NHTC management has failed to provide guidance for the most recent quarter end for the first time in over 7 years.
The Chinese government has cracked down on MLM companies. Consumer sentiment in China has negatively shifted, causing the Chinese market to structurally decline with no chance of mid-term recovery.
Multiple of NHTC's competitors have guided down for the full year due to weakness/no sales in China. The silence from NHTC's management is deafening.
NHTC faces multiple lawsuits, an SEC investigation, and negative scrutiny from Chinese government. NHTC is now significantly cash flow negative and will likely remain as such for the foreseeable future.
NHTC should be trading at discount to liquidation value due to the evaporation of ~90% of the company's revenues and no evident growth opportunities to offset loss of Chinese business.
Natural Health Trends Corporation (NHTC) is an international direct-selling and e-commerce company whose subsidiaries sell personal care, wellness, and quality of life products under the NHT Global brand. The company is headquartered in Hong Kong (where they moved in January 2019 from California), and 85%+ of their business comes from direct selling products in China. The company drives sales through a multi-level marketing member network, along with operating an e-commerce website for the Chinese market.
In January 2019, the Chinese government implemented a 100-day Campaign to review MLM companies and direct selling products. Since then, the vast majority of the company’s sales have dried up, which has been coupled with a broader negative shift in consumer sentiment. We do not expect sales to recover meaningfully any time soon, which should result in the company running off its cash balance for the foreseeable future. Further, we believe the lack of disclosure from management regarding preliminary earnings (after a long history of similar disclosures), lack of commentary regarding how detrimental the 100-day Campaign has been to the company, and lack of insights into their view on broader controversy surrounding direct selling in China is telling. While part of an earnings miss might already be priced into the stock, we do not believe the market fully appreciates how bad earnings might be when they are released on Wednesday, August 7th, 2019.
We want to thank Ravenwood Capital Management and Unemon (website, SA Blog) for their extensive work on NHTC over the last several months/years. I would encourage everyone to read their research as they do a much better job of going over the history of the company and the short thesis, of which I only briefly cover below.
On January 5th, 2019, CCTV (the state-run TV outlet in China) ran an expose questioning MLM and direct selling practices, specifically calling out NHTC (the program focused on Ranjian Global, which is the name of NHTC’s Chinese counterpart; the full English transcript of the broadcast is at the bottom of this report in 6.3.19 Exhibit A). The program focused on one of their main products, Noni Juice, which is allegedly marketed by sellers who claim the product is an effective remedy against cancer, gout, insomnia, kidney deficiencies, excessive stress, depression and obesity (please see 6.3.19 Exhibit A, pg. 3). The program also insinuated that NHTC might operate as an illegal pyramid scheme (please see 6.3.19 Exhibit A, pg. 12).
NHTC management denied the allegations at first (and blamed short sellers, which historically rarely works out well for company management), but later on retracted their statements and apologized. About a week later, the Chinese government instituted a 100-day Campaign to review all direct selling activities, which effectively cut off 85%+ of NHTC’s sales for the quarter. In light of the 100-day Campaign, NHTC management commented:
“While the results of this program are not yet clear, the Company believes this is a positive development that will benefit Chinese consumers and NHT Global in the long-term.”
Management also cited increasing global trade tensions, the slowing Chinese economy, and a weaker Chinese currency as detractors from performance, all of which continue to be issues for the company. During their full year preliminary earnings release several weeks later, management claimed that:
“we voluntarily decided in January to temporarily suspend our member activities while proactively cooperating with all relevant government agencies to ensure we continue to conduct our business in compliance with all applicable laws in China”
While management has a decidedly rosier view of their role reacting to the government’s investigations, we doubt complying with a government campaign and review of member activities and selling products is “voluntary.”
The company went on to delay the filing of their 10-K, which pushed out the filing of their Q1 2019 10-Q. The 10-Q showed sales for the quarter had dropped off 63% from the same quarter in 2018 (pg. 2 in the linked 10-Q), and would likely have been lower if the company were not allowed to operate for the first part of January.
