HERBALIFE LTD. quarterly report, Q3 FY2014

Herbalife Ltd. — Form 10-Q Summary

Reporting period: Quarter and nine months ended September 30, 2014. Unaudited results; comparisons are with the corresponding 2013 periods unless stated otherwise. Herbalife sells nutrition and personal-care products through a global network of 3.9 million independent Members in 91 countries; China uses a distinct sales model.

Financial performance

Metric	Q3 2014	Q3 2013	Nine months 2014	Nine months 2013
Net sales	$1,256.2 million	$1,213.5 million	$3,825.0 million	$3,556.4 million
Operating income	$27.6 million	$192.1 million	$351.5 million	$553.4 million
Net income	$11.2 million	$142.0 million	$205.4 million	$404.0 million
Diluted EPS	$0.13	$1.32	$2.22	$3.75
Operating cash flow	Not separately provided	Not separately provided	$449.5 million	$577.0 million

• Q3 net sales rose 3.5%; nine-month sales rose 7.6%. Management reported local-currency growth of 6.3% and 11.3%, respectively.
• Q3 gross margin was 79.7%, down from 80.4%; nine-month gross margin was 80.0%, unchanged. Q3 operating margin fell to 2.2% from 15.8%; nine-month operating margin was 9.2% versus 15.6%.
• SG&A rose to $609.7 million in Q3 from $409.7 million, and to $1,573.7 million for nine months from $1,174.6 million. The largest stated driver was Venezuela foreign-exchange losses; China service-provider fees and other business and legal expenses also increased.
• Q3 interest expense, net, was $19.9 million versus $4.7 million; nine-month net interest expense was $56.2 million versus $15.7 million. Other expense was $9.8 million in Q3 and $13.0 million year to date, principally Venezuelan bond impairments.
• Q3 income-tax benefit was $13.3 million despite a pretax loss of $2.1 million; the reported quarterly effective tax rate was 647.9%. Management attributed the unusually large benefit primarily to revising the estimated annual tax rate and recognizing a tax benefit on Venezuelan foreign-exchange losses.

Balance sheet, liquidity and capital allocation

• At September 30, cash and cash equivalents were $678.1 million, down from $973.0 million at December 31, 2013. Working capital was $508.8 million, down from $720.9 million.
• Total debt was $1,827.9 million: $875.0 million under the senior secured credit facility and $952.9 million carrying value for $1.15 billion principal of 2.00% convertible notes due 2019. The company reported compliance with credit-facility covenants and $195.8 million of undrawn capacity.
• Shareholders’ equity moved from $551.4 million at year-end 2013 to a deficit of $420.6 million. The company repurchased $1,278.4 million of shares during the nine months, including forward transactions; it also issued the convertible notes. It ended the quarter with $232.9 million of remaining repurchase authorization. The quarterly dividend was discontinued in April 2014; $30.4 million of dividends had been paid during the first quarter.
• Nine-month investing cash outflow was $151.8 million, including $140.0 million of cash purchases of property and equipment. Management reported capital expenditures, including capital leases and accrued expenditures, of $121.6 million, compared with $89.5 million in 2013, and expected full-year 2014 capital expenditures of approximately $170–$180 million.
• Cash declined by $294.8 million during the nine months, including a $234.7 million adverse effect from exchange-rate changes. Operating cash flow was lower year over year, while financing cash flow included $1.15 billion of convertible-note proceeds, $1.278 billion of share repurchases, and $123.8 million paid for capped calls.

Material changes and operating trends

• China was the strongest reported growth market: Q3 sales increased 32.6% and nine-month sales 50.7%. EMEA sales increased 12.5% and 19.6%, respectively. South and Central America sales fell 14.9% in Q3 and 4.4% year to date; Asia Pacific excluding China declined 1.2% year to date.
• Worldwide Volume Points increased 0.3% in Q3 and 4.7% year to date. Average active sales leaders increased 7.8% and 9.4%, respectively. Management reported a 51.8% sales-leader retention rate for the latest requalification period, excluding China and temporarily Venezuela.
• Shipping and handling revenue fell substantially year over year, partly reflecting the company’s 2013 pricing-structure changes; management said those changes did not materially affect total sales or profitability.

Outlook, risks, contingencies and unusual items

• Venezuela: Currency controls restrict repatriation and access to U.S. dollars. At September 30 the company remeasured Bolivar-denominated balances at the SICAD II rate of 50 Bolivars per U.S. dollar. Q3 included $17.1 million of SICAD I and $98.0 million of SICAD II foreign-exchange losses, $7.6 million of inventory write-downs, and $7.0 million of long-lived-asset impairments. The filing identifies a combined $139.5 million pretax unfavorable Q3 impact from Venezuelan FX losses and asset impairments, including bond impairment. Future access to exchange mechanisms and rates remains uncertain; reported Venezuelan asset values may not represent amounts ultimately realizable. In October, the company received approval to exchange a small amount of Bolivars at the SICAD II rate and entered a local-manufacturing agreement expected to begin production in 2015.
• Legal and regulatory: The FTC issued a Civil Investigative Demand in March 2014 concerning advertising, marketing, and sale of business opportunities; the company is cooperating and cannot predict the investigation’s scope or outcome. In the Bostick litigation, the parties had agreed on principal settlement terms: $15 million cash and up to $2.5 million of product returns, subject to court approval; the company said amounts were adequately reserved. A securities class action alleging misstatements about the business and its practices was pending, and the company intended to defend it. The filing also describes tax disputes and audits, including a Mexican 2007 assessment of approximately $22 million; the company disputed the assessment and said it did not consider a loss probable. Other tax matters include a previously nullified Mexican assessment of approximately $85 million that could potentially be reissued, plus assessments in India, Spain, Brazil and Italy.
• The company continued to incur legal and advisory costs related to public allegations by a short-selling hedge fund manager: $6.0 million in Q3 and $18.3 million for nine months. FTC-related expenses were $4.6 million in Q3 and $10.6 million year to date. The filing also cites a $17.5 million Q3 legal reserve for Bostick.
• Management said cash, operating cash flow and available credit were expected to be sufficient for working capital, capital expenditures and foreseeable liquidity needs for the next 12 months and thereafter. No earnings or revenue guidance was provided; management cautioned that interim results are not necessarily indicative of full-year results.
• Principal risks include the evolving Venezuelan currency and operating environment; regulatory and legal scrutiny of the network-marketing model; Member recruitment, retention and conduct; foreign exchange; China licensing and regulatory requirements; product and supplier risks; and the significant debt, covenant and potential dilution or cash-settlement obligations associated with the convertible notes.
• Management concluded disclosure controls were effective as of September 30, 2014 and reported no material change in internal control over financial reporting during the quarter.

Key facts for investors to verify

• How much of the sharp earnings decline reflects recurring operating costs versus Venezuela remeasurement, impairments, legal costs and non-cash convertible-note interest.
• Whether Venezuela can obtain foreign currency, realize the reported value of its Bolivar assets, and implement local manufacturing as planned.
• The status, potential financial exposure and timing of the FTC inquiry, Bostick settlement approval, securities litigation and tax assessments.
• Debt-covenant headroom, future cash requirements and the consequences of convertible-note conversion, including cash settlement and possible dilution.
• Whether growth in China and EMEA can offset weakness in South and Central America and parts of Asia Pacific, and whether Member retention and productivity remain supportive.