MANNATECH INC - Quarter Report: 2003 September (Form 10-Q)

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2003

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2003.

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     .

Commission File No. 000-24657

MANNATECH, INCORPORATED

(Exact Name of Registrant as Specified in its Charter)

600 S. Royal Lane, Suite 200

Coppell, Texas 75019

(Address of Principal Executive Offices, including Zip Code)

Registrant’s Telephone Number, including Area Code: (972) 471-7400

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x     No ¨.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨.

As of October 31, 2003, the number of shares outstanding of the registrant’s sole class of common stock, par value $0.0001 per share was 25,854,190.

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Mannatech, Incorporated

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Since its initial public offering, Mannatech’s common stock has traded on the NASDAQ National Market under the symbol “MTEX.” Corporate filings can be viewed on the SEC’s website www.sec.gov or on Mannatech’s corporate website at www.mannatech.com. The filings can also be obtained by contacting Mannatech’s investor relations department at IR@mannatech.com or calling 972-471-6512.

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PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

MANNATECH, INCORPORATED

CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

See accompanying notes to consolidated financial statements.

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MANNATECH, INCORPORATED

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2003

(in thousands, except per share information)

See accompanying notes to consolidated financial statements.

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MANNATECH, INCORPORATED

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2003

(in thousands)

See accompanying notes to consolidated financial statements.

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MANNATECH, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1 ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Mannatech, Incorporated (the “Company”) was incorporated in the state of Texas on November 4, 1993 and is located in Coppell, Texas. The Company develops and sells high-quality, proprietary nutritional supplements, topical products, and weight-management products primarily through a network-marketing system operating in the United States, Canada, Australia, the United Kingdom, Japan, and New Zealand. Independent associates (“associates”) purchase the Company’s products at published wholesale prices for the primary purpose of personal consumption and selling to retail customers. Members (“members”) purchase the Company’s products at a discount from published retail prices. Only independent associates are eligible to earn commissions and incentives on their downline growth and sales volume. The Company has nine wholly-owned subsidiaries of which three of its subsidiaries are active and are as follows:

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information, the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, the consolidated financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. However, in the opinion of Company’s management, the accompanying unaudited consolidated financial statements contain all adjustments, including normal recurring adjustments, considered necessary for a fair statement of the Company’s consolidated financial information as of, and for, the periods presented. The consolidated results of operations of an interim period are not necessarily indicative of the consolidated results of operations to be expected for the fiscal year. For further information, refer to the Company’s consolidated financial statements and accompanying footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2002.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Revenue Recognition

The Company’s revenues are primarily derived from sales of products, sales of starter and renewal packs, and shipping fees. Substantially all product sales are sold to associates at published wholesale prices and to members at discounted published retail prices. The Company records a sales return reserve for expected sales refunds based on its historical experience.

The Company defers all of its revenue until its customers receive their shipments. The Company also defers a portion of its revenue from the sale of its starter and renewal packs because of a one-year magazine subscription offered in some of its packs. In addition, the Company also defers the portion of revenue from each pack that exceeds the total average wholesale value of all individual components included in such packs. The Company amortizes its deferred revenue components over twelve months. Total deferred revenue for the Company was $1.1 million and $2.1 million at December 31, 2002 and September 30, 2003, respectively.

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Shipping and Handling Costs

The Company records freight and shipping revenues collected from associates and members as revenue. The Company records shipping and handling costs associated with shipping products to its associates and members as selling and administrative expenses. Total shipping and handling costs included in selling and administrative expenses were approximately $1.9 million for the three months ended September 30, 2002, $2.5 million for the three months ended September 30, 2003, $5.3 million for the nine months ended September 30, 2002 and $6.9 million for the nine months ended September 30, 2003.

Accounting for Stock-Based Compensation

Periodically, the Company issues stock options to both employees and nonemployees. For stock-based compensation issued to nonemployees, the Company follows Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation.” Under SFAS 123, stock-based compensation to nonemployees is measured by the fair value at the date of grant. The Company grants stock options to nonemployees for terms no longer than ten years and the stock options generally vest over three years.

For stock-based compensation issued to employees and members of the Board of Directors, the Company follows Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and its related interpretations. Under the recognition and measurement principles of APB 25, no compensation expense is recognized unless the market price of the stock option exceeds the exercise price on the date of grant. Stock options granted to employees and members of its Board of Directors are nontransferable and are granted for terms no longer than ten years at an exercise price that may not be less than 110% of the fair value of the Company’s common stock on the date of grant. Stock options generally vest over three to five years for employees and members of its Board of Directors.

