Description

I am short Natural Health Trends Corp (NHTC). I believe the company is a pyramid scheme selling garbage products and its stock will crash when the scheme unravels. Thankfully I haven’t needed to spend $50 million investigating this, nor does my pitch have a 360 page slide deck.

NHTC is a “network marketing company” (their words) selling various lotions, powders, juices, and a dream to become wealthy and live a glamorous lifestyle. The products are generic yet make bold promises using comically stupid language. For example, their Cluster X2 is purified water with a “high level of electromagnetic power” that can “increase cellular hydration.” This is like GE marketing lightbulbs as "photonic-based pigmentation enhancement devices." Ultimately, it’s a 4oz bottle of water that costs $75. Considering the ingredients are mostly just water and a couple of fruit juice extracts, it’s disconcerting that the product loudly warns people not to have it touch a metal utensil.

Another product, Alura Lux, is a cream that promises to cure (among other things) headaches, lip fullness, fertility, lacerations, libido, and even hemorrhoids – not bad! I can’t help but wonder if this was inspired by some poor soul who desired a product that could simultaneously help their anal fissures, sinus pressure, ulcers, and vaginal lubrication. A 17ml bottle of Alura Lux costs $51, and its ingredients are water, lemon juice, menthol, and petroleum jelly. (It’s not lost on me that this writeup is probably the first stock pitch in history to include the words “anal fissures” and “vaginal lubrication.” Btw I dare anyone to do a google image search for “anal fissures”...I'm too scared)

Phew, finally a product that can help both my cranium AND my anus. And here I've been using two separate products all these years like a sucker.

Hopefully you get the point: it’s stupid. NHTC and its products have actually been around for years, and NHTC has gone through this cycle before. In 2003, the predecessor company, Lexxus, inexplicably took off and new member count grew exponentially, going from 11,000 in 2002 to almost 120,000 in 2005. NHTC’s stock exploded, going from $1 to $26 in about a year, however by late 2006 was back at $1 after a series of problems and an unsurprising decline in membership. One very interesting thing to note is that the stock peaked long before member count peaked, and when NHTC reported its first sequential decline in members in the second quarter of 2006, the stock was already 70% off its high. The key takeaway is that the stock peaked when the rate of change in new members peaked (2004)...I’ll explain later why this is a critical point.

I confess I have no idea how a particular pyramid scheme catches on when it does, but for whatever reason the NHTC story is back. Importantly, 94% of revenue is in Hong Kong, with most of sales to Chinese mainlanders. NHTC does not have a license to engage in direct selling in China so instead they do things online and through “independent” distributors based in Hong Kong...frankly it all sounds rather dodgy. They have applied for licenses but it doesn’t sound promising, and they commented to me it could be “years.” Here is a brief explanation of how it works and some of the risks:

In contrast to our operations in other parts of the world, we have not implemented a direct sales model in China. The Chinese government permits direct selling only by organizations that have a license that we do not have, and has also adopted anti-multilevel marketing legislation.   We operate an e-commerce direct selling model in Hong Kong and recognize 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.

Any determination that our operations or activities, or the activities of our individual distributors 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 our future ability to obtain business licenses or expand into new locations, changes to our business model, the termination of required licenses to conduct business, or other actions, any of which could materially harm our business, financial condition and results of operations. -

2014 10K

NHTC has been in various forms of licensing limbo for as far back as the 10K’s go. Getting affected by regulatory actions isn’t new to the company:

On April 12, 2004, an investigative television program was aired nationwide in the People's Republic of China with respect to the operation of the Company's Lexxus Hong Kong subsidiary and the Lexxus representative office located in Beijing. The report alleged, among other things, that unlicensed network-marketing activities were being conducted by Lexxus' independent distributors in China and that many independent distributors were unsuccessful in their efforts to generate profits. Lexxus currently conducts operations in 30 countries, including Hong Kong, and requires that its independent distributors comply with all applicable local laws. - 2004 10K

To be clear, I can’t prove anything about the legality of NHTC’s operations in China (nor am I alleging anything) and it might be both entirely legal and far enough inside the lines that there isn’t material risk of adverse developments. But that would be kinda surprising. What we know is the following:

1. NHTC still relies almost entirely on its Chinese operations.

2. The CEO was the CFO at the time of the prior bad acts.

3. The new member growth is exponential despite the same stupid products.

4. Today’s Chinese sales practices don’t “sound” convincingly legitimate.

5. Generally, this is the type of business that needs to bend/break rules to be successful.

Anyway, why short NHTC? Because it’s not a multi-level marketing company, I believe it’s effectively a pyramid scheme. A key fact to distinguish NHTC as a pyramid scheme is that new members have to buy into the system. This initial cost to join is one of the telltale signs of a pyramid scheme (as opposed to a run-of-the-mill crappy multi-level marketing company) since the business is predicated on little more than member growth instead of selling products to customers.

