NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. NATURE OF OPERATIONS, BASIS OF PRESENTATION AND CONSOLIDATION
Nature of Operations
Natural Health Trends Corp., a Delaware corporation (whether or not including its subsidiaries, the “Company”), is an international direct-selling and e-commerce company. Subsidiaries controlled by the Company sell personal care, wellness, and “quality of life” products under the “NHT Global” brand.
The Company’s wholly-owned subsidiaries have an active physical presence in the following markets: the Americas, which consists of the United States, Canada, Cayman Islands, Mexico and Peru; Greater China, which consists of Hong Kong, Taiwan and China; Southeast Asia, which consists of Singapore, Malaysia, Thailand and Vietnam; South Korea; Japan; India; and Europe. The Company also operates in Russia and Kazakhstan through an engagement with a local service provider.
Basis of Presentation
The unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. As a result, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. In the opinion of management, the accompanying unaudited interim consolidated financial statements contain all adjustments, consisting of normal recurring adjustments, considered necessary for a fair statement of the Company’s financial information for the interim periods presented. The results of operations of any interim period are not necessarily indicative of the results of operations to be expected for the fiscal year. These consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s 2018 Annual Report on Form 10-K filed with the United States Securities and Exchange Commission (SEC) on April 26, 2019.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and all of its wholly-owned subsidiaries. All significant inter-company balances and transactions have been eliminated in consolidation.
Reclassification
Certain prior year amounts in the balance sheet have been reclassified to conform to current year presentation.
Recent Accounting Pronouncements
In February 2016, the FASB established Topic 842,
Leases
, by issuing ASU No. 2016-02, which requires lessees to recognize the rights and obligations created by leases on the balance sheet and disclose key information about leasing arrangements. Topic 842 was subsequently amended by ASU No. 2018-11,
Targeted Improvements, ASU No. 2018-10, Codification Improvements to Topic 842
, and ASU No. 2018-01,
Land Easement Practical Expedient for Transition to Topic 842
. The new standard establishes a right-of-use (ROU) model that requires a lessee to recognize a ROU asset and lease liability on the balance sheet for all leases with a term longer than 12 months. Leases are classified as finance or operating, with classification affecting the pattern and classification of expense recognition in the statement of operations. Effective January 1, 2019, the Company adopted the new standard using the effective date as its date of initial application. The new standard provided a number of optional practical expedients in transition. The Company elected the “package of practical expedients”, which permits entities not to reassess under the new lease standard prior conclusions about lease identification, lease classification and initial direct costs. Upon adoption, the Company recognized operating lease liabilities on its balance sheet for
$4.5 million
, with corresponding ROU assets of the same amount based on the present value of the remaining minimum rental payments under current leasing standards for existing operating leases. See Note 7 for additional information.
In August 2018, the SEC issued Release No. 33-10532 that amends and clarifies certain financial reporting requirements. The principal change to the Company’s financial reporting is the requirement to disclose in interim periods on Form 10-Q the changes in stockholder’s equity as prescribed by Rule 3-04 of Regulation S-X.
Other recently issued accounting pronouncements did not or are not believed by management to have a material impact on the Company’s present or future financial statements.
2. REVENUE
Revenue Recognition
All revenue is recognized when the performance obligations under a contract are satisfied. Product sales are recognized 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 the Company’s delivery to the carrier that completes delivery to the members, which is commonly referred to as “F.O.B. Shipping Point.” The Company’s sales arrangements do not contain right of inspection or customer acceptance provisions other than general rights of return. These contracts are generally short-term in nature.
Actual product returns are recorded as a reduction to net sales. The Company estimates and accrues a reserve for product returns based on its return policies and historical experience. The reserve 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
5%
of sales. Sales returns were
2%
for each of the
three months ended
March 31, 2019
and
2018
, respectively. No material changes in estimates have been recognized during the periods presented. See Note 5 for additional information.
The Company has elected to account for shipping and handling activities performed after title has passed to members as a fulfillment cost, and accrues for the costs of shipping and handling if revenue is recognized before the contractually obligated shipping and handling activities occurs. 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. Costs of events and member training are included within selling, general and administrative expenses.