For disclosure purposes only, the Company estimated the fair value for all stock options granted on the date of grant using the Black-Scholes option-pricing model and estimated the amount of expense that it would have recognized for each stock option granted over its vesting period. The following table illustrates the effect on the Company’s net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to all of its stock options:

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Earnings Per Share

Basic earnings per share (“EPS”) calculations are based on the weighted-average number of the Company’s common shares outstanding during the period, while diluted EPS calculations are calculated using the weighted-average number of common shares and dilutive common share equivalents outstanding during each period. The Company’s closing prices of $1.35 and $5.46 per share at September 30, 2002 and 2003, respectively, were used to calculate the dilution of its stock options and warrants in the EPS calculation.

The following data shows the amounts used in computing EPS and their effect on the Company’s weighted-average number of common shares and dilutive common share equivalents for the three months ended September 30, 2002 and 2003. At September 30, 2002, 2,648,000 common stock options and 100,000 warrants were excluded from the diluted EPS calculation and at September 30, 2003, 714,100 of the common stock options and 100,000 warrants were excluded from the diluted EPS calculation, as their effect was antidilutive. The amounts are rounded to the nearest thousand, except for per share amounts.

The following data shows the amounts used in computing EPS and their effect on the Company’s weighted-average number of common shares and dilutive common share equivalents for the nine months ended September 30, 2002 and 2003. At September 30, 2002, 2,648,000 common stock options and 100,000 warrants were excluded from the diluted EPS calculation and at September 30, 2003, 714,100 of the common stock options and 100,000 warrants were excluded from the diluted EPS calculation, as their effect was antidilutive. The amounts are rounded to the nearest thousand, except for per share amounts.

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NOTE 2 INVESTMENTS

The Company accounts for its investments in accordance with the provisions of Statement of Financial Accounting Standards No. 115 (“SFAS 115”), “Accounting for Certain Investments in Debt and Equity Securities.” Under SFAS 115, debt securities that have readily determinable fair values are classified in three categories: held-to-maturity, trading securities, and available-for-sale. The Company’s investments are all categorized as available-for-sale and are recorded at fair value, which is determined based on quoted market prices with unrealized gains and losses included in shareholders’ equity, net of tax. Any realized gains and losses on sales of its investments are included in other income (expense), net in the accompanying Statement of Operations. At September 30, 2003, the Company’s investments consisted of the following:

Investments by contractual maturity at September 30, 2003 are as follows:

NOTE 3 INVENTORIES

At December 31, 2002 and September 30, 2003, inventories consisted of the following:

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NOTE 4 COMPREHENSIVE INCOME

Comprehensive income is defined as the change in equity of a business enterprise during a period related to transactions and other events and circumstances from nonowner sources. Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. The Company’s comprehensive income includes foreign currency translation adjustments and unrealized gains from its investments classified as available-for-sale. Comprehensive income is as follows:

NOTE 5 COMMITMENTS AND CONTINGENCIES

Leases and a line of credit

In 2002, the Company leased approximately $0.3 million of computer hardware under a noncancellable master-operating lease, which contains seven separate three-year operating leases that expire at various times through October 2005. The master-operating lease requires the Company to restrict cash of $345,000 as collateral for the life of the lease. In April 2003, the Company obtained two additional master operating leases, with a financial institution to lease additional computer hardware in an amount up to $0.8 million. As of September 30, 2003, the Company had leased approximately $0.4 million related to these master operating leases that is payable through October 2006.

In March 2003, the Company entered into a one-year, $2.0 million line of credit with one of its primary banking institutions, J.P. Morgan/Chase Bank. Through November 1, 2003, the Company had not drawn on its line of credit. The line of credit agreement does not contain any financial covenants or any commitment fees; however, the Company is required to restrict $2.1 million of its cash as collateral for this line of credit.

Purchase commitment

Since 1994, the Company has maintained a purchase commitment with one of its suppliers to purchase Manapol^®, a raw material found in a majority of the Company’s products. In November 2003, the Company agreed in principle to renew this purchase agreement under which the Company and its manufacturers will be required to collectively purchase approximately $2.4 million of the raw material through October 2004.

