10-K 1 a06-2013_110k.htm ANNUAL REPORT PURSUANT TO SECTION 13 AND 15(D)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-K

(Mark One)

x

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

 

For the fiscal year ended December 31, 2005

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 of

 

(I.R.S. Employer

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)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, Par Value $0.001 Per Share


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes o   No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.   Yes o   No x

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    x

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

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 Act).   Yes o   No x

The aggregate market value of common stock held by non-affiliates of the registrant as of July 2, 2005 was approximately $433,062,000.

The number of shares outstanding of the registrant’s common stock as of February 24, 2006 was 18,442,698.

Documents incorporated by reference. The registrant incorporates information required by Part III (Items 10, 11, 12, 13, and 14) of this report by reference to the registrant’s definitive proxy statement to be filed pursuant to Regulation 14A for the 2006 Annual Shareholders Meeting.

 




USANA HEALTH SCIENCES, INC.

FORM 10-K

For the Fiscal Year Ended December 31, 2005

INDEX

 

 

 

Page

 

 

 

Part I

 

 

 

 

 

Item 1

 

Business

 

 

3

 

 

Item 1A

 

Risk Factors

 

 

20

 

 

Item 1B

 

Unresolved Staff Comments

 

 

30

 

 

Item 2

 

Properties

 

 

30

 

 

Item 3

 

Legal Proceedings

 

 

30

 

 

Item 4

 

Submission of Matters to a Vote of Security Holders

 

 

30

 

 

 

 

Part II

 

 

 

 

 

Item 5

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

 

31

 

 

Item 6

 

Selected Financial Data

 

 

33

 

 

Item 7

 

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

 

 

34

 

 

Item 7A

 

Quantitative and Qualitative Disclosures About Market Risk

 

 

48

 

 

Item 8

 

Financial Statements and Supplementary Data

 

 

49

 

 

Item 9

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 

 

 

49

 

 

Item 9A

 

Controls and Procedures

 

 

49

 

 

Item 9B

 

Other Information

 

 

53

 

 

 

 

Part III

 

 

 

 

 

Item 10

 

Directors and Executive Officers of the Registrant

 

 

53

 

 

Item 11

 

Executive Compensation

 

 

53

 

 

Item 12

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   

 

 

53

 

 

Item 13

 

Certain Relationships and Related Transactions

 

 

53

 

 

Item 14

 

Principal Accounting Fees and Services

 

 

53

 

 

 

 

Part IV

 

 

 

 

 

Item 15

 

Exhibits, Financial Statement Schedules

 

 

53

 

 

Signatures

 

 

55

 

 

 

2




PART I

Item 1. Business

General

USANA Health Sciences, Inc. (“We,” “USANA” or the “Company”) is a Utah corporation, founded in 1992 by Myron W. Wentz, Ph.D., that develops and manufactures high-quality, science-based nutritional and personal care products, with a commitment to continuous product innovation and sound scientific research. We distribute and sell our products through a network marketing system, a form of direct selling, using independent distributors that we refer to as “Associates.”  We also sell our products directly to “Preferred Customers” who purchase our products for personal use and are not permitted to resell or distribute the products. As of December 31, 2005, we had approximately 133,000 active Associates and 70,000 active Preferred Customers worldwide, which accounted for 86% and 14% of net sales, respectively, during fiscal year 2005. For purposes of this report, we only count as active those Associates and Preferred Customers who have purchased product from USANA at any time during the most recent three-month period.

We maintain executive offices and principal facilities at 3838 West Parkway Boulevard, Salt Lake City, Utah 84120. Our telephone number is (801) 954-7100. We maintain a World Wide Web site at www.usanahealthsciences.com. The information on our Web site should not be considered part of this report on Form 10-K.

Overview of Business Segments

We have two reportable business segments: Direct Selling and Contract Manufacturing.

Direct Selling

The Direct Selling segment represents the Company’s principal line of business: developing, manufacturing, and distributing premium, science-based nutritional and personal care products. Under this segment, we sell products from two primary product lines: USANA® Nutritionals, which includes quality supplements and functional foods, and Sensé—beautiful science® (Sensé), a unique line of skin and personal care products. We also offer sales and marketing tools designed to assist our Associates in building their businesses and selling our products, as well as combination packs, which include a variety of products from each product line. In 2005, USANA Nutritionals and Sensé™ product lines represented approximately 82% and 15% of product sales in this segment, respectively. Sales from other items, the majority of which include marketing and sales tools, accounted for the remaining 3% of product sales in this segment during 2005. Our top-selling products as a percent of product sales in this segment during 2005 were: USANA Essentials at 22%, the HealthPak 100™ at 13%, and Proflavanol® at 10%, all of which are part of the USANA Nutritionals product line. Our product lines are focused and compact, with products we believe can provide health benefits to a significant percentage of our customers. Additionally, while not required, our products are designed, manufactured, packaged, and labeled by us at levels that we believe are consistent with pharmaceutical standards.

We distribute and sell our products through a network marketing system using independent distributors that we refer to as “Associates.”  We also sell products directly to “Preferred Customers” who purchase products for personal use and are not permitted to resell or distribute the products. Associates purchase product not only for their own consumption, but are encouraged to build and manage their own sales force by recruiting, managing, and training others to sell our products. Associates are compensated for a percentage of the sales (purchases) generated by their business group (downline). Associates can also receive compensation on product they sell at retail prices, rather than the wholesale prices at which they purchase product. We consider our high quality products, compact product lines, rewarding compensation

3




plan, and weekly Associate incentive payments to be attractive components of the USANA network marketing system. We believe that network marketing is an effective way to distribute our products because it allows person-to-person product education, which is not readily available through traditional distribution channels. Additionally, we feel that network marketing appeals to a broad cross-section of people, particularly those seeking to supplement their income, start a home-based business, or pursue entrepreneurial opportunities other than conventional full-time employment.

Our products are distributed and sold in the United States, Canada, and Mexico, which we define as our North American markets; and Australia-New Zealand, Hong Kong, Japan, Taiwan, South Korea, and Singapore, which we define as our Pacific Rim markets. North America is our primary region with sales representing 66.5% of net segment sales in 2005; however, the Pacific Rim markets continue to account for an increasing proportion of total net segment sales. Our Pacific Rim markets contributed to net segment sales in 2005 as follows:

·Australia-New Zealand

 

14.2

%

·Hong Kong

 

4.0

%

·Japan

 

3.2

%

·Taiwan

 

6.3

%

·South Korea

 

1.5

%

·Singapore

 

4.3

%

 

Net sales reported for each operating region within this segment are determined by the location from which the product shipment originates and are reported for the last three fiscal years, along with other segment financial information, in Note L beginning on page F-24 to the Consolidated Financial Statements. Regional sales are further broken down on pages 36 and 40. This segment contributed $319.6 million, or 97.5%, to consolidated net sales during the year ended December 31, 2005.

Contract Manufacturing

Principal operations for the Contract Manufacturing segment are conducted in a facility located in Draper, Utah, and primarily consist of the manufacture of the Company’s Sensé™ line of skin and personal care products. Contract manufacturing services are also provided to a limited number of external customers through this facility. We acquired this facility with the purchase of Wasatch Products Development, Inc. (WPD) in July 2003 as part of a vertical integration strategy that allowed us to bring the production of our Sensé product line in-house.

In October 2005, we completed the acquisition of a manufacturing facility in Tianjin, China for $1.4 million in cash. This facility does not currently manufacture any USANA products.

This segment contributed $8.1 million, or 2.5%, to consolidated net sales during the year ended December 31, 2005. Our contract manufacturing facility located in Draper, Utah accounted for 99.2% of net segment sales during the year, and the manufacturing facility in China accounted for the remaining 0.8% of net segment sales. During the fourth quarter of 2005, our Draper, Utah contract manufacturing facility accounted for 97.3% of net segment sales, and our China manufacturing facility accounted for the remaining 2.7% of net segment sales. Net sales for this segment for the last three fiscal years are reported, along with other segment financial information, in Note L beginning on page F-24 to the Consolidated Financial Statements.

4




Industry Overview

The nutrition industry includes many small- and medium-sized companies that manufacture and distribute products generally intended to maintain the body’s health and general well being. Products within the industry are commonly classified into the following four major categories:

·       Nutritional Supplements—products such as vitamins and minerals, specialty supplements, herbs and botanicals, sports performance enhancers, meal replacements, dietary supplements, and compounds derived from the aforementioned;

·       Natural and Organic Foods—products such as cereals, milk, non-dairy beverages, and frozen entrees;

·       Functional Foods—products with added ingredients or fortification specifically for health or performance purposes; and

·       Natural Personal Care—products combining nutrition with skin care.

In their October/November 2004 issue, the Nutrition Business Journal (“NBJ”) reported that global nutrition industry sales increased 8.4% to over $182 billion for the year 2003. According to NBJ, of that $182 billion, nutritional supplements contributed $61.9 billion, natural & organic foods $38.2 billion, functional foods $65.5 billion, and natural personal care $16.4 billion.

We believe that the following factors drive growth in the nutrition industry:

·       The general public’s heightened awareness and understanding of the connection between diet and health;

·       The aging population in most of our markets, particularly the baby-boomer generation, which tends to use more nutritional supplementation as it ages;

·       Rising health care costs and the worldwide trend toward preventive health care; and

·       Product introductions in response to new scientific findings.

Nutritional products are distributed through six major sales channels. Each channel has changed in recent years, primarily due to advances in technology and communications that have resulted in improved product distribution and faster dissemination of information. The major sales channels are as follows:

·       Mass market retailers, including mass merchandisers, drug stores, supermarkets, and discount stores;

·       Natural health food retailers;

·       Network marketing;

·       Mail order;

·       Healthcare professionals and practitioners; and

·       The Internet.

We distribute our products through the network marketing channel. According to the World Federation of Direct Selling Associations (“WFDSA”), the direct sales industry currently generates approximately $99 billion annually in worldwide sales with approximately 55 million independent distributors.

According to WFDSA international statistics, the United States remains the largest market for direct sales, with $29.9 billion in annual sales and 13.6 million independent distributors. According to the Direct

5




Selling Association, wellness products, which include nutritional supplements and functional foods, account for 15.3%, and personal care products account for 29.4%, of U.S. direct sales, respectively.

We believe that we are well positioned to capitalize on growth trends in direct sales, as both a developer and manufacturer of nutritional supplements and personal care products, utilizing our network marketing distribution system.

Operating Strengths

Our principal objective is to be a leading developer, manufacturer, and distributor of science-based nutritional health and skin care products. Our strategy to achieve this objective is to capitalize on our operating strengths, which include our development and sale of science-based products, our strong research and development capability, our in-house manufacturing capacity, our rewarding compensation plan for Associates, and our experienced management team.

Science-based Products.   We have developed a very focused and compact line of high-quality health products based upon a combination of published research, in vitro and in vivo testing, in-house and third-party clinical studies, and sponsored research. Our products are designed, manufactured, packaged, and labeled by us at levels that we believe are consistent with pharmaceutical standards. We also believe that the identification and delivery of essential vitamins, minerals, and other micro-nutrients, as well as macro-nutrients, will help individuals achieve and maintain long-term health. As the manufacturer of most of our products, we control the quality from start to finish, which we believe is a key competitive advantage.

Strong Research and Development.   Dr. Wentz directs our research and development efforts, supported by a team of 25 scientists and researchers, including five scientists holding Ph.D. degrees. In our research and development laboratories, our scientists and researchers:

·       Investigate in vitro and in vivo activity of new natural extracts and formulated products;

·       Identify and research combinations of nutrients that may be candidates for new products;

·       Develop new nutritional ingredients for use in supplements;

·       Study the metabolic activity of existing and newly identified nutritional ingredients;

·       Enhance existing products, as new discoveries in nutrition and skin care are made; and

·       Formulate products to meet regulatory requirements in all of our markets.

In addition, we continue to perform double-blind, placebo-controlled, clinical studies intended to further evaluate the efficacy of our products.

In-house Manufacturing.   We now manufacture products that account for approximately 78% of product sales in our Direct Selling segment. We believe that our ability to manufacture our own products is a significant competitive advantage for the following reasons:

·       We can better control the quality of raw materials and the purity and potency of finished products;

·       We can more reliably monitor the manufacturing process to reduce the risk of product contamination; and

·       We believe we can better manage the underlying costs associated with manufacturing our products.

Attractive Associate Compensation Plan and Benefits.   We are committed to providing a highly competitive compensation plan to attract and retain Associates, who constitute our sales force. We believe the USANA Associate compensation plan (the “Compensation Plan”) is one of the most financially rewarding in the network marketing industry. Associate incentives totaled $128.7 million, or 40.3% of net sales for the Direct Selling segment in 2005. We pay Associate incentives weekly. The Compensation Plan

6




is a global-seamless plan, meaning that Associates can be compensated each week for their business success in any market in which we conduct business. To support our Associates, we sponsor events throughout the year, which offer information about our products and our network marketing system. These meetings are designed to assist Associates in business development and to provide a forum for interaction with successful Associates and the USANA management team.

Experienced Management Team.   Our management team includes individuals with expertise in various scientific and managerial disciplines, including nutrition, product research and development, international development, marketing, customer network development, information technology, finance, and operations. The current executive management team has been in place for several years and is responsible for supporting growth and international expansion, strengthening our financial condition, and improving our internal controls.

Growth Strategy

We seek to grow our business by pursuing the following strategies:

Attract and Retain Associates and Preferred Customers.   We recognize the need to continue to attract and retain Associates. In 2005, we maintained our emphasis on the partnership between the USANA management team and our Associate leaders. Through this partnership, our Associate leaders continued hosting “Health & Freedom” meetings and increased the number of online presentations, both aimed at presenting the business opportunity to potential Associates and providing additional training and resources for existing Associates. In addition to our Annual International Convention, we held several regional events in key growth areas to provide support and training to new Associates in these areas. In the trainings and events held during the year, we focused on the importance of “Delayed Gratification” in our business and the time it takes to build a successful business through training, sponsoring, and acquiring a strong customer base. Additionally, we suggested the use of accolades we have received from various business sources in substantiating our business.

