Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Business Overview
We are an international direct-selling and e-commerce company. Subsidiaries controlled by us sell personal care, wellness, and “quality of life” products under the “NHT Global” brand. Our wholly-owned subsidiaries have an active physical presence in the following markets: North America, which consists of the United States, Canada, Cayman Islands and Mexico; Greater China, which consists of Hong Kong, Taiwan and China; Southeast Asia, which consists of Singapore, Malaysia and Vietnam; South Korea; Japan; Europe and Peru. We also operate through an engagement of a third-party service provider in Russia and Kazakhstan.
Our member network operates in a seamless manner from market to market, except for our China market where we sell to consumers through an e-commerce platform, and our Russia and Kazakhstan market where our engagement of a third-party service provider results in a different economic structure than in our other markets. Otherwise, we believe that all of our other operating segments are similar in the nature of the products sold, the product acquisition process, the types of customers products are sold to, the methods used to distribute the products, and the nature of the regulatory environment. There is no separate segment manager who is held accountable by our chief operating decision-makers, or anyone else, for operations, operating results and planning for neither the China market or Russia and Kazakhstan market on a stand-alone basis, and neither market is material for the periods presented. As such, we consider ourselves to be in a single reporting segment and operating unit structure.
As of
March 31, 2017
, we were conducting business through
113,710
active members, compared to
118,960
three months ago and
119,800
a year ago. We consider a member “active” if they have placed at least one product order with us during the preceding year. Our priority is to focus our resources in our most promising markets, which we consider to be Greater China and countries where our existing members have the connections to recruit prospects and sell our products, such as Southeast Asia. We have also begun to invest some resources in Mexico and Peru.
We generate approximately
98%
of our net sales from subsidiaries located outside North America, with sales of our Hong Kong subsidiary representing
91%
of net sales in the latest fiscal quarter. Because of the size of our foreign operations, operating results can be impacted negatively or positively by factors such as foreign currency fluctuations, and economic, political and business conditions around the world. In addition, our business is subject to various laws and regulations, in particular regulations related to direct selling activities that create uncertain risks for our business, including improper claims or activities by our members and potential inability to obtain necessary product registrations. For further information regarding some of the risks associated with the conduct of our business in China, see generally in “Part I, Item 1A, Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2016, and more specifically under the captions “Risk Factors - Because our Hong Kong operations account for a substantial portion of our overall business...” and “Risk Factors - Our operations in China are subject to compliance with a myriad of applicable laws and regulations...”.
China has been and continues to be our most important business development project. We operate an e-commerce direct selling model in Hong Kong that generates revenue derived from the sale of products to members in Hong Kong and elsewhere, including China. Substantially all of our Hong Kong revenues are derived from the sale of products that are delivered to members in China. Through a separate Chinese entity, we operate an e-commerce retail platform in China. We believe that neither of these activities requires a direct selling license in China, which we do not currently hold. We have previously sought to obtain a direct selling license, and in August 2015 initiated the process for submitting a new preliminary application for a direct selling license in China. If we are able to obtain a direct selling license in China, we believe that the incentives inherent in the direct selling model in China would incrementally benefit our existing business. Increased sales in China, not expected to be material at least initially if any, that could be derived from obtaining a direct selling license may be partially offset by the higher fixed costs associated with the establishment and maintenance of required service centers, branch offices, manufacturing facilities, certification programs and other legal requirements. We are unable to predict whether and when we will be successful in obtaining a direct selling license to operate in China, and if we are successful, when we will be permitted to conduct direct selling operations and whether such operations would be profitable.
Income Statement Presentation
We mainly derive revenue from sales of products. Substantially all of our product sales are to independent members at published wholesale prices. Product sales are recorded when the products are shipped and title passes to independent members, which generally is upon our delivery to the carrier that completes delivery to the members. We estimate and accrue a reserve for product returns based on our return policies and historical experience. Enrollment package revenue, including any nonrefundable set-up fees, is deferred and recognized over the term of the arrangement, generally twelve months. We bill members for shipping charges and recognize the freight revenue in net sales. Event and training revenue is deferred and recognized as the event or training occurs.