Various taxes on the sale of products to members are collected by the Company as an agent and remitted to the respective taxing authority. These taxes are presented on a net basis and recorded as a liability until remitted to the respective taxing authority.
Deferred Revenue
The Company primarily receives payment by credit card at the time members place orders. Amounts received for unshipped product are considered a contract liability and are recorded as deferred revenue. The decrease in deferred revenue for the three months ended
March 31, 2019
is primarily due to
$5.0 million
of revenue recognized during the quarter that was included in deferred revenue as of December 31, 2018 offset by
$2.0 million
of cash payments received for unshipped product during the first quarter. See Note 4 for additional information.
Disaggregation of Revenue
The Company sells products to a member network that operates in a seamless manner from market to market, except for the Chinese market where it sells to consumers through an e-commerce retail platform and the Russia and Kazakhstan market where the Company operates through an engagement of a third-party service provider.
The following table sets forth revenue by market for the periods indicated (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended March 31,
|
|
2019
|
|
2018
|
Americas
1
|
$
|
1,515
|
|
|
7.8
|
%
|
|
$
|
1,536
|
|
|
2.9
|
%
|
Hong Kong
2
|
15,366
|
|
|
79.5
|
|
|
47,619
|
|
|
91.0
|
|
China
|
1,056
|
|
|
5.5
|
|
|
1,259
|
|
|
2.4
|
|
Taiwan
|
634
|
|
|
3.3
|
|
|
1,061
|
|
|
2.0
|
|
South Korea
|
106
|
|
|
0.5
|
|
|
119
|
|
|
0.2
|
|
Japan
|
44
|
|
|
0.2
|
|
|
65
|
|
|
0.1
|
|
Singapore
|
12
|
|
|
0.1
|
|
|
31
|
|
|
0.1
|
|
Malaysia
|
34
|
|
|
0.2
|
|
|
43
|
|
|
0.1
|
|
Russia and Kazakhstan
|
218
|
|
|
1.1
|
|
|
203
|
|
|
0.4
|
|
Europe
|
343
|
|
|
1.8
|
|
|
431
|
|
|
0.8
|
|
Total
|
$
|
19,328
|
|
|
100.0
|
%
|
|
$
|
52,367
|
|
|
100.0
|
%
|
1
United States, Canada, Mexico and Peru
2
Substantially all of our Hong Kong revenues are derived from the sale of products that are delivered to members in China. See “Item 1A. Risk Factors” in our most recent Annual Report on Form 10-K.
The Company’s net sales by product and service are as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
Three Months Ended March 31,
|
|
2019
|
|
2018
|
Product sales
|
$
|
18,523
|
|
|
$
|
49,365
|
|
Freight and other
|
1,500
|
|
|
3,752
|
|
Less: sales returns
|
(695
|
)
|
|
(750
|
)
|
Total net sales
|
$
|
19,328
|
|
|
$
|
52,367
|
|
Concentration
No single market other than Hong Kong had net sales greater than 10% of total net sales. Sales are made to the Company’s members and no single customer accounted for 10% or more of net sales for the
three months ended
March 31, 2019
and
2018
. However, the Company’s business model can result in a concentration of sales to several different members and their network of members. Although no single member accounted for 10% or more of net sales, the loss of a key member or that member’s network could have an adverse effect on the Company’s net sales and financial results.
Arrangements with Multiple Performance Obligations
The Company’s contracts with customers may include multiple performance obligations. For such arrangements, the Company allocates revenues to each performance obligation based on its relative standalone selling price. The Company generally determines standalone selling prices based on the prices charged for individual products to similar customers.
Practical Expedients
The Company generally expenses sales commissions when incurred because the amortization period would have been one year or less. These costs are recorded in commissions expense.
The Company does not provide certain disclosures about unsatisfied performance obligations for contracts with an original expected length of one year or less.
3. NET INCOME (LOSS) PER COMMON SHARE
Diluted net income per common share is determined using the weighted-average number of common shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents. The dilutive effect of non-vested restricted stock is reflected by application of the treasury stock method. Under the treasury stock method, the amount of compensation cost for future service that the Company has not yet recognized and the amount of tax benefit that would be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares.
