UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


 

FORM 10-Q

(Mark One)

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

For the quarterly period ended September 30, 2006

 

 

OR

 

 

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

For the transition period from                       to                            

 

Commission file number: 0-21116


USANA HEALTH SCIENCES, INC.

(Exact name of registrant as specified in its charter)

 

Utah

 

87-0500306

(State or other jurisdiction

 

(I.R.S. Employer

of incorporation or organization)

 

Identification No.)

 


 

3838 West Parkway Blvd., Salt Lake City, Utah 84120

(Address of principal executive offices, Zip Code)


(801) 954-7100

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filing and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):

Large accelerated filer o

Accelerated filer x

Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o  No x

The number of shares outstanding of the registrant’s common stock as of November 1, 2006 was 17,780,696.

 




USANA HEALTH SCIENCES, INC.

FORM 10-Q

For the Quarterly Period Ended September 30, 2006

INDEX

 

 

 

 

Page

 

 

 

 

 

 

 

 

PART I. FINANCIAL INFORMATION

 

 

 

 

 

 

 

Item 1

 

Financial Statements

 

 

 

 

Consolidated Balance Sheets

 

 

 

 

Consolidated Statements of Earnings — Quarter Ended

 

 

 

 

Consolidated Statements of Earnings — Nine Months Ended

 

 

 

 

Consolidated Statement of Stockholders’ Equity and Comprehensive Income

 

 

 

 

Consolidated Statements of Cash Flows

 

 

 

 

Notes to Consolidated Financial Statements

 

 

Item 2

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

Item 3

 

Quantitative and Qualitative Disclosures About Market Risk

 

 

Item 4

 

Controls and Procedures

 

 

 

 

 

 

 

 

 

PART II.OTHER INFORMATION

 

 

 

 

 

 

 

Item 1A

 

Risk Factors

 

 

Item 2

 

Unregistered Sales of Equity Securities and Use of Proceeds.

 

 

Item 6

 

Exhibits.

 

 

 

 

 

 

 

Signatures

 

 

 

 

 

 

 

 

 

 

 

2




PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

USANA HEALTH SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands)

 

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

 

 

 

 

(unaudited)

 

ASSETS

 

 

 

 

 

Current assets

 

 

 

 

 

Cash and cash equivalents

 

$

10,579

 

$

20,977

 

Inventories

 

22,223

 

22,497

 

Prepaid expenses and other current assets

 

6,024

 

6,833

 

Deferred income taxes

 

3,004

 

2,715

 

 

 

 

 

 

 

Total current assets

 

41,830

 

53,022

 

 

 

 

 

 

 

Property and equipment, net

 

23,302

 

25,764

 

 

 

 

 

 

 

Goodwill

 

5,690

 

5,690

 

 

 

 

 

 

 

Other assets

 

2,886

 

2,349

 

 

 

$

73,708

 

$

86,825

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities

 

 

 

 

 

Accounts payable

 

$

4,955

 

$

8,928

 

Other current liabilities

 

21,601

 

25,954

 

 

 

 

 

 

 

Total current liabilities

 

26,556

 

34,882

 

 

 

 

 

 

 

Long-term liabilities

 

1,414

 

 

 

 

 

 

 

 

Stockholders’ equity

 

 

 

 

 

Common stock, $0.001 par value; authorized 50,000 shares, issued and outstanding 18,343 shares as of December 31, 2005 and 17,811 shares as of September 30, 2006

 

18

 

18

 

Additional paid-in capital

 

9,161

 

11,996

 

Retained earnings

 

35,720

 

39,110

 

Accumulated other comprehensive income

 

839

 

819

 

 

 

 

 

 

 

Total stockholders’ equity

 

45,738

 

51,943

 

 

 

$

73,708

 

$

86,825

 

 

The accompanying notes are an integral part of these statements.

3




 

USANA HEALTH SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS

(in thousands, except per share data)

(unaudited)

 

 

Quarter Ended

 

 

 

October 1,

 

September 30,

 

 

 

2005

 

2006

 

 

 

 

 

 

 

Net sales

 

$

82,225

 

$

95,187

 

 

 

 

 

 

 

Cost of sales

 

19,760

 

22,188

 

 

 

 

 

 

 

Gross profit

 

62,465

 

72,999

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

Associate incentives

 

32,545

 

38,483

 

Selling, general and administrative

 

14,756

 

17,898

 

Research and development

 

551

 

881

 

 

 

 

 

 

 

Total operating expenses

 

47,852

 

57,262

 

 

 

 

 

 

 

Earnings from operations

 

14,613

 

15,737

 

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

Interest income

 

143

 

141

 

Interest expense

 

(8

)

 

Other, net

 

37

 

(73

)

 

 

 

 

 

 

Other income, net

 

172

 

68

 

 

 

 

 

 

 

Earnings before income taxes

 

14,785

 

15,805

 

 

 

 

 

 

 

Income taxes

 

4,743

 

5,582

 

 

 

 

 

 

 

Net earnings

 

$

10,042

 

$

10,223

 

 

 

 

 

 

 

Earnings per common share

 

 

 

 

 

Basic

 

$

0.53

 

$

0.57

 

Diluted

 

$

0.51

 

$

0.55

 

 

 

 

 

 

 

Weighted-average common shares outstanding

 

 

 

 

 

Basic

 

18,867

 

17,780

 

Diluted

 

19,755

 

18,486

 

 

 

 

 

 

 

 

The accompanying notes are an integral part of these statements

4




 

USANA HEALTH SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS

(in thousands, except per share data)

(unaudited)

 

 

Nine Months Ended

 

 

 

October 1,

 

September 30,

 

 

 

2005

 

2006

 

 

 

 

 

 

 

Net sales

 

$

240,818

 

$

278,749

 

Cost of sales

 

57,269

 

65,802

 

Gross profit

 

183,549

 

212,947

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

Associate incentives

 

94,006

 

111,365

 

Selling, general and administrative

 

44,773

 

53,515

 

Research and development

 

1,839

 

2,443

 

 

 

 

 

 

 

Total operating expenses

 

140,618

 

167,323

 

 

 

 

 

 

 

Earnings from operations

 

42,931

 

45,624

 

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

Interest income

 

340

 

446

 

Interest expense

 

(11

)

(4

)

Other, net

 

(59

)

257

 

 

 

 

 

 

 

Other income, net

 

270

 

699

 

 

 

 

 

 

 

Earnings before income taxes

 

43,201

 

46,323

 

 

 

 

 

 

 

Income taxes

 

14,688

 

16,196

 

 

 

 

 

 

 

Net earnings

 

$

28,513

 

$

30,127

 

 

 

 

 

 

 

Earnings per common share

 

 

 

 

 

Basic

 

$

1.50

 

$

1.66

 

Diluted

 

$

1.44

 

$

1.60

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

 

 

 

 

Basic

 

18,961

 

18,130

 

Diluted

 

19,849

 

18,830

 

 

 

 

 

 

 

 

The accompanying notes are an integral part of these statements.