In 2006, we intend to grow our business by continuing to focus on our two core values, “True Health” and “True Wealth.”  We plan to accomplish this by increasing the number of active Associates and teaching them how to build a strong customer base. By leveraging the current growth we have in our Associate field, we believe we can continue to attract individuals that are interested in joining a winning team and starting a home-based business with USANA. We will emphasize our new RESET™ Weight Management Program, as well as several other contests, incentives, and recognitions that are geared toward those interested in growing their USANA Business to a new level during the year. We will continue to emphasize “Sharing USANA” by educating our Associates on ways they can improve their effectiveness in presenting sales tools and product samples to prospects and the steps they can take to follow-up with prospects. We plan to leverage our many accomplishments, positive press, and break-through technology to demonstrate our competitive advantages within the industry. We also believe that actively promoting the success stories of our Associates in the field will likely increase rank advancements, the number of Associates receiving commissions, and awareness of preventive health. We intend to improve our training and recognition of Associate accomplishments in order to strengthen the commitment and success of our sales force. Moreover, we believe that an increasing interest from business and health care professionals, amateur and professional athletes, clubs, and associations will allow us to reach even more potential customers during 2006.

Enter New Markets.   We believe that significant growth opportunities continue to exist in markets where we currently conduct business and in new international markets. New markets are selected following an assessment of several factors, including market size, anticipated demand for USANA products, receptivity to network marketing, and ease of entry, which includes consideration of possible regulatory restrictions on our products or our network marketing system. We have begun to register certain products

7




with regulatory and government agencies in preparation for further international expansion. Wherever possible, we expect to seamlessly integrate the Compensation Plan in each market to allow Associates to receive commissions for global—not merely local—product sales. The seamless downline structure is designed to allow an Associate to build a global network by creating downlines across national borders. Associates are not required to establish new downlines or to re-qualify for higher levels of compensation in newly opened markets. We believe this seamless Compensation Plan can significantly enhance our ability to expand internationally, and we intend, where permitted, to integrate future markets into this plan.

Introduce New and Re-formulate Existing Products.   Our research and development team is continually researching the latest scientific findings related to nutrition, looking at new technology and attending scientific conferences. If, in the process, we see potential for a new product that provides a true health benefit addressing a particular health issue, and if we believe its benefits can be realized by a significant percentage of our customers, we will generally pursue development of that product. We also upgrade our products every two to five years to incorporate the latest science in nutrition. In 2005, we announced and introduced our new RESET Weight Management Program and accompanying RESET™ kit. We also reformulated our Nutrimeal™ shakes, improving their glycemic index score, as well as their taste. Additionally we created sample packets of our Nutrimeal shakes, which are not only great for sampling, but for convenience as well.

Pursue Strategic Acquisitions.   We believe that attractive acquisition opportunities may arise in the future. We intend to pursue strategic acquisition opportunities that would grow our customer base, expand our product lines, enhance our manufacturing and technical expertises, allow vertical integration, or otherwise complement our business or further our strategic goals.

Products

Our primary product lines within the Direct Selling segment consist of USANA® Nutritionals and Sensé™. The USANA® Nutritionals product line is further categorized into three separate classifications: Essentials, Optimizers, and Macro Optimizers.

USANA® Nutritionals

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: Usanimals™, a formulation of vitamins, minerals, and antioxidants, in an easy-to-take chewable tablet for children 13 months to 12 years old, and Body Rox™, a nutritional supplement containing 31 essential vitamins, minerals, antioxidants, and cofactors for adolescents 12 to 18 years old. USANA 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 USANA Essentials are also provided in a convenient pillow pack format, HealthPak 100™.

Optimizers are more targeted supplements designed to meet individual health and nutritional needs. Products in this category include Proflavanol®, Poly C®, Procosa® II, CoQuinone® 30, BiOmega-3™, E-Prime™, Active Calcium™, Active Calcium™ Chewable, PhytoEstrin™, Palmetto Plus™, Ginkgo-PS™, Garlic EC™, Visionex®, and OptOmega®.

Macro Optimizers include healthy, low-glycemic functional foods and other related products. Nutrimeal, Fibergy®, SoyaMax™ drink mixes, and Nutrition and Fibergy Bars™ are included in this product category. At our Annual International Convention held in September, we announced and introduced our new RESET Weight Management Program designed to assist in a long-term change in diet,

8




and accompanying RESET kit. The RESET kit is conveniently packaged in a self-contained box with everything needed to complete a five-day regimen, designed to assist in losing weight and alleviating carbohydrate and sugar cravings. With the introduction of the RESET Weight Management Program, as mentioned above, we also announced the reformulation of our Nutrimeal shakes and created Nutrimeal shake sample packets.

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. These products are produced with our patent-pending self-preserving technology. This new technology 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, Nutritious Crème Masque, Revitalizing Shampoo, Nourishing Conditioner, Firming Body Nourisher, Energizing Shower Gel, and Intensive Hand Therapy.

All Other

In addition to these 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 or sales tools include product brochures and business forms designed by us and printed by outside publishers. 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. We also write and develop our own materials for CDs and DVDs, which are produced by our wholly owned subsidiary, FMG Productions. New Associates are required to purchase a starter kit, which contains USANA training materials that assist 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 percentages of total product revenue for the Direct Selling segment that were contributed by our major product lines for the last three fiscal years:

 

 

Sales By Product Line
Year Ended

 

Product Line

 

 

 

2003

 

2004

 

2005

 

USANA® Nutritionals

 

 

 

 

 

 

 

 

 

 

 

 

 

Essentials*

 

 

39

%

 

 

38

%

 

 

38

%

 

Optimizers

 

 

34

%

 

 

34

%

 

 

34

%

 

Macro Optimizers

 

 

8

%

 

 

10

%

 

 

10

%

 

Sensé—beautiful science® 

 

 

14

%

 

 

14

%

 

 

15

%

 

All Other

 

 

5

%

 

 

4

%

 

 

3

%

 


*                    The Essentials category under the USANA® Nutritionals product line includes USANA Essentials, HealthPak 100™, Body Rox™, and Usanimals™.

9




Key Products

The following highlights sales data for our top-selling products as a percentage of Direct Selling segment product sales for the last three fiscal years.

 

 

Year Ended

 

 

 

2003

 

2004

 

2005

 

USANA® Essentials

 

 

22

%

 

 

24

%

 

 

22

%

 

HealthPack 100™

 

 

9

%

 

 

11

%

 

 

13

%

 

Proflavanol® 

 

 

9

%

 

 

10

%

 

 

10

%

 

 

Research and Development

We are committed to providing our customers with advanced health products that reduce the risk of chronic degenerative disease and promote long-term health. We have developed a very compact and focused line of products through our research and development program, which is based upon established research methodologies. Our research facilities are located at our Salt Lake City headquarters, and are equipped to conduct analytical testing of raw ingredients, raw material extraction research, in vitro and in vivo testing, and human bioavailability studies. Additionally, our scientists are continuously reviewing the latest published research on nutrition, attending scientific conferences, and working in collaboration with a number of outside research institutions and researchers. With the acquisition of our own skin care manufacturing facility in 2003, our research and development expertise also includes formulation development and quality control of skin and personal care products.

We follow pharmaceutical standards established by the U.S. Pharmacopeia in the development and reformulation of our products. Our ingredients are selected to meet a number of criteria, including, but not limited to: safety, potency, purity, stability, bioavailability, natural versus synthetic, and whether the ingredients are reliably available. We control the quality of our products beginning at the development stage, and maintain our quality control through manufacturing, packaging, and labeling. In fiscal years 2003, 2004, and 2005, we expended $1.4 million, $2.0 million, and $2.3 million, respectively, on company-sponsored research and development activities. We intend to continue to dedicate resources at similar levels for the research and development of new products and the reformulation of existing products.

Manufacturing and Quality Assurance

Tablet manufacturing is conducted at our Salt Lake City, Utah manufacturing facility. The production process for tablet-based products includes identifying and evaluating suppliers of raw materials, acquiring raw materials, analyzing raw material quality, weighing or otherwise measuring the raw materials, mixing raw materials into batches, forming the mixtures into tablets, coating and sorting the tablets, analyzing tablet quality, packaging finished products, and analyzing finished product quality.

Our tablet manufacturing process uses automatic and semi-automatic equipment. We conduct sample testing of raw materials and finished products for purity, potency, and composition conforming to strict specifications. Constructed in 1996, the tablet production facility is registered with the U.S. Food and Drug Administration (“FDA”) and Health Canada and has been inspected and certified by the Australian Therapeutic Goods Administration (“TGA”). In the United States, the manufacture of nutritional supplements and related products requires compliance with food-level Good Manufacturing Practice regulations (“GMP’s”). We believe that our processes comply with the FDA’s more demanding drug-level GMP’s. The certification by the TGA also denotes compliance with that agency’s drug-level GMP’s.

In addition to tablet manufacturing, we also manufacture premium personal care products at our Draper, Utah manufacturing facility, which we acquired in July of 2003 as part of a vertical integration strategy to bring the production of our Sensé™ product line in-house. Contract manufacturing services are

10




also provided to a limited number of third-party customers through this facility. During 2004, we completed construction upgrades to our Draper, Utah manufacturing facility that were designed to conform it to the FDA’s GMP’s. The production process for personal care products includes identifying and evaluating suppliers of raw materials, acquiring raw materials, analyzing raw material quality, weighing or otherwise measuring the raw materials, mixing raw materials into batches, analyzing liquid batch quality, packaging finished products, and analyzing finished product quality.

Our Draper manufacturing facility is registered with the FDA as a pharmaceutical facility, consistent with a facility that manufactures over-the-counter personal care products. The facility has standard kettles and technology for producing batches of personal care items and semi-automatic packaging equipment for packaging the end product. It employs qualified staff to develop, implement, and maintain a quality system that we believe is consistent with requirements under drug-level GMP’s.

We contract with third-party manufacturers and suppliers for the production of some of our products. These third-party suppliers and manufacturers produce and, in most cases, package these products according to formulations developed by or in conjunction with our in-house product development team. Products currently supplied through third parties include gelatin-capsuled supplements, Garlic EC™, OptOmega® , certain powdered drink mixes, and nutrition and fiber bars.

We conduct quality control processes in two in-house laboratories located in Salt Lake City, Utah. In the microbiology laboratory, scientists test for biological contamination of raw materials and finished goods. In the analytical chemistry laboratory, scientists test for chemical contamination and accurate active ingredient levels of raw materials and finished products. Both laboratories conduct stability tests on finished products to determine product shelf life. Our laboratory staff also performs chemical assays on vitamin and mineral constituents under United States Pharmacopoeia methods and other internally validated methods. In addition to the quality control and clinical laboratories, our headquarters facility also houses a laboratory designated for research and development.

Most of the raw ingredients used in the manufacture of our products, for both the Direct Selling and Contract Manufacturing segments, are available from a number of suppliers. We have not generally experienced difficulty in obtaining necessary quantities of raw ingredients. When supplies of certain raw materials have tightened, we have been able to find alternative sources of raw materials, as needed, and believe we will be able to do so in the future, if the need arises.

In 2003 we began experiencing a shortage in supply of one of our raw materials, Coenzyme Q10 (CoQ10). At that time awareness of the benefits derived from CoQ10 had increased dramatically, causing a sharp increase in demand and a subsequent shortage in supply. Although we had qualified multiple sources for this raw ingredient, as a result of the increased demand and shortage in supply, our purchase price on this raw ingredient continued to dramatically increase through 2004 and the first part of 2005. By mid-2005 some suppliers had re-tooled their manufacturing facilities to increase production capacity of CoQ10, and more competitors entered the market, which has caused supply to increase and purchase prices to decline.

Our Salt Lake City, Utah manufacturing facility has five kitting or dispensing rooms, four large blenders, seven production tablet presses, three coaters, three sorting lines, two bottling lines, and two pillow-pack lines. We currently operate two ten-hour shifts, four days per week. There is, however, no restriction from processes or equipment to add and additional shift for increased capacity. Based on equipment capacity and current product mix, the average manufacturing and packaging utilization rate is at approximately 66% of capacity, assuming two ten-hour shifts, four days per week.

Our Draper, Utah manufacturing facility currently produces an average of 6.8 million filled containers per annum. Assuming two ten-hour shifts per day, four days per week, the facility uses approximately 64% of manufacturing and packaging capacity.

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Distribution and Marketing

We distribute products through a network marketing system, which is a form of person-to-person direct selling through a network of vertically organized independent distributors who purchase products at wholesale prices from the manufacturer and then make retail sales to consumers. The emergence of readily available means of mass communication, such as personal computers, facsimiles, low-cost long distance telephone services, satellite conferencing and the Internet, has contributed to the rapid growth of network marketing. The concept of network marketing is based on the strength of personal recommendations that frequently come from friends, neighbors, relatives, and close acquaintances. We believe that network marketing is an effective way to distribute our products because it allows person-to-person product education, which is not as readily available through other distribution channels.

A person who wishes to sell USANA products must join our independent sales force as an Associate. A person becomes an Associate by completing an application under the sponsorship of an existing Associate. The new Associate then becomes part of the sponsoring Associate’s downline sales organization. New Associates sign a written contract and agree to adhere to the USANA policies and procedures. New Associates are also required to purchase a starter kit that includes a detailed manual, including our policies and procedures. Starter kits are sold at our cost for a purchase price of approximately $49. We also offer starter kits in an electronic format at a lower price, which are also sold at our cost.

Subject to payment of an annual renewal fee, Associates may continue to distribute products until they voluntarily withdraw or are terminated. Initial training of Associates about the products, the Compensation Plan, network marketing, and about USANA is provided primarily by an Associate’s sponsor and others in their sales organization. In addition, we develop and sell training materials and sales tools to assist Associates in building their businesses. We also periodically sponsor and conduct regional, national, and international Associate events and intensive leadership training seminars. Attendance at these sessions is voluntary, and we undertake no generalized effort to provide individualized training to Associates, although experience shows that the most effective and successful Associates participate in training activities. Associates may not sell competitive products to other USANA Associates or solicit USANA Associates to participate in other network marketing opportunities. Our policies and procedures also restrict Associates’ advertising and representations or claims concerning USANA products or the Compensation Plan.