Brief History of MLMs and NHTC in China
In 1998, China banned all direct selling activities by foreign based firms in mainland China. By 2005, the country had lifted the ban on direct selling, but still outlawed pyramid schemes. Chinese scrutiny over direct selling/MLM companies is nothing new (see a NYT article from 2018 here, and an overview of MLM from Dezan Shira & Associates originally from 2015 here). In fact, television exposes of MLM companies (and specifically NHTC) are nothing new. From the 2005 10-K (pg. 14) (h/t Ravenwood Capital Management):
“…in April 2004, an investigative television program was aired in the People’s Republic of China with respect to the operations of the Company’s Hong Kong subsidiary and the Lexxus representative office located in Beijing. The television program made allegations that Lexxus’s Hong Kong operations engaged in fraudulent activities and sold products without proper permits.”
While exposes and government intervention may be nothing new, we believe now NHTC is more precariously perched from a financial perspective, as well as from a regulatory scrutiny perspective. After the report aired, NHTC stock traded from around $20 per share to under $2 just three years later, and we believe due to the intensity of the current 100-day Campaign, NHTC may be in runoff mode.
The Broader Industry Has Declined in China
The 100-day Campaign was technically concluded in April, but other direct selling companies have commented that they continue to face a challenging business environment in China. According to NHTC’s management in their 2019 Q1 earnings release on May 7th:
“While the 100-day campaign expired in late April, there has been no official conclusion to end the program.”
From the Q1 2019 conference call on May 7th, Chris Sharng (CEO of NHTC) had this to say:
“we didn't see an official conclusion to end the 100-day campaign. And we also learned rather early on in this campaign that according to directors from the central government, the interpretation and the enforcement of the campaign were left to the local government. Therefore, I expect that we will have to work our way through the process, province by province and city by city for some time. And we do regularly communicate with our contacts at various levels of the government, and we will follow due guidance.”
This tells us that the 100-day Campaign was still effective mid-way through May, so roughly half of the quarter. Since NHTC management has been silent for most of the quarter, one has to look to other sources to figure out how bad the second quarter really was. NHTC’s two closest comparable companies are USANA Health Sciences, Inc. (USNA) and Nu Skin Enterprises, Inc. (NUS). Both companies initially expected the operating environment in China to get better in Q2 2019 after the 100-day Campaign expired, but in retrospect their optimism was not warranted. To their credit, the management of USNA came out on July 2nd and revised earnings downward, stating that:
“the Company disclosed the challenging consumer environment it encountered in China during the [second] quarter, due largely to the negative media coverage of the health products and direct selling industries in China. The Company also disclosed that it expected to see a more typical operating environment in China beginning in the second quarter, and that its business would continue to accelerate during the second half of the year. During the second quarter, however, the Company continued to encounter a challenging consumer environment in China and, consequently, net sales for the quarter were softer than previously expected. The Company now believes that it may experience sales softness in China throughout 2019”
Further, USNA’s management stated that:
“We began executing our planned promotional activity for 2019 during the second quarter, including in China. The promotions we offered have historically generated meaningful sales and customer growth, but did not generate the results we anticipated during the second quarter, as consumer sentiment remained low. Although we are confident that our strategy will drive long-term growth in the business, we now believe that it may take several months for consumer sentiment to return to normal in China.”
Nu Skin’s management also revised guidance downward, and shared a similar sentiment in their preliminary earnings release on July 16th, stating:
“We are adjusting our guidance for the year primarily due to a reduced revenue outlook in Mainland China following the government’s 100-day campaign to review and inspect the health products and direct selling industries… Continued restrictions on sales meetings, as well as media scrutiny, have negatively impacted consumer sentiment and contributed to this adjustment. While we anticipated we could begin holding meetings in the second quarter, meeting approvals for the industry have been significantly more restrictive than expected and remain limited”
The individual stocks of both companies dropped after releasing their preliminary guidance (USNA dropped 18% and NUS dropped 19%). The important thing to pay attention to, in our opinion, is that there has been a significant negative shift in consumer sentiment against the direct selling industries, and one that (according to management of USNA and NUS), isn’t going away any time soon.
Separately, it seems there continues to be restrictions on holding sales meetings (a significant driver of increasing active customers, driving new sales, and maintaining repeat customers and sales) in certain Chinese provinces, which does not bode well for the recovery of the direct selling industry for the rest of the year. While USNA and NUS both have significant lines of business outside of China, NHTC does not. Thus, the continued softness in sales, the restrictions on holding sales meetings, and the broad negative shifts in consumer sentiment are likely to affect NHTC much more than their competitors.