5




 

USANA HEALTH SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME

Nine Months Ended October 1, 2005 and September 30, 2006

(in thousands)

(unaudited)

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

Additional

 

 

 

Other

 

 

 

 

 

Common Stock

 

Paid-in

 

Retained

 

Comprehensive

 

 

 

 

 

Shares

 

Value

 

Capital

 

Earnings

 

Income (Loss)

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Nine Months Ended October 1, 2005

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at January 1, 2005

 

18,953

 

$

19

 

$

11,853

 

$

34,496

 

$

1,475

 

$

47,843

 

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

Net earnings

 

 

 

 

28,513

 

 

28,513

 

Foreign currency translation adjustment, net

 

 

 

 

 

(596

)

(596

)

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

27,917

 

Common stock retired

 

(353

)

 

(3,948

)

(11,053

)

 

(15,001

)

Common stock issued under equity-based award plan, including tax benefit of $3,551

 

333

 

 

6,241

 

 

 

6,241

 

Balance at October 1, 2005

 

18,933

 

$

19

 

$

14,146

 

$

51,956

 

$

879

 

$

67,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Nine Months Ended September 30, 2006

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2005

 

18,343

 

$

18

 

$

9,161

 

$

35,720

 

$

839

 

$

45,738

 

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

Net earnings

 

 

 

 

30,127

 

 

30,127

 

Foreign currency translation adjustment, net

 

 

 

 

 

(20

)

(20

)

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

30,107

 

Common stock retired

 

(868

)

(1

)

(6,367

)

(26,737

)

 

(33,105

)

Common stock awarded to Associates

 

2

 

1

 

100

 

 

 

101

 

Equity-based compensation expense

 

 

 

3,468

 

 

 

3,468

 

Common stock issued under equity-based award plan, including tax benefit of $3,090

 

334

 

 

5,634

 

 

 

5,634

 

Balance at September 30, 2006

 

17,811

 

$

18

 

$

11,996

 

$

39,110

 

$

819

 

$

51,943

 

 

The accompanying notes are an integral part of these statements.

6




 

USANA HEALTH SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

 

Nine Months Ended

 

 

 

October 1,

 

September 30,

 

 

 

2005

 

2006

 

 

 

 

 

 

 

Increase (decrease) in cash and cash equivalents

 

 

 

 

 

Cash flows from operating activities

 

 

 

 

 

Net earnings

 

$

28,513

 

$

30,127

 

Adjustments to reconcile net earnings to net cash provided by operating activities

 

 

 

 

 

Depreciation and amortization

 

4,353

 

4,249

 

(Gain) loss on sale of property and equipment

 

7

 

(2

)

Equity-based compensation expense

 

 

3,468

 

Excess tax benefit from equity-based payment arrangements

 

 

(2,109

)

Common stock awarded to Associates

 

 

101

 

Deferred income taxes

 

(255

)

(1,309

)

Allowance for inventory valuation

 

1,296

 

1,813

 

Changes in operating assets and liabilities:

 

 

 

 

 

Inventories

 

(9,079

)

(1,897

)

Prepaid expenses and other assets

 

667

 

(544

)

Accounts payable

 

1,836

 

3,953

 

Other current liabilities

 

5,427

 

7,189

 

 

 

 

 

 

 

Total adjustments

 

4,252

 

14,912

 

 

 

 

 

 

 

Net cash provided by operating activities

 

32,765

 

45,039

 

 

 

 

 

 

 

Cash flows from investing activities

 

 

 

 

 

Proceeds from the sale of property and equipment

 

17

 

17

 

Purchases of property and equipment

 

(3,668

)

(6,278

)

 

 

 

 

 

 

Net cash used in investing activities

 

(3,651

)

(6,261

)

 

 

 

 

 

 

Cash flows from financing activities

 

 

 

 

 

Proceeds from exercise of equity-based awards

 

2,690

 

2,544

 

Excess tax benefit from equity-based payment arrangements

 

 

2,109

 

Redemption of common stock

 

(15,001

)

(33,105

)

 

 

 

 

 

 

Net cash used in financing activities

 

(12,311

)

(28,452

)

 

 

 

 

 

 

Effect of exchange rate changes on cash and cash equivalents

 

(549

)

72

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

16,254

 

10,398

 

 

 

 

 

 

 

Cash and cash equivalents, beginning of period

 

15,067

 

10,579

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

31,321

 

$

20,977

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

8

 

$

5

 

Income taxes

 

11,002

 

15,788

 

 

 

 

 

 

 

 

The accompanying notes are an integral part of these statements.

7




USANA HEALTH SCIENCES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

Basis of Presentation

The unaudited interim consolidated financial information of USANA Health Sciences, Inc. and Subsidiaries (the “Company” or “USANA”) has been prepared in accordance with Article 10 of Regulation S-X promulgated by the Securities and Exchange Commission.  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 pursuant to such rules and regulations.  In the opinion of management, the accompanying interim consolidated financial information contains all adjustments, consisting of normal recurring adjustments, necessary to present fairly the Company’s financial position as of September 30, 2006, and results of operations for the quarters and nine months ended October 1, 2005 and September 30, 2006.  These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.  The results of operations for the quarter and nine months ended September 30, 2006 may not be indicative of the results that may be expected for the fiscal year ending December 30, 2006.

Recently Issued Accounting Standards

In June 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (“FIN 48”), which clarifies the accounting for uncertainty in income tax positions. FIN 48 defines the threshold for recognizing tax return positions in the financial statements as “more likely than not” that the position is sustainable, based on technical merits of the provision. FIN 48 also provides guidance on the measurement, classification and disclosure of tax return positions in the financial statements. FIN 48 is effective for the first reporting period beginning after December 15, 2006, with the cumulative effect of the change in accounting principle recorded as an adjustment to the beginning balance of retained earnings in the period of adoption. The Company’s accounting for income tax contingency reserves is not based on the provisions of FIN 48 because its financial statements for the nine months ended September 30, 2006 have been issued without the early adoption of the provisions of this interpretation.  The Company is currently evaluating the impact of adopting FIN 48 on its consolidated financial statements.

In June 2006, the FASB ratified the consensuses of Emerging Issues Task Force (“EITF”) Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF 06-3”).  EITF 06-3 clarifies that the scope of this Issue includes any tax assessed by a governmental authority that is imposed concurrently with or subsequent to a revenue-producing transaction between a seller and a customer and indicates that the income statement presentation on either a gross basis or a net basis of the taxes within the scope of the Issue is an accounting policy decision that should be disclosed. Furthermore, for taxes reported on a gross basis, an enterprise should disclose the amounts of those taxes in interim and annual financial statements for each period for which an income statement is presented. The consensus is effective, through retrospective application, for periods beginning after December 15, 2006.  The Company currently presents taxes on a net basis within the scope of this issue.