The Compensation Plan provides several opportunities for Associates to earn compensation, provided they are willing to consistently work at building, training, and retaining their downline organizations to sell USANA products to consumers. We believe this Compensation Plan is distinctive for its weekly distributions and equitable payouts, which are designed to create appropriate incentives for the sale of USANA products. Each Associate must purchase and sell products in order to earn commissions and bonuses. Associates cannot simply recruit others for the purpose of developing a downline and earn income passively, depending solely on the efforts of the downline.

Associates can earn compensation primarily in three ways:

·       Generating sales volume points based on their sales activity and the sales activity of their downline sales organization;

·       Participating in a leadership bonus pool based on certain performance requirements; and

·       Purchasing products at wholesale prices from USANA and selling them to consumers at higher retail prices.

We also offer Associates the opportunity to earn additional compensation through Company-sponsored promotions and contests. Most of our products are assigned sales volume points. Commission

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payments to Associates are based on total personal and downline sales volume points, with commissions paid weekly. As an Associate successfully expands his or her downline sales organization and as those in the downline also successfully expand, the Associate can receive higher commissions.

We endeavor to seamlessly integrate this Compensation Plan across all markets in which USANA products are sold, allowing Associates to receive commissions for global—not merely local—product sales. This seamless downline structure is designed to allow an Associate to build a global network by creating downlines across national borders. Associates may expand their downline organizations into new markets without establishing new downlines or requalifying for higher levels of compensation in the newly opened markets. We believe this seamless Compensation Plan significantly enhances our ability to expand internationally, and we intend, where permitted, to continue to integrate new markets into this plan.

Most Associates sell our products on a part-time basis and consume them personally. The sponsoring of new Associates results in the creation of multiple levels within our network marketing structure. Sponsored Associates are referred to as the “downline” of the sponsoring Associate. Downline Associates may also sponsor new Associates, creating additional levels in their network, but also forming a part of the same downline as the original sponsoring Associate. Associates interested in earning additional income who successfully expand their business network or downline can qualify for higher levels of compensation, as well as leadership bonuses, by attaining certain sales volume levels and demonstrating leadership abilities. We do not pay commissions based on recruiting or sponsorship activity.

We also sell directly to customers who purchase products only for personal consumption. This program is our “Preferred Customer” program. Preferred Customers may not resell or distribute the products. We believe this program gives us access to a market that would otherwise be missed, by targeting customers who enjoy USANA products, but who prefer not to maintain a sales, distribution, or other business relationship with USANA. Although our policies prohibit Preferred Customers from engaging in retail sales of products purchased through the program, they may enroll as Associates at any time if they desire. Only Associates are eligible to earn commissions and participate in the Compensation Plan.

Product Returns

Our product return policy allows retail customers to return the unused portion of any product to the Associate who sold them the product for a full cash refund. We reimburse our Associates based on the original form of payment or with product or credit on account upon receipt of proper documentation and the return of the remaining product.

All returned product within the first 30 days following purchase is refunded at 100% of the sales price to all non-Associate customers. This 30-day return policy is offered to Associates only on their first order. All other returned product that is unused and resalable is refunded up to one year from the date of purchase at 100% of the sales price less a 10% restocking fee. Return of product that was not damaged at the time of receipt by the Associate may result in cancellation of the Associate’s distributorship according to the terms of the Associate agreement. During fiscal years 2003, 2004, and 2005 returns as a percentage of net sales were 2.4%, 2.1%, and 1.5%, respectively.

Major Customers

Sales in our Direct Selling segment are made to independent Associates and Preferred Customers. No single customer accounted for 5% or more of net sales in any of the last three fiscal years. Associates are independent contractors and are not agents, employees, or legal representatives of USANA. Our employees and affiliates cannot be Associates, although there is no prohibition on their family members becoming Associates as long as they do not reside in the same household as the employee or affiliate. Associates may sell products only in countries where we have approved the sale of our products.

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In the Contract Manufacturing segment, we had two customers in 2005 that each accounted for more than 10% of segment sales.

Compliance by Associates

From time to time Associates fail to adhere to the USANA policies and procedures, including those governing the marketing of our products or making representations regarding the Compensation Plan. We systematically review reports of alleged Associate misbehavior. Infractions of the policies and procedures are reported to a compliance committee that determines what disciplinary action may be warranted in each case. If we determine that an Associate has violated any of the USANA policies and procedures, we may take a number of disciplinary actions. For example, we may impose sanctions, such as warnings, fines or probation. We also may withdraw or deny awards, suspend privileges, withhold commissions until specific conditions are satisfied, or take other appropriate actions at our discretion. More serious infractions may result in termination of the Associate’s purchase and distribution rights completely.

Information Technology

We believe that the ability to efficiently manage distribution, compensation, manufacturing, inventory control, and communications functions through the use of sophisticated and dependable information processing systems is critical to our success. To optimally support our customer base and core business processes, our information technology resources consist of a customized, Web-enabled order-entry system and an Enterprise Resource Planning system that operate on an Oracle platform and are fully integrated worldwide. Our information systems are maintained primarily by our in-house staff.

Regulatory Matters

Product Regulation.   Numerous governmental agencies in the United States and other countries regulate the manufacturing, packaging, labeling, advertising, promoting, distributing, and the selling of nutrition, health, beauty, and weight management products. In the United States advertisement of our products is regulated by the Federal Trade Commission (“FTC”) under the FTC Act and, where such advertising is considered to be product labeling by the FDA, under the Food, Drug, and Cosmetic Act (“FD&C”) and regulations promulgated under that act. USANA products are also subject to regulation by, among others, the Consumer Product Safety Commission, the US Department of Agriculture, and the Environmental Protection Agency. The manufacturing, labeling, and advertising of products are also regulated by various governmental agencies in each foreign country in which they are distributed. For example, in Australia we are subject to the Therapeutic Goods Administration and in Japan to the Ministry of Health, Labor and Welfare.

Our largest product group in terms of sales includes products that are regulated as dietary supplements under the FD&C. Dietary supplements are also regulated in the United States under the Dietary Supplement Health and Education Act of 1994 (“DSHEA”). We believe DSHEA provides a favorable regulatory climate to the dietary supplement industry. Some of our powdered drink, food bar, and other nutrition products are regulated as foods under the Nutrition Labeling and Education Act of 1990 (“NLEA”). The NLEA establishes requirements for ingredient and nutritional labeling and labeling claims for foods. Although we believe our product claims comply with the law, we may need to revise some product labeling at a future date if labeling requirements change.

Under these regulations, a dietary supplement that contains a new dietary ingredient (defined as an ingredient not on the market before October 15, 1994) must have a history of use or other evidence of safety establishing that it is reasonably expected to be safe. The manufacturer must notify the FDA at least 75 days before marketing products containing new dietary ingredients and provide the FDA with the

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information upon which the manufacturer based its conclusion that the product has a reasonable expectation of safety.

On March 13, 2003, the FDA announced a proposal for new GMP’s specific to dietary supplements. As of December 31, 2005, there has been no update to the FDA’s proposal for new dietary supplement GMP’s. These GMP’s, if promulgated, may be significantly more rigorous than currently applicable GMP’s. We believe that we currently manufacture our dietary supplement products according to the standards of the FDA’s pharmaceutical-level GMP’s. If new GMP’s are adopted, however, we may be required to expend additional capital and resources on manufacturing controls in the future in order to comply with the law.

Other products include cosmetics and products that are deemed to be over-the-counter (“OTC”) drugs. In general, our cosmetic products are not subject to pre-market approval by the FDA. However, cosmetics are subject to regulation by the FDA under the FD&C adulteration and misbranding provisions. Cosmetics also are subject to specific labeling regulations, including warning statements, if the safety of a cosmetic is not adequately substantiated or if the product may be hazardous, as well as ingredient statements and other packaging requirements under the Fair Packaging and Labeling Act. Cosmetics that meet the definition of a drug (i.e., that are intended to treat or prevent disease or affect the structure or function of the body), such as our sunscreens, are regulated as drugs. OTC drug products may be marketed if they conform to the requirements of the OTC monograph that is applicable to that drug. Drug products not conforming to monograph requirements require an approved New Drug Application (“NDA”) before marketing. Under these provisions, if the agency were to find that a product or ingredient of one of our OTC drug products is not generally recognized as safe and effective or is not included in a final monograph applicable to one of our OTC drug products, we will have to reformulate or cease marketing that product until it is the subject of an approved NDA or until the time, if ever, that the monograph is amended to include the product. If such an agency ruling were to become final, we would be required to stop marketing the product as currently formulated. Whether or not an OTC drug product conforms to a monograph or is subject to an approved NDA, the drug must comply with other requirements under the FDCA, including GMP’s, labeling, and the FDCA’s misbranding and adulteration provisions.

Advertising of products is subject to regulation by the FTC under the FTC Act. Section 5 of the FTC Act prohibits unfair methods of competition and unfair or deceptive acts or practices in or affecting commerce. Section 12 of the FTC Act provides that disseminating any false advertisement pertaining to drugs or foods, which would include dietary supplements, is an unfair or deceptive act or practice. Under the FTC’s Substantiation Doctrine, an advertiser is required to have a “reasonable basis” for all objective product claims before the claims are made. Failure to adequately substantiate claims may be considered either deceptive or unfair practices. Pursuant to this FTC requirement, we are required to have adequate substantiation for all material advertising claims made for our products.

In recent years the FTC has initiated numerous investigations of and actions against dietary supplement, weight management, and cosmetic products and companies. The FTC has issued a guidance document to assist companies in understanding and complying with the substantiation requirement. We believe that we have organized the documentation to support our advertising and promotional practices in compliance with these guidelines.

The FTC may enforce compliance with the law in a variety of ways, both administratively and judicially, using compulsory process, cease and desist orders, and injunctions. FTC enforcement can result in orders requiring, among other things, limits on advertising, corrective advertising, consumer redress, divestiture of assets, rescission of contracts, and such other relief as the agency deems necessary to protect the public. Violation of these orders could result in substantial financial or other penalties. We have not been notified that we were the subject of any action by the FTC, but any action in the future by the FTC could materially adversely affect our ability to successfully market our products.

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The events of September 11, 2001 highlighted the need to enhance the security of the U.S. food supply. Congress responded by passing the Public Health Security and Bioterrorism Preparedness and Response Act of 2002 (“Bioterrorism Act”). We expect that several provisions of the Bioterrorism Act will place additional regulatory compliance issues upon us. For example, one provision in the Bioterrorism Act requires the Secretary of Health and Human Services to develop regulations that mandate domestic and foreign facilities that manufacture, process, pack, or hold food for human or animal consumption in the United States to register with the FDA. On November 24, 2003, we fulfilled this requirement by registering with the FDA. Another provision of the Bioterrorism Act mandates that the FDA receive prior notification of all food importation. Although some of our raw materials and certain manufactured product may originate outside of the United States, we procure these items from entities in the United States. From time to time we may bring consumable products that we have sent from our Salt Lake facility to our international locations back into the United States from one or more of these locations. When bringing these products back into the United States from any international location, we are required to comply with this notification requirement.

In markets outside the United States, prior to commencing operations or marketing products, we may be required to obtain approvals, licenses, or certifications from a country’s ministry of health or comparable agency. Approvals or licensing may be conditioned on reformulation of USANA products for the market or may be unavailable with respect to certain products or product ingredients. We must also comply with local product labeling and packaging regulations that vary from country to country. Foreign regulatory requirements have not placed a significant burden on our ability to operate in current foreign countries.

We cannot predict the nature of any future laws, regulations, interpretations, or applications, nor can we determine what effect additional governmental regulations or administrative orders, when and if promulgated, would have on our business in the future. Future changes could include requirements for the reformulation of certain products to meet new standards, the recall or discontinuation of certain products that cannot be reformulated, additional record keeping, expanded documentation of the properties of certain products, expanded or different labeling, and additional scientific substantiation. Any or all of these requirements could have a material adverse effect on our business, financial condition, and results of operations.

Network Marketing Regulation.   Laws and regulations in each country in which we operate prevent the use of deceptive or fraudulent practices that have sometimes been inappropriately associated with legitimate direct selling and network marketing activities. These laws include anti-pyramiding, securities, lottery, referral selling, anti-fraud and business opportunity statutes, regulations, and court cases. Illegal schemes, typically referred to as “pyramid,” “chain distribution,” or “endless chain” schemes, compensate participants primarily or solely for the introduction or enrollment of additional participants into the scheme. Often these schemes are characterized by large up-front entry or sign-up fees, over-priced products of low value, little or no emphasis on the sale or use of products, high-pressure recruiting tactics, and claims of huge and quick financial rewards requiring little or no effort. Generally these laws are directed at ensuring that product sales ultimately are made to consumers and that advancement within sales organizations is based on sales of the enterprise’s products, rather than investments in the organizations or other non-retail sales related criteria or activity. Where required by law, we obtain regulatory approval of our network marketing system, or, where approval is not required or available, the favorable opinion of local counsel as to regulatory compliance.

In addition to federal regulation in the United States, each state has enacted its own “Little FTC Act” to regulate sales and advertising. Occasionally we receive requests to supply information regarding our network marketing plan to regulatory agencies. Although we have from time to time modified our network marketing system to comply with interpretations of various regulatory authorities, we believe that our network marketing program is in compliance with laws and regulations relating to network marketing

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activities in our current markets. Nevertheless, we remain subject to the risk that, in one or more of our present or future markets, the marketing system or the conduct of certain Associates could be found not to be in compliance with applicable laws and regulations. Failure by an Associate or us to comply with these laws and regulations could have a material adverse effect on our business in a particular market or in general. Any or all of these factors could adversely affect the way we do business and could affect our ability to attract potential Associates or enter new markets. In the United States, the FTC has been active in its enforcement efforts against both pyramid schemes and legitimate network marketing organizations with certain legally problematic components, having instituted several enforcement actions resulting in signed settlement agreements and payment of large fines. Although to our knowledge we have not been the target of an FTC investigation, there can be no assurance that the FTC will not investigate us in the future.

