NATURAL HEALTH TRENDS CORP - Quarter Report: 2006 June (Form 10-Q)

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)


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

For the quarterly period ended June 30, 2006


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

For the transition period from to

Commission File Number: 0-26272

NATURAL HEALTH TRENDS CORP.

(Exact name of registrant as specified in its charter)


Delaware		59-2705336
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

2050 Diplomat Drive
Dallas, Texas		75234
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (972) 241-4080

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 þ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer o Non-Accelerated filer þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ

At August 7, 2006, the number of shares outstanding of the registrant’s common stock was 8,199,933 shares.

NATURAL HEALTH TRENDS CORP. AND SUBSIDIARIES
Quarterly Report on Form 10-Q
June 30, 2006

INDEX


		Page
PART I — FINANCIAL INFORMATION

Item 1. Financial Statements:
Consolidated Balance Sheets		1
Consolidated Statements of Operations		2
Consolidated Statements of Cash Flows		3
Notes to the Consolidated Financial Statements		4
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		14
Item 3. Quantitative and Qualitative Disclosures About Market Risk		22
Item 4. Controls and Procedures		23

PART II — OTHER INFORMATION

Item 1. Legal Proceedings		26
Item 1A. Risk Factors		26
Item 6. Exhibits		26

Signatures		27
Certification of the Principal Executive Officer Pursuant to Section 302
Certification of the Chief Financial Officer Pursuant to Section 302
Certification of the Principal Executive Officer Pursuant to Section 906
Certification of the Chief Financial Officer Pursuant to Section 906

FORWARD-LOOKING STATEMENTS

Certain statements contained in this report constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements included in this report, other than statements of historical facts, regarding our strategy, future operations, financial position, estimated revenues, projected costs, prospects, plans and objectives are forward-looking statements. When used in this report, the words “believe,” “anticipate,” “intend,” “estimate,” “expect,” “project,” “could,” “would,” “may,” “plan,” “predict,” “pursue,” “continue,” “feel” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words.

We cannot guarantee future results, levels of activity, performance or achievements, and you should not place undue reliance on our forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including the risk described in Risk Factors, and elsewhere in this report. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or strategic investments. In addition, any forward-looking statements represent our expectation only as of the date of this report and should not be relied on as representing our expectations as of any subsequent date. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our expectations change.

Although we believe that the expectations reflected in any of our forward-looking statements are reasonable, actual results could differ materially from those projected or assumed in any of our forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to change and to inherent risks and uncertainties, such as those disclosed in this report. Important factors that could cause our actual results, performance and achievements, or industry results to differ materially from estimates or projections contained in forward-looking statements include, among others, the following:

	§		our relationship with our distributors;

	§		our need to continually recruit new distributors;

	§		our internal controls and accounting methods may require further modification;

	§		adverse consequences from audit committee investigations or management changes;

	§		regulatory matters governing our products and network marketing system;

	§		regulatory matters pertaining to direct-selling laws, specifically in China;

	§		our ability to recruit and maintain key management,

	§		adverse publicity associated with our products or direct selling organizations;

	§		product liability claims;

	§		our reliance on outside manufacturers;

	§		risks associated with operating internationally, including foreign exchange risks;

	§		product concentration;

	§		dependence on increased penetration of existing markets;

	§		the competitive nature of our business; and

	§		our ability to generate sufficient cash to operate and expand our business.

Market data and other statistical information used throughout this report is based on independent industry publications, government publications, reports by market research firms or other published independent sources and on our good faith estimates, which are derived from our review of internal surveys and independent sources. Although we believe that these sources are reliable, we have not independently verified the information and cannot guarantee its accuracy or completeness.

Additional factors that could cause actual results to differ materially from our forward-looking statements are set forth in this Quarterly Report on Form 10-Q, including under the heading “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in our financial statements and the related notes.

Forward-looking statements in this Quarterly Report on Form 10-Q speak only as of the date hereof, and forward looking statements in documents attached are incorporated by reference speak only as of the date of those documents. The Company does not undertake any obligation to update or release any revisions to any forward-looking statement or to report any events or circumstances after the date hereof or to reflect the occurrence of unanticipated events, except as required by law. Unless otherwise noted, the terms “we,” “our,” “us,” “Company,” refer to Natural Health Trends Corp. and its subsidiaries.

PART I — FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

NATURAL HEALTH TRENDS CORP. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In Thousands, Except Share Data)


	December			June
	31, 2005			30, 2006
				(Unaudited)
ASSETS

Current assets:
Cash and cash equivalents	$	18,470		$	14,680
Restricted cash		903			746
Accounts receivable		300			250
Inventories, net		12,993			11,228
Other current assets		4,632			5,312

Total current assets		37,298			32,216
Property and equipment, net		3,143			4,019
Goodwill		14,145			14,145
Intangible assets, net		4,529			4,050
Other assets		4,833			5,031

Total assets	$	63,948		$	59,461


LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:
Accounts payable	$	2,023		$	1,730
Income taxes payable		1,308			1,278
Accrued distributor commissions		4,001			3,824
Other accrued expenses		6,827			6,862
Deferred revenue		9,897			9,028
Debt		109			86
Other current liabilities		2,537			2,802

Total current liabilities		26,702			25,610
Commitments and contingencies
Minority interest		77			85
Stockholders’ equity:
Preferred stock, $0.001 par value; 5,000,000 shares authorized; none issued and outstanding		—			—
Common stock, $0.001 par value; 50,000,000 shares authorized, 7,108,867 and 8,199,933 shares issued and outstanding at December 31, 2005 and June 30, 2006, respectively		7			8
Additional paid-in capital		69,417			69,735
Accumulated deficit		(32,668	)		(36,617	)
Accumulated other comprehensive income:
Foreign currency translation adjustment		413			640

Total stockholders’ equity		37,169			33,766

Total liabilities and stockholders’ equity	$	63,948		$	59,461

The accompanying notes are an integral part of these consolidated financial statements.

NATURAL HEALTH TRENDS CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(In Thousands, Except Per Share Data)


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2006			2005			2006
Net sales	$	49,959		$	36,321		$	92,718		$	75,795
Cost of sales		12,440			8,501			20,606			16,574

Gross profit		37,519			27,820			72,112			59,221
Operating expenses:
Distributor commissions		27,599			18,761			48,872			39,446
Selling, general and administrative expenses		12,308			12,213			21,554			23,937
Recovery of KGC receivable		—			(314	)		—			(314	)

Total operating expenses		39,907			30,660			70,426			63,069

Income (loss) from operations		(2,388	)		(2,840	)		1,686			(3,848	)
Other income (expense), net		(399	)		228			(673	)		387

Income (loss) before income taxes and minority interest		(2,787	)		(2,612	)		1,013			(3,461	)
Income tax benefit (provision)		674			(189	)		(314	)		(444	)
Minority interest		(46	)		(14	)		(63	)		(44	)

Net income (loss)	$	(2,159	)	$	(2,815	)	$	636		$	(3,949	)


Income (loss) per share:
Basic	$	(0.32	)	$	(0.34	)	$	0.09		$	(0.50	)

Diluted	$	(0.32	)	$	(0.34	)	$	0.08		$	(0.50	)


Weighted-average number of shares outstanding:
Basic		6,853			8,200			6,836			7,957

Diluted		6,853			8,200			8,184			7,957

The accompanying notes are an integral part of these consolidated financial statements.

NATURAL HEALTH TRENDS CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(In Thousands)


	Six Months Ended June 30,
	2005			2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)	$	636		$	(3,949	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization of property and equipment		162			519
Amortization of intangibles		466			479
Minority interest		63			44
Stock-based compensation		—			301
Imputed interest on KGC installment payable		—			(358	)
Recovery of KGC receivable		—			(314	)
Imputed compensation		33			—
Changes in assets and liabilities:
Accounts receivable		(116	)		62
Inventories		186			1,767
Other current assets		(2,500	)		(1,062	)
Other assets		(712	)		(77	)
Accounts payable		412			(293	)
Income taxes payable		11			(40	)
Accrued distributor commissions		1,675			(170	)
Other accrued expenses		1,987			2
Deferred revenue		4,466			(878	)
Other current liabilities		802			245

Net cash provided by (used in) operating activities		7,571			(3,722	)


CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(1,151	)		(1,403	)
Decrease in restricted cash		389			135
Decrease in certificate of deposit		—			104
Proceeds from KGC receivable (see Note 4)		—			1,014

Net cash used in investing activities		(762	)		(150	)


CASH FLOWS FROM FINANCING ACTIVITIES:
Payments on debt		(407	)		(23	)
Proceeds from issuance of common stock		643			18
Offering costs		(97	)		—

Net cash provided by (used in) financing activities		139			(5	)


Effect of exchange rates on cash and cash equivalents		67			87

Net increase (decrease) in cash and cash equivalents		7,015			(3,790	)
CASH AND CASH EQUIVALENTS, beginning of period		22,324			18,470

CASH AND CASH EQUIVALENTS, end of period	$	29,339		$	14,680

The accompanying notes are an integral part of these consolidated financial statements.

NATURAL HEALTH TRENDS CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. NATURE OF OPERATIONS AND BASIS OF PRESENTATION

Nature of Operations

Natural Health Trends Corp. (the “Company”) is an international direct-selling organization headquartered in Dallas, Texas. The Company was originally incorporated as a Florida corporation in 1988. The Company merged into one of its subsidiaries and re-incorporated in the State of Delaware effective June 29, 2005. Subsidiaries controlled by the Company sell personal care, wellness, and “quality of life” products under the “NHT Global” brand to an independent distributor network that either uses the products themselves or resells them to consumers. Prior to June 1, 2006, the Company marketed its “NHT Global” branded products under the name “Lexxus International”. As part of this worldwide name change, the Company’s U.S. subsidiary changed its name from Lexxus International, Inc. to NHT Global, Inc (“NHT Global U.S.”). Effective July 1, 2006, the Company sold its equity interests in eKaire.com, Inc. and other subsidiaries that distribute nutritional supplements aimed at general health and wellness (see Note 8).

The Company’s majority-owned subsidiaries have an active physical presence in the following markets: North America, which consists of the United States and Canada; Greater China, which consists of Hong Kong, Macau, Taiwan and China; Southeast Asia, which consists of Singapore, the Philippines and Indonesia; Australia and New Zealand; South Korea; Japan; Latin America, which primarily consists of Mexico; and Slovenia.

