USANA Health Sciences Inc (USNA) 2006 Q2 法說會逐字稿

Good morning ladies and gentlemen. Thank you for standing by. Welcome to that USANA Health Sciences second-quarter earnings conference call. At this time all participants are in a listen-only mode. Following today's presentation, instructions will be given for the question-and-answer session. (OPERATOR INSTRUCTIONS) As a reminder this conference is being recorded today, Wednesday July 19 of 2006. I would now like to turn the conference over to Riley Timmer. Please go ahead.

Thank you, Mary. Good morning everyone. We appreciate you joining us this morning to review our second-quarter results. As a reminder, today's conference call is being broadcast live via Webcast and can be accessed directly from our website at @www.USANAHealthSciences.com. Shortly following the call a replay will be available on our website.

Before we begin as a reminder during the course of this conference call management will make forward-looking statements regarding future events or the future financial performance of our Company. Those statements involve risks and uncertainties that could cause actual results to differ perhaps materially from the results projected in such forward-looking statements. We caution you that these statements should be considered in conjunction with the disclosures including specific risk factors and financial data contained in our most recent filings with the SEC.

Also during the course of this call, management will discuss non-GAAP information. An example of a non-GAAP measure we provide is our customer account data. We provide this and other non-GAAP measures to assist investors in understanding our operating performance.

I will now turn the call over to Gil Fuller, Executive Vice President and CFO.

Thanks, Riley, and good morning everyone and thank you for joining us to review USANA's strong second-quarter results. I'm pleased this morning to be joined by Dave Wentz, our President, who you will hear from shortly. Also in attendance this morning is Bradford Richardson, Executive Vice President of Asia-Pacific and Doug Hekking, our Vice President of Finance.

This morning I plan to update you on the strong financial results we continued to achieve in the second quarter and also talk about our guidance for the third quarter and full year 2006. In terms of second-quarter results, net sales came in at the high end of our guidance, the highest quarterly sales ever reported. We are pleased to report net sales of $93.9 million, an increase up 14.5% compared with $82 million reported in the second quarter of 2005.

Net sales growth this quarter was driven by a 13.6% increase in the number of Active Associates and a 13.6% increase in the number of preferred customers compared to the second quarter of last year. Additionally, our macro optimizers, or functional foods product line improved to 14.1% of product sales compared with 9.1% of product sales in the second quarter of last year.

Our monthly auto ship auto rate continued its consistently strong pace and represented 53% of our total product sales during the second quarter. Earnings per share for the second quarter which includes equity based compensation expense increased to $0.55 compared with $0.48 per share in the second quarter of 2005 which excluded equity compensation expense. Equity based compensation expense decreased earnings per share by $0.04 in the second quarter. Excluding this expense, earnings per share would have been $0.59, an increase of about 23% compared to the second quarter of 2005.

Let's now go through the major line items on the statement of earnings. First, for comparative purposes, I will give you the impact of that equity-based compensation expense that I had on our second quarter by line item. In cost of goods sold, $143,000; SG&A expense, $931,000; and R&D expense, $131,000 for a total reduction of $1.2 million.

Our gross margins in the second quarter of 2006 improved slightly as a percentage of net sales to [76%] compared with 76.2% in the second quarter of 2005. If you look at our direct selling segment alone, the gross profit margins improved to 78.8% in the second quarter compared with 78.5 in the second quarter of last year. This improvement can primarily be attributed to lower pricing on certain raw materials which were in short supply in 2005.

Looking ahead, we believe that we will achieve additional progress in our consolidated gross margins throughout the year. This anticipated progress can be attributed reductions in the prices of certain raw materials and because the contract manufacturing segment which has lower gross margins continues to become a smaller portion of total sales.

Associate incentive expense in the second quarter was 41.1% of our direct selling revenue, compared with 40% of direct selling revenue in the second quarter of last year. As planned and as previously noted, the level of payout increased year-over-year because of an additional emphasis on contests and certain incentive promotions. These incentive programs are designed to increase excitement, enthusiasm, for driving the topline growth and have historically been successful. Based on our continued strong sales growth in our existing markets and particularly in some of our most mature markets, we believe the increases in payouts are having a positive impact on our results. We expect associate incentive expense going forward to be approximately 41% of direct selling revenue.

Selling, general and administrative spending increased relative to net sales to 19.2% during the second quarter of 2006 compared with 18.5% in the prior year second quarter. As I noted earlier, equity-based compensation expense increased SG&A by $931,000 this quarter. If you exclude equity-based compensation expense, our SG&A relative to net sales was 18.2% in the second quarter of this year. This year-over-year improvement was due to leverage achieved as we continue to grow our net sales. We believe SG&A costs in the third quarter of 2006 as a percent of net sales will be slightly lower than the second quarter of 2006.

In regards to the balance sheet, our cash balance at the end of the quarter was $9.2 million compared to $10.7 million at year end and $25.5 million at the end of the first quarter. During the second quarter we invested $30.1 million in cash to buy back approximately 800,000 shares under our share repurchase program. Currently we have $10.6 million available under our share purchase authorization.

Notwithstanding the excellent growth in sales, inventories decreased to $20.4 million at the end of the quarter. Please note that we plan to carry modestly higher inventories over the next couple of quarters as we prepare for our annual convention in mid-September.