In September 2006, the SEC issued Staff Accounting Bulletin 108 (“SAB 108”) “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.”  SAB 108 provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment.  SAB 108 requires registrants to quantify the impact of correcting misstatements on the current year financial statements using both the rollover and iron curtain approaches.  The rollover approach quantifies a misstatement based on the amount of the error originating in the current year income statement.  The iron curtain approach quantifies a misstatement based on the effects of correcting the misstatement existing in the balance sheet at the end of the current year, irrespective of the misstatement’s year(s) of origination.  The Company will be required to adopt the provisions of SAB 108 for its fiscal year ending December 30, 2006.  Management believes the provisions of SAB 108 will have no material effect on the Company’s financial position or results of operations.

8




 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement addresses how to calculate fair value measurements required or permitted under other accounting pronouncements. Accordingly, this statement does not require any new fair value measurements. However, for some entities, the application of this statement will change current practice. SFAS No. 157 is effective for the Company beginning January 1, 2008. The Company is currently evaluating the impact of this standard.

NOTE A — EQUITY-BASED COMPENSATION

Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment,” using the modified prospective application.  Under this method, compensation expense includes the estimated fair value of equity awards earned during the reported periods.  Expense for equity awards earned is determined based on grant date fair value previously calculated for pro forma disclosures under SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—An Amendment of FASB Statement No. 123.”  Equity-based compensation expense recognized for the quarter and nine months ended September 30, 2006 was comprised as follows:

 

Quarter

 

Nine Months

 

 

 

Ended

 

Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2006

 

 

 

 

 

 

 

Cost of sales

 

$

145

 

$

415

 

Selling, general and administrative

 

1,033

 

2,670

 

Research and development

 

138

 

383

 

 

 

$

1,316

 

$

3,468

 

 

The impact of equity-based compensation expense on net earnings and earnings per share for the quarter and nine months ended September 30, 2006 can be found in the pro forma table in this footnote.  The Company currently estimates that equity-based compensation expense will reduce basic and diluted earnings per share in 2006 by $0.18.  The following table shows the remaining unrecognized compensation expense on a pre-tax basis related to all types of equity awards outstanding as of September 30, 2006.  This table does not include an estimate for future grants that may be issued.

Remainder of 2006

 

$

1,321

 

2007

 

5,222

 

2008

 

4,846

 

2009

 

2,967

 

2010

 

2,356

 

Thereafter

 

512

 

 

 

$

17,224

 

 

The cost above is expected to be recognized over a weighted-average period of 2.4 years.

Prior to the adoption of SFAS No. 123(R), the Company presented all tax benefits resulting from equity-based compensation as cash flows from operating activities in the condensed consolidated statements of cash flows.  SFAS No. 123(R) requires cash flows resulting from tax deductions in excess of the grant-date fair value of equity awards to be included in cash flows from financing activities.  The excess tax benefits of $2,109 related to equity-based compensation included in cash flows from financing activities during the nine months ended September 30, 2006 would have been included in cash flows from operating activities if the Company had not adopted SFAS No. 123(R).

9




 

NOTE A — EQUITY-BASED COMPENSATION — CONTINUED

The Company has elected to follow the transition guidance indicated in Paragraph 81 of SFAS No. 123(R) for purposes of calculating the pool of excess tax benefits available to absorb possible future tax deficiencies.  As such, the Company has calculated its historical “APIC pool” of windfall tax benefits using the long-form method.

As permitted by SFAS No. 148, prior to the adoption of SFAS No. 123(R), the Company accounted for equity award expense under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” under which no compensation was recognized in the Company’s financial statements for the quarter and nine months ended October 1, 2005.  In connection with the modified prospective method, disclosures made for periods prior to the adoption of SFAS No. 123(R) do not reflect restated amounts.

The following table presents equity-based compensation expense included in the Company’s financial statements for the quarter and nine months ended September 30, 2006.  Also illustrated are the pro forma effects on net earnings and earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 123, as amended by SFAS No. 148, to equity-based compensation for the quarter and nine months ended October 1, 2005:

 

 

 

 

Quarter Ended

 

Nine Months Ended

 

 

 

 

 

October 1,
2005

 

September 30,
2006

 

October 1,
2005

 

September 30,
2006

 

 

 

 

 

 

 

 

 

 

 

 

 

Net earnings

 

As reported

 

$

10,042

 

$

10,223

 

$

28,513

 

$

30,127

 

Add: Compensation cost included in reported net income

 

 

 

 

870

 

 

2,374

 

Deduct: Total compensation expense under the fair value method for all awards

 

 

 

(491

)

(870

)

(1,406

)

(2,374

)

Net earnings

 

Pro forma

 

$

9,551

 

$

10,223

 

$

27,107

 

$

30,127

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - basic

 

As reported

 

$

0.53

 

$

0.57

 

$

1.50

 

$

1.66

 

 

 

Pro forma

 

$

0.51

 

$

0.57

 

$

1.43

 

$

1.66

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - diluted

 

As reported

 

$

0.51

 

$

0.55

 

$

1.44

 

$

1.60

 

 

 

Pro forma

 

$

0.48

 

$

0.55

 

$

1.37

 

$

1.60

 


* For the quarter and nine months ended September 30, 2006, earnings per basic and diluted share were reduced $0.05 and $0.13, respectively, from what earnings would have been exclusive of equity-based compensation.

The Company’s 2006 Equity Incentive Award Plan (the “2006 Plan”), which was approved by the shareholders at the Annual Shareholders’ Meeting held on April 19, 2006, allows for the grant of various equity awards including stock-settled stock appreciation rights, stock options, deferred stock units, and other types of equity-based awards to the Company’s officers, key employees, and non-employee directors.  Prior to the approval of the 2006 Plan, the Company maintained the 2002 Stock Option Plan (the “2002 Plan”), which was limited to the granting of incentive and non-qualified stock options.  Between January 1, 2006 and April 19, 2006, the Company granted options for 175 shares of stock under the 2002 Plan.  Options granted under the 2002 Plan generally vest 20% each year on the anniversary of the grant date and expire five to ten years from the date of grant.  The 2006 Plan replaces the 2002 Plan for all future grants, and no new awards will be granted under the 2002 Plan.  The 2006 Plan authorized 5,000 shares of common stock for issuance, of which 4,654 shares were available for future issuance as of September 30, 2006.  Of

10




 

NOTE A — EQUITY-BASED COMPENSATION — CONTINUED

the 346 shares granted under the 2006 Plan, 340 were stock-settled stock appreciation rights, 3 were stock options, and 3 were deferred stock units.  The Company’s Compensation Committee has initially determined that awards to be granted to officers and key employees under the 2006 Plan will generally vest 20% each year on the anniversary of the grant date and expire five to five and one-half years from the date of grant.  Awards of stock options and stock-settled stock appreciation rights to be granted to non-employee directors will generally vest 25% each quarter commencing on the last day of the fiscal quarter in which the awards are granted, and will expire five years to five and one-half years from the date of grant.  Awards of deferred stock units are full-value shares at the date of grant, vesting over the periods of service, and do not have expiration dates.