As part of my research I posed as a prospect and on several occasions spoke to NHTC’s international recruiter who went into more detail about the system. I got the full pitch on how to sell the products and what the various terms were. The compensation plan isn’t too dissimilar from multi-level marketing companies in that it’s wildly convoluted and has new members may choose to buy into the system at different tiers – bronze, silver, and gold/platinum. (Side note: does anyone want to be part of my downline?)

Bronze is effectively pointless since it comes with almost no ability to earn any commission and you have to purchase products from NHTC at retail prices. This level exists to give the illusion of choice. Silver is almost as useless, although slightly better. Then there’s the gold/platinum level, which has the best compensation potential and allows members to purchase products from NHTC at 30-40% discounts from retail prices. Gold and platinum have the same compensation plans, but the platinum level provides members with free lifetime back office support. Everything is clearly designed to steer people towards the gold/platinum levels.

Below are screen grabs are from the initial order form which shows that new members are required to make large purchases if they want to be eligible for bonuses, which is the whole point of joining in the first place.

The “BV” is the points assigned to products on which commission is paid, and at the gold/platinum level the BV is typically about .5x the dollar cost of the product (although every product has its own unique BV set by NHTC). Platinum requires a minimum initial purchase of $2,250 while gold is about $1,900. Admittedly, NHTC isn’t putting a gun to anyone’s heads, and I suppose in some ways this is actually clever and perhaps not “technically” a pyramid scheme, but none of this changes the dynamic that members “effectively” have to pay large sums to join, meaning a substantial portion of NHTC’s revenue is just inventory build within its membership base. In addition to the new member initial inventory order, there are a couple other key things to understand.

In my conversations with the company's recruiter, he stated that the vast majority of members in Asia join at the platinum level. This means we can be reasonably certain that most new members are in fact spending a minimum of ~$2,250 when they join.

Members are not paid a commission for recruiting a new member, and if they do recruit a new member who becomes part of their downline, they are not paid a commission for that new member’s initial order. This is stated in their compensation plan, and I confirmed it with the recruiter and company IR as well. This is further supported by the 10K:

“Distributors are not required to sponsor other distributors as their down-line, and we do not pay any commissions for sponsoring new distributors”

“We pay commissions to eligible NHT Global distributors based on product purchases by such distributors’ down-line distributors during a given commission period.” - 2014 10K

This is a really important point because it means commission paid by NHTC is only related to downline revenue, not initial inventory orders by new members.

A quick recap of the most relevant information to understand NHTC’s model:

1)     The system is designed to steer new members to the highest level.

2)     The cost of the initial order at the highest level is about $2,250.

3)     The company pays no commission on initial order.

4)     Commission expense is only for downline revenue.

I’ll let interested people model this all out themselves since it’s pretty simple. When you multiply $2,250 by the number of new members per quarter, it’s immediately clear that about half of NHTC’s total revenue is from initial inventory orders. You can subtract that number from the total revenue to get the downline revenue. When you model commission expense as a function of downline revenue rather than total revenue, it shows that downline revenue today has negative margins. Commission expense as a percent of downline revenue has increased substantially over time, going from 45% in 2011 to 89% in 2014 and even 101% in the most recent quarter.

Again, to be clear, commission expense shouldn’t be calculated as a percent of total revenue because half of the revenue (initial inventory orders) has no commission associated with it. The steady increase in commission as a percent of downline revenue represents NHTC offering higher and higher supplemental rewards for members, and it’s something that the company has explained on conference calls.

“Now what has changed is the supplemental commissions that we pay out in the form of incentive rewards that includes attached reward we call supreme bonus also based on performance and that money goes to supplement the midlevel leaders in our organization that really comprises most of the activities in the market and that also goes to road incentive trips. We had a trip earlier this year in Germany, the performance qualification period was last year. Now we’re running a trip that will go to New Zealand next year. The number of qualifiers for program such as Supreme Bonus and the incentive trips had gone up as our volume went up. It went up more than what we expected and also we’re increasing the cost per capita for the incentive trips. So that constitutes the increase in our commissions.” – Chris Sharng, CEO. Q2 Conference Call

Another clue that something with NHTC is amiss is that their total revenue per member has increased at a rapid rate despite exponential growth in members. This inherently doesn’t make sense since new sales people generally take time to get ramped up, regardless of the type of company. Over a period when new sales people are accelerating, you should see the sales per employee decline, and you almost certainly wouldn’t see material improvements in average productivity. Compare 2013 to 2014, when EPS increased 350% and new members increased from 6,840 to 26,840. Somehow the total revenue per average member increased from $2,178 to $3,043. This means that new members generated roughly twice the revenue as existing members. I can think of only three possible explanations:

1)     The products super-duper awesome (high incidence rate of anal fissures in China?) and members who are brand new are able to sell tons of products immediately.  This seems insane.

