HERBALIFE LTD. quarterly report, Q3 FY2018

Herbalife Nutrition Ltd. — Q3 2018 Form 10-Q

Reporting period: Three and nine months ended September 30, 2018. Unaudited results; dollar amounts are in millions except per-share data. Herbalife sells nutrition and personal-care products through independent Members, and through a distinct service-provider model in China.

Financial performance and liquidity

Metric	Q3 2018	Q3 2017	Nine months 2018	Nine months 2017
Net sales	$1,242.8	$1,085.4	$3,705.2	$3,334.4
Gross profit	$1,024.7	$870.0	$3,011.8	$2,695.6
Operating income	$187.3	$119.3	$534.9	$468.0
Net income	$71.2	$54.5	$247.7	$277.3
Diluted EPS	$0.49	$0.33	$1.64	$1.63

Q3 sales rose 14.5% and nine-month sales rose 11.1% year over year. Management attributed growth mainly to higher sales volume; reported results were also materially affected by foreign exchange and price increases, particularly in Venezuela.
Gross margin was 82.5% in Q3 versus 80.2%, and 81.3% for nine months versus 80.8%. Operating margin was 15.1% and 14.4%, respectively; net margin was 5.7% and 6.7%.
Worldwide Volume Points increased 15.0% in Q3 and 8.8% year to date. Growth was broad, while South and Central America declined 8.0% in Q3; management cautioned that some Asia Pacific Q3 strength reflected factors it did not expect to continue.
Operating cash flow was $509.7 versus $404.4 for the first nine months. Capital expenditures were $55.2; management expected full-year 2018 capital expenditures of approximately $85–$95.
Cash and cash equivalents were $1,110.5 at quarter-end. Working capital was $210.5, down from $953.5 at December 31, 2017, primarily due to lower cash and higher current debt. Total debt carrying value was $2,446.6, including $672.2 current; scheduled principal payments totaled $2,628.7. Shareholders’ deficit was $761.1.
Interest expense, net, was $39.9 in Q3 and $124.1 for nine months, up from $38.4 and $106.5. The nine-month effective tax rate rose to 29.4% from 23.3%, with U.S. tax reform and income mix cited as factors.

Changes and unusual items

Q3 net income increased 30.6%, while nine-month net income declined 10.7%. Higher sales and contribution margin supported both periods; nine-month results also reflected higher SG&A, lower China grant income, higher interest and taxes, and debt- and CVR-related losses.
Other expense included a $35.4 loss on refinancing the 2017 secured credit facility and a Q3 $4.6 gain on revaluing the tender-offer contingent value right. Nine-month other expense also included a $13.1 loss on extinguishing convertible notes and an $11.4 CVR revaluation loss.
In August, Herbalife refinanced its secured facility with a new $1.25 billion facility and issued $400 million of 7.25% senior notes due 2026. The new facility had $1.0 billion drawn and an undrawn $250 million revolver at September 30. The company reported compliance with debt covenants.
$675 million principal of 2.00% convertible notes due August 2019 remained outstanding and was classified as current debt. The new credit facility has conditional early-maturity provisions tied to outstanding convertible-note principal and leverage ratios.
The company repurchased approximately $600 million of shares in its May tender offer at $52.50 per share. Cash-flow statement share repurchases were $740.6 for nine months. A new five-year $1.5 billion repurchase authorization was approved after quarter-end, replacing the prior program.
Herbalife adopted ASC 606 in 2018 using the modified retrospective method. The filing reports a $2.3 reduction to opening retained earnings; the standard’s reported impact on nine-month net income was not material.

Outlook, risks, and contingencies

No earnings or revenue guidance is provided. Management said operating cash flow, cash, available credit and capital-market access were expected to meet foreseeable liquidity needs, including over the next 12 months.
Management cited continued investment in Member productivity, customer-oriented selling, product access and expansion, while noting weaker or transitioning markets in South and Central America. Mexico tariffs on U.S.-imported products could pressure future sales or require price increases.
The FTC consent order requires enhanced U.S. sales documentation, compliance controls and independent audits for seven years. The company said it believed the U.S. distributor compensation cap would not apply in 2018, subject to verification under the order.
SEC and DOJ investigations into China anti-corruption compliance remained ongoing; a separate SEC inquiry into China marketing-plan disclosures was described as nearing conclusion, but the outcome and any loss could not be estimated. China customs began an audit covering 2015–2017.
Material disclosed contingencies include Mexican tax assessments and delayed VAT refunds, Brazilian and other foreign tax disputes, and product-liability exposure. The company generally stated it did not believe losses were probable; several potential outcomes could not be reasonably estimated.
Key risks include Member recruitment and retention, regulatory compliance and network-marketing scrutiny, China licensing and regulatory uncertainty, foreign exchange and currency restrictions, debt maturities and covenants, and product and reputational risks. Management reported disclosure controls were effective at September 30, 2018.

Important facts for investors to verify

Whether sales and Volume Point growth persist after currency effects, price changes, Venezuela-related distortions and temporary regional factors are separated.
Liquidity and refinancing plans for the $675 million 2019 convertible notes and the credit facility’s conditional maturity provisions.
Compliance with the FTC consent order, including eligible U.S. sales thresholds, distributor compensation and audit outcomes.
Progress and potential financial consequences of China investigations, tax assessments, VAT recoveries and other legal contingencies.
The sustainability of share repurchases given the company’s debt, working-capital decline and shareholders’ deficit.