The Company continues to use the Black-Scholes option pricing model to estimate fair value of equity awards, which requires the input of highly subjective assumptions, including the expected stock price volatility.  Prior to the implementation of SFAS No. 123(R), expected volatility represented the historical share prices of the Company’s common stock over the expected life of the award and the risk-free interest rate was based on the U.S. Treasury yield curve on the date of grant with respect to the expected life of the award.  Expected life was based on the contractual term of the award.  Grant price was the market value on the date of grant, established by averaging the closing price of the Company’s common stock over the five trading days preceding the date of grant.

Preceding the adoption of SFAS No. 123(R), the Company engaged a third-party valuation expert to analyze assumptions used by the Company and to determine changes necessary for a more accurate reflection of the estimated fair value of equity awards granted by the Company.  Based on this analysis, the Company decided that, effective January 1, 2006, expected volatility will be calculated by averaging the historical volatility of the Company and a peer group index.  The risk-free interest rate will continue to be based on the U.S. Treasury yield curve on the date of grant with respect to the expected life of the award.  Also, effective January 1, 2006, due to the “plain vanilla” characteristics of the Company’s stock options, the simplified method, as permitted by the guidance provided in Staff Accounting Bulletin No. 107, will be used to determine expected life while permitted.  Awards will continue to be granted at the market value on the date of grant, which is established by averaging the closing price of the Company’s common stock over the five trading days preceding the date of grant.  We estimate that the equity-based compensation expense included in earnings before income taxes for the nine months ended September 30, 2006 was decreased by approximately $254 due to the above mentioned change in assumptions used to estimate fair value of awards granted during the nine months ended September 30, 2006.

The following table includes weighted-average assumptions used to calculate the fair value of awards granted during the periods indicated, as well as the weighted-average fair value of awards granted.  Deferred stock units are full-value shares at the date of grant and have been excluded from the table below.

 

 

Quarter Ended

 

Nine Months Ended

 

 

 

October 1,

 

September 30,

 

October 1,

 

September 30,

 

 

 

2005

 

2006

 

2005

 

2006

 

Expected volatility

 

*

 

57.04

%

71.69

%

57.04

%

Risk-free interest rate

 

*

 

5.04

%

3.87

%

4.81

%

Expected life

 

*

 

4.250 yrs.

 

5.250 yrs.

 

4.137 yrs.

 

Expected dividend yield

 

*

 

0.00

%

0.00

%

0.00

%

Weighted-average fair value of awards granted

 

*

 

$

18.47

 

$

26.84

 

$

18.77

 

 

 

 

 

 

 

 

 

 

 


*   No grants were issued during period.

There were no deferred stock units granted during the quarter ended September 30, 2006.  The weighted-average fair value and grant price of the three deferred stock units granted during the nine months ended September 30, 2006 was $37.60.

11




 

NOTE A — EQUITY-BASED COMPENSATION — CONTINUED

A summary of the Company’s stock option and stock-settled stock appreciation right activity for the nine months ended September 30, 2006 is as follows:

 

 

Shares

 

Weighted-
average
Exercise
Price*

 

Weighted-average
Remaining
Contractual Term

 

Aggregate
Intrinsic
Value**

 

Outstanding at December 31, 2005

 

1,773

 

$

17.43

 

6.97

 

$

37,121

 

Granted

 

518

 

$

38.00

 

 

 

 

 

Exercised

 

(334

)

$

7.61

 

 

 

 

 

Canceled or expired

 

(12

)

$

27.69

 

 

 

 

 

Outstanding at September 30, 2006

 

1,945

 

$

24.53

 

5.98

 

$

39,058

 

Exercisable at September 30, 2006

 

746

 

$

19.58

 

6.89

 

$

18,696

 

 

 

 

 

 

 

 

 

 

 


*                    All awards are granted at the market value on the date of grant, which is established by averaging the closing price of the Company’s common stock over the five trading days preceding the date of grant.

**             Aggregate intrinsic value is defined as the difference between the current market value and the exercise price of awards that were in-the-money, and is estimated using the closing price of the Company’s common stock on the last trading day of the period.

Total intrinsic value of awards exercised during the nine month periods ending October 1, 2005 and September 30, 2006, which includes stock options and stock-settled stock appreciation rights, was $12,035 and $11,313, respectively.

A summary of the Company’s deferred stock unit activity for the nine months ended September 30, 2006 is as follows:

 

Shares

 

Weighted-
average Fair
Value

 

Nonvested at December 31, 2005

 

 

$

 

Granted

 

3

 

$

37.60

 

Vested

 

(1

)

$

37.60

 

Canceled or expired

 

 

$

 

 

 

 

 

 

 

Nonvested at September 30, 2006

 

2

 

$

37.60

 

 

The total fair value of awards that vested during the nine months ended October 1, 2005 and September 30, 2006 was $2,962 and $3,274, respectively.  This total fair value included equity-based awards issued in the form of stock options, stock-settled stock appreciation rights, and deferred stock units.

 

12




 

NOTE B — INVENTORIES

Inventories consist of the following:

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

Raw materials

 

$

11,878

 

$

10,480

 

Work in progress

 

3,533

 

4,129

 

Finished goods

 

9,482

 

10,968

 

 

 

24,893

 

25,577

 

 

 

 

 

 

 

Less allowance for inventory valuation

 

2,670

 

3,080

 

 

 

$

22,223

 

$

22,497

 

 

NOTE C — PREPAID EXPENSES AND OTHER CURRENT ASSETS

Prepaid expenses and other current assets consist of the following:

 

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

Prepaid expenses

 

$

2,038

 

$

858

 

Miscellaneous receivables, net

 

3,537

 

4,477

 

Other current assets

 

449

 

1,498

 

 

 

$

6,024

 

$

6,833

 

 

13




 

NOTE D — PROPERTY AND EQUIPMENT

Cost of property and equipment and their estimated useful lives is as follows:

 

 

 

December 31,

 

September 30,

 

 

 

Years

 

2005

 

2006

 

 

 

 

 

 

 

 

 

Buildings

 

40

 

$

10,377

 

$

10,672

 

Laboratory and production equipment

 

5-7

 

9,706

 

10,701

 

Sound and video library

 

5

 

600

 

600

 

Computer equipment and software

 

3-5

 

23,083

 

23,431

 

Furniture and fixtures

 

3-5

 

2,654

 

2,707

 

Automobiles

 

3-5

 

248

 

239

 

Leasehold improvements

 

3-5

 

2,709

 

2,790

 

Land improvements

 

15

 

931

 

931

 

 

 

 

 

50,308

 

52,071

 

 

 

 

 

 

 

 

 

Less accumulated depreciation and amortization

 

 

 

29,605

 

32,711

 

 

 

 

 

20,703

 

19,360

 

Land

 

 

 

2,064

 

2,068

 

Deposits and projects in process

 

 

 

535

 

4,336

 

 

 

 

 

$

23,302

 

$

25,764

 

 

NOTE E — GOODWILL

Goodwill represents the excess of the purchase price paid for acquired entities over the fair market value of the net assets acquired.  As of September 30, 2006, goodwill totaled $5,690, comprising $4,267 that was associated with the July 1, 2003 acquisition of Wasatch Product Development, Inc. (WPD) and $1,423 that was associated with the February 1, 2004 acquisition of FMG.  No events have occurred subsequent to either acquisition that have resulted in an impairment of the original goodwill amounts initially recorded from the transactions.  In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill must be tested at least annually and if the carrying amount of goodwill exceeds its fair value, an impairment loss must be recognized in an amount equal to that excess.