Lack of Management Disclosure and Comment
Given the impact on the stock price for both USNA and NUS, it makes sense why NHTC’s management wouldn’t come out with negative guidance. NHTC’s management has a history of not disclosing material events (see the first section on the lack of disclosures in January, as well as Unemon’s older work on his blog/Twitter, specifically his work on prior times the company has been raided), and we believe this is more of the same.
Since Q1 2012, NHTC management has filed a preliminary earnings report around 13 days after quarter end, with the quarterly filing following about a month or so after quarter end (this excludes Q1 2019 due to the NT 10-K pushing off the filing of the 10-Q). As of the writing of this article (August 5th, 2019), we are 36 days after quarter end and management hasn’t given any preliminary indication of earnings like they have every quarter for the last 7 years. With all competitors guiding down due to trouble with sales in China, we believe the lack of disclosure is a classic tell, and that the earnings report will be significantly worse than expected.
We believe that one could reasonably short the stock based on this piece of data alone. If there were any positive news to report about the quarter, why wouldn’t management have come out and given some guidance? Their silence, on the other hand, is deafening.
Ravenwood Capital Management pointed out that, thanks to a FOIA requestfrom January 2019, the company “voluntarily” disclosed there had been an ongoing SEC investigation for 2.5 years in their delayed 2018 10-K (pg. 14), stating:
"Since August 2016, the SEC has been conducting a non-public investigation to determine whether there have been violations of the federal securities laws relating to the trading of the Company’s securities. The Company has fully cooperated with the SEC and has and continues to provide documents in response to subpoenas. The SEC has expressly stated that its document requests should not be construed as an indication that any violation of law has occurred, or as a reflection upon any person, entity, or security. The amount of time needed to resolve this matter is uncertain, and the Company cannot predict the outcome or whether it will face additional governmental inquiries or other actions."
SEC investigations do not generally take several years to wrap up if the issue is not substantial, and we agree with Ravenwood that it is odd that an insider trading investigation would take so long to conclude. Given all of the above, it is easy to wonder if there were other reasons for NHTC’s shift of headquarters from California to Hong Kong in January 2019.
Decline in Active Customers and Revenues
NHTC’s active customers and revenues have been in decline for three years prior to the miss in Q1 2019.
The interesting part that the filings don’t immediately show you is how NHTC measures active members differently than both NUS and USNA. NHTC considers a member “active” if they have purchased a product within the last year (pg. 15), whereas both NUS (Customers, pg. 19) and USNA (Active Customers, pg. 19) define customers as those who have purchased a product during the last three months. NHTC’s active member count declined by 10.7% during Q1 2019, which means they had the customers roll off who were no longer customers in Q1 2018. We believe, when compared on an apples-to-apples basis with NUS and USNA, NHTC’s active member account is materially lower than they are reporting due to the substantial shift in consumer sentiment.
Selling Without a License - Sustainable?
Pyramid schemes are illegal in China. To operate within the country, MLM companies must obtain a state-issued license to operate a direct selling business within China (important side note: NHTC has never had a direct selling license, although they have been in the application process for years). During the 100-day Campaign, the Chinese government suspended all direct selling licenses, and by reading between the lines in the above linked NHTC Q1 earnings announcement and NUS and USNA Q2 preliminary earnings announcements, it is likely that direct selling licenses haven’t been re-issued for all Chinese provinces yet.
NHTC bulls and management have previously claimed that the company doesn’t need a direct selling license because they do their business through an e-commerce website based out of Hong Kong. Their products are then shipped to a third-party Chinese distributor, where they are eventually delivered to the end consumer (for a more in-depth look at how they do this, see the CCTV report transcript in 6.3.19 Exhibit A at the bottom of this report, starting at the end of pg. 5).
For management’s view on how NHTC sells in China, here’s an excerpt from the NHTC 2017 10-K (pg. 49):
“A substantial portion of the Company’s sales are generated in Hong Kong ... Substantially all of the Company’s Hong Kong revenues are derived from the sale of products that are delivered to members in China. In contrast to the Company’s operations in other parts of the world, the Company has not implemented a direct sales model in China. The Chinese government permits direct selling only by organizations that have a license, which the Company has applied for, and has also adopted anti-multilevel marketing legislation. The Company operates an e-commerce direct selling model in Hong Kong and recognizes the revenue derived from sales to both Hong Kong and Chinese members as being generated in Hong Kong. Products purchased by members in China are delivered to third parties that act as the importers of record under agreements to pay applicable duties. In addition, through a Chinese entity, the Company sells products in China using an e-commerce retail model...