We cannot predict the nature of any future law, regulation, interpretation, or application, nor can we predict what effect additional governmental legislation or regulations, judicial decisions, or administrative orders, when and if promulgated, would have on our business in the future. It is possible that future developments may require that we revise our network marketing program. Any or all of these requirements could have a material adverse effect on our business, results of operations, and financial condition.

Transfer Pricing Regulation.   We have adopted transfer prices, which are supported by a formal transfer pricing study for the sale of products to our subsidiaries in accordance with applicable transfer pricing laws. In addition, agreements between the subsidiaries and the parent corporation have been entered into for services and contractual obligations, such as the payment of Associate incentives that are also supported by the same formal transfer pricing study. If the United States Internal Revenue Service or the taxing authorities of any other jurisdiction were to successfully challenge these agreements or require changes in our standard transfer pricing practices for products, we could become subject to higher taxes and our earnings may be adversely affected if our foreign tax credit was limited on our U.S. tax return. The tax treaties between the United States and most foreign countries provide for competent authority relief to avoid any double taxation. We believe that we operate in compliance with all applicable transfer pricing regulations. However, there can be no assurance that we will continue to be found to be operating in compliance with transfer pricing regulations or that those laws will not be modified, which may require changes in our operating procedures.

Competition

The business of developing and distributing nutritional and personal care products, such as those we sell and distribute, is highly competitive due to the nature of the industry. The nutritional supplement market is characterized by:

·       Large selections of essentially similar products that are difficult to differentiate;

·       Retail consumer emphasis on value pricing;

·       Changing formulations based on evolving scientific research;

·       Low barriers to entry resulting from low brand loyalty, rapid change, widely available manufacturing, low regulatory requirements, and ready access to large distribution channels; and

·       A lack of uniform standards regarding product ingredient sources, potency, purity, absorption rate, and form.

Similar factors are also characteristic of products comprising our other product lines.

Numerous manufacturers, distributors, and retailers compete for consumers and, in the case of other network marketing companies, for distributors. We compete directly with other entities that develop,

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manufacture, market, and distribute products in each of our product lines. We compete with these entities by emphasizing the underlying science, value, and superior quality of our products, as well as the convenience and financial benefits afforded by our network marketing system and Compensation Plan. However, many of our competitors are substantially larger, have greater financial resources, and have broader name recognition than we have. There can be no assurance that we will be able to effectively compete in this intensely competitive environment.

Our markets are highly sensitive to the introduction of new products that may rapidly capture a significant share of those markets. Our product offerings in each product category are relatively few, compared to the wide variety of products offered by many of our competitors, and are often premium priced. As a result, our ability to remain competitive depends in part upon the successful introduction of new products and enhancements of existing products.

We also compete with other network marketing organizations for the time, attention, and commitment of new and current Associates. Our ability to remain competitive in this regard depends, in significant part, on our success in recruiting and retaining Associates. We believe that we offer a rewarding Associate Compensation Plan and attractive Associate benefits and services. To the extent practicable, our Associate Compensation Plan is designed to be seamless, permitting international expansion without re-qualification or re-entry requirements. We also pay Associate incentives weekly, reducing the time an Associate must wait between purchase and sale of products and payment of commissions. However, there can be no assurance that our programs for recruiting and retaining Associates will be successful. The pool of individuals interested in the business opportunities presented by network marketing tends to be limited in each market and is reduced to the extent other network marketing companies successfully recruit these individuals into their businesses. Although we believe that we offer an attractive opportunity for our Associates, there can be no assurance that other network marketing companies will not be able to recruit our existing Associates or deplete the pool of potential Associates in a given market.

We believe that the leading network marketing company in the world, based on total sales, is Amway Corporation and its affiliates, and that Avon Products, Inc. is the leading direct seller of beauty and related products worldwide. Leading competitors in the nutritional network marketing and nutritional product industry include Herbalife, Inc., Market America, Inc., Nature’s Sunshine Products, Inc., Nu Skin Enterprises, Inc., NBTY, Inc., and Schiff Nutrition International, Inc. We believe there are other manufacturers of competing product lines that may launch direct selling enterprises, which will compete with us in certain product lines and for Associates. There can be no assurance that we will be able to successfully meet the challenges posed by this increased competition.

Intellectual Property

Trademarks.   We have developed and we use registered trademarks in our business, particularly relating to our corporate and product names. We own 14 trademarks registered with the United States Patent and Trademark Office. We also have one pending application to register a trademark in the United States. Federal registration of a trademark enables the registered owner of the mark to bar the unauthorized use of the registered mark in connection with a similar product in the same channels of trade by any third party anywhere in the United States, regardless of whether the registered owner has ever used the trademark in the area where the unauthorized use occurs. We have filed applications and own trademark registrations, and we intend to register additional trademarks in foreign countries where USANA products are or may be sold in the future. Protection afforded to registered trademarks in some jurisdictions may not be as extensive as the protection available in the United States.

We also claim ownership and protection of certain product names, unregistered trademarks, and service marks under common law. Common law trademark rights do not provide the same level of protection afforded by registration of a trademark. In addition, common law trademark rights are limited

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to the geographic area in which the trademark is actually used. We believe these trademarks, whether registered or claimed under common law, constitute valuable assets, adding to recognition of USANA, and the marketing of USANA products. We therefore believe that these proprietary rights have been and will continue to be important in enabling us to compete.

Trade Secrets.   We own certain intellectual property, including trade secrets, that we seek to protect, in part, through confidentiality agreements with employees and other parties, although some employees involved in research and development activities have not entered into these agreements. Even where these agreements exist, there can be no assurance that these agreements will not be breached, that we would have adequate remedies for any breach, or that our trade secrets will not otherwise become known to or independently developed by competitors. Our proprietary product formulations are generally considered trade secrets, but are not otherwise protected under intellectual property laws.

Patents.   We have two patents, issued in 2002, which will continue in force for 17 years from the date of issue. These patents are process patents and relate to the method of extracting an antioxidant from olives and the waste products of olive oil production. In 2003, we entered into a licensing agreement with a supplier to make olive extract using our patented process. Currently, it is very difficult to determine the exact future benefit of these patents. However, we believe that the patents have the potential to generate additional revenue in the future through new product development and royalties from licensing.

Products within the Contract Manufacturing segment are developed on behalf of customers and are labeled under customer brand names. We currently do not possess intellectual property claims for products in this segment.

We intend to protect our legal rights concerning intellectual property by all appropriate legal action. Consequently, we may become involved from time to time in litigation to determine the enforceability, scope, and validity of any of the foregoing proprietary rights. Any patent litigation could result in substantial cost and divert the efforts of management and technical personnel.

Seasonality

We believe that the impact of seasonality on results of operations is not material for either the Direct Selling or Contract Manufacturing segments.

Backlog

Products sold within the Direct Selling segment are typically shipped within 72 hours after the receipt of the order. As of February 24, 2006, there was no significant backlog in either the Direct Selling or Contract Manufacturing segment.

Working Capital Practices

We maintain sufficient amounts of inventory in stock for our Direct Selling segment in order to provide a high level of service to Associates and Preferred Customers. Substantial inventories are required to meet the needs of our dual role as manufacturer and distributor. Our Contract Manufacturing segment maintains adequate amounts of commodity inventory (that which can be used for various customers) and minimal quantities of specialty inventory (that which is ordered specifically for the needs of individual customers) to meet customer demand. We also watch seasonal commodity markets and may buy ahead of normal demand to hedge against cost and supply risks.

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Environment

We are not aware of any instance in which we have contravened federal, state, or local provisions enacted for or relating to protection of the environment or in which we otherwise may be subject under environmental laws to liability for environmental conditions that could materially affect operations.

Employees

As of February 24, 2006, we had 769 employees worldwide, as measured by full time equivalency. Our employees are not currently represented by a collective bargaining agreement, and we have not experienced work stoppages as a result of labor disputes. We believe our relationship with our employees is good.

Additional Available Information

We make available, free of charge at our corporate web site, copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to these reports as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC pursuant to Section 13(a) or 15(d) of the Exchange Act. This information may also be obtained from the SEC’s on-line database located at www.sec.gov.

Item 1A. Risk Factors

Forward-Looking Statements and Certain Risks

The statements contained in this report that are not purely historical are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act. These statements relate to our expectations, hopes, beliefs, commitments, intentions, and strategies regarding the future. They may be identified by the use of words or phrases, such as “believe,” “expect,” “anticipate,” “should,” “plan,” “estimate,” and “potential,” among others. Forward-looking statements include, but are not limited to, statements contained in “Business” and “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 and capital spending needs. Actual results could differ materially from the anticipated results or other expectations expressed in these forward-looking statements or for the reasons discussed below. The fact that some of the risk factors may be the same or similar to past reports we have 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 are part of doing business in the industry in which we operate 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 these forward-looking statements. Among others, risks and uncertainties that may affect our business, financial condition, performance, development, and results of operations include the following:

As a network marketing company, we are dependent upon an independent sales force and we do not have direct control over the marketing of our products.   We rely on non-employee, independent Associates to purchase, market, and sell our products. Associates are independent contractors who purchase products directly for their own use or for resale. Associates typically work at the distribution of the products on a part-time basis and may and likely will engage in other business activities, some of which may compete with us. We have a large number of Associates and a relatively small corporate staff to implement our marketing programs and to provide motivational support to our Associates. We undertake minimal effort to provide individual training to Associates. Associates may voluntarily terminate their agreements with us at any time. There is typically significant turnover in Associates from year to year.

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Because of this high turnover, we must continually recruit new Associates. Our net sales are directly dependent upon the efforts of these non-employee, independent Associates. Future growth in sales volume will depend in large part upon our success in increasing the number of new Associates and improving the productivity of Associates.

Our net sales are significantly affected by our success in growing existing markets, as well as opening new markets. If we lose market share in existing markets or are unable to open new markets we might have difficulty achieving our long-term objectives.   We experienced revenue growth in 2003 and 2004 due in part to the successful expansion of our operations into Taiwan, South Korea, Singapore and Mexico. North Korea has experienced significant political tension created by North Korean government actions involving its nuclear program. There is no assurance that this situation will not adversely affect our operations in South Korea or that the tensions created by the situation in North Korea will not adversely affect our other operations in neighboring countries, such as Japan, Hong Kong, and Taiwan. If the political situation in North Korea adversely affects the economies or political situation in South Korea or our existing markets in the region, our net sales and profits in fiscal year 2006 may be affected.

In 2005 we planned to open one new market, however, we have not yet received all required local government approvals to commence operations in that market. If we are unable to obtain local government approval, our net sales and profits in fiscal year 2006 may fall short of guidance for the year.

On December 1, 2005, China announced the adoption of new regulations governing direct selling. Single-level compensation models are permissible under the new regulations, however, these regulations prohibit multi-level compensation models as practiced by USANA and many other direct selling companies. If we were to enter the Chinese market we would be required to adjust our compensation and selling model to comply with the specific form of direct selling permissible under the new regulations. These adjustments could require more time and effort to enter the Chinese market than would otherwise be necessary if multi-level compensation models were permissible. Additionally, modifying our successful compensation plan and sales model may create uncertainty regarding our expectations for success after entering the market.

If the number or productivity of independent Associates does not increase, our revenue will not increase.   To increase revenue, we must increase the number and/or the productivity of our Associates. We can provide no assurances that the number of Associates will increase or remain constant, or that their productivity will increase. We experienced a 33.3%, 29.5%, and 16.7% increase in active Associates during 2003, 2004, and 2005 respectively. The number of active Associates may not increase and could decline in the future. Associates may terminate their services at any time, and, like most direct selling companies, we experience a high turnover among Associates from year to year. We cannot accurately predict any fluctuation in the number and productivity of Associates because we primarily rely upon existing Associates to sponsor and train new Associates and to motivate new and existing Associates. Operating results could be adversely affected if our existing and new business opportunities and products do not generate sufficient economic incentive or interest to retain existing Associates and to attract new Associates.

The violation of marketing or advertising laws by Associates in connection with the sale of our products or the promotion of our Compensation Plan could adversely affect our business.   New Associates sign a written contract and agree to adhere to the USANA policies and procedures. Although these policies and procedures prohibit Associates from making certain claims regarding products or income potential from the distribution of the products, Associates may from time to time, without our knowledge and in violation of our policies, create promotional materials or otherwise provide information that does not accurately describe our marketing program. They also may make statements regarding potential earnings, product claims, or other matters in violation of our policies or applicable laws and regulations concerning these matters. These violations may result in legal action against us by regulatory

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agencies or state attorneys general. Legal actions against Associates or others associated with us could lead to increased regulatory scrutiny of our business, including our network marketing system. We take what we believe to be commercially reasonable steps to monitor Associate activities to guard against misrepresentation and other illegal or unethical conduct by Associates and to assure that the terms of our Compensation Plan are observed. There can be no assurance, however, that our efforts in this regard will be sufficient to accomplish this objective. Publicity resulting from these Associate activities can also make it more difficult for us to attract and retain Associates and may have an adverse effect on our business, financial condition, and results of operations.

Network marketing is subject to intense government scrutiny and regulation, which adds to the expense of doing business and the possibility that changes in the law might adversely affect our ability to sell some of our products in certain markets.   Network marketing systems such as ours are frequently subject to laws and regulations directed at ensuring that product sales are made to consumers of the products and that compensation, recognition, and advancement within the marketing organization are based on the sale of products rather than investment in the sponsoring company. We are subject to the risk that, in one or more of our present or future markets, our marketing system could be found not to comply with these laws and regulations or may be prohibited. Failure to comply with these laws and regulations or such a prohibition could have a material adverse effect on our business, financial condition, and results of operations. Further we may simply be prohibited from distributing products through a network-marketing channel in some foreign countries, or be forced to alter our Compensation Plan.

Our business is subject to the effects of adverse publicity and negative public perception.   Our ability to attract and retain Associates and to sustain and enhance sales through our Associates can be affected by adverse publicity or negative public perception regarding our industry, our competition, or our business generally. This negative public perception may include publicity regarding the legality of network marketing, the quality or efficacy of nutritional supplement products or ingredients in general or our products or ingredients specifically, and regulatory investigations, regardless of whether those investigations involve us or our Associates or the business practices or products of our competitors or other network marketing companies. There can be no assurance that we will not be subject to adverse publicity or negative public perception in the future or that such adverse publicity will not have a material adverse effect on our business, financial condition, and results of operations.