Basis of Presentation

The unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. As a result, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. In the opinion of management, the accompanying unaudited interim consolidated financial statements contain all adjustments, consisting of normal recurring adjustments, considered necessary for a fair statement of the Company’s financial information for the interim periods presented. The results of operations of any interim period are not necessarily indicative of the results of operations to be expected for the fiscal year. These consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in our 2005 amended Annual Report on Form 10-K/A filed with the United States Securities and Exchange Commission (SEC) on May 31, 2006.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

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

Effective December 31, 2005, the Company sold its 51% equity interest in its Eastern European business, KGC Networks Pte Ltd. (“KGC”). As a result, the results of operations of KGC are not included in the Company’s consolidated statement of operations for the three and six months ended June 30, 2006.

Use of Estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reported period. Actual results may differ from these estimates.

determination of liabilities related to sales returns, distributor commissions, and income taxes. Various assumptions and other factors prompt the determination of these significant estimates. The process of determining significant estimates is fact specific and takes into account historical experience and current and expected economic conditions. Historically, actual results have not significantly deviated from those determined using the estimates described above.

Reclassification

Certain restricted cash balances have been reclassified in the prior year consolidated balance sheet to conform to current year presentation.

Revenue Recognition

Product sales are recorded when the products are shipped and title passes to independent distributors. Product sales to distributors are made pursuant to a distributor agreement that provides for transfer of both title and risk of loss upon our delivery to the carrier that completes delivery to the distributors, which is commonly referred to as “F.O.B. Shipping Point.” The Company primarily receives payment by credit card at the time distributors place orders. Amounts received for unshipped product are recorded as deferred revenue. The Company’s sales arrangements do not contain right of inspection or customer acceptance provisions other than general rights of return.

Actual product returns are recorded as a reduction to net sales. The Company estimates and accrues a reserve for product returns based on its return policies and historical experience.

During April 2005, the Company launched a new product line, Gourmet Coffee Café, which consists of coffee machines and the related coffee and tea pods, in the North American market. As the Gourmet Coffee Café is a very different product than the Company’s other products and since there is no basis to reasonably estimate the Company’s sales returns or warranty obligation, the Company has deferred all revenue generated from the sale of coffee machines and the related coffee and tea pods until sufficient return and warranty experience on the product can be established. The deferral totaled approximately $1.7 million and $1.2 million in revenue and related costs, respectively, for product shipped through June 30, 2006. The deferred costs are recorded in other current assets as the sales return period for distributors is only valid for one year from date of shipment. Since the launch, the Company has experienced a high rate of defects and product returns. As a result, the Company has delayed continued sales of our existing inventory of this product and approached the manufacturer for resolution. The manufacturer has agreed to repair all of the machines in our existing inventory and provide discounts on future purchases. The Company is currently planning to re-start the sale of the coffee machines in the first half of 2007.

Shipping charges billed to distributors are included in net sales. Costs associated with shipments are included in cost of sales.

Income Per Share

Basic income per share is computed by dividing net income applicable to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted income per share is determined using the weighted-average number of common shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents, consisting of shares that might be issued upon the exercise of outstanding stock options and warrants. In periods where losses are reported, the weighted-average number of common shares outstanding excludes common stock equivalents because their inclusion would be anti-dilutive.

The dilutive effect of stock options and warrants is reflected by application of the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefit that would be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares. The potential tax benefit derived from exercise of non-qualified stock options has been excluded from the treasury stock calculation as the Company is uncertain that the benefit will be realized.


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2006			2005		2006
	(In Thousands, Except Per Share Data)
Net income (loss)	$	(2,159	)	$	(2,815	)	$	636	$	(3,949	)

Basic weighted-average number of shares outstanding		6,853			8,200			6,836		7,957
Effect of dilutive stock options and warrants		—			—			1,348		—

Diluted weighted-average number of shares outstanding		6,853			8,200			8,184		7,957


Income (loss) per share:
Basic	$	(0.32	)	$	(0.34	)	$	0.09	$	(0.50	)
Diluted	$	(0.32	)	$	(0.34	)	$	0.08	$	(0.50	)

Options and warrants to purchase 2,992,228 shares of common stock were outstanding during the three months ended June 30, 2005, but were not included in the computation of diluted income per share because of the net loss reported for the three months ended June 30, 2005. Options to purchase 310,000 shares of common stock were outstanding during the six months ended June 30, 2005, but were not included in the computation of diluted income per share because the exercise prices were greater than the average market price of the common shares.

Options and warrants to purchase 1,782,628 and 3,022,628 shares of common stock were outstanding during the three and six months ended June 30, 2006, respectively, but were not included in the computation of diluted income per share because of the net loss reported for the three and six months ended June 30, 2006. Options and warrants for 702,124 and 1,080,504 shares of common stock, respectively, were still outstanding at June 30, 2006. Such warrants expire on October 6, 2009. The options have expirations through June 23, 2014.

Recent Accounting Pronouncement

In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting for uncertainty in tax positions. This Interpretation requires the Company to recognize in its financial statements the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective January 1, 2007, with the cumulative effect, if any, of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company is currently evaluating the impact of adopting FIN 48 on the consolidated financial statements.

3. STOCK-BASED COMPENSATION

The Company maintains the 2002 Stock Option Plan (the “Plan”) which provides for the granting of incentive and nonqualified stock options to employees, officers of the Company, members of the board of directors, or consultants. The terms of any particular grant are determined by the board of directors or a committee appointed by the board of directors. Historically, the terms have ranged from five to ten years. Stock options granted to employees and officers of the Company generally vest over three years, and stock options granted to members of the board of directors generally vest immediately. In 2005, the Company amended the Plan to increase the maximum number of shares available to be issued to 1,550,000 shares of common stock. As of June 30, 2006, 967,876 shares remained available to be granted under the Plan.

From January 2001 through April 2003, the Company granted 1,331,500 stock options outside of Plan. The grant included 570,000 options granted to the LaCore and Woodburn Partnership, an entity controlled by Mark Woodburn, former President and director of the Company, and Terry LaCore, former Chief Executive Officer of NHT Global U.S. and former director of the Company; 600,000 options granted to Mr. LaCore; 30,000 options granted to Benchmark Consulting Group (which was subsequently assigned to the LaCore and Woodburn Partnership); 120,000 options granted to members of the Company’s board of directors; 1,500 granted to an employee; and 10,000 options granted to then unrelated parties.

On February 10, 2006, the Company entered into an Escrow Agreement (the “Agreement”) with Messrs. Woodburn and LaCore, the LaCore and Woodburn Partnership, and Krage and Janvey LLP, as escrow agent (the “Agent”). Pursuant to the Agreement, (i) the Company issued and deposited with the Agent stock certificates in the name of the Agent representing an aggregate of 1,081,066 shares of the Company’s common stock (the “Escrowed Shares”) and (ii) Woodburn and LaCore deposited with the Agent $1,206,000

in immediately available funds (the “Cash Deposit”). The Escrowed Shares are the shares of common stock issued upon the cashless exercise of options issued in 2001 and 2002 to LaCore and the LaCore and Woodburn Partnership for 1,200,000 shares of common stock exercisable at $1.00 and $1.10 per share. The number of Escrow Shares is based upon the closing price of the Company’s common stock on February 9, 2006 of $10.14 and the surrender of 118,934 option shares as payment of the aggregate exercise price of $1,206,000.

The Escrowed Shares were issued pursuant to Section 4(2) of the Securities Act of 1933, as amended, to the Agent upon receipt from the Agent of an irrevocable proxy to the Company to vote the Escrowed Shares on all matters presented at meetings of stockholders or any written consent executed in lieu thereof. The parties have agreed that the Agent will hold the Escrowed Shares and the Cash Deposit until it receives (i) joint written instructions from the Company, Woodburn and LaCore, or (ii) a final non-appealable order from a court of competent jurisdiction. Each of the Company and Woodburn and LaCore has further agreed that all current and future rights, claims, defenses and causes of actions they have or may have against each other are preserved.

As of June 30, 2006, 120,000 options granted outside of the Plan remain outstanding.

Adoption of SFAS 123(R) and Transition

Prior to January 1, 2006, the Company accounted for its stock-based compensation plans under the recognition and measurement provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation.” The Company did not recognize compensation cost related to stock options granted to its employees and non-employee directors that had an exercise price equal to or above the market value of the underlying common stock on the date of grant.

Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R), “Share-Based Payment,” and related interpretations using the modified-prospective transition method. The modified-prospective transition method does not allow for restatement of prior periods and accordingly, the results of operations for the three and six months ended June 30, 2006 and future periods will not be comparable to our historical results of operations. Under the modified-prospective transition method, compensation cost recognized in the first quarter of 2006 includes (1) compensation cost for all stock-based awards granted prior to, but not yet vested as of, January 1, 2006 based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, and (2) compensation cost for all stock-based awards granted on or subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). Compensation cost is presented in the same lines as cash compensation paid to the same individuals.

As a result of adopting SFAS No. 123(R) on January 1, 2006, the Company recognized stock-based compensation of approximately $124,000 and $301,000 for the three and six months ended June 30, 2006, respectively, which approximates $0.01 and $0.04 per share, respectively. Because the Company maintained a full valuation allowance on its deferred tax assets, the Company did not recognize any tax benefit related to stock-based compensation for the three and six months ended June 30, 2006.

As of June 30, 2006, there was $1.2 million of total unrecognized stock-based compensation on a pre-tax basis related to non-vested stock options. These costs are expected to be recognized over a weighted-average period of 2.3 years.

Pro Forma Information Under SFAS No. 123(R) for Periods Prior to January 1, 2006

The following table illustrates the effect on net income and income per share if the Company had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation for the three and six months ended June 30, 2005 (in thousands, except per share data):


	Three Months Ended			Six Months Ended
	June 30, 2005			June 30, 2005
Net income (loss), as reported	$	(2,159	)	$	636
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		—			—
Deduct: Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(20	)		(40	)

Pro forma net income (loss)	$	(2,179	)	$	596

Basic income (loss) per share:
As reported	$	(0.32	)	$	0.09
Pro forma	$	(0.32	)	$	0.09
Diluted income (loss) per share:
As reported	$	(0.32	)	$	0.08
Pro forma	$	(0.32	)	$	0.07

No options were granted during the six months ended June 30, 2005.

