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

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion is intended to assist in the understanding of our consolidated financial position and results of operations for the nine months ended September 30, 2012 as compared to the same period in 2011, and should be read in conjunction with Item I "Financial Statements" in Part I of this quarterly report on Form 10-Q. Unless stated otherwise, all financial information presented below, throughout this report, and in the consolidated financial statements and related notes includes Mannatech and all of our subsidiaries on a consolidated basis.

COMPANY OVERVIEW Since November 1993, we have continued to develop innovative, high-quality, proprietary nutritional supplements, topical and skin care products, and weight-management products that are sold through a global network marketing system. We operate in the United States, Canada, Australia, the United Kingdom, Japan, New Zealand, the Republic of Korea, Taiwan, Denmark, Germany, South Africa, the Republic of Namibia (via South Africa), Singapore, Austria, the Netherlands, Norway, Sweden, Mexico, the Czech Republic, Estonia, Finland, and the Republic of Ireland. Our Switzerland office was created to manage certain day-to-day business needs of non-North American markets.

We conduct our business as a single operating segment and primarily sell our products through a network of approximately 233,000 associates and members who have purchased our products and/or packs within the last 12 months, who we refer collectively to as current associates and members. New recruits and pack sales are leading indicators for the long-term success of our business. New recruits include new associates and members purchasing our packs and products for the first time. We operate as a seller of nutritional supplements, topical and skin care products, and weight-management products through our network marketing distribution channels operating in twenty-two countries. We review and analyze net sales by geographical location and by packs and products on a consolidated basis. Each of our subsidiaries sells similar products and exhibits similar economic characteristics, such as selling prices and gross margins.

Because we sell our products through network marketing distribution channels, the opportunities and challenges that affect us most are: recruitment of new and retention of associates and members; entry into new markets and growth of existing markets; niche market development; new product introduction; and investment in our infrastructure.

Current Economic Conditions and Recent Developments During the third quarter of 2012, we continued building the foundation for future revenue growth. The recruitment of new associates and members in the third quarter of 2012 increased 15% compared to third quarter of 2011. The increase in recruitment is due to an increase in the number of first-time members. We believe the increase was due to the offering of NutriVerus powder for sale in the United States and the introduction of the 4Free Discount Program in the United States and Canada. In tandem, we believe these programs offer a business building opportunity to the associates previously not available to them. We introduced NutriVerus powder to our markets in the Republic of Korea, Japan, Australia, New Zealand, Singapore, Taiwan, and Canada during the third quarter and early in the fourth quarter of 2012. The offering of NutriVerus powder in our European and South Africa markets is planned for late 2012 or early 2013, depending on regulatory approvals.

We continue to experience a declining sales trend in the third quarter equivalent to the declines experienced in the first and second quarters of 2012. Although recruitment of associates and members increased for the nine months ended September 30, 2012, the revenue from the sale of products and packs decreased as compared to the nine months ended September 30, 2011.

One of our goals during 2012 was to restore profitability and reduce operational expenses. In July 2012, the Company expanded its use of third-party logistic providers into our United States operations. Our largest warehouse, located in Coppell, Texas, was sublet to a third-party logistics company for operation. We believe this will decrease shipping times to our associates and members in the United States by taking advantage of distribution capabilities of the third-party logistics company on the west coast and east coast. Additionally, by subletting our warehouse space to the third-party logistics company, we are monetizing our excess warehouse space, which reduces our costs of operations.

In August 2012, we also moved our European inventory from England to another third-party logistics company located in the Netherlands. This allows us to concentrate on our core competencies and offering our associates and members in our European markets an improved distribution experience.

Our on-going reduction of operational expenses assisted in our achieving net income of $2.2 million for the third quarter of 2012. Other non-cash items impacting profitability included a reduction in a previously recognized deferred tax asset valuation allowance of approximately $1.0 million, a release of reserves related to transaction taxes of $0.8 million due to expiration of statutes of limitations, and income from foreign currency exchange rate fluctuations of $0.5 million. As illustrated, we remain dedicated to our 2012 goal of restoring profitability. We expect our continuation of targeted expense reductions to have a positive impact on profitability and cash flow.

16 -------------------------------------------------------------------------------- RESULTS OF OPERATIONS The table below summarizes our consolidated operating results in dollars and as a percentage of net sales for the three months ended September 30, 2012 and 2011 (in thousands, except percentages): Change from 2012 2011 2012 to 2011 Total % of Total % of dollars net sales dollars net sales Dollar Percentage Net sales $ 43,049 100.0 % $ 50,520 100 % $ (7,471 ) (14.8 )% Cost of sales 6,755 15.7 % 7,407 14.7 % (652 ) (8.8 )% Commissions and incentives 18,658 43.3 % 22,041 43.6 % (3,383 ) (15.3 )% 25,413 59.0 % 29,448 58.3 % (4,035 ) (13.7 )% Gross profit 17,636 41.0 % 21,072 41.7 % (3,436 ) (16.3 )% Operating expenses: Selling and administrative expenses 10,516 24.4 % 12,373 24.5 % (1,857 ) (15.0 )% Depreciation and amortization 703 1.6 % 2,644 5.2 % (1,941 ) (73.4 )% Other operating costs 5,328 12.4 % 7,627 15.1 % (2,299 ) (30.1 )% Total operating expenses 16,547 38.4 % 22,644 44.8 % (6,097 ) (26.9 )% Income (loss) from operations 1,089 2.5 % (1,572 ) (3.1 )% 2,661 169.3 % Interest income (expense) 6 0 % (4 ) 0.0 % 10 250.0 % Other income (expense), net 455 1.1 % (1,557 ) (3.1 )% 2,012 129.2 % Income (loss) before income taxes 1,550 3.6 % (3,133 ) (6.2 )% 4,683 149.5 % Benefit (provision) for income taxes 663 1.5 % (530 ) (1.0 )% 1,193 225.1 % Net income (loss) $ 2,213 5.1 % $ (3,663 ) (7.3 )% $ 5,876 160.4 % The table below summarizes our consolidated operating results in dollars and as a percentage of net sales for the nine months ended September 30, 2012 and 2011 (in thousands, except percentages): Change from 2012 2011 2012 to 2011 Total % of Total % of dollars net sales dollars net sales Dollar Percentage Net sales $ 131,162 100.0 % $ 152,782 100 % $ (21,620 ) (14.2 )% Cost of sales 20,038 15.3 % 22,164 14.5 % (2,126 ) (9.6 )% Commissions and incentives 56,280 42.9 % 66,644 43.6 % (10,364 ) (15.6 )% 76,318 58.2 % 88,808 58.1 % (12,490 ) (14.1 )% Gross profit 54,844 41.8 % 63,974 41.9 % (9,130 ) (14.3 )% Operating expenses: Selling and administrative expenses 33,793 25.8 % 43,202 28.3 % (9,409 ) (21.8 )% Depreciation and amortization 4,082 3.1 % 8,132 5.3 % (4,050 ) (49.8 )% Other operating costs 19,342 14.7 % 23,439 15.3 % (4,097 ) (17.5 )% Total operating expenses 57,809 43.6 % 74,773 48.9 % (17,556 ) (23.5 )% Loss from operations (2,373 ) (1.8 )% (10,799 ) (7.1 )% 8,426 78.0 % Interest income (expense) (26 ) 0.0 % (3 ) 0.0 % (23 ) (766.7 )% Other income (expense), net 542 0.4 % (1,094 ) (0.7 )% 1,636 149.5 % Loss before income taxes (1,857 ) (1.4 )% (11,896 ) (7.8 )% 10,039 84.4 % Benefit (provision) for income taxes 215 0.1 % (1,795 ) (1.2 )% 2,010 112.0 % Net loss $ (1,642 ) (1.3 )% $ (13,691 ) (9.0 )% $ 12,049 88.0 % 17-------------------------------------------------------------------------------- Consolidated net sales by customer location for the three months ended September 30, 2012 and 2011 were as follows (in millions, except percentages): Net Sales in Dollars and as a Percentage of Consolidated Net Sales 2012 2011 United States $ 16.9 39.3 % $ 20.4 40.4 % Japan 6.4 14.9 % 7.7 15.2 % Republic of Korea 6.0 14.0 % 6.0 11.9 % Canada 3.6 8.4 % 4.1 8.1 % Australia 3.5 8.1 % 4.4 8.7 % South Africa(1) 2.0 4.6 % 2.3 4.5 % Singapore 0.8 1.9 % 1.4 2.8 % Czech Republic(2) 0.7 1.6 % - - New Zealand 0.5 1.2 % 0.6 1.2 % Taiwan 0.5 1.2 % 1.1 2.2 % United Kingdom(3) 0.5 1.2 % 0.5 (4) 1.0 % Germany 0.4 0.9 % 0.5 1.0 % Norway 0.3 0.7 % 0.4 0.8 % The Netherlands 0.3 0.7 % 0.3 0.6 % Mexico 0.2 0.5 % 0.4 0.8 % Austria 0.1 0.2 % 0.2 0.4 % Denmark 0.1 0.2 % 0.1 0.2 % Finland(5) 0.1 0.2 % - - Sweden 0.1 0.2 % 0.1 0.2 % Total $ 43.0 100 % $ 50.5 100 % ________________________ (1) Includes sales for the Republic of Namibia, where the Company began operations in August 2011.