Cost of sales consists primarily of products purchased from third-party manufacturers, freight cost for transporting products to our foreign subsidiaries and shipping products to members, import duties, packing materials, product royalties, costs of promotional materials sold to our members at or near cost, and provisions for slow moving or obsolete inventories. Cost of sales also includes purchasing costs, receiving costs, inspection costs and warehousing costs.
Member commissions
are our most significant expense and are classified as an operating expense. Under our compensation plan, members are paid weekly commissions by our subsidiary in which they are enrolled, generally in their home country currency, for product purchases by their down-line member network across all geographic markets. Our China subsidiary maintains an e-commerce retail platform and does not pay any commissions. This “seamless” compensation plan enables a member located in one country to enroll other members located in other countries where we are authorized to conduct our business. Currently, there are basically two ways in which our members can earn income:
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through commissions paid on product purchases made by their down-line members; and
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through retail markups on sales of products purchased by members at wholesale prices (in the majority of our markets, sales are for personal consumption only and income may not be earned through retail mark-ups on sales in that market).
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Each of our products is designated a specified number of bonus volume points. Commissions are based on total personal and group bonus volume points per weekly sales period. Bonus volume points are essentially a percentage of a product’s wholesale price. As the member’s business expands from successfully enrolling other members who in turn expand their own businesses by selling product to other members, the member receives higher commissions from purchases made by an expanding down-line network. In some of our markets, to be eligible to receive commissions, a member may be required to make nominal monthly or other periodic purchases of our products. Certain of our subsidiaries do not require these nominal purchases for a member to be eligible to receive commissions. In determining commissions, the number of levels of down-line members included within the member’s commissionable group increases as the number of memberships directly below the member increases.
Under our current compensation plan, certain of our commission payouts may be limited to a hard cap dollar amount per week or a specific percentage of total product sales. In some markets, commissions may be further limited. In some markets, we also pay certain bonuses on purchases by up to three generations of personally enrolled members, as well as bonuses on commissions earned by up to three generations of personally enrolled members. Members can also earn income, trips and other prizes in specific time-limited promotions and contests we hold from time to time. Member commissions are dependent on the sales mix and, for the first
three
months of
2017
and
2016
, represented
43%
and
47%
, respectively, of net sales. Occasionally, we make modifications and enhancements to our compensation plan to help motivate members, which can have an impact on member commissions.We may also enter into agreements for business or market development, which could result in additional compensation to specific members.
Selling, general and administrative expenses consist of administrative compensation and benefits (including stock-based compensation), travel, credit card fees and assessments, professional fees, certain occupancy costs, and other corporate administrative expenses. In addition, this category includes selling, marketing, and promotion expenses (including the costs of member training events and conventions). Because our various member conventions are not always held at the same time each year, interim period comparisons will be impacted accordingly.
The functional currency of our international subsidiaries is generally their local currency. Local currency assets and liabilities are translated at the rates of exchange on the balance sheet date, and local currency revenues and expenses are translated at average rates of exchange during the period. Equity accounts are translated at historical rates. The resulting translation adjustments are recorded directly into accumulated other comprehensive income.
Sales by our foreign subsidiaries are generally transacted in the respective local currencies and are translated into U.S. dollars using average rates of exchange for each monthly accounting period to which they relate. Most of our product purchases from third-party manufacturers are transacted in U.S. dollars. Consequently, our sales and net earnings are affected by changes in currency exchange rates, with sales and earnings generally increasing with a weakening U.S. dollar and decreasing with a strengthening U.S. dollar, see “Item 3. Quantitative and Qualitative Disclosures About Market Risk” and more specifically under the caption “Foreign Currency Exchange Risk” for further information.
Results of Operations
The following table sets forth our operating results as a percentage of net sales for the periods indicated.