During July 2006, an independent third party conducted the annual impairment test of goodwill related to the acquisition of WPD.  The fair market value of the net assets of WPD was estimated using widely accepted valuation methods, including both a market approach and an income approach.  In determining the fair market value as part of the impairment test, certain assumptions were used to project future results that management believes are reasonable, given current facts and circumstances; however, there can be no assurance that, under the assumptions used, these projections will materialize.  Based upon the results of the independent appraisal, the fair market value of the net assets of WPD has been determined to be in excess of the carrying amount of the net assets, and, therefore, no impairment loss for goodwill has been recognized.

14




 

NOTE F — OTHER CURRENT LIABILITIES

Other current liabilities consist of the following:

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

Associate incentives

 

$

3,528

 

$

5,367

 

Accrued employee compensation

 

6,257

 

5,481

 

Income taxes

 

2,429

 

2,209

 

Sales taxes

 

2,354

 

2,511

 

Associate promotions

 

616

 

517

 

Unearned revenue

 

1,903

 

2,797

 

Provision for returns and allowances

 

943

 

886

 

All other

 

3,571

 

6,186

 

 

 

$

21,601

 

$

25,954

 

 

NOTE G — COMMON STOCK AND EARNINGS PER SHARE

Basic earnings per share are based on the weighted-average number of shares outstanding for each period.  Weighted-average shares issued and weighted-average shares redeemed during the periods indicated have been included in the calculation of weighted-average shares outstanding for basic earnings per share.  Diluted earnings per common share are based on shares outstanding (computed under basic EPS) and potentially dilutive shares.  Shares included in diluted earnings per share calculations include equity-based awards that are in-the-money but have not yet been exercised.

 

For the Quarter Ended

 

 

 

October 1,

 

September 30,

 

 

 

2005

 

2006

 

Earnings available to common shareholders

 

$

10,042

 

$

10,223

 

 

 

 

 

 

 

Basic EPS

 

 

 

 

 

Shares

 

 

 

 

 

Common shares outstanding entire period

 

18,953

 

18,343

 

Weighted-average common shares:

 

 

 

 

 

Issued during period

 

266

 

263

 

Canceled during period

 

(352

)

(826

)

Weighted-average common shares outstanding during period

 

18,867

 

17,780

 

Earnings per common share - basic

 

$

0.53

 

$

0.57

 

 

 

 

 

 

 

Diluted EPS

 

 

 

 

 

Shares

 

 

 

 

 

Weighted-average shares outstanding during period - basic

 

18,867

 

17,780

 

Dilutive effect of equity-based awards

 

888

 

706

 

Weighted-average shares outstanding during period - diluted

 

19,755

 

18,486

 

Earnings per common share - diluted

 

$

0.51

 

$

0.55

 

 

Options to purchase 16 shares of stock were excluded from the computation of EPS for the quarter ended September 30, 2006 due to their exercise price being greater than the average market price of the shares.

15




 

NOTE G — COMMON STOCK AND EARNINGS PER SHARE — CONTINUED

 

For the Nine Months Ended

 

 

 

October 1,

 

September 30,

 

 

 

2005

 

2006

 

Earnings available to common shareholders

 

$

28,513

 

$

30,127

 

 

 

 

 

 

 

Basic EPS

 

 

 

 

 

Shares

 

 

 

 

 

Common shares outstanding entire period

 

18,953

 

18,343

 

Weighted-average common shares:

 

 

 

 

 

Issued during period

 

198

 

184

 

Canceled during period

 

(190

)

(397

)

Weighted-average common shares outstanding during period

 

18,961

 

18,130

 

Earnings per common share - basic

 

$

1.50

 

$

1.66

 

 

 

 

 

 

 

Diluted EPS

 

 

 

 

 

Shares

 

 

 

 

 

Weighted-average shares outstanding during period - basic

 

18,961

 

18,130

 

Dilutive effect of equity-based awards

 

888

 

700

 

Weighted-average shares outstanding during period - diluted

 

19,849

 

18,830

 

Earnings per common share - diluted

 

$

1.44

 

$

1.60

 

 

Options to purchase 218 shares of stock were excluded from the computation of EPS for the nine months ended September 30, 2006, due to their exercise price being greater than the average market price of the shares.

During the nine months ended September 30, 2006, and October 1, 2005, the Company expended $33,105 and $15,001 to purchase 868 and 353 shares, respectively, which reduced the number of shares issued and outstanding for these periods.

NOTE H — SEGMENT INFORMATION

The Company’s operations are distinguished by regions served and method of distribution employed.  Two reportable business segments are recognized by the Company: Direct Selling and Contract Manufacturing.  These operating segments are evaluated regularly by management in determining the allocation of resources and in assessing the performance of the Company.  Management evaluates performance based on net sales and the amount of operating income or loss.  Segment profit or loss is based on profit or loss from operations before income taxes.  All intercompany transactions, intercompany profit, currency gains and losses, interest income and expense, and income taxes are excluded from the Company’s determination of segment profit or loss.

Direct Selling

The Company’s Direct Selling segment develops, manufactures, and distributes nutritional, weight management, and personal care products, and is the primary segment in which the Company operates.  Products are distributed through a network marketing system using independent distributors referred to as “Associates.”  Products are also sold directly to “Preferred Customers,” who purchase products for personal use and are not permitted to resell or distribute the products.

Selected financial information for the Direct Selling segment is reported for two geographic regions: North America and Pacific Rim.  North America includes the United States, Canada, and Mexico.  All other entities outside of North America are located within the Pacific Rim region, which includes Australia-New Zealand, Hong Kong, Japan, Taiwan, South Korea, and

16




NOTE H — SEGMENT INFORMATION — CONTINUED

 

Singapore.  The Pacific Rim region will also include Malaysia, where, as previously announced, we expect to begin operations in the first quarter of 2007.

The profitability of each reported region within the Direct Selling segment is representative of what is controllable within that region by local management and is not necessarily indicative of actual profit or loss generated by a fully burdened region.  However, the presentation of the data is consistent with how management evaluates each region and the respective markets within that region.