For the six-month period ended July 1, 2006, consolidated net sales were $183.6 million, an increase of 15.7% compared with $158.6 million in the first six months of 2005. Earnings from operations for the first six months of 2006 were $29.9 million, an increase of 5.5% compared with $28.3 million for the same period in 2005. Earnings from operations for the first six months of 2006 were reduced by $2.2 million due to the required expensing of equity-based compensation.

We achieved net earnings in the first six months of 2006 of $19.9 million, an increase of 7.8% compared with net earnings of $18.5 million in the first six months of 2005. Excluding the expense of equity-based compensation, this increase in net earnings would have been 15.9%. Earnings per share increased 11.8% in the first six months of 2006 to $1.04, compared with $0.93 in the first six months of 2005. Excluding the expense of equity-based compensation, this increase in earnings per share would have been 20.4%.

Now before I turn the time over to Dave, I will comment on our future guidance. We continue to wait for government approval for our business license in our planned new market. Due to the uncertainty of obtaining this license, we have decided to remove any potential guidance from that market from our 2006 guidance. We are updating our full-year 2006 guidance and issuing third-quarter guidance neither of which include any sales from our planned new market. Accordingly, we expect sales in the third quarter to be in the range of 94 to $96 million compared with $82.2 million in the third quarter of last year for a growth rate of 14% to 17%.

And by the way, historically we do experience some seasonality during the third quarter. It is typically our softest reporting period during the year due to the slowdown that seems to happen prior to our international convention. We expect earnings per share in the third quarter of 2006 to be between $0.55 and $0.57 including the adjustment for expensing of equity-based compensation for a growth rate of 8% to 12%. Excluding expense of equity-based compensation we expense earning per share in the third quarter of 2006 to be between $0.60 and $0.62, a growth rate of 18% to 22%.

Now let's look at full-year guidance. We believe that net sales growth for 2006 excluding entry into a new market will range between 15% and 17% compared with 2005. Additionally, we expect earnings per share growth for the full year 2006 to be between 17% and 20% excluding the impact of expensing equity-based compensation. We do expect equity-based compensation to degrease our earnings per share for the full year of 2006 by approximately $0.18. Note that this earnings per share estimate also assumes a tax rate for 2006 of 34.8% compared with 33.7% tax rate for 2005.

I will now turn the time over to Dave to comment on our recent operating activities.

Good morning everyone. The second quarter was once again a very strong quarter for USANA and marked the 16th consecutive quarter of record sales and we achieved strong growth in most of our markets including our most mature markets.

First let's look at the sales results in our two main geographic regions. Net sales in North America, our most mature region increased 19% compared with the same quarter of 2005. Excluding the positive impact of currency fluctuations, sales in this region would have increased 15.8%. The growth in this region was driven by particularly strong sales in the U.S., the Company's largest market and strong results in Canada as well. Sales during the second quarter were up 20.4% in the U.S. and up 17.8% in Canada compared with the second quarter of last year. Mexico also aided the growth in this region improving 11.8%.

The number of Active Associates in North America increased 16.9% to 90,000 compared with 77,000 in the second quarter of 2005. The interest and excitement around our low-glycemic functional foods continues to be very strong. This product category increased to 14.1% of sales from 9.1% of sales in the second quarter of '05.

Field engagement has been very strong and was represented by the 20% growth of associates in the U.S. during the second quarter. We are pleased to see additional leadership emerge from the contest and incentives programs that we have been promoting.

In the Pacific Rim region, sales improved 4.8% over the same quarter of last year. Excluding the negative impact of currency fluctuations, sales in the Pacific Rim region would have increased 7.7%. This increase was primarily attributable to growth in the Australia and New Zealand market which was up 9.3% and in South Korea which was up 33.2% over the second quarter of last year. The number of Active Associates in the Pacific Rim region increased 8.3% to 52,000 compared with 48,000 in the second quarter of '05.

While we are disappointed that the opening of our new market has taken longer than planned, we are pleased with our ability to continue to generate strong growth in our existing markets. Our focus for the remainder of 2006 is to grow in our 12 existing markets. We will continue to develop unique contests and incentives promotions that we believe will push our associates to grow the business at a faster rate. We are committed to developing the finest sales pools in the industry. Our goal is to make the business of selling USANA products as simple as possible.

During the third quarter we will be hosting our annual international convention in Salt Lake City. This year we are anticipating hosting nearly 10,000 of our associates from around the world at this four-day celebration. This exciting event will feature new products and sale tool introductions, motivational speakers and product and business building education.

Finally in regards to China. We continue to prepare for the submission required to obtain a direct-selling license but we are also carefully watching the trials and tribulations of our contributors competitors who are trying to force their way into this market. We are not rushing into this market but we are in the process of fitting out manufacturing facilities, pursuing product regulatory approvals, assessing sites for conventional service centers, and defining an acceptable compensation model. All of these efforts are part of the extensive tablework that is required for a direct-selling license submission. As this is a new process for both USANA and the regulatory authorities in China, we believe that the final submission may require longer timelines than earlier believed.

We are not aware of any major competitors, other than Avon, who have received their approval. We continue to pursue a long-term strategy for this large and potentially lucrative market.

