Thursday, February 05, 2015

Crook vs. Crook: Why Former Congressman Michael Grimm is a Dumb Crook

In my first segment of a series of Op-ed articles about white-collar crime on CNBC, I examine the case of former Republican Congressman Michael Grimm who recently pleaded guilty to income tax evasion and awaits sentencing on June 8, 2015.

New York City’s high sales tax rate provides a powerful incentive for businesses to underreport cash sales.

According to the indictment, Michael Grimm skimmed cash sales, reaping an off-the-top 8.875% reward from stealing the sales taxes. Next, Grimm paid some of his employees in cash (off-the-books) thereby evading paying payroll taxes, unemployment insurance, and disability insurance. The net profits Grimm reaped from skimming cash was income tax evasion.

However, as a former FBI special agent, you would expect him to learn from the mistakes of the criminals he busted, but he didn't.

Read my Op-ed here: http://www.cnbc.com/id/102401283.



Written by, Sam E. Antar

Monday, September 08, 2014

Nu Skin Inventory Red Flags Remain Even After $50 Million Impairment Charge

On July 22, 2014, I warned investors that Utah-based multi-level marketing company Nu Skin Enterprises' (NYSE: NUS) surging inventory levels might lead it "to recognize a material impairment charge against inventory in a future period." On August 4, 2014, in a follow-up blog post co-authored with Zac Prensky, we warned investors about a massive inventory pile up in Mainland China. On August 6, 2014, Nu Skin reported its second quarter 2014 financial results and recorded "a $50 million write-down of Mainland China inventory." However, even after the $50 million inventory impairment charge, the pile of remaining unimpaired inventory is equal to enough merchandise to fulfill 335 days of sales versus only 146 days of sales in the comparable second quarter of the previous year. Therefore, there is a high risk that Nu Skin may have to reduce gross margins to clear out excessive inventories and there remains a high risk that it may have to report another material inventory impairment charge.

Background

Days-Sales-in-Inventory (DSI) measures the number of days it takes for a company to turn its inventory into sales. DSI is computed as follows: (Ending inventory/Cost of goods sold during the period) X number of days in the period. If the DSI number grows over time it indicates that a company's inventory turnover is decreasing because it is taking longer periods of time for a company to turn its inventory into sales. A continuously growing DSI can indicate one or more of the following: inventory mismanagement, potential inventory impairment, OR an overstatement of inventories to inflate profits

Second quarter financial results

In the second quarter of 2014, Nu Skin reported $650.0 million of revenues compared to $671.3 million in the second quarter of 2013. Its revenues were $50 million below the $700 million of guidance it gave investors on May 6, 2014. During the second quarter earnings call, CFO Ritch N. Wood said:

So while we reported gross margin for the quarter 76% without this $50 million inventory charge, gross margin would have been a solid 83.7% that's compared to 83.4% in the prior year.

Ritch Wood was quick to offer up pro forma numbers purporting that Nu Skin's gross profit margins would have been higher excluding the $50 million inventory impairment charge. However, he did not offer the flipside of those same pro forma numbers showing that gross inventory levels continued to grow larger excluding the same impairment charge. Without the impairment charge, inventories would have increased to a record $439.7 million in second quarter of 2014 compared to $410.7 million in the previous first quarter. More significantly, days-sales-in-inventory (DSI) would have grown 158% higher to a record 377 days in the second quarter of 2014 versus 146 days in the comparable second quarter of 2013.


Even if we take into account the $50 million inventory impairment, at the end of the second quarter of 2014 Nu Skin carried enough unimpaired inventories to fulfill 335 days of sales versus only 146 days in the comparable second quarter of 2013. Its days-sales-in-inventory was 129% higher in 2014 compared to 2013.

Note: Days-sales-in-inventory (DSI) excluding the effect of the inventory impairment is calculated as follows: [Ending inventory/ (cost of goods sold - impairment charge)] X 91 days. Cost of goods sold - impairment charge = cost of goods sold for unimpaired inventory. Ending inventory reported by Nu Skin is the same as the carrying value of unimpaired inventory.

Risk of reduced gross margins and another material inventory impairment charge

After inventory is impaired, it still physically exists until it is disposed of by the company. It is merely carried on a company's books at its market value. Initially, a company records its inventory at cost. When the value of inventory declines below cost, the company makes the following entries on its books: (1) increase cost of goods sold and (2) increase inventory reserve account. The inventory reserve account is a "contra-asset account" and it reduces the gross value of inventory reported on a company's balance sheet. The inventory value reported on a company's balance sheet is the net of its gross inventory (at cost) less its inventory reserve account (impairment).

