News Column

MANNATECH INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 5, 2014

The following discussion is intended to assist in the understanding of our consolidated financial position and results of operations for the three and six months ended June 30, 2014 as compared to the same period in 2013, and should be read in conjunction with Item I "Financial Statements" in Part I of this quarterly report on Form 10-Q. Unless stated otherwise, all financial information presented below, throughout this report, and in the consolidated financial statements and related notes includes Mannatech and all of our subsidiaries on a consolidated basis.



COMPANY OVERVIEW

Since November 1993, we have continued to develop innovative, high-quality, proprietary nutritional supplements, topical and skin care products, and weight-management products that are sold through a global network marketing system. We operate in three regions: (i) North America (the United States, Canada and Mexico); (ii) EMEA (Austria, the Czech Republic, Denmark, Estonia, Finland, Germany, the Republic of Ireland, Namibia, the Netherlands, Norway, South Africa, Sweden, and the United Kingdom); and (iii) Asia/Pacific (Australia, Japan, New Zealand, the Republic of Korea, Singapore, Taiwan and Hong Kong). Our Switzerland office manages certain day-to-day business needs of non-North American markets. We conduct our business as a single operating segment and primarily sell our products through a network of approximately 239,000 active independent associates and members who have purchased our products and/or packs within the last 12 months, who we refer to as active independent associates and members. New recruits and pack sales are leading indicators for the long-term success of our business. New recruits include new independent associates and members purchasing our packs and products for the first time. We operate as a seller of nutritional supplements, topical and skin care products, and weight-management products through our network marketing distribution channels operating in twenty-three countries. We review and analyze net sales by geographical location and by packs and products on a consolidated basis. Each of our subsidiaries sells similar products and exhibits similar economic characteristics, such as selling prices and gross margins. Because we sell our products through network marketing distribution channels, the opportunities and challenges that affect us most are: recruitment of new and retention of active independent associates and members; entry into new markets and growth of existing markets; niche market development; new product introduction; and investment in our infrastructure.



Current Economic Conditions and Recent Developments

Overall net sales increased $1.5 million, or 3.4% during the three months ended June 30, 2014, as compared to the same period in 2013 as revenue per active associate and member increased in North America and Asia/Pacific. Our operations outside of North America accounted for approximately 54.9% of our consolidated net sales. The number of active independent associates and members at June 30, 2014 decreased 0.4% as compared to the same period in 2013. The decrease in continuing associates and members was partially offset by the increase in new associates and members. We are experiencing strong demand for our products from the Asia/Pacific region, and net sales increased by 7.5% for the three month period ending June 30, 2014, compared to the same period in 2013, and sales increased by 7.2% for the six months ending June 30, 2014, compared to the same period in 2013. Additionally, we pre-launched the Uth skin care product in certain Asia/Pacific markets, and these pre-launch activities resulted in over $2.8 million in orders, which are reflected on our June 30, 2014 balance sheet as customer deposits that can be recognized as revenue upon fulfillment in subsequent periods. We paid $0.8 million in commissions on these orders, and at June 30, 2014, these orders generated accrued commission payable of $0.5 million. Demand for certain products and raw materials remained weak. We took charges to the inventory allowance of $0.8 million and $1.7 million in the three months and six months ending June 30, 2014, respectively, which reduced our gross profit. We are introducing promotions in future months that are intended to minimize future inventory charges; however, these promotions may impact overall profitability (see Results of Operations - Gross Profit below for more information). During the three months ending June 30, 2014, our customers used loyalty points at a higher rate, compared to the prior three quarters. This has been anticipated as the loyalty points expire one year after vesting. During the six months ending June 30, 2014, independent associates and members applied $4.6 million to loyalty purchases, and we deferred net sales of $8.3 million for future loyalty redemptions. At June 30, 2014, our deferred revenue balance on our balance sheet was $11.3 million, of which $9.1 million is attributed to the loyalty program. 15 -------------------------------------------------------------------------------- Table of Contents Finally, our income tax expense primarily reflects the uneven performance in various markets; however, as we work towards our operations being uniformly profitable, we anticipate that our effective tax rate will decrease. We believe these tax rates are transitional, and we are engaged in additional activity to accelerate top line growth and to ensure all markets contribute to overall profitability (see Results of Operations - (Provision) Benefit for Income Taxes below for more information). RESULTS OF OPERATIONS The table below summarizes our consolidated operating results in dollars and as a percentage of net sales for the three months ended June 30, 2014 and 2013 (in thousands, except percentages): Change from 2014 2013 2014 to 2013 Total % of Total % of dollars net sales dollars net sales Dollar Percentage Net sales $ 46,302 100.0 % $ 44,801 100.0 % $ 1,501 3.4 % Cost of sales 9,738 21.0 % 8,694 19.4 % 1,044 12.0 % Gross profit 36,564 79.0 % 36,107 80.6 % 457 1.3 % Operating expenses: Commissions and incentives 19,782 42.7 % 19,181 42.8 % 601 3.1 % Selling and administrative expenses 8,946 19.3 % 8,541 19.1 % 405 4.7 % Depreciation and amortization 421 0.9 % 588 1.3 % (167 ) (28.4 )% Other operating costs 6,815 14.7 % 6,247 13.9 % 568 9.1 % Total operating expenses 35,964 77.6 % 34,557 77.1 % 1,407 4.1 % Income from operations 600 1.4 % 1,550 3.5 % (950 ) (61.3 )% Interest income 35 0.1 % 17 0.0 % 18 105.9 % Other income (expense), net 192 0.4 % (1,420 ) (3.2 )% 1,612 113.5 % Income before income taxes 827 1.9 % 147 0.3 % 680 462.6 % (Provision) benefit for income taxes (1,519 ) (3.3 )% 637 1.4 % (2,156 ) (338.5 )% Net income (loss) $ (692 ) 1.4 % $ 784 1.7 % $ (1,476 ) (188.3 )% 16