The Company believes that its e-commerce direct selling model in Hong Kong does not violate any applicable laws in China, even though it is used for the internet purchase of the Company’s products by members in China. The Company also believes that its Chinese entity, including its e-commerce retail platform, is operating in compliance with applicable Chinese laws. However, there can be no assurance that the Chinese authorities will agree with the Company’s interpretations of applicable laws and regulations or that China will not adopt new laws or regulations. Should the Chinese government determine that the Company’s activities violate China’s direct selling or anti-multilevel marketing legislation, or should new laws or regulations be adopted, there could be a material adverse effect on the Company’s business, financial condition and results of operations.
Although the Company attempts to work closely with both national and local Chinese governmental agencies in conducting its business, the Company’s efforts to comply with national and local laws may be harmed by a rapidly evolving regulatory climate, concerns about activities resembling violations of direct selling or anti-multi-level marketing legislation, subjective interpretations of laws and regulations, Chinese nationals collaborating with short traders to damage the Company’s business and activities by individual members that may violate laws notwithstanding the Company’s strict policies prohibiting such activities. Any determination that the Company’s operations or activities, or the activities of its individual members or employee sales representatives, or importers of record are not in compliance with applicable laws and regulations could result in the imposition of substantial fines, extended interruptions of business, restrictions on the Company’s future ability to obtain business licenses or expand into new locations, changes to its business model, the termination of required licenses to conduct business, or other actions, any of which could materially harm the Company’s business, financial condition and results of operations”
If this strategy were sustainable, why would NHTC consistently apply for direct selling licenses, and yet never have received one?
We believe that most risks the company has outlined above have come to fruition. Furthermore, given the draconian crackdown on direct selling businesses as a result of the original broadcast/exposes in January 2019 (especially when one considers the programs targeted NHTC specifically), it stands to reason that the government may have come down on NHTC harder than their competitors.
(We also like any company that blames short sellers as a potential risk to their future operations. Is there historically a better tell?)
Other Legal Overhangs
The company has been sued in U.S. courts over making materially false and misleading statements about the legality of their operations in China. From the Q1 2019 10-Q (pg. 14):
“On January 8, 2019, the Company and its two executive officers were named in a putative securities class action filed in the United States District Court for the Central District of California, captioned Kauffman v. Natural Health Trends Corp., Case No. 2:19-cv-00163... The complaint alleges, in part, that the Company made materially false and misleading statements regarding the legality of its business operations in China, including running an allegedly illegal multilevel marketing business... The plaintiff has until June 3, 2019 to file an amended complaint. Defendants believe that these claims are without merit and intend to vigorously defend against them.”
The plaintiffs in this suit did file the amended complaint, and NHTC has until September 1st to respond. Given the lawsuit is a class action, the penalties if management has been found to make materially false and misleading statements (of which we believe there is a significant possibility) could be detrimental to the future financial health of the company (see the Kauffman v. Natural Health Trends Corp lawsuit cited above at the end of this report, titled 6.3.19 Amended Complaint, with relevant information starting on pg. 2).
What Comes Next?
On the quarter earnings call on Friday, we expect management to play up the following:
Expansion into new markets
In prior 10 Qs/Ks and earnings releases (most recently in the Q1 2019 earnings call here), management has talked about how they’re expanding rapidly into new markets including Peru, India, Bolivia, Colombia, and Mexico. While we expect management to spend quite some time talking about expansion into new markets, we do not believe that any marginal increase in business from other markets will be enough to put a dent in the loss of business from China.
NHTC management stated on the Q1 2019 conference call to have started shipping products to India in March. We went back and looked at the company's Revenue Recognition policies in the company’s 10-Q, which state:
“All revenue is recognized when the performance obligations under a contract are satisfied. Product sales are recorded when the products are shipped and title passes to independent members. Product sales to members are made pursuant to a member agreement that provides for transfer of both title and risk of loss upon the Company’s delivery to the carrier that completes delivery to the members”
We found it odd that management would say product was shipping into India in March when no such product was recorded in their financial statements. We are expecting management to clarify this point on tomorrow's earnings call.
Lastly, why would management say product has already shipped (read “sold”) into India in March when they are hosting a pre-launch event in April (see Unemon’s tweet here)? The timing seems off from our perspective.