The loss of key management personnel would adversely affect our business.   Our Founder, Chairman and CEO, Dr. Wentz, is a highly visible spokesman for our products and our business, and our message is based in large part on the vision and reputation of Dr. Wentz, which helps distinguish us from our competitors. The loss or limitation of Dr. Wentz as the lead spokesman for our mission, business and products could have a material adverse effect upon our business, financial condition, and results of operations. In addition, our executive officers, including executive vice presidents, are primarily responsible for our day-to-day operations, and we believe our success depends in part on our ability to retain our executive officers, to compensate our executive officers at attractive levels, and to continue to attract additional qualified individuals to our management team. We cannot guarantee continued service by our key executive officers. We do not maintain key man life insurance on any of our executive officers, nor do we have an employment agreement with any of our executive officers. The loss or limitation of the services of any of our executive officers or the inability to attract additional qualified management personnel could have a material adverse effect on our business, financial condition, and results of operations.

The beneficial ownership of a significant percentage of our common stock gives Dr. Wentz effective control and limits the influence of other shareholders on important policy and management issues.   Gull Holdings, Ltd., an entity that is solely owned and controlled by Dr. Wentz, owned 45.01% of our outstanding common stock at December 31, 2005. By virtue of this stock ownership, Dr. Wentz is able to exert significant influence over the election of the members of our Board of Directors and our business

22




affairs. This concentration of ownership could also have the effect of delaying, deterring, or preventing a change in control that might otherwise be beneficial to shareholders. In addition, Dr. Wentz also currently serves on the Board of Directors. There can be no assurance that conflicts of interest will not arise with respect to this directorship or that conflicts will be resolved in a manner favorable to other shareholders of the Company.

Our products and manufacturing activities are subject to extensive government regulation, which could limit or prevent the sale of our products in some markets.   The manufacture, packaging, labeling, advertising, promotion, distribution, and sale of our products are subject to regulation by numerous national and local governmental agencies in the United States and other countries. Failure to comply with FDA regulatory requirements may result in, among other things, injunctions, product withdrawals, recalls, product seizures, fines, and criminal prosecutions. Any action of this type by the FDA could materially adversely affect our ability to successfully market our products. In addition, if the FTC has reason to believe the law is being violated (e.g., we do not possess adequate substantiation for product claims), it can initiate an enforcement action. The FTC has a variety of processes and remedies available to it for enforcement, both administratively and judicially, including compulsory process authority, cease and desist orders, and injunctions. FTC enforcement could result in orders requiring, among other things, limits on advertising, consumer redress, divestiture of assets, rescission of contracts, and such other relief as may be deemed necessary. Violation of these orders could result in substantial financial or other penalties. Any action by the FTC could materially adversely affect our ability to successfully market our products.

In markets outside the United States, prior to commencing operations or marketing our products, we may be required to obtain approvals, licenses, or certifications from a country’s ministry of health or comparable agency. For example, our manufacturing facility has been registered with the FDA and Health Canada and is certified by Australia’s TGA. Approvals or licensing may be conditioned on reformulation of products or may be unavailable with respect to certain products or product ingredients. We must also comply with product labeling and packaging regulations that vary from country to country. These activities are also subject to regulation by various agencies or the countries in which our products are sold.

We cannot predict the nature of any future laws, regulations, interpretations, or applications, nor can we determine what effect additional governmental regulations or administrative orders, when and if promulgated, would have on our business in the future. They could include, however, requirements for the reformulation of certain products to meet new standards, the recall or discontinuance of certain products, additional record keeping and reporting, expanded documentation of the properties of certain products, expanded or different labeling, and additional scientific substantiation. Any or all of these requirements could have a material adverse effect on us.

As we continue to expand into international markets, our business becomes increasingly subject to political and economic risks. Changes in these markets could adversely affect our business.   We commenced operations in Australia and New Zealand in February 1998, in the United Kingdom in December 1998, and in Hong Kong in November 1999. In 2000, we began limited business activity in Japan and launched more formal operations there in October 2001. In October 2002, we began business operations in Taiwan. We ceased operations in the United Kingdom at the end of the first quarter of 2000. We commenced operations in South Korea and Singapore in July and November 2003, respectively, and opened operations in Mexico during March 2004. We believe that our ability to achieve future growth is dependent in part on our ability to continue our international expansion efforts. However, there can be no assurance that we will be able to grow in our existing international markets, enter new international markets on a timely basis, or that new markets will be profitable. We must overcome significant regulatory and legal barriers before we can begin marketing in any foreign market. Also, before marketing commences it is difficult to assess the extent to which our products and sales techniques will be accepted or successful in any given country. In addition to significant regulatory barriers, we may also encounter problems conducting operations in new markets with different cultures and legal systems from those

23




encountered elsewhere. We may be required to reformulate certain of our products before commencing sales in a given country. Once we have entered a market, we must adhere to the regulatory and legal requirements of that market. No assurance can be given that we will be able to successfully reformulate our products in any of our current or potential international markets to meet local regulatory requirements or attract local customers. The failure to do so would have a material adverse effect on our business, financial condition, and results of operations. There can be no assurance that we will be able to obtain and retain necessary permits and approvals or that we will have sufficient capital to finance our expansion efforts in a timely manner. In many market areas, other network marketing companies already have significant market penetration, the effect of which could be to desensitize the local Associate population to a new opportunity, such as USANA, or to make it more difficult for us to recruit qualified Associates. There can be no assurance that, even if we are able to commence operations in foreign countries, there will be a sufficiently large population of persons inclined to participate in our network marketing system. We believe our future success will depend in part on our ability to seamlessly integrate our Compensation Plan across all markets in which our products are sold. There can be no assurance that we will be able to further develop and maintain a seamless compensation program.

An increase in the amount of incentives paid to Associates would reduce profitability.   The payment of Associate incentives is a significant expense. These incentives include commissions, leadership bonuses, and certain awards and prizes. From time to time we have changed our Compensation Plan to better manage these incentives as a percentage of net sales. For example, during the third quarter of 1997, we introduced a broad re-pricing strategy across our product lines, creating a spread between the price the Associate pays for the product and the sales volume point value associated with the product. At the same time, we changed our leadership bonus program, increasing the payout from 2.0% to 3.0% of total sales volume points. In February 2000, we introduced a broad re-pricing initiative, reducing the average price of our products by approximately 24%. This initiative decreased the amount of incentives as a percentage of net sales. Management closely monitors the amount of Associate incentives paid as a percentage of net sales and may adjust our Compensation Plan to prevent Associate incentives from having a significant adverse effect on earnings. There can be no assurance that these changes or future changes to the Compensation Plan or product pricing will be successful in maintaining the level of Associate incentives expense as a percentage of net sales. Furthermore, these changes may make it difficult to recruit and retain qualified and motivated Associates. An increase in incentive payments to Associates as a percentage of net sales would reduce our profitability.

We are subject to risks associated with our reliance upon information technology systems.   Our success is dependent on the accuracy, reliability, and proper use of sophisticated and dependable information processing systems and management information technology. Our information technology systems are designed and selected in order to facilitate order entry and customer billing, maintain Associate and Preferred Customer records, accurately track purchases and incentive payments, manage accounting, finance and manufacturing operations, generate reports, and provide customer service and technical support. Although off-site data back-up is maintained, it is possible that an interruption in these systems could have a material adverse effect on our business, financial condition, and results of operations.

The loss of a significant Associate or downline organization could adversely affect our business.   We rely on the successful efforts of certain Associates. Our Compensation Plan is designed to permit Associates to sponsor new Associates, creating multiple “business centers,” or levels in the marketing structure. Sponsored Associates are referred to as “downline” Associates within the sponsoring Associate’s “downline network.”  If these downline Associates in turn sponsor new Associates, additional business centers are created, with the new downline Associates becoming part of the original sponsor’s downline network. As a result of this network marketing system, Associates develop business relationships with other Associates. The loss of a key Associate or group of Associates, large turnovers or decreases in the size of the Associate force, seasonal or other decreases in purchase volume, sales volume reduction, the

24




costs associated with training new Associates, and other related expenses may adversely affect our business, financial condition, and results of operations. Moreover, our ability to continue to attract and retain Associates can be affected by a number of factors, some of which are beyond our control, including:

·       General business and economic conditions;

·       Public perceptions about network marketing programs;

·       High-visibility investigations or legal proceeding against network marketing companies by federal or state authorities or private citizens;

·       Public perceptions about the value and efficacy of nutritional, personal care, or weight management products generally; and

·       Other competing network marketing organizations entering into the marketplace that may recruit our existing Associates or reduce the potential pool of new Associates.

There can be no assurance that we will be able to continue to attract and retain Associates in numbers sufficient to sustain future growth or to maintain present growth levels, which could have a material adverse effect on our business, financial condition, and results of operations.

Our business is subject to the risks associated with intense competition from larger, wealthier, and more established competitors.   We face intense competition in the business of distributing and marketing nutritional supplements, vitamins and minerals, personal care products, and other nutritional products as described in greater detail in “Business—Competition.”  Numerous manufacturers, Associates, and retailers compete actively for consumers and, in the case of other network marketing companies, for Associates. There can be no assurance that we will be able to compete in this intensely competitive environment. In addition, nutrition and personal care products can be purchased in a wide variety of channels of distribution, including retail stores. Our product offerings in each product category are also relatively small compared to the wide variety of products offered by many other companies.

We are also subject to significant competition from other network marketing organizations for the time, attention, and commitment of new and existing Associates. Our ability to remain competitive depends, in significant part, on our success in recruiting and retaining Associates. There can be no assurance that our programs for recruiting and retaining Associates will be successful. The pool of individuals interested in the business opportunities presented by direct selling tends to be limited in each market, and it is reduced to the extent other network marketing companies successfully recruit these individuals into their businesses. Although we believe we offer an attractive opportunity for Associates, there can be no assurance that other network marketing companies will not be able to recruit our existing Associates or deplete the pool of potential Associates in a given market.

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Taxation and transfer pricing considerations affect our operations.   Our principal domicile is the United States. The following table summarizes 2005 sales data as a percentage of consolidated net sales and the associated statutory income tax rates for each of our geographic regions (sales data for the United States region includes 2.5% of net consolidated sales contributed by the Contract Manufacturing segment):

Region

 

 

 

% Net Sales

 

Tax Rate

 

United States

 

 

44.0%

 

 

37.5%

 

Canada

 

 

19.0%

 

 

36.0%

 

Australia / New Zealand

 

 

13.8%

 

 

30.0% / 33.0%

 

Hong Kong

 

 

3.9%

 

 

17.5%

 

Japan

 

 

3.1%

 

 

46.3%

 

Taiwan

 

 

6.2%

 

 

25.0%

 

South Korea

 

 

1.5%

 

 

18.0%

 

Singapore

 

 

4.2%

 

 

20.0%

 

Mexico

 

 

4.3%

 

 

30.0%

 

 

In many countries, including the United States, we are subject to transfer pricing and other tax regulations designed to ensure appropriate levels of income are reported as earned by our U.S. and foreign entities and are taxed accordingly. Although we believe that we are in compliance with all applicable regulations and restrictions, we are subject to the risk that taxing authorities could audit our transfer pricing and related practices and assert that additional taxes are owed. Under tax treaties, we are eligible to receive foreign tax credits in the United States for foreign taxes actually paid abroad. At this time there are no major audits in progress. In the event future audits or assessments are concluded adversely to us, we may or may not be able to offset the consolidated effect of foreign income tax assessments through the use of U.S. foreign tax credits. Currently, we are utilizing all foreign tax credits in the year in which they arise. Because the laws and regulations governing U.S. foreign tax credits are complex and subject to periodic legislative amendment, we cannot be sure that we would in fact be able to take advantage of any foreign tax credits in the future. As a result, adverse outcomes in these matters could have a material impact on our financial condition and operating results.

Exchange rate fluctuations affect our foreign operations and could reduce our net sales and earnings.   Over the past several years, a significant amount of our net sales have been generated outside the United States. We intend to continue to expand our foreign operations, exposing us to risks of changes in social, political, and economic conditions in foreign countries, including changes in the laws and policies that govern foreign investment in countries where we have operations. Since a significant portion of our sales is in foreign countries, exchange rate fluctuations may have a significant effect on our sales and earnings. Further, if exchange rates fluctuate dramatically, it may become uneconomical for us to establish or continue activities in certain countries. For instance, changes in currency exchange rates may affect the relative prices at which we and our foreign competitors sell similar products in the same market. As our business expands outside the United States, an increasing share of our net sales and cost of sales will be transacted in currencies other than the U.S. dollar. Accounting practices require that our non-U.S. financial results be converted to U.S. dollars for reporting purposes. Consequently, our reported net earnings may be significantly affected by fluctuations in currency exchange rates, with earnings generally increasing with a weaker U.S. dollar and decreasing with a strengthening U.S. dollar. Product purchases by our foreign subsidiaries are transacted in U.S. dollars. As operations expand in countries where foreign currency transactions may be made, our operating results will be increasingly subject to the risks of exchange rate fluctuations and we may not be able to accurately estimate the impact of these changes on our future business, product pricing, results of operations, or financial condition. In addition, the value of the U.S. dollar in relation to other currencies may also adversely affect our sales to customers outside the United States. We enter into forward and option foreign exchange contracts to manage currency

26




fluctuations on certain commitments denominated in foreign currency, including intercompany cash transfers. We generally do not use derivative instruments for speculative purposes. There can be no assurance that foreign currency contract transactions will protect operating results and cash flows from potentially adverse effects of currency exchange fluctuations. Those adverse effects would also adversely affect our business, financial condition, and results of operations.