(2) The Company began operations in the Czech Republic in June 2011; net sales for 2011 are included in net sales for the United Kingdom.

(3) Includes sales for Estonia and the Republic of Ireland, where the Company began operations in June 2011. Their combined consolidated sales for the three months ended September 30, 2012 were less than $0.1 million and are included in net sales for the United Kingdom.

(4) Includes sales for the Czech Republic, where the Company began operations in June 2011.

(5) The Company began operations in Finland in June 2011.

18-------------------------------------------------------------------------------- Consolidated net sales by customer location for the nine months ended September 30, 2012 and 2011 were as follows (in millions, except percentages): Net Sales in Dollars and as a Percentage of Consolidated Net Sales 2012 2011 United States $ 54.1 41.2 % $ 64.0 41.9 % Japan 20.0 15.3 % 22.9 15.0 % Republic of Korea 16.9 12.9 % 17.4 11.4 % Canada 11.3 8.6 % 12.3 8.0 % Australia 10.9 8.3 % 13.3 8.7 % South Africa(1) 5.9 4.5 % 6.5 4.3 % Singapore 1.9 1.4 % 2.8 1.8 % Taiwan 1.7 1.3 % 3.4 2.2 % New Zealand 1.5 1.1 % 1.9 1.2 % United Kingdom(2) 1.2 0.9 % 1.4 (3) 0.9 % Germany 1.3 1.0 % 1.5 1.0 % Norway 1.1 0.8 % 1.4 0.9 % Czech Republic(4) 0.9 0.7 % - - The Netherlands 0.8 0.6 % 0.9 0.6 % Mexico 0.6 0.5 % 1.7 1.1 % Austria 0.3 0.2 % 0.7 0.5 % Denmark 0.2 0.2 % 0.3 0.2 % Finland(5) 0.2 0.2 % - - Sweden 0.2 0.2 % 0.4 0.3 % Ireland 0.1 0.1 % - - Total $ 131.1 100 % $ 152.8 100 % ________________________ (1) Includes sales for the Republic of Namibia, where the Company began operations in August 2011.

(2) Includes sales for Estonia and the Republic of Ireland, where the Company began operations in June 2011. Their combined consolidated sales for the nine months ended September 30, 2012 were less than $0.1 million and are included in net sales for the United Kingdom.

(3) Includes sales for the Czech Republic, where the Company began operations in June 2011.

(4) The Company began operations in the Czech Republic in June 2011; net sales for 2011 are included in net sales for the United Kingdom.

(5) The Company began operations in Finland in June 2011.

Net Sales For the three and nine months ended September 30, 2012, our operations outside of the United States accounted for approximately 60.7% and 58.8%, respectively, of our consolidated net sales, whereas in the same period in 2011, our operations outside of the United States accounted for approximately 59.6% and 58.1%, respectively, of our consolidated net sales.

Consolidated net sales for the three months ended September 30, 2012 decreased by $7.5 million, or 14.8%, to $43.0 million as compared to the same period in 2011. United States sales decreased by $3.5 million, or 17.2%, to $16.9 million, while international sales decreased by $4.0 million, or 13.3%, to $26.1 million for the three months ended September 30, 2012 as compared to the same period in 2011.

Consolidated net sales for the nine months ended September 30, 2012 decreased by $21.6 million, or 14.2%, to $131.1 million as compared to the same period in 2011. United States sales decreased by $9.9 million, or 15.5%, to $54.1 million, while international sales decreased by $11.8 million, or 13.3%, to $77.0 million for the nine months ended September 30, 2012 as compared to the same period in 2011.

Fluctuation in foreign currency exchange rates for the three and nine months ended September 30, 2012, had an overall unfavorable impact of approximately $1.0 million and $1.8 million, respectively, on our net sales. The net sales impact is calculated as the difference between (1) the current period's net sales in USD and (2) the current period's net sales in local currencies converted to USD by applying average exchange rates for the same periods ended September 30, 2011.