The following tables illustrate the computation of basic and diluted net income (loss) per common share for the periods indicated (in thousands, except per share data):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended March 31,
|
|
2019
|
|
2018
|
|
Income (loss)
(Numerator)
|
|
Shares
(Denominator)
|
|
Per Share Amount
|
|
Income (loss)
(Numerator)
|
|
Shares
(Denominator)
|
|
Per Share Amount
|
Basic net income (loss) per common share:
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) available to common stockholders
|
$
|
(1,923
|
)
|
|
11,333
|
|
|
$
|
(0.17
|
)
|
|
$
|
8,824
|
|
|
11,286
|
|
|
$
|
0.78
|
|
Effect of dilutive securities:
|
|
|
|
|
|
|
|
|
|
|
|
Non-vested restricted stock
|
—
|
|
|
—
|
|
|
|
|
|
—
|
|
|
2
|
|
|
|
|
Diluted net income per common share:
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) available to common stockholders plus assumed conversions
|
$
|
(1,923
|
)
|
|
11,333
|
|
|
$
|
(0.17
|
)
|
|
$
|
8,824
|
|
|
11,288
|
|
|
$
|
0.78
|
|
In periods when losses are reported, the weighted-average number of common shares outstanding excludes common stock equivalents because their inclusion would be anti-dilutive. As such, non-vested restricted stock totaling
196
s
hares were not included for the
three
months ended
March 31, 2019
.
4. BALANCE SHEET COMPONENTS
The components of certain balance sheet amounts are as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
March 31, 2019
|
|
December 31, 2018
|
Cash, cash equivalents and restricted cash:
|
|
|
|
Cash
|
$
|
32,722
|
|
|
$
|
47,323
|
|
Cash equivalents
|
85,977
|
|
|
85,330
|
|
|
118,699
|
|
|
132,653
|
|
Restricted cash
|
3,068
|
|
|
2,998
|
|
|
$
|
121,767
|
|
|
$
|
135,651
|
|
Inventories:
|
|
|
|
Finished goods
|
$
|
11,608
|
|
|
$
|
11,171
|
|
Raw materials
|
1,221
|
|
|
1,145
|
|
Reserve for obsolescence
|
(519
|
)
|
|
(151
|
)
|
|
$
|
12,310
|
|
|
$
|
12,165
|
|
Other accrued expenses:
|
|
|
|
Sales returns
|
$
|
508
|
|
|
$
|
801
|
|
Employee-related expense
|
2,770
|
|
|
4,051
|
|
Warehousing, inventory-related and other
|
1,545
|
|
|
1,269
|
|
|
$
|
4,823
|
|
|
$
|
6,121
|
|
Deferred revenue:
|
|
|
|
Unshipped product
|
$
|
1,581
|
|
|
$
|
4,574
|
|
Auto ship advances
|
1,928
|
|
|
1,876
|
|
Other
|
245
|
|
|
345
|
|
|
$
|
3,754
|
|
|
$
|
6,795
|
|
5. FAIR VALUE MEASUREMENTS
As of
March 31, 2019
, cash and cash equivalents include the Company’s investments in debt securities, comprising municipal notes and bonds and corporate debt, commercial paper, money market funds and time deposits. The Company considers all highly liquid investments with original maturities of three months or less when purchased and have insignificant interest rate risk to be cash equivalents. Debt securities classified as cash equivalents are required to be accounted for in accordance with the FASB Accounting Standards Codification (“ASC”) 320,
Investments - Debt and Equity Securities
. As such, the Company determined its investments in debt securities held at
March 31, 2019
should be classified as available-for-sale and are carried at fair value with unrealized gains and losses reported in accumulated other comprehensive income in stockholders’ equity. The cost of debt securities is adjusted for amortization of premiums and discounts to maturity. This amortization is included in other income. Realized gains and losses, as well as interest income, are also included in other income. The fair values of securities are based on quoted market prices.
The carrying amounts of the Company’s financial instruments, including cash and cash equivalents and accounts payable, approximate fair value because of their short maturities. The carrying amount of the noncurrent restricted cash approximates fair value since, absent the restrictions, the underlying assets would be included in cash and cash equivalents.
Accounting standards permit companies, at their option, to choose to measure many financial instruments and certain other items at fair value. The Company has elected to not fair value existing eligible items.