-------------------------------------------------------------------------------- Table of Contents The table below summarizes our consolidated operating results in dollars and as a percentage of net sales for the six months ended June 30, 2014 and 2013 (in thousands, except percentages): Change from 2014 2013 2014 to 2013 Total % of Total % of dollars net sales dollars net sales Dollar Percentage Net sales $ 89,265 100.0 % $ 86,467 100.0 % $ 2,798 3.2 % Cost of sales 19,136 21.4 % 16,391 19.0 % 2,745 16.7 % Gross profit 70,129 78.6 % 70,076 81.0 % 53 0.1 % Operating expenses: Commissions and incentives 36,750 41.2 % 36,722 42.5 % 28 0.1 % Selling and administrative expenses 16,822 18.8 % 17,172 19.9 % (350 ) (2.0 )% Depreciation and amortization 807 0.9 % 1,225 1.4 % (418 ) (34.1 )% Other operating costs 13,771 15.4 % 12,752 14.7 % 1,019 8.0 % Total operating expenses 68,150 76.3 % 67,871 78.5 % 279 0.4 % Income from operations 1,979 2.3 % 2,205 2.5 % (226 ) (10.2 )% Interest income 36 0.0 % 4 0.0 % 32 800.0 % Other (expense), net (144 ) (0.2 )% (1,003 ) (1.2 )% 859 85.6 % Income before income taxes 1,871 2.1 % 1,206 1.3 % 665 55.1 % (Provision) benefit for income taxes (2,335 ) (2.6 )% 222 0.3 % (2,557 ) (1,151.8 )% Net income (loss) $ (464 ) (0.5 )% $ 1,428 1.6 % $ (1,892 ) (132.5 )% 17

-------------------------------------------------------------------------------- Table of Contents Non-GAAP Financial Measures To supplement our financial results presented in accordance with generally accepted accounting principles in the United States ("GAAP"), we disclose operating results that have been adjusted to exclude the impact of changes due to the translation of foreign currencies into U.S. dollars, including changes in: Net Sales, Deferred Revenue, Gross Profit, and Income from Operations. We refer to these adjusted financial measures as Constant dollar items, which are Non-GAAP financial measures. We believe these measures provide investors an additional perspective on trends. To exclude the impact of changes due to the translation of foreign currencies into U.S. dollars, we calculate current year results and prior year results at a constant exchange rate, which is the prior year's rate. Currency impact is determined as the difference between actual growth rates and constant currency growth rates. Three month period ended June 30, June 30, 2014 2013 Change GAAP Non-GAAP GAAP Measure: Measure: Measure: Total $ Constant $ Total $ Dollar Percent Net Sales $ 46.3$ 45.8$ 44.8$ 1.0 2.2 % Product 37.2 36.9 38.9 (2.0 ) (5.1 ) % Pack 7.3 7.0 3.9 3.1 79.5 % Other 1.8 1.9 2.0 (0.1 ) (5.0 ) % Deferred Revenue 11.3 11.5 1.5 10.0 666.7 % Gross Profit 36.6 36.1 36.1 -- -- % Income from Operations 0.6 0.5 1.6 (1.1 ) (68.8 ) % Six month period ended June 30, June 30, 2014 2013 Change GAAP Non-GAAP GAAP Measure: Measure: Measure: Total $ Constant $ Total $ Dollar Percent Net Sales $ 89.3$ 90.0$ 86.5$ 3.5 4.0 % Product 71.7 72.4 76.2 (3.8 ) (4.9 ) % Pack 14.0 13.9 6.3 7.6 120.6 % Other 3.6 3.7 4.0 (0.3 ) (7.5 ) % Gross Profit 70.1 70.6 70.1 0.5 0.7 % Income from Operations 2.0 1.8 2.2 (0.4 ) (18.2 ) % 18

-------------------------------------------------------------------------------- Table of Contents Consolidated net sales by region for the three months ended June 30, 2014 and 2013 were as follows (in millions, except percentages):



Net Sales in Dollars and as a Percentage of Consolidated Net Sales

Region 2014 2013 North America $ 20.9 45.1 % $ 21.3 47.6 % Asia/Pacific 21.4 46.3 % 19.9 44.4 % EMEA 4.0 8.6 % 3.6 8.0 % Total $ 46.3 100.0 % $ 44.8 100 %



Consolidated net sales by customer location for the six months ended June 30, 2014 and 2013 were as follows (in millions, except percentages):

Net Sales in Dollars and as a Percentage of Consolidated Net Sales

Region 2014 2013 North America $ 41.2 46.1 % $ 41.8 48.3 % Asia/Pacific 40.4 45.3 % 37.7 43.6 % EMEA 7.7 8.6 % 7.0 8.1 % Total $ 89.3 100.0 % $ 86.5 100.0 % Net Sales Consolidated net sales for the three months ended June 30, 2014 increased by $1.5 million, or 3.4%, to $46.3 million as compared to the same period in 2013. Consolidated net sales for the six months ended June 30, 2014 increased by $2.8 million, or 3.2%, to $89.3 million as compared to the same period in 2013. North American sales decreased by $0.4 million, or 1.9%, to $20.9 million for the three months ended June 30, 2014 as compared to the same period in 2013. North American sales decreased by $0.6 million to $41.2 million for the six months ended June 30, 2014 as compared to the same period in 2013. The decline in revenue for both the three and six months ended June 30, 2014 as compared to the same periods in 2013 is primarily due to fewer active independent associates and members.



For the three and six months ended June 30, 2014, our operations outside of North America accounted for approximately 54.9% and 53.9%, respectively, of our consolidated net sales, whereas in the same period in 2013, our operations outside of North America accounted for approximately 52.4% and 51.7%, respectively, of our consolidated net sales.

Asia/Pacific sales increased by $1.5 million, or 7.5%, to $21.4 million for the three months ended June 30, 2014 as compared to $19.9 million for the same period in 2013. In constant dollars, net sales would have increased 4.0% to $20.7 million; the currency impact was primarily due to appreciation of the Korean won. Asia/Pacific sales increased by $2.7 million, or 7.2%, to $40.4 million for the six months ended June 30, 2014 as compared to the same period in 2013. For the three and six months ended June 30, 2014, compared to the same period in 2013, the number of active associates increased and also the revenue per active independent associate and member increased. EMEA sales increased by $0.4 million, or 11.1%, to $4.0 million for the three months ended June 30, 2014 as compared to the same period in 2013, and EMEA sales increased by $0.7 million, or 10.0%, to $7.7 million for the six months ended June 30, 2014 as compared to the same period in 2013. These sales increases were due to increases in active members and associates, partially offset by fluctuations in foreign currency exchange rates and in a decrease in the revenue generated per active associate and member. In constant dollars, net sales for the three months ended June 30, 2014 would have increased 16.7% to $4.2 million, and net sales for the six months ended June 30, 2014 would have increased 18.6% to $8.3 million; the currency impact was primarily due to the South Africa Rand. 19 -------------------------------------------------------------------------------- Table of Contents Fluctuation in foreign currency exchange rates for the three months ended June 30, 2014 had an overall favorable impact on our net sales of approximately $0.5 million, as appreciation of the Korean Won was partially offset by depreciation of the Yen, Australian Dollar and South African Rand. For the six months ended June 30, 2014, fluctuation in foreign currency exchange had an overall unfavorable impact on our net sales of approximately $0.7 million, largely attributed to the South African Rand. During this period, in the Asia/Pacific region, gains from a stronger Korean Won were offset by losses from a weaker Yen and Australian Dollar. The net sales impact is calculated as the difference between (1) the current period's net sales in USD and (2) the current period's net sales in local currencies converted to USD by applying average exchange rates for the same periods ended June 30, 2013.