19 -------------------------------------------------------------------------------- Net sales by country in transactional currency for the three and nine months ended September 30, 2012 and 2011 were as follows (in millions, except percentages): Three Months Change Transactional Transactional Country Currency 2012 2011 currency Percentage Australia AUD 3.5 4.1 (0.6 ) (14.6 )% Austria, Germany, the Netherlands, the Czech Republic, Estonia, Finland, the Republic of Ireland EUR 1.2 0.8 0.4 50.0 % Denmark DKK 0.3 0.5 (0.2 ) (40.0 )% Japan JPY 501.5 597.2 (95.7 ) (16.0 )% Mexico MXN 2.9 5.5 (2.6 ) (47.3 )% New Zealand NZD 0.6 0.7 (0.1 ) (14.3 )% Norway NOK 1.8 2.4 (0.6 ) (25.0 )% Republic of Korea KRW 6,814.3 6,449.9 364.4 5.6 % Singapore SGD 1.0 1.7 (0.7 ) (41.2 )% South Africa ZAR 16.6 15.9 0.7 4.4 % Sweden SEK 0.6 0.7 (0.1 ) (14.3 )% Taiwan TWD 16.4 29.5 (13.1 ) (44.4 )% United Kingdom GBP 0.3 0.3 - - Nine Months Change Transactional Transactional Country Currency 2012 2011 currency Percentage Australia(1) AUD 10.6 13.3 (2.7 ) (20.3 )% Austria, Germany, the Netherlands, the Czech Republic, Estonia, Finland, the Republic of Ireland(2) EUR 2.8 2.2 0.6 27.3 % Denmark DKK 1.0 1.5 (0.5 ) (33.3 )% Japan JPY 1,585.8 1,843.2 (257.4 ) (14.0 )% Mexico MXN 7.8 20.7 (12.9 ) (62.3 )% New Zealand NZD 1.9 2.4 (0.5 ) (20.8 )% Norway NOK 6.0 7.2 (1.2 ) (16.7 )% Republic of Korea KRW 19,140.6 18,975.7 164.9 0.9 % Singapore(1) SGD 2.4 2.8 (0.4 ) (14.3 ) % South Africa ZAR 47.2 45.5 1.7 3.7 % Sweden SEK 1.6 2.3 (0.7 ) (30.4 )% Taiwan TWD 50.4 96.0 (45.6 ) (47.5 )% United Kingdom GBP 0.8 0.9 (0.1 ) (11.1 )% ______________________________________________________ (1) In March 2011, we started transacting sales in Singapore dollars (SGD).

Prior to March 2011, sales in Singapore were transacted in Australian dollars.

(2) We began operations in the Czech Republic, Estonia, Finland and the Republic of Ireland in June 2011.

20-------------------------------------------------------------------------------- Our total sales and sales mix could be influenced by any of the following: · changes in our sales prices; · changes in consumer demand; · changes in the number of associates and members; · changes in competitors' products; · changes in economic conditions; · changes in regulations; · announcements of new scientific studies and breakthroughs; · introduction of new products; · discontinuation of existing products; · adverse publicity; · changes in our commissions and incentives programs; · direct competition; and · fluctuations in foreign currency exchange rates.

Our sales mix for the three and nine months ended September 30, was as follows (in millions, except percentages): Three Months Change 2012 2011 Dollar Percentage Consolidated product sales $ 38.3 $ 43.0 $ (4.7 ) (10.9 )% Consolidated pack sales 3.0 5.5 (2.5 ) (45.5 )% Consolidated other, including freight 1.7 2.0 (0.3 ) (15.0 )% Total consolidated net sales $ 43.0 $ 50.5 $ (7.5 ) (14.9 )% Nine Months Change 2012 2011 Dollar Percentage Consolidated product sales $ 117.1 $ 129.6 $ (12.5 ) (9.6 )% Consolidated pack sales 9.1 16.9 (7.8 ) (46.2 )% Consolidated other, including freight 4.9 6.3 (1.4 ) (22.2 )% Total consolidated net sales $ 131.1 $ 152.8 $ (21.7 ) (14.2 )% Pack sales correlate to new associates who purchase starter packs and to continuing associates who purchase upgrade or renewal packs. However, there is no direct correlation between product sales and the number of new and continuing associates and members because associates and members utilize products at different volumes.

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

21 -------------------------------------------------------------------------------- Product sales for the three months ended September 30, 2012 decreased by $4.7 million, or 10.9%, as compared to the same period in 2011. The decrease in product sales was primarily due to the loss of existing associates, which resulted in a decline in the number of orders placed during the period. The average order value for the three months ended September 30, 2012 was $153 as compared to $159 for the same period in 2011. Approximately $1.6 million of the reduction in product sales resulted from the decrease in average order value. Additionally, the decrease in products sales was also due to a decline in the number of orders processed during the three months ended September 30, 2012, which decreased by 6.7% as compared to the same period in 2011. This decrease was consistent with the decline in the number of continuing associates and members as described in detail below.

Product sales for the nine months ended September 30, 2012 decreased by $12.5 million, or 9.6%, as compared to the same period in 2011. The decrease in product sales was primarily due to the reduction in the number of new associates and the loss of existing associates, which resulted in a decline in the number of orders placed during the period. The average order value for the nine months ended September 30, 2012 was $155 as compared to $156 for the same period in 2011. The 0.4% reduction in average order value resulted in an approximately $0.5 million loss in revenue. The number of orders processed during the nine months ended September 30, 2012 decreased by 8.7% as compared to the same period in 2011. This decrease was consistent with the decline in the number of continuing associates and members as described in detail below.

Pack Sales Packs may be purchased by our associates who wish to build a Mannatech business.

These packs are offered to our associates at a discount from published retail prices. There are several pack options available to our associates. In certain markets, pack sales are completed during the final stages of the registration process and can provide new associates with valuable training and promotional materials, as well as products for resale to retail customers, demonstration purposes, and personal consumption. Business-building associates can also purchase an upgrade pack, which provides the associate with additional promotional materials, additional products, and eligibility for additional commissions and incentives. Many of our business-building associates also choose to purchase renewal packs to satisfy annual renewal requirements to continue to earn various commissions.

The dollar amount of pack sales associated with new and continuing associates was as follows, for the three and nine months ended September 30 (in millions, except percentages): Three Months Change 2012 2011 Dollar Percentage New $ 2.0 $ 4.0 $ (2.0 ) (50.0 )% Continuing 1.0 1.5 (0.5 ) (33.3 )% Total $ 3.0 $ 5.5 $ (2.5 ) (45.5 )% Nine Months Change 2012 2011 Dollar Percentage New $ 6.3 $ 11.8 $ (5.5 ) (46.6 )% Continuing 2.8 5.1 (2.3 ) (45.1 )% Total $ 9.1 $ 16.9 $ (7.8 ) (46.2 )% Total pack sales for the three months ended September 30, 2012 decreased by $2.5 million, or 45.5%, to $3.0 million, as compared to $5.5 million for the same period in 2011. Average pack value for the three months ended September 30, 2012 was $159 as compared to $254 for the same period in 2011. The total number of packs sold decreased by 2,700, or 12.4%, to 19,000, and the average pack value decreased by $95, or 37.4%, for the three months ended September 30, 2012, as compared to the same period in 2011. The decrease in the average pack value is due to a change in the sales mix of the type of packs purchased. Approximately $1.8 million of the reduction in pack sales resulted from the decrease in average pack value with the remaining decrease attributable to the decline in the number of packs sold during the period.