Available-for-sale investments included in cash equivalents at the end of each period were as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
March 31, 2019
|
|
December 31, 2018
|
|
Adjusted Cost
|
|
Gross Unrealized Losses
|
|
Fair Value
|
|
Adjusted Cost
|
|
Gross Unrealized Losses
|
|
Fair Value
|
Municipal bonds and notes
|
$
|
4,188
|
|
|
$
|
—
|
|
|
$
|
4,188
|
|
|
$
|
12,149
|
|
|
$
|
(7
|
)
|
|
$
|
12,142
|
|
Corporate debt securities
|
48,535
|
|
|
(16
|
)
|
|
48,519
|
|
|
51,862
|
|
|
(26
|
)
|
|
51,836
|
|
Financial institution instruments
|
33,270
|
|
|
—
|
|
|
33,270
|
|
|
21,352
|
|
|
—
|
|
|
21,352
|
|
Total available-for-sale investments
|
$
|
85,993
|
|
|
$
|
(16
|
)
|
|
$
|
85,977
|
|
|
$
|
85,363
|
|
|
$
|
(33
|
)
|
|
$
|
85,330
|
|
Financial institution instruments include instruments issued or managed by financial institutions such as money market fund deposits and time deposits.
FASB Topic 820,
Fair Value Measurements
, establishes a fair value hierarchy that requires the use of observable market data, when available, and prioritizes the inputs to valuation techniques used to measure fair value in the following categories:
Level 1: Quoted market prices in active markets for identical assets or liabilities.
Level 2: Observable market-based inputs or unobservable inputs that are corroborated by market data.
Level 3: Unobservable inputs that are not corroborated by market data.
The tables below present the Company’s hierarchy for assets measured at fair value on a recurring basis as of March 31, 2019 and December 31, 2018.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
March 31, 2019
|
|
Level 1
|
|
Level 2
|
|
Level 3
|
|
Total
|
Amounts included in cash and cash equivalents
|
$
|
85,977
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
85,977
|
|
Total assets measured at fair value on a recurring basis
|
$
|
85,977
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
85,977
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2018
|
|
Level 1
|
|
Level 2
|
|
Level 3
|
|
Total
|
Amounts included in cash and cash equivalents
|
$
|
85,330
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
85,330
|
|
Total assets measured at fair value on a recurring basis
|
$
|
85,330
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
85,330
|
|
6. STOCKHOLDERS’ EQUITY
Dividends
The following table summarizes the Company’s cash dividend activity for the
three months ended
March 31, 2019
(in thousands, except per share data):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Declaration Date
|
|
Per Share
|
|
Amount
|
|
Record Date
|
|
Payment Date
|
January 27, 2019 (special)
|
|
0.08
|
|
|
$
|
912
|
|
|
March 5, 2019
|
|
March 15, 2019
|
January 27, 2019
|
|
0.16
|
|
|
$
|
1,824
|
|
|
March 5, 2019
|
|
March 15, 2019
|
|
|
$
|
0.24
|
|
|
$
|
2,736
|
|
|
|
|
|
Declaration and payment of any future dividends on shares of common stock will be at the discretion of the Company’s Board of Directors.
Stock Repurchases
On January 12, 2016, the Board of Directors authorized an increase to the Company’s stock repurchase program first approved on July 28, 2015 from
$15.0 million
to
$70.0 million
. Repurchases are expected to be executed to the extent that the
Company’s earnings and cash-on-hand allow, and will be made in accordance with all applicable securities laws and regulations, including Rule 10b-18 of the Exchange Act. For all or a portion of the authorized repurchase amount, the Company may enter into one or more plans that are compliant with Rule 10b5-1 of the Exchange Act that are designed to facilitate these purchases. The stock repurchase program does not require the Company to acquire a specific number of shares, and may be suspended from time to time or discontinued. As of
March 31, 2019
,
$32.0 million
of the
$70.0 million
stock repurchase program approved on July 28, 2015 and increased on January 12, 2016 remained available for future purchases, inclusive of related estimated income tax.