With that I'll now turn the call over to the operator who will [aid] the Q&A session.

(OPERATOR INSTRUCTIONS) Scott Van Winkle with Canaccord Adams.

Hi, gentlemen, a few questions. First on your guidance, Gil, 15% to 17% revenue growth, that looks like a little bit better than what you put up this quarter. Are you expecting any incremental boost in the back half of this year, new products at convention or you are just throwing a range out there?

Scott, we do think that we will see some back end strength this year. We are quite pleased about what is planned for the convention. And just looking at field engagement and some of the other things that we have planned to increase that field engagement, we are looking for a bit better second half.

Now you've had a real good track record the last couple of years with new products, Sense' and then Reset. Something coming in September?

You have been to several of these conventions I think, Scott, and you know that we always have something exciting. And this year should not be any different. We always take a little different focus as you mentioned we've had Sense', we've had the Reset program, functional foods and so forth. This one will be also a little different but we think very exciting.

Okay, well great. The gross margin is still negative in the contract manufacturing. Can you talk a little bit about your plans there or is there some kind of weird allocation and corporate overhead in there that makes that happen?

Yes, let me comment on that. There is no question that we tend to view this as a segment almost like a cost center is I think part of the issue here as we said repeatedly, we didn't make that acquisition to get into contract manufacturing. So in some ways it tends to be out there more like a cost center almost than a profit center. But during this quarter we did have a bit of catch up to do in analyzing inventory and recognizing some of it was obsolete. And so if we went back and did a little adjusting there, it would have had a positive contribution this quarter. We are hopeful that that will be big case for the next two quarters this year that we will see some positive contribution from contract manufacturing.

Okay. And I don't know if I missed the comments from Dave but anything special in Taiwan?

Taiwan has some introductions of new competitors so they have been fending off the new competitors as they come in. And I'm confident that they will continue to grow now that they have warded of the launches of some competitors. There is always -- when the number of competitors come on the market at one time there is always a little stress as people look around and try to figure out what to do and then they move forward after the novelty is gone from those new competitors. So I hope to see growth going forward.

Asia in general was a little stronger for you this quarter than the first quarter. A lot of direct sellers have been seeing softer trends in kind of Greater China and Japan. Do you think there is more competition broadly or is it just it doesn't look like it is a softer economic environment over there. Is anything kind of big picture you see happening in the Asian market for direct selling?

Well we have had another -- in Taiwan we have had another credit card crisis like we had when we opened Korea. Unfortunately, our timing was bad on that, where they are restricting credit cards for Taiwan and increasing the minimum payment. So that is changing some economics in Taiwan. The rest of the markets, I don't -- I see a little bit of struggle in Japan with some of our competitors. Their economic situation is up in the air. But Asia should continue to grow and we believe that we have a lot of potential there.

Okay. And Gil, I know you are not giving guidance for' 07. But you know last year a lot of us didn't forecast the extra spending in China in '06. That caught us by surprise at the end of the third quarter when you did give guidance. Is there anything you can think of that might be a little weird happening in '07 another new market you are spending on? Anything special, an extra convention here or there that we should think about that maybe have an early warning for us?

I think on the contrary, Scott, I think we've probably learned a little bit from last year. We are not going to hold -- we are going to hold an Asia Pacific convention but it won't be on the last two days of the first quarter like we did this year. It will be in Sydney. And I should mention by the way that our registrations for that convention are running way ahead of expectations in Sydney. So we are looking forward to that. So I don't think we will have the same surprise on the cost side that we had this past March when we had our Asia Pacific convention.

As Dave mentioned, we are continuing labor on China and the other markets that we haven't announced yet -- that will be where our focus and those expense levels will build into our guidance when we start talking about '07 guidance. We will try our very best not to have -- get a little bit of a blind side like we had this first quarter when we reported.

Okay. And just on your new market. The regulatory holdup, is it -- you may have said this in the past and I apologize. Was it product registration or business opportunity registration?

It is not product registration. We have product registration as I understand it. It really is on the business side and that is where the non-transparency has been so frustrating that we just don't know. At this point when we get the license assuming it happens, you know, some time in the next year or something, who knows when, next week or next year? But that's when we will come out with something. But clearly on the business side.

Okay, thank you very much.

Tim Ramey with D.A. Davidson.

Good morning. Can you hear me okay? I'm on a car phone.

We can.

Okay, thanks. And congratulations, what a great quarter. I was wondering, Gil, the functional food segment has become a meaningful size of the business now and as I recall much of that was done by third parties. Are you bringing more of that in-house or what is your plan there for the manufacturer?

Yes, let me have Dave respond to that. I think we are making some progress there.

Well, we are doing some of the food products out of house but we have brought some of them in house and we are looking to slowly bring a little bit more in at a time. We definitely had drink capabilities here but we don't ever plan to have bar capabilities at this facility at least currently we don't have any plans to have bar capabilities. So it will probably be a half and half situation, maybe a little more with drinks being a larger percentage. We have backup vendors for drinks and other things if we choose to do so but if we can reduce costs, we will bring more and more in house.

Is there a margin impact with that move, Dave?