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Three Months Ended March 31,
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2017
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2016
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Net sales
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100.0
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%
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100.0
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%
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Cost of sales
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18.8
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19.2
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Gross profit
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81.2
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80.8
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Operating expenses:
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Commissions expense
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43.4
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47.2
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Selling, general and administrative expenses
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15.9
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14.7
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Depreciation and amortization
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0.2
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0.1
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Total operating expenses
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59.5
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62.0
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Income from operations
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21.7
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18.8
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Other income (expense), net
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0.3
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—
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Income before income taxes
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22.0
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18.8
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Income tax provision
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4.5
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3.6
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Net income
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17.5
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%
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15.2
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%
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Net
Sales
The following table sets forth revenue by market for the periods indicated (in thousands):
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Three Months Ended March 31,
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2017
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2016
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North America
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$
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1,460
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2.4
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%
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$
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1,063
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1.4
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%
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Hong Kong
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54,567
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91.1
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68,159
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91.7
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China
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1,754
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2.9
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3,315
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4.5
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Taiwan
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1,158
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2.0
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1,225
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1.6
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South Korea
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122
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0.2
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201
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0.3
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Japan
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27
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—
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20
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—
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Singapore
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45
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0.1
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26
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—
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Russia and Kazakhstan
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217
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0.4
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205
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0.3
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Europe
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524
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0.9
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132
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0.2
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Total
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$
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59,874
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100.0
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%
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$
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74,346
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100.0
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%
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Net sales were
$59.9 million
for the
three months ended March 31, 2017
compared with
$74.3 million
for the comparable period a year ago, a decrease of $14.4 million, or
19%
. Hong Kong net sales, substantially all of which were shipped to members residing in China, decreased
$13.6 million
, or
20%
, over the comparable period a year ago. The sales decrease was primarily attributable to the timing of our re-branded Ambassador Academy, an event traditionally held in January of each year that was held in March during 2017.
Outside of our Hong Kong business, net sales decreased
$880,000
, or
14%
, over the comparable
three
month period a year ago, driven by a
47%
decrease in our China e-commerce business, offset by a
297%
increase in Europe and a 37% increase in North America. The $1.6 million net sales decrease in our China e-commerce business was primarily the result of decreased sales of our
Home
product line.
As of
March 31, 2017
, deferred revenue was
$4.3 million
, which primarily consisted of
$1.4 million
pertaining to unshipped product orders,
$2.4 million
pertaining to auto ship advances and
$432,000
pertaining to unamortized enrollment package revenue.
Gross Profit
Gross profit was
81.2%
of net sales for the three months ended
March 31, 2017
compared with
80.8%
of net sales for the three months ended
March 31, 2016
. The gross profit margin percentage increase was primarily due to lower logistics costs.
Commissions
Commissions were
43.4%
of net sales for the three months ended
March 31, 2017
, compared with
47.2%
of net sales for the three months ended
March 31, 2016
. The decrease as a percentage of net sales for the
three
month period ended
March 31, 2017
primarily resulted from lower estimated costs for on-going cash and other incentive programs.
Selling, General and Administrative Expenses
Selling, general and administrative expenses were
$9.5 million
for the
three months ended March 31, 2017
compared with
$10.9 million
in the same period a year ago. Selling, general and administrative expenses decreased by
13%
during the current-year period mainly due to a decrease in employee-related costs offset by an increase in professional fees as compared to the same period in the prior year.
Income Taxes
An income tax provision of
$2.7 million
was recognized during each of the three month periods ended
March 31, 2017
and
2016
. As a result of capital return activities approved by the Board of Directors during the first quarter of 2016 and anticipated future capital return activities, we determined that a portion of our undistributed foreign earnings were no longer deemed reinvested indefinitely by our non-U.S. subsidiaries. We repatriated $19.8 million to the U.S. during the three months ended March 31, 2016, part of which was offset by U.S. net operating losses. Accordingly, the deferred tax liability previously established for undistributed foreign earnings up to existing U.S. net operating losses was reduced. We will continue to periodically reassess the needs of our foreign subsidiaries and update our indefinite reinvestment assertion as necessary. To the extent that additional foreign earnings are not deemed permanently reinvested, we expect to recognize additional income tax provision at the applicable U.S. corporate tax rate.
Liquidity and Capital Resources
At
March 31, 2017
, our cash and cash equivalents totaled
$134.7 million
. Total cash and cash equivalents increased by
$8.8 million
from
December 31, 2016
to
March 31, 2017
. We consider all highly liquid investments with original maturities of three months or less, when purchased, to be cash equivalents. As of
March 31, 2017
, we had
$70.5 million
in available-for-sale investments classified as cash equivalents. In addition, cash and cash equivalents included $128.9 million held in bank accounts overseas, which included
$7.0 million
held in banks located within China subject to foreign currency controls.