Valuation and Expense Information under SFAS No. 123(R)

The Company continues to use the Black-Scholes option pricing model to estimate fair value of equity awards, which requires the input of highly subjective assumptions. Due to the “plain vanilla” characteristics of the Company’s stock options, the simplified method, as permitted by the guidance provided in Staff Accounting Bulletin No. 107, is used to determine expected life. Expected volatility is based on the historical volatility of the Company’s common stock computed over a period generally commensurate with the expected life of the stock options. The risk-free interest rate is based on the U.S. Treasury yield at the time of grant. Forfeitures are estimated based on comparable data because we have limited relevant historical information. Compensation cost is recognized on a straight-line basis over the awards’ vesting periods.

No stock options were granted by the Company during the three months ended June 30, 2006. During the six months ended June 30, 2006, the Company granted 20,000 stock options with a weighted-average fair value of $5.67 per share. The fair value of each option grant was estimated on the date of grant with the following weighted-average assumptions: expected life of 3.1 years, risk-free interest rate of 4.6%, expected volatility of 92%, and dividend yield of zero.

A summary of the status and activity of the Company’s stock option awards is as follows:


						Wtd. Avg.
				Wtd. Avg.		Remaining		Aggregate
				Exercise		Contractual		Intrinsic
	Shares			Price		Life		Value¹
Outstanding at December 31, 2005		1,922,124		$	5.17		5.9	$	11,431
Granted		20,000			9.31		—		—
Exercised		(1,091,066	)		1.01		—		—
Forfeited or expired		(148,934	)		2.82		—		—

Outstanding at March 31, 2006		702,124			12.25		4.4		630
Granted		—			—		—		—
Exercised		—			—		—		—
Forfeited or expired		—			—		—		—

Outstanding at June 30, 2006		702,124			12.25		4.2		266


Vested and expected to vest at June 30, 2006		691,168			12.28		4.2		266
Exercisable at June 30, 2006		517,136			12.94		4.0		266


¹		Aggregate intrinsic value is defined as the positive difference between the current market value and the exercise price and is estimated using the closing price of the Company’s common stock on the last trading day of the periods ended as of the dates indicated (in thousands).

No stock options were exercised during the three months ended June 30, 2006. The total intrinsic value of stock options exercised during the six months ended June 30, 2006 was $9,701,000. No options were exercised during the six months ended June 30, 2005. The total fair value of stock options vested during each of the three months ended June 30, 2005 and 2006 was $20,000, and the total fair value of stock options vested during the six months ended June 30, 2005 and 2006 was $72,000 and $178,000, respectively.

A summary of the Company’s non-vested stock activity is as follows:


				Wtd. Avg.
				Fair Value
				at Grant
	Shares			Date
Non-vested at December 31, 2005		222,980		$	6.74
Granted		12,000			6.03
Vested		(17,496	)		6.69
Forfeited or expired		(30,000	)		6.49

Non-vested at March 31, 2006		187,484			6.74
Granted		—			—
Vested		(2,496	)		7.87
Forfeited or expired		—			—

Non-vested at June 30, 2006		184,988			6.72

4. SALE OF KGC NETWORKS

Effective December 31, 2005, the Company entered into a Stock Purchase Agreement with Bannks Foundation (“Bannks”), a Lichtenstein foundation and owner of 49% of the common shares of KGC Networks Pte Ltd. (“KGC”), a Singapore corporation, pursuant to which the Company sold to Bannks 51,000 common shares representing the Company’s 51% of the outstanding shares of capital stock of KGC for a total cash purchase price of $350,000.

At the same time and as a condition of the sale, the Company entered into a separate agreement pursuant to which KGC is obligated to pay to the Company 24 monthly payments of approximately $169,000 each, including interest at 2.5%, to settle an outstanding inter-company payable in the amount of approximately $2.1 million and to pay for inventories ordered and partially delivered totaling approximately $884,000, as well as the Company’s undertaking to continue to supply KGC with certain products for a period of at least 48 months. The Company discounted the 24 monthly payments based on its cost of capital and recorded the receivable at $3.1 million, of which $1.7 million is considered non-current. Given its interest in the retained profits and cumulative translation adjustment of KGC of approximately $434,000, the Company recognized a nominal gain on sale. Since the receivable from KGC is unsecured, the Company recorded a reserve totaling approximately $2.8 million, which will be reduced as payments are received. As of June 30, 2006, KGC is current on all monthly payments due, and as such, the Company reversed $314,000 of the reserve.

KGC sells the Company’s products into a separate network of independent distributors located primarily in Russia and other Eastern European countries. Upon the effective date of the transactions above, the Company no longer consolidates the financial statements of KGC. The Company does not believe these transactions result in a discontinued operation as the Company will continue to supply KGC with a significant amount of product for the foreseeable future. Therefore, the results of KGC for the first six months of 2005 have been reported in results from operations.

Had KGC not been reflected in results from operations, the Company’s statement of operations for the first three and six months of 2005 would have reflected the following (in thousands):


	Three Months Ended						Six Months Ended
	June 30, 2005						June 30, 2005
				As					As
	Actual			Adjusted			Actual		Adjusted
Net sales	$	49,959		$	41,729		$	92,718	$	76,084
Gross profit		37,519			30,924			72,112		58,824
Distributor commissions		27,599			23,645			48,872		40,908
Income (loss) from operations		(2,388	)		(1,628	)		1,686		1,688

5. COMPREHENSIVE INCOME (LOSS) (In Thousands)


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2006			2005		2006
Net income (loss)	$	(2,159	)	$	(2,815	)	$	636	$	(3,949	)
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment		(42	)		89			84		227

Comprehensive income (loss)	$	(2,201	)	$	(2,726	)	$	720	$	(3,722	)

6. CONTINGENCIES

Legal Matters

During the fall of 2003, the customs agency of the government of South Korea brought a charge against LXK, Ltd. (“LXK”), the Company’s wholly-owned subsidiary operating in South Korea, with respect to the importation of the Company’s Alura product. The customs agency alleges that Alura is not a cosmetic product, but rather should be categorized and imported as a pharmaceutical product. On February 18, 2005, the Seoul Central District Court ruled against LXK and fined it a total of 206.7 million Korean won (approximately $213,000 at June 30, 2006). LXK also incurred related costs of 40.0 million Korean won (approximately $41,000 at June 30, 2006) as a result of the judgment. The Company recorded a reserve for the entire 246.7 million Korean won at December 31, 2004 and has appealed the ruling. On May 10, 2006, an intermediate court of appeals issued a ruling that the Company believes reversed that part of the judgment that had imposed 186.7 million Korean won of the fine, but upheld the fine of 20.0 million Korean won (which has already been paid) and the ruling that Alura cannot be imported as a cosmetic product. LXK has filed an appeal of this ruling with the Korean Supreme Court. The Company has been unable to determine with certainty that it will not be subject to the fine of 186.7 million Korean won if the appeal is unsuccessful, and will therefore continue to reserve 226.7 million Korean won (approximately $234,000 at June 30, 2006). The inability to sell Alura in South Korea if the appeal is unsuccessful is not anticipated to have a material adverse effect on the financial condition, results of operations, cash flow or business prospects of LXK.

On or around March 31, 2004, NHT Global U.S. received a letter from John Loghry, a former NHT Global distributor, alleging that NHT Global U.S. had wrongfully terminated an alleged oral distributorship agreement with Mr. Loghry and that the Company had breached an alleged oral agreement to issue shares of the Company’s common stock to Mr. Loghry. On May 13, 2004, NHT Global U.S. and the Company filed an action against Mr. Loghry in the United States District Court for the Northern District of Texas (the “Loghry Case”) seeking, inter alia, unspecified damages from Mr. Loghry for disparagement and a declaration that Mr. Loghry was not wrongfully terminated and is not entitled to recover anything from NHT Global U.S. or the Company. Mr. Loghry filed counterclaims against the Company and NHT Global U.S. asserting his previously threatened claims. In September 2004, Mr. Loghry filed third party claims against certain officers of the Company and NHT Global U.S., including against Terry LaCore, former Chief Executive Officer of NHT Global U.S. and former director of the Company, and Mark Woodburn, former President and director of the Company, for fraud, Messrs. LaCore, Woodburn, and a certain NHT Global distributor for conspiracy to commit fraud and tortuous interference with contract. In February 2005, the court dismissed all of Mr. Loghry’s claims against the individual defendants, except the claims for fraud and conspiracy to commit fraud. Mr.Loghry then filed amended counterclaims and, on June 2, 2005, the Company and the other counterclaim defendants moved to dismiss the counterclaims on the grounds that the claims were barred by Mr. Loghry’s failure to disclose their existence when he filed for personal bankruptcy in September 2002. On June 30, 2005, the U.S. Bankruptcy Court for the District of Nebraska granted Mr. Loghry’s request to reopen his bankruptcy case. On September 6, 2005, the United States Trustee filed an action in the U.S. District Court for the District of Nebraska (the “Trustee’s Case”) against the Company; NHT Global U.S.; Messrs. LaCore and Woodburn; Curtis Broome, President of Greater China and Southeast Asia; and a certain independent distributor of NHT Global U.S., essentially alleging the same claims asserted by Loghry in the Northern District of Texas. On February 21, 2006, the Trustee’s Case was transferred to the United States District Court for the Northern District of Texas. The Loghry Case is set for trial on the Court’s October 2006 docket. The Trustee’s Case has not yet been set for trial. The Company has filed, and the Trustee has opposed, a motion to consolidate the Loghry Case and the Trustee’s Case. The Court has not yet ruled on that motion. In addition, the Company has filed a motion for summary judgment, which is still pending. The Company continues to deny the allegations by Loghry and the United States Trustee and intends to vigorously contest their claims. An unfavorable judgment could have a material adverse effect on the financial condition of the Company.

On November 1, 2004, Toyota Jidosha Kabushiki Kaisha (d/b/a Toyota Motor Corporation) and Toyota Motor Sales, U.S.A. (the “Toyota Entities”) filed a complaint against the Company and NHT Global U.S. in United States District Court for the Central District of California (CV04-9028). The complaint alleges trademark and service mark dilution, unfair competition, trademark and service mark infringement, and trade name infringement, each with respect to Toyota’s Lexus trademark. The Company reached a settlement agreement, dated August 31, 2005, under which the Toyota Entities agreed to terminate their claims against the Company, and the

Company agreed to discontinue use of the Lexxus name and mark and change the name of its Lexxus operations and domain names by June 1, 2006, and sell or otherwise dispose of all product inventory marked with the name Lexxus by December 1, 2006. In compliance with this settlement agreement, the Company has since June 1, 2006, used the name NHT Global in place of Lexxus and Lexxus International and has changed the domain name for its NHT Global business. Continued compliance with this settlement could, however, have a material adverse effect on the financial condition, results of operations, cash flow or business prospects of the Company.