Our total sales and sales mix could be influenced by any of the following:

changes in our sales prices;

changes in consumer demand;

changes in the number of associates and members;

changes in competitors' products;

changes in economic conditions;

changes in regulations;



announcements of new scientific studies and breakthroughs;

introduction of new products;

discontinuation of existing products;

adverse publicity;



changes in our commissions and incentives programs;

direct competition; and



fluctuations in foreign currency exchange rates.

Our sales mix for the three and six months ended June 30, was as follows (in millions, except percentages):

Three Months



Change

2014 2013 Dollar Percentage Consolidated product sales $ 37.2$ 38.9$ (1.7 ) (4.4 )% Consolidated pack sales 7.3 3.9 3.4 87.2 % Consolidated other, including freight 1.8 2.0 (0.2 ) (10.0 )% Total consolidated net sales $ 46.3$ 44.8$ 1.5 3.4 % Six Months Change 2014 2013 Dollar Percentage Consolidated product sales $ 71.7$ 76.2$ (4.5 ) (5.9 )% Consolidated pack sales 14.0 6.3 7.7 122.2 % Consolidated other, including freight 3.6 4.0 (0.4 ) (10.0 )% Total consolidated net sales $ 89.3$ 86.5$ 2.8 3.2 % Pack sales correlate to new associates who purchase starter packs and to continuing associates who purchase upgrade or renewal packs. However, there is no direct correlation between product sales and the number of new and continuing associates and members because associates and members utilize products at different volumes. 20 -------------------------------------------------------------------------------- Table of Contents Product Sales



Substantially all of our product sales are made to associates at published wholesale prices. We also sell our products to members at discounted published retail prices.

Product sales for the three months ended June 30, 2014 decreased $1.7 million or 4.4% from the same period in 2013 primarily because of deferred revenue (see Revenue Recognition and Deferred Commissions in Note 1 of the unaudited consolidated financial statements). The average order value for the three months ended June 30, 2014 was $165 as compared to $153 for the same period in 2013, and this increase in order value resulted in more revenue. The number of orders processed during the three months ended June 30, 2014 decreased by 0.6%, as compared to the same period in 2013. Product sales for the six months ended June 30, 2014 decreased by $4.5 million, or 5.9%, as compared to the same period in 2014 primarily because of deferred revenue (see Revenue Recognition and Deferred Commissions in Note 1 of the unaudited consolidated financial statements). The average order value for the six months ended June, 2014 was $159, as compared to $153 for the same period in 2013. The 3.9% increase in average order value resulted in more revenue. The number of orders processed during the six months ended June 30, 2014 increased by 0.2%, as compared to the same period in 2013.



Pack Sales

Packs may be purchased by our associates who wish to build a Mannatech business. These packs are offered to our associates at a discount from published retail prices. There are several pack options available to our associates. In certain markets, pack sales are completed during the final stages of the registration process and can provide new associates with valuable training and promotional materials, as well as products for resale to retail customers, demonstration purposes, and personal consumption. Business-building associates can also purchase an upgrade pack, which provides the associate with additional promotional materials, additional products, and eligibility for additional commissions and incentives. Many of our business-building associates also choose to purchase renewal packs to satisfy annual renewal requirements to continue to earn various commissions. The dollar amount of pack sales associated with new and continuing associates was as follows, for the three and six months ended June 30 (in millions, except percentages): Three Months Change 2014 2013 Dollar Percentage New $ 2.4$ 2.6$ (0.2 ) (7.7 )% Continuing 4.9 1.3 3.6 276.9 % Total $ 7.3$ 3.9$ 3.4 87.2 % Six Months Change 2014 2013 Dollar Percentage New $ 4.5$ 4.0$ 0.5 12.5 % Continuing 9.5 2.3 7.2 313.0 % Total $ 14.0$ 6.3$ 7.7 122.2 % Total pack sales for the three months ended June 30, 2014 increased by $3.4 million, or 87.2%, to $7.3 million, as compared to $3.9 million for the same period in 2013. Average pack value for the three months ended June 30, 2014 was $240 as compared to $141 for the same period in 2013. During the three month period ended June 30, 2014, the total number of packs sold increased by 2,700, or 9.7%, to 30,400 and the average pack value increased by $99 to $240, when compared to the period in the prior year. The increase in the average pack value is due to improvements in pack value and an increase in the price of the pack. Total pack sales for the six months ended June 30, 2014 increased by $7.7 million, or 122.2%, to $14.0 million, as compared to $6.3 million for the same period in 2013. Average pack value for the six months ended June 30, 2014 was $250, as compared to $134 for the same period in 2013. The total number of packs sold increased by 9,300, or 20.0%, to 46,600. The increase in the average pack value is due to improvements in pack value and an increase in the price of the pack. 21 -------------------------------------------------------------------------------- Table of Contents Recruiting decreased 13.0% in the second quarter of 2014 as compared to the second quarter of 2013. The number of new independent associates and members for the second quarter of 2014 was approximately 31,500, as compared to 36,200 in 2013. We implemented new incentive programs in major countries during 2014 that changed the incentive program qualification criteria and extended the qualifying period to be longer than the 2013 qualifying period. We believe these changes had a negative impact on the comparability of the recruiting of new associates and members in the second quarter 2014 as compared to the same period in 2013. The approximate number of new and continuing independent associates and members who purchased our packs or products during the twelve months ended June 30, 2014 and 2013 were as follows: 2014 2013 New 113,000 47.3 % 108,000 45.0 % Continuing 126,000 52.7 % 132,000 55.0 % Total 239,000 100.0 % 240,000 100.0 %



During 2013 and continuing into 2014, we took the following actions to recruit and retain associates and members:

explored new international markets;

launched an aggressive marketing and educational campaign;

continued to strengthen compliance initiatives;

concentrated on publishing results of research studies and clinical trials

related to our products;



initiated additional incentives;

explored new advertising and educational tools to broaden name recognition; and

implemented changes to our global associate career and compensation plan.