22 -------------------------------------------------------------------------------- Total pack sales for the nine months ended September 30, 2012 decreased by $7.8 million, or 46.2%, to $9.1 million, as compared to $16.9 million for the same period in 2011. Average pack value for the nine months ended September 30, 2012 was $160 as compared to $249 for the same period in 2011. The total number of packs sold decreased by 10,400, or 15.3%, to 57,600, and the average pack value decreased by $89, or 35.7%, for the nine months ended September 30, 2012, as compared to the same period in 2011. The decrease in the average pack value is due to a change in the sales mix of the type of packs purchased. Approximately $5.1 million of the reduction in pack sales resulted from the decrease in average pack value with the remaining decrease attributable to the decline in the number of packs sold during the period.

The approximate number of new and continuing associates and members who purchased our packs or products during the years ended December 31, 2009, 2010, and 2011 and each of the trailing twelve month periods ended March 31, June 30, and September 30 of 2011 and 2012 were as follows: Twelve Months Ended December 31, 2011 December 31, 2010 December 31, 2009 New 77,000 33.6 % 89,000 32.8 % 145,000 36.7 % Continuing 152,000 66.4 % 182,000 67.2 % 250,000 63.3 % Total 229,000 100.0 % 271,000 100.0 % 395,000 100.0 % September 30, 2011 June 30, 2011 March 31, 2011 New 82,000 34.3 % 85,000 34.3 % 87,000 33.9 % Continuing 157,000 65.7 % 163,000 65.7 % 170,000 66.1 % Total 239,000 100.0 % 248,000 100.0 % 257,000 100.0 % September 30, 2012 June 30, 2012 March 31, 2012 New 95,000 40.8 % 87,000 37.8 % 80,000 35.2 % Continuing 138,000 59.2 % 143,000 62.2 % 147,000 64.8 % Total 233,000 100.0 % 230,000 100.0 % 227,000 100.0 % The tables above reflect a change in the tabulation of continuing members capable of placing an order. In prior reporting periods, continuing associates and members included all members capable of placing an order since 2007. The tables above reflect only those members placing orders within the last twelve months of each respective reporting period.

As indicated above, for the years ended December 31, 2009 and 2010, there was an overall decrease of 124,000, or 31.4%. For the years ended December 31, 2010 and 2011, there was an overall decrease of 42,000, or 15.5%.

For the trailing twelve months periods ended March 31, 2011 and 2012, there was an overall decrease of 30,000, or 11.7%. For the trailing twelve months periods ended June 30, 2011 and 2012, there was an overall decrease of 18,000, or 7.3%. For the trailing twelve months periods ended September 30, 2011 and 2012, there was an overall decrease of 6,000, or 2.5%. As illustrated above, the overall declines were due to a reduction in the recruitment of new associates and members, as well as attrition of continuing associates and members.

Beginning in the second quarter of 2012, the recruitment of associates and members increased in comparison to both the first quarter 2012 and the second quarter 2011. This was primarily due to the May 2012 introduction of the 4Free discount program in North America. This trend has continued in the third quarter of 2012 where the recruitment of associates and members exceeded the level attained in both the second quarter 2012 and the third quarter 2011.

23 -------------------------------------------------------------------------------- During 2011 and 2012, we took the following actions to recruit and retain associates and members: • announced pre-registration in new international markets; • launched marketing and educational campaigns, including the 4Free discount program; • initiated additional incentives; • explored new advertising and educational tools to broaden name recognition; and • implemented changes to our global associate career and compensation plan.

Other Sales Other sales consisted of: (i) sales of promotional materials; (ii) training and event registration fees; (iii) monthly fees collected for our Success Tracker tool, a customized electronic business-building and educational materials database for our associates that helps stimulate product sales and provide business management; (iv) monthly fees collected for Navig8, a comprehensive global business system that provides tools and resources to help associates build their businesses; (v) freight revenue charged to our associates and members; and (vi) a reserve for estimated sales refunds and returns.

For the three months ended September 30, 2012, other sales decreased by $0.3 million, or 15.0%, to $1.7 million, as compared to $2.0 million for the same period in 2011. Other sales for the nine months ended September 30, 2012 decreased by $1.4 million, or 22.2%, to $4.9 million, as compared to $6.3 million for the same period in 2011. The decrease was primarily due to a decrease in freight fees resulting from the reduction in the number of product and pack shipments.

Gross Profit For the three months ended September 30, 2012, gross profit decreased by $3.4 million, or 16.3%, to $17.6 million, as compared to $21.0 million for the same period in 2011. For the three months ended September 30, 2012, gross profit as a percentage of net sales decreased to 41.0%, as compared to 41.7% for the same period in 2011. The decrease in gross profit as a percentage of net sales is primarily due to an increase in the cost of inventory as compared to the same period in 2011.

For the nine months ended September 30, 2012, gross profit decreased by $9.1 million, or 14.3%, to $54.8 million, as compared to $64.0 million for the same period in 2011. For the nine months ended September 30, 2012, gross profit as a percentage of net sales decreased slightly to 41.8%, as compared to 41.9% for the same period in 2011. The decrease in gross profit as a percentage of net sales is primarily due to an increase in the cost of inventory as compared to the same period in 2011.

Cost of sales during the three months ended September 30, 2012 decreased by 8.8%, or $0.7 million, to $6.8 million, as compared to $7.4 million for the same period in 2011. The reduction in cost of sales was primarily due to the decline in sales for the quarter. Cost of sales as a percentage of net sales for the three months ended September 30, 2012 was 15.7%, as compared to 14.7% for the same period in 2011. The increase in cost of sales as a percentage of net sales was primarily due to an increase in the cost of inventory offset by a reduction in the in-bound freight expense as compared to the same period in 2011.

Cost of sales during the nine months ended September 30, 2012 decreased by 9.6%, or $2.1 million, to $20.0 million, as compared to $22.2 million for the same period in 2011. The reduction in cost of sales was primarily due to the decline in sales for the year and a reduction in inventory adjustments related to obsolete inventory. Cost of sales as a percentage of net sales for the nine months ended September 30, 2012 was 15.3%, as compared to 14.5% for the same period in 2011. The increase in cost of sales as a percentage of net sales was primarily due to an increase in the cost of inventory offset by a reduction in inventory obsolescence as compared to the same period in 2011.

24 -------------------------------------------------------------------------------- Commission costs for the three months ended September 30, 2012 decreased by 16.2%, or $3.4 million, to $17.9 million, as compared to $21.3 million for the same period in 2011. The decrease in commissions was primarily due to the decrease in commissionable net sales. For the three months ended September 30, 2012, commissions as a percentage of net sales decreased to 41.5% from 42.2% for the same period in 2011 primarily resulting from the decline in pack sales that earn a higher rate of commission.

Commission costs for the nine months ended September 30, 2012 decreased by 15.7%, or $10.0 million, to $53.7 million, as compared to $63.7 million for the same period in 2011. The decrease in commissions was due to the decrease in commissionable net sales. For the nine months ended September 30, 2012, commissions as a percentage of net sales decreased to 41.0% from 41.7% for the same period in 2011, primarily resulting from the decline in pack sales (noted above), that earn a higher rate of commission.