On November 12, 2004, Dorothy Porter filed a complaint against the Company in the United States District Court for the Southern District of Illinois alleging that she sustained a brain hemorrhage after taking Formula One, an ephedra-containing product marketed by Kaire Nutraceuticals, Inc., a former subsidiary of the Company, and, thereafter, eKaire.com, Inc., a wholly-owned subsidiary of the Company. Ms. Porter has sued the Company for strict liability, breach of warranty and negligence. The Company intends to defend this case vigorously and on December 27, 2004 filed an answer denying the allegations contained in the complaint. On March 7, 2005, a Notice of Tag-Along Action was filed by Ms. Porter with the Judicial Panel on Multidistrict Litigation. The case was subsequently transferred for pre-trial purposes to the consolidated Ephedra Products Liability proceedings in the United States District Court for the Southern District of New York. If the case proceeds to a jury trial, the matter will be transferred back to the Southern District of Illinois and tried in that District. Full discovery between the parties in this action began in Spring 2006. The Company does not believe that the plaintiff can demonstrate that its products caused the alleged injury and intends to vigorously defend this action.”

On January 13, 2005, Nature’s Sunshine Products, Inc. and Nature’s Sunshine Products de Mexico S.A. de C.V. (collectively “Nature’s Sunshine”) filed suit against the Company in the Fourth Judicial District Court, Utah County, State of Utah seeking injunctive relief and unspecified damages against the Company, NHT Global U.S., the Company’s Mexican subsidiary, and the Company’s Mexico management team, Oscar de la Mora Romo and Jose Villarreal Patino, alleging among other things that the Company’s employment of De la Mora and Villarreal violated or could lead to the violation of certain non-compete, non-solicitation, and confidentiality agreements allegedly in effect between De la Mora and Villarreal and Nature’s Sunshine. After the Company removed the case to federal court, Nature’s Sunshine voluntarily dismissed its lawsuit and filed a new lawsuit in the Fourth Judicial District Court in Utah County, Utah. After a hearing on August 22, 2005, the district court preliminarily enjoined Messrs. De la Mora and Villarreal from disclosing any confidential information of Nature’s Sunshine or soliciting any employee or distributor of Nature’s Sunshine or inducing them to terminate their relationship with Nature’s Sunshine. The court refused, however, to enjoin Messrs. De la Mora or Villarreal from competing with Nature’s Sunshine. Nature’s Sunshine subsequently filed a petition for interlocutory review with the Utah Supreme Court. The Supreme Court delegated the petition to the Utah Court of Appeals, which denied the petition. On April 6, 2006, a mutual agreement was entered into with Messrs. De la Mora and Villarreal terminating their employment between them and affiliates of the Company. Nevertheless, Nature’s Sunshine continues to seek damages from the Company and Messrs. De la Mora and Villarreal for alleged solicitation of Nature Sunshine’s employees and distributors. If the Company or Messrs. De la Mora and Villarreal are unsuccessful in defending this action, the Company may be required to pay any damages and attorneys’ fees that may be assessed against it.

On or about March 1, 2006, the Company hired Peter Dale, a former executive with the Nature’s Sunshine subsidiary doing business in Japan, Nature’s Sunshine Japan Co., Ltd. (“NSJ”), to serve as an executive vice president with responsibilities in Asia. NSJ alleges that Mr. Dale has signed an agreement containing covenants of non-competition, non-solicitation, and confidentiality, and that it believes Mr. Dale’s employment with the Company would violate the non-competition covenant. As of June 30, 2006, no lawsuit has been filed. If Nature’s Sunshine files suit, the Company and Mr. Dale intend to vigorously defend against the enforcement of the non-competition covenant. However, if Nature’s Sunshine were to prevail in such a lawsuit, Mr. Dale could be enjoined from working for the Company until February 15, 2007 which could have a material adverse effect on the Company’s business in Japan.

Currently, there is no other significant litigation pending against the Company other than as disclosed in the paragraphs above. From time to time, the Company may become a party to litigation and subject to claims incident to the ordinary course of the Company’s business. Although the results of such litigation and claims in the ordinary course of business cannot be predicted with certainty, the Company believes that the final outcome of such matters will not have a material adverse effect on the Company’s business, results of operations or financial condition. Regardless of outcome, litigation can have an adverse impact on the Company because of defense costs, diversion of management resources and other factors.

Other Matters

Effective October 3, 2005, the Board of Directors of the Company appointed Robert H. Hesse, a member of the Company’s Board of Directors since July 2004, as the Company’s Interim Chief Executive Officer. On March 10, 2006, the Company and Mr. Hesse entered into a letter agreement dated March 1, 2006, pursuant to which Mr. Hesse agreed to continue acting as the interim chief executive officer of the Company. In addition to continuing his base pay of $2,000 per day, the Company agreed to pay Mr. Hesse a retention bonus equal to $300,000, of which $150,000 was due and payable upon executing the letter agreement and $150,000 was due

within five days after satisfactory completion of Mr. Hesse’s term as Interim Chief Executive Officer, which was scheduled to conclude when the new chief executive officer commenced his or her employment with the Company. On March 28, 2006, the Board of Directors and Mr. Hesse mutually agreed that Mr. Hesse had completed his assignment as the Interim Chief Executive Officer of the Company, effective immediately. On May 5, 2006, the Company paid $150,000 to Mr. Hesse as provided in the March 10, 2006 letter agreement. Mr. Hesse has released the Company from all other obligations under that letter agreement and, effective May 5, 2006, resigned from the Company’s Board of Directors.

On April 18, 2006, the Company received a letter from The Nasdaq Stock Market (“Nasdaq”) stating that the Company was not in compliance with Marketplace Rule 4310(c)(14), which obligates listed issuers to timely file those reports and other documents required to be filed with the Securities and Exchange Commission. On May 8, 2006, the Company filed its Annual Report on Form 10-K with respect to Parts 1 and 2, and on May 31, 2006 the Company filed an amendment to its Annual Report on Form 10-K/A with respect to Parts 2 and 3. On May 23, 2006, the Company received a letter from Nasdaq stating that it had not received the Company’s Form 10-Q for the quarter ended March 31, 2006, and that these delinquencies would be considered at a hearing on June 1, 2006, to determine the Company’s continued listing. On June 1, 2006, a Hearing Panel appointed by Nasdaq conducted a hearing to determine if the Company’s common stock should be delisted from the Nasdaq National Market. Since the Company filed a completed Annual Report on form 10-K/A and its Quarterly Report on Form 10-Q, on June 23, 2006, the Company was informed by Nasdaq that it is eligible for continued listing. The Company has become current with its filings with the Securities and Exchange Commission and is now in full compliance with Nasdaq Marketplace Rules.

7. RELATED PARTY TRANSACTIONS

In August 2001, the Company entered into a written lease agreement and an oral management agreement with S&B Business Services, an affiliate of Brad LaCore, the brother of Terry LaCore, former Chief Executive Officer of NHT Global U.S. and a director of the Company, and Sherry LaCore, Brad LaCore’s spouse. Under the terms of the two agreements, S&B Business Services provided warehouse facilities and certain equipment, managed and shipped inventory, provided independent distributor support services and disbursed payments to independent distributors. In exchange for these services, the Company paid $18,000 annually for leasing the warehouse, $3,600 annually for the lease of warehouse equipment and $120,000 annually for the management services provided, plus an annual average of approximately $12,000 for business related services. The Company paid S&B Business Services approximately $39,000 and $3,000 during the three month periods ended June 30, 2005 and 2006, respectively, and approximately $78,000 and $18,000 during the six month periods ended June 30, 2005 and 2006, respectively.

The payment disbursement function was transferred to the Company’s Dallas head office during the third quarter of 2005. In January 2006, the Company hired Sherry LaCore as an employee and simultaneously terminated the oral management agreement with S&B Business Services. Additionally, the Company closed the warehouse facility by the end of March 2006 and terminated the related lease agreement.

A director of the Company’s China subsidiary is the sole director of Access Int’l (Zhuhai Ftz) Warehousing & Trading Co. Ltd. and its group (collectively, “Access”), a transportation and logistics company, and the owner of Info Development Ltd. (“Info”), an import services company, both of which provided services to the Company’s Hong Kong subsidiary. Payments totaling approximately $1,926,000 were paid to Access and Info during the three and six month periods ended June 30, 2005. Payments totaling approximately $133,000 and $382,000 were paid to Access and Info during the three and six month periods ended June 30, 2006, respectively. At June 30, 2006, approximately $18,000 was due to Info.

On November 10, 2005, an independent investigator retained by the Company’s Audit Committee learned that an entity controlled by Messrs. Woodburn and LaCore received payments from an independent distributor of the Company’s products during 2001 through August 2005. The Company believes that Messrs. Woodburn and LaCore received from such independent distributor a total of approximately $1.4 million and $1.1 million, respectively. The Company believes that the fees paid by the Company to such independent distributor were not in excess of the amounts due under the Company’s regular distributor compensation plan.

Approximately $2.4 million of the funds paid by the independent distributor to Messrs. Woodburn and LaCore were paid at the direction of Messrs. Woodburn and LaCore to an entity that is partially owned by Mr. Woodburn’s father and Randall A. Mason, the Chairman of the Company’s Board of Directors and former Chairman of the Company’s Audit Committee. The funds were subsequently paid to an entity controlled by Messrs. Woodburn and LaCore at their direction. After investigation by the Audit Committee, the Board of Directors of the Company concluded that Mr. Mason was unaware that these payments were directed by Messrs. Woodburn and LaCore to an entity partially owned by him until uncovered by the Audit’s Committee’s independent investigator on November 10, 2005, and that Mr. Mason was not involved in any misconduct and received no pecuniary benefit from the payments made by the independent distributor. However, since payments were directed into an entity that is partially owned by

Mr. Mason, he could no longer be considered “independent” in accordance with the rules of Nasdaq and under the federal securities laws. Therefore, effective November 11, 2005, Mr. Mason resigned as Chairman and a member of the Company’s Audit Committee.

On November 14, 2005, in light of the information learned by the Company’s Audit Committee on November 10, 2005, the Company terminated the employment of each of Messrs. Woodburn and LaCore. No severance has been paid by the Company to Messrs. Woodburn and LaCore and the Audit Committee has investigated and is now considering claims or actions that the Company may bring against them.