Other Sales Other sales consisted of: (i) freight revenue charged to our active associates and members; (ii) sales of promotional materials; (iii) monthly fees collected for Success TrackerTM and Navig8 customized electronic business-building and educational materials, databases and applications; (iv) training and event registration fees; and (v) a reserve for estimated sales refunds and returns. Promotional materials, training, database applications and business management tools support our independent associates, which in turn helps stimulate product sales. For the three months ended June 30, 2014, other sales decreased by $0.2 million, or 10.0%, to $1.8 million, as compared to $2.0 million for the same period in 2013. Other sales for the six months ended June 30, 2014 decreased by $0.4 million, or 10.0%, to $3.6 million, as compared to $4.0 million for the same period in 2013. The decrease was primarily due to a decrease in Success TrackerTM sales and freight fees charged on our product and pack shipments, which was offset by an increase in sales refunds.



Gross Profit

During the three months ended June 30, 2014, gross profit increased by $0.5 million, or 1.3%, to $36.6 million, as compared to $36.1 million for the same period in 2013 primarily because of increasing sales. For the three months ended June 30, 2014, gross profit as a percentage of net sales decreased to 79.0%, as compared to 80.6% for the same period in 2013. The Company took a charge to allowance for obsolete inventory of $0.8 million during the second quarter, which was attributed to $0.5 million for raw materials and $0.3 million for finished goods. During the same period 2013, the charge for allowance for obsolete inventory was $0.1 million. For the six months ended June 30, 2014 and 2013, gross profit was $70.1 million. For the six months ended June 30, 2014, gross profit as a percentage of net sales decreased to 78.6%, as compared to 81.0% for the same period in 2013. The reduction in gross profit was the charge to allowance for obsolete inventory in the second quarter plus a charge for obsolete inventory during the first quarter of $0.9 million that was attributed to $0.4 million for raw materials and $0.5 million for finished goods. During the same six month period in 2013, the charge for allowance for obsolete inventory was $0.2 million. 22 -------------------------------------------------------------------------------- Table of Contents Commission and Incentives Commission costs for the three months ended June 30, 2014 increased by 5.6%, or $1.0 million, to $18.8 million, as compared to $17.8 million for the same period in 2013. The increase in commissions was due to the increase in commissionable net sales. For the three months ended June 30, 2014, commissions as a percentage of net sales increased to 40.6% from 39.9% for the same period in 2013 due to the commission expense on the Uth pre-launch in certain Asia/Pacific markets (see Current Economic Conditions and Recent Developments.) Commission costs for the six months ended June 30, 2014 increased $0.6 million to $35.2 million, compared to $34.6 million for the same period in 2013. For the six months ended June 30, 2014, commissions as a percentage of net sales decreased to 39.5% from 40.0% for the same period in 2013. Incentive costs for the three months ended June 30, 2014 decreased by $0.3 million, to $1.0 million, as compared to $1.3 million for the same period in 2013. The costs of incentives as a percentage of net sales decreased during this period to 2.2% from 2.9% for the same period in 2013. Incentive costs for the six months ended June 30, 2014 decreased $0.6 million, to $1.5 million, as compared to $2.1 million for the same period in 2013. The costs of incentives as a percentage of net sales decreased during this period to 1.7%, as compared to 2.5% for the same period in 2013.



Selling and Administrative Expenses

Selling and administrative expenses include a combination of both fixed and variable expenses. These expenses consist of compensation and benefits for employees, temporary and contract labor, and marketing-related expenses, such as monthly magazine development costs and costs related to hosting our corporate-sponsored events.

For the three months ended June 30, 2014, selling and administrative expenses increased by $0.4 million, or 4.7%, to $8.9 million, as compared to $8.5 million for the same period in 2013 due to increased marketing costs. Selling and administrative expenses as a percentage of net sales for the three months ended June 30, 2014 increased to 19.3% from 19.1% for the same period in 2013. For the six months ended June 30, 2014, selling and administrative expenses decreased by $0.4 million, or 2.0%, to $16.8 million, as compared to $17.2 million for the same period in 2013. The decrease in selling and administrative expenses consisted primarily of a decrease in payroll and payroll-related costs of $0.8 million which was offset by an increase in marketing costs of $0.3 million and stock-based compensation expense of $0.2 million. Selling and administrative expenses as a percentage of net sales for the six months ended June 30, 2014 decreased to 18.8% from 19.9% for the same period in 2013. Other Operating Costs Other operating costs include travel, accounting, legal and consulting fees, credit card processing fees, banking fees, off-site storage fees, utilities, and other miscellaneous operating expenses. Changes in other operating costs are associated with changes in our net sales. For the three months ended June 30, 2014, other operating costs increased by $0.6 million, or 9.1%, to $6.8 million, as compared to $6.2 million for the same period in 2013. For the three months ended June 30, 2014, other operating costs as a percentage of net sales increased to 14.7% from 13.9% for the same period in 2013. For the six months ended June 30, 2014, other operating costs increased by $1.0 million, or 8.0%, to $13.8 million, as compared to $12.8 million for the same period in 2013. For the six months ended June 30, 2014, other operating costs as a percentage of net sales increased to 15.4% from 14.7% for the same period in 2013. For the three and six month periods ending June 30, 2014, the increase in other operating costs were primarily due to the office and credit card expenses. 23 -------------------------------------------------------------------------------- Table of Contents Depreciation and Amortization Expense Depreciation and amortization expense for the three months ended June 30, 2014 decreased to $0.4 million, as compared to $0.6 million for the same period in 2013. As a percentage of net sales, depreciation and amortization expense was 0.9%, as compared to 1.3% for the same period in 2013. Depreciation and amortization expense for the six months ended June 30, 2014 decreased to $0.8 million, as compared to $1.2 million for the same period in 2013. As a percentage of net sales, depreciation and amortization expense was 0.9%, as compared to 1.4% for the same period in 2013.



Other Income (Expense), Net

Other income (expense), net primarily consists of foreign currency gains and losses related to the remeasurement of our foreign subsidiaries' assets, liabilities, revenues, and expenses to the United States Dollar and revaluing monetary accounts in the United States, Switzerland, Japan, Republic of Korea, Taiwan, Norway, Sweden, and Mexico using current and weighted-average currency exchange rates. Net foreign currency transaction gains and losses are the result of the United States dollar fluctuating in value against foreign currencies. Other income (expense), net for the three months ended June 30, 2014 was $0.2 million, as compared to other income (expense), net of ($1.4) million for the same period in 2013; the improvement in other income is due to foreign currency exchange during the three months ended June 30, 2014, as compared to the same period in 2013. Other income (expense), net for the six months ended June 30, 2014 was ($0.1) million, as compared to other income, net of ($1.0) million for the same period in 2013, the improvement in other expense is associated with foreign currency exchange during the six months ended June 30, 2014, as compared to the same period in 2013.