Incentive costs for the three months ended September 30, 2012 increased by 9.9%, or $0.1 million, to $0.8 million, as compared to $0.7 million for the same period in 2011. The costs of incentives as a percentage of net sales increased to 1.8%, as compared to 1.4% for the same period in 2011.

Incentive costs for the nine months ended September 30, 2012 decreased by 9.4%, or $0.3 million, to $2.6 million, as compared to $2.9 million for the same period in 2011. For the nine months ended September 30, 2012, costs of incentives as a percentage of net sales were relatively flat at 2.0% as compared to 1.9% for the same period in 2011.

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

For the three months ended September 30, 2012, selling and administrative expenses decreased by $1.9 million, or 15.0%, to $10.5 million, as compared to $12.4 million for the same period in 2011. The decrease in selling and administrative expenses primarily consisted of decreases of $1.7 million in compensation and benefits, $0.3 million in temporary and contract labor expenses and $0.1 million in marketing-related expenses. The decreases were partially offset by a $0.2 million increase in warehouse expense owing to the new arrangement with Integrated Distribution and Logistics Direct, LLC (doing business as SPExpress) whereby Mannatech began outsourcing its United States warehousing and distribution functions to SPExpress beginning in July 2012.

Selling and administrative expenses, as a percentage of net sales, for the three months ended September 30, 2012 remained relatively flat at 24.4% from 24.5% for the same period in 2011.

For the nine months ended September 30, 2012, selling and administrative expenses decreased by $9.4 million, or 21.8%, to $33.8 million, as compared to $43.2 million for the same period in 2011. The decrease in selling and administrative expenses primarily consisted decreases of $6.8 million in compensation and benefits, $1.2 million in temporary and contract labor expenses, $0.8 million in marketing-related expenses, and $0.6 million in freight expense. Selling and administrative expenses, as a percentage of net sales, for the nine months ended September 30, 2012 decreased to 25.8% from 28.3% for the same period in 2011.

Other Operating Costs Other operating costs include travel, accounting, legal and consulting fees, royalties, credit card processing fees, banking fees, off-site storage fees, utilities, and other miscellaneous operating expenses. Changes in other operating costs are associated with changes in our net sales.

For the three months ended September 30, 2012, other operating costs decreased by $2.3 million, or 30.1%, to $5.3 million, as compared to $7.6 million for the same period in 2011. For the three months ended September 30, 2012, other operating costs as a percentage of net sales decreased to 12.4% from 15.1% for the same period in 2011. The decrease in other operating costs was primarily due to a reduction in transactional sales tax expense accruals of $0.8 million relating to the expiration of certain statutes of limitations, office expenses of $0.6 million, repairs and maintenance costs of $0.2 million, legal fees of $0.2 million, travel expenses of $0.3 million, and credit card fees of $0.2 million.

For the nine months ended September 30, 2012, other operating costs decreased by $4.1 million, or 17.5%, to $19.3 million, as compared to $23.4 million for the same period in 2011. For the nine months ended September 30, 2012, other operating costs as a percentage of net sales decreased to 14.7% from 15.3% for the same period in 2011. The decrease in other operating costs was primarily due to a reduction in transactional sales tax expense accruals of $0.8 million relating to the expiration of certain statute of limitations, office expenses of $1.5 million, credit card fees of $0.7 million, travel related costs of $0.5 million, legal, accounting and consulting fees of $0.3 million, and repairs and maintenance costs of $0.3 million.

25 -------------------------------------------------------------------------------- Depreciation and Amortization Expense Depreciation and amortization expense for the three months ended September 30, 2012 decreased by 73.4%, or $1.9 million, to $0.7 million, as compared to $2.6 million for the same period in 2011. As a percentage of net sales, depreciation and amortization expense was 1.6% as compared to 5.2% for the same period in 2011.

Depreciation and amortization expense for the nine months ended September 30, 2012 decreased by 49.8%, or $4.0 million, to $4.1 million, as compared to $8.1 million for the same period in 2011. As a percentage of net sales, depreciation and amortization expense was 3.1% as compared to 5.3% for the same period in 2011.

For each of the three and nine months ended September 30, 2012, the decrease in depreciation expense was due to the Company's Enterprise Resource Planning software system becoming fully depreciated at the end of the first quarter of 2012.

Other Income (Expense), Net Other income (expense), net primarily consists of foreign currency gains and losses related to translating our foreign subsidiaries' assets, liabilities, revenues, and expenses to the United States dollar and revaluing monetary accounts in the United States, Switzerland, Japan, Republic of Korea, Taiwan, Norway, Sweden, and Mexico using current and weighted-average currency exchange rates. Net foreign currency transaction gains and losses are the result of the United States dollar fluctuating in value against foreign currencies.

Other income (expense), net for the three months ended September 30, 2012 was $0.5 million, as compared to other expense, net of ($1.6) million during the same period in 2011.

Other income (expense), net for the nine months ended September 30, 2012 was $0.5 million, as compared to other expense, net of ($1.1) million for the same period in 2011.

(Provision) Benefit for Income Taxes (Provision) benefit for income taxes includes current and deferred income taxes for both our domestic and foreign operations. Our statutory income tax rates by jurisdiction are as follows for the three and nine months ended September 30: Country 2012 2011 Australia 30.0 % 30.0 % Canada 26.0 % 28.0 % Denmark 25.0 % 25.0 % Japan 42.0 % 42.0 % Mexico 30.0 % 30.0 % Norway 28.0 % 28.0 % Republic of Korea 22.0 % 22.0 % Singapore 17.0 % 17.0 % South Africa 28.0 % 28.0 % Sweden 26.3 % 26.3 % Switzerland 16.2 % 16.2 % Taiwan 17.0 % 17.0 % United Kingdom 24.0 % 26.0 % United States 37.5 % 37.5 % 26-------------------------------------------------------------------------------- Income from our international operations is subject to taxation in the countries in which we operate. Although we may receive foreign income tax credits that would reduce the total amount of income taxes owed in the United States, we may not be able to fully utilize our foreign income tax credits in the United States.

We use the recognition and measurement provisions of FASB ASC Topic 740, Income Taxes, to account for income taxes. The provisions of the Income Tax Topic require a company to record a valuation allowance when the "more likely than not" criterion for realizing net deferred tax assets cannot be met. Furthermore, the weight given to the potential effect of such evidence should be commensurate with the extent to which it can be objectively verified. As a result, we reviewed the operating results, as well as all of the positive and negative evidence related to realization of such deferred tax assets, to evaluate the need for a valuation allowance in each tax jurisdiction. As of September 30, 2012 and December 31, 2011, we maintained the following valuation allowances for deferred tax assets totaling $9.8 million and $9.5 million, respectively, as we believe the "more likely than not" criterion for recognition and realization purposes, as defined in FASB ASC Topic 740, cannot be met: September 30, December 31, Country 2012 2011 (in millions) Mexico $ 2.3 $ 1.9 Norway 0.2 0.2 Sweden 0.2 0.1 Switzerland 0.9 0.8 Taiwan 1.2 1.1 United States 5.0 5.4 Total $ 9.8 $ 9.5 The dollar amount of the provisions for income taxes is directly related to our profitability and changes in the taxable income among countries. For the three and nine months ended September 30, 2012, our effective tax rate was a benefit of 42.8% and 11.6%, respectively, as compared to a provision of 16.9% and 15.1% for the same period in 2011, respectively. For the three months ended September 30, 2012 and 2011, the Company's effective income tax rate was determined based on the estimated annual effective income tax rate with adjustments for valuation allowances.