Disruptions to shipping channels that we use to distribute our products to international warehouses may adversely affect our margins and profitability in those markets.   In 2004 the financial press reported congestion at West Coast ports caused by increasing cargo volumes, a lack of capacity on the railroads, and a shortage of manpower. We felt the effects in our container shipments to Australia, which required additional use of airfreight to meet demand. Port congestion has since been relieved. Although there was no significant port congestion this year through the months when retailers prepare for the holidays, we continue to watch for signs of upcoming congestion. Congestion to ports can affect previously negotiated contracts with shipping companies resulting in unexpected increases in shipping costs. Our freight forwarders will continue to exercise flexibility in the selection of ports and carriers to provide the best service.

The inability to obtain adequate supplies of raw materials for products at favorable prices, or at all, could have a material adverse effect on our business, financial condition, and results of operations.   We depend on outside suppliers for raw materials. We acquire all of our raw materials for the manufacture of our products from third-party suppliers. Normally, materials used in manufacturing our products are purchased on account or by purchase order. We have very few long-term agreements for the supply of these materials. There is a risk that any of our suppliers or manufacturers could discontinue selling their products to us. Although we believe that we could establish alternate sources for most of our products, any delay in locating and establishing relationships with other sources could result in product shortages and back orders for the products, with a resulting loss of net sales. In certain situations, we may be required to alter our products or to substitute different products from another source. In addition, we rely on third-party manufacturers for several of our products, including our food bars and certain drink mixes. We have in the past discontinued or temporarily stopped sales of certain products manufactured by third parties while those products were on back order. There can be no assurance that suppliers will provide the raw materials needed by us in the quantities requested or at prices we are willing to pay. Because we do not control the actual production of these raw materials, we are also subject to delays caused by interruption in production of materials based on conditions not within our control, including weather, crop conditions, transportation interruptions, strikes by supplier employees, and natural disasters or other catastrophic events.

Shortages of raw materials used in certain of our products may temporarily adversely affect our margins and our profitability related to the sale of those products.   Many nutritional supplement companies that manufacture products containing Coenzyme Q10 (CoQ10) have experienced a shortage in supply of this raw material component during the year 2005. The sharp increase in demand, which began in 2003, caused a shortage in supply while suppliers worked to re-tool their manufacturing facilities to increase production capacity in order to meet the growing demand. Certain of our nutritional products were affected by this raw material shortage. We have identified multiple sources to supply quality raw ingredients; however, quantities of materials acquired during this shortage were purchased at higher prices, which negatively impacted gross margins for those products affected. By mid-2005 some suppliers had re-tooled their manufacturing facilities to increase production capacity of CoQ10, and more competitors entered the market to produce it, which has caused supply to increase and purchase prices to decline.

Nutritional supplement products may be supported by only limited availability of conclusive clinical studies.   Our products include nutritional supplements that are made from vitamins, minerals, herbs, and other substances for which there is a long history of human consumption. Some of our products contain innovative ingredients or combinations of ingredients. Although we believe all of our products to be safe

27




when taken as directed, there is little long-term experience with human consumption of certain of these product ingredients or combinations of ingredients in concentrated form. We conduct research and test the formulation and production of our products, but we have performed or sponsored only limited clinical studies. Furthermore, because we are highly dependent on consumers’ perception of the efficacy, safety, and quality of our products, as well as similar products distributed by other companies, we could be adversely affected in the event those products should prove or be asserted to be ineffective or harmful to consumers or in the event of adverse publicity associated with illness or other adverse effects resulting from consumers’ use or misuse of our products or a competitor’s similar products.

As a manufacturer we may be subject to product liability claims.   As a manufacturer and a distributor of products for human consumption and topical application, we could become exposed to product liability claims and litigation. Additionally, the manufacture and sale of these products involves the risk of injury to consumers as a result of tampering by unauthorized third parties or product contamination. To date, we have not been party to any product liability litigation, although certain individuals have asserted that they have suffered adverse consequences as a result of using our nutritional products. These matters historically have been settled to our satisfaction and have not resulted in material payments. We are aware of no instance in which any of our products are or have been defective in any way that could give rise to material losses or expenditures related to product liability claims. Although we maintain product liability insurance, which we believe to be adequate for our needs, there can be no assurance that we will not be subject to claims in the future or that our insurance coverage will be adequate or that we will be able to maintain adequate insurance coverage.

Our business is subject to particular intellectual property risks.   Most of our products are not protected by patents. The labeling regulations governing our nutritional supplements require that the ingredients of such products be precisely and accurately indicated on product containers. Accordingly, patent protection for nutritional supplements often is impractical given the large number of manufacturers who produce nutritional supplements having many active ingredients in common. Additionally, the nutritional supplement industry is characterized by rapid change and frequent reformulations of products as the body of scientific research and literature refines current understanding of the application and efficacy of certain substances and interactions among various substances. In this respect, we maintain an active research and development program that is devoted to developing better, purer, and more effective formulations of our nutritional or other products. We protect our investment in research, as well as the techniques we use to improve the purity and effectiveness of our products, by relying on trade secret laws. We have also entered into confidentiality agreements with certain of our employees involved in research and development activities. Additionally, we endeavor to seek, to the fullest extent permitted by applicable law, trademark and trade dress protection for our products, which protection has been sought in the United States, Canada, and many of the other countries in which we are either presently operating or plan to commence operations in the near future. Notwithstanding our efforts as described above, there can be no assurance that these efforts to protect our trade secrets and trademarks will be successful. Nor can there be any assurance that third parties will not assert claims against us for infringement of the proprietary rights of others. If an infringement claim is asserted, we may be required to obtain a license of such rights, pay royalties on a retrospective or prospective basis, or terminate our manufacturing and marketing of our products that are alleged to have infringed. Litigation with respect to such matters could result in substantial costs and diversion of management and other resources and could have a material adverse effect on our business, financial condition, and operating results. There can be no assurance that third-party claims will not in the future adversely affect our business, financial condition, and results of operations.

Our manufacturing activity is subject to certain risks.   We manufacture approximately 78% of the products sold to our customers. As a result, we are dependent upon the uninterrupted and efficient operation of our manufacturing facilities in Salt Lake City, Utah. Those operations are subject to power

28




failures, the breakdown, failure, or substandard performance of equipment, the improper installation or operation of equipment, natural or other disasters, and the need to comply with the requirements or directives of government agencies, including the FDA. There can be no assurance that the occurrence of these or any other operational problems at our facility would not have a material adverse effect on our business, financial condition, and results of operations. We are subject to a variety of environmental laws relating to the storage, discharge, handling, emission, generation, manufacture, use and disposal of chemicals, solid and hazardous waste, and other toxic and hazardous materials. Our manufacturing operations presently do not result in the generation of material amounts of hazardous or toxic substances. Nevertheless, complying with new or more stringent laws or regulations, or more vigorous enforcement of current or future policies of regulatory agencies, could require substantial expenditures and could have a material adverse effect on our business, financial condition, and results of operations. Environmental laws and regulations require us to maintain and comply with a number of permits, authorizations, and approvals and to maintain and update training programs and safety data regarding materials used in our processes. Violations of those requirements could result in financial penalties and other enforcement actions, and could require us to halt one or more portions of our operations until a violation is cured. The combined costs of curing incidents of non-compliance, resolving enforcement actions that might be initiated by government authorities, or satisfying business requirements following any period affected by the need to take such actions could have a material adverse effect on our business, financial condition, and results of operations.

Our stock price has been volatile and subject to various market conditions.   There can be no assurance that an active market in our stock will be sustained. The trading price of our common stock has been subject to wide fluctuations. The price of our common stock may fluctuate in the future in response to quarter-to-quarter variations in operating results, material announcements by us or our competitors, governmental regulatory action, conditions in the nutritional supplement industry, or other events or factors, many of which are beyond our control. In addition, the stock market has historically experienced significant price and volume fluctuations, which have particularly affected the market prices of many dietary and nutritional supplement companies and which have, in certain cases, not had a strong correlation to the operating performance of these companies. Our operating results in future quarters may be below the expectations of securities analysts and investors. If that were to occur, the price of our common stock would likely decline, perhaps substantially.

We may incur liability under our “Athlete Guarantee” program, if and to the extent participating athletes make a successful claim against USANA for testing positive for certain banned substances while taking USANA nutritional supplements.   USANA believes that its nutrition supplement products are free from substances that have been banned by world-class training and competitive athletic programs. The Company further believes that while its products promote good health, they are not otherwise considered to be “performance enhancing” as that term has been used in defining substances that are banned from use in international competition by the World Anti-Doping Agency (“WADA”). For many years, USANA has been a sponsor of Olympic athletes and professional competitors around the world. These athletes have been tested on many occasions and have never tested positive for banned substances as a result of taking USANA nutritional products. To back up its claim that athletes who use the Company’s products as part of their training regimen will not be consuming banned substances, the Company has offered to enter into agreements with select athletes in Canada, which state that, during the term of the agreement, should the athlete test positive for a banned substance included in the WADA, and should such positive result be the result of taking USANA nutritional products, USANA would compensate that athlete up to one million Canadian dollars based on the athlete’s personal level of competition, endorsement, and other income, as well as other factors. To mitigate potential exposure under these agreements, we:

·       Designate lots identified as dedicated to the program and retain additional samples;

·       Store designated lot samples externally with a third party; and

29




·       Establish a chain of custody that requires signatures on behalf of USANA and the third party to transfer possession of the product lots and that restricts access by USANA employees after the transfer.

This program is open only to elite world-class athletes in Canada and all applicants are subject to screening and acceptance by the Company in its sole discretion. Contracts are tailored to fit the athlete’s individual circumstances and the amount of the Company’s exposure is limited based on the level of sponsorship of the participating athlete. Although the Company believes that the pool of current and potential participants in the program is very small, there is no guarantee that an athlete accepted in the program will not successfully make a claim against the guarantee, which would require that the Company pay the athlete under the terms of its agreement with that athlete. The Company currently has no insurance to protect it from potential claims under this program.

Item 1B. Unresolved Staff Comments

We received no written comments from the Commission staff regarding periodic or current reports under the Act in the 180 days previous to December 31, 2005.

Item 2. Properties

Our corporate headquarters building is located in Salt Lake City, Utah in a 192,000 square foot facility on a company-owned 16-acre parcel. The allocation of this space at our corporate headquarters is as follows: approximately 56,000 square feet for manufacturing, packaging, and distribution; approximately 65,000 square feet of warehouse space; and approximately 71,000 square feet occupied by executive and administrative personnel, customer service, research and development, and three laboratories. We own our corporate headquarters facility, as well as the production studio and office space purchased in connection with our acquisition of FMG.

We lease properties used primarily as regional offices and distribution warehouses located in Canada, Australia, New Zealand, Hong Kong, Japan, Taiwan, South Korea, Singapore, and Mexico. We also lease office space in China. Our primary facility in the Contract Manufacturing segment is located in Draper, Utah. We also now have a manufacturing facility in China. We lease our contract manufacturing facility located in Draper, Utah and own the manufacturing facility in China.

In 2006 we will begin construction of an addition to our corporate headquarters building, which will be occupied by executive and administrative personnel, and will include additional warehouse space. We hope to have this construction complete by the end of 2006. Aside from the strain we feel on office space for executive and administrative personnel, we believe that all other facilities are suitable for their respective uses and are, in general, adequate for our present and near-term future needs. Current monthly lease commitments for the properties under lease total approximately $258,000. All properties are part of the Direct Selling segment with the exception of the Draper, Utah and China facilities that are used by the Contract Manufacturing segment.

Item 3. Legal Proceedings

From time to time, we become a party to lawsuits and claims that arise in the ordinary course of business relating to employment, intellectual property, and other matters. We believe that such current claims, individually or in the aggregate, will not result in a material adverse effect on our business, financial position, or results of operations.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of shareholders during the quarter ended December 31, 2005.

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PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information

Our common stock trades on The NASDAQ National Market Systemâ under the symbol “USNA.”  The following table contains the reported high and low sale prices for our common stock as reported on The NASDAQ National Market System for the periods indicated:

2004

 

 

 

High

 

Low

 

First Quarter

 

$

36.59

 

$

22.89

 

Second Quarter

 

$

32.47

 

$

23.07

 

Third Quarter

 

$

35.75

 

$

25.81

 

Fourth Quarter

 

$

36.50

 

$

27.77

 

 

2005

 

 

 

High

 

Low

 

First Quarter

 

$

52.93

 

$

32.60

 

Second Quarter

 

$

48.48

 

$

40.07

 

Third Quarter

 

$

54.10

 

$

41.87

 

Fourth Quarter

 

$

48.50

 

$

37.30

 

 

On February 24, 2006, the high and low sales prices of our common stock as reported by NASDAQ were $42.32 and $41.87, respectively.

Shareholders

As of February 24, 2006, we had approximately 500 holders of record of our common stock.

Dividends

We have never declared or paid cash dividends on our common stock. Future cash dividends, if any, will be determined by the Board of Directors and will be based on earnings, available capital, our financial condition, and other factors deemed relevant by the Board of Directors.

31




Share Repurchases

Purchases made during the quarter ended December 31, 2005 and for each fiscal month therein are summarized in the following table:

Issuer Purchases of Equity Securities
(amounts in thousands, except per share data)

Period

 

 

 

Total Number
of Shares
Purchased

 

Average
Price Paid
per Share

 

Total Number of 
Shares Purchased
as Part of Publicly
Announced Plans
or Programs

 

Approximate Dollar
Value of Shares
that May Yet Be
Purchased Under the
Plans or Programs*

 

October 2, 2005 through November 5, 2005(fiscal October)

 

 

503

 

 

 

$

43.42

 

 

 

503

 

 

 

$

3,159

 

 

November 6, 2005 through December 3, 2005 (fiscal November)

 

 

202

 

 

 

$

41.26

 

 

 

202

 

 

 

$

44,824

 

 

December 4, 2005 through December 31, 2005 (fiscal December)

 

 

103

 

 

 

$

39.07

 

 

 

103

 

 

 

$

40,800

 

 

Total

 

 

808

 

 

 

$

42.33

 

 

 

808

 

 

 

 

 

 


*                    At the beginning of the fourth quarter, the Company had $24,999 remaining under the share repurchase plan. Following repurchases totaling near the approved amount, the Board of Directors approved an additional $50,000 for share repurchases as announced in a publicly issued press release in November, 2005. There currently is no expiration date on the approved repurchase amount.