There have been some, definitely, for some of the drinks. Some of the drinks have been kind of breakeven cost basis and we are looking for ways to also make those a beneficial bring in house. But until we make them more beneficial we are not forcing them in house.

Okay.

Overall, Tim, we have seen some margin improvement on that product line because of the steps that Dave has mentioned.

Good stuff. And on the Asia markets, you mentioned this was the best sequential improvement in four quarters. I'd expect to see some lift out of your convention there. How do you feel you would judge yourself on the success of the convention? Was it successful or less than your expectations?

I think it was successful. It was our first, it was a learning experience. And a lot of the bugs that I expected didn't happen. So it was a very smooth and very excited group that was there. We wish it had been a bigger group there. Unfortunately it was a little smaller than we had hoped for it. But it was our first and so I'm sure a lot of people waited to see what the first one was like before committing to the second one. But we are definitely seeing the commitment to the second one now, the second one is looking incredible. And it will be a much cheaper venue so with increased registrations and cheaper cost, it should be a much more profitable event than the last one which was a learning experience for us.

Very good, thanks.

Andy Speller with A.G. Edwards.

Thanks, good morning. Dave, can you just give us some examples of what you guys are going to be doing in terms of unique contests and some of the sales tools that you are going to be looking to motivate folks in the back half of the year?

Well, we just concluded one contest at the end of June. We had a six-month contest which we have relaunched due to the enthusiasm we saw with this last one. We had a number of huge rank events and some people stepping up and getting reenergized and remotivated. So the second half of the year we will have the same contest and we believe that will drive sales nicely. In addition, we have smaller contests running underneath, shorter ones to create deadlines. Currently we are in the middle of the USANA games which is a team building contest where people groove up in teams of five to 15 people, are cannibal to each other, their scores are looked at individually and their team scores calculated to see how they compete against other teams in their league. For any of you who play fantasy football or something, it's something of that nature. We've used our online technology to create an accountability, team building games where they compete and it really gets excitement going, drives people to push each other to reach new levels. And so we've got that going on underneath for the next couple of months. Very excited about that.

And we will have a whole bunch of new tools at convention. We are focusing on one in particular that we are very excited about that we've seen a number of our competitors have great success with. And we are looking to launch that wit large fanfare at the convention and focus on that for the next year and see if we can make it easy and duplicatable for associates who are new to the business to tell the story without having to learn everything and have the fear that they can't tell the story themselves. We are trying to produce those tools that allow the tool to tell the story for them. So we are very excited about that launch at convention.

On the contest that you just relaunched, is that across multiple geographies or is that in specific geographies?

Oh, yes, sorry, the six-month "Share in the Success" contest is a worldwide contest where we will be distributing $1 million to our top 100 growers. The USANA games is a North American contest. They have been more online savvy and really taken to this contest. That is a local one, while the Asia-Pacific countries are doing their own (indiscernible) contests underneath the "Share in the Success".

Okay. And then Bradford, while we've got you there can you just kind of talk about what some others are going through in China and just kind of your thoughts about the whole situation and how you are positioned? And I guess you guys said you thought the whole process is taking longer than anticipated. What previously did you think how long would it take to get your license and now how long do you think it is going to take?

First of all just speak about our competitors. In the public space you can certainly see companies who are public and what has happened to them in the first quarter of the last year seeing 25% to 30% drops in revenue. And that certainly has been a concern because you look at the government's law that came out in December of last year; they basically said that they will not allow a multilevel type of compensation. They will only allow a single level which has reduced the opportunity for a number of people as they look at the opportunity of direct selling as the multilevel component and it's one that is very attractive.

So first of all people are saying that the marketplace is less attractive given this very, very restrictive law. I think from an outlook standpoint, those companies are very concerned about the growth opportunities in China under the new regime.

Second of all, the time frame. No one is basically getting license approved. So it is hard to say. The government is adding new stipulations, new sub regulations on top of the regulations. And companies are scrambling to meet the requirements. So many companies that have extensive facilities in China still have not gotten their approvals either. Avon is the only major company. So it is hard to know exactly what will happen. Our goal is to keep proceeding on the process and watch what our competitors are doing and make the required investments but do it in a conservative fashion.

Okay, it sounds good. And then Gil, just a couple of financial questions. We kind of passed through some of the things. Let me just kind of back up and make sure I got the numbers right. First of all, can you give the breakout in terms of how the costs hit in the first quarter for the equity comp? If you have those handy?

You know, let's see -- it was 947,000 in total in the first quarter. And the distribution would be virtually identical if you just --

-- in terms of percent?

I don't have the breakdown with me, the first quarter. But the 1.2 in the second quarter would be broken down percentagewise virtually the same.

Okay. And then as we look on going forward we should break down the additional amount similarly through the categories?

Yes, that same relationship will hold.

Okay. And then you said that if you look at gross margin on direct selling you said it went up -- it was 78.8 versus 78.5, is that right?

Yes.

Okay. And then you said you expect that to continue to go up in the back half? Is that right?

We do expect some continued improvement.

Okay. And then you said moving into the third quarter from an SG&A percent standpoint you expect it to go down slightly in the third quarter, is that right?

We do expect some additional improvement on the SG&A.

Okay. Alright, and then lastly --

Relative to sales, of course.