27 -------------------------------------------------------------------------------- LIQUIDITY AND CAPITAL RESOURCES Cash and Cash Equivalents As of September 30, 2012, our cash and cash equivalents decreased by 29.2%, or $5.0 million, to $12.8 million from $18.1 million as of December 31, 2011. The majority of the decrease in cash and cash equivalents was primarily due to the $2.8 million associated with the settlement of litigation in the first quarter of 2012 and $1.1 million of cash used to purchase inventory. The restricted cash balance was increased during the period ending September 30, 2012 by $0.3 million with funds from the cash and cash equivalents balances. Finally, fluctuations in currency rates produced a decline of $0.8 million in cash and cash equivalents. The remaining change in cash and cash equivalents was related to recurring operating sources and uses of cash and cash equivalents.

Our principal use of cash is to pay for operating expenses, including commissions and incentives, capital assets, inventory purchases, international expansion, and to pay quarterly cash dividends. In August 2009, the quarterly cash dividend was suspended and remained suspended as of September 30, 2012. We fund our business objectives, operations, and expansion of our operations through net cash flows from operations rather than incurring long-term debt.

Working Capital Working capital represents total current assets less total current liabilities.

At September 30, 2012, our working capital increased by $0.4 million, or 3.7%, to $12.3 million from $11.9 million at December 31, 2011. The increase in working capital primarily related to a decrease in accrued expenses associated with the settlement of litigation in the first quarter of 2012 and a drop in commissions payable due to the decline in sales.

Net Cash Flows Our net consolidated cash flows consisted of the following, for the nine months ended September 30 (in millions): Used in: 2012 2011 Operating activities $ (3.1 ) $ (0.3 ) Investing activities $ (0.5 ) $ (0.4 ) Financing activities $ (0.8 ) $ (1.1 ) Operating Activities Cash used in operating activities was $3.1 million for the nine months ended September 30, 2012 compared to cash used in operating activities of $0.3 million for the same period in 2011. The cash used for the period primarily relates to the one-time payment of $2.6 million made to Marinova Pty. Limited pursuant to the settlement agreement reached during the first quarter of 2012 and $1.1 million of cash used to purchase inventory.

We will continue to aggressively identify opportunities and reduce operational expenses. We expect that our net operating cash flows for the remainder of the year will be sufficient to fund our current operations. There can be no assurance, however, that we will continue to generate cash flows at or above current levels. Certain events, such as the uncertainty of the worldwide economic environment or the realization of other risk factors, could impact our available cash or our ability to generate cash flows from operations.

Investing Activities For the nine months ended September 30, 2012, our net investing activities used cash of $0.5 million compared to cash used of $0.4 million for the same period of 2011. We used cash of $0.3 million to purchase capital assets as compared to purchasing $0.6 million in capital assets for the same period in 2011. In 2012, we had an increase in restricted cash of $0.3 million as compared to a $0.1 million decrease for the same period in 2011.

28 -------------------------------------------------------------------------------- Financing Activities For the nine months ended September 30, 2012 and 2011, we used cash of $0.8 million and $1.1 million, respectively, for repayment of capital lease obligations.

General Liquidity and Cash Flows Short Term Liquidity We believe our existing liquidity and anticipated return to positive cash flows from operations are adequate to fund our normal expected future business operations and possible international expansion costs for the next 12 months. As the Company's primary source of liquidity is the cash flow from operations, this determination is dependent on the Company reversing the revenue trend and/or continuing to reduce operational expenses. However, if our existing capital resources or cash flows become insufficient to meet current business plans, projections, and existing capital requirements, we may be required to raise additional funds, which may not be available on favorable terms, if at all.

We entered into an Investment Agreement with Dutchess Opportunity Fund, II, LP, a Delaware limited partnership on September 16, 2010. The Investor committed to purchase, subject to certain restrictions and conditions, up to $10 million of our common stock, over a period of 36 months from the first trading day following the effectiveness of the registration statement, which was October 28, 2010. We may draw funds from the Equity Line by selling shares of common stock to the Investor from time to time. We will not receive any proceeds from the resale of these shares of common stock offered by the Investor. We will, however, receive proceeds from the sale of shares to the Investor pursuant to the Equity Line. The proceeds will be used for general working capital needs and for other general corporate purposes. Please see Note 6 (Shareholders' Equity) to our consolidated financial statements for more information on the Equity Line. As of September 30, 2012, no shares of common stock have been issued pursuant to the Investment Agreement.

We are engaged in ongoing audits in various tax jurisdictions and other disputes in the normal course of business. It is impossible at this time to predict whether we will incur any liability, or to estimate the ranges of damages, if any, in connection with these matters. Adverse outcomes on these uncertainties may lead to substantial liability or enforcement actions that could adversely affect our cash position. For more information, see Note 3 "Income Taxes" and Note 7 "Litigation".

Long Term Liquidity We believe our anticipated return to positive cash flows from operations should be adequate to fund our normal expected future business operations and possible international expansion costs for the long term. As the Company's primary source of liquidity is from the cash flow from operations, this determination is dependent on the Company reversing the revenue trend and/or continuing to reduce operational expenses. However, if our existing capital resources or cash flows become insufficient to meet anticipated business plans and existing capital requirements, we may be required to raise additional funds, which may not be available on favorable terms, if at all.

Our future access to the capital markets may be adversely impacted if we fail to maintain compliance with the Nasdaq Marketplace Rules for the continued listing of our stock. The Company continuously monitors its compliance with the Nasdaq continued listing rules.

29 -------------------------------------------------------------------------------- CONTRACTUAL OBLIGATIONS The following summarizes our future commitments and obligations associated with various agreements and contracts as of September 30, 2012, for the years ending December 31 (in thousands): Remaining 2012 2013 2014 2015 2016 Thereafter Total Capital lease 130 obligations $ 290 $ 599 $ 539 $ 339 $ $ 12 $ 1,909 Purchase obligations 2,961 1,811 1,830 1,200 - - 7,802 Operating leases(1) 760 1,957 1,088 1,003 807 955 6,570 Post-employment royalty 128 492 492 246 - - 1,358 Employment agreements 546 739 - - - - 1,285 Total commitments and obligations $ 4,685 $ 5,598 $ 3,949 $ 2,788 $ 937 $ 967 $ 18,924 ______________________________________________________ (1) Does not include all purchase commitments, since many such agreements do not obligate the Company to take the product or service. For purposes of the table, a purchase obligation is defined as "an agreement to purchase goods or services that is non-cancelable, enforceable and legally binding on the Company that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction." (2) Excludes approximately $7.1 million of finished product purchase orders that may be cancelled or delivery dates changed as of September 30, 2012.