32




Item 6.   Selected Financial Data

The selected consolidated financial data set forth below with respect to the consolidated statements of earnings and consolidated balance sheets for each of the last five fiscal years are derived from our audited consolidated financial statements for the relevant periods. The data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the audited consolidated financial statements and related notes thereto that are included in this report.

 

 

Fiscal Year*

 

 

 

2001

 

2002

 

2003

 

2004

 

2005

 

 

 

(in thousands, except per share data)

 

Consolidated Statements of Earnings Data:

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

114,280

 

$

133,776

 

$

200,013

 

$

272,824

 

$

327,742

 

Cost of sales

 

32,802

 

33,392

 

44,422

 

66,822

 

78,016

 

Gross profit

 

81,478

 

100,384

 

155,591

 

206,002

 

249,726

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

Associate incentives

 

43,912

 

51,174

 

78,675

 

104,433

 

128,698

 

Selling, general, and administrative

 

32,286

 

35,382

 

44,413

 

54,692

 

60,326

 

Research and development

 

1,080

 

1,035

 

1,384

 

2,031

 

2,339

 

Total operating expenses

 

77,278

 

87,591

 

124,472

 

161,156

 

191,363

 

Earnings from operations

 

4,200

 

12,793

 

31,119

 

44,846

 

58,363

 

Other income (expense), net

 

(692

)

(221

)

192

 

233

 

487

 

Earnings before income taxes

 

3,508

 

12,572

 

31,311

 

45,079

 

58,850

 

Income taxes

 

1,309

 

4,069

 

10,494

 

14,302

 

19,856

 

Net earnings

 

$

2,199

 

$

8,503

 

$

20,817

 

$

30,777

 

$

38,994

 

Earnings per share:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.11

 

$

0.45

 

$

1.09

 

$

1.61

 

$

2.07

 

Diluted

 

$

0.11

 

$

0.41

 

$

0.98

 

$

1.51

 

$

1.98

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

19,356

 

18,884

 

19,018

 

19,163

 

18,873

 

Diluted

 

19,412

 

20,647

 

21,319

 

20,415

 

19,721

 

Dividends per share

 

 

 

 

 

 

 

 

 

As of

 

 

 

Dec. 29,

 

Dec. 28,

 

Jan. 3,

 

Jan. 1,

 

Dec. 31,

 

 

 

2001

 

2002

 

2004

 

2005

 

2005

 

 

 

(in thousands, except other data)

 

Consolidated Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

2,465.00

 

$

6,686.00

 

$

18,965.00

 

$

15,067.00

 

$

10,579.00

 

Working capital

 

$

350.00

 

$

1,228.00

 

$

18,330.00

 

$

18,073.00

 

$

15,274.00

 

Current assets

 

$

14,189.00

 

$

18,907.00

 

$

38,249.00

 

$

40,823.00

 

$

41,830.00

 

Total assets

 

$

35,354.00

 

$

39,113.00

 

$

65,127.00

 

$

71,664.00

 

$

73,708.00

 

Long-term debt, less current maturities

 

$

6,000.00

 

$

2,572.00

 

$

 

$

 

$

 

Stockholders’ equity

 

$

14,527.00

 

$

18,093.00

 

$

44,371.00

 

$

47,843.00

 

$

45,738.00

 

Other Data:

 

 

 

 

 

 

 

 

 

 

 

Active Associates

 

56,000

 

66,000

 

88,000

 

114,000

 

133,000

 

Active Preferred Customers

 

41,000

 

45,000

 

51,000

 

63,000

 

70,000

 

Total Active Customers

 

97,000

 

111,000

 

139,000

 

177,000

 

203,000

 


*                    The Company’s fiscal year ends on the Saturday closest to December 31. The 2001, 2002, 2004, and 2005 fiscal years were 52-week years. Fiscal year 2003 was a 53-week year.

33




Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of financial condition and results of operations should be read in conjunction with the audited consolidated financial statements and notes thereto appearing elsewhere in this report.

Overview

We develop and manufacture high-quality nutritional and personal care products that are distributed through a network marketing system. Net sales are primarily dependent upon the efforts of a network of independent Associates who purchase products and sales materials. We also sell products directly to Preferred Customers who purchase products for personal use and are not permitted to resell or distribute the products. As of December 31, 2005, we had approximately 133,000 active Associates and approximately 70,000 active Preferred Customers worldwide. For purposes of this report, we only count as active customers those Associates and Preferred Customers who have purchased product from USANA at any time during the most recent three-month period.

As discussed more fully in Note L of the audited consolidated financial statements included in this report, we have two reportable segments: Direct Selling and Contract Manufacturing. The Direct Selling segment constitutes our principal line of business: developing, manufacturing, and distributing premium, science-based nutritional and personal care products through a network marketing system. The Contract Manufacturing segment exists primarily to manufacture and package the Company’s SenséÔ product line of skin and personal care products, but also includes contract manufacturing services provided to a limited number of third-party customers.

We recognize revenue when products are shipped and title passes to our customers. In 2005, sales in the nine markets within our Direct Selling segment contributed to consolidated net sales as follows:

North America

 

 

 

United States

 

41.5

%

Canada

 

19.0

%

Mexico

 

4.3

%

North America Total

 

64.8

%

Pacific Rim

 

 

 

Australia-New Zealand

 

13.8

%

Hong Kong

 

3.9

%

Japan

 

3.1

%

Taiwan

 

6.2

%

South Korea

 

1.5

%

Singapore

 

4.2

%

Pacific Rim Total

 

32.7

%

Segment Total

 

97.5

%

 

Sales from the Contract Manufacturing segment accounted for the remaining 2.5% of consolidated net sales in 2005.

As we expand our business into additional international markets, we expect international operations to account for an increasing percentage of net sales.

Cost of sales primarily consists of expenses related to raw materials, labor, quality assurance, and overhead costs that are directly associated with the production and distribution of products and sales materials, as well as duties and taxes associated with product exports. As international sales increase as a

34




percentage of net sales, cost of sales could increase slightly, reflecting additional duties, freight, and other expenses associated with international growth.

Associate incentive expenses are incurred only by the Direct Selling segment and represent the most significant expense for this segment at 40.3% of net segment sales in 2005. Associate incentives include commissions and leadership bonuses that are paid weekly, based on sales volume points. Certain promotions and contests are also reported as Associate incentives. Products are assigned a sales volume point value that is independent of the product’s price. Associates earn commissions based on sales volume points generated in their downline sales organization. Starter kits and sales tools have no sales volume point value, and commissions are not paid on the sale of these items.

Selling, general, and administrative expenses include wages and benefits, depreciation and amortization, rents and utilities, Associate events, promotion and advertising, and professional fees along with other marketing and administrative expenses. Wages and benefits represent the largest component of selling, general, and administrative expenses. Significant depreciation and amortization expense is incurred as a result of continued investments in computer and telecommunications equipment and systems to support international expansion. We anticipate that significant additional capital investments will be required in future periods to promote and support anticipated growth in sales and the increasing size of our customer base.

Research and development expenses include costs incurred in developing new products, enhancing existing products, and formulating products for introduction into international markets.

Results of Operations

The following table summarizes the consolidated operating results as a percentage of net sales, respectively, for the periods indicated:

 

 

Fiscal Year

 

 

 

2003

 

2004

 

2005

 

Consolidated Statements of Earnings Data:

 

 

 

 

 

 

 

Net sales

 

100.0

%

100.0

%

100.0

%

Cost of sales

 

22.2

 

24.5

 

23.8

 

Gross profit

 

77.8

 

75.5

 

76.2

 

Operating expenses:

 

 

 

 

 

 

 

Associate incentives

 

39.3

 

38.3

 

39.3

 

Selling, general, and administrative

 

22.2

 

20.0

 

18.4

 

Research and development

 

0.7

 

0.7

 

0.7

 

Total operating expenses

 

62.2

 

59.0

 

58.4

 

Earnings from operations

 

15.6

 

16.5

 

17.8

 

Other income, net

 

0.1

 

0.1

 

0.2

 

Earnings before income taxes

 

15.7

 

16.6

 

18.0

 

Income taxes

 

5.3

 

5.2

 

6.1

 

Net earnings

 

10.4

%

11.4

%

11.9

%

 

Fiscal Year 2005 compared to Fiscal Year 2004

Net Sales.   Net sales increased 20.1% to $327.7 million in 2005, an increase of $54.9 million, from $272.8 million in 2004. During 2005, net sales in the Direct Selling segment increased by $57.1 million, while net sales in the Contract Manufacturing segment declined $2.2 million from 2004.

35




The following table summarizes the growth in net sales by segment and geographic region for the fiscal years ended January 1, 2005 and December 31, 2005:

Net Sales By Segment and Region
(in thousands)

 

 

Year Ended

 

Change from

 

Percent

 

Segment / Region

 

 

 

2004

 

2005

 

Prior Year

 

Change

 

Direct Selling

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

North America

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

$

113,579

 

41.6%

 

$

136,123

 

41.5%

 

 

$

22,544

 

 

19.8%

 

Canada

 

52,552

 

19.3%

 

62,193

 

19.0%

 

 

9,641

 

 

18.3%

 

Mexico

 

8,296

 

3.0%

 

14,060

 

4.3%

 

 

5,764

 

 

69.5%

 

North America Total

 

174,427

 

63.9%

 

212,376

 

64.8%

 

 

37,949

 

 

21.8%

 

Pacific Rim

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Australia-New Zealand

 

35,684

 

13.1%

 

45,367

 

13.8%

 

 

9,683

 

 

27.1%

 

Hong Kong

 

11,117

 

4.0%

 

12,622

 

3.9%

 

 

1,505

 

 

13.5%

 

Japan

 

9,218

 

3.4%

 

10,323

 

3.1%

 

 

1,105

 

 

12.0%

 

Taiwan

 

16,009

 

5.9%

 

20,225

 

6.2%

 

 

4,216

 

 

26.3%

 

South Korea

 

5,742

 

2.1%

 

4,882

 

1.5%

 

 

(860

)

 

(15.0)%

 

Singapore

 

10,316

 

3.8%

 

13,811

 

4.2%

 

 

3,495

 

 

33.9%

 

Pacific Rim Total

 

88,086

 

32.3%

 

107,230

 

32.7%

 

 

19,144

 

 

21.7%

 

Segment Total

 

262,513

 

96.2%

 

319,606

 

97.5%

 

 

57,093

 

 

21.7%

 

Contract Manufacturing

 

10,311

 

3.8%

 

8,136

 

2.5%

 

 

(2,175

)

 

(21.1)%

 

Consolidated

 

$

272,824

 

100.0%

 

$

327,742

 

100.0%

 

 

$

54,918

 

 

20.1%

 

 

The increase in net sales contributed by the Direct Selling segment can be primarily attributed to the following factors:

·       A 16.7% increase in the active Associate base and an 11.1% increase in the active Preferred Customer base for the year ended 2005;

·       A $5.8 million increase in Mexico due to a full year of operations; and

·       Stronger foreign currencies relative to the U.S. dollar, which positively affected the translation of sales in foreign currencies by $7.8 million.

The decrease in net sales of our Contract Manufacturing segment can be attributed to an increased focus on the manufacture of our SenséÔ line and a decreased emphasis on our third-party business.

The Company follows the practice of providing guidance concerning anticipated net sales. Management currently anticipates annual net sales to grow between 15% and 20% for fiscal year 2006. We expect our sales increase will come from our Direct Selling segment.

36




The following tables summarize the growth in active customers for the Direct Selling segment by geographic region as of the dates indicated:

Active Associates By Region
(rounded to the nearest thousand)

 

 

As of

 

As of

 

Change from

 

Percent

 

Region

 

 

 

January 1, 2005

 

December 31, 2005

 

Prior Year

 

Change

 

North America

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

43,000

 

37.7%

 

51,000

 

38.3%

 

 

8,000

 

 

18.6%

 

Canada

 

22,000

 

19.3%

 

23,000

 

17.3%

 

 

1,000

 

 

4.5%

 

Mexico

 

7,000

 

6.1%

 

8,000

 

6.0%

 

 

1,000

 

 

14.3%

 

North America Total

 

72,000

 

63.1%

 

82,000

 

61.6%

 

 

10,000

 

 

13.9%

 

Pacific Rim

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Australia-New Zealand

 

14,000

 

12.3%

 

17,000

 

12.8%

 

 

3,000

 

 

21.4%

 

Hong Kong

 

5,000

 

4.4%

 

4,000

 

3.0%

 

 

(1,000

)

 

(20.0)%

 

Japan

 

4,000

 

3.5%

 

5,000

 

3.8%

 

 

1,000

 

 

25.0%

 

Taiwan

 

9,000

 

7.9%

 

13,000

 

9.8%

 

 

4,000

 

 

44.4%

 

South Korea

 

2,000

 

1.8%

 

2,000

 

1.5%

 

 

 

 

0.0%

 

Singapore

 

8,000

 

7.0%

 

10,000

 

7.5%

 

 

2,000

 

 

25.0%

 

Pacific Rim Total

 

42,000

 

36.9%

 

51,000

 

38.4%

 

 

9,000

 

 

21.4%

 

Total

 

114,000

 

100.0%

 

133,000

 

100.0%

 

 

19,000

 

 

16.7%

 

 

We believe that various factors contributed to the increase in the number of active Associates during 2005, including enthusiasm surrounding the new self-preserving SenséÔ product line, ongoing communication with Associate leaders in the field, and company-sponsored events and promotions to motivate Associates.

