of that in the second quarter, yet your sequential growth didn't move.

Yes. You know, it's tempting to be disappointed with results in Japan. I mean, I've wrestled with this myself. Should we be satisfied with what we saw or should we not? You know, to me, honestly, the dynamic that's going on in that market that is -- that causes me -- that is just frankly a bit of a revelation for us, really isn't scanner-specific, but what we're seeing in the market, Doug, is healthy distribution trends. And, you know, I don't want to create any inappropriate ethnic profiles here, but we have found that the Japanese tend to be more methodical and more prudent in their approach to the business than other societies are in the first place. You know, they are not people who run out of the room with their hair on fire after you give a certain speech. They're methodical in the way they go about their business-building activities.

But what has been interesting to us is that as our subscription programs have grown and our consumption base becomes more and more stable, which we think is a good thing because our retention rates have improved quite dramatically, we're also seeing at the same time a secondary effect from that, which is that the pop that we previously generated out of some of our product promotions has been more -- has been muted a bit. So whereas we used to run a product promotion that would offer, for example, perhaps free shipping, you know, for a certain level of product purchases, because we now offer free shipping on our subscription program, it's taking a little bit of the pop out of some of those promotions. And if there is anything that was perhaps mildly disappointing in the quarter to us, it was just that revolution, that as the subscription program grows we don't get quite the pop we used to out of promotions.

Apart from that I don't think that -- we ended -- we ended the quarter strong. We started this quarter strong. I don't think that anything that's going on there is a sign that the scanner program isn't going to work.

I'm just going to jump in real quick and clarify a question earlier from Scott. Our SG&A in Japan is about 20% of our overall G&A expenses.

Okay. Thank you.

Your next question comes from Joe Norton.

Yes, thanks. Just a couple of follow-ups on some of the discussion about China. First of all, just to be clear on what the guidance that sales would be flat sequentially in the third quarter and up in the fourth quarter, was that correct?

Yes, up sequentially in the fourth quarter.

Up sequentially. Right. And is that -- is the difference there just sort of the assumption about the change in the compensation system, or is that having to do with reps or -- just sort of, what accounts for the difference between third quarter and --

Yes. The issue of us basically encouraging people not to expect sequential growth in Q3 is a transition issue related to the transition of our compensation plan. Our remuneration system.

And just to clarify, that would be up -- if we were flat third quarter with second quarter, it would put us up year-over-year about 10%.

Okay. And then it sounds like there's maybe a growing sense that the multi-level system will work in China, but I'm just curious, if it doesn't, do you feel comfortable or confident that this -- the plan that you're using now would be workable and agreeable to the government? If they do decide to just stay with a single-level system?

I think we're in pretty good shape because we've been doing it now for over two and a half years, and the government understands what we're doing and they're fine with it.

Yes, but I mean the new compensation system that you're just implementing.

Yes, the new compensation system is simply more generous to sales leaders in the same structure. So I wouldn't expect the changes that we've implemented to be problematic even if they are less restrictive on the issue of multi-level compensation.

Okay. Then just to clarify it. I thought in the past we had talked about a six-month transition process from when the regs came out, and today we are talking about a three-month transition process. Is that -- just sort of from when the regs are issued to when we could sort of anticipate a fully converted system in China?

Well, I think we're talking about a two- to three-month licensing process and then a transition process that will follow after that, but the transition process is really related to province-by-province approvals and dependent upon how many storefronts are required in each province. And so if they stick with something that's similar to the previous indication with respect to the required storefronts, then it could be six months before we have all of the storefronts in place. If they loosen that requirement, then it would expedite the transition process

Okay. And do you think that the July 1 change in the compensation, does that sort of give you a jump start on that? Kind of getting ahead of the actual regs coming out?

I think it is a jump start, yes.

Okay. And then just to follow up. Could you -- you mentioned storefronting being one of the potential modifications. Can you give any more details on what they're thinking about there?

