LifeVantage Corporation
Q4 2016 Earnings Call Transcript

Published: 13 Dec 2016

[Operator:]

Good day, ladies and gentlemen. Thank you for standing by. Welcome to today’s LifeVantage Fourth Quarter Fiscal 2016 and First Quarter Fiscal 2017 Earnings Conference. At this time, all participants are in a listen only mode. Following the formal remarks, we will conduct a question and answer session, and instructions will be provided at that time. Hosting today’s conference will be Scott Van Winkle with ICR. As a remainder, today’s conference is being recorded. At this time, I would like to turn the conference over to Mr. Van Winkle. Please go ahead, sir.

[Scott Van Winkle:]

Thank you, and good afternoon, ladies and gentlemen. Welcome to LifeVantage Corporation’s conference call to discuss the recently filed fiscal 2016 results and first quarter 2017 results. On the call today from LifeVantage will be prepared remarks from Garry Mauro, Chairman of the Board of Directors; Darren Jensen, Chief Executive Officer; and Mark Jaggi, Chief Financial Officer. By now, everyone should have access to the earnings release which went out this afternoon at approximately 4

[Darren Jensen:]

Thanks Scott and good afternoon, everyone. Let me begin by acknowledging that this has been a long process, longer than we had anticipated to report on our fiscal 2016 results and filed our 10-K and first quarter 10-Q, both of which were filed this afternoon. With today’s SEC filings, we are again current with our financial reporting and in compliance with our Zions Bank credit line. We expect that these filings will also bring us back into compliance with NASDAQ listing rules. While we experienced a delay in our financial reporting and understand our shareholders’ concern over the length of time this process took, I can assure you that we’ve remained focused on our day-to-day operations, supporting both our distributors and customers. I’m pleased to report that the audit committee review is now complete and we can begin to refocus our investors’ attention on our business performance and growth objectives. Before we discuss our recent financial results, I’d like to turn the call over to our Chairman of the Board of Directors, Garry Mauro to address the recent audit committee review. Garry?

[Garry Mauro:]

Thank you, Darren, and good afternoon. On behalf of the Board of Directors, I want to address our shareholders regarding the delayed financial statements and the comprehensive review of our international business procedures. During the 2016 fiscal year closing process, employees in our tax department raised concerns about our international policies dealing with how our products are purchased or sold in some international markets, and taxes and tariffs associated with those sales. It is important to note that these potential policy weaknesses were identified internally. Once the Board was notified, our audit committee initiated an independent review utilizing independent external legal counsel and independent external accounting experts. A formal SOX complaint was submitted by an employee after the review was underway, and the audit committee took this information into account and evaluated and completed due diligence on all issues raised. We analyzed transactions, policies, and procedures to determine there were weaknesses and determined why they may have happened. We aspire to best practices in all areas, and the depth of this process was to ensure just that. The questions we addressed in our review revolved around several policies and procedures concerning distributor activities in select international markets, but as the review progressed, the scope was expanded to a general review of our policies and procedures across all international markets. The type of activities reviewed included our products being purchased for personal consumption and being taken into markets where they had not been approved for resale. In general, most countries haven’t allowed us for the personal importation of products for personal use. However, we identified an increase in this type of activity that needed additional review primarily for tariff and tax purposes. It is important, if we haven’t placed the policies, procedures, and internal systems to help ensure compliance, reduce the risk of abuse, and establish best practices well above our broader industries. Once the review was concluded, we then took steps to implement the appropriate remedial measures. As part of this comprehensive review, we engaged international advisors with relevant country-specific expertise to help ensure our policies and procedures were appropriately aligned with local rules. Finally, we could not issue our 10-K until all of these steps were complete to ensure that we were fully compliant and to ascertain if there was any impact to our financial statements. Ultimately, other than the high cost of the external experts utilized in the review, which totaled approximately $2.5 million to $3 million, the impact to our delayed financials was negligible. However, we concluded that we had material weaknesses in some of our international controls. and our auditors issued an adverse opinion relating to our internal control over financial reporting. We have already taken action to outsource our international tax and tariff responsibilities to help remediate this weakness. Our Board of Directors and the entire LifeVantage management team are committed to transparent, accurate and, thorough financial reporting and disclosure. While the duration of the review and filings delay was longer than we or our shareholders preferred, our number one goal was to complete a thorough and comprehensive evaluation. We utilized independent forensic accountants and outside counsels, both domestically and in international markets to ensure thoroughness and to support our conclusions. Our corporate philosophy is to ensure dedication to high-quality ethical business practices in financial reporting. We have now instituted best practices that will make us a stronger company with improved policies, procedures, and control as a result. The Board appreciates the patience of our shareholders and the diligent work of the entire LifeVantage team during this process. The Board is fully confident and supportive of the quality leadership of Darren and his management team. We’re fully committed to the success of this Company and fully believe this painful investment of both time and money will drive long-term shareholder value. Now, let me turn this back over to Darren.