Separation agreements

On April 15, 2003, Robert M. Henry resigned from the Company as its Chief Executive Officer and as a member of its Board of Directors, and the Company entered into a Separation Agreement with Mr. Henry. Under the terms of the Separation Agreement and because of the termination of Mr. Henry’s employment agreement, which would have expired on December 31, 2004, the Company is required to pay Mr. Henry approximately $1.3 million, of which $0.9 million remained unpaid at September 30, 2003. Of the remaining $0.9 million, approximately $0.1 million will be paid during the remainder of 2003, $0.4 million in 2004, and $0.4 million in 2005. The severance payments primarily related to the Company’s contractual obligations of Mr. Henry’s terminated employment agreement, outplacement fees, attorney fees, relocation fees, health and life insurance, and title to his leased vehicle. In addition, the Company extended the term of Mr. Henry’s 266,667 vested stock options to the earlier of ten years from the original date of grant or one year after Mr. Henry’s death and recorded a one-time non-cash compensation charge of $0.6 million. Pursuant to the Separation Agreement, Mr. Henry agreed to provide certain consulting services to the Company through December 31, 2005 and is prohibited from being affiliated with another dietary supplement network-marketing company that specializes in products that are glyconutritional or aloe-based for a specified period.

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In September 2003, the Company recorded a severance charge of $0.3 million related to the resignation of Mr. Brad Wayment, its Senior Vice President of Marketing. Subsequently, in October 2003, the Company entered into an agreement with Mr. Wayment whereby the Company agreed to accelerate the vesting period of 16,666 of Mr. Wayment’s stock options and to extend the term of Mr. Wayment’s 100,000 stock options from November 14, 2003 until October 13, 2004. The change in Mr. Wayment’s stock options resulted in the Company recording an additional non-cash compensation charge of $0.3 million, in the fourth quarter of 2003.

Non-compete and confidentiality agreement

In July 2002, the Company entered into a Non-Compete and Confidentiality Agreement with Dr. H. Reginald McDaniel, a former medical director who resigned from the Company in June 2002. Under the terms of the Non-Compete and Confidentiality Agreement, the Company agreed to pay Dr. McDaniel $25,000 a month for one year, as consideration for his continued compliance with the non-compete clause of this agreement. In July 2003, the Company agreed in principal to renew the term of this Non-Compete and Confidentiality Agreement for an additional year and agreed to continue to pay Dr. McDaniel $25,000 a month through June 2004.

Agreements for employment, consulting, lock-up and royalties

In October 2001, the Company entered into an agreement with Mr. J. Stanley Fredrick to pay him $185,000 per year for consulting services and a lock-up provision, which prohibited him from selling his Mannatech stock while the agreement was in effect. In June 2003, the Company modified this agreement to increase the annual payment to $285,000 because Mr. Fredrick was providing additional advice and performing various functions for the Company. In November 2003, the Company cancelled this agreement and entered into a new Lock-Up Agreement whereby the Company will pay Mr. Fredrick $185,000 per year. In addition, on November 6, 2003, the Company elected Mr. Fredrick as the Lead Director for its Board of Directors and agreed to pay him $100,000 annually.

The Company maintains a royalty agreement with Jett, a high level associate and a 4.8% shareholder whereby the Company agreed to pay him a royalty of $5.00 for each specific training material and sales aid that is developed by him and sold by the Company, up to $1.6 million. At September 30, 2003, the Company paid Jett accumulated royalties associated with this agreement of $0.4 million.

On August 7, 2003, the Company entered into a new two-year Employment Agreement and a separate Royalty Agreement with Dr. Bill H. McAnalley, its Chief Science Officer. Under the terms of the Employment Agreement, the Company agreed to pay Dr. McAnalley a specified annual salary and the greater of his annual royalties or an annual executive bonus. The Company does not anticipate Dr. McAnalley’s annual royalties to exceed his annual executive bonus for 2003. Either party may cancel the Employment Agreement; however, if the Company cancels without cause, the Company would be required to pay Dr. McAnalley’s minimum salary either for the remaining duration of the employment agreement or for twelve months, whichever is longer. Under the terms of his Royalty Agreement, the Company is required to pay Dr. McAnalley or his heirs royalties that are based on the increase in product sales volume. The Royalty Agreement is effective during the course of Dr. McAnalley’s employment plus ten years thereafter.