Relative to sales, yes. And then lastly, if you can give kind of the product sales breakout if you have it among the different categories, that would be great?

Yes, give us a second here and we can get to that. Just walking down through these, first of all, Nutritionals in total were 84.8% of sales. And Sense', 11.5% of sales and breaking down Nutritionals into the three components the way we look at it, the essentials in its various forms, 37.9%; optimizers, 32.8%; and then our functional foods or what we call macro optimizers, 14.1%. Then you have other sales tools and other things are about 3.5 or 3.7%.

Okay, great. Thanks.

Doug Lane with Avondale Partners.

Good morning everybody. A couple of questions. First, on the contract manufacturing business, that is up 39% so far this year. And I just wanted to get a feel for what is driving that growth? And is that number sustainable into the back half of the year?

No, we look for lower numbers in the next two quarters. The first two quarters in a way was a bit of catch-up and also there is some seasonality in that contract manufacturing business that we are beginning to understand. It seems that those first two quarters are always the strongest quarters. The last two quarters of the year seem to be more modest quarters. So we would expect to see lower numbers from contract manufacturing in each of the next two quarters.

Lower than the first two quarters or lower than the year-ago quarters?

Lower than the first two quarters. We did 2.2 -- I'm sorry -- 2.8 in the second quarter and about 2.6 or so in -- 2.3 in the first quarter of this year. And we would look to see numbers probably just under 2 million in the next two quarters from there.

Okay.

I'll tell you, as a percentage of the total, it is going to go down.

Because it has been up the first half?

Yes, in the first half it was a little higher than we expected.

Okay.

We had 3% -- in the first quarter it was 3.2% of sales and in the second quarter we just completed, it was 3% of sales. And then if you go back to the second quarter of '05 it was 2.7% of sales. So it is down sequentially, and it will continue to go down sequentially and it is up slightly year-over-year.

Okay. I know you don't want to talk about '07 specifically but just directionally, let's talk about a couple of items if you don't mind. Sticking with contact manufacturing. Do you expect that to be less as a percent of sales in '07 than it was in '06?

Yes.

Okay. And then on the tax rate which you brought down a little bit this year, is that a good number to go into '07 with, the 34.8%?

That is a little tougher one to get at, Doug. If it for me I would probably do that. I wouldn't want to get any better than that, that is for sure. We are still waiting for some of the details of this new manufacturing credit to flow down to us and understand how that will impact us versus this DTI aspect of manufacturing credits that is now being phased out.

But base case we shouldn't go back to 35.5 in '07, should we?

You know, Doug, it is just too early for me to say that. I wouldn't want to be held on that one. We certainly hope not.

Okay. Moving on then. Also in '07 you talked about China and I think the last time we talked you were still looking to be able to book revenues some time in '07 from China. Is that still in the cards or should we move China back to '08 at this point?

Well, my view and Dave may want to either trump me or add to this. But we are certainly hopeful that we see something in China in '07. It might be at the back and. And when we give our '07 guidance, which we have traditionally given our first look in October in connection with our third-quarter earnings release, we'll put some flesh on that and expound more. Probably see things a little more clearly at that point.

But you still plan to apply for your license in the second half of this year, correct?

Those are the current plans. But as Bradford mentioned in his comments, we really want to wait and see what we can learn from -- you know, we are preparing all the paperwork, and the product registration stuff is done, the licensing aspects related to that is done; we're sitting out in this little plant we've got in [Tsengin] to do some of the manufacturing. We are doing all of those kind of things in preparation of filing that application. We have not pulled the trigger on it yet. We are really hoping to see what might come back for example from the Nu Skin and others and their applications if we can learn something before we submit ours.

Well I know you guys -- I mean on one hand you don't want to comment on competitors but on the other hand I know you guys work as a group with the Chinese government. So to the extent you or Bradford could talk about the Amway, Nu Skin, Herbal Life, the big billion dollar plus global direct sellers, what it looks like for them getting a license? As far as I know we've got Avon as a global player and then three local Chinese players that have been granted a license. What does the landscape look like today for the big global players like Amway, Nu Skin and Herbal Life?

All I can say about that is at a recent international council meeting of the Direct Selling Association everyone is expressing great concern about the timelines and the additional regulations that are being put on companies pursuant to getting a license and it has been a much more difficult process. Partially because it is a new process for the Chinese government and they are running into additional questions. And as you've seen many companies with large operations in China still do not have their licenses and there is a lot of frustration about that.

I think as we had understood originally it was supposed to be about a 90-day turnaround, wasn't it Bradford? That was at least talked about. But it certainly has not talked worked out that way. But it is a big market, an important market, one that certainly has potential to be important for us.

Before I move on, certainly frustration is a word that has been used with China a lot over the last two or three ears. Can you give us an update on what you think -- I know you really can't forecast the timing but I'm just wondering if you see additional regulation coming down? And at what level have the negotiations gotten to? In other words, is this still at the point where the governments are talking to each other? Are we at the point now where just the companies and the trade associations are talking with the ministry?

We have gotten a huge amount of support from the USTR as well as other government bodies. But the viewpoint that we have heard recently from the Chinese government is the law is out, put in your applications, start doing business. There is not a large openness to continue debating this issue from the Chinese government. That is our most recent viewpoint.