Restricted Stock
At the Company’s annual meeting of stockholders held on April 7, 2016, the Company’s stockholders approved the Natural Health Trends Corp. 2016 Equity Incentive Plan (the “2016 Plan”) to replace its 2007 Equity Incentive Plan. The 2016 Plan allows for the grant of various equity awards including incentive stock options, non-statutory options, stock, stock units, stock appreciation rights and other similar equity-based awards to the Company’s employees, officers, non-employee directors, contractors, consultants and advisors of the Company. Up to
2,500,000
shares of the Company’s common stock (subject to adjustment under certain circumstances) may be issued pursuant to awards granted. At
March 31, 2019
,
2,337,068
shares remained available for issuance under the 2016 Plan.
On February 1, 2019, the Company granted
22,603
shares of restricted common stock under the 2016 Plan to certain employees for the purpose of further aligning their interest with those of its stockholders and settling fiscal 2018 performance incentives totaling
$377,000
. The shares vest on a quarterly basis over the next three years and are subject to forfeiture in the event of their termination of service to the Company under specified circumstances.
The following table summarizes the Company’s restricted stock activity under the 2016 Plan:
|
|
|
|
|
|
|
|
|
Shares
|
|
Wtd. Avg. Price at Date of Issuance
|
Nonvested at December 31, 2018
|
45,486
|
|
|
$
|
21.61
|
|
Granted
|
22,603
|
|
|
16.67
|
|
Vested
|
(13,553
|
)
|
|
24.96
|
|
Nonvested at March 31, 2019
|
54,536
|
|
|
18.73
|
|
Accumulated Other Comprehensive Loss
The changes in accumulated other comprehensive loss by component for the first
three
months of 2019 were as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Foreign Currency Translation Adjustment
|
|
Unrealized Gains/(Losses) on Available-For-Sale Investments
|
|
Total
|
Balance, December 31, 2018
|
$
|
(1,217
|
)
|
|
$
|
(33
|
)
|
|
$
|
(1,250
|
)
|
Other comprehensive income
|
259
|
|
|
17
|
|
|
276
|
|
Balance, March 31, 2019
|
$
|
(958
|
)
|
|
$
|
(16
|
)
|
|
$
|
(974
|
)
|
7. LEASES
The Company leases
9,600
square feet of office space in Hong Kong with a term expiring in February 2021.
The Company leases
4,900
square feet of office space in Rolling Hills Estates, California with a term expiring in September 2025. To help further develop the market for its products in North America, the Company leases
2,400
,
1,600
and
2,000
square feet of retail space in Monterey Park, California, Richmond, British Columbia, and Metuchen, New Jersey, respectively. The Monterey Park, Richmond and Metuchen locations have terms expiring in August 2020, February 2021, and November 2022, respectively.
The Company leases
9,000
square feet of office and retail space in Peru with a term expiring in July 2019. The Company leases
nine
branch offices throughout China, and additional office space in Japan, Taiwan, South Korea, Singapore, Malaysia,
Vietnam, Indonesia, Thailand, and the Cayman Islands. The Company also leases a multi-purpose facility and factory in Zhongshan, China and
11
service stations throughout the city of Guangzhou, China that serve or will in the future serve the needs of its Chinese consumers. The Company contracts with third parties for fulfillment and distribution operations in all of its international markets. None of the Company’s third party logistics contracts contain a lease as the Company does not have the right to access the warehouses or move its inventories at will.
The components of lease cost for the three months ended March 31, 2019 were as follows (in thousands):
|
|
|
|
|
Operating leases
|
$
|
509
|
|
Short-term leases
|
66
|
|
Total lease cost
|
$
|
575
|
|
Cash paid for amounts included in the measurement of operating leases liabilities was
$511,000
for the three months ended March 31, 2019.
The weighted-average remaining lease term and discount rate related to operating leases as of March 31, 2019 were as follows:
|
|
|
|
Weighted-average remaining lease term (in years)
|
3.4
|
|
Weighted-average discount rate
|
5.5
|
%
|
As most of our leases do not provide an implicit rate, the Company used its incremental borrowing rate, or the rate of each of its subsidiaries if available, based on the information available at the lease commencement date to determine the present value of lease payments.