Contract Manufacturing

Operating activities for the Contract Manufacturing segment primarily exist for the production of the Company’s Sensé™ line of skin and personal care products.  In addition to the production of the Sensé product line, contract manufacturing services are provided to a limited number of external customers.  This segment includes operations located in Draper, Utah and at a facility in Tianjin, China, which the Company acquired in October 2005.  Manufacturing and packaging activities for the Company’s Sensé products began at the Draper, Utah facility during the fourth quarter of 2003.  In the third quarters of 2005 and 2006, we had three and two external customers, respectively, that accounted for more than ten percent of segment sales.

Financial information summarized by operating segment and geographic region for the quarters ended October 1, 2005 and September 30, 2006 is listed below:

 

Net Sales to
External
Customers

 

Inter-segment
Revenues

 

Earnings
before Income
Taxes

 

Quarter ended October 1, 2005:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Direct Selling

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

North America

 

$

53,861

 

$

17,065

 

$

8,195

 

Pacific Rim

 

26,689

 

1,467

 

6,645

 

 

 

 

 

 

 

 

 

Segment Total

 

80,550

 

18,532

 

14,840

 

 

 

 

 

 

 

 

 

Contract Manufacturing

 

1,675

 

1,066

 

22

 

 

 

 

 

 

 

 

 

Reportable Segments Total

 

82,225

 

19,598

 

14,862

 

 

 

 

 

 

 

 

 

Unallocated and Other *

 

 

(19,598

)

(77

)

 

 

 

 

 

 

 

 

Consolidated Total

 

$

82,225

 

$

 

$

14,785

 


*       “Unallocated and Other” includes certain corporate items and eliminations that are not allocated to the operating segments.

17




NOTE H — SEGMENT INFORMATION — CONTINUED

 

 

Net Sales to
External
Customers

 

Inter-segment
Revenues

 

Earnings
before Income
Taxes

 

Quarter ended September 30, 2006:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Direct Selling

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

North America

 

$

61,384

 

$

14,735

 

$

19,145

 

Pacific Rim

 

32,023

 

1,354

 

18,862

 

 

 

 

 

 

 

 

 

Segment Total

 

93,407

 

16,089

 

38,007

 

 

 

 

 

 

 

 

 

Contract Manufacturing

 

1,780

 

1,081

 

(167

)

 

 

 

 

 

 

 

 

Reportable Segments Total

 

95,187

 

17,170

 

37,840

 

 

 

 

 

 

 

 

 

Unallocated and Other *

 

 

(17,170

)

(22,035

)

 

 

 

 

 

 

 

 

Consolidated Total

 

$

95,187

 

$

 

$

15,805

 

 

Financial information summarized by operating segment and geographic region for the nine months ended October 1, 2005 and September 30, 2006 is listed below:

 

 

Net Sales to
External
Customers

 

Inter-segment
Revenues

 

Earnings
before Income
Taxes

 

Long-lived
Assets

 

Total
Assets

 

Nine months ended October 1, 2005:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Direct Selling

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

North America

 

$

155,383

 

$

50,316

 

$

22,615

 

$

21,825

 

$

65,080

 

Pacific Rim

 

79,628

 

4,125

 

19,359

 

2,861

 

11,653

 

 

 

 

 

 

 

 

 

 

 

 

 

Segment Total

 

235,011

 

54,441

 

41,974

 

24,686

 

76,733

 

 

 

 

 

 

 

 

 

 

 

 

 

Contract Manufacturing

 

5,807

 

4,937

 

793

 

6,444

 

14,327

 

 

 

 

 

 

 

 

 

 

 

 

 

Reportable Segments Total

 

240,818

 

59,378

 

42,767

 

31,130

 

91,060

 

 

 

 

 

 

 

 

 

 

 

 

 

Unallocated and Other *

 

 

(59,378

)

434

 

161

 

3,681

 

 

 

 

 

 

 

 

 

 

 

 

 

Consolidated Total

 

$

240,818

 

$

 

$

43,201

 

$

31,291

 

$

94,741

 

 


*       “Unallocated and Other” includes certain corporate items and eliminations that are not allocated to the operating segments.

18




NOTE H — SEGMENT INFORMATION — CONTINUED

 

 

 

Net Sales to
External
Customers

 

Inter-segment
Revenues

 

Earnings
before Income
Taxes

 

Long-lived
Assets

 

Total
Assets

 

Nine months ended September 30, 2006:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Direct Selling

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

North America

 

$

183,719

 

$

47,401

 

$

34,531

 

$

23,635

 

$

57,938

 

Pacific Rim

 

87,518

 

3,998

 

33,266

 

2,584

 

12,969

 

 

 

 

 

 

 

 

 

 

 

 

 

Segment Total

 

271,237

 

51,399

 

67,797

 

26,219

 

70,907

 

 

 

 

 

 

 

 

 

 

 

 

 

Contract Manufacturing

 

7,512

 

3,406

 

(349

)

7,699

 

13,226

 

 

 

 

 

 

 

 

 

 

 

 

 

Reportable Segments Total

 

278,749

 

54,805

 

67,448

 

33,918

 

84,133

 

 

 

 

 

 

 

 

 

 

 

 

 

Unallocated and Other *

 

 

(54,805

)

(21,125

)

(115

)

2,692

 

 

 

 

 

 

 

 

 

 

 

 

 

Consolidated Total

 

$

278,749

 

$

 

$

46,323

 

$

33,803

 

$

86,825

 

 


*       “Unallocated and Other” includes certain corporate items and eliminations that are not allocated to the operating segments.

19




 

Item 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of USANA’s financial condition and results of operations should be read in conjunction with the Unaudited Consolidated Financial Statements and Notes thereto contained in this quarterly report.

General

USANA Health Sciences, Inc. develops and manufactures high-quality nutritional, weight management, and personal care products.  We market our products on the basis of high levels of bioavailability, safety, and quality.  We distribute our products through a network marketing system using independent distributors whom we refer to as “Associates.”  As of September 30, 2006, we had approximately 145 thousand active Associates worldwide.  We also sell products directly to “Preferred Customers,” who purchase our products for personal use and are not permitted to resell or distribute the products.  As of September 30, 2006, we had approximately 76 thousand active Preferred Customers worldwide.  The majority of sales in the Direct Selling segment come from Associates.  For the nine months ended September 30, 2006, sales to Associates accounted for approximately 86% of net sales for the Direct Selling segment.  For purposes of this report, we only count as active customers those Associates and Preferred Customers who have purchased products from USANA at any time during the most recent three-month period.

Our fiscal year end is the Saturday closest to December 31 of each year.  Fiscal year 2005 ended on December 31, 2005, and fiscal year 2006 will end on December 30, 2006.

As discussed more fully in Note H – Segment Information to the Consolidated Financial Statements, we have two reportable segments: Direct Selling and Contract Manufacturing.  The Direct Selling segment constitutes our principal line of business: developing, manufacturing, and distributing nutritional, weight management, and personal care products through a network marketing system.  The Contract Manufacturing segment consists of manufacturing and packaging the Company’s Sensé™ product line of skin and personal care products as well as contract manufacturing services provided to a limited number of third-party customers.