[Darren Jensen:]

Thank you, Garry. Before I update you on our business progress and activities, let me walk you through some of the remedial measures being implemented as a result of the recent review. As Garry noted, we identified a few international policy weaknesses that are now being addressed. We are implementing changes that include enhanced support from our country-specific experts including legal, tax, and customs advice. Given the complexity of operating in multiple international markets, we’ve also begun to outsource key activities where external support is more effective and efficient. Let me highlight some of the specific policy weaknesses discovered and the steps we’ve taken. First, in certain markets, the documentation verification obtained during the enrollment process for people who wanted to become independent distributors was insufficient. We have received local advice and now where necessary require in-person verification of local resident identification. Second, we’ve instituted enhanced policies regarding the purchase for personal consumption of products in markets where such products are not registered or otherwise restrict our direct selling model. Third, policies regarding distributor payments were not appropriately documented in some markets. We have strengthened these policies and instituted new controls covering payments in local markets and currencies. Fourth, transfer pricing and commissions rebalancing procedures in international markets have been refined to more effectively provide for consistency in cross-border purchases. For example, a distributor may purchase in one market with delivery to customers in another market where pricing, currency, and commission rates could vary. Fifth, we have structurally aligned ourselves to outsource tax and tariff advisory functions to ensure we have access to the most up-to-date market-specific expertise. Sixth, we have started evaluating and reallocating our personnel to ensure that each market has adequate resources to support our enhanced processes and controls. We will also establish and conduct companywide training programs. We’ll continue to refine and update all of our international country operating and launch policies to ensure best practices are followed. The vast majority of these enhancements will improve our controls without any measurable impact to our distributors or our sales activities. A few of the remedies being implemented will have and in some cases have already had an impact on our sales levels. This impact materialized to a modest extent during the first quarter of fiscal 2017 as initial actions were taken during the review process. We immediately eliminated substantially all non-resident purchases worldwide. Additionally, new policies around verification of local market resident identification had interrupted sales in one market. The impact to our in-market sales levels should be more evident in the second quarter. Our new policies will again allow non-resident purchases for personal consumption in markets where this practice is permitted. We anticipate that in the third quarter, we will begin to regain a portion of these sales. I believe these enhanced policies and controls will provide proper guidance within which we can build our global business opportunity. Turning now to our operating results. First, I will highlight our fiscal 2016 achievements. We ended the year with continued strong year-over-year revenue and earnings growth during the fourth quarter of fiscal 2016. Our fiscal 2016 revenue was in line with the guidance range we provided after the third quarter and our earnings per share performance exceeded guidance. First, we generated 8.5% revenue growth during fiscal 2016, when compared to fiscal 2015, reversing revenue decline into accelerating year-over-year growth. Second, we posted 31.8% growth compared to the prior year in adjusted earnings per share, also a reversal of declines in the prior year. Third, we accelerated our product development efforts launching both the PhysIQ weight management system and Protandim NRF1 Synergizer, and each is quickly becoming important contributor to our product portfolio. Fourth, the Asia Pacific region has returned to growth with sequential growth as the year progressed and year-over-year growth during Q4. Fifth, we entered Europe with launches in both the UK and the Netherlands. Sixth, we had strong additions to our management team across key executive positions. Finally, we completed our eight-point growth strategy, which contributed to our strong fiscal 2016 financial performance. This allowed us to enter fiscal 2017 in a much stronger position than where we begin the year-end fiscal 2016. We are aggressively pursuing our multiyear strategic plan, which will enable us to expand upon our achievements to-date and further build the platform for growth and financial success. The strategic plan has four areas of focus with eight key initiatives and 64 projects supporting the plan. The four areas of focus are