In the second quarter 2014, 10-Q report page 14, Nu Skin disclosed "adjustments" to its inventory "carrying value" but did not make it clear whether the impaired inventory was still on hand for future sale (albeit to recover costs) or was actually discarded (trashed as unsaleable):

14. ADJUSTMENT TO INVENTORY
During the second quarter of 2014, the Company made a determination to adjust its inventory carrying value. Heightened media and regulatory scrutiny in Mainland China in the first part of 2014, and the voluntary actions the Company took in response to such scrutiny, had a negative impact on the size of the Company's limited-time offer in June, which significantly reduced its expectations for plans to sell TR90 in a limited-time offer later in 2014 or the beginning of 2015. This resulted in a $50 million write-down of estimated surplus inventory in Mainland China. Total adjustments to the Company's inventory carrying value as of June 30, 2014 and December 31, 2013 were $58.0 million and $5.9 million, respectively. [Emphasis added.]

If Nu Skin still intends to sell its impaired inventory to recover costs, the age of its other unimpaired inventory will invariably grow longer. Even if we assume that Nu Skin trashed $50 million of impaired inventory as unsaleable, the days-sales-in-inventory on its remaining unimpaired inventories will likely continue to grow since it is carrying an excessive level of merchandise while it is projecting significant declines in second half revenues.

Nu Skin projected third quarter 2014 revenues in the range of $620 million to $640 million compared to $908.3 million revenues in same quarter of 2013. It projected fourth quarter 2014 revenues in the range of $650 million to $675 million compared to $1.056 billion in the same quarter of 2013. Its revenue guidance amounts to a decline in second half 2014 revenues of 33% to 35%. At the beginning of the second half of 2014, Nu Skin carried $389.7 million of inventories compared to $178.2 million at the beginning of the second half of 2013. It carried 118.7% more inventories going into the second half 2014. Therefore, it appears that Nu Skin is excessively overstocked at a time when its revenues are expected to significantly decline. That's a significant red flag.

Written by:

Sam E. Antar

Disclosure

I am a convicted felon and a former CPA. As the CFO of Crazy Eddie, I helped mastermind one of the largest securities frauds uncovered during the 1980's. Today, I advise federal and state law enforcement agencies about white-collar crime and train them to identify and catch the crooks. Often, I refer cases to them as an independent whistleblower. I teach about white-collar crime for government entities, businesses, professional organizations, and colleges and universities. I perform forensic accounting services for law firms and other clients.

I do not own any Nu Skin securities long or short.

Monday, August 04, 2014

Why Nu Skin Must Come Clean on Troubling Inventory Red Flags

Co-authored by Sam E. Antar and Zachary Prensky

This coming Wednesday morning, Utah based multi-level marketing company Nu Skin Enterprises (NYSE: NUS) is scheduled to report its second quarter earnings. In its Q1 2014 10-Q report issued in May, major questions were left unanswered as inventories ballooned to $410 million. This pile of inventory is equal to enough merchandise to fulfill 346 days of sales – compared to only 149 days of sales in the comparable first quarter of the previous fiscal year. It's an increase of 132% over the prior year – an enormous red flag that shareholders would have expected management to explain in significant detail.

Rising inventory levels don't square with management's explanation

In its Q1 2014 10-Q report (page 17), Nu Skin claimed that, "we built a large amount of inventory during the first quarter for planned product launches in 2014...." However, Nu Skin’s excuse does not square with its own reported numbers. In reality, the inventory buildup had been going on for some time.

Since 2011, there is a clear and growing trend of inventory pileup – even as management consistently beats its most optimistic revenue guidance. See the chart below:


In the second half of 2013, Nu Skin introduced its ageLOC TR90 weight management system through limited-time offerings in each of its regions. Those sales were carefully choreographed with local management to maximize short term purchases of ageLOC TR90 under the rubric of a limited-time offer (LTO). On the surface, the new product introductions appeared to be highly successful. Revenues during the second half of 2013 rose 78.7% to $1.96 billion compared to $1.099 billion in the second half of 2012 fueled most by growth in Mainland China. In the 2013 10-K report (page 55), management had this to say about ageLOC TR90’s contribution to revenues:

In the second half of 2013, the successful limited-time offers of ageLOC TR90 generated approximately $550 million in revenue with over half of this volume coming from the Greater China region.