Our primary product lines within the Direct Selling segment consist of USANAâ Nutritionals and Sensé – beautiful scienceâ (Sensé).  The USANAâ Nutritionals product line is further categorized into three separate classifications: Essentials, Optimizers, and Macro Optimizers.  Additionally, we offer combination packs, which generally contain a variety of products from each product line.

USANAâ Nutritionals.

The Essentials include core vitamin and mineral supplements that provide a foundation of advanced nutrition for every age group.  To help meet the “essential” nutrient needs of children and teens during the years of development, when good nutrition is especially important, USANA offers: UsanimalsÔ, a formulation of vitamins, minerals, and antioxidants, in an easy-to-take chewable tablet for children 13 months to 12 years old; and Body RoxÔ, a nutritional supplement containing 31 essential vitamins, minerals, antioxidants, and cofactors for adolescents 12 to 18 years old.  USANAâ Essentials for adults is a combination of two products: Mega Antioxidant, a balanced, high-potency blend of 30 vitamins, antioxidants, and other important nutrients to support cellular metabolism and to counteract free-radical damage; and Chelated Mineral, a complete spectrum of essential minerals in balanced, highly bioavailable forms.  The USANAâ Essentials are also provided in a convenient pillow pack format, HealthPak 100Ô.

Optimizers are more targeted supplements designed to meet individual health and nutritional needs.  Products in this category include Proflavanolâ, Poly Câ, Procosaâ II, CoQuinoneâ 30, BiOmega-3Ô, E-PrimeÔ, Active CalciumÔ, Body RoxÔ - Active CalciumÔ Chewable, PhytoEstrinÔ, Palmetto PlusÔ, Ginkgo-PSÔ, Garlic ECÔ, Visionexâ, OptOmegaâ, and Hepasil DTX™.  This product category also now includes the unique TenX™ Antioxidant Blast, which is an antioxidant-rich supplement bar that was introduced at our International Convention held in September 2006.

The Macro Optimizers include healthy, low-glycemic convenience foods and other related products.  NutrimealÔ, Fibergyâ, and SoyaMaxÔ drink mixes, and Nutrition and Fibergy Bars™ are included in this product category.  Also included in

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this product category is our RESET™ Weight Management Program designed to assist in a long-term change in diet, and the accompanying RESET kit.  The RESET kit is conveniently packaged in a self-contained box with the USANA products needed to complete a five-day regimen, designed to assist in losing weight and providing a start to a long-term change in diet.

Sensé - beautiful scienceâ

The Sensé™ product line includes premium, science-based personal care products that support healthy skin and hair by providing advanced topical nourishment, moisturization, and protection.  This line is formulated with our patent-pending, self-preserving technology, which uses a unique blend of botanicals, antioxidants, and active ingredients to keep products fresh, without adding traditional chemical preservatives.  Products in this line include Perfecting Essence, Gentle Daily Cleanser, Hydrating Toner, Daytime Protective Emulsion, Eye Nourisher, Night Renewal, Serum Intensive, Rice Bran Polisher, Revitalizing Shampoo, Nourishing Conditioner, Firming Body Nourisher, Energizing Shower Gel, and Intensive Hand Therapy.

All Other

In addition to our principal product lines, we have developed and sell to Associates materials and online tools designed to assist them in building their businesses and selling products.  These resource materials and sales tools include product brochures and business forms that are designed by us internally and printed by outside publishers.  Materials written and developed by us for CDs and DVDs are published by our wholly-owned subsidiary USANA Studios, aka FMG Productions.  We also provide re-prints from time to time from other commercial publications that feature USANA and may be used as a sales tool.  As an example, in September 2006 we purchased large quantities of the November issue of Success from Home magazine featuring USANA to resell to our Associates.  Additionally, we periodically contract with authors and publishers to produce or provide books, tapes, and other items dealing with health topics and personal motivation, which we then sell to Associates.  New Associates are required to purchase a starter kit, which contains USANA training materials that assist the Associates in starting and growing their businesses.  Associates do not earn commissions on the sale of starter kits or sales tools.

The following table summarizes the approximate percentage of total product revenue for the Direct Selling segment contributed by major product line for the nine months ended as of the dates indicated:

 

Sales By Product Line

 

 

 

Nine Months Ended

 

 

 

October 1,

 

September 30,

 

Product Line

 

2005

 

2006

 

USANAâ Nutritionals

 

 

 

 

 

Essentials *

 

38

%

38

%

Optimizers

 

34

%

34

%

Macro Optimizers

 

9

%

13

%

Sensé – beautiful scienceâ

 

15

%

11

%

All Other

 

4

%

4

%


* The Essentials category under the USANAâ Nutritionals product line includes USANAâ Essentials, HealthPak 100Ô, Body RoxÔ, and UsanimalsÔ.

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Key Products

The following highlights sales data for our top-selling products as a percentage of Direct Selling segment product sales for the nine months ended as of the dates indicated:

 

Nine Months Ended

 

 

 

October 1,

 

September 30,

 

 

 

2005

 

2006

 

USANAâ Essentials

 

23

%

21

%

HealthPak 100 ™

 

13

%

14

%

Proflavanolâ

 

10

%

9

%

 

Forward-Looking Statements

The statements contained in this report that are not purely historical are considered to be “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 and Section 21E of the Securities Exchange Act.  These statements represent our expectations, hopes, beliefs, anticipations, commitments, intentions and strategies regarding the future.  They may be identified by the use of words or phrases such as “believes,” “expects,” “anticipates,” “should,” “plans,” “estimates,” and “potential,” among others.  Forward-looking statements include, but are not limited to, statements contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations regarding our financial performance, revenue and expense levels in the future and the sufficiency of our existing assets to fund future operations, growth, and capital spending needs.  Readers are cautioned that actual results could differ materially from the anticipated results or other expectations expressed in these forward-looking statements for the reasons detailed in our most recent Annual Report on Form 10-K at pages 20 through 30.  The fact that some of the risk factors may be the same or similar to our past reports filed with the Securities and Exchange Commission means only that the risks are present in multiple periods.  We believe that many of the risks detailed here and in the Company’s other SEC filings are part of doing business in the industry in which we operate and compete and will likely be present in all periods reported.  The fact that certain risks are endemic to the industry does not lessen their significance.  The forward-looking statements contained in this report are made as of the date of this report and we assume no obligation to update them or to update the reasons why actual results could differ from those projected in such forward-looking statements.  Among others, risks and uncertainties that may affect our business, financial condition, performance, development and results of operations include:

·                  Our ability to attract and maintain a sufficient number of Associates;

·                  High turnover of Associates;

·                  Our dependence upon a network marketing system to distribute our products;

·                  Activities of our independent Associates;

·                  Our planned expansion into international markets, including delays in commencement of sales in any new market, delays in compliance with local marketing or other regulatory requirements, or changes in target markets;

