I think there is a good chance that Nature's Sunshine Products Inc. (NSP) is in the midst of meaningful turnaround led by a new CEO Michael Dean and newly constituted board of directors. I believe there is big upside if I'm right and limited downside if my judgment proves to be wrong.

Evidence of a turnaround:

In the most recently announced first quarter 2011 results, the company reported operating income of $7.6mm with margins of 8%.  This is on a company that has an enterprise value of $100mm. I have shown below the first quarter figures for the previous four years. It is worth noting that in 2010 and 2009, the first quarter marked the worst quarterly results for the entire year - if we should only be so lucky this year (however, unlikely for reasons I will discuss later).

NSP is a multi-level marketer that has an almost 40 year history of manufacturing and marketing health and personal care products.  Below are randomly picked annual results to provide some margin perspective.

Margins have varied for the past 20 years; 1998 marked the highest EBIT margins in history, while 2007 marked the lowest at 1%. The 20 year average EBIT margin is 6.7%, which the company is well below today. So while operating margins for the first quarter of 2011 look way out of whack relative to recent history, there was a time when this performance was typical.

Additionally, when you look at some of the competitors in the industry, it is apparent that there is substantial room for improvement.

Some history:

So why does the past five years show such poor margins and a cumulative net loss of $9mm (note that cumulative free cash flow over this time equals a positive $36mm)? What started with possible violations of Foreign Corrupt Practices Act in 2006 (settled in 2009 for $600K), ended up in delayed SEC filings, KPMG's resignation, the firing of the CFO, and subsequent DOJ and SEC investigations. For anyone interested in more detail, the article below does a good job of giving you the blow by blow. 

http://members.ethisphere.com/?forecast_cloudy

With all the turmoil finally in the rear view mirror, investors at today's valuation get the taint of the old but the upside of the new. The new includes CEO Michael Dean and what I consider to be one of the more sophisticated boards you will see on a $150mm market cap company. Michael was brought in July 2010 with a background that included stints at Bain, Disney, and Mediaur Technologies (interesting to note that Herbalife's Michael Johnson - the best CEO in the space - also came from Disney). Dean has taken steps to improve sales growth (basically re-launched the core NSP business in March 2011) and increase profitability by closing unprofitable foreign operations (took a $7mm charge on shutting down the Brazil operation in 2010), carefully managing and supporting the distribution network, and rationalizing the company's product offerings.

The seven person board today is completely new with the exception of Co-Founder Kristine Hughes. The most recent addition is Mark Genender, and I have pasted his bio below. While increased sophistication, relevant experience, and alignment of interest at the board level is no guarantee for success, I think it certainly improves the odds.

Mark Genender is a Partner in the investment firm Red Mountain Capital Partners LLC, based in Los Angeles. Prior to joining Red Mountain earlier this year, Mr. Genender was a Managing Director in the Retail and Consumer Group at the Carlyle Group. Prior to Carlyle, Mr. Genender co-founded and was a Partner at Star Avenue Capital, a consumer growth equity vehicle which he formed in 2008. From 1996 to 2008, Mr. Genender was a Managing Director at Fenway Partners, LLC both in New York and then in Los Angeles. Previous to Fenway, Mr. Genender held senior sales and marketing positions with Nabisco Holdings Inc. and PepsiCo Inc., and served as a Financial Analyst in the M&A department with Goldman, Sachs & Co. in London and New York. Mr. Genender received his A.B. from Princeton University, and his M.B.A from INSEAD in France.

One of the interesting items in the proxy is the fact that the board has partially tied Dean's compensation package to hitting specific operating margins (6%, 8%, and 10% target levels) over a sustained period of time. The folks who know the company best obviously think 8% to 10% margins are achievable.  

More on Q1 2011:

NSP has three divisions that distribute products to consumers through an independent sales force comprised of Managers (higher level and 30,300 total) and Distributors (694,400 total). Nature's Sunshine U.S., International, and Synergy Worldwide make up the three divisions. Synergy was a 2000 acquisition and is showing the highest sales growth of any of the segments.

Margins at all three divisions showed meaningful improvement in the first quarter. The largest contributor in the quarter to improved margins was the lower SG&A margins which decreased to 34.9% versus the 41.2% in Q1 2010. The 10Q lays out the specific items that drove SG&A lower. The only item that I think necessary to partially back out is the $1.5 million decrease in U.S. convention related costs. Spending on trips for high achieving distributors is an important part of the business, and Q1 benefited likely at the expense of the next few quarters. 

Valuation:

You have a $160mm market cap with $60mm of cash and no debt. On an LTM basis, the company has generated $24mm in EBITDA and $19mm in free cash flow. Over the past ten years, a period where I believe the company was stress tested like never before, the company generated $102mm in free cash flow. This would suggest the $19mm LTM number - unless Q1 is indicative of higher margins going forward - is not the right normalized number to be using. I like to think of $10mm as my downside free cash flow number.

Below are different scenarios for where the stock could trade based on how much top line growth we get and where operating margins end up going. I have also included some different comp valuation metrics. My base case calls for 5% top line growth and margins in 2012 ending up around 7%. You end up getting 70% upside if the company is valued on its 10 year average EV/EBIT multiple of 8x.  Should top line growth come in even higher, you have the potential for much more explosive returns given the re-rating that is likely to occur from Mr. Market.

Other tidbits:

• The company currently has no real investor relations effort (no conference calls, no annual reports, no conference attendance etc.). I think this will change sometime over the next year.

• Use of the cash balance will be determined by the board, which I'm comfortable with.
• Compare the fortunes of Mannatech versus Herbalife. Good management is key in this industry.

• Wall Street hates the MLM business model but it does generate meaningful cash flow, and I think a take private here is a realistic assumption if the stock price stays dormant.

• The NBTY merger document (bought for 9x EBITDA by Carlyle) lays out more supporting evidence that NSP is materially undervalued compared to peers based on any metric.

Risks:

• Dean owns very few shares.

• Exposure to consumer spending (although one could argue that high unemployment helps boost the Manager base).

• The renewal rate for independent distributors is approximately 45% annually. The company needs to attract new distributors every year to grow its business.

• Continued good operating performance
• Wise deployment of cash
• Investor roadshow