Yes. They're considering increasing the commission cap, which I believe previously was indicated at 25% of sales. We look for that to increase to 30%. As I indicated, they are going to be -- they're going to enable imported products into China as long as the company importing them is manufacturing them outside of China as opposed to third-party manufacturing, which will still be restricted. They're also opening up other product categories to direct selling, which doesn't impact us directly because our product categories were previously acceptable. But there are other product categories that other direct sellers will be able to offer.

Okay. Thanks. And then just -- since I don't think we've talked about any other country besides China or Japan -- well, I guess the U.S. What -- any more detail on what happened in South Korea? That drove such strong -- was that just the change in the compensation plan or was that the scanner? What do you think was driving that?

The South Korea growth is scanner-driven.

Wow.

And it's actually very -- it's really a healthy growth for the quarter, given the fact that other direct selling companies are struggling in that market. So, scanner's had a very positive impact there.

Okay. Great. Thank you.

You bet. Thanks, Joe.

Your next question comes from Gillian Koptusario [ph].

Good morning. It looks like your guidance for Indonesia is at the low end of your prior guidance of 15 to $20 million. Do you expect a slow start there, or is there anything else that has prompted you to become more conservative?

No. We have not been prompted to become more conservative. If our prior guidance was 15 to 20 in the first year, you should stick with that.

Okay. Great. And it looks like you lowered your guidance in China to 115 to $120 million. What would the downside of this number be if regulations are further delayed?

You know, we really have tried to avoid building any benefit from regulations into our numbers. So I think the numbers we've provided are numbers we're comfortable with if the direct selling regs are delayed a little bit.

Okay. But I believe that you're going to open about 180 stores by year-end; is that correct

That's kind of the plan. Again, we'll sync that up in terms of timing with the regulations. We hate to open too many stores which add expense and, as you know, stores are not what drive our revenue. It's really increase in sales reps. So we will time the opening of our stores with both the requirements of the regulations and the timing of the regulations.

Great. Just another question on the portable imaging instrument. Have you decided how much you will charge for that tool?

No. Still being modeled. But this device is nowhere near as expensive as the biophotonic scanner. It will be much less expensive:

Okay. And my understanding is that the launch of this device will actually require a new product line that would be available in monthly supplies? Have you developed those?

Yes. You know, we -- we are emphasizing our monthly subscription programs to such a degree that having Nu Skin products also available for monthly subscription would be helpful. It's just a little more complicated on the personal care front to provide product in that exact quantity. So we're working on various programs to make Nu Skin products also attractive for subscription programs, but it probably will not entail dramatic repackaging of those products.

Great. Thanks a lot.

Next question comes from Chris Ferrara.

I'm back. On the reemphasize of the Nu Skin products, is there any consideration to the fact that there's a chance you could be cannibalizing what's pretty strong momentum on the Pharmanex by diverting distributor attention back to the Nu Skin side when you already have something really good with Pharmanex growth?

Yes, those are always the balls we juggle, Chris, with all the initiatives we introduce. But what is interesting to me is we have felt in the past that we just wanted to have one thing spotlighted at a time. And yet, we've learned in the U.S., for example, that it is possible for us to launch strong initiatives in multiple divisions and have them all fare well. This past quarter, for example, Photomax launches in the U.S. at the same time G3 launches for Pharmanex, and both received decent attention. So, you know, what we're really trying to do is hold the Nu Skin line and not have any rug [ph]. I think we can do that.

And I just wanted to -- I know this is -- you could sort let your imagination do the work, but with China, with the change in comp model, can you just walk me through how one of your distributors in China is thinking about the world and why that person is going to sell less, owing to business interruption or model changes than they would have had you not made the change. I mean, the consumer take-away, presumably, is going to be similar. People who want to use the products, it's going to be similar. So, I guess, why would you have a slowdown?

Well, you know the sales force really structures their activity around how the compensation plan is structured. And we believe that the changes that were made on July 1st will be very positively received by the sales force. It just takes them some time to figure out how that's going to impact their current income level, how they need to adjust their sales presentation, and it's just simply absorbing the new information, understanding it and figuring out compelling ways to regurgitate it as they go about their business building effort. And that's really it.

In this environment, we're new, and direct selling is new to the market. So it just, I think, creates a little bit more of a challenge with consumers who might be a little bit more skeptical about the nature of the changes or the rationale for the changes, the motivations for the changes, than consumers would be in other markets where change is more common.