[Mark Jaggi:]

Thanks, Darren. Good afternoon, everyone. I’m going to briefly discuss the fourth quarter and fiscal year ended June 30, 2016, and then turn my attention to the first quarter of fiscal 2017. During the fourth quarter, we reported revenue of $53 million, an increase of 17.1% when compared to $45.3 million for the prior-year period. For the full year, fiscal 2016, we reported $206.5 million in sales, an 8.5% increase over the prior year and within our guidance range of $205 million to $210 million. Foreign currency changes were approximately 2% favorable during Q4, but negatively impacted the full year by about 1%. By region, revenue in the Americas increased 17.1% year-over-year to $39.5 million during the fourth quarter and increased 14.6% to $158.3 million for the full year 2016. Revenue in the Asia Pacific and Europe region increased 16.9% year-over-year to $13.5 million during the fourth quarter but declined 7.6% to $48.2 million for the full year. As you may recall, earlier in the fiscal year, we posted softer quarterly sales in Japan, which led to the full year decline in the Asia Pacific and Europe region. The improved trends were evident in the positive fourth quarter growth. Looking at our customers, we ended the fourth quarter of fiscal 2016 with 69,000 total active distributors, up from 65,000 a year ago. The number of preferred customers at the end of fourth quarter of fiscal 2016 was 117,000, up from 115,000 a year ago. Our gross profit margin during both the fourth quarter and fiscal year was between 160 and 170 basis points below the prior year. The decline in the full year is largely due to a $2 million reduction in cost of goods sold in the prior year related to insurance proceeds from a product recall. The remainder of the lower gross margin percentage largely reflects the changing product mix and higher inventory carrying costs. Commission and incentive expenses as a percent of sales were higher for both the fourth quarter and fiscal year. As we noted on prior calls, we had made investments to drive sales earlier in the year but expected commission and incentive expense to moderate back towards historical levels, below 50%. This did occur as expected and commission and incentive expenses were 48.3% of revenue during the fourth quarter. Adjusted EBITDA was $5.6 million for the fourth quarter of 2016 compared to $3.1 million for the prior year period, while adjusted EBITDA for the full year 2016 was $19.7 million compared with $17.4 million in the prior year. Net income for the fourth quarter was $2.4 million or $0.16 per diluted share, this compares to $0.2 million or $0.02 per diluted share in the same period of 2015. For the full year 2016, net income was $6.0 million or $0.41 per share compared to $7.0 million or $0.49 per share in the prior year. Adjusted net income was $3.2 million for the fourth fiscal quarter of 2016 or $0.22 per diluted share compared to adjusted net income of $0.7 million or $0.05 per diluted share for the comparable period in fiscal 2015. For the full year 2016 adjusted net income was $9.1 million or $0.62 per share compared to $6.6 million or $0.47 per share in fiscal 2015. Our $0.62 of adjusted EPS exceeded our full year guidance range of $0.53 to $0.58. Please note that the adjustments to net income for the fourth quarter of fiscal 2016 relate to a roughly $800,000 after tax write-off of capitalized software development costs, and the de minimis adjustment for executive transition costs. The capitalized software write-off relates to the prior development of the distributor compensation system that began in fiscal 2013. Management concluded that superior alternative systems are now available and has suspended developments of the prior systems. Turning to our fiscal 2016 year-end balance sheet, our cash and cash equivalents as of June 30, 2016 were $7.9 million compared to $13.9 million at the end of fiscal year 2015. During the fourth fiscal quarter of 2016, we invested an additional $8.1 million in incremental inventory when compared to the third quarter inventory balance. We had begun to build inventory during Q3 to support growth and facilitate new product launches. We anticipate to being able to level off our inventory levels during the fourth quarter. However, we encountered some forecasting and purchasing miscalculations that caused inventory to build beyond our internal goals. Standing at 270 days of inventory at fiscal year-end, we were candidly quite a bit above our target. However, we saw improvements during the first quarter of fiscal 2017 and expect the improvements to continue. Inventory purchases are being managed aggressively as we return to our targeted level of inventory. Despite our significant inventory investment during the fourth quarter, our net debt still stood at just $1.5 million as of June 30, 2016, which is flat with the level at the end of the third quarter and down from $5.8 million at June 30, 2015. Turning to the first quarter of fiscal 2017, we reported 21% revenue growth over the prior year period to $54.9 million. As Darren noted, we saw strong double-digit growth in both the Americas and Asia Pacific and Europe. Revenue in our Americas region rose 15.6% to $40.1 million while Asia Pacific and Europe revenue rose 38.9% to $14.8 million. Currency was favorable to reported revenue by 4.6%, primarily due to the relative strength of the Japanese yen. The gross profit margin was down roughly 70 basis points year-over-year to 83.9%, given continued changes in sales mix and increased inventory carrying costs. Commissions and incentive expenses continued to revert toward normalized levels following approximately 70 basis points year-over-year to 47.9%. Operating income was down year-over-year to $2.0 million versus $2.7 million in the prior year period, primarily due to higher event expense, given one additional event compared to the prior year, also higher stock compensation expense in the first quarter of fiscal 2017 when compared to the first quarter of fiscal 2016 related to prior year stock awards, and investments and infrastructure and people to support our growth expectations and enhance processes and controls. Operating income in the first quarter of fiscal 2017 includes approximately $1 million of costs associated with the audit committee’s independent review, while operating income in the first fiscal quarter of 2016 includes $1.1 million of executive transition costs. Adjusted EBITDA for the first quarter was $4.3 million, compared to $4.5 million in the prior year period. During the first quarter of fiscal 2017, net income was $1.2 million or $0.08 per diluted share, which is fairly consistent with reported net income of $1.1 million or $0.08 per share in the prior year period. On an adjusted basis, which excludes the costs associated with the audit committee review of about $700,000 after-tax during the first quarter of 2017 and excludes approximately $700,000 of executive transition costs during the first quarter of fiscal 2016, net income was $1.9 million or $0.13 per fully diluted share versus $1.7 million or $0.13 per fully diluted share in the prior year period. We ended the first fiscal quarter of 2017 with $10.2 million of cash and $8.9 million of debt. While our inventory levels are still well above our target at $23.9 million, we saw an absolute decline from the end of fiscal 2016, which contributed to our $2.9 million of cash from operations during Q1 or $2.8 million of free cash flow after considering our modest level of CapEx. As Garry and Darren stated, there were no material changes to our previously issued financials, as a result of the audit committee’s independent review. However, in our 10-K, you will notice that we concluded that we had a material weakness in our internal controls generally related to our international operations and that our auditors issued an adverse opinion relating to our internal control over financial reporting. Additionally, we have updated our public disclosures as a result of the review process and our enhanced policies and procedures. Now, let me turn the call back to Darren.