Active Preferred Customers By Region
(rounded to the nearest thousand)

 

 

As of

 

As of

 

Change from

 

Percent

 

Region

 

 

 

January 1, 2005

 

December 31, 2005

 

Prior Year

 

Change

 

North America

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

38,000

 

60.3%

 

44,000

 

62.9%

 

 

6,000

 

 

15.8%

 

Canada

 

17,000

 

27.0%

 

18,000

 

25.7%

 

 

1,000

 

 

5.9%

 

Mexico

 

1,000

 

1.6%

 

1,000

 

1.4%

 

 

 

 

0.0%

 

North America Total

 

56,000

 

88.9%

 

63,000

 

90.0%

 

 

7,000

 

 

12.5%

 

Pacific Rim

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Australia-New Zealand

 

5,000

 

7.9%

 

6,000

 

8.6%

 

 

1,000

 

 

20.0%

 

Hong Kong

 

1,000

 

1.6%

 

**

 

0.0%

 

 

(1,000

)

 

(100.0)%

 

Japan

 

1,000

 

1.6%

 

1,000

 

1.4%

 

 

 

 

0.0%

 

Taiwan

 

**

 

0.0%

 

**

 

0.0%

 

 

 

 

N/A

 

South Korea

 

**

 

0.0%

 

**

 

0.0%

 

 

 

 

N/A

 

Singapore

 

**

 

0.0%

 

**

 

0.0%

 

 

 

 

N/A

 

Pacific Rim Total

 

7,000

 

11.1%

 

7,000

 

10.0%

 

 

 

 

0.0%

 

Total

 

63,000

 

100.0%

 

70,000

 

100.0%

 

 

7,000

 

 

11.1%

 


**             Active Preferred Customer count is less than 500.

37




Total Active Customers By Region
(rounded to the nearest thousand)

 

 

As of

 

As of

 

Change from

 

Percent

 

Region

 

 

 

January 1, 2005

 

December 31, 2005

 

Prior Year

 

Change

 

North America

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

81,000

 

45.8%

 

95,000

 

46.8%

 

 

14,000

 

 

17.3%

 

Canada

 

39,000

 

22.0%

 

41,000

 

20.2%

 

 

2,000

 

 

5.1%

 

Mexico

 

8,000

 

4.5%

 

9,000

 

4.4%

 

 

1,000

 

 

12.5%

 

North America Total

 

128,000

 

72.3%

 

145,000

 

71.4%

 

 

17,000

 

 

13.3%

 

Pacific Rim

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Australia-New Zealand

 

19,000

 

10.8%

 

23,000

 

11.3%

 

 

4,000

 

 

21.1%

 

Hong Kong

 

6,000

 

3.4%

 

4,000

 

2.0%

 

 

(2,000

)

 

(33.3)%

 

Japan

 

5,000

 

2.8%

 

6,000

 

3.0%

 

 

1,000

 

 

20.0%

 

Taiwan

 

9,000

 

5.1%

 

13,000

 

6.4%

 

 

4,000

 

 

44.4%

 

South Korea

 

2,000

 

1.1%

 

2,000

 

1.0%

 

 

 

 

0.0%

 

Singapore

 

8,000

 

4.5%

 

10,000

 

4.9%

 

 

2,000

 

 

25.0%

 

Pacific Rim Total

 

49,000

 

27.7%

 

58,000

 

28.6%

 

 

9,000

 

 

18.4%

 

Total

 

177,000

 

100.0%

 

203,000

 

100.0%

 

 

26,000

 

 

14.7%

 

 

Gross Profit.   Consolidated gross profit increased to 76.2% of net sales in 2005 from 75.5% in 2004. This improvement in consolidated gross profit can primarily be attributed to a decrease in the impact that the Contract Manufacturing segment had on the total, and to a lesser extent, modest leverage benefits gained on a rising sales base.

Gross profit in the Direct Selling segment increased modestly in 2005 to 78.3% of net segment sales, compared to 78.0% in 2004. This modest improvement can primarily be attributed to leverage benefits on semi-variable costs realized on a rising sales base.

The Contract Manufacturing segment generated no gross profit from its third-party customers for the year 2005, compared to gross profit of 12.5% in 2004. The decline in gross profit margin from third-party customers can primarily be attributed to production inefficiencies in the segment’s third-party business. The Contract Manufacturing business was acquired primarily as a means to produce the Company’s SenséÔ product line, not for the third-party business.

We anticipate improvement to the gross profit margins in each of our business segments throughout 2006 due to lower expected costs on certain raw materials and improved production efficiency.

Associate Incentives.   Expenses related to Associate incentives are only incurred by the Direct Selling segment and represent the most significant cost as a percentage of net sales for this segment. Associate incentives increased to 40.3% of net segment sales in 2005, compared to 39.8% in 2004. The increase in Associate incentives relative to net segment sales can be attributed to a higher payout rate of base commissions generated, as well as an increase in promotions during 2005.

In the third quarter of 2005 we began an initiative to increase rewards to our top-performing Associates through contests, promotions, and other incentives designed to assist them in growing their respective businesses. We anticipate that this initiative will result in Associate incentives increasing to approximately 41% of net sales in our Direct Selling segment in 2006.

Selling, General, and Administrative.   Selling, general, and administrative expenses decreased to 18.4% of net sales in 2005 from 20.0% in 2004. The decrease, as a percentage of net sales, can be attributed to leverage gained on the increase in sales during 2005.

38




In absolute terms, our selling, general and administrative expenses increased $5.6 million from 2004 to 2005, which was attributable to an increase in spending in many of our markets to support growing sales and an increasing number of Associates.

We believe that for the first time in several years, selling, general, and administrative expenses will increase as a percentage of net sales in 2006 when compared to 2005. A portion of the selling, general, and administrative expenses to support our growing sales and Associate base operate in a step function such that incremental costs are expected to be incurred at a rate faster than the top line is anticipated to grow. Additionally, we will begin expensing equity compensation during 2006 of which the vast majority will be included in selling, general, and administrative expenses.

Income Taxes.   Income taxes totaled 33.7% of earnings before income taxes in 2005, compared with 31.7% in 2004. The increase in the effective tax rate for 2005 can be attributed to the first 20% phase out of the Extraterritorial Income Exclusion, which was only partially offset by a new 3% deduction for Qualified Production Activities. Additionally, in 2004 we received a favorable settlement from a foreign tax audit that was not repeated in 2005.

We expect the effective tax rate for 2006 will be approximately 35.5% due to an additional 20% phase out of the Extraterritorial Income Exclusion benefit to a total 40% phase out, with no increases in the current 3% deduction of Qualified Production Activities Income.

Net Earnings.   Net earnings increased 26.7% to $39.0 million in 2005, an increase of $8.2 million, from $30.8 million in 2004. The increase in net earnings can be primarily attributed to increased net sales and improved operating margins.

Diluted earnings per share improved to $1.98 in 2005, an increase of $0.47, from $1.51 in 2004. We expect earnings per share for fiscal year 2006 to grow between 15% and 20%, excluding the expensing of equity compensation required under SFAS No. 123(R) for the first time in 2006. We anticipate implementation of SFAS No. 123(R) will decrease 2006 earnings per share by approximately $0.14.

Fiscal Year 2004 compared to Fiscal Year 2003

Net Sales.   Net sales increased 36.4%, or $72.8 million, to $272.8 million for 2004, from $200.0 million in 2003. This increase consisted of $64.3 million associated with our Direct Selling segment and $8.5 million associated with our Contract Manufacturing segment acquired in July 2003.

39




The following table summarizes the growth in net sales by segment and geographic region for the fiscal years ended January 3, 2004 and January 1, 2005.

Net Sales By Segment and Region
(in thousands)

 

 

Year Ended

 

Change from

 

Percent

 

Segment / Region

 

 

 

2003

 

2004

 

Prior Year

 

Change

 

Direct Selling

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

North America

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

$

91,033

 

45.5%

 

$

113,579

 

41.6%

 

 

$

22,546

 

 

24.8%

 

Canada

 

44,187

 

22.1%

 

52,552

 

19.3%

 

 

8,365

 

 

18.9%

 

Mexico

 

 

0.0%

 

8,296

 

3.0%

 

 

8,296

 

 

N/A

 

North America Total

 

135,220

 

67.6%

 

174,427

 

63.9%

 

 

39,207

 

 

29.0%

 

Pacific Rim

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Australia-New Zealand

 

29,508

 

14.8%

 

35,684

 

13.1%

 

 

6,176

 

 

20.9%

 

Hong Kong

 

8,850

 

4.4%

 

11,117

 

4.0%

 

 

2,267

 

 

25.6%

 

Japan

 

6,537

 

3.3%

 

9,218

 

3.4%

 

 

2,681

 

 

41.0%

 

Taiwan

 

13,619

 

6.8%

 

16,009

 

5.9%

 

 

2,390

 

 

17.5%

 

South Korea

 

3,515

 

1.8%

 

5,742

 

2.1%

 

 

2,227

 

 

63.4%

 

Singapore

 

920

 

0.5%

 

10,316

 

3.8%

 

 

9,396

 

 

1,021.3%

 

Pacific Rim Total

 

62,949

 

31.6%

 

88,086

 

32.3%

 

 

25,137

 

 

39.9%

 

Segment Total

 

198,169

 

99.2%

 

262,513

 

96.2%

 

 

64,344

 

 

32.5%

 

Contract Manufacturing

 

1,844

 

0.8%

 

10,311

 

3.8%

 

 

8,467

 

 

459.2%

 

Consolidated

 

$

200,013

 

100.0%

 

$

272,824

 

100.0%

 

 

$

72,811

 

 

36.4%

 

 

The increase in net sales contributed by the Direct Selling segment can be primarily attributed to the following factors:

·       An 18% increase in the number of active Associates and a 22% increase in the number of active Preferred Customers for the year ended 2004 in markets that were open the full year in both 2004 and 2003;

·       A $2.2 million and $9.4 million increase in South Korea and Singapore, respectively, due to a full year of operations; and

·       Stronger foreign currencies relative to the U.S. dollar, which positively affected the translation of sales in foreign markets by $9.1 million.

We commenced operations in Mexico in March 2004, which contributed $8.3 million to net sales for 2004.

Total sales reported in 2003 included one additional week worth of sales totaling approximately $4.0 million (fiscal year 2003 was a 53-week year and fiscal year 2004 was a 52-week year).

The increase in net sales contributed by the Contract Manufacturing segment can be primarily attributed to the following factors:

·       A full year of operations for the segment that commenced in July 2003;

·       A significant increase in sales to the segment’s primary customer during 2004; and

·       New contracts added during 2004.

40




The following tables summarize the growth in active customers for the Direct Selling segment by geographic region as of the dates indicated:

Active Associates By Region
(rounded to the nearest thousand)

 

 

As of

 

As of

 

Change from

 

Percent

 

Region

 

 

 

January 3, 2004

 

January 1, 2005

 

Prior Year

 

Change

 

North America

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

35,000

 

39.8%

 

43,000

 

37.7%

 

 

8,000

 

 

22.9%

 

Canada

 

19,000

 

21.6%

 

22,000

 

19.3%

 

 

3,000

 

 

15.8%

 

Mexico

 

 

0.0%

 

7,000

 

6.1%

 

 

7,000

 

 

N/A

 

North America Total

 

54,000

 

61.4%

 

72,000

 

63.1%

 

 

18,000

 

 

33.3%

 

Pacific Rim

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Australia-New Zealand

 

13,000

 

14.8%

 

14,000

 

12.3%

 

 

1,000

 

 

7.7%

 

Hong Kong

 

4,000

 

4.5%

 

5,000

 

4.4%

 

 

1,000

 

 

25.0%

 

Japan

 

3,000

 

3.4%

 

4,000

 

3.5%

 

 

1,000

 

 

33.3%

 

Taiwan

 

8,000

 

9.1%

 

9,000

 

7.9%

 

 

1,000

 

 

12.5%

 

South Korea

 

4,000

 

4.5%

 

2,000

 

1.8%

 

 

(2,000

)

 

(50.0)%

 

Singapore

 

2,000

 

2.3%

 

8,000

 

7.0%

 

 

6,000

 

 

300.0%

 

Pacific Rim Total

 

34,000

 

38.6%

 

42,000

 

36.9%

 

 

8,000

 

 

23.5%

 

Total

 

88,000

 

100.0%

 

114,000

 

100.0%

 

 

26,000

 

 

29.5%

 

 

We believe that various factors contributed to the increase in the 2004 active Associate base, including new market openings, on-going communication with Associate leaders in the field, improved infrastructure to enhance the Associate service level, and company-sponsored events and promotions to motivate Associates.

Active Preferred Customers By Region
(rounded to the nearest thousand)

 

 

As of

 

As of

 

Change from

 

Percent

 

Region

 

 

 

January 3, 2004

 

January 1, 2005

 

Prior Year

 

Change

 

North America

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

31,000

 

60.8%

 

38,000

 

60.3%

 

 

7,000

 

 

22.6%

 

Canada

 

15,000

 

29.4%

 

17,000

 

27.0%

 

 

2,000

 

 

13.3%

 

Mexico

 

 

0.0%

 

1,000

 

1.6%

 

 

1,000

 

 

N/A

 

North America Total

 

46,000

 

90.2%

 

56,000

 

88.9%

 

 

10,000

 

 

21.7%

 

Pacific Rim

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Australia-New Zealand

 

4,000

 

7.8%

 

5,000

 

7.9%

 

 

1,000

 

 

25.0%

 

Hong Kong

 

1,000

 

2.0%

 

1,000

 

1.6%

 

 

 

 

0.0%

 

Japan

 

**

 

0.0%

 

1,000

 

1.6%

 

 

1,000

 

 

N/A

 

Taiwan

 

**

 

0.0%

 

**

 

0.0%

 

 

 

 

N/A

 

South Korea

 

**

 

0.0%

 

**

 

0.0%

 

 

 

 

N/A

 

Singapore

 

**

 

0.0%

 

**

 

0.0%

 

 

 

 

N/A

 

Pacific Rim Total

 

5,000

 

9.8%

 

7,000

 

11.1%

 

 

2,000

 

 

40.0%

 

Total

 

51,000

 

100.0%

 

63,000

 

100.0%

 

 

12,000

 

 

23.5%

 


**             Active Preferred Customer count is less than 500.

41




Total Active Customers By Region
(rounded to the nearest thousand)

 

 

As of

 

As of

 

Change from

 

Percent

 

Region

 

 

 

January 3, 2004

 

January 1, 2005

 

Prior Year

 

Change

 

North America

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

United States

 

66,000

 

47.5%

 

81,000

 

45.8%

 

 

15,000

 

 

22.7%

 

Canada

 

34,000

 

24.5%

 

39,000

 

22.0%