Herbalife Ltd. — Q1 2017 Form 10-Q
Reporting period: Three months ended March 31, 2017. Unaudited results; comparisons are with Q1 2016 unless otherwise noted. Amounts are in U.S. dollars; financial statement figures are in millions except per-share data.
Business context
Herbalife sells nutrition and personal-care products in 94 countries, primarily through independent Members. China uses a distinct model involving service providers, sales representatives and retail stores. The company reports a combined primary segment and China separately.
Financial results and liquidity
| Metric | Q1 2017 | Q1 2016 / comparison |
|---|---|---|
| Net sales | $1,102.1 | $1,119.6; down 1.6% reported and flat in local currency |
| Gross profit / gross margin | $897.5 / 81.4% | $906.5 / 81.0% |
| Operating income / margin | $143.8 / 13.0% | $168.3 / 15.0% |
| Net income / margin | $85.2 / 7.7% | $95.8 / 8.6%; net income down 11.1% |
| Diluted EPS | $0.98 | $1.12 |
| Net interest expense | $30.2 | $24.9 |
| Operating cash flow | $175.5 | $141.1 |
| Capital expenditures | $18.5 incurred | $22.5 incurred |
Gross margin improved 40 basis points, aided by sourcing and self-manufacturing savings, pricing and lower inventory write-downs; currency and country mix partly offset those benefits. Operating income declined as royalty overrides and SG&A rose. SG&A increased to $438.6 from $427.1, including higher China service fees, salaries and benefits, and Member promotion costs. The effective tax rate fell to 25.0% from 33.2%, partly due to discrete tax benefits, including $4.3 of excess share-based compensation tax benefits.
Cash and equivalents were $1,782.9 at March 31, versus $844.0 at December 31, 2016. The increase primarily reflects financing activity, not operating cash generation: financing provided $780.5, including $1,274.0 of new-facility borrowings, partly offset by $413.4 of debt principal payments and other financing uses. Working capital was $1,468.9, up from $671.0 at year-end.
Carrying-value debt totaled $2,302.8, compared with $1,447.9 at December 31. The February refinancing established a $1.3 billion term loan and a $150 million revolver; $410.0 was used to repay the old revolving facility. The new facility’s weighted average borrowing rate was 5.97%, versus 4.29% at year-end. The $1.15 billion principal amount of 2.00% convertible notes matures August 2019. The credit facility requires a minimum $200.0 million consolidated cash balance and compliance with leverage and other covenants; Herbalife reported compliance at quarter-end. Management estimated that a 1 percentage-point rate change could alter annual interest expense by about $13 million.
Changes, trends and management commentary
- Worldwide Volume Points rose 1.4%; management said China’s 17.3% increase was materially boosted by orders placed ahead of a price increase effective April 1. Some orders were shipped or received after quarter-end, so related revenue was deferred. Management expected this pull-forward to weigh on China sales volume in Q2.
- Regional sales were mixed: EMEA increased 5.7%; North America declined 6.6%; Mexico declined 4.5% in reported dollars but rose 7.6% in local currency; South and Central America declined 3.6%; Asia Pacific excluding China declined 0.6%. South Korea sales fell 26.9%, while Brazil’s local-currency sales fell 17.3%.
- Management attributed the North America volume decline partly to Member training and documentation changes under the FTC Consent Order. It said the adjustment may continue to affect the region during 2017, while not expecting a long-term material adverse impact.
- Sales leader retention outside China was 60.9% for the latest requalification period, compared with 54.2% a year earlier; the filing notes exclusions and adjustments affecting comparability.
- Management forecast full-year 2017 capital expenditures of approximately $125–$155 million. The filing does not provide a numerical revenue or earnings guidance range.
Risks, contingencies and unusual items
- FTC Consent Order: The 2016 settlement included a $200 million payment and U.S. business-model, sales-tracking, recordkeeping and marketing requirements, plus seven years of independent compliance audits. Herbalife said implementation costs and Member adjustments could affect sales and profitability; failure to comply could have a material adverse effect. Certain tracking requirements were due by May 25, 2017.
- Tax and regulatory matters: Disputed assessments include a Mexican tax matter originally assessed at about $61 million; a Mexican 2007 assessment of about $15.7 million; and a Brazilian São Paulo assessment of about $51.3 million. The company said it had not accrued losses for these matters because it did not consider losses probable, and it could not reasonably estimate possible losses in certain cases. On April 6, 2017, a Mexican court ruling favored the tax authority on the core issue; Herbalife intended to appeal. The SEC and Department of Justice also requested information concerning anti-corruption compliance in China; scope and outcome were uncertain.
- Other unusual costs: Q1 2017 net income included $8.5 million of pre-tax FTC implementation expenses, $3.8 million relating to regulatory inquiries, and $1.5 million relating to legal and advisory work responding to market allegations. Non-cash interest tied to the convertible notes and forward transactions had a $12.6 million unfavorable impact.
- Share repurchases: The board authorized a new $1.5 billion program through February 2020. The company repurchased approximately 1.1 million shares for $60.7 million during the quarter; remaining authorization was $1,439.3 million. It reported an additional approximately 1.0 million shares repurchased for $57.9 million in April.
- Other outlook and risk factors: The filing highlights Member recruitment and retention, FTC-order compliance, foreign exchange, China licensing and regulatory uncertainty, product and tax litigation, and short-seller-related publicity and share-price volatility. The planned CEO transition from Michael O. Johnson to Richard P. Goudis was scheduled for June 1, 2017.
Most important facts for investors to verify
- Whether the China pre-price-increase orders and expected Q2 volume reversal develop as management described, and how much of Q1 activity converted to recognized sales.
- Progress and audit results for FTC Consent Order compliance, including eligible U.S. retail sales, distributor compensation requirements and related costs.
- Debt-service capacity and covenant headroom after the refinancing, including the 2019 convertible-note maturity and exposure to variable interest rates.
- Developments, potential financial exposure and appeal status for Mexican and Brazilian tax disputes, and the China anti-corruption inquiry.
- Whether regional sales and Member retention trends improve, particularly in North America, South and Central America, and South Korea, and whether planned capital spending remains within the stated range.