(Provision) Benefit for Income Taxes

(Provision) benefit for income taxes includes current and deferred income taxes for both our domestic and foreign operations. Our statutory income tax rates by jurisdiction are as follows for the three and six months ended June 30: Country 2014 2013 Australia 30.0% 30.0% Canada 26.5% 26.5% Denmark 24.5% 25.0% Japan 39.4% 39.4% Mexico 30.0% 30.0% Norway 27.0% 28.0% Republic of Korea 22.0% 22.0% Singapore 17.0% 17.0% South Africa 28.0% 28.0% Sweden 22.0% 22.0% Switzerland 16.2% 16.2% Taiwan 17.0% 17.0% United Kingdom 21.0% 23.0% United States 37.5% 37.5% Cyprus 12.5% 12.5% Hong Kong 16.5% 16.5% Ukraine 18.0% 19.0% Gibraltar 10.0% -- Income from our international operations is subject to taxation in the countries in which we operate. Although we may receive foreign income tax credits that would reduce the total amount of income taxes owed in the United States, we may not be able to fully utilize our foreign income tax credits in the United States. 24 -------------------------------------------------------------------------------- Table of Contents We use the recognition and measurement provisions of FASB ASC Topic 740, Income Taxes, to account for income taxes. The provisions of the Income Tax Topic require a company to record a valuation allowance when the "more likely than not" criterion for realizing net deferred tax assets cannot be met. Furthermore, the weight given to the potential effect of such evidence should be commensurate with the extent to which it can be objectively verified. As a result, we reviewed the operating results, as well as all of the positive and negative evidence related to realization of such deferred tax assets to evaluate the need for a valuation allowance in each tax jurisdiction. For each of the periods ended June 30, 2014 and December 31, 2013, we maintained the following valuation allowances for deferred tax assets totaling $5.5 million as we believe the "more likely than not" criterion for recognition and realization purposes, as defined in FASB ASC Topic 740, cannot be met (in millions): June 30, December 31, Country 2014 2013 Mexico $ 2.9 $ 2.7 Norway 0.2 0.2 Sweden 0.1 0.1 Switzerland 0.1 0.2 Taiwan 1.3 1.2 Ukraine 0.2 0.1 United States 0.7 0.8 Total $ 5.5 $ 5.3 The dollar amount of the provisions for income taxes is directly related to our profitability and changes in the taxable income among countries. For the three and six months ended June 30, 2014, our effective tax rate was 183.7% and 124.8%, respectively, as compared to (429.5%) and (18.4)% for the same periods in 2013, respectively. For the three and six months ended June 30, 2014 and 2013, the Company's effective income tax rate was determined based on the estimated annual effective income tax rate. For the six months ended June 30, 2014, the effective tax rates for the six months ended 2014 were higher than what would have been expected if the federal statutory rate were applied to income before taxes. Items increasing the effective income tax rate included the change in the valuation allowances associated with certain deferred tax assets, US federal tax on deemed foreign dividend distribution, and the unfavorable rate differences from foreign jurisdictions. To supplement our financial results presented in accordance with GAAP, we reconcile from the federal statutory income tax rate to the effective tax rate (a GAAP financial measure), which we believe provides investors an additional perspective on trends related to our taxes. Effective tax rate Three months Six months ended ended June 30, June 30 2014 2013 2014 2013 Federal statutory income taxes 35.0 % 35.0 %



35.0 % 35.0 %

State income taxes (0.3 %) 9.7 %



0.5 % 2.1 %

Difference in foreign and US tax

on foreign operations 19.0 % 125.6 %



15.4 % 21.6 %

Uncertain tax positions 5.5 % (41.2 %)



4.4 % 0.1 %

NOL and charitable valuation 19.4 % 88.3 % 22.6 % 7.9 % Intercompany dividend 50.6 % -- % 22.3 % -- % IRS settlement -- % (692.7 %) -- % (85.0 %) Other 54.5 % 45.8 % 24.6 % (0.1 %) Effective tax rate 183.7 % (429.5 %) 124.8 % (18.4 %)



We anticipate the effective tax rate will decline as profitability is achieved uniformly across all regions. As in prior periods, additional profitability growth should be achieved by continuing to grow revenue as well as targeted expense reductions.

25 -------------------------------------------------------------------------------- Table of Contents The effective tax rates for the three and six months ended June 30, 2014 were higher than what would have been expected if the federal statutory rate were applied to income before taxes. Items increasing the effective income tax rate included the change in the valuation allowances associated with certain deferred tax assets and the unfavorable rate differences from foreign jurisdictions. In the second quarter 2014, it was determined a deemed intercompany dividend had occurred in 2012 and 2013 related to an intercompany working capital loan that originated in 2012; the Company recorded the expense, which is not material to the financial statements for the year. We have not initiated any further intercompany transactions like the 2012 transaction, nor do we anticipate the need for further transactions of this type.



LIQUIDITY AND CAPITAL RESOURCES

Cash and Cash Equivalents

As of June 30, 2014, our cash and cash equivalents increased by 29.8%, or $6.1 million, to $26.5 million from $20.4 million as of December 31, 2013. Our restricted cash balance was increased during the period ending June 30, 2014 by $0.1 million to $5.9 million from $5.8 million. Fluctuations in currency rates produced an increase of $0.5 million in cash and cash equivalents. Our principal use of cash is to pay for operating expenses, including commissions and incentives, capital assets, inventory purchases, and international expansion. The quarterly cash dividend has been suspended since August 2009. Business objectives, operations, and expansion of operations are funded through net cash flows from operations rather than incurring long-term debt. Working Capital Working capital represents total current assets less total current liabilities. At June 30, 2014, our working capital decreased by $1.1 million, or 8.1%, to $12.5 million from $13.6 million at December 31, 2013. The decrease in working capital is primarily related to the deferred revenue and deferred costs (see Revenue Recognition and Deferred Commissions in Note 1: Organization and Summary of Significant Accounting Policies of the unaudited consolidated financial statements).