Got it. Okay. And lastly the changes to the associate incentives that you put in place this year, is that permanent so that we should have -- be modeling in this new higher level of associate payout? And from where you sit today without necessarily going into specifics, are there going to be additional changes to the payout in 2007?

I think we are about where we went to be. We've got enough money put aside to stimulate the leadership that is growing and give them incentives and give them something substantial to work for. But I think we've come to a nice area where we can -- we have our base so to speak, our base salary as they build their commissions but we also have the bonuses that are enough to trigger additional activity from our leaders who want to bring in the most people. So I think we are pretty comfortable where we are right now and we're just going to continue to improve the ways that we distribute those monies as we learn more and more. But the monies I think are about where they should be.

Okay.

I'd just add one other comment there. It is really what I think what we have been able to do here is this notion of pay for performance built into these things rather than structural changes to our commission plans.

Okay, thank you.

Mimi Sokolowski with Sidoti & Co.

Thank you. Dave, first question is for you. I don't think you've ever just quantified any sort of a retention rate. But with the new changes and nuances to the compensation, have you seen that retention rate change at all?

Retention rates for the 14 years I've been here are just pretty much steady. Human nature people are what they are. A certain percent will build this business and a certain percent will refuse to talk to a single soul about it. So we don't -- I mean we see a little fluctuation but it always balances out to be about the same thing. Growth tends to help a little bit as more people are having success. But it all evens out in the end.

Okay. How about have you or Bradford observed change in the quality of your associates in North America?

That would be hard to I guess -- quality as in say enroll more people or --?

-- or perhaps more diligent, more focused, more active on the recruiting front.

No, it tends to be human nature. Numbers are what they are from what we've seen. I wouldn't say that we've gotten recruited people who now recruit two more people than the people used to in the old days. It is pretty even.

Mimi, we do have some great leaders, great distributors I think in all of our markets in a couple of these companies now. Certainly my view is that we have just outstanding associates. In fact a survey we did, I can't remember how long ago, but not that long ago, we had about 80% or so in North America. First time people had experienced network marketing. In other words we weren't attracting just other network marketers but new people which is very encouraging.

Not only selling your company but selling the industry as well?

Right.

Okay, that's important. Dave, I think I have two more questions for you and then Gil one for you. Japan, a tiny market for you guys but perhaps somewhat important on a global scale. Second quarter of revenue declined there. Are there any observations you can make that you couldn't make in the first quarter?

Japan is definitely an important market for us. We are working to get a strong management team there. We've struggled to find the right management team for Japan. And so that is our number one focus to find the right people to lead that market. We are hopeful that once we find that right person or group of people that they will be able to give the Japanese associates the comfort and the trust level that we've got a stable management team there that they feel confident putting their futures into.

Sure, I understand how that works culturally. So that makes sense. And then the last for you, Dave, on the regulatory front. Have you heard any chatter or could you elaborate on any changes that might be passed through, changes that might allude to a new cooling off period? Like a seven-day period following the initiated contact for a potential partnership with USANA?

Yes, there has definitely been a proposal put out there, SEC proposal on how this opportunity should be viewed. And we are lobbying heavily with the entire direct selling association to make sure that we get to a situation that we are comfortable with. We are pretty confident that there won't be anything that disrupts business very much. Probably not even at all. And even if it does, we feel that would our integrity with the things we've done in the past we -- even if we have to do things we will stand head and shoulders above the others. So we are not concerned about it at all. We are working on it. We are pursuing the lobbying, we are helping there where we can but we are not that concerned with it.

Okay. And then, Gil, just some cash flow questions for you on the quarter. Thanks, Dave, too. Cash from operations in the quarter and CapEx? Do you have them handy?

Yes, I think I can put my hands on those here in just a minute. CapEx I think was about $1.7 million or so in the first quarter -- I'm sorry, in the second quarter. About 1.5 in the first-quarter. So we do have a project underway here of adding some additional capacity at our Salt Lake facility. And so I would expect that to ramp up in the second half of the year into the first and second quarter of next year.

And cash from operations in the second quarter?

Let's see if I've got that handy. About -- free cash flow in the second quarter is about $13.2 million.

So that is cash flow after CapEx?

That is right. And from an EBITDA standpoint, we continue to run about that 17.9%, 18% in EBITDA so one of the great things about this model is it is great for the cash flow, no question.

Absolutely. Okay, thanks very much, guys.

Rommel Dionisio with Wedbush Morgan.

Good morning. I wonder if I could just ask a question on China. You didn't -- you saw a similar magnitude of growth in Active Associates but you saw a very nice acceleration I think relative to the prior quarters in terms of the topline. I wonder if you could just talk about what are the key drivers there? Was it new products or just some incentives during the quarter that really helped drive the topline in Canada?

Could you repeat that, where were you referring to?

Canada.

Canada.

I'm sorry we had heard China so we were --

Maybe I said China, I apologize.

We were thinking in the wrong spots --

We don't have any associates in China.

In Canada, you were talking about the revenue growth?

Yes. I mean you saw very nice revenue growth during the quarter I wonder if you could discuss what were some of the key drivers there in terms of the increased productivity and the acceleration we saw this quarter relative to some of the more recent quarters?