2)     There is a tremendous amount of inventory build happening amongst members, and relatively few products are being sold to consumers for consumption. This is somewhat common among pyramids so I wouldn’t be surprised if this is a partial answer, which would still make NHTC a pyramid scheme destined to collapse.

3)     New members typically spend a minimum of $2,250 to buy into the system, which is more than members generate in downline revenue, and the acceleration in new members is therefore lifting the average revenue per member.

Just isolating the Hong Kong membership and revenue you can see how the productivity uplift is derived from new members placing large initial inventory orders. Not surprisingly, the revenue per average member exploded in 2011, the first year of net member growth after five years of declines, and years of attrition from the worst performing members.

Once you break out the two revenue streams and their respective costs, it’s clear how the whole operation works. On one hand you’ve got sales to new members, which is wildly profitable because there is no associated commission expense. In a perfect world, this would be NHTC’s (and every other dumb company’s) business model, and they could sell their wares to the public for 80% gross margins with little-to-no infrastructure and print money. Of course, this is a BS business, so a traditional model doesn’t fly. (See my comments on the old Perion thread for some context about how inherently crappy products require creative monetization techniques) But then on the other hand, you’ve got sales by existing distributors to customers who intend on actually consuming the products (we’ll assume). These downline sales have extraordinarily high commission expense to the point where I estimate this whole channel is currently unprofitable. Same pointless products being sold, but two very different ways of making money.

This also shows the feedback loop that exists in a pyramid scheme. The company offers higher commissions and better rewards, which attracts more new members, which drives sales to the company, which allows them to offer increasingly higher commissions, which attracts more new members, etc. Here’s the fatal flaw though: NHTC not only needs more new members, but needs new members at an increasing rate in order to show growth. I realize I’m not saying anything groundbreaking and that this is just another run-of-the-mill pyramid scheme, but once new members decelerate, growth vanishes. As a public company, I believe there is a strong likelihood that when member growth decelerates, it will trigger a feedback loop in the other direction, causing a death spiral. Earnings declines trigger a falling stock trigger worry among members trigger members moving on to the next get-rich-quick scheme, wash rinse repeat. Being public means everyone gets to see it unfold, and NHTC would likely be helpless to stop it. For example, from 2013-2015, NHTC added 6,840, 26,840, and 60,000 new members, respectively (2015 is my estimate). If in 2016 NHTC added 25,000 new members – a respectable performance all things considered – ceteris paribus, EPS would go from about $4.00 to negative $4.00, which would also deplete all of their cash as well.

However, the company isn’t static, and rather than lose copious amounts of money they would choose to slash commission rates in order to prevent gigantic losses. While this would provide a lift to the financials, it would undoubtedly exacerbate the underlying problem of membership growth, because why would members stick with a system that’s materially reducing commissions? This is exactly what happened before, and here is what the company had to say about commission rates during the last bust:

Distributor commissions decreased by $33.2 million, or 49%, mainly due to the decrease in product sales, as well as a decrease in the overall commission rate that resulted from the implementation of a significant commission plan change during the second quarter of 2007, less supplemental commissions paid in North America, fewer commissions earned in the newer markets of Japan, Latin America, and Europe, and efforts to align the overall commission payout in South Korea with our other markets. The result of the last significant commission plan change during the second quarter of 2007 was less than satisfying. While the payout as a percentage of sales was lowered, sales have decreased significantly since the effective date of the change. - 2007 10K

As you can see, they manage the commission rate on-the-fly, hoping to keep it from not bankrupting them, but all it really does is make the core problem worse. It’s just more evidence of the feedback loop and how a deceleration in new member growth sets it all in motion. The first mentioning of the commission rate reduction was in Q2 2006, the first time membership fell.

The financials from the previous peak illustrate all of this. In 2005, when the new membership growth rate began rolling over, NHTC went from generating about $.50 in EPS in 2004 to losing about $.70 in EPS in 2005. This was in a year when they still grew members by 37%, and still they managed to lose money. Why? I believe because it’s because of the mechanics I described above, and the company can’t handle decelerating new member growth. In 2006, despite having 8% more members vs just two years prior, the losses were huge. As the membership declines accelerated into 2007, the losses grew exponentially and the company ran into liquidity problems.