Net Cash Flows

Our net consolidated cash flows consisted of the following, for the six months ended June 30 (in millions):

Used in: 2014 2013 Operating activities $ 7.4$ 5.3 Investing activities $ (1.2 )$ (0.3 ) Financing activities $ (0.6 )$ (0.8 ) Operating Activities Cash provided in operating activities was $7.4 million for the six months ended June 30, 2014, as compared to cash provided in operating activities of $5.3 million for the same period in 2013. The most significant changes in operating cash flows were related to our loyalty program and the strong demand during the second quarter of 2014 in Korea for our Uth skin care product launch. We defer certain components of our revenue and commission expense as discussed in Revenue Recognition and Deferred Commissions in Note 1 Organization and Summary of Significant Accounting Policies. We defer the recognition of revenue on payments received and related commission expenses on payments made. Payments received related to the revenue deferral were a source of $4.8 million cash for the six months ended June 30, 2014, as compared to $0.0 million for the same period in 2013. Commission payments related to the expense deferral used $1.9 million in cash for the six months ended June 30, 2014, as compared to $0.1 million for the same period in 2013. 26 -------------------------------------------------------------------------------- Table of Contents Additionally, we pre-launched the Uth skin care product in certain Asia/Pacific markets, and these pre-launch activities resulted in over $2.8 million in orders. These payments to us are reflected on our June 30, 2014 balance sheet as customer deposits. We paid $0.8 million of commissions on these orders, and at June 30, 2014, these orders generated accrued commission payable of $0.5 million. Customer deposits at December 31, 2013 were $0.2 million.



Investing Activities

For the six months ended June 30, 2014 and 2013, we invested cash of $1.2 million and $0.3 million, respectively. During the six months ended June 30, 2014, we invested $0.7 million in leasehold improvements in our Korean offices and training centers, and we invested $0.5 million for computer hardware and software. Financing Activities For the six months ended June 30, 2014 and 2013, we used $0.7 million and $0.8 million to repay capital lease obligations. We received approximately $0.1 million in proceeds from stock options exercised during the six months ended June 30, 2014.



General Liquidity and Cash Flows

Short Term Liquidity

We believe our existing liquidity and anticipated return to positive cash flows from operations are adequate to fund our normal expected future business operations and possible international expansion costs for the next 12 months. As our primary source of liquidity is our cash flow from operations, this will be dependent on our ability to maintain and increase revenue and/or continue to reduce operational expenses. However, if our existing capital resources or cash flows become insufficient to meet current business plans, projections, and existing capital requirements, we may be required to raise additional funds, which may not be available on favorable terms, if at all. We are engaged in ongoing audits in various tax jurisdictions and other disputes in the normal course of business. It is impossible at this time to predict whether we will incur any liability, or to estimate the ranges of damages, if any, in connection with these matters. Adverse outcomes on these uncertainties may lead to substantial liability or enforcement actions that could adversely affect our cash position. For more information, see Note 3 Income Taxes and Note 7 Litigation to our consolidated financial statements.



Long Term Liquidity

We believe our anticipated return to positive cash flows from operations should be adequate to fund our normal expected future business operations and possible international expansion costs for the long term. As our primary source of liquidity is from our cash flow from operations, this will be dependent on our ability to maintain and increase revenue and/or continue to reduce operational expenses. However, if our existing capital resources or cash flows become insufficient to meet anticipated business plans and existing capital requirements, we may be required to raise additional funds, which may not be available on favorable terms, if at all. Our future access to the capital markets may be adversely impacted if we fail to maintain compliance with the Nasdaq Marketplace Rules for the continued listing of our stock. We continuously monitor our compliance with the Nasdaq continued listing rules. 27 -------------------------------------------------------------------------------- Table of Contents CONTRACTUAL OBLIGATIONS



The following summarizes our future commitments and obligations associated with various agreements and contracts as of June 30, 2014, for the years ending December 31 (in thousands):

Remaining 2014 2015 2016 2017 2018 2019 Thereafter Total Capital lease obligations and other financing arrangements $ 770$ 640$ 359$ 230$ 109 $ - $ - $ 2,108 Purchase obligations(1) (2) 4,437 1,200 300 - - - - 5,937 Operating leases 994 1,697 1,354 1,210 587 - - 5,842 Post-employment royalty 43 25 - - - - - 68 Employment agreements 357 357 - - - - - 714 Royalty agreement 42 66 - - - - - 108 Tax liability (3) 37 33 242 443 - - - 755 Other obligations(4) 92 302 267 91 52 79 741 1,624 Total commitments and obligations $ 6,772$ 4,320$ 2,522$ 1,974$ 748$ 79$ 741$ 17,156



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(1) For purposes of the table, a purchase obligation is defined as an agreement

to purchase goods or services that is non-cancelable, enforceable and legally

binding on the Company that specifies all significant terms, including: fixed

or minimum quantities to be purchased; fixed, minimum or variable price

provisions; and the approximate timing of the transaction.

(2) Excludes approximately $9.5 million of finished product purchase orders that

may be cancelled or delivery dates changed as of June 30, 2014.

(3) Represents the tax liability associated with uncertain tax positions, see

Note 3 "Income Taxes" to our consolidated financial statements.

(4) Other obligations are composed of pension obligations related to the

Company's Japan operations (approximately $1.2 million), lease restoration

obligations (approximately $0.4 million).

We have maintained purchase commitments with certain raw material suppliers to purchase minimum quantities and to ensure exclusivity of our raw materials and the proprietary nature of our products. Currently, we have two supply agreements that require minimum purchase commitments. We also maintain other supply agreements and manufacturing agreements to protect our products, regulate product costs, and help ensure quality control standards. These agreements do not require us to purchase any set minimums. We have no present commitments or agreements with respect to acquisitions or purchases of any manufacturing facilities; however, management from time to time explores the possible benefits of purchasing a raw material manufacturing facility to help control costs of our raw materials and help ensure quality control standards.