(3) Excludes estimated lease restoration costs in the amount of $0.4 million as of September 30, 2012.

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

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

CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The application of GAAP requires us to make estimates and assumptions that affect the reported values of assets and liabilities at the date of our financial statements, the reported amounts of revenues and expenses during the reporting period, and the related disclosures of contingent assets and liabilities. We use estimates throughout our financial statements, which are influenced by management's judgment and uncertainties. Our estimates are based on historical trends, industry standards, and various other assumptions that we believe are applicable and reasonable under the circumstances at the time the consolidated financial statements are prepared. Our Audit Committee reviews our critical accounting policies and estimates. We continually evaluate and review our policies related to the portrayal of our consolidated financial position and consolidated results of operations that require the application of significant judgment by our management. We also analyze the need for certain estimates, including the need for such items as allowance for doubtful accounts, inventory reserves, long-lived fixed assets and capitalization of internal-use software development costs, reserve for uncertain income tax positions and tax valuation allowances, revenue recognition, sales returns, and deferred revenues, accounting for stock-based compensation, and contingencies and litigation. Historically, actual results have not materially deviated from our estimates. However, we caution readers that actual results could differ from our estimates and assumptions applied in the preparation of our consolidated financial statements. If circumstances change relating to the various assumptions or conditions used in our estimates, we could experience an adverse effect on our financial position, results of operations, and cash flows. We have identified the following applicable critical accounting policies and estimates as of September 30, 2012: 30 -------------------------------------------------------------------------------- Inventory Reserves Inventory consists of raw materials, finished goods, and promotional materials that are stated at the lower of cost (using standard costs that approximate average costs) or market. We record the amounts charged by the vendors as the costs of inventory. Typically, the net realizable value of our inventory is higher than the aggregate cost. Determination of net realizable value can be complex and, therefore, requires a high degree of judgment. In order for management to make the appropriate determination of net realizable value, the following items are considered: inventory turnover statistics, current selling prices, seasonality factors, consumer demand, regulatory changes, competitive pricing, and performance of similar products. If we determine the carrying value of inventory is in excess of estimated net realizable value, we write down the value of inventory to the estimated net realizable value.

We also review inventory for obsolescence in a similar manner, and any inventory identified as obsolete is reserved or written off. Our determination of obsolescence is based on assumptions about the demand for our products, product expiration dates, estimated future sales, and general future plans. We monitor actual sales compared to original projections, and if actual sales are less favorable than those originally projected by us, we record an additional inventory reserve or write-down. Historically, our estimates have been close to our actual reported amounts. However, if our estimates regarding inventory obsolescence are inaccurate or consumer demand for our products changes in an unforeseen manner, we may be exposed to additional material losses or gains in excess of our established estimated inventory reserves.

Long Lived Fixed Assets and Capitalization of Software Development Costs In addition to capitalizing long lived fixed asset costs, we also capitalize costs associated with internally-developed software projects (collectively "fixed assets") and amortize such costs over the estimated useful lives of such fixed assets. Fixed assets are carried at cost, less accumulated depreciation computed using the straight-line method over the assets' estimated useful lives.

Leasehold improvements are amortized over the shorter of the remaining lease terms or the estimated useful lives of the improvements. Expenditures for maintenance and repairs are charged to operations as incurred. If a fixed asset is sold or otherwise retired or disposed of, the cost of the fixed asset and the related accumulated depreciation or amortization is written off and any resulting gain or loss is recorded in other operating costs in our consolidated statement of operations.

We review our fixed assets for impairment whenever an event or change in circumstances indicates the carrying amount of an asset or group of assets may not be recoverable, such as plans to dispose of an asset before the end of its previously estimated useful life. Our impairment review includes a comparison of future projected cash flows generated by the asset, or group of assets, with its associated net carrying value. If the net carrying value of the asset or group of assets exceeds expected cash flows (undiscounted and without interest charges), an impairment loss is recognized to the extent the carrying amount exceeds the fair value. The fair value is determined by calculating the discounted expected future cash flows using an estimated risk-free rate of interest. Any identified impairment losses are recorded in the period in which the impairment occurs. The carrying value of the fixed asset is adjusted to the new carrying value, and any subsequent increases in fair value of the fixed asset are not recorded. In addition, if we determine the estimated remaining useful life of the asset should be reduced from our original estimate; the periodic depreciation expense is adjusted prospectively, based on the new remaining useful life of the fixed asset.

The impairment calculation requires us to apply judgment and estimates concerning future cash flows, strategic plans, useful lives, and discount rates.

If actual results are not consistent with our estimates and assumptions, we may be exposed to an additional impairment charge, which could be material to our results of operations. In addition, if accounting standards change, or if fixed assets become obsolete, we may be required to write off any unamortized costs of fixed assets, or if estimated useful lives change, we would be required to accelerate depreciation or amortization periods and recognize additional depreciation expense in our consolidated statement of operations.

31 -------------------------------------------------------------------------------- Historically, our estimates and assumptions related to the carrying value and the estimated useful lives of our fixed assets have not materially deviated from actual results. As of September 30, 2012, the estimated useful lives and net carrying values of fixed assets were as follows: Net carrying value at Estimated September 30, useful life 2012 Computer software 3 to 5 years $ 0.3 million Computer hardware 3 to 5 years 1.6 million 2 to 10 Leasehold improvements years(1) 2.2 million Office furniture and equipment 5 to 7 years 1.2 million Automobiles 3 to 5 years 0.1 million Total net carrying value at September 30, 2012 $ 5.4 million _____________________ (1) We amortize leasehold improvements over the shorter of the useful estimated life of the leased asset or the lease term.

The net carrying costs of fixed assets and construction in progress are exposed to impairment losses if our assumptions and estimates of their carrying values change, there is a change in estimated future cash flow, or there is a change in the estimated useful life of the fixed asset. Based on management's analysis, no impairment indicators existed for the nine months ended September 30, 2012.