However, despite a huge growth in revenues and beating its most optimistic revenue guidance during that period, the amount of time it took Nu Skin to sell its inventory increased 30.2% to 190 days as of 12/31/13 compared to 146 days on 6/30/13, at the start of its launch of ageLOC TR90. This trend took a major ramp in the first quarter of 2014, where for the first time in the company’s history its warehouses are holding enough merchandise to cover practically the next 12 months of sales (346 days). Despite management’s claim that inventory ballooned because of planned product launches, Wall Street analysts seem unimpressed as their most recent consensus estimates call for year-over-year revenue declines during the remainder of 2014.

Inventory purchase obligations compound problem

Companies the size of Nu Skin can’t exactly turn off the manufacturing lines for six months while they whittle down inventory to normalized levels. According to its most recent 10-K report (page 2), Nu Skin utilizes a number of 3rd party contract manufacturers, mainly located in the US (except for China, where the company does its own manufacturing).

Nu Skin must work closely with its raw material suppliers and US contract manufacturers to plan ahead for inventory production as factories of this size cannot be turned on or off on a dime. As disclosed in the 2013 10-K (page 65), at year-end Nu Skin had $155.9 million of minimum outstanding purchase obligations as compared to 2013’s company-wide cost of goods sold of $505.8 million. Curiously, this figure like many important inventory-related metrics is deliberately not disclosed on a quarterly basis.

What has gone largely unnoticed is that in December 2012 the amount of purchase obligations was $32.1 million as compared to 2012's company-wide cost of goods sold of $353.2 million (See 2012 10-K report, page 59). This is a five-fold jump between 2012 and 2013 – yet overall cost of goods sold grew only 43% year-over-year. There is only one geographic location whose revenue grew at more than 100%+ year-over-year and could be responsible for this massive growth in future obligations – China.


What is the composition of Nu Skin's inventory and where is it located?

Nowhere in the 2014 Q1 10-Q report or in the accompanying management call with shareholders on May 6th did the company disclose (a) where the bulk of its inventory is located, and (b) what products comprise the majority of its inventory. These two questions are perhaps the single most important metrics that management needs to disclose on Wednesday in order to determine whether or not Nu Skin is heading for a potentially crippling write-down of inventory. As we noted above, the massive buildup in inventory cannot solely be attributed to planned product launches during the remainder of 2014.

Why is the makeup of the inventory so crucial? This is because a truthful answer to the question would shed light on the biggest question mark hanging over management’s performance to date: Is the massive buildup of inventory in any way related to global missteps with ageLOC TR90 rollouts?

Last year’s global launch of ageLOC TR90 was met with mixed results. For example, during the last two quarters of 2013, 35.6 % Greater China revenue came from limited-time offer (LTO) sales of TR90 compared to only 17.26% for Japan. Are the excess inventories TR90 supplies in China or are they being stored in Japan or some other location with tepid demand?

See the chart below:


Note: In Q4 2013, Nu Skin reduced its revenues going back at least three years to correct an accounting error in classifying certain rebates (2013 10-K report, page 50). The error caused relatively minor changes in previously reported revenues for the first three quarters of 2013. While the company revised its quarterly revenues on a consolidated basis (page 68), it did not revise its quarterly revenues by region. To calculate revenues by region for the last six months of 2013, we subtracted six month revenues from full year revenues for each region. There may be slight discrepancies in revenues numbers for each region during that period. Nu Skin did not report LTO revenues for the individual Americas and EMEA regions. The combined LTO revenues for both regions were computed by subtracting LTO revenues disclosed for other regions from total LTO revenues.

In the Q1 2014 10-Q report (page 13), management hinted at problems with its limited-time offer ageLOC TR90 product launch:

We believe the significant 2013 sales and the three-month supply kit configuration decreased consumer demand in subsequent regional limited-time offers of this product during the first quarter. In addition, TR90 was developed to decrease fat without sacrificing lean muscle. The result is a healthier body composition but not necessarily maximum weight loss. Our research shows that some consumers of TR90 were dissatisfied with the extent of their weight loss. [Emphasis added.]

Management is on record as stating that the customers of ageLOC TR90 were sold on 90 day supplies of product:

TR90 so far has only been sold in LTOs in a three month supply. We believe that consumers will benefit from being able to try the product first before making a three-month commitment. In addition, we have also realized that with weight management probably more than with any other category, it is tough to take a product off the market post LTO. Consumers in weight management just don't enjoy a start again/stop again reality. [Emphasis added.]

Did first time customers use the product for 90 days and then decline to reorder? Is the Chinese subsidiary or some other subsidiary sitting on piles of TR90 refills that are languishing unsold?