OFF-BALANCE SHEET ARRANGEMENTS

We do not have any special-purpose entity arrangements, nor do we have any off-balance sheet arrangements.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The application of GAAP requires us to make estimates and assumptions that affect the reported values of assets and liabilities at the date of our financial statements, the reported amounts of revenues and expenses during the reporting period, and the related disclosures of contingent assets and liabilities. We use estimates throughout our financial statements, which are influenced by management's judgment and uncertainties. Our estimates are based on historical trends, industry standards, and various other assumptions that we believe are applicable and reasonable under the circumstances at the time the consolidated financial statements are prepared. Our Audit Committee reviews our critical accounting policies and estimates. We continually evaluate and review our policies related to the portrayal of our consolidated financial position and consolidated results of operations that require the application of significant judgment by our management. We also analyze the need for certain estimates, including the need for such items as allowance for doubtful accounts, inventory reserves, long-lived fixed assets and capitalization of internal-use software development costs, reserve for uncertain income tax positions and tax valuation allowances, revenue recognition, sales returns, and deferred revenues, accounting for stock-based compensation, and contingencies and litigation. Historically, actual results have not materially deviated from our estimates. However, we caution readers that actual results could differ from our estimates and assumptions applied in the preparation of our consolidated financial statements. If circumstances change relating to the various assumptions or conditions used in our estimates, we could experience an adverse effect on our financial position, results of operations, and cash flows. We have identified the following applicable critical accounting policies and estimates as of June 30, 2014: 28 -------------------------------------------------------------------------------- Table of Contents Inventory Reserves Inventory consists of raw materials, finished goods, and promotional materials that are stated at the lower of cost (using standard costs that approximate average costs) or market. We record the amounts charged by the vendors as the costs of inventory. Typically, the net realizable value of our inventory is higher than the aggregate cost. Determination of net realizable value can be complex and, therefore, requires a high degree of judgment. In order for management to make the appropriate determination of net realizable value, the following items are considered: inventory turnover statistics, current selling prices, seasonality factors, consumer demand, regulatory changes, competitive pricing, and performance of similar products. If we determine the carrying value of inventory is in excess of estimated net realizable value, we write down the value of inventory to the estimated net realizable value. We also review inventory for obsolescence in a similar manner, and any inventory identified as obsolete is reserved or written off. Our determination of obsolescence is based on assumptions about the demand for our products, product expiration dates, estimated future sales, and general future plans. We monitor actual sales compared to original projections, and if actual sales are less favorable than those originally projected by us, we record an additional inventory reserve or write-down. Historically, our estimates have been close to our actual reported amounts. However, if our estimates regarding inventory obsolescence are inaccurate or consumer demand for our products changes in an unforeseen manner, we may be exposed to additional material losses or gains in excess of our established estimated inventory reserves.



Revenue Recognition and Deferred Commissions

The Company's revenue is derived from sales of individual products, sales of its starter and renewal packs, and shipping fees. Substantially all of the Company's product and pack sales are made to associates at published wholesale prices and to members at discounted published retail prices. The Company records revenue net of any sales taxes and records a reserve for expected sales returns based on its historical experience. The Company recognizes revenue from shipped packs and products upon receipt by the customer. Corporate-sponsored event revenue is recognized when the event is held. The Company defers certain components of its revenue. Deferred revenue consisted primarily of: (i) sales of packs and products shipped but not received by the customers by the end of the respective period; (ii) revenue from the loyalty program; and (iii) prepaid registration fees from customers planning to attend a future corporate-sponsored event. During the third quarter of 2013, the Company started a loyalty program through which customers earn loyalty points from qualified automatic orders, which can be applied to future purchases. The Company defers the dollar equivalent in revenue of these points until the points are applied or forfeited, which includes an estimate of the percentage of the unvested loyalty points that are expected to be forfeited. In total current assets, the Company defers commissions on (i) the sales of packs and products shipped but not received by the customers by the end of the respective period and (ii) the loyalty program.



Long Lived Fixed Assets and Capitalization of Software Development Costs

In addition to capitalizing long lived fixed asset costs, we also capitalize costs associated with internally-developed software projects (collectively "fixed assets") and amortize such costs over the estimated useful lives of such fixed assets. Fixed assets are carried at cost, less accumulated depreciation computed using the straight-line method over the assets' estimated useful lives. Leasehold improvements are amortized over the shorter of the remaining lease terms or the estimated useful lives of the improvements. Expenditures for maintenance and repairs are charged to operations as incurred. If a fixed asset is sold or otherwise retired or disposed of, the cost of the fixed asset and the related accumulated depreciation or amortization is written off and any resulting gain or loss is recorded in other operating costs in our consolidated statement of operations. We review our fixed assets for impairment whenever an event or change in circumstances indicates the carrying amount of an asset or group of assets may not be recoverable, such as plans to dispose of an asset before the end of its previously estimated useful life. Our impairment review includes a comparison of future projected cash flows generated by the asset, or group of assets, with its associated net carrying value. If the net carrying value of the asset or group of assets exceeds expected cash flows (undiscounted and without interest charges), an impairment loss is recognized to the extent the carrying amount exceeds the fair value. The fair value is determined by calculating the discounted expected future cash flows using an estimated risk-free rate of interest. Any identified impairment losses are recorded in the period in which the impairment occurs. The carrying value of the fixed asset is adjusted to the new carrying value, and any subsequent increases in fair value of the fixed asset are not recorded. In addition, if we determine the estimated remaining useful life of the asset should be reduced from our original estimate; the periodic depreciation expense is adjusted prospectively, based on the new remaining useful life of the fixed asset. 29 -------------------------------------------------------------------------------- Table of Contents The impairment calculation requires us to apply judgment and estimates concerning future cash flows, strategic plans, useful lives, and discount rates. If actual results are not consistent with our estimates and assumptions, we may be exposed to an additional impairment charge, which could be material to our results of operations. In addition, if accounting standards change, or if fixed assets become obsolete, we may be required to write off any unamortized costs of fixed assets, or if estimated useful lives change, we would be required to accelerate depreciation or amortization periods and recognize additional depreciation expense in our consolidated statement of operations. Historically, our estimates and assumptions related to the carrying value and the estimated useful lives of our fixed assets have not materially deviated from actual results. As of June 30, 2014, the estimated useful lives and net carrying values of fixed assets were as follows:



Net carrying value at

Estimated useful life June 30, 2014 Computer hardware and software 3 to 5 years $ 0.7 million Leasehold improvements 2 to 10 years(1) 1.8 million Office furniture and equipment 5 to 7 years 0.6 million Automobiles 3 to 5 years 0.1 million Construction in Progress (CIP) 1.2 million Total net carrying value at June 30, 2014 $ 4.4 million



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(1) We amortize leasehold improvements over the shorter of the useful estimated

life of the leased asset or the lease term.

The net carrying costs of fixed assets and construction in progress are exposed to impairment losses if our assumptions and estimates of their carrying values change, there is a change in estimated future cash flow, or there is a change in the estimated useful life of the fixed asset. Based on management's analysis, no impairment indicators existed for the six months ended June 30, 2014.