[Darren Jensen:]

Thank you, Mark. Now, I’d like to review guidance. In fiscal 2017, we expect to generate full year revenue in the range of $207 million to $212 million, which reflects the disruption in sale during Q1 and Q2 as we reviewed and updated our international policies and procedures. We anticipate fiscal 2017 adjusted earnings per diluted share in the range of $0.40 to $0.47. Our fiscal 2017 adjusted EPS guidance excludes significant costs associated with the audit committee review and any potential additional non-operating adjustments, which we cannot reasonably estimate at this time. Further, given the timing of this conference call, we have visibility into the second quarter of fiscal 2017 and we’d like to provide you with the second quarter revenue guidance. We expect second quarter revenue in the range of $48 million to $49 million, which would be down sequentially versus the first quarter of fiscal 2017. During the second quarter, our sales have been negatively impacted by the disruptions surrounding our policy changes affecting international markets. Additionally, our October Elite Academy event in Orlando, Florida was disrupted by Hurricane Matthew, which caused airport closures and significantly limited the number of distributors that could attend the event. As such, our event related sales were lower than expected. Please note that we do not intend to provide quarterly guidance on an ongoing basis. However, the unique timing of this conference call relative to our second quarter calendar provides this opportunity. Again, we thank you for your patience and know many of you have been frustrated with the duration of the reporting delay. We have been equally as frustrated and assume full responsibility. As such, our senior management team is foregoing much of the bonus awards for fiscal 2016 that were otherwise payable under our cash incentive plans given the length of the delay and costs associated with review. Again, we thank you for your support and interest in LifeVantage. I’d now like to open the call up to questions.