In addition, a loan made by the Company under the direction of Mr. Woodburn in the aggregate principal amount of $256,000 in February 2004 was previously recorded as a loan to a third party. On November 10, 2005, the Audit Committee investigator learned that the Company actually loaned the funds to an entity owned and controlled by the parents of Mr. Woodburn. The loan was repaid in full, partially by an entity controlled by a third party and partially by an entity controlled by Mr. Woodburn in December 2004.

On March 23, 2006, an independent investigator retained by the Audit Committee of the Board of Directors confirmed that affiliates of immediate family members of Mr. Woodburn have owned since 1998, and continue to own on March 23, 2006, equity interests in Aloe Commodities (“Aloe”), the largest manufacturer of the Company and the supplier of the Skindulgence^® Line and LaVie™ products, representing approximately 5% of the outstanding shares of Aloe. The Company paid Aloe and certain of its affiliates approximately $2,348,000 and $4,135,000 during the three and six month periods ended June 30, 2005, respectively. The Company paid Aloe and certain of its affiliates approximately $1,557,000 during the three and six month periods ended June 30, 2006. At June 30, 2006, approximately $816,000 was due to Aloe and certain of its affiliates.

8. SUBSEQUENT EVENTS

Effective July 1, 2006, the Company entered into a Stock Purchase Agreement with Kaire International (Canada) Ltd. (“Kaire International”) pursuant to which the Company sold to Kaire International 1,000 common shares of eKaire.com (“eKaire”), a Delaware corporation, representing 100% of the total number of common shares of eKaire outstanding; 510 common shares of Kaire Nutraceuticals Australia Pty. Limited (“Kaire Australia”), an Australian company, representing the Company’s 51% of the total number of common shares of Kaire Australia outstanding; and 510 common shares of Kaire Nutraceuticals New Zealand Limited (“Kaire New Zealand”), a New Zealand company, representing the Company’s 51% of the total number of common shares of Kaire New Zealand outstanding (collectively, the “Kaire Entities”) for book value, which approximates $150,000.

On July 31, 2006, the Company entered into a letter agreement (the “Agreement”) with Stephanie Hayano pursuant to which Ms. Hayano has agreed to serve as the President and Chief Executive Officer of the Company and to serve on the Company’s Board of Directors. Under the Agreement, the Company has agreed to pay Ms. Hayano an annual base salary of $300,000 plus an annual bonus equal to 50% of her base salary if certain annual performance goals for the Company are achieved. For fiscal 2006, the Company has agreed to pay Ms. Hayano an annual bonus equal to $62,500. In addition, the Company has agreed to pay a temporary living allowance equal to $5,000 per month through January 31, 2007, or until she relocates to the Dallas metropolitan area, whichever is sooner. Ms. Hayano has also been granted options to purchase 150,000 shares of the Company’s common stock at an exercise price of $2.79 per share (the closing price on The Nasdaq Stock Market on July 31, 2006, the date of grant). The options vest in equal annual installments over three years and expire on July 31, 2011.

Following Ms. Hayano’s relocation to the Dallas metropolitan area, she will be entitled to severance in the event that her employment is terminated by the Company without Cause (as defined in the Agreement) or in connection with a Change of Control (as defined in the Agreement). She is also entitled severance in the event that she terminates her employment for Good Reason (as defined in the agreement). Ms. Hayano shall receive as severance the continuation of her base salary for up to two years for a termination without Cause or for Good Reason, or up to three years for a termination in connection with a Change of Control.

In addition, the Company and Ms. Hayano entered into a Non-Competition and Proprietary Rights Assignment Agreement dated July 31, 2006 pursuant to which Ms. Hayano has agreed (i) to keep certain Company information confidential, (ii) to assign the rights to certain work product to the Company, (iii) not to compete with the Company during the term of her employment and for six months thereafter, and (iv) not to solicit Company customers or distributors during the term of her employment and for twelve months thereafter.

In August 2006, the Company was advised by the Staff of the SEC that it is conducting an informal inquiry into matters that are the subject of previously disclosed investigations by the Company’s Audit Committee, including the payments received by two former officers and directors of the Company from an independent distributor. In connection with the inquiry, the SEC staff has requested that the Company voluntarily provide it with certain information and documents, including information gathered by the independent investigator engaged by the Company’s Audit Committee. The Company intends to cooperate with the SEC inquiry.

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management’s Discussion and Analysis should be read in conjunction with Management’s Discussion and Analysis included in our 2005 amended Annual Report on Form 10-K/A filed with the United States Securities and Exchange Commission (SEC) on May 31, 2006, and our other filings, including Current Reports on Form 8-K, filed with the SEC through the date of this report.

Company Overview

The Company is an international direct-selling organization. Subsidiaries controlled by the Company sell personal care, wellness, and “quality of life” products under the “NHT Global” brand to an independent distributor network that either uses the products themselves or resells them to consumers. Prior to June 1, 2006, the Company marketed its “NHT Global” branded products under the name, “Lexxus International”. As part of this worldwide name change, the Company’s U.S. subsidiary changed its name from Lexxus International, Inc. to NHT Global, Inc (“NHT Global U.S.”). Effective July 1, 2006, the Company sold its equity interests in eKaire.com, Inc. and other subsidiaries that distribute nutritional supplements aimed at general health and wellness (see Note 8 to the consolidated financial statements).

NHT Global commenced operations in January 2001 and has experienced tremendous growth. As of June 30, 2006, it is conducting business in at least 15 countries through approximately 114,000 active distributors. We consider a distributor “active” if they have placed at least one product order with us during the preceding year.

Although we have experienced significant revenue growth over the last few years due in part to our efforts to expand into new markets, we do not intend to devote material resources to opening any additional foreign markets in 2006. Our priority for the remainder of 2006 is to progress further on developing the Japanese, Mexican and Chinese markets.

In year 2005 and the first six months of 2006, we generated greater than 90% of our revenue from outside North America, with sales in Hong Kong representing approximately 62% and 70% of revenue, respectively. Because of the size of our foreign operations, operating results can be impacted negatively or positively by factors such as foreign currency fluctuations, and economic, political and business conditions around the world. In addition, our business is subject to various laws and regulations, in particular regulations related to direct selling activities that create certain risks for our business, including improper claims or activities by our distributors and potential inability to obtain necessary product registrations.

Had KGC not been reflected in results from operations, the Company’s statement of operations for the three and six months ended June 30, 2005 would have reflected the following (in thousands):


	Three Months Ended						Six Months Ended
	June 30, 2005						June 30, 2005
	Actual			As Adjusted			Actual		As Adjusted
Net sales	$	49,959		$	41,729		$	92,718	$	76,084
Gross profit		37,519			30,924			72,112		58,824
Distributor commissions		27,599			23,645			48,872		40,908
Income (loss) from operations		(2,388	)		(1,628	)		1,686		1,688

China is currently the Company’s most important business development project. New direct selling legislation was adopted in December 2005, while multi-level marketing was banned in November 2005 by the government in China. Before the formal adoption of direct selling laws, many of the international direct selling companies started to operate in China in a retail format. In June 2004, NHT Global obtained a license to engage in retail business in China. The license stipulates a capital requirement of $12.0 million over a three-year period, including a $1.8 million initial payment that the Company made in January 2005. In December 2005, the Company submitted a preliminary application for a direct selling license and fully capitalized its Chinese entity with the $12.0 million cash infusion. In June 2006, the Company submitted a final application package.

During 2005 and the first six months of 2006, approximately 62% and 70% of our revenue, respectively, was generated in Hong Kong. Most of the Company’s Hong Kong revenues are derived from the sale of products that are delivered to members in China. After consulting with outside professionals, the Company believes that our Hong Kong e-commerce business does not violate any applicable laws in China even though it is used for the internet purchases of our products by buyers in China. But the government in China could, in the future, officially interpret its laws and regulations – or adopt new laws and regulations – to prohibit some or all of our e-commerce activities with China and, if our members engage in illegal activities in China, those actions could be attributable to us.

The Company is unable to predict whether it will be successful in obtaining a direct selling license to operate in China, and if it is successful, when it will be permitted to commence direct selling operations there. Further, even if the Company is successful in obtaining a direct selling license to do business in China, it is uncertain as to whether the Company will generate profits from such operations.

Income Statement Presentation

The Company derives its revenue from sales of its products, sales of its enrollment packages, and from shipping charges. Substantially all of its product sales are to independent distributors at published wholesale prices. We translate revenue from each market’s local currency into U.S. dollars using average rates of exchange during the period. The following table sets forth revenue by market and product line for the time periods indicated (in thousands).


	Three Months Ended June 30,								Six Months Ended June 30,
	2005				2006				2005				2006
North America	$	4,296	8.6	%	$	3,241	8.9	%	$	8,952	9.7		$	6,247	8.2	%
Hong Kong		32,041	64.1			24,093	66.3			57,249	61.7			53,213	70.2
Taiwan		935	1.9			1,148	3.2			1,813	2.0			1,914	2.5
Southeast Asia		1,526	3.0			595	1.6			2,806	3.0			858	1.1
Russia and Eastern Europe¹		8,230	16.5			—	—			16,634	17.9			—	—
South Korea		2,129	4.3			3,541	9.8			3,613	3.9			6,228	8.2
Australia/New Zealand		402	0.8			282	0.8			738	0.8			591	0.8
Japan		—	—			2,318	6.4			—	—			4,130	5.5
Latin America		—	—			775	2.1			—	—			1,923	2.6

Total NHT Global		49,559	99.2			35,993	99.1			91,805	99.0			75,104	99.1
North America		291	0.6			242	0.7			689	0.8			507	0.7
Australia/New Zealand		109	0.2			86	0.2			224	0.2			184	0.2

Total eKaire		400	0.8			328	0.9			913	1.0			691	0.9

	$	49,959	100	%	$	36,321	100	%	$	92,718	100	%	$	75,795	100	%


¹		The Company no longer consolidates the operating results of KGC for periods beginning after December 31, 2005 as it sold its 51% interest in KGC to Bannks Foundation effective December 31, 2005.

Cost of sales consist primarily of products purchased from third-party manufacturers, freight cost of shipping products to distributors and import duties for the products, costs of promotional materials sold to the Company’s distributors at or near cost, and provisions for slow moving or obsolete inventories. Cost of sales also includes purchasing costs, receiving costs, inspection costs and warehousing costs.