Uncertain Income Tax Positions and Tax Valuation Allowances

As of June 30, 2014, we recorded $0.1 million in taxes payable and $0.7 million in other long-term liabilities on our consolidated balance sheet related to uncertain income tax positions. As required by FASB ASC Topic 740, Income Taxes, we use judgments and make estimates and assumptions related to evaluating the probability of uncertain income tax positions. We base our estimates and assumptions on the potential liability related to an assessment of whether the income tax position will "more likely than not" be sustained in an income tax audit. We are also subject to periodic audits from multiple domestic and foreign tax authorities related to income tax and other forms of taxation. These audits examine our tax positions, timing of income and deductions, and allocation procedures across multiple jurisdictions. As part of our evaluation of these tax issues, we establish reserves in our consolidated financial statements based on our estimate of current probable tax exposures. Depending on the nature of the tax issue, we could be subject to audit over several years. Therefore, our estimated reserve balances and liability related to uncertain income tax positions may exist for multiple years before the applicable statute of limitations expires or before an issue is resolved by the taxing authority. Additionally, we may be requested to extend the statute of limitations for tax years under audit, which may cause the classification between current and long-term to change. We believe our tax liabilities related to uncertain tax positions are based upon reasonable judgment and estimates; however, if actual results materially differ, our effective income tax rate and cash flows could be affected in the period of discovery or resolution. We also review the estimates and assumptions used in evaluating the probability of realizing the future benefits of our deferred tax assets and record a valuation allowance when we believe that a portion or all of the deferred tax assets may not be realized. If we are unable to realize the expected future benefits of our deferred tax assets, we are required to provide a valuation allowance. We use our past history and experience, overall profitability, future management plans, and current economic information to evaluate the amount of valuation allowance to record. As of June 30, 2014, we maintained a valuation allowance for deferred tax assets arising from our operations of $5.5 million because they did not meet the "more likely than not" criteria as defined by the recognition and measurement provisions of FASB ASC Topic 740, Income Taxes.



In

addition, as of June 30, 2014, we had deferred tax assets, after valuation allowance, totaling $6.1 million, which may not be realized if our assumptions and estimates change, which would affect our effective income tax rate and cash flows in the period of discovery or resolution. 30 -------------------------------------------------------------------------------- Table of Contents Product Return Policy We stand behind our packs and products and believe we offer a reasonable and industry-standard product return policy to all of our customers. We do not resell returned products. Refunds are not processed until proper approval is obtained. All refunds must be processed and returned in the same form of payment that was originally used in the sale. Each country in which we operate has specific product return guidelines. However, we allow our associates and members to exchange products as long as the products are unopened and in good condition. Our return policies for our retail customers and our associates and members are as follows:



Retail Customer Product Return Policy. This policy allows a retail customer to

return any of our products to the original associate who sold the product and

receive a full cash refund from the associate for the first 180 days following

the product's purchase if located in the United States and Canada, and for the

first 90 days following the product's purchase in the remaining countries. The

associate may then return or exchange the product based on the associate product return policy.



Associate and Member Product Return Policy. This policy allows the associate or

member to return an order within one year of the purchase date upon terminating

his/her account. If an associate or member returns a product unopened and in

good condition, he/she may receive a full refund minus a 10% restocking fee. We

may also allow the associate or member to receive a full satisfaction guarantee

refund if they have tried the product and are not satisfied for any reason,

excluding promotional materials. This satisfaction guarantee refund applies in

the United States and Canada, only for the first 180 days following the

product's purchase, and applies in the remaining countries for the first 90

days following the product's purchase; however, any commissions earned by an

associate will be deducted from the refund. If we discover abuse of the refund

policy, we may terminate the associate's or member's account.

Historically, sales returns estimates have not materially deviated from actual sales returns, as the majority of our customers who return merchandise do so within the first 90 days after the original sale. Based upon our return policies and historical experience, we estimate a sales return reserve for expected sales refunds over a rolling six month period. If actual results differ from our estimated sales returns reserves due to various factors, the amount of revenue recorded each period could be materially affected. Historically, our sales returns have not materially changed through the years and have averaged 1.5% or less of our gross sales. 31 -------------------------------------------------------------------------------- Table of Contents Accounting for Stock-Based Compensation We grant stock options to our employees, board members, and consultants. At the date of grant, we determine the fair value of a stock option award and recognize compensation expense over the requisite service period, or the vesting period of such stock option award, which is two to four years. The fair value of the stock option award is calculated using the Black-Scholes option-pricing model ("calculated fair value"). The Black-Scholes option-pricing model requires us to apply judgment and use highly subjective assumptions, including expected stock option life, expected volatility, expected average risk-free interest rates, and expected forfeiture rates. For the six months ended June 30, 2014, our assumptions and estimates used for the calculated fair value of stock options granted in 2014 were as follows: February April May 2014 2014 2014 Grant Grant Grant Estimated fair value per share of options granted: $ 12.09$ 10.60$ 9.02 Assumptions: Annualized dividend yield 0.0 % 0.0 % 0.0 % Risk-free rate of return 1.4 % 1.5 % 1.3 % Common stock price volatility 80.2 %



80.5 % 79.8 %

Expected average life of stock options (in years) 4.5



4.5 4.5

The assumptions we use are based on our best estimates and involve inherent uncertainties related to market conditions that are outside of our control. If actual results are not consistent with the assumptions we use, the stock-based compensation expense reported in our consolidated financial statements may not be representative of the actual economic cost of stock-based compensation. For example, if actual employee forfeitures significantly differ from our estimated forfeitures, we may be required to make an adjustment to our consolidated financial statements in future periods. As of June 30, 2014, using our current assumptions and estimates, we anticipate recognizing $0.8 million in gross compensation expense through 2018 related to unvested stock options outstanding. If we grant additional stock options in the future, we would be required to recognize additional compensation expense over the vesting period of such stock options in our consolidated statement of operations. Gross compensation expense would equal the calculated fair value of such stock options, which is dependent on the assumptions used to calculate such fair value, but has historically ranged between 34% to 69% of the exercise price multiplied by the number of stock options awarded. As of June 30, 2014, we had 136,695 shares available for grant in the future.



Contingencies and Litigation

Each quarter, we evaluate the need to establish a reserve for any legal claims or assessments. We base our evaluation on our best estimates of the potential liability in such matters. The legal reserve includes an estimated amount for any damages and the probability of losing any threatened legal claims or assessments. We consult with our general and outside counsel to determine the legal reserve, which is based upon a combination of litigation and settlement strategies. Although we believe that our legal reserve and accruals are based on reasonable judgments and estimates, actual results could differ, which may expose us to material gains or losses in future periods. If actual results differ, if circumstances change, or if we experience an unanticipated adverse outcome of any legal action, including any claim or assessment, we would be required to recognize the estimated amount which could reduce net income, earnings per share, and cash flows.



RECENT ACCOUNTING PRONOUNCEMENTS

See "Recent Accounting Pronouncements" in Note 8 of the Notes to our Consolidated Financial Statements, which is incorporated herein by reference.

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