The annual scheduled lease payments of our operating lease liabilities as of March 31, 2019 were as follows (in thousands):
|
|
|
|
|
Remainder of 2019
|
$
|
1,435
|
|
2020
|
1,566
|
|
2021
|
530
|
|
2022
|
403
|
|
2023
|
247
|
|
Thereafter
|
400
|
|
Total lease payments
|
$
|
4,581
|
|
Less: imputed interest
|
(474
|
)
|
Present value of lease liabilities
|
$
|
4,107
|
|
For all asset classes, the Company elected not to recognize assets or liabilities at the acquisition date for leases that, at the acquisition date, have a remaining lease term of 12 months or less. Additionally, for all asset classes, the Company choose not to separate nonlease components from lease components and instead account for the combined lease and nonlease components associated with that lease component as a single lease component.
8. INCOME TAXES
The effective income tax rate for the three months ended March 31, 2019 was impacted by recording the effect of the Tax Cuts and Jobs Act (the “Tax Act”), enacted on December 22, 2017 by the U.S. government. The Tax Act makes broad and complex changes to the Internal Revenue Code of 1986, as amended, which has affected the Company’s quarter ended March 31, 2019, including, but not limited to, requiring an annual tax on the earnings and profits of any greater than 10% owned foreign controlled corporation.
On December 22, 2017, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 118 (“SAB 118”), which provides guidance on accounting for tax effects of the Tax Act. SAB 118 provided a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740,
Income Taxes
. In accordance with the expiration of the SAB 118 measurement period, we completed the assessment of the
income tax effect of the Tax Act for the year ended December 31, 2017 in the fourth quarter of tax year 2018. All adjustments recorded to the provisional amounts have been included as an adjustment to income tax expense.
As a result of the Tax Act, the Company recorded additional income tax expense due to the Global Intangible Low Taxed Income inclusion on current earnings and profits of greater than 10% owned foreign controlled corporations (“GILTI”). To determine the amount of GILTI inclusion, the Company must determine, in addition to other factors, the current earnings of foreign controlled corporations, as well as the amount of foreign taxes paid by the foreign entities. The law provides that corporate taxpayers may benefit from a 50% reduction in the GILTI inclusion, subject to certain limitations, which effectively reduces the 21% U.S. corporate tax rate on the foreign income to an effective rate of 10.5%. The GILTI inclusion further provides for a foreign tax credit in connection with the foreign taxes paid. The Company is projecting to record income tax expense for GILTI of
$140,000
, net of
$473,000
foreign tax credits for the year ending December 31, 2019. Such projected expense has been included in the effective tax rate applied to the quarter.
As of March 31, 2019, the Company does not have a valuation allowance against its U.S. deferred tax assets. The Company analyzed all sources of available income and determined that they are more likely than not to realize the tax benefits of their deferred assets.
As of March 31, 2019, the Company has a valuation allowance against certain foreign deferred tax assets. The Company is recording a valuation allowance in foreign jurisdictions with an overall net operating 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.
As of March 31, 2019, the Company has
no
U.S. federal net operating loss or credit carryforwards as any attributes generated are expected to be fully utilized to offset tax in the current year. At December 31, 2018, the Company had foreign net operating loss carryforwards of approximately
$1.2 million
in various jurisdictions with various expirations.
As a result of capital return activities, the Company determined that a portion of its current undistributed foreign earnings is no longer deemed reinvested indefinitely by its non-U.S. subsidiaries. For state income tax purposes, the Company will continue to periodically reassess the needs of its foreign subsidiaries and update its indefinite reinvestment assertion as necessary. To the extent that additional foreign earnings are not deemed permanently reinvested, the Company expects to recognize additional income tax provision at the applicable state corporate income tax rate. As of March 31, 2019, the Company has recorded a state deferred tax liability for earnings that the Company plans to repatriate out of accumulated earnings in future periods. Due to the Tax Act, repatriation from foreign subsidiaries will be offset with a dividends received deduction, resulting in little to no impact on federal tax expense. All undistributed earnings in excess of 50% of current earnings on an annual basis are intended to be reinvested indefinitely as of March 31, 2019.