Debt Capital Raise
Given the majority of the company’s business has virtually ceased, we view a debt raise as unlikely unless it had an extremely high interest rate and/or significantly dilutive terms attached (death spiral financing). We also don’t believe the company wants/needs to raise debt capital immediately, or wants to obligate themselves to the accompanying interest payments.
Equity Capital Raise
We also view an equity capital raise as unlikely unless it is at significantly discounted terms. An equity capital raise would also dilute current stakeholders and, when viewed from the light of their previous stock buybacks (at much higher prices than today), could be viewed as an admission of incompetence by management. Finally, an equity raise would be most telling about the nature of the business going forward, the environment in which the business operates, and the overall quality of NHTC’s management.
We doubt the likelihood of a buyout immediately, given the evaporation of 85% of the company’s business. It is now a loss-making operation from a free cash flow perspective with only a toehold in other markets. In our opinion, the company has a pipedream of expansion opportunities, and is significantly overvalued at current prices. Why wouldn’t a buyer just wait to purchase the assets of the company after NHTC has burned cash for several months, or just purchase the assets out of bankruptcy outright?
Ultimately, we believe the writing is on the wall for NHTC.
What is NHTC Worth?
NHTC has paid dividends regularly every quarter for the last several years, although they switched to a stock buyback in lieu of dividends for Q2. During this past quarter, they initiated a stock repurchase agreement with the largest shareholder George Broady. Ravenwood Capital Management does a great job of walking through the mechanics of the buyback (side note: Mr. Broady had taken out a line of credit against his and his wife’s shares with an unnamed bank. Once he started selling in May, the company was forced to disclose that the lender had upped his collateral requirements on the line of credit. We do not believe this means much for the stock, but it stands to reason the lender wasn’t happy he was liquidating his pledged shares). We calculated that the company spent a little under $6.7mm buying stock in the open market and from Mr. Broady.
NHTC management had $32mm remaining of buyback power (see here), and we estimate a little under $25.3mm of dry powder remains. For our calculation of share value, we assumed NHTC did not buy back any further shares, as buying shares above book value would likely be a terrible allocation of shareholder capital by further diluting their already declining book value, restricting future liquidity, and magnifying losses per share going forward (granted, none of that stopped management announcing the previous buyback plan when they knew Chinese sales had been materially impacted, so who knows).
To value the company, we used the net-net approach to see what the company could reasonably expect to receive in a liquidation scenario. We did not include restricted cash in our calculation, as it is cash required to be held on deposit with the Chinese government that the company had to put up when applying for direct sales licenses, and we believe in the case of any action by the Chinese government that the cash held on deposit will be forfeited. We started with the Cash & Equivalents from the Q1 10-Q, marked inventories and other current assets down 60%, subtracted all liabilities, and then adjusted for cash spent on buybacks. We kept operating cash flow burn in line with the previous quarter, with a slight upward adjustment given the company was still operating for part of January, although we believe OCF burn will be significantly higher this quarter. We also adjusted OCF for where we are so far through this quarter ($12mm burn per quarter multiplied by 1.5 quarters gives us $18mm OCF burn). This led us to a liquidation value of $38.1mm, representing a 47.5% decline from Monday’s closing price.
We believe this downside is consistent with the 15-20% drops in both USNA and NUS stock after they guided down for the rest of the year, especially when considering how much more as a percent of their business NHTC derives from sales in China. Admittedly, the $3.53/share figure is likely overstated when one considers that the costs of liquidation would likely be considerable (subtracting out the rest of this quarter's OCF burn plus one quarter for liquidation, which we view as rushed, and then applying a 20% discount for the liquidation process gives us a value of $1.49/share). Long term, we believe the company is worth substantially less than $3.53 and could be ultimately worth $0.
Potential Further Detractors
The valuation does not include any of the following potential detractors:
Negative outcome of investigations by the SEC
Crack down by the Chinese government
Worse performance over the quarter than anticipated
Consumer sentiment not positively shifting in China
Global macroeconomic headwinds (US/China trade disputes, weakening of Yuan, etc.)
Significant cash burn to ramp up operations in India and elsewhere without subsequent return on investment
More regulatory scrutiny from other countries in which NHTC operates
Any negative outcomes from class action lawsuits filed
Short NHTC on potentially worse than expected earnings, lack of comment or disclosure from management, a broadly declining industry, negative consumer sentiment, terrible capital allocation, potential legal overhangs, and a potential crack down by the Chinese government.