Well the North America really responded to our last contest in the last six months. So a lot of the excitement and energy was in North America. We are hoping to see more of that filter into Asia-Pacific in the second half of the year as they understand the contest better and realize the amounts of money that can be earned by growing their business. So North America took off with this contest and just pushed hard. We've got a lot of enthusiasm, a lot of positives, feelings and sentiments out in the field. So when the leader is excited and working everything runs nicely. And we are just trying to do our best to communicate with them, partner with them, let them be heard and let them know how valuable they are and right now spirits are high in U.S. and Canada definitely.

Okay, thanks very much. Nice quarter.

[Phil Fisher] with [Travelet].

Great quarter. A couple of questions for you. On the new market that you've now eliminated from this year's revenue guidance, does that actually benefit your earnings slightly because you are no longer incurring costs you though you'd be incurring in the year? Or is that -- how does that impact the earnings?

Good question, Phil. In the second quarter we had about $220,000 or something before tax in both combined in that new market and in China from which we had no revenue against. But we would expect that now that we are almost in a wait and see thing and maybe modifying applications and so forth in this other market, that we would expect those expenses to moderate some. But it is not a huge deal but it should moderate some.

Okay. So you are not going to be incurring some kind of cost you'd expected to incur in '06 when you -- under your prior expectations?

We are hoping that it will be a very minimal cost as we wait to see and not put in a lot of money into the market preparing it. We are taking a step back and waiting and seeing without putting a lot of expenses into it. It definitely costs more the more markets we open. And so if we can get our growth locally it is definitely more profitable growth.

Have you reduced your cost expenditure assumptions for China for the remainder of '06?

Not for China.

Okay. But you have for the other market?

Yes.

Okay. And should we expect that other market to open in '07 or not?

We are no longer guessing. We will let you know as soon as we know.

Okay.

We certainly are always looking at new markets. And recognizing that there is some terrific markets still out there for us. But we got excellent growth in our existing markets and with China on the horizon hopefully this other one will come along, there should be plenty of opportunity for us.

Okay. On the contract manufacturing side, were margins up versus Q2 of '05 or down versus Q2 of '05?

Margins improved somewhat in Q2 of '05 especially when we take out the (multiple speakers).

Q2 '06 you mean?

I'm sorry, in '06 we are better than '05 especially if you take out the kind of the inventory adjustments we had to make. They did improve.

When did you have to make inventory adjustments?

In the current quarter. It was not a big deal but it was an overall company but to the contract manufacturing, it reflected that we had made some progress in margins.

Okay. So was there any onetime benefit that ran through the quarter due to inventory adjustments?

No.

And then on the functional foods, I assume Reset is a big part of that. Are margins in that business better than the remainder of your businesses or not?

The margins on functional foods in general are a bit lower than our other two product lines. But they are improving, Phil. As I think Dave mentioned earlier we are doing some things, bringing some of the things in house and we are seeing improvements there. And when we reformulated and relaunched this last fall we also were able to improve the margins a bit as well.

Okay. A couple more questions. On the associate incentive as a percentage of revenues clearly that has been successful for you in terms of helping to stimulate your revenues. Why wouldn't you just continue to bring that up as a percentage of sales as the pay off has been as successful as it has?

Well, we want to keep some powder dry. We wanted to keep some in reserves and not make sure that we create expectations out in the field too quickly. Once it comes to be expected it is no longer as appreciated. So we are -- that is why we are keeping this money coming in various contests, no predictability, continued incentives to drive them without it becoming an expectation that doesn't drive them. And so we are using as much money as we think we need to keep them excited but we are not going to pour it at all in at once so that we don't have anything if we need it down the road to use to incent people. So we are using a little bit and we are using what we think is enough to get them going but we are saving as much as possible for any particular times that we want to do a heavy push.

So is it expected to go up as a percentage of revenues in '07 or stay flat with '06?

We are pretty comfortable with where it is now. I think as we were more profitable we gave a little bit more back to the field and I think they appreciated that. And I think we've got a nice balance right now.

Okay. And then one last question for you, I used the midpoint of your '06 guidance and then I subtract the first half from that, and you'd subtract midpoint of the Q3 guidance from it. I'm coming up with a Q4 EPS number of around $0.56 for guidance. Was that intentional? Is that the number I should be using for Q4?

I'd have to crank that math and see if that -- we haven't of course specifically identified the quarter but if you put in the range numbers that probably is the way it works out, Phil.

Okay, so I should -- okay, great. All right, gentlemen. Thanks a lot. Great quarter.

[Dale Laceski] with [Chesmore Capital].

Hey, guys. A nice quarter. A few questions for you. Gil, do you have the depreciation for the quarter handy?

If you give me just a minute we can probably get that -- 1.5 million in the quarter.

1.5 even?

Let me see if I can get more precise -- 1,460,000.

Okay. And how does that number look going forward do you think?

Well, you know it has been pretty flat. I would expect it would stay that way. When we have the addition to our new facility or the add-on here in Salt Lake City it made tick up some but that's -- you are probably looking at a year from now before that starts to crank in. And of course by then other things will have probably diminished some. So we don't look for any spikes in that. It should remain steady. It may be creeping somewhat higher as the new facility comes online here in 12 months or so.