The Company and its subsidiaries file tax returns in the United States, California, New Jersey and Texas and various foreign jurisdictions. During the fourth quarter of 2018, the Company was notified that it was selected for audit of the 2016 tax year by the U.S. Internal Revenue Service. For purposes of this audit, fiscal years 2007 through 2016 are open for examination by tax authorities as a result of net operating loss carryovers from older years being used to offset income in recent tax years. No adjustments have been proposed at this time. The Company is no longer subject to state income tax examinations for years prior to 2014. No other jurisdictions are currently examining any income tax returns of the Company.
9. COMMITMENTS AND CONTINGENCIES
Securities Class Action
On January 8, 2019, the Company and its
two
executive officers were named in a putative securities class action filed in the United States District Court for the Central District of California, captioned
Kauffman v. Natural Health Trends Corp.
, Case No. 2:19-cv-00163. The complaint purports to assert claims on behalf of all persons who purchased or otherwise acquired our common stock between April 27, 2016 and January 5, 2019, inclusive, under (i) Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 promulgated thereunder against the Company and Chris T. Sharng and Timothy S. Davidson (together, the “Individual Defendants”), and (ii) Section 20(a) of the Exchange Act against the Individual Defendants. The complaint alleges, in part, that the Company made materially false and misleading statements regarding the legality of its business operations in China, including running an allegedly illegal multilevel marketing business. The complaint seeks an indeterminate amount of damages, plus interest and costs. On May 3, 2019, the court issued an order appointing Xia Yang as lead plaintiff and appointing The Rosen Law Firm, P. A. as lead counsel. The plaintiff has until June 3, 2019 to file an amended complaint. Defendants believe that these claims are without merit and intend to vigorously defend against them.
Other Matters
The Company is currently involved in a legal matter with one of its vendors and an outside party. Per the royalty agreement with the vendor, the Company believes that it is fully indemnified in the event of an unfavorable outcome and any potential settlement costs related to the matter would be fully covered by the Company’s vendor.
Since August 2016, the SEC has been conducting a non-public investigation to determine whether there have been violations of the federal securities laws relating to the trading of the Company’s securities. The Company has fully cooperated with the SEC and has and continues to provide documents in response to subpoenas. The SEC has expressly stated that its document requests should not be construed as an indication that any violation of law has occurred, or as a reflection upon any person, entity, or security. The amount of time needed to resolve this matter is uncertain, and the Company cannot predict the outcome or whether it will face additional governmental inquiries or other actions.
10. RELATED PARTY TRANSACTIONS
In February 2013, the Company entered into a Royalty Agreement and License with Broady Health Sciences, L.L.C., a Texas limited liability company, (“BHS”) regarding the manufacture and sale of a product called
ReStor™
. George K. Broady, a director of the Company and beneficial owner of more than
5%
of its outstanding common stock, is owner of BHS. Under the agreement, the Company agreed to pay BHS a royalty based on a price per unit in return for the right to manufacture (or have manufactured), market, import, export and sell this product worldwide, with certain rights being exclusive outside the United States. Such royalties were
$27,000
and
$83,000
for the three months ended
March 31, 2019
and
2018
, respectively. The Company is not required to purchase any product under the agreement, and the agreement may be terminated at any time on
120 days
’ notice or, under certain circumstances, with no notice. Otherwise, the agreement terminates March 31, 2020.
The Company procured in China and arranged for shipment to The Aberdeen Group, LLC (“Aberdeen”)
one
order of apparel products in the amount of
$7,100
during the three months ended March 31, 2019. Aberdeen is owned
40%
by Sharng Holdings, which is wholly-owned by the Company’s president, Chris T. Sharng, and his wife,
40%
by Mr. Broady, and
20%
by an unrelated third party. Aberdeen promptly paid the Company for the product and shipping cost incurred. Given the Company’s provision of such product sourcing service to Aberdeen, Aberdeen also paid the Company a market-based fee consistent with the provision of such service of
$420
. The Company analyzed the nature of the transaction with Aberdeen to determine whether it could be construed a violation under the guidelines of Section 402 of the Sarbanes-Oxley Act of 2002. The Company, through advice from its legal counsel, concluded that there is not a reasonable possibility that the transaction with Aberdeen would be deemed a violation of Section 402. This relationship between the Company and Aberdeen ceased following the completion of this transaction.