But, you know, I don't want to overexaggerate this issue. I mean, we are not going to face transition challenges that are comparable to what our friends at Avon are experiencing. They have a much bigger -- a much bigger challenge than we do. It's just that in this transition phase, people -- it's reasonable for us to not assume much growth there.

Got it. Thank you.

Our next questions comes from Mimi Sokolowski.

Thank you. Truman, I just have really one question about the groundwork that you've laid down in China. Obviously, you want to hit the ground running when the licensing opportunity comes through. Would you mind just outlining that groundwork as far as distribution, manufacturing, the storefronts you have, and relate those to what you think the requirements are going to be or what they are now?

Sure.

Thank you.

It really starts at the beginning of the product distribution chain. I mean, as you know, we had to build a manufacturing plant there for our Nu Skin products. Similarly, we've built a Pharmanex manufacturing plant and are in the process of building another Pharmanex manufacturing plant for export, and so it really starts at the very beginning of our distribution chain. And --

So, is that three plants in total, or was that two?

Yes, that's three. And we also have a scanner manufacturing plant there, so that's four.

So it really starts there. And then from an infrastructure perspective, the storefront requirement, obviously, has us managing that element of the business as well. We're at 125 stores. We continue to close unproductive stores and open other stores as we deem appropriate. I believe in the second quarter we closed about 10 stores and opened about 15. So, you know, we just monitor activity in these stores to make sure we're getting a decent return and that the stores are in a decent location.

And would you remind of the preliminary requirement for stores in each province?

Yes. The thought has been that at least 10 storefronts would be required in each province. And we understand that that is changing. We're not sure exactly how. I mean, this is still up in the air. But we do believe that at the central government level they have wanted to be more permissive than what that prior indication was.

Okay.

So it really starts with those things, and beyond that, our transition effort is really designed to just enable people to enjoy the full economics of our business opportunity that our sales force enjoys elsewhere in the world, even if we have to run it through a different employee sales structure.

Vis-a-vis that 5% payout to the employees?

Yes.

Okay.

And that's really it.

Okay. I think that three-pronged structure about covers it. I just wanted to keep the big picture in mind and see which -- where Nu Skin stood at this time. Thank you.

You bet.

Our next question comings from Kathleen Reed.

Hi. Just a quick follow-up. I wanted to know how many Pharmanex products did you launch in the second quarter? I think you did three in the first quarter.

Are you talking about in China?

Yes. I'm sorry. Yes. It was in China.

I believe there was just one additional product launched in the second quarter.

Okay. Do you have to get a special -- does each of those products have to go through an approval process?

Yes.

Are you on schedule, behind schedule, where you'd like to be, in terms of those in China?

I think we're right where we expect to be with the product approval process.

And do you have a goal for those for the whole year, or is it more just your revenue goal for China?

Well, in terms of number, we're focused on our most significant Pharmanex products, and so for the remainder of the year it will be another 1 or 2 products and that's about it.

Okay. And are you already selling LifePak in China?

Yes.

Okay. Great. Thanks.

You bet.

At this time you have no further questions. Are there any closing remarks?

Yes. Thank you for joining us. I know that there are a lot of questions and concerns, about China in particular. I hope that we haven't overblown the extent of our transition issues there, because at the end of the day this is a big market with plenty of opportunity for not only us but all of our competitors as well. You know, the problems that Avon has articulated are going to be dealt with and they're going to be just fine in that market as we are. Nothing has happened here that changes our approach to the market at all.

Let me just state in closing too that I know that many of our shareholders expressed a desire to come and visit our convention. This October our convention is scheduled October 8, 9, and 10, and it's going to be fun. In fact, we -- one of the people who's coming to talk to our sales force is Lance Armstrong, which will be, obviously, very exciting for our sales force, given his level of achievement in the athletic world. He will be speaking to our group on Friday evening, October 9, if any of you are interested in attending that.

So thank you for being with us on the call and we're available to answer questions, as always.

Thank you. That does conclude today's conference call. You may now disconnect.