·                  Rigorous government scrutiny of network marketing practices;

·                  Potential political events that may negatively affect economic conditions;

·                  Potential natural disasters that may negatively affect economic conditions;

·                  Potential effects of adverse publicity regarding nutritional supplements or the network marketing industry;

·                  Reliance on key management personnel, including our Founder, Chairman of the Board of Directors, and Chief Executive Officer Myron W. Wentz, Ph.D.;

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·                  Extensive government regulation of the Company’s products and manufacturing;

·                  Potential inability to sustain or manage growth, including the failure to continue to develop new products;

·                  An increase in the amount of Associate incentives paid;

·                  Our reliance on the use of information technology;

·                  The adverse effect of the loss of a high-level sponsoring Associate together with a group of leading Associates in that person’s downline;

·                  The loss of product market share or Associates to competitors;

·                  Potential adverse effects of taxation and transfer pricing regulations including regulations governing distinctions between and Company responsibilities to employees and independent contractors;

·                  The fluctuation in the value of foreign currencies against the US dollar;

·                  Our reliance on outside suppliers for raw materials;

·                  Shortages of raw materials used in certain of our products;

·                  Significant price increases of our key raw materials;

·                  Product liability claims and other risks associated with our manufacturing activity;

·                  Intellectual property risks;

·                  Liability claims associated with our “Athlete Guarantee” program; and

·                  Disruptions to shipping channels used to distribute products to international warehouses.

Results of Operations

Summary of Financial Results and Recent Developments

Consolidated net sales for the quarter and nine months ended September 30, 2006 continued to improve over prior year results, increasing 15.8% for both the quarter and nine month period.  Excluding the positive impact of foreign currency fluctuation, sales increased 14.7% and 14.9%, respectively, for the quarter and nine months ended September 30, 2006.  Overall, sales growth can be attributed to an increase in the number of active Associates in most countries within the Direct Selling segment.  In terms of sales growth, the third quarter is seasonally our weakest quarter of the year.  The summer vacation season in North America, along with the anticipation for new products introduced at our International Convention typically held toward the end of the third quarter each year, generally bring some seasonality and softness to our business in the third quarter.

Net income for the third quarter and first nine months of 2006 increased 1.8% and 5.7%, respectively, over the same periods in 2005.  As a percentage of net sales, net income decreased from 12.2% for the third quarter of 2005, to 10.7% for the third quarter of 2006, and from 11.8% for the first nine months of 2005, to 10.8% for the first nine months of 2006.  Two items that have most significantly influenced net earnings for the year have been increased net sales and the recognition of equity-based compensation expense as a result of the adoption of SFAS No. 123(R) (equity-based compensation expense was not recognized in prior years’ income statements), which is discussed further below.

One of the key highlights of the current year quarter was the Company’s annual International Convention held in Salt Lake City, Utah, where nearly 7,000 Associates from 12 different countries were in attendance.  At Convention, we introduced a new Optimizer supplement, TenX™ Antioxidant Blast, a unique dietary supplement fruit bar that provides the equivalent of two fruit servings and is fortified with important antioxidants, including quercetin and our patented Olivol® olive-fruit extract.

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We also announced that we will be featured in the November issue of Success from Home magazine, a commercial publication on home-based business opportunities.  We have purchased large quantities of the November issue of this magazine and have priced them for sale to our Associates at cost.  We are also offering free shipping of the magazines for a limited time to Associates who maintain a 56-pack on their autoship.  In addition, for a limited time Associates who purchase a 56-pack of the Success from Home magazine are eligible to participate in a matching check opportunity.  We believe that the above mentioned promotions have the potential to drive distribution of this magazine and ultimately result in additional Associates and higher net sales.

Also at the end of the third quarter we received a business license in Malaysia and subsequently announced that we expect to begin operations there in the first quarter of 2007.  In 2007 we will continue to focus on growing our business in existing markets, as well as developing our business in Malaysia.

Implementation of SFAS No. 123(R)

Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123(R), which requires equity-based compensation expense to be recognized in financial statements.  The Company used the modified prospective application to adopt these provisions.  Under this method, compensation expense includes the estimated fair value of equity awards earned during the reported period.  Our financial statements for 2006 interim periods reflect equity-based compensation expense, which has not been reflected in either interim or annual financial statements for fiscal years prior to 2006.  Equity-based compensation expense recognized in the financial statements for the quarter and nine months ended September 30, 2006 was as follows:

 

Quarter

 

Nine Months

 

 

 

Ended

 

Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2006

 

 

 

(in thousands)

 

(in thousands)

 

 

 

 

 

 

 

Cost of sales

 

$

145

 

$

415

 

Selling, general and administrative

 

1,033

 

2,670

 

Research and development

 

138

 

383

 

 

 

 

 

 

 

 

 

$

1,316

 

$

3,468

 

 

Net of tax, earnings for the quarter and nine months ended September 30, 2006 were reduced by $870 thousand and $2.4 million, respectively due to equity-based compensation expense.  Earnings per basic and diluted share were reduced $0.05 and $0.13, respectively, from what earnings would have been exclusive of equity-based compensation.  The Company currently estimates that equity-based compensation expense will reduce basic and diluted earnings per share in 2006 by $0.18.  The following table shows remaining unrecognized compensation expense on a pre-tax basis related to all types of equity awards outstanding as of September 30, 2006.  This table does not include an estimate for future grants that may be issued.

 

(in thousands)

 

Remainder of 2006

 

$

1,321

 

2007

 

5,222

 

2008

 

4,846

 

2009

 

2,967

 

2010

 

2,356

 

Thereafter

 

512

 

 

 

$

17,224

 

 

The expense above is expected to be recognized over a weighted-average period of 2.4 years.

More information on the Company’s equity-based compensation plans and the accounting for equity-based compensation expense can be found in Note A—Equity-Based Compensation, to the consolidated financial statements.

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Quarters Ended October 1, 2005 and September 30, 2006

Net Sales.  Net sales increased 15.8% to $95.2 million for the quarter ended September 30, 2006, an increase of $13.0 million, from $82.2 million for the comparable quarter of 2005.  During the current quarter, net sales in the Direct Selling segment increased by $12.9 million, and net sales in the Contract Manufacturing segment increased by $0.1 million, when compared with the same period in 2005.

The following table summarizes the changes in net sales by segment and country for the fiscal quarters ended October 1, 2005 and September 30, 2006.

 

 

Sales By Segment and Region

 

 

 

 

 

 

 

(in thousands)

 

 

 

 

 

 

 

Quarter Ended

 

Change from

 

Percent

 

Segment / Region

 

October 1, 2005

 

September 30, 2006

 

Prior Year

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Direct Selling

 

 

 

 

 

 

 

 

 

 

 

 

 

North America

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

$

35,181

 

42.8

%

$

40,015

 

42.0

%

$

4,834

 

13.7

%

Canada

 

15,231

 

18.5

%

16,814

 

17.7

%

1,583

 

10.4

%

Mexico