Okay. Going back to the associate incentive, the prior gentlemen just brought it up. Did I hear you correctly on the prepared comments -- did you say 41%?

Yes, of direct selling revenue. You have to be a little careful with the face of the income statement. You have to deduct out the third-party contracting revenue in order to get that math to work.

Okay. And I don't have that math in front of me. Is that --?

We can get that to you.

Is that quite close to where you were for the quarter? I think you were 39 overall. But -- close to 40.

Overall we were 39.9. If you take out contract manufacturing of 2.8 million out of the [93.9], it would come out to 41.1.

Okay so you are saying that you are going to be pretty much where you are at, okay.

Correct. But that note from for the year earlier the '05 second-quarter that was 40%. So we're about 100 basis points higher. And for those on line who have followed us awhile, that is what we had said we would be doing.

Right, I know it had been trickling up and I thought that you guys had stated you expected it to sort of stay at that level. That's why I was thrown off by the 41 but I see you are using a different sales base, no problem. I'm a little bit new to the story, without getting too long-winded, could you guys just comment a little bit on the product portfolio last year versus this year, Q2, so we could better understand the organic growth of the products?

Well, our product portfolio stayed pretty consistent. We tried to stay at 50 SKUs between the nutritional products, the supplements, the food products and the skin and personal care products. Our goal is to not add a lot of additional products but to reformulate and improve our existing products to maintain our SKU and profitability levels. We also as we add new products tend to drop off the bottom sellers. It stayed a nice range at 50 SKUs which our part-time distributors can handle without feeling overwhelmed that they have to know 1000 different products to sell to their customers. Is that the question you were looking --?

Yes, no, exactly -- that's very helpful. And going forward I presume it is a similar strategy or would there be any noteworthy comments with respect to perhaps new categories or even if you swapped a category that you think might have a hotter growth rate next year, anything pertinent?

Our feeling is that we are going to stay with these three categories if you look at it that way, two categories if you want to break it down that way and not spread into any others. We are also focused heavily on keeping it right about 50 SKUs. So you will not see us get into different ranges of products. You won't see us expand our SKUs quite a bit. It will just stay around the 50 range which has proven successful for the last number of years.

I would just toss in another little comment on that also. These products never get stale because one of our strategies has been to reformulate and refresh these as the science indicates. So rather than rolling out new ones, as Dave mentioned, it's refresh, reformulate, reexcite, that's kind of our approach.

It allows our part-time people to just learn a little bit about the products they know rather than having to learn a whole new product.

Gil, do you have the basic and diluted shares at the end of the quarter, not the average but the end?

I think I may only have the average, that was in the press release. I don't know if I have the absolute number. Let's see, the actual outstanding shares is that what you are looking for?

Yes.

The actual outstanding shares that is not including options, not including SARS, etc., etc., was 17.7 million.

At the end?

At the end of the quarter.

Okay.

The absolute number at the end of the quarter without any dilution, any consideration of options, in the money options and so forth.

And then two quick ones. The last conference call with respect to margin you had indicated you expected to see some further improvements on account of the fact that you were buying some raw material a little bit better than you had in recent quarters. Have you pretty much realized all of that? Where are you at on that front?

I think we will continue to see some progress. In my prepared comments, we had suggested that we thought we would see some continued improvement for the rest of the year in the gross margin line. And part of it is the trickle through impact of seeing in a couple of cases the cost of certain raw materials coming down.

Okay. Okay, so fairly favorable trends in that regard and you don't see any procurement issues in the near term?

Currently but there can always be surprises which happened to us in the past that caused us to have those higher raw material costs. If a shortage due to crop, due to the weather, too hot, too rainy, whatever, there can be shortages. And so we can't predict them at this time but we don't see anything coming down the pipe currently.

Okay. And then lastly, I'm just a little bit confused with respect to the new market. Is it more of a timing issue or an if issue?

We have said all along it was a timing issue. The time has been long enough that sometimes you wonder if it isn't an if issue. But no, at this point at least my view is that this is a timing issue. Bradford, you may have a comment on that. I mean we are waiting to see and we are doing -- trying to do some other things to move it along.

To Gil's point, we still do believe it is a timing issue. There is a lot of work that can be done to make this happen and we just have to continue on the path. It is a very nontransparent process so sometimes it does seem a little troubling. But we will keep working on that and get back to you if we have new updates.

Would you expect to update us on that in between quarterly calls?

You know the day they stamp our license we will be out with a press release. Until they do we'll probably just keep giving you the same lines here that we are working on. Of course if we make a decision that we are going to throw in the towel and not go there, we would also comment on that. But that is not the case.

All right, guys. Very nice job. Impressive quarter, impressive margins, keep it up.

Thank you. Management, there are no further questions. I'll turn it back to you for any closing comments you may have.

Thank you for your questions. We continue to remain confident in the future outlook for USANA and the investment opportunity we provide. If you do have any remaining questions, please feel free to contact us at investor.relations at US.USANA.com or call Riley Timmer, the Manager of investor relations at 801-954-7922. We do appreciate your interest in USANA and thank you for joining us on the call this morning.

Thank you. Ladies and gentlemen, that concludes today's teleconference. We thank you again for your participation. And at this time you may disconnect.