NOTE 6 RECENT ACCOUNTING PRONOUNCEMENTS

SFAS 143. In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 143 (“SFAS 143”) “Accounting for Asset Retirement Obligations.” SFAS 143 is effective for fiscal years beginning after June 15, 2002. SFAS 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be determined. In addition, SFAS 143 requires the related asset retirement costs to be capitalized as part of the carrying amount of the long-lived asset and to be amortized over the life of the lease. On January 1, 2003, the Company adopted SFAS 143, which resulted in an increase in its leasehold improvements and long-term liabilities of $250,000 for the estimated restoration costs of its Japanese leased facilities. The Company considered the cumulative effect of this adjustment and the impact on its net income to be insignificant.

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FIN 45. In November 2002, FASB issued Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 is applicable to guarantees issued or modified after December 31, 2002. FIN 45 expands the existing disclosure required for most guarantees, including loan guarantees such as standby letters of credit. FIN 45 also requires a company to recognize an initial liability for the fair market value of the obligations it assumes under that guarantee upon issuance and disclosure of certain information about the guarantee in its interim and annual financial statements. The adoption of this interpretation did not have a significant impact on the Company’s financial condition, results of operations, or cash flows.

FIN 46. In January 2003, FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” FIN 46 is effective for variable interest entities created after January 31, 2003 and is required to be adopted for variable interest entities that existed prior to February 1, 2003 by December 31, 2003. FIN 46 is an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The adoption of this interpretation is not expected to have a significant impact on the Company’s financial condition, results of operations, or cash flows.

SFAS 149. In April 2003, FASB issued Statement of Financial Accounting Standards No. 149 (“SFAS 149”), “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS 149 amends SFAS 133 “Accounting for Derivative Instruments and Hedging Activities” and the related implementation guidance and is effective for contracts entered into or modified after September 30, 2003, except for hedging relationships designated after September 30, 2003. SFAS 149 clarifies the definition of a derivative and amends the financial accounting and reporting required for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. In addition, SFAS 149 improves the financial reporting requirements by requiring more consistent reporting of contracts as either derivatives or hybrid instruments. The adoption of SFAS 149 did not have a significant impact on the Company’s financial condition, results of operations, or cash flows.

SFAS 150. In May 2003, FASB issued Statement of Financial Accounting Standards No. 150 (“SFAS 150”), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS 150 broadens the definition of financial instruments and establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 also requires that an issuer classify a financial instrument that is within its scope as a liability or as an asset. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. SFAS 150 is to be implemented by reporting the cumulative effect of any change in accounting principle at the beginning of the period adopted. The adoption of SFAS 150 is not expected to have a significant impact on the Company’s financial condition, results of operations, or cash flows.

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NOTE 7 SEGMENT INFORMATION

The Company aggregates its operating segments because it believes it operates as a single reportable segment as a seller of nutritional supplements in six different countries. The Company’s management reviews its financial information by country and concentrates its internal reporting and analysis of revenues on pack sales and product sales. The Company sells its products through its independent associates and distributes its products through similar distribution channels in each country. Each of the Company’s operations sells primarily the same products and possesses similar economic characteristics such as similar gross margins. No single associate accounted for more than 10% of its total sales for the three or nine months ended September 30, 2002 and 2003, respectively. Net sales by country are as follows:

A summary of the Company’s pack and product sales are as follows:

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion is intended to assist in the understanding of Mannatech’s financial position and its results of operations for the three and nine months ended September 30, 2003 compared to the same period in 2002. The Consolidated Financial Statements and related notes should be referred to in conjunction with this discussion. Unless stated otherwise, all financial information presented below, throughout this report, and in its Consolidated Financial Statements and related notes includes Mannatech and all of its subsidiaries on a consolidated basis.

Overview and Critical Accounting Policies and Estimates

For nearly a decade, Mannatech has developed innovative, high-quality, proprietary nutritional supplements, topical products, and weight-management products that are sold through a global network-marketing system throughout the United States, Canada, Australia, the United Kingdom, Japan, and New Zealand. New Zealand began operations on June 10, 2002 and is serviced by Mannatech’s Australian subsidiary. Mannatech operates as a single segment and primarily sells its products through a network of approximately 243,000 independent associates and members who have purchased Mannatech’s packs and products within the last twelve months.