Distributor commissions are our most significant expense and are classified as operating expenses. Under our compensation plan, distributors are paid weekly commissions in the distributor’s home country, in their local currency, for product sold by that distributor’s down-line distributor network across all geographic markets. Distributors are not paid commissions on purchases or sales of our products made directly by them. This “seamless” compensation plan enables a distributor located in one country to sponsor other distributors located in other countries where we are authorized to do business. Currently, there are two fundamental ways in which our distributors can earn income:

	•		Through retail markups on sales of products purchased by distributors at wholesale prices; and

	•		Through a series of commissions paid on product purchases made by their down-line distributors.

Each of our products carries a specified number of sales volume points. Commissions are based on total personal and group sales volume points per sales period. Sales volume points are essentially based upon a percentage of a product’s wholesale cost. To be eligible to receive commissions, a distributor may be required to make nominal monthly purchases of our products. Certain of our subsidiaries do not require these nominal purchases for a distributor to be eligible to receive commissions. In determining commissions, the number of levels of down-line distributors included within the distributor’s commissionable group increases as the number of distributorships directly below the distributor increases. Distributor commissions are dependent on the sales mix and, for 2005, typically ranged between 45% and 55% of net sales. From time to time we make modifications and enhancements to our compensation plan to help motivate distributors, which can have an impact on distributor commissions. From time to time, we also enter into agreements for business or market development, which may result in additional compensation to specific distributors.

Selling, general and administrative expenses consist of administrative compensation and benefits, travel, credit card fees and assessments, professional fees, certain occupancy costs, depreciation and amortization, and other corporate administrative expenses. In addition, this category includes selling, marketing, and promotion expenses including costs of distributor conventions which are designed to increase both product awareness and distributor recruitment. Because our various distributor conventions are not always held at the same time each year, interim period comparisons will be impacted accordingly.

Provision for income taxes depends on the statutory tax rates in each of the jurisdictions in which we operate. We implemented a foreign holding and operating company structure for our non-United States businesses effective December 1, 2005. This new structure re-organizes our non-United States subsidiaries in the Cayman Islands. Though our goal is to improve the overall tax rate, there is no assurance that the new tax structure could be successful. If the United States Internal Revenue Service or the taxing authorities of any other jurisdiction were to successfully challenge these agreements, plans, or arrangements, or require changes in our transfer pricing practices, we could be required to pay higher taxes, interest and penalties, and our earnings would be adversely affected.

Critical Accounting Policies and Estimates

In response to SEC Release No. 33-8040, “Cautionary Advice Regarding Disclosure about Critical Accounting Policies” and SEC Release Number 33-8056, “Commission Statement about Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the Company has 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 the Company’s management.

The most significant accounting estimates inherent in the preparation of the Company’s financial statements include estimates associated with obsolete inventory and the fair value of acquired intangible assets and goodwill, as well as those used in the determination of liabilities related to sales returns, distributor commissions, and income taxes. Various assumptions and other factors prompt the determination of these significant estimates. The process of determining significant estimates is fact specific and takes into account historical experience and current and expected economic conditions. Historically, actual results have not significantly deviated from those determined using the estimates described above. If circumstances change relating to the various assumptions or other factors used in such estimates the Company could experience an adverse effect on its consolidated financial condition, changes in financial condition, and results of operations. The Company’s critical accounting policies at June 30, 2006 include the following:

Inventory Valuation. The Company reviews its inventory carrying value and compares it to the net realizable value of its inventory and any inventory value in excess of net realizable value is written down. In addition, the Company reviews its inventory for obsolescence and any inventory identified as obsolete is reserved or written off. The Company’s determination of obsolescence is based on assumptions about the demand for its products, product expiration dates, estimated future sales, and management’s future plans. Also, if actual sales or management plans are less favorable than those originally projected by management, additional inventory reserves or write-downs may be required. The Company’s inventory value at June 30, 2006 was approximately $11.2 million, net of reserve of $0.6 million. Inventory write-downs for the three and six months ended June 30, 2006 were not significant.

Valuation of Goodwill and Impairment Analysis. The Company has adopted Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate that they may be impaired. At June 30, 2006, goodwill of approximately $14.1 million was reflected on the Company’s balance sheet. No impairment of goodwill has been identified in any of the periods presented. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company reviews the book value of its property and equipment and intangible assets whenever an event or change in circumstances indicates that the net book value of an asset or group of assets may be unrecoverable. The Company’s impairment review includes a comparison of future projected cash flows (undiscounted and without interest charges) generated by the asset or group of assets with its associated carrying value. The Company believes its expected future cash flows approximate or exceed its net book value. However, if circumstances change and the net book value of the asset or group of assets exceeds expected cash flows, the Company would have to recognize an impairment loss to the extent the net book value of the asset exceeds its fair value. At June 30, 2006, the net book value of the Company’s property and equipment and intangible assets were approximately $4.0 million and $4.1 million, respectively. No such losses were recognized for the three and six months ended June 30, 2006.

Allowance for Sales Returns. An allowance for sales returns is provided during the period the product is shipped. The allowance is based upon the return policy of each country, which varies from 14 days to one year, and their historical return rates, which range from approximately 1% to approximately 11% of product sales. Sales returns are approximately 4% of product sales for the six months ended June 30, 2005 and 2006. The allowance for sales returns was approximately $1.7 million and $1.8 million at December 31, 2005 and June 30, 2006, respectively. No material changes in estimates have been recognized for the three and six months ended June 30, 2006.

Revenue Recognition. Product sales are recorded when the products are shipped and title passes to independent distributors. Product sales to distributors are made pursuant to a distributor agreement that provides for transfer of both title and risk of loss upon our delivery to the carrier that completes delivery to the distributors, which is commonly referred to as “F.O.B. Shipping Point.” The Company primarily receives payment by credit card at the time distributors place orders. The Company’s sales arrangements do not contain right of inspection or customer acceptance provisions other than general rights of return. Amounts received for unshipped product are recorded as deferred revenue. Such amounts totaled approximately $1.5 million at December 31, 2005 and $1.1 million at June 30, 2006 respectively. Shipping charges billed to distributors are included in net sales. Costs associated with shipments are included in cost of sales.

During April 2005, the Company launched a new product line, Gourmet Coffee Café, which consists of coffee machines and the related coffee and tea pods, in the North American market. As the Gourmet Coffee Café is a very different product than the Company’s other products and since there is no basis to reasonably estimate the Company’s sales returns or warranty obligation, the Company has deferred revenue generated from their sale until sufficient return and warranty experience on the product can be established. The deferral totaled approximately $1.7 million and $1.2 million in revenue and related costs, respectively, for product shipped through June 30, 2006. The deferred costs are recorded in other current assets, as the sales return period for distributors is only for a year. Since the launch, the Company has experienced a high rate of defects and product returns. As a result, the Company has delayed continued sales of our existing inventory of this product and approached the manufacturer for resolution. The manufacturer has agreed to repair all of the machines in our existing inventory and provide discounts on future purchases. The Company is currently planning to re-start the sale of the coffee machines in the first half of 2007.

Enrollment package revenue, including any nonrefundable set-up fees, is deferred and recognized over the term of the arrangement, generally twelve months. Enrollment packages provide distributors access to both a personalized marketing website and a business management system. No upfront costs are deferred as the amount is nominal. Costs associated with shipments are included in cost of sales. At June 30, 2006, enrollment package revenue totaling $6.2 million was deferred. Although the Company has no immediate plans to significantly change the terms or conditions of enrollment packages, any changes in the future could result in additional revenue deferrals or could cause us to recognize the deferred revenue over a longer period of time.

Tax Valuation Allowance. The Company evaluates the probability of realizing the future benefits of any of its deferred tax assets and records a valuation allowance when it believes a portion or all of its deferred tax assets may not be realized. At June 30, 2006, the

valuation allowance equaled its net deferred tax assets due to the uncertainty of future operating results. The valuation allowance will be reduced at such time as management believes it is more likely than not that the deferred tax assets will be realized. Any reductions in the valuation allowance will reduce future income tax provisions.

Results of Operations

The following table sets forth our operating results as a percentage of net sales for the periods indicated.


	Three Months Ended June30,						Six Months Ended June 30,
	2005			2006			2005			2006
Net sales		100.0	%		100.0	%		100.0	%		100.0	%
Cost of sales		24.9			23.4			22.2			21.9

Gross profit		75.1			76.6			77.8			78.1
Operating expenses:
Distributor commissions		55.3			51.7			52.7			52.0
Selling, general and administrative expenses		24.6			33.6			23.3			31.6
Recovery of KGC receivable		—			(0.9	)		—			(0.4	)

Total operating expenses		79.9			84.4			76.0			83.2

Income (loss) from operations		(4.8	)		(7.8	)		1.8			(5.1	)
Other income (expense), net		(0.8	)		0.6			(0.7	)		0.5

Income (loss) before income taxes and minority interest		(5.6	)		(7.2	)		1.1			(4.6	)
Income tax benefit (provision)		1.4			(0.5	)		(0.3	)		(0.6	)
Minority interest		(0.1	)		—			(0.1	)		—

Net income (loss)		(4.3	)%		(7.7	)%		0.7	%		(5.2	)%

Net Sales. Net sales were $36.3 million for the three months ended June 30, 2006 compared to $50.0 million for the three months ended June 30, 2005. This decrease of $13.7 million, or 27%, was largely due to the sale of KGC effective December 31, 2005. Excluding KGC, the Company’s net sales decreased $5.4 million, or 13%, for the three months ended June 30, 2006 over the comparable period in the prior year. This decrease was primarily due to hesitation among the Hong Kong-registered members against an uncertain regulatory environment in China. Hong Kong net sales decreased $7.9 million, or 25%, over the comparable period a year ago. Also, net sales for North America were down $1.1 million, or 24%, versus the comparable period a year ago. Partly offsetting the decrease, South Korea net sales increased $1.4 million, or 66%, compared to the same period in 2005, as it experienced a significant increase in its distributor count and introduced new products to the local market. Japan registered $2.3 million in net sales, and Mexico about $0.8 million. A year ago, advanced sales to Japanese distributors from Singapore were approximately $1.4 million.

Net sales were $75.8 million for the six months ended June 30, 2006 compared to $92.7 million for the six months ended June 30, 2005. This decrease of $16.9 million, or 18%, was due to the sale of KGC effective December 31, 2005. Excluding KGC, the Company’s net sales were approximately flat for the six months ended June 30, 2006 over the comparable period in the prior year. Decreases in Hong Kong net sales (down $4.0 million or 7% versus the comparable period a year ago) and North America (down $2.9 million or 30%) were offset by net sales generated in Japan ($4.1 million), Mexico ($1.9 million), and an increase in South Korea net sales (up 72% or $2.6 million). A year ago, advanced sales to Japanese distributors from Singapore were approximately $2.4 million.