Uncertain Income Tax Positions and Tax Valuation Allowances As of September 30, 2012, we recorded $1.5 million in other long-term liabilities and $1.6 million in taxes payable on our consolidated balance sheet related to uncertain income tax positions. The decrease of the other long-term liabilities in the three and nine months ended September 30, 2012 is due to the unrecognized tax benefit being offset against the deferred tax assets. As required by FASB ASC Topic 740, Income Taxes, we use judgments and make estimates and assumptions related to evaluating the probability of uncertain income tax positions. We base our estimates and assumptions on the potential liability related to an assessment of whether the income tax position will "more likely than not" be sustained in an income tax audit. We are also subject to periodic audits from multiple domestic and foreign tax authorities related to income tax and other forms of taxation. These audits examine our tax positions, timing of income and deductions, and allocation procedures across multiple jurisdictions. As part of our evaluation of these tax issues, we establish reserves in our consolidated financial statements based on our estimate of current probable tax exposures. Depending on the nature of the tax issue, we could be subject to audit over several years. Therefore, our estimated reserve balances and liability related to uncertain income tax positions may exist for multiple years before the applicable statute of limitations expires or before an issue is resolved by the taxing authority. Additionally, we may be requested to extend the statute of limitations for tax years under audit. The majority of our current tax liability related to uncertain tax positions is associated with an ongoing IRS audit. It is reasonably possible the tax jurisdiction may request that the statute of limitations be extended, which may cause the classification between current and long-term to change. We believe our tax liabilities related to uncertain tax positions are based upon reasonable judgment and estimates; however, if actual results materially differ, our effective income tax rate and cash flows could be affected in the period of discovery or resolution.

Our 2005-2009 tax years remain subject to examination by the IRS for United States federal tax purposes. On May 26, 2011 the IRS issued a RAR detailing proposed adjustments for the tax years under examination. The net tax deficiency associated with the RAR is $8.5 million plus penalties of $1.5 million. On July 8, 2011, we filed a protest letter challenging the proposed adjustments contained in the RAR and are pursuing resolution of these items with the Appeals Division of the IRS. On July 26, 2012, the Company participated in a hearing with the Appeals Division of the IRS, and the Company believes the net tax deficiency should approximate amounts recorded as uncertain income tax positions. There are other ongoing audits in various international jurisdictions that are not material to our financial statements.

We also review the estimates and assumptions used in evaluating the probability of realizing the future benefits of our deferred tax assets and record a valuation allowance when we believe that a portion or all of the deferred tax assets may not be realized. If we are unable to realize the expected future benefits of our deferred tax assets, we are required to provide a valuation allowance. We use our past history and experience, overall profitability, future management plans, and current economic information to evaluate the amount of valuation allowance to record. As of September 30, 2012, we maintained a valuation allowance for deferred tax assets arising from our operations of $9.8 million because they did not meet the "more likely than not" criteria as defined by the recognition and measurement provisions of FASB ASC Topic 740, Income Taxes. In addition, as of September 30, 2012, we had deferred tax assets, after valuation allowance, totaling $3.4 million, which may not be realized if our assumptions and estimates change, which would affect our effective income tax rate and cash flows in the period of discovery or resolution.

32 -------------------------------------------------------------------------------- Revenue Recognition and Deferred Revenue We derive revenue from sales of individual products, sales of starter and renewal packs, and shipping fees. Substantially all product and pack sales are made to associates at published wholesale prices and to members at discounted published retail prices. We record revenue net of any sales taxes and record a reserve for expected sales returns based on historical experience. We recognize revenue from shipped packs and products upon receipt by the customer. We recognize corporate-sponsored event revenue when the event is held. We defer certain components of our revenue, which primarily consists of: (i) revenue received from sales of packs and products shipped but not received by the customers at period end; and (ii) revenue received from prepaid registration fees from customers planning to attend a future corporate-sponsored event. At September 30, 2012, total deferred revenue was $2.2 million. Significant changes in our shipping methods could result in additional revenue deferrals.

Product Return Policy We stand behind our packs and products and believe we offer a reasonable and industry-standard product return policy to all of our customers. We do not resell returned products. Refunds are not processed until proper approval is obtained. All refunds must be processed and returned in the same form of payment that was originally used in the sale. Each country in which we operate has specific product return guidelines. However, we allow our associates and members to exchange products as long as the products are unopened and in good condition.

Our return policies for our retail customers and our associates and members are as follows: · Retail Customer Product Return Policy. This policy allows a retail customer to return any of our products to the original associate who sold the product and receive a full cash refund from the associate for the first 180 days following the product's purchase if located in the United States and Canada, and for the first 90 days following the product's purchase in the remaining countries. The associate may then return or exchange the product based on the associate product return policy.

· Associate and Member Product Return Policy. This policy allows the associate or member to return an order within one year of the purchase date upon terminating his/her account. If an associate or member returns a product unopened and in good condition, he/she may receive a full refund minus a 10% restocking fee. We may also allow the associate or member to receive a full satisfaction guarantee refund if they have tried the product and are not satisfied for any reason, excluding promotional materials. This satisfaction guarantee refund applies in the United States and Canada, only for the first 180 days following the product's purchase, and applies in the remaining countries for the first 90 days following the product's purchase; however, any commissions earned by an associate will be deducted from the refund. If we discover abuse of the refund policy, we may terminate the associate's or member's account.

Historically, sales returns estimates have not materially deviated from actual sales returns, as the majority of our customers who return merchandise do so within the first 90 days after the original sale. Based upon our return policies and historical experience, we estimate a sales return reserve for expected sales refunds over a rolling six month period. If actual results differ from our estimated sales returns reserves due to various factors, the amount of revenue recorded each period could be materially affected. Historically, our sales returns have not materially changed through the years and have averaged 1.5% or less of our gross sales.

33 -------------------------------------------------------------------------------- Accounting for Stock-Based Compensation We grant stock options to our employees, board members, and consultants. At the date of grant, we determine the fair value of a stock option award and recognize compensation expense over the requisite service period, or the vesting period of such stock option award, which is two to four years. The fair value of the stock option award is calculated using the Black-Scholes option-pricing model ("calculated fair value"). The Black-Scholes option-pricing model requires us to apply judgment and use highly subjective assumptions, including expected stock option life, expected volatility, expected average risk-free interest rates, and expected forfeiture rates. For the nine months ended September 30, 2012, our assumptions and estimates used for the calculated fair value of stock options granted in 2012 were as follows: January 2012 Grant May 2012 Grant Estimated fair value per share of options granted: $ 2.64 $ 3.21 Assumptions: Annualized dividend yield 0.00% 0.00% Risk-free rate of return 0.75% 0.62% Common stock price volatility 78.4% 81.6% Expected average life of stock options (in years) 4.5 4.5 The assumptions we use are based on our best estimates and involve inherent uncertainties related to market conditions that are outside of our control. If actual results are not consistent with the assumptions we use, the stock-based compensation expense reported in our consolidated financial statements may not be representative of the actual economic cost of stock-based compensation. For example, if actual employee forfeitures significantly differ from our estimated forfeitures, we may be required to make an adjustment to our consolidated financial statements in future periods. As of September 30, 2012, using our current assumptions and estimates, we anticipate recognizing $0.1 million in gross compensation expense through 2014 related to unvested stock options outstanding.

If we grant additional stock options in the future, we would be required to recognize additional compensation expense over the vesting period of such stock options in our consolidated statement of operations. Gross compensation expense would equal the calculated fair value of such stock options, which is dependent on the assumptions used to calculate such fair value, but has historically ranged between 34% to 69% of the exercise price multiplied by the number of stock options awarded. As of September 30, 2012, we had 140,008 shares available for grant in the future.

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

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

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