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For a complete review of Mannatech’s critical accounting policies and new accounting pronouncements that may impact Mannatech’s operations, refer to Mannatech’s Annual Report on Form 10-K for the year ended December 31, 2002. In response to SEC Release No. 33-8040, “Cautionary Advice Regarding Disclosure About Critical Accounting Policies,” Mannatech identified certain policies that are important to the portrayal of its consolidated financial condition and consolidated results of operations. These policies require the application of significant judgment by Mannatech’s management. Mannatech periodically analyzes the need for certain estimates, including the need for such items as inventory reserves, impairment of long-lived assets, tax valuation allowances, provisions for doubtful accounts, revenue recognition, sales returns, contingencies and litigation. Mannatech bases any estimates needed on its historical experience, industry standards, and various other assumptions that may be reasonable under the circumstances. Mannatech cautions its readers that actual results could differ from its estimates under different assumptions or conditions. If circumstances change relating to the various assumptions or conditions used in such estimates Mannatech could experience an adverse effect on its consolidated financial condition, changes in financial condition, and results of operations. Mannatech’s critical accounting policies at September 30, 2003 include the following:

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General Summary

Mannatech aggregates its operating segments because it believes it operates as a single reportable segment as a seller of nutritional supplements in six different countries. Mannatech’s management reviews its financial information by country and concentrates its internal reporting and analysis on its pack sales and product sales. Mannatech sells its products through independent associates and distributes its products through similar distribution channels in each country. Each of Mannatech’s operations sells primarily the same products and possesses similar economic characteristics such as similar gross margins.

Mannatech derives its revenues from sales of its products, sales of its starter and renewal packs, and from shipping fees. Substantially all product sales are sold to independent associates at published wholesale prices and sold to members at discounted published retail prices. Mannatech believes the vast majority of its product sales are for personal consumption; however, Mannatech cannot distinguish its personal consumption sales from any of its other sales because it has no involvement in its products after delivery other than usual and customary product returns.

Mannatech periodically changes its starter and renewal packs to meet current market demands. Each of its starter and renewal pack includes some combination of Mannatech’s products and promotional materials. Mannatech tries to offer comparable packs in each country in which it does business; however, because each country has different regulatory guidelines, not all of Mannatech’s packs can be offered in all countries. Consolidated net sales by country, in millions, are as follows:

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

For the nine months ended September 30, 2003, Mannatech’s foreign operations accounted for one-third of its consolidated net sales, whereas in the same period in 2002, Mannatech’s foreign operations accounted for only one-quarter of its consolidated net sales. Mannatech is considering plans to accelerate its planned international expansion into South Korea to the second half of 2004 and into Taiwan in the first quarter of 2005. In June 2003, Mannatech entered into a consulting agreement with a consultant to help stimulate sales for its Canadian operations. Mannatech believes the increase in its overall consolidated net sales is largely attributable to the following:

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For the third quarter of 2003, Mannatech reported its highest quarterly pack sales in its ten-year history. For the third quarter of 2003, Mannatech’s quarterly pack sales increased 49.3% to $10.6 million from $7.1 million for the third quarter of 2002. For the third quarter of 2003, Mannatech signed up 32,000 new independent associates and members, which increased the total new associates and members who signed up within the twelve months ended September 30, 2003 to 87,000. In contrast, Mannatech signed up 19,000 new independent associates and members during the third quarter of 2002, which increased the total new associates and members who signed up within the twelve months ended September 30, 2002 to 61,000.

Mannatech believes its annual travel incentive program is uniquely designed to increase the number of independent associates purchasing its products and is also used as a motivational vehicle for retaining its independent associates. Mannatech’s annual travel incentive usually has a qualification period of between four- and seven-months, during which an independent associate qualifies for the annual travel incentive by earning points primarily on the sales of high dollar packs and product purchases, and by achieving the necessary group point volume growth requirements. Under its annual travel incentive program, Mannatech requires its associates to maintain their associate position and its associates are prohibited from subsequently returning any qualifying packs or products, except to subsequently exchange for like-kind products and packs. Mannatech believes its annual travel incentive program has been instrumental in increasing the number of independent associates, as reflected by the 32.6% increase in pack sales for the nine months ended September 30, 2003 compared to the comparable period in 2002. The number of new independent associates and members and the number of continuing independent associates and members who purchased Mannatech’s products within the last twelve months are as follows: