10-Q 1 d582913d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

 

(Mark One)

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

For the quarterly period ended September 30, 2013

OR

 

¨ 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: 1-32381

 

 

HERBALIFE LTD.

(Exact name of registrant as specified in its charter)

 

 

 

Cayman Islands   98-0377871

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

P.O. Box 309GT

Ugland House, South Church Street

Grand Cayman, Cayman Islands

(Address of principal executive offices) (Zip code)

(213) 745-0500

(Registrant’s telephone number, including area code)

 

 

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  ¨    No  x

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨ (Do not check if a smaller reporting company)    Smaller reporting company   ¨

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

Number of shares of registrant’s common shares outstanding as of October 23, 2013 was 101,268,818.

 

 

 


Table of Contents

HERBALIFE LTD.

 

PART I. FINANCIAL INFORMATION   

Item 1.

 

Financial Statements

     4   

Unaudited and Unreviewed Condensed Consolidated Balance Sheets

     4   

Unaudited and Unreviewed Condensed Consolidated Statements of Income

     5   

Unaudited and Unreviewed Condensed Consolidated Statements of Comprehensive Income

     6   

Unaudited and Unreviewed Condensed Consolidated Statements of Cash Flows

     7   

Notes to Unaudited and Unreviewed Condensed Consolidated Financial Statements

     8   

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     23   

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

     40   

Item 4.

 

Controls and Procedures

     42   

Forward Looking Statements

     42   
PART II. OTHER INFORMATION   

Item 1.

 

Legal Proceedings

     43   

Item 1A.

 

Risk Factors

     43   

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

     58   

Item 3.

 

Defaults Upon Senior Securities

     59   

Item 4.

 

Mine Safety Disclosures

     59   

Item 5.

 

Other Information

     59   

Item 6.

 

Exhibits

     59   

Signatures and Certifications

     63   

 

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EXPLANATORY NOTE

As previously disclosed, on April 8, 2013, KPMG LLP, or KPMG, notified Herbalife Ltd., or the Company, that KPMG resigned, effective immediately, as the Company’s independent accountant. KPMG stated it had concluded it was no longer independent because of the then-alleged insider trading in the Company’s securities by one of KPMG’s former partners who, until April 5, 2013, was the KPMG engagement partner on the Company’s audit. KPMG advised the Company it resigned as the Company’s independent accountant solely due to the impairment of KPMG’s independence resulting from its now former partner’s unlawful activities and not for any reason related to the Company’s financial statements, its accounting practices, the integrity of the Company’s management or for any other reason.

As a result of the then-alleged insider trading activity by its now former partner and KPMG’s resulting resignation on April 8, 2013, KPMG notified the Company its independence had been impaired and had no option but to withdraw its audit reports on the Company’s financial statements for the fiscal years ended December 31, 2010, 2011 and 2012 and the effectiveness of internal control over financial reporting as of December 31, 2010, 2011 and 2012 and that such reports should no longer be relied upon as a result of KPMG’s lack of independence created by the circumstances described above. The Company’s Audit Committee and management continue to believe that the Company’s financial statements covering the referenced periods, notwithstanding the revisions discussed in Note 2, Significant Accounting Policies under the heading Revision of Prior Period Financial Statements, fairly present, in all material respects, the financial condition and results of operations of the Company as of the end of and for the referenced periods and may continue to be relied upon and that the Company’s internal control over financial reporting was effective during these periods.

Also, as a result of KPMG’s resignation, the unaudited interim financial information presented in this Quarterly Report on Form 10-Q has not been reviewed by an outside independent registered public accounting firm as required by the rules of the Securities and Exchange Commission, or the SEC. As a result, this Quarterly Report on Form 10-Q is considered deficient and the Company continues not to be timely or current in its filings under the Securities Exchange Act of 1934, as amended, or the Exchange Act. While this filing does not comply with the requirements of Regulation S-X, and should not be interpreted to be a substitute for the review that would normally occur by the Company’s independent registered public accounting firm, the Company’s Audit Committee and management believe that the interim financial information presented herein fairly presents, in all material respects, the financial condition and results of operations of the Company as of the end of and for the referenced periods and may be relied upon. Except for the absence of this review of the unaudited interim financial information discussed above, the Company believes this Quarterly Report on Form 10-Q fully complies with the requirements of the Exchange Act and the Company believes it is prudent to file this Report with the SEC in spite of the current circumstances to provide the financial and other information set forth herein to its shareholders and other interested parties.

On May 21, 2013, the Audit Committee of the Company’s Board of Directors engaged PricewaterhouseCoopers LLP, or PwC, to serve as the Company’s new independent registered public accounting firm to audit the Company’s financial statements for its fiscal year ending December 31, 2013 and to re-audit the Company’s financial statements for the fiscal years ended December 31, 2012, 2011 and 2010. PwC has also been engaged to review the Company’s interim financial information for the three months ended March 31, 2013, the three and six months ended June 30, 2013, and the three and nine months ended September 30, 2013.

The Chief Executive Officer and Chief Financial Officer believe, to the best of their knowledge, that the unaudited interim financial information presented herein accurately portrays the financial condition and results of the Company. To that end, they have provided the certifications under Section 302 of the Sarbanes-Oxley Act of 2002, or SOX. The SOX Section 906 certification is omitted from this filing only because, as a result of KPMG’s former partner’s actions as described above, the unaudited interim financial information presented herein has not been reviewed by an independent registered public accountant under Statement of Auditing Standards 100, or SAS 100. The Company believes that this report otherwise meets all of the qualifications of the Exchange Act and the rules and regulations thereunder governing the preparation and filing of periodic reports as referenced in the certifications. Before the Company’s officers can make a SOX Section 906 certification, PwC must complete its review of the unaudited interim financial information presented herein under SAS 100, as required by SEC rules. Once PwC completes its re-audit of the Company’s financial statements for the fiscal years ended December 31, 2012, 2011 and 2010, and completes its SAS 100 review of this unaudited interim financial information and the unaudited financial information for applicable prior periods, the Company will file an amendment to this report with the SOX Section 906 certification as soon as practicable.

See Note 2, Significant Accounting Policies, for information on the matters discussed above.

 

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

HERBALIFE LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited and Unreviewed)

 

     September 30,
2013
    December 31,
2012
 
    

(In thousands, except share and

par value amounts)

 
ASSETS     

CURRENT ASSETS:

    

Cash and cash equivalents

   $ 892,548      $ 333,534   

Receivables, net of allowance for doubtful accounts of $1,769 (2013) and $2,273 (2012)

     109,830        116,139   

Inventories

     347,735        339,411   

Prepaid expenses and other current assets

     174,840        145,624   

Deferred income taxes

     53,880        49,339   
  

 

 

   

 

 

 

Total current assets

     1,578,833        984,047   
  

 

 

   

 

 

 

Property, at cost, net of accumulated depreciation and amortization of $309,372 (2013) and $255,862 (2012)

     267,850        242,886   

Deferred compensation plan assets

     25,843        24,267   

Deferred financing costs, net

     5,528        7,462   

Other assets

     49,006        48,805   

Marketing related intangibles and other intangible assets, net

     310,897        311,186   

Goodwill

     105,490        105,490   
  

 

 

   

 

 

 

Total assets

   $ 2,343,447      $ 1,724,143   
  

 

 

   

 

 

 
LIABILITIES AND SHAREHOLDERS’ EQUITY     

CURRENT LIABILITIES:

    

Accounts payable

   $ 82,989      $ 75,209   

Royalty overrides

     252,677        243,351   

Accrued compensation

     99,765        95,220   

Accrued expenses

     241,359        181,523   

Current portion of long-term debt

     75,061        56,302   

Advance sales deposits

     73,618        49,432   

Income taxes payable

     42,494        61,325   
  

 

 

   

 

 

 

Total current liabilities

     867,963        762,362   
  

 

 

   

 

 

 

NON-CURRENT LIABILITIES:

    

Long-term debt, net of current portion

     875,018        431,305   

Deferred compensation plan liability

     35,049        29,454   

Deferred income taxes

     64,500        62,982   

Other non-current liabilities

     45,326        42,557   
  

 

 

   

 

 

 

Total liabilities

     1,887,856        1,328,660   
  

 

 

   

 

 

 

CONTINGENCIES

    

SHAREHOLDERS’ EQUITY:

    

Common shares, $0.001 par value; 1.0 billion shares authorized; 101.3 million (2013) and 106.9 million (2012) shares outstanding

     101        107   

Paid-in-capital in excess of par value

     304,638        303,975   

Accumulated other comprehensive loss

     (27,371     (31,695

Retained earnings

     178,223        123,096   
  

 

 

   

 

 

 

Total shareholders’ equity

     455,591        395,483   
  

 

 

   

 

 

 

Total liabilities and shareholders’ equity

   $ 2,343,447      $ 1,724,143   
  

 

 

   

 

 

 

See the accompanying notes to unaudited and unreviewed condensed consolidated financial statements.

 

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HERBALIFE LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited and Unreviewed)

 

     Three Months Ended      Nine Months Ended  
     September 30,
2013
     September 30,
2012
     September 30,
2013
     September 30,
2012
 
     (In thousands, except per share amounts)  

Product sales

   $ 1,062,962       $ 869,542       $ 3,069,581       $ 2,574,256   

Shipping & handling revenues

     150,581         147,345         486,848         438,754   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net sales

     1,213,543         1,016,887         3,556,429         3,013,010   

Cost of sales

     238,415         201,597         711,616         601,478   
  

 

 

    

 

 

    

 

 

    

 

 

 

Gross profit

     975,128         815,290         2,844,813         2,411,532   

Royalty overrides

     373,241         330,247         1,116,821         982,975   

Selling, general & administrative expenses

     409,747         324,200         1,174,574         926,903   
  

 

 

    

 

 

    

 

 

    

 

 

 

Operating income

     192,140         160,843         553,418         501,654   

Interest expense, net

     4,726         3,546         15,658         8,088   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income before income taxes

     187,414         157,297         537,760         493,566   

Income taxes

     45,464         45,424         133,775         141,811   
  

 

 

    

 

 

    

 

 

    

 

 

 

NET INCOME

   $ 141,950       $ 111,873       $ 403,985       $ 351,755   
  

 

 

    

 

 

    

 

 

    

 

 

 

Earnings per share:

        

Basic

   $ 1.39       $ 1.03       $ 3.92       $ 3.09   

Diluted

   $ 1.32       $ 0.98       $ 3.75       $ 2.95   

Weighted average shares outstanding:

        

Basic

     102,200         108,816         103,096         113,838   

Diluted

     107,777         113,646         107,759         119,376   

Dividends declared per share

   $ 0.30       $ 0.30       $ 0.90       $ 0.90   

See the accompanying notes to unaudited and unreviewed condensed consolidated financial statements.

 

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HERBALIFE LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited and Unreviewed)

 

     Three Months Ended     Nine Months Ended  
     September 30,
2013
     September 30,
2012
    September 30,
2013
    September 30,
2012
 
     (In thousands)  

Net income

   $ 141,950       $ 111,873      $ 403,985      $ 351,755   

Other comprehensive income:

         

Foreign currency translation adjustment, net of income taxes of $(1,799) and $579 for the three months ended September 30, 2013 and 2012, respectively, and $(3,610) and $(1,493) for the nine months ended September 30, 2013 and 2012, respectively

     15,025         9,113        (2,906     5,189   

Unrealized gain (loss) on derivatives, net of income taxes of $(214) and $(1,038) for the three months ended September 30, 2013 and 2012, respectively, and $1,490 and $(1,377) for the nine months ended September 30, 2013 and 2012, respectively

     1,887         (2,811     7,230        (4,005
  

 

 

    

 

 

   

 

 

   

 

 

 

Total other comprehensive income (loss)

     16,912         6,302        4,324        1,184   
  

 

 

    

 

 

   

 

 

   

 

 

 

Total comprehensive income (loss)

   $ 158,862       $ 118,175      $ 408,309      $ 352,939   
  

 

 

    

 

 

   

 

 

   

 

 

 

See the accompanying notes to unaudited and unreviewed condensed consolidated financial statements.

 

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HERBALIFE LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited and Unreviewed)

 

     Nine Months Ended  
     September 30,
2013
    September 30,
2012
 
     (In thousands)  

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net income

   $ 403,985      $ 351,755   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     63,207        55,402   

Deficiency in (Excess) tax benefits from share-based payment arrangements

     2,586        (28,073

Share-based compensation expenses

     21,882        20,850   

Amortization of deferred financing costs

     1,937        1,135   

Deferred income taxes

     (7,532     (8,249

Unrealized foreign exchange transaction (gain) loss

     585        (3,529

Foreign exchange loss from Venezuela currency devaluation

     15,116        —    

Other

     1,661        172   

Changes in operating assets and liabilities:

    

Receivables

     1,624        (26,444

Inventories

     (19,775     (58,705

Prepaid expenses and other current assets

     (15,330     (7,977

Other assets

     (678     (3,098

Accounts payable

     8,569        22,674   

Royalty overrides

     13,959        22,432   

Accrued expenses and accrued compensation

     65,868        20,028   

Advance sales deposits

     27,038        7,384   

Income taxes

     (13,313     29,118   

Deferred compensation plan liability

     5,595        5,015   
  

 

 

   

 

 

 

NET CASH PROVIDED BY OPERATING ACTIVITIES

     576,984        399,890   
  

 

 

   

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES

    

Purchases of property, plant and equipment

     (91,782     (59,229

Proceeds from sale of property, plant and equipment

     121        243   

Deferred compensation plan assets

     —         (3,466
  

 

 

   

 

 

 

NET CASH USED IN INVESTING ACTIVITIES

     (91,661     (62,452
  

 

 

   

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES

    

Dividends paid

     (92,651     (102,687

Borrowings from long-term debt

     763,232        1,387,557   

Principal payments on long-term debt

     (300,733     (1,090,748

Deferred financing costs

     —         (4,460

Share repurchases

     (275,821     (506,331

(Deficiency in) Excess tax benefits from share-based payment arrangements

     (2,586     28,073   

Proceeds from exercise of stock options and sale of stock under employee stock purchase plan

     975        10,819   
  

 

 

   

 

 

 

NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES

     92,416        (277,777
  

 

 

   

 

 

 

EFFECT OF EXCHANGE RATE CHANGES ON CASH

     (18,725     3,286   
  

 

 

   

 

 

 

NET CHANGE IN CASH AND CASH EQUIVALENTS

     559,014        62,947   

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

     333,534        258,775   
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 892,548      $ 321,722   
  

 

 

   

 

 

 

CASH PAID DURING THE PERIOD

    

Interest paid

   $ 18,005      $ 10,263   
  

 

 

   

 

 

 

Income taxes paid

   $ 163,843      $ 123,063   
  

 

 

   

 

 

 

See the accompanying notes to unaudited and unreviewed condensed consolidated financial statements.

 

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HERBALIFE LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited and Unreviewed)

1. Organization

Herbalife Ltd., a Cayman Islands exempt limited liability company, or Herbalife, was incorporated on April 4, 2002. Herbalife Ltd. (and together with its subsidiaries, the “Company”) is a leading global nutrition company that sells weight management products, nutritional supplements, energy, sports & fitness products and personal care products utilizing network marketing distribution. As of September 30, 2013, the Company sold its products to and through a network of 3.6 million independent distributors, which included 0.2 million in China. In China, the Company currently sells its products through retail stores, sales representatives, sales officers and independent service providers. The Company reports revenue in six geographic regions: North America; Mexico; South and Central America; EMEA, which consists of Europe, the Middle East and Africa; Asia Pacific (excluding China); and China.

2. Significant Accounting Policies

Basis of Presentation

The unaudited and unreviewed interim financial information of the Company has been prepared in accordance with Article 10 of the Securities and Exchange Commission’s, or the SEC, Regulation S-X. Accordingly, as permitted by Article 10 of the SEC’s Regulation S-X, it does not include all of the information required by generally accepted accounting principles in the U.S., or U.S. GAAP, for complete financial statements. The condensed consolidated balance sheet at December 31, 2012 was derived from the previously audited financial statements at that date subject to revisions as discussed below, where, as previously disclosed, the Company’s former independent registered public accounting firm’s audit opinions have now been withdrawn, and does not include all the disclosures required by U.S. GAAP, as permitted by Article 10 of the SEC’s Regulation S-X. The Company’s unaudited and unreviewed condensed consolidated financial statements as of September 30, 2013, and for the three and nine months ended September 30, 2013 and 2012, include Herbalife and all of its direct and indirect subsidiaries. In the opinion of management, the accompanying financial information contains all adjustments, consisting of normal recurring adjustments, necessary to present fairly the Company’s unaudited and unreviewed condensed consolidated financial statements as of September 30, 2013, and for the three and nine months ended September 30, 2013 and 2012. These unaudited and unreviewed condensed consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, or the 2012 10-K. Operating results for the three and nine months ended September 30, 2013, are not necessarily indicative of the results that may be expected for the year ending December 31, 2013.

The unaudited interim financial information presented in this Quarterly Report on Form 10-Q has not been reviewed by an independent registered public accounting firm as the Company’s former independent registered public accounting firm resigned on April 8, 2013. See the Explanatory Note to this Quarterly Report on Form 10-Q for a further description. As a result, this Quarterly Report on Form 10-Q is considered deficient and the Company continues not to be timely or current in its filings under the Securities Exchange Act of 1934, as amended, or the Exchange Act. While this filing does not comply with the requirements of Regulation S-X, and should not be interpreted to be a substitute for the review that would normally occur by the Company’s independent registered public accounting firm, the Company’s Audit Committee and management believe that the interim financial information presented herein fairly present, in all material respects, the financial condition and results of operations of the Company as of the end of and for the referenced periods and may be relied upon. Except for the absence of this review of the unaudited interim financial information discussed above and the omission of the SOX 906 certification discussed in greater detail in the Explanatory Note, this Quarterly Report on Form 10-Q fully complies with the requirements of the Exchange Act and the Company believes it is prudent to file this Report with the SEC in spite of the current circumstances to provide the financial and other information set forth herein to its shareholders and other interested parties. Once PwC completes its re-audit of the Company’s financial statements for the fiscal years ended December 31, 2012, 2011 and 2010, and completes its SAS 100 review of this unaudited interim financial information and the unaudited financial information for applicable prior periods, the Company will file an amendment to this Quarterly Report on Form 10-Q as soon as practicable.

New Accounting Pronouncements

In February 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, No. 2013-04, Liabilities (Topic 405): Obligations Resulting from Joint and Several Liability Arrangements for which the Total Amount of the Obligation Is Fixed at the Reporting Date (a consensus of the FASB Emerging Issues Task Force). This ASU addresses the recognition, measurement, and disclosure of certain obligations resulting from joint and several arrangements including debt arrangements, other contractual obligations, and settled litigation and judicial rulings. The ASU is effective for public entities for fiscal years, and interim periods within those years, beginning after December 15, 2013. The Company is evaluating the potential impact of this adoption on its consolidated financial statements.

 

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In March 2013, the FASB issued ASU No. 2013-05, Foreign Currency Matters (Topic 830): Parent’s Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity (a consensus of the FASB Emerging Issues Task Force). This ASU addresses the accounting for the cumulative translation adjustment when a parent either sells a part or all of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary or group of assets that is a nonprofit activity or a business within a foreign entity. This ASU is effective prospectively for fiscal years, and interim periods within those years, beginning after December 15, 2013. The Company is evaluating the potential impact of this adoption on its consolidated financial statements.

In July 2013, the FASB issued ASU No. 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (a consensus of the Emerging Issues Task Force). This ASU addresses when unrecognized tax benefits should be presented as reductions to deferred tax assets for net operating loss carryforwards in the financial statements. This ASU is effective prospectively for fiscal years, and interim periods within those years, beginning after December 15, 2013. Early adoption and retrospective application is permitted. The Company is evaluating the potential impact of this adoption on its consolidated financial statements.

Revision of Prior Period Financial Statements

During the quarter ended June 30, 2013, in connection with preparing the unaudited and unreviewed interim financial information presented in the Quarterly Report on Form 10-Q for that period, prior period errors were identified which affected the interim period ended June 30, 2013, and the annual periods ended December 31, 2012, 2011 and 2010, including the applicable interim periods. These income tax errors primarily relate to income tax expenses calculated on intercompany inventory transactions and the Company’s application of ASC 740-10-25-3(e) and ASC 810-10-45-8. As a result of its misapplication of these accounting standards, the Company’s income tax expenses and net income within its consolidated statement of income were misstated. There were also certain amounts within the Company’s other consolidated financial statements that were misstated. The Company has reflected the correction of these identified prior period errors in the periods in which they originated.

In evaluating whether the Company’s previously issued consolidated financial statements were materially misstated, the Company considered the guidance in ASC Topic 250, Accounting Changes and Error Corrections, ASC Topic 250-10-S99-1, Assessing Materiality, and ASC Topic 250-10-S99-2, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. The Company concluded that these errors were not material, individually or in the aggregate, to any of the prior reporting periods, and therefore, amendments of previously filed reports were not required. If the entire correction was recorded in the second quarter of 2013, it was expected that the cumulative amount would not be material for the fiscal year ending December 31, 2013. As such, this cumulative amount could have been recorded as an out of period adjustment during the second quarter of 2013. However, because the Company will be amending its Annual Report on Form 10-K for the fiscal year ended December 31, 2012 due to its predecessor auditors withdrawing their opinions, and will be amending its Quarterly Reports on Form 10-Q for the fiscal quarters ended March 31, 2013, June 30, 2013, and September 30, 2013, and any other Quarterly Reports on Form 10-Q that are deficient due to the absence of a SAS 100 review, the Company decided to revise its applicable prior period financial statements so that the financial statements included therein and herein do not include these income tax errors. The Company believes this approach is more beneficial to investors due to the Company’s unusual facts and circumstances surrounding its predecessor auditors resigning and withdrawing their audit opinions and the Company being required to file future amendments to its Annual Report on Form 10-K and Quarterly Reports on Form 10-Q referenced above. As such, the revisions for these corrections are and will be reflected in the financial information of the applicable prior periods and will be reflected in future filings containing such financial information. The Company has also provided, within this Note, the financial statement items that were impacted and included within its prior period consolidated balance sheets and full year prior period consolidated statements of income so this financial information is presented timely to the Company’s shareholders and other interested parties.

The effects of these prior period errors in the condensed consolidated financial statements are as follows:

Condensed Consolidated Balance Sheets

 

     December 31, 2012      December 31, 2011  
     As  Previously
Reported
     As Adjusted      As  Previously
Reported
     As Adjusted  
     (In thousands, except per share amount)  

Prepaid expenses and other current assets

   $ 125,425       $ 145,624       $ 117,073       $ 134,605   

Deferred income taxes

   $ 49,339       $ 49,339       $ 55,615       $ 54,949   

Total current assets

   $ 963,848       $ 984,047       $ 768,819       $ 785,685   

Total assets

   $ 1,703,944       $ 1,724,143       $ 1,446,209       $ 1,463,075   

Income taxes payable

   $ 15,854       $ 61,325       $ 31,415       $ 62,283   

Total current liabilities

   $ 716,891       $ 762,362       $ 548,689       $ 579,557   

Deferred income taxes

   $ 62,982       $ 62,982       $ 72,348       $ 70,390   

Total liabilities

   $ 1,283,189       $ 1,328,660       $ 886,021       $ 914,931   

Retained earnings

   $ 148,368       $ 123,096       $ 305,931       $ 293,887   

Total shareholders’ equity

   $ 420,755       $ 395,483       $ 560,188       $ 548,144   

Total liabilities and shareholders’ equity

   $ 1,703,944       $ 1,724,143       $ 1,446,209       $ 1,463,075   

 

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Condensed Consolidated Statements of Income

 

     Three Months Ended
September 30, 2012
     Nine Months Ended
September 30, 2012
 
     As  Previously
Reported
     As Adjusted      As  Previously
Reported
     As Adjusted  
     (In thousands, except per share amount)  

Income taxes

   $ 39,518       $ 45,424       $ 134,257       $ 141,811   

Net Income

   $ 117,779       $ 111,873       $ 359,309       $ 351,755   

Basic earnings per share

   $ 1.08       $ 1.03       $ 3.16       $ 3.09   

Diluted earnings per share

   $ 1.04       $ 0.98       $ 3.01       $ 2.95   

 

     Year Ended
December 31, 2012
     Year Ended
December 31, 2011
     Year Ended
December 31, 2010
 
     As  Previously
Reported
     As Adjusted      As  Previously
Reported
     As Adjusted      As  Previously
Reported
     As Adjusted  
     (In thousands, except per share amount)  

Income taxes

   $ 173,716       $ 186,944       $ 147,201       $ 144,820       $ 80,880       $ 87,212   

Net Income

   $ 477,190       $ 463,962       $ 412,578       $ 414,959       $ 299,215       $ 292,883   

Basic earnings per share

   $ 4.25       $ 4.13       $ 3.51       $ 3.53       $ 2.51       $ 2.46   

Diluted earnings per share

   $ 4.05       $ 3.94       $ 3.30       $ 3.32       $ 2.37       $ 2.32   

Condensed Consolidated Statements of Comprehensive Income

 

     Three Months Ended
September 30, 2012
     Nine Months Ended
September 30, 2012
 
     As  Previously
Reported
     As Adjusted      As  Previously
Reported
     As Adjusted  
     (In thousands)  

Net Income

   $ 117,779       $ 111,873       $ 359,309       $ 351,755   

Total comprehensive income

   $ 124,081       $ 118,175       $ 360,493       $ 352,939   

Condensed Consolidated Statement of Cash Flows

 

     Nine Months Ended
September 30, 2012
 
     As  Previously
Reported
    As Adjusted  
     (In thousands)  

Net Income

   $ 359,309      $ 351,755   

Deferred income taxes

   $ (9,246   $ (8,249

Income taxes

   $ 22,561      $ 29,118   

Venezuela

Currency restrictions enacted by the Venezuelan government have become more restrictive and have impacted the ability of the Company’s subsidiary in Venezuela, Herbalife Venezuela, to timely obtain U.S. dollars in exchange for Venezuelan Bolivars, or Bolivars, at the official foreign exchange rate from the Venezuelan government and its foreign exchange commission, CADIVI. The application and approval process continue to be delayed and the Company’s ability to timely obtain U.S. dollars at the official exchange rate remains uncertain. In recent instances, the Company has been unsuccessful in obtaining U.S. dollars at the official rate and it remains uncertain whether the Company’s current pending applications and future anticipated applications will be approved.

 

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In February 2013, the Venezuela government announced that it devalued its Bolivar currency and will eliminate the SITME regulated system. The SITME 5.3 Bolivars per U.S. dollar rate was eliminated and the CADIVI rate has been devalued from 4.3 Bolivars to 6.3 Bolivars per U.S. dollar. This new CADIVI rate is approximately 16% less favorable than the previously published 5.3 SITME rate. The Company recognized approximately $15.1 million of net foreign exchange losses within its condensed consolidated statement of income during the first quarter of 2013, as a result of remeasuring the Company’s Bolivar denominated monetary assets and liabilities at this new CADIVI rate of 6.3 Bolivars per U.S. dollar. The majority of these foreign exchange losses related to the approximately $16.9 million devaluation of Herbalife Venezuela’s Bolivar denominated cash and cash equivalents. In March 2013, the Venezuelan government also announced they will introduce an additional complimentary exchange mechanism known as SICAD. It is currently unknown whether Herbalife Venezuela will be able to access this new exchange mechanism and the Company is currently assessing and monitoring the restrictions and exchange rates relating to this alternative mechanism.

During the nine months ended September 30, 2013, the Company also recognized $0.7 million of foreign exchange losses as a result of exchanging Bolivars for U.S. dollars using alternative legal exchange mechanisms that were approximately 75% less favorable than the new CADIVI rate. During the nine months ended September 30, 2013, the Company exchanged 5.6 million Bolivars for $0.2 million U.S. dollars using these alternative legal exchange mechanisms. The Company did not exchange Bolivars for U.S. dollars using these alternative legal exchange mechanisms during the three months ended June 30, 2013 or the three months ended September 30, 2013. As of September 30, 2013, Herbalife Venezuela’s net monetary assets and liabilities denominated in Bolivars were approximately $146.7 million, and included approximately $150.1 million in Bolivar denominated cash and cash equivalents. These Bolivar denominated assets and liabilities were remeasured at the CADIVI rate. The Company remeasures its Bolivars at the official published CADIVI rate given the limited availability of alternative exchange mechanisms and the uncertainty in the effective exchange rate for alternative exchange mechanisms. These remeasured amounts, including cash and cash equivalents, being reported on the Company’s condensed consolidated balance sheet using the published CADIVI rate may not accurately represent the amount of U.S. dollars that the Company could ultimately realize. While the Company continues to monitor the exchange mechanisms and restrictions under CADIVI, and assess and monitor the current economic and political environment in Venezuela, there is no assurance that the Company will be able to exchange Bolivars into U.S. dollars on a timely basis. Herbalife Venezuela’s net sales represented approximately 5% and 3% of the Company’s consolidated net sales for the nine months ended September 30, 2013 and 2012, respectively, and its total assets represented approximately 9% and 7% of the Company’s consolidated total assets as of September 30, 2013 and December 31, 2012, respectively. As of September 30, 2013 and December 31, 2012, the majority of its total assets consisted of Bolivar denominated cash and cash equivalents.

See the Company’s 2012 10-K for further information on Herbalife Venezuela and Venezuela’s highly inflationary economy.

3. Inventories

Inventories consist primarily of finished goods available for resale. Inventories are stated at lower of cost (primarily on the first-in, first-out basis) or market. The following are the major classes of inventory:

 

     September 30,
2013
     December 31,
2012
 
     (In millions)  

Raw materials

   $ 24.3       $ 19.6   

Work in process

     1.8         1.9   

Finished goods

     321.6         317.9   
  

 

 

    

 

 

 

Total

   $ 347.7       $ 339.4   
  

 

 

    

 

 

 

4. Long-Term Debt

Long-term debt consists of the following:

 

     September 30,
2013
     December 31,
2012
 
     (In millions)  

Borrowings under the senior secured credit facility

   $ 950.0       $ 487.5   

Capital leases

     0.1         0.1   
  

 

 

    

 

 

 

Total

     950.1         487.6   

Less: current portion

     75.1         56.3   
  

 

 

    

 

 

 

Long-term portion

   $ 875.0       $ 431.3   
  

 

 

    

 

 

 

On March 9, 2011, the Company entered into a $700.0 million senior secured revolving credit facility, or the Credit Facility, with a syndicate of financial institutions as lenders and terminated its prior senior secured credit facility, or the Prior Credit Facility. The Credit Facility has a five year maturity and expires on March 9, 2016. Based on the Company’s consolidated leverage ratio, U.S.

 

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dollar borrowings under the Credit Facility bear interest at either LIBOR plus the applicable margin between 1.50% and 2.50% or the base rate plus the applicable margin between 0.50% and 1.50%. The base rate under the Credit Facility represents the highest of the Federal Funds Rate plus 0.50%, one-month LIBOR plus 1.00%, and the prime rate offered by Bank of America. The Company, based on its consolidated leverage ratio, pays a commitment fee between 0.25% and 0.50% per annum on the unused portion of the Credit Facility. The Credit Facility also permits the Company to borrow limited amounts in Mexican Peso and Euro currencies based on variable rates.

In March 2011, the Company used $196.0 million in U.S. dollar borrowings under the Credit Facility to repay all amounts outstanding under the Prior Credit Facility. The Company incurred approximately $5.7 million of debt issuance costs in connection with the Credit Facility. These debt issuance costs were recorded as deferred financing costs on the Company’s consolidated balance sheet and are being amortized over the term of the Credit Facility.

On July 26, 2012, the Company amended the Credit Facility to include a $500.0 million term loan with a syndicate of financial institutions as lenders, or the Term Loan. The Term Loan is a part of the Credit Facility and is in addition to the Company’s current revolving credit facility. The Term Loan matures on March 9, 2016. The Company will make regular scheduled payments for the Term Loan consisting of both principal and interest components. Based on the Company’s consolidated leverage ratio, the Term Loan bears interest at either LIBOR plus the applicable margin between 1.50% and 2.50% or the base rate plus the applicable margin between 0.50% and 1.50% which are the same terms as the Company’s revolving credit facility.

In July 2012, the Company used all $500.0 million of the borrowings under the Term Loan to pay down amounts outstanding under the Company’s revolving credit facility. The Company incurred approximately $4.5 million of debt issuance costs in connection with the Term Loan. The debt issuance costs are recorded as deferred financing costs on the Company’s consolidated balance sheet and will be amortized over the life of the Term Loan. On September 30, 2013 and December 31, 2012, the weighted average interest rate for borrowings under the Credit Facility, including borrowings under the Term Loan, was 2.18% and 1.96%, respectively.

The Credit Facility requires the Company to comply with a leverage ratio and a coverage ratio. In addition, the Credit Facility contains customary covenants, including covenants that limit or restrict the Company’s ability to incur liens, incur indebtedness, make investments, dispose of assets, make certain restricted payments, pay dividends, repurchase its common shares, merge or consolidate and enter into certain transactions with affiliates. As of September 30, 2013 and December 31, 2012, the Company was compliant with its debt covenants under the Credit Facility. The fair value of the outstanding borrowings on the Company’s revolving credit facility and Term Loan approximated their carrying values as of September 30, 2013, due to their variable interest rates which reprice frequently and represent floating market rates. The fair value of the outstanding borrowings on the Company’s revolving credit facility and Term Loan are determined by utilizing Level 2 inputs as defined in Note 12, Fair Value Measurements, such as observable market interest rates and yield curves.

During the three months ended March 31, 2013, the Company borrowed an aggregate amount of $513.0 million and paid a total amount of $25.5 million under the Credit Facility. During the three months ended June 30, 2013, the Company paid a total amount of $12.5 million and did not make any borrowings under the Credit Facility. During the three months ended September 30, 2013, the Company borrowed an aggregate amount of $250.0 million and paid a total amount of $262.5 million under the Credit Facility. As of September 30, 2013 and December 31, 2012, the U.S. dollar amount outstanding under the Credit Facility was $950.0 million and $487.5 million, respectively. Of the $950.0 million U.S. dollar amount outstanding under the Credit Facility as of September 30, 2013, $450.0 million was outstanding on the Term Loan and $500.0 million was outstanding on the revolving credit facility. Of the $487.5 million U.S. dollar amount outstanding under the Credit Facility as of December 31, 2012, $487.5 million was outstanding on the Term Loan and no amounts were outstanding on the revolving credit facility. There were no outstanding foreign currency borrowings as of September 30, 2013 and December 31, 2012 under the Credit Facility.

As of September 30, 2013, the aggregate annual maturities of the Credit Facility were expected to be $18.8 million for remainder of 2013, $81.2 million for 2014, $100.0 million for 2015, and $750.0 million for 2016.

Interest expense was $6.7 million and $5.0 million for the three months ended September 30, 2013 and 2012, respectively, and $21.1 million and $12.4 million for the nine months ended September 30, 2013 and 2012, respectively.

5. Contingencies

The Company is from time to time engaged in routine litigation. The Company regularly reviews all pending litigation matters in which it is involved and establishes reserves deemed appropriate by management for these litigation matters when a probable loss estimate can be made.

As a marketer of dietary and nutritional supplements, and other products that are ingested by consumers or applied to their bodies, the Company has been and is currently subjected to various product liability claims. The effects of these claims to date have not been material to the Company, and the reasonably possible range of exposure on currently existing claims is not material to the Company. The Company believes that it has meritorious defenses to the allegations contained in the lawsuits. The Company currently maintains product liability insurance with an annual deductible of $10 million.

 

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Table of Contents

Certain of the Company’s subsidiaries have been subject to tax audits by governmental authorities in their respective countries. In certain of these tax audits, governmental authorities are proposing that significant amounts of additional taxes and related interest and penalties are due. The Company and its tax advisors believe that there are substantial defenses to governmental allegations that additional taxes are owed, and the Company is vigorously contesting the additional proposed taxes and related charges. On May 7, 2010, the Company received an assessment from the Mexican Tax Administration Service in an amount equivalent to approximately $87 million, translated at the period ended spot rate, for various items, the majority of which was Value Added Tax, or VAT, allegedly owed on certain of the Company’s products imported into Mexico during the years 2005 and 2006. This assessment is subject to interest and inflationary adjustments. On July 8, 2010, the Company initiated a formal administrative appeal process. On May 13, 2011, the Mexican Tax Administration Service issued a resolution on the Company’s administrative appeal. The resolution nullified the assessment. Since the Mexican Tax Administration Service can further review the tax audit findings and re-issue some or all of the original assessment, the Company commenced litigation in the Tax Court of Mexico in August 2011 to dispute the assertions made by the Mexican Tax Administration Service in the case. The Mexican Tax Administration Service filed a response which was received by the Company in April 2012. The response challenged the assertions that the Company made in its August 2011 filing. Litigation in this case is currently ongoing.

Prior to the nullification of the Mexican Tax Administration Service assessment relating to the 2005 and 2006 years the Company entered into agreements with certain insurance companies to allow for the potential issuance of surety bonds in support of its appeal of the assessment. Such surety bonds, if issued, would not affect the availability of the Company’s Credit Facility. These arrangements with the insurance companies remain in place in the event that the assessment is re-issued.

The Mexican Tax Administration Service commenced audits of the Company’s Mexican subsidiaries for the period from January to September 2007 and on May 10, 2013, the Company received an assessment of approximately $22 million, translated at the period ended spot rate, related to that period. On July 11, 2013, the Company filed an administrative appeal disputing the assessment. The Company has not recognized a loss as the Company does not believe a loss is probable.

The Mexican Tax Administration Service audited the Company’s Mexican subsidiaries for the 2011 year. The audit focused on importation and VAT issues. On June 25, 2013, the Mexican Tax Administration Service closed the audit of the 2011 year without any assessment.

The Company has not recognized a loss with respect to any of these Mexican matters as the Company, based on its analysis and guidance from its advisors, does not believe a loss is probable. Further, the Company is currently unable to reasonably estimate a possible loss or range of loss that could result from an unfavorable outcome if the assessment was re-issued or any additional assessments were to be issued for these or other periods. The Company believes that it has meritorious defenses if the assessment is re-issued or would have meritorious defenses if any additional assessment is issued.

The Company received an assessment from the Spanish Tax Authority in an amount equivalent to approximately $4.3 million translated at the period ended spot rate, for withholding taxes, interest and penalties related to payments to Spanish distributors for the 2003-2004 periods. The Company appealed the assessment to the National Appellate Court (Audiencia Nacional). Based on the ruling of the National Appellate Court, substantially all of the assessment was nullified. The Company began withholding taxes on payments to Spanish distributors for the 2012 year. If the Spanish Tax Authority raises the same issue in later years, the Company believes that it has meritorious defenses. The Company has not recognized a loss as the Company does not believe a loss is probable. The Company is currently unable to reasonably estimate a possible loss or range of loss that could result from an unfavorable outcome if additional assessments for other periods were to be issued.

The Company received a tax assessment in September 2009, from the Federal Revenue Office of Brazil in an amount equivalent to approximately $3.8 million U.S. dollars, translated at the period ended spot rate, related to withholding/contributions based on payments to the Company’s distributors during 2004. The Company has appealed this tax assessment to the Administrative Council of Tax Appeals (2nd level administrative appeal) as it believes it has meritorious defenses and it has not recognized a loss as the Company does not believe a loss is probable. The Company is currently unable to reasonably estimate the amount of the loss that may result from an unfavorable outcome if additional assessments for other periods were to be issued.

The Company received an order from a Rome Labor Court on behalf of the Social Security Authority on March 1, 2012, to pay an amount equivalent to approximately $7.2 million U.S. dollars, translated at the period ended spot rate, for social contributions, interest and penalties related to payments to Italian distributors from 2002 through 2005. The Company has filed a writ with the Rome Labor Court appealing the order and the Social Security Authority filed a response brief. At a hearing on July 12, 2012, the Social Security Authority announced its intention to withdraw their claim as well as the order to pay the assessment. A hearing on this matter was originally scheduled for October 23, 2012 but it has been postponed and is rescheduled for June 26, 2014. The Company has not recognized a loss as the Company does not believe a loss is probable.

These matters may take several years to resolve. While the Company believes it has meritorious defenses, it cannot be sure of their ultimate resolution. Although the Company may reserve amounts for certain matters that the Company believes represent the most likely outcome of the resolution of these related disputes, if the Company is incorrect in its assessment, the Company may have to record additional expenses, when it becomes probable that an increased potential liability is warranted.

 

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6. Segment Information

The Company is a nutrition company that sells a wide range of weight management products, nutritional supplements and personal care products. The Company’s products are manufactured by third party providers and by the Company in its Changsha, Hunan, China extraction facility, Suzhou, China facility and in its Lake Forest, California facility, and then are sold to independent distributors who consume and sell Herbalife products to retail consumers or other distributors. Revenues reflect sales of products by the Company to its distributors and are categorized based on geographic location.

As of September 30, 2013, the Company sold products in 88 countries throughout the world and was organized and managed by geographic regions. The Company aggregates its operating segments, excluding China, into one reporting segment, or the Primary Reporting Segment, as management believes that the Company’s operating segments have similar operating characteristics and similar long term operating performance. In making this determination, management believes that the operating segments are similar in the nature of the products sold, the product acquisition process, the types of customers to whom products are sold, the methods used to distribute the products, and the nature of the regulatory environment. China has been identified as a separate reporting segment as it does not meet the criteria for aggregation. The operating information for the Primary Reporting Segment and China, and sales by product line are as follows:

 

     Three Months Ended      Nine Months Ended  
     September 30,
2013
     September 30,
2012
     September 30,
2013
     September 30,
2012
 
     (In millions)  

Net Sales:

           

Primary Reporting Segment

           

United States

   $ 223.6       $ 202.9       $ 681.5       $ 625.5   

Mexico

     141.2         127.5         419.8         364.0   

South Korea

     111.5         109.3         333.5         314.9   

Others

     600.5         499.8         1,798.3         1,497.2   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Primary Reporting Segment

     1,076.8         939.5         3,233.1         2,801.6   

China

     136.7         77.4         323.3         211.4   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Net Sales

   $ 1,213.5       $ 1,016.9       $ 3,556.4       $ 3,013.0   
  

 

 

    

 

 

    

 

 

    

 

 

 

Contribution Margin(1)(2):

           

Primary Reporting Segment

           

United States

   $ 90.7       $ 91.0       $ 284.9       $ 280.0   

Mexico

     65.1         54.9         187.7         147.8   

South Korea

     57.8         53.9         169.4         150.9   

Others

     265.7         215.5         797.2         659.6   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Primary Reporting Segment

     479.3         415.3         1,439.2         1,238.3   

China

     122.6         69.7         288.9         190.3   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Contribution Margin

   $ 601.9       $ 485.0       $ 1,728.1       $ 1,428.6   
  

 

 

    

 

 

    

 

 

    

 

 

 

Selling, general and administrative expenses(2)

     409.7         324.2         1,174.6         926.9   

Interest expense, net

     4.7         3.5         15.7         8.1   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income before income taxes

     187.5         157.3         537.8         493.6   

Income taxes

     45.5         45.4         133.8         141.8   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net Income

   $ 142.0       $ 111.9       $ 404.0       $ 351.8   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net sales by product line:

           

Weight Management

   $ 772.9       $ 635.9       $ 2,262.7       $ 1,884.5   

Targeted Nutrition

     280.7         237.4         815.1         703.3   

Energy, Sports and Fitness

     65.5         54.8         188.9         155.4   

Outer Nutrition

     36.4         34.2         112.4         108.6   

Literature, promotional and other(3)

     58.0         54.6         177.3         161.2   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Net Sales

   $ 1,213.5       $ 1,016.9       $ 3,556.4       $ 3,013.0   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net sales by geographic region:

           

North America

   $ 228.7       $ 208.8       $ 697.6       $ 644.2   

Mexico

     141.2         127.5         419.8         364.0   

South and Central America

     241.2         167.5         683.1         485.6   

EMEA

     181.7         147.5         537.6         463.1   

Asia Pacific

     284.0         288.2         895.0         844.7   

China

     136.7         77.4         323.3         211.4   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Net Sales

   $ 1,213.5       $ 1,016.9       $ 3,556.4       $ 3,013.0   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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(1) Contribution margin consists of net sales less cost of sales and royalty overrides.
(2) Service fees to China independent service providers totaling $61.0 million and $34.4 million for the three months ended September 30, 2013 and 2012, respectively, and totaling $145.7 million and $93.7 million for the nine months ended September 30, 2013 and 2012, respectively, are included in selling, general and administrative expenses while distributor compensation for all other countries is included in contribution margin.
(3) Product buybacks and returns in all product categories are included in the literature, promotional and other category.