As of June 30, 2006, the operating subsidiaries of the Company had approximately 117,000 active distributors, compared to 122,000 and 106,000 active distributors at December 31, 2005 and June 30, 2005, respectively, excluding KGC. This decrease is due to the uncertain regulatory environment in China that is currently impacting the Hong Kong-based business.

As of June 30, 2006, the Company had deferred revenue of approximately $9.0 million, of which approximately $1.1 million pertained to product sales and approximately $6.2 million pertained to unamortized enrollment package revenue. Additionally, deferred revenue included approximately $1.7 million of Gourmet Coffee Café product shipped but unrecognized as of June 30, 2006 (approximately $1.2 million in Gourmet Coffee Café related costs are also deferred and recorded in other current assets as of June 30, 2006).

Cost of Sales. Cost of sales was $8.5 million, or 23.4% of net sales, for the three months ended June 30, 2006 compared with $12.4 million, or 24.9% of net sales, for the three months ended June 30, 2005. Excluding KGC, cost of sales decreased $2.3 million, or 21%, for the three months ended June 30, 2006 over the comparable period in the prior year, due primarily to the decrease in net sales. Additionally, excluding KGC, cost of sales as a percentage of net sales was 25.9% in the comparable period in the prior year.

The percentage decrease results from greater importation cost incurred in Hong Kong a year ago as the Company implemented changes in its logistical processes on product delivered into China.

Cost of sales was $16.6 million, or 21.9% of net sales, for the six months ended June 30, 2006 compared with $20.6 million, or 22.2% of net sales, for the six months ended June 30, 2005. Excluding KGC, cost of sales decreased $0.7 million, or 4%, for the six months ended June 30, 2006 over the comparable period in the prior year, due primarily to the decrease in net sales. Additionally, excluding KGC, cost of sales as a percentage of net sales was 22.7% in the comparable period in the prior year. The percentage decrease results from greater importation cost incurred in Hong Kong a year ago as the Company implemented changes in its logistical processes on product delivered into China.

Gross Profit. Gross profit was $27.8 million, or 76.6% of net sales, for the three months ended June 30, 2006 compared with $37.5 million, or 75.1% of net sales, for the three months ended June 30, 2005. Excluding KGC, gross profit was 74.1% of net sales in the comparable period in the prior year, and decreased $3.1 million, or 10%, in the three months ended June 30, 2006, as a result of decreased sales.

Gross profit was $59.2 million, or 78.1% of net sales, for the six months ended June 30, 2006 compared with $72.1 million, or 77.8% of net sales, for the six months ended June 30, 2005. Excluding KGC, gross profit was 77.3% of net sales in the comparable period in the prior year, and increased $0.4 million, or 1%, in the six months ended June 30, 2006.

Distributor Commissions. Distributor commissions were $18.8 million, or 51.7% of net sales, for the three months ended June 30, 2006 compared with $27.6 million, or 55.3% of net sales, for the three months ended June 30, 2005. Excluding KGC, distributor commissions decreased by $4.9 million, or 21%, mainly due to the decrease in net sales. Additionally, excluding KGC, distributor commissions as a percentage of sales decreased five points from 56.7% a year ago primarily as a result of less supplemental commission programs in the current year, specifically in Hong Kong, and a reduction in the overall commission rate in South Korea.

Distributor commissions were $39.4 million, or 52.0% of net sales, for the six months ended June 30, 2006 compared with $48.9 million, or 52.7% of net sales, for the six months ended June 30, 2005. Excluding KGC, distributor commissions decreased by $1.5 million, or 4%, mainly due to the decrease in net sales. Additionally, excluding KGC, distributor commissions as a percentage of sales decreased two points from 53.8% a year ago primarily as a result of fewer commissions earned in newer markets such as Japan and Mexico, and a reduction in the overall commission rate in South Korea.

Selling, General and Administrative Expenses. Selling, general and administrative expenses were $12.2 million, or 33.6% of net sales, for the three months ended June 30, 2006 compared with $12.3 million, or 24.6% of net sales, for the three months ended June 30, 2005. Excluding KGC, selling, general and administrative expenses were 21.3% of net sales in the comparable period in the prior year, and increased by $3.3 million, or 37%, in the three months ended June 30, 2006, mainly due to increases in the following:

	•		costs of opening new markets in Mexico ($0.4 million) and Japan ($1.2 million);

	•		costs of expansion into China ($0.4 million); and

	•		higher audit fees, personnel costs (including stock-based compensation), and travel costs in North America ($1.5 million), offset by a decrease in convention cost as the North American Convention was held in the first quarter of 2006 as compared to the second quarter a year ago ($0.7 million).

Selling, general and administrative expenses were $23.9 million, or 31.6% of net sales, for the six months ended June 30, 2006 compared with $21.6 million, or 23.3% of net sales, for the six months ended June 30, 2005. Excluding KGC, selling, general and administrative expenses were 21.3% of net sales in the comparable period in the prior year, and increased by $7.7 million, or 48%, in the six months ended June 30, 2006, mainly due to increases in the following:

	•		costs of opening new markets in Mexico ($0.9 million) and Japan ($2.3 million);

	•		costs of expansion into China ($0.8 million);

	•		increased personnel costs and professional fees in Hong Kong ($0.5 million); and

	•		higher audit fees, legal fees, personnel costs (including stock-based compensation), and travel costs in North America ($2.6 million).

Other Income (Expense). Other income was $0.2 million for the three months ended June 30, 2006 compared with an expense of $0.4 million for the three months ended June 30, 2005. For the first six months of the year, other income was $0.4 million compared with an expense of $0.7 million a year ago. This increase in other income for the six month period results primarily from interest income, including imputed interest of $0.4 million on the KGC receivable, and a reduction in foreign currency losses of $0.6 million due to the elimination of the Company’s exposure to the euro.

Income Taxes. The Company recorded a provision of $0.2 million and $0.4 million during the three and six months ended June 30, 2006, respectively, related to its international operations. The Company did not recognize a tax benefit for U.S. tax purposes due to uncertainty that the benefit will be realized. The Company recorded an income tax benefit of $0.7 million, or 24% of income before income taxes and minority interest, for the three months ended June 30, 2005, and a provision of $0.3 million, or 31% of income before income taxes and minority interest, for the six months ended June 30, 2005.

Minority Interest. Minority interest expense was $14 thousand for the three months ended June 30, 2006 compared to expense of $46 thousand for the three months ended June 30, 2005. Minority interest expense was $44 thousand for the six months ended June 30, 2006 compared to expense of $63 thousand for the six months ended June 30, 2005. Since the sale of KGC, minority interest expense has become insignificant.

Net Income (Loss). Net loss was $2.8 million, or 7.7% of net sales, for the three months ended June 30, 2006 compared to net loss of $2.2 million, or 4.3% of net sales, for the three months ended June 30, 2005. Net loss was $3.9 million, or 5.2% of net sales, for the six months ended June 30, 2006 compared to net income of $0.6 million, or 0.7% of net sales, for the six months ended June 30, 2005. The increased losses were primarily due to lower sales in Hong Kong, and higher selling, general and administrative costs, specifically in North America and the new markets of Mexico, Japan, and China.

Liquidity and Capital Resources

Cash generated from operations has been the main funding source for the Company’s working capital and capital expenditure. In the past, the Company also borrowed from institutions and individuals and issued preferred stock. In October 2004, the Company raised approximately $16 million, net of transaction fees, through a private equity placement. The Company is constantly evaluating its financial needs and potential sources of additional funding. At June 30, 2006, the Company’s cash and cash equivalents totaled approximately $14.7 million.

At June 30, 2006, the ratio of current assets to current liabilities was 1.26 to 1.00 and the Company had working capital of approximately $6.6 million. Working capital as of June 30, 2006 decreased $4.0 million compared to that as of December 31, 2005.

Cash used in operations for the six months ended June 30, 2006 was approximately $3.7 million. Cash was mainly utilized due to the incurrence of net losses and decreases in current liabilities, including deferred revenue, partly offset by a reduction in existing inventories.

Cash used in by investing activities during the period was approximately $0.2 million, which primarily results from investment in property and equipment, offset by proceeds received on the KGC receivable. Cash used in financing activities during the period was approximately $5 thousand due to repayment of debt. Total cash and cash equivalents decreased by approximately $3.8 million during the period.

The Company believes that its existing liquidity and cash flows from operations, including its cash and cash equivalents, should be adequate to fund normal business operations expected in the future.

The Company intends to continue to open additional operations in new foreign markets after 2006. The Company plans to focus on further developing the Japanese, the Mexican and the Chinese markets in the next twelve months. The Company does not expect the sale of its equity interests in eKaire.com and other subsidiaries effective July 1, 2006 (see Note 8 to the consolidated financial statements), to have a significant impact on its financial condition, results of operations, or cash flows.

Related Party Transactions

S&B Business Services. Additionally, the Company closed the warehouse facility by the end of March 2006 and terminated the related lease agreement.

Adoption of SFAS 123(R)

provisions of SFAS No. 123, and (2) compensation cost for all stock-based awards granted on or subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). Compensation cost is presented in the same lines as cash compensation paid to the same individuals.

Recent Accounting Pronouncement

Off – Balance Sheet Arrangements

The Company does not utilize off-balance sheet financing arrangements other than in the normal course of business. The Company finances the use of certain facilities, office and computer equipment, and automobiles under various operating lease agreements.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Foreign Currency Risk

In the first six months of 2006, approximately 91% of our revenue was recorded in markets outside the United States. However, that figure does not accurately reflect our foreign currency exposure mainly because the Hong Kong dollar is pegged to the U.S. dollar. We also purchase all inventories in U.S. dollars. Therefore, our currency exposure, mainly to the Korean won, Singapore dollar, New Taiwan dollar, Japanese yen, Mexican peso, and Australian dollar, represents approximately 21% of our revenue in the first six months of 2006. The Company incurred a foreign currency loss of $115 thousand and $195 thousand for the three and six months ended June 30, 2006, respectively.

In preparing our consolidated financial statements, we translate revenue and expenses in foreign countries from their local currencies into U.S. dollars using the average exchange rates for the period. The local currency of each subsidiary’s primary markets is considered the functional currency. The effect of the translation of the Company’s foreign operations is included in accumulated other comprehensive income within stockholders’ equity and does not impact the statement of operations.