[Operator:]

Thank you. [Operator Instructions] And we’ll go first to Will Hamilton with Manatuck Hill.

[Will Hamilton:]

Hi. Good afternoon, guys. If I were to boil down the conclusion on audit review, is it essentially that certain distributors were selling into certain markets where they shouldn’t have been or that certain shipments were going to certain markets where they shouldn’t have been going?

[Darren Jensen:]

The audit committee…

[Will Hamilton:]

Trying to get a better determination of what was concluded, sorry.

[Darren Jensen:]

The conclusion? Basically, what you’re saying, the conclusion was that some independent contractor distributors were personally importing product that was purchased in a market and then they took it into a different market. That was one of the issues that was being reviewed. Correct.

[Will Hamilton:]

Okay. And then can you quantify how much in the name of sales was there in 2016?

[Darren Jensen:]

In the 10-K, we released -- yes, it’s approximately 8% of sales.

[Will Hamilton:]

8% of the sales and 16 were to like these non-residential side?

[Darren Jensen:]

Correct.

[Will Hamilton:]

Okay. And so talking, what was that 13 million, 14 million, 15 million?

[Darren Jensen:]

It would be $17 million.

[Mark Jaggi:]

It’s about $17 million, Will. And that was subject to the review.

[Will Hamilton:]

And so, we’re losing much of that this year, right? You might -- you think you might recoup in the right process, some of those sales in the second half, but through the right means versus what was being done before?

[Darren Jensen:]

As I said, roughly 8% of our sales were the subject of the review. Going forward, we can refocus and remove this distraction and focus on our strategic plans. So, the impact from what we can see primarily affects Q2 and I think it’s evident in our low guidance.

[Will Hamilton:]

So, yes, so the sequential decline of say 6 million or so in Q2 is primarily because…

[Darren Jensen:]

Part of that is related to the hurricane…

[Will Hamilton:]

Primarily because of Hurricane.

[Darren Jensen:]

Yes to the Hurricane.

[Will Hamilton:]

Would that have been about a 1 million or something?

[Darren Jensen:]

Yes, probably approximately a $1 million or so.

[Will Hamilton:]

Just question on SG&A. So, if I take out the roughly $1 million out from the audit, you’re at about $16 million or so -- or I’m sorry $16.5 million. What should be sort of a run rate going forward for SG&A excluding further audit costs?

[Mark Jaggi:]

So, well, just to be clear, the SG&A in total, as you said, is about $4 million up on a quarter-over-quarter basis. There’s -- a 1 million of that related to the review and then you’ve got some where we had an event in Japan where prior year we didn’t have any event in Japan, we had essentially been on a…

[Will Hamilton:]

Hold pattern?

[Mark Jaggi:]

Yes, hold pattern really in Japan at the time. And so, we started spending a little bit more there. We also have a much larger event in the United States then we used to have, and that was another roughly 700,000. So, you’ve got a couple of million right there. Furthermore, as Darren pointed out executing on the strategic plan, this disruption in our business guides us lower, but regardless of the disruption in Q1 and Q2, we have a strategic plan, and our infrastructure is really ahead of our revenue, given the disruption. So, investments in SG&A are simply ahead of our revenue right now. Forward, we’re looking pretty stable. But we didn’t want to bring that -- we don’t want to bring that back hard right now as we focus on growth and the strategic plan.

[Will Hamilton:]

And my last question is just on the inventory, is there any risk that the $23 million, $24 million goes bad obsolete like just being some of it maybe food related that might expire?

[Mark Jaggi:]

Well, I’ll answer that one. There is always risk at something what expire. But right now recognizing that that was an issue and a very big disappointment for us, we’re aggressively moving forward with our sales plans and promotions to drive down that inventory as soon as possible in order to eliminate risk of expiration.

[Operator:]

[Operator Instructions]. We’ll hear next from Steven Martin with Slater.