As of
March 31, 2017
, the ratio of current assets to current liabilities was
2.60
to 1.00 and we had
$90.2 million
of working capital. Working capital as of
March 31, 2017
increased
$6.1 million
compared to our working capital as of
December 31, 2016
, due primarily to an increase in cash from operations during the
three months ended March 31, 2017
.
Cash provided by operations was
$13.8 million
for the first
three
months of
2017
and remained consistent with the comparable period of
2016
, primarily due to the reduction in inventories and inventory-related deposits.
Cash flows used in investing activities totaled
$72,000
during the first
three
months of
2017
. Software development costs of
$46,000
were incurred during the first
three
months of
2017
for our enhancement of our back office software platform. Cash flows used in investing activities totaled
$240,000
during the first
three
months of 2016 and consisted primarily of buildout costs of $185,000 at our Canadian Healthy Lifestyle Center in Vancouver, British Columbia.
Cash flows used in financing activities during the first
three
months of
2017
consisted solely of dividend payments totaling $5.0 million. Cash flows used in financing activities during the first
three
months of 2016 totaled
$18.9 million
, and consisted primarily of $18.3 million in stock repurchases.
We believe that our existing internal liquidity, supported by cash on hand and cash flows from operations should be adequate to fund normal business operations and address our financial commitments for the foreseeable future.
We do not have any significant unused sources of liquid assets. If necessary, we may attempt to generate more funding from the capital markets, but currently we do not believe that will be necessary.
Our priority is to focus our resources on investing in our most important markets, which we consider to be Greater China and countries where our existing members may have the connections to recruit prospects and sell our products, such as Southeast Asia. We will continue to invest in our Mainland China entity for such purposes as establishing China-based manufacturing capabilities, increasing public awareness of our brand and our products, sourcing more Chinese-made products, building a chain of service stations, opening additional Healthy Lifestyle Centers or branch offices, adding local staffing and other requirements for a China direct selling license application. We also have begun to invest some resources in Central and South America.
Critical Accounting Policies and Estimates
A summary of our significant accounting policies is provided in Note 1 of the Notes to Consolidated Financial Statements in “Item 8. Financial Statements and Supplementary Data” of our Annual Report on Form 10-K filed with the United States Securities and Exchange Commission (SEC) on March 10, 2017. The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reported period. The process of determining significant estimates is fact specific and takes into account historical experience and current and expected economic conditions. To the extent that there are material differences between the estimates and actual results, future results of operations will be affected.
Critical accounting policies and estimates are defined as both those that are material to the portrayal of our financial condition and results of operations and as those that require management’s most subjective judgments. Management believes our critical accounting policies and estimates are those related to revenue recognition, as well as those used in the determination of liabilities related to sales returns, member commissions and income taxes.
Revenue Recognition.
Product sales are recorded when the products are shipped and title passes to independent members. Product sales to members are made pursuant to a member agreement that provides for transfer of both title and risk of loss upon our delivery to the carrier that completes delivery to the members, which is commonly referred to as “F.O.B. Shipping Point.” We primarily receive payment by credit card at the time members place orders. Our sales arrangements do not contain right of inspection or customer acceptance provisions other than general rights of return. Amounts received for unshipped product are recorded as deferred revenue. Such amounts totaled
$1.4 million
and
$2.2 million
at
March 31, 2017
and
December 31, 2016
, respectively. Shipping charges billed to members are included in net sales. Costs associated with shipments are included in cost of sales. Event and training revenue is deferred and recognized as the event or training occurs.
Enrollment package revenue, including any nonrefundable set-up fees, is deferred and recognized over the term of the arrangement, generally twelve months. Enrollment packages provide members access to both a personalized marketing website and a business management system. No upfront costs are deferred as the amount is nominal. At
March 31, 2017
and
December 31, 2016
, enrollment package revenue totaling
$432,000
and
$430,000
was deferred, respectively. Although we have no immediate plans to significantly change the terms or conditions of enrollment packages, any changes in the future could result in additional revenue deferrals or could cause us to recognize the deferred revenue over a longer period of time. Additionally, deferred revenue includes advances for auto ship orders. In certain markets, when a member’s cumulative commission income reaches a certain threshold, a percentage of the member’s weekly commission is held back as an advance and applied to an auto ship order once the accumulated amount of the advances is sufficient to pay for the pre-selected auto ship package of the member. Such advances were
$2.4 million
and
$2.3 million
at
March 31, 2017
and
December 31, 2016
, respectively.