With the large cut in active salespeople operating in China ( “Sales Leaders”, Nu Skin’s term for individuals engaged in hawking goods for resale to others, dropped 49% in the quarter due to various regulatory concerns) if global inventory is heavily weighted towards that region, then the oversupply isn’t going to get whittled down anytime soon.

Clearly the 346 day supply of global inventory is sitting somewhere, made up of something. If a large proportion of it is TR90 goods located in geographies where the reorder levels are poor, it is inevitable that Nu Skin shareholders are staring at an imminent inventory write-down. Management doesn’t provide enough quarterly disclosure to support its claims that their “optimism for China remains intact” (transcript, May 6th, 2014 earnings call). If management truly wishes for its shareholders to share such optimism it should start by giving a detailed breakdown on inventory both inside and outside China.

What management must do

It’s very simple: if Nu Skin has hit the wall in getting customers hooked on buying overpriced weight loss pills direct from your neighbor, then the first place you would see the flashing reds lights warning of trouble ahead would be in the inventory buildup. We have shown how it is extremely likely – given the growth in future purchasing obligations – that the inventory buildup is most likely affecting China the most. Providing shareholders with a detailed breakdown of where the inventory is located and what it’s comprised of is the only way these nagging issues can be laid to rest.

Written by,

Sam E. Antar and Zachary Prensky

Disclosure - Sam E. Antar

Sam E. Antar is a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, Mr. Antar helped mastermind one of the largest securities frauds uncovered during the 1980s. Today, he advises federal and state law enforcement agencies about white-collar crime and trains them to identify and catch white-collar criminals. Mr. Antar refers cases to them as an independent whistleblower. He teaches about white-collar crime for government entities, businesses, professional organizations, and colleges and universities. In addition, he performs forensic accounting services for law firms and other clients. Sam E. Antar does not own any Nu Skin securities long or short and has no financial relationship with Zachary Prensky.

Disclosure - Zachary Prensky

At the time of the publication of this report, Zachary Prensky and/or affiliates hold short positions in Nu Skin common stock. More of Mr. Prensky's research can be found at the website of his firm, Little Bear Investments LLC.

Tuesday, July 22, 2014

Do Nu Skin Inventory Red Flags Spell Trouble Ahead?

Last Friday morning, a comment posted on Twitter by Marc Cohodes about Nu Skin Enterprises (NYSE: NUS), a Utah based multi-level marketing company, caught my curiosity. Cohodes is a legendary short-seller with an excellent track record and looks for "fads, frauds, and failures" involving public companies. He wrote, "The Clown who runs NUS tried to squeeze shorts. Screw him! He will get what's coming to him in spades one day. Too much Inventory is an issue." Afterwards, I decided to take a close look at Nu Skin's financial reports. So far, my first issue is that management's explanation for its massive increase in inventory levels does not square against its own historical numbers, guidance it gave to investors, and analysts' consensus estimates. In addition, Nu Skin may be have to take significant margin reductions to unload its excess inventory and possibly have to recognize a material impairment charge against inventory in a future period.

Background

Generally, if a company is efficient at managing its inventory levels, its inventory and cost of goods sold should grow in tandem over time. If a company becomes more efficient at managing its inventory levels, its cost of goods sold will grow faster than inventory reflecting shorter periods of time to turnover its inventory into revenues. However, over the last seven quarters, Nu Skin's reported inventory levels grew significantly faster than its growth in cost of goods sold resulting in longer periods of time to turn its inventory into sales.

A more troubling issue is that Nu Skin's reported revenues exceeded its own maximum revenue projections while its inventory turnover decreased for each of the last seven quarters. In two of those seven quarters, Nu Skin beat its maximum revenue guidance by over $90 million. Generally, it provided revenue guidance for the current quarter approximately 4 to 5 weeks into same quarter. Therefore, Nu Skin already possessed several weeks of sales data before it provided revenue guidance for the entire 13 week quarterly period. Since Nu Skin's reported revenues exceeded its most optimistic forecasts within a relatively short period of time, its inventory turnover should have increased because it should have ended the period with fewer inventories on hand than it had anticipated. However, an analysis of Nu Skin's numbers indicates that it is taking progressively longer periods of time to turn its inventory into sales.