As currency rates change, translation of our foreign currency functional businesses into U.S. dollars affects year-over-year comparability of equity. We do not plan to hedge translation risks because cash flows from our international operations are generally reinvested locally. Changes in the currency exchange rates that would have the largest impact on translating our international net assets included Korean won, New Taiwan dollar, Australian dollar and Canadian dollar. Japanese yen and Mexican peso are expected to become more significant.

Hedging

Our exposure to foreign currency fluctuation is expected to increase as the Company further develops the markets in Japan, Mexico and China. The Company currently has no specific plans, but expects to evaluate whether it should use forward or option contracts to hedge its foreign currency exposure.

Seasonality

Generally our revenue has not been impacted by seasonality on any significant basis. From quarter to quarter, the Company is somewhat impacted by seasonal factors and trends such as major cultural events and vacation patterns. For example, most Asian markets celebrate their respective local New Year in the first quarter, which generally has a small negative impact on that quarter. We believe that direct selling in the United States and Europe is also generally negatively impacted during the month of August, which is in our third quarter, when many individuals, including our distributors, traditionally take time off for vacations.

The Company’s spending is materially effected by the major events planned for at different times of the year. A major promotional event could significantly increase the reported expenses during the quarter in which the event actually takes place, while the revenue that might be generated by the event may not occur in the same reporting period.

Interest Rate Risk

As of June 30, 2006, we do not think the Company has any exposure to interest rate risk as the Company has limited borrowings that are interest rate sensitive.

Item 4. CONTROLS AND PROCEDURES

Our management is responsible for establishing and maintaining an adequate level of internal controls over financial reporting. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles (“GAAP”). Internal control over financial reporting includes policies and procedures that:

	•		pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company;

	•		provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and

	•		provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the consolidated financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with existing policies or procedures may deteriorate.

The following material weaknesses in our internal control over financial reporting were reported in our 2005 Annual Report on Form 10-K filed with the United States Securities and Exchange Commission on May 8, 2006:

	•		We did not maintain an effective control environment because (1) we lack an effective anti-fraud program to detect and prevent fraud, for example, relating to the previous top two executive officers of the Company, Mark Woodburn and Terry LaCore, in terms of (i) conflicts of interests related to executive officers, especially their financial dealings with independent distributors and other vendors, and (ii) proper supervision of the executives conduct separating their executive duties from personal financial interests outside the Company, (2) we failed to perform background checks consistently on personnel being placed into positions of responsibility, (3) an adequate tone was not set from the top as control measures in place were ignored by the previous top two executives and the importance of controls was not properly emphasized and communicated throughout the Company and (4) we did not effectively address the control deficiencies noted in the fiscal year 2004 external audit;

	•		We did not maintain effective monitoring controls over financial reporting because (1) our policies regarding review, supervision and monitoring of our accounting operations throughout the Company were not fully designed, in place, or operating effectively and (2) we do not have an internal audit function;

	•		We did not maintain effective control over period-end financial close and reporting because (1) we lacked sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of GAAP commensurate with our financial reporting requirements to prepare, review and approve account reconciliations and

supporting schedules, and (2) our legacy accounting systems do not facilitate the appropriate review and approval over the recording of journal entries to ensure the accuracy and completeness of the journal entries recorded;

	•		We did not maintain effective controls over the disbursement function since we (1) lacked adequate segregation of duties and (2) lacked appropriate review, approval, and supporting documentation;

	•		We did not maintain effective controls over the payroll function since we (1) lacked adequate segregation of duties and (2) lacked appropriate review, approval, and supporting documentation;

	•		We did not maintain effective controls over the inventory function since we (1) did not maintain restricted access to the inventory detail schedule used to support the general ledger balances and (2) used the periodic inventory system and performed monthly inventory counts using physical inventory count sheets lacking reviewer documentation;

	•		We lacked documentation with respect to certain related party transactions, subsidiary operations and expense reimbursement procedures. In addition, sufficient policies regarding loans to employees and third parties had not been adopted or implemented, and policies related to independent distributor relationships were inadequate;

	•		We lacked timely resolution of identified accounting and legal issues, and as a result, did not timely complete period-end financial statements and reporting; and

	•		We do not have all material contracts in writing and approved by all parties.

Each of the control deficiencies described above could result in a misstatement of the aforementioned accounts or disclosures that would result in a material misstatement to the annual or interim consolidated financial statements that would not be prevented or detected. Management has determined that each of the control deficiencies constitutes a material weakness.

Based on this evaluation, the Company’s Chief Financial Officer has concluded that our disclosure controls and procedures at December 31, 2005 were not effective to provide reasonable assurance that information required to be disclosed in the reports we file and submit under the Exchange Act is recorded, processed, summarized and reported as and when required.

In light of this conclusion and as part of the preparation of this report, we have applied compensating procedures and processes as necessary to ensure the reliability of our financial reporting. Accordingly, management believes, based on its knowledge, that (1) this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made not misleading with respect to the period covered by this report, and (2) the financial statements, and other financial information included in this report, fairly present in all material respects our financial condition as of December 31, 2005 and June 30, 2006, and our results of operations and cash flows for each of the three and six month periods ended June 30, 2005 and 2006.

Changes in Internal Control Over Financial Reporting

During the six months ended June 30, 2006, there were no additional changes in our internal control over financial reporting that occurred during the period that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

In light of the noted material weaknesses, we have instituted, and will continue to institute, control improvements that we believe will reduce the likelihood of similar errors:

	•		We plan to devote more resources to developing an anti-fraud program to detect and prevent fraud. The program may include the hiring of outside or in-house counsel to be dedicated to the development and enforcement of compliance programs. Background checks will be performed on personnel being placed into positions of material responsibility. The compliance program also will include a communication project to set the right tone from the top. Additionally, we also plan to allocate additional resources to following up on addressing control deficiencies identified in the previous audits;

	•		The Company intends to develop additional policies and procedures to further strengthen its reporting, including the areas of revenue recognition, sales and expense cut-off and sales returns. In addition, we plan to evaluate hiring additional resources to perform the internal audit function;

	•		The Company began implementation of the Oracle E-Business Suite during the fourth quarter of 2005 and commenced use of certain functionality on January 1, 2006 that address certain of the material weaknesses listed above, including the effective

control over period-end financial close and reporting and the effective control over certain accounting functions. The Oracle implementation should facilitate the appropriate review and approval over the recording of journal entries to ensure the accuracy and completeness of the journal entries recorded. Additionally, the Company has made changes to its corporate accounting staff, including the hiring or contracting of additional personnel in the U.S. In December 2005, the Company hired a new general counsel to assist in the legal and compliance effort. The new general counsel commenced work in January 2006;

	•		Additional segregation of duties and appropriate review, approval, and supporting documentation were installed in 2006 to maintain effective controls over the disbursement function. We are developing policies for proper documentation, review and approval related to related party transactions, subsidiary operations, distributor compensation adjustments, employee loans, expense reimbursements, and distributor relationships;

	•		Additional segregation of duties and appropriate review, approval, and supporting documentation have been implemented since 2005 year end to maintain effective controls over the payroll function;

	•		With the implementation of the Oracle e-Business Suite’s financial reporting package, we should be able to further restrict access to the inventory detail schedule used to support the general ledger balances. With additional implementation of Oracle applications, we plan to eventually replace the current periodic inventory system, relying on monthly inventory counts using physical inventory count sheets, with a perpetual inventory system. Meanwhile, more procedures will be installed for review of inventory count documentation;

	•		Additional processes will be instituted to timely resolve identified accounting and legal issues so that period-end financial statements and reporting can be timely completed; and

	•		Stronger policy enforcement will be pushed down throughout the Company to eliminate executives making verbal agreements ahead of properly approved written contracts.

Furthermore, certain of these remediation efforts, primarily associated with our information technology infrastructure and related controls, will require significant ongoing effort and investment. Our management, with the oversight of our audit committee, will continue to identify and take steps to remedy known material weaknesses as expeditiously as possible and enhance the overall design and capability of our control environment. We intend to further expand our staff, accounting policy and controls capabilities by attracting additional talent and enhancing training in such matters. We believe that the foregoing actions have improved and will continue to improve our internal control over financial reporting, as well as our disclosure controls and procedures.

If the remedial policies and procedures we have implemented, and continue to implement, are insufficient to address the material weakness or if additional significant deficiencies or other conditions relating to our internal controls are discovered in the future, we may fail to meet our future reporting obligations, our financial statements may contain material misstatements and our operating results may be adversely affected. Any such failure could also adversely affect the results of the periodic management evaluations and annual auditor attestation reports regarding the effectiveness of our internal controls over financial reporting, which will be required when the SEC’s rules under Section 404 of the Sarbanes-Oxley Act of 2002 become applicable to us beginning with the filing of our Annual Report on Form 10-K for the year ended December 31, 2007. Internal control deficiencies could also cause investors to lose confidence in our reported financial information. Although we believe that we have addressed, or will address in the near future, our material weakness in internal controls, we cannot guarantee that the measures we have taken to date or any future measures will remediate the material weakness identified or that any additional material weakness or significant deficiencies will not arise in the future due to a failure to implement and maintain adequate internal controls over financial reporting.

PART II — OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

The Company is subject to certain legal proceedings which could have an adverse effect on its business, results of operations, or financial condition. For information relating to such legal proceedings, see Note 6 in the Notes to Consolidated Financial Statements contained in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Item 1A. RISK FACTORS

The Company is exposed to certain risks factors that may affect operations. The significant risk factors known to the Company are described in Item 1A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, which was filed with the Securities and Exchange Commission on May 8, 2006. There have been no material changes from the risk factors as previously disclosed in that Form 10-K, except for the following.

We May Be Required To Raise Additional Capital If Revenue Continues To Decline, But Additional Capital May Not Be Available On Terms Acceptable To Us, Or At All.

We believe that our existing cash and cash equivalents will be sufficient to meet our working capital needs, capital expenditure requirements, and commitments for at least the next 12 months. However, it is possible that we may need to raise additional funds to finance these activities if we experience significant further declines in revenue. As such, we may not be able to obtain additional funds on favorable terms, or at all.

Item 6. EXHIBITS


31.1		Certification of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of the Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


		NATURAL HEALTH TRENDS CORP.

Date: August 11, 2006		/s/ Stephanie S. Hayano Stephanie S. Hayano
		Chief Executive Officer
		(Principal Executive Officer)

NATURAL HEALTH TRENDS CORP - Quarter Report: 2006 June (Form 10-Q)

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