What’s also interesting is that the commission expense as a percent of estimated downline revenue previously peaked at about the same time as the membership growth rate in 2004 (I admit this is harder to triangulate the farther back I go, so I have less confidence about the accuracy of these estimates). Not only that but the prior peak in the amount is similar to my estimate of what the company recently reported. It stands to reason that NHTC began reducing commissions in 2006 in order to preserve cash, and that this was probably a major contributing factor in the following acceleration of membership losses. It’s all part of the feedback loop.

Historically, NHTC only makes money when both the growth in membership is positive and the rate of change in new members is positive. In 2005, the growth rate decelerated and that’s when the losses began. Once the high margin revenue from new members can’t offset the losses from downline commission and G&A, it blows up.

There are some other issues worth mentioning.

I have heard speculation that NHTC primarily exists as a way for Chinese mainlanders to launder money into HKD, similar to how many people used Macau casinos for laundering services. The idea is that mainlanders would go to Hong Kong to purchase NHTC’s overpriced crap, then cut a side deal with the distributor whom they bought it from to split the commissions paid by NHTC in HKD. I honestly have no idea if this is true, it’s just pure speculation...I mention this only to see if anyone else can shed some light on it.

The cash on the balance sheet is misleading. At September 30, NHTC’s balance sheet showed $94.6 million in cash, however, only about half of it truly belongs to NHTC, while the other half belongs to distributors via various forms of deferred commissions. Furthermore, NHTC has less than $500,000 in the US, while the rest is in mostly in Hong Kong. (I highly recommend listening to the 3rd quarter conference call where this issue was explained to a bewildered shareholder)

The company has entered into four buybacks in the last 13 months:

1)     November 2014 - $1.5 million

2)     January 2015 - $1.1 million

3)     May 2015 - $5.0 million

4)     July 2015 - $15.0 million (remains outstanding)

All four buybacks were private transactions with George Broady, who sits on the board of directors and is the company’s largest shareholder. NHTC’s CEO, Chris Sharng, has repeatedly described Broady as a “reluctant seller” who only entered into the plan so that his pro-rata ownership in the company wasn’t increased. No basis was given for why this was important. George’s past isn’t exactly marked with success. He took a security camera company called Ultrak public in the late 1990’s, only to have the stock collapse after a series of acquisitions. I wish I could say for certain what George’s actual ownership was, but he’s not so good at filing timely form 4’s, having missed deadlines for 62 transactions in 2014, according to a footnote in the proxy. Somewhere along the way he moved into the nutritional supplements business and became a garden-variety snake oil salesman, and today owns Broady Health Sciences which NHTC buys some products from.

The auditor is a high-quality shop called Lane Gorman Trubitt and the 2014 audit fees amounted to a mere $98,520. There were no fees for any tax work at all. I'm sure that's a good sign.

It seems like there’s a decent likelihood that this could rip my face off in the short-run - I can accept that given what I believe is the almost certain downside. It’s a little hard to tell what inning it’s in, but I suspect the later ones as there have been some signs of fatigue. I wish I had a mathematical proof that this will blow-up next quarter, but I don’t. I will point to a few things that help give me some comfort about shorting NHTC now:

1. Hong Kong membership today is above where it previously peaked.

2. New member growth is higher than it was in the previous cycle.

3. Downline commission expense rate is where it previously peaked.

4. The stock fell after the company reported good third quarter earnings.

5. Share buybacks of insider George Broady’s stock are accelerating.

6. The Chinese economy isn’t so hot, I'm told.

Of these I think #3 is probably the most tangible sign that NHTC is at or approaching peak since they're pretty much at the natural limit of what they can pay in sales commissions, and it's safe to assume that the rising commission rate played a significant role in attracting new members.

NHTC will earn about $4.00 in EPS in 2015, putting the stock at about 11x P/E. This is inline with multi-level marketing companies. At 2.3x EV/S it’s materially more expensive than multi-level marketing companies which trade between 0.9-1.5x EV/S. In order to grow EPS by 25% in 2016, I estimate NHTC would have to add about 87,000 new members, which is possible but seems like a stretch. But even if this happens the stock shouldn’t trade much higher than $50-60 (I hope)...I doubt current shareholders are in this for 25% EPS growth, so I don’t think it’s unreasonable that it could trade lower on those results. Even if I’m incorrect about a few details about the company, I take comfort in understanding the general nature of the company and knowing that once it starts breaking down, there is likely no reversing the trend. When NHTC inevitably prints decelerating new members, the flawed model will be evident and I think the stock will get nuked and shareholders will need a metric ton of Alura Lux to relieve them of their headaches, hemorrhoids, and naturally, anal fissures.

Plenty of borrow is available at a cost of  ~7%.

Catalyst

Valeant discovers a cure for anal fissures

Bill Ackman announces he's shorting shares of NHTC with all proceeds going to Martin Shkreli's legal defense