Calculations

Days-Sales-in-Inventory (DSI) measures the number of days it takes for a company to turn its inventory into sales. DSI is computed as follows: (Ending inventory/Cost of goods sold during the period) X number of days in period. If the DSI number grows over time it indicates that a company's inventory turnover is decreasing because it is taking longer periods of time for a company to turn its inventory into sales. In general, a growing DSI could indicate one or more of the following potential red flags:
  1. A company is mismanaging its inventory,
  2. A company may be required to reduce gross margins in future periods to sell slow moving products to normalize inventory levels,
  3. A company may be required to take a one-time material impairment charge against earnings in a future period to write-down to the cost of slow moving or obsolete inventory to its lower market value, or
  4. A company is possibly inflating inventory numbers to overstate income by either fabricating inventory numbers or by its failure to write-down inventory to market value.
Click on the image below to enlarge it.



Note: In Q4 2013, Nu Skin reduced its revenues and selling expense going back at least three years to correct an accounting error in classifying certain rebates. According to the company, the reclassification had no effect on gross profit, operating income, net income or comprehensive income, the consolidated balance sheet or cash flow (2013 10-K report page 50). However, the error caused relatively small changes in previously reported revenues. For 2012 and 2013, I used the revised quarterly revenue numbers tucked inside page 68 of its 2013 10-K report. However, Nu Skin did not disclose the effect of the revenue correction on 2011's quarterly numbers. Therefore, I used 2011's quarterly revenue numbers as they were originally reported in filings with the S.E.C. to make comparisons against management's 2011 quarterly revenue guidance. The error had no effect on DSI calculations.

Huge surge in inventories during latest quarter

In the latest quarter ended March 31, 2014 (Q1 2014), Nu Skin's reported revenues exceeded its maximum revenue projection by $1.1 million. Its cost of goods sold increased by 18.6% over the previous year's first quarter (Q1 2013). However, its inventories mushroomed 175.5% to $410.7 million compared to $149.1 million in the same period of the previous year. It took Nu Skin 346.4 days to turn its inventory into sales in Q1 2014 compared to only 149.1 days in Q1 2013, an increase of 132.3% extra days to sell its products. In Q1 2014, DSI was over three times the level it was in Q1 2011.

Rising inventory levels don't square with management's explanation

In its Q1 2014 10-Q report, Nu Skin claimed that, "we built a large amount of inventory during the first quarter for planned product launches in 2014...." However, its disproportionate buildup in inventories does not square against its own historical numbers, guidance it gave to investors, and analysts' consensus projections. DSI has been progressively growing from 2011 levels. (Click on the image below to enlarge it.)


In Q1 2013, Nu Skin turned its inventory into sales 0.6 times (cost of goods sold $90 million/inventory $149.1 million). In Q1 2014, its inventory mushroomed to $410.7 million. To maintain the same rate of inventory turnover in Q1 2014 as it did in Q1 2013, Nu Skin would have needed to sell inventory costing it $247.9 million during Q1 2014 (Q1 2013 inventory turnover 0.6 X Q1 2014 inventory $410.7 million). In Q1 2014, Nu Skin realized revenues on its inventory at a multiple of 6.29 times its cost ($671.1 million revenues/$106.7 million cost of goods sold). Therefore, the approximate amount of revenues required for Nu Skin to maintain its historical level of inventory turnover without eroding gross profit margins was $1.559 billion for that quarter.

However, Nu Skin reported only $671.1 million revenues for Q1 2014. In May 2014, Nu Skin projected only $700 million of revenues for Q2 2014. The current analyst consensus estimate for Q2 2012 is $712.2 million in revenues, Q3 2014 is $858.5 million in revenues, and Q4 2014 is $948.2 million in revenues. The analyst consensus estimate for revenues in full year 2014 is $3.19 billion, slightly higher than revenues of $3.17 billion reported for 2013.

There are plenty of other issues of concern involving Nu Skin's multi-level marketing business model, domestic and foreign regulatory issues, its apparent dislike of whistleblowers and financial disclosures, but it will have to wait for another day. If Nu Skin's management does not act like mature grownups, I might make investigating and reporting about the company my new hobby. Right now, I have my doubts on management's story about its disproportionately huge rise in inventory levels.

Written by:

Sam E. Antar

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could. If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today. I do not want or seek forgiveness for my vicious crimes from my victims. My past sins are unforgivable.

There is a saying, "It takes one to know one." I've done professional work for the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify fraud and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. In addition, I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities. In addition, I perform forensic accounting services for law firms and other clients.

I do not own any Nu Skin securities long or short and I have no financial relationship with Marc Cohodes, but in 2011 he did name a rooster after me. PricewaterhouseCoopers, Nu Skin's auditors, has sponsored many events where I appeared as a speaker on accounting irregularities, securities fraud, and other white-collar crime.

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