Allowance for Sales Returns.
An allowance for sales returns is provided during the period the product is shipped. The allowance is based upon the return policy of each country, which varies from 14 days to one year, and their historical return rates, which range from 1% to 7% of sales. Sales returns were 1% of sales for the three month periods ended
March 31, 2017
and
2016
. The allowance for sales returns was
$2.2 million
and
$1.6 million
at
March 31, 2017
and
December 31, 2016
, respectively. No material changes in estimates have been recognized during the periods presented.
Commissions.
Independent members earn commissions based on total personal and group bonus volume points per weekly sales period. Each of our products are designated a specified number of bonus volume points, which is essentially a percentage of the product’s wholesale price. We accrue commissions when earned and as the related revenue is recognized and pay commissions on product sales generally two weeks following the end of the weekly sales period.
Independent members may also earn incentives based on meeting certain qualifications during a designated incentive period, which may range from several weeks to up to a year. These incentives may be both monetary and non-monetary in nature. For each individual incentive, we estimate the total number of qualifiers as well as the expected per qualifier cost and accrue all costs associated with incentives throughout the qualification period. We regularly review and update, if necessary, the estimates of both qualifiers and cost as more information is obtained during the qualification period. Any resulting change in total cost is recognized over the remaining qualification period. Accrued commissions, including the estimated cost of our international recognition incentive program and other supplemental programs, totaled
$13.2 million
and
$13.6 million
at
March 31, 2017
and
December 31, 2016
, respectively.
Income Taxes.
Deferred income taxes are recognized for differences between the financial reporting and tax bases of assets and liabilities at enacted statutory rates for the years in which the temporary differences are expected to be recovered or settled. We evaluate the probability of realizing the future benefits of any of our deferred tax assets and record a valuation allowance when we believe a portion or all of our deferred tax assets may not be realized. Deferred tax expense or benefit is a result of changes in deferred tax assets and liabilities. Based on the technical merits of our tax position, tax benefits may be recognized if we determine it is more likely than not that our position will be sustained on examination by tax authorities. The complex nature of these estimates requires us to anticipate the likely application of tax law and make judgments on the largest benefit that has a greater than fifty percent likelihood of being realized prior to the completion and filing of tax returns for such periods. As of
March 31, 2017
, we no longer have a valuation allowance against our U.S. deferred tax assets. We maintain a valuation allowance in certain foreign jurisdictions with an overall tax loss. The valuation allowance will be reduced at such time as management believes it is more likely than not that the deferred tax assets will be realized. Any reductions in the valuation allowance will reduce future income tax provision.
Provision for income taxes depends on the statutory tax rates in each of the jurisdictions in which we operate. An income tax provision of
$2.7 million
was recognized during the three month periods ended
March 31, 2017
and 2016. As a result of capital return activities, we determined that a portion of our current undistributed foreign earnings are no longer deemed reinvested indefinitely by our non-U.S. subsidiaries. We will continue to periodically reassess the needs of our foreign subsidiaries and update our indefinite reinvestment assertion as necessary. To the extent that additional foreign earnings are not deemed permanently reinvested, we expect to recognize additional income tax provision at the applicable U.S. corporate tax rate. As of
March 31, 2017
, we have accrued tax liabilities for earnings that we plan to repatriate out of accumulated earnings in future periods. All undistributed earnings in excess of 50% of current earnings on an annual basis are intended to be reinvested indefinitely as of
March 31, 2017
.
We estimate what our effective tax rate will be for the full fiscal year at each interim reporting period and record a quarterly tax provision based on that estimated effective tax rate. Throughout the year that estimated rate may change based on variations in our business, changes in our corporate structure, changes in the geographic mix and amount of income, applicable tax laws and regulations, communications with tax authorities, as well as our estimated and actual level of annual pre-tax income. We adjust our income tax provision in the reporting period in which the change in our estimated rate occurs so that the year-to-date provision is consistent with the anticipated annual tax rate.