[Steven Martin:]

Hi, guys. I guess, I am less concerned about the past and more concerned about the future. So, if I take your guidance for the year, your actual first quarter and your guidance for the second quarter, you’re going to do about $104 million in the first half? And if I subtract that from your guidance for the full year, you’re going to do about $106 million in the second half and that gets you to about 210. I’m sorry?

[Mark Jaggi:]

Yes. Between 207 to 212.

[Steven Martin:]

Right. Okay. I picked the midpoint. That is a down second half versus the yield that you just reported to us, because you did 53 million in the third quarter -- I’m sorry, you did 53 million in the fourth quarter you just reported and 56 million in the third quarter you reported a while ago. So that would mean 109 million in second six months. So, I guess my question is with all the new products and all the growth you’re talking about, you’re going to have a down back half with SG&A up large and inventory up significantly. And I don’t understand given the nature of business, I hate to be tough guys. But I don’t understand how you get to 270 days of inventory. When you’re -- a good chunky of your Protandim and product shipments or sort of regular monthly. And the corollary to that is given that your cost of sales about runs $7 million or $8 million a month -- a quarter, why were you only able to reduce inventory 1 million? I’ll leave it to you now.

[Mark Jaggi:]

Okay. There were multiple questions in there. So, let me hope that I get those, first on the guidance. Obviously, we’re being conservative on the guidance, considering the disruption that we had with Q2. It’s my belief that most of the damage will be limited to Q2 and we’ll spend rest of the recovering and returning back to the growth model. Looking at, you mentioned the inventory levels. Frankly speaking, there is not an excuse for that. There were errors that were made and we are in the process of driving that inventory down as quickly as possible. We are also implementing a new MRP system. And inside that process there were errors that happened. So basically, there were some miscalculations of our inventory needs relative to our position at time and we identified the issues and responded. However, there were required volumes associated with orders from third party suppliers that complicated matters. But in the end, we had too much inventory with mistake; it wasn’t something that was planned.

[Steven Martin:]

I understand, but I mean all the electronic and MRP systems are great, but didn’t someone sort of -- I’ve highlighted that to you -- the last quarter you were able to report to us, I said your inventories were too high. And I don’t understand why they just don’t come down quicker, you shut the [Indiscernible]?

[Mark Jaggi:]

One, I would say, we’re trying to drive them down as quickly as possible, we are estimating anywhere between $0.5 million to $1 million per month per quarter -- per month. So we are driving it down and again there was no excuse to go that high.

[Steven Martin:]

Okay. Let me -- with all -- so when you look around the globe at the back half of the year, again, it’s the future I care about not the past.

[Mark Jaggi:]

Yes.

[Steven Martin:]

When you look around the globe at the back half of the year, you’ve added a whole bunch of countries which frankly I didn’t understand why you were adding them, while you were going through all the stuff you were going through, but where do you expect -- regionally country wise, where do you expect pluses and where do you expect minuses?

[Darren Jensen:]

Pluses right now, high point, [ph] I expect pluses in the United States; we are getting strong growth out of Canada, as well as in Australia. We don’t report individually per market, but I’m very positive on those areas. Areas I’m also quite positive and with some of the changes and the new people that we brought on to support Japan, which is our second largest market. I think we’ve seen that market finally begin to turn. And so, I would say the positive areas definitely Japan, Canada, Australia, the United States; those are the high points that I’m looking at. We are also in addition – I’ve mentioned little earlier today that in January, we are launching our NRF1 product into Japan, the first -- our round with that where we limited it to just one event and sold it was very successful. So, we are hoping to generate a lot of excitement in that market next month.

[Steven Martin:]

Okay. I will wait and take some time with you guys later.

[Mark Jaggi:]

Thank you.

[Operator:]

And we have no further questions at this time. I’ll turn the conference back to you all for closing remarks.

[Darren Jensen:]

All right. Thank you, everyone for joining us today. We appreciate all of your patience and continued support. We look forward to continuing our growth initiatives and progress during fiscal 2017. And I hope to be speaking and meeting with many of you over the next few months. Have a good day.

[Operator:]

Again, that will conclude today’s conference. Thank you all for joining us.