As of September 30, 2013 and December 31, 2012, total assets for the Company’s Primary Reporting Segment were $2,145.6 million and $1,607.2 million, respectively. Total assets for the China segment were $197.8 million and $116.9 million as of September 30, 2013 and December 31, 2012, respectively. As of September 30, 2013 and December 31, 2012, goodwill allocated to the Company’s reporting units included in the Company’s Primary Reporting Segment was $102.4 million for both periods. Goodwill allocated to the China segment was $3.1 million as of September 30, 2013 and December 31, 2012.

7. Share-Based Compensation

The Company has share-based compensation plans, which are more fully described in Note 9, Share-Based Compensation, to the Consolidated Financial Statements in the 2012 10-K. During the nine months ended September 30, 2013, the Company granted stock awards subject to continued service, consisting of stock appreciation rights, or SARs, and stock units with vesting terms fully described in the 2012 10-K. There were no stock options granted during the nine months ended September 30, 2013.

For the three months ended September 30, 2013 and 2012, share-based compensation expense amounted to $6.6 million and $8.4 million, respectively. For the nine months ended September 30, 2013 and 2012, share-based compensation expense amounted to $21.9 million and $20.8 million, respectively. As of September 30, 2013, the total unrecognized compensation cost related to all non-vested stock awards was $30.3 million and the related weighted-average period over which it is expected to be recognized is approximately 1.1 years.

The following tables summarize the activity under all share-based compensation plans for the nine months ended September 30, 2013:

 

Stock Options & SARs

   Awards     Weighted
Average
Exercise
Price
     Weighted
Average
Remaining
Contractual
Term
     Aggregate
Intrinsic
Value(1)
 
     (In thousands)                   (In millions)  

Outstanding at December 31, 2012(2)(3)

     11,333      $ 28.62         5.9 years       $ 119.1   

Granted

     85      $ 35.46         

Exercised

     (10   $ 9.07         

Forfeited

     (28   $ 44.23         
  

 

 

         

Outstanding at September 30, 2013(2)(3)

     11,380      $ 28.65         5.1 years       $ 467.9   
  

 

 

         

Exercisable at September 30, 2013(2)

     7,590      $ 20.82         4.1 years       $ 371.5   
  

 

 

         

 

(1) The intrinsic value is the amount by which the current market value of the underlying stock exceeds the exercise price of the stock awards.
(2) Includes 1.5 million market condition SARs.
(3) Includes 0.9 million market and performance condition SARs.

The weighted-average grant date fair value of SARs granted during the three months ended September 30, 2013 and 2012 was $0 and $16.54, respectively. The weighted-average grant date fair value of SARs granted during the nine months ended September 30, 2013 and 2012 was $11.85 and $15.35, respectively. The total intrinsic value of stock options and SARs exercised during the three months ended September 30, 2013 and 2012 was $0.1 million and $2.3 million, respectively. The total intrinsic value of stock options and SARs exercised during the nine months ended September 30, 2013 and 2012 was $0.3 million and $96.6 million, respectively.

 

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Incentive Plan and Independent Directors Stock Units

   Shares     Weighted
Average
Grant Date
Fair Value
 
     (In thousands)        

Outstanding and non-vested December 31, 2012

     321.6      $ 11.70   

Granted

     7.6      $ 35.63   

Vested

     (193.5   $ 13.84   

Forfeited

     (0.2   $ 53.60   
  

 

 

   

Outstanding and non-vested at September 30, 2013

     135.5      $ 9.91   
  

 

 

   

The total vesting date fair value of stock units which vested during the three months ended September 30, 2013 and 2012, was $0.4 million and $1.1 million, respectively. The total vesting date fair value of stock units which vested during the nine months ended September 30, 2013 and 2012, was $7.2 million and $24.1 million, respectively.

The Company recognizes excess tax benefits associated with share-based compensation to shareholders’ equity only when realized. When assessing whether excess tax benefits relating to share-based compensation have been realized, the Company follows the with-and-without approach. Under this approach, excess tax benefits related to share-based compensation are not deemed to be realized until after the utilization of all other tax benefits available to the Company, which are also subject to applicable limitations. As of September 30, 2013 and December 31, 2012, the Company had $29.1 million and $25.9 million, respectively, of unrealized excess tax benefits.

8. Income Taxes

Income taxes were $45.5 million and $133.8 million for the three and nine months ended September 30, 2013, as compared to $45.4 million and $141.8 million for the same periods in 2012. The effective income tax rate was 24.3% and 24.9% for the three and nine months ended September 30, 2013, as compared to 28.9% and 28.7% for the same periods in 2012. The decrease in the effective tax rate for the three and nine months ended September 30, 2013, as compared to the same periods in 2012, was primarily due to an increase of net benefits from discrete events, principally related to the expiration of statute of limitations related to certain tax contingencies and tax planning items related to certain income tax return filings, partially offset by the impact of changes in the geographic mix of the Company’s income.

As of September 30, 2013, the total amount of unrecognized tax benefits, including related interest and penalties was $33.1 million. If the total amount of unrecognized tax benefits was recognized, $26.3 million of unrecognized tax benefits, $3.4 million of interest and $0.8 million of penalties would impact the effective tax rate.

The Company believes that it is reasonably possible that the amount of unrecognized tax benefits could decrease by up to approximately $9.8 million within the next twelve months. Of this possible decrease, $6.8 million would be due to the settlement of audits or resolution of administrative or judicial proceedings. The remaining possible decrease of $3.0 million would be due to the expiration of statute of limitations in various jurisdictions.

9. Derivative Instruments and Hedging Activities

Interest Rate Risk Management

The Company previously engaged in an interest rate hedging strategy for which the hedged transactions were the forecasted interest payments on the Credit Facility. The hedged risk was the variability of forecasted interest rate cash flows, where the hedging strategy involved the purchase of interest rate swaps. These interest rate swaps expired in July 2013 and the Company has not entered into new interest swap arrangements as of September 30, 2013.

During August 2009, the Company entered into four interest rate swap agreements with an effective date of December 31, 2009. The agreements collectively provided for the Company to pay interest for less than a four-year period at a weighted average fixed rate of 2.78% on notional amounts aggregating to $140.0 million while receiving interest for the same period at the one month LIBOR rate on the same notional amounts. As discussed above, these agreements expired in July 2013. These swaps at inception were designated as cash flow hedges against the variability in the LIBOR interest rate on the Company’s term loan under the Prior Credit Facility or against the variability in the LIBOR interest rate on the replacement debt. The Company’s term loan under the Prior Credit Facility was terminated in March 2011 and refinanced with the Credit Facility as discussed further in Note 4, Long-Term Debt. Until their expiration in July 2013, the Company’s swaps were effective and were designated as cash flow hedges against the variability in certain LIBOR interest rate borrowings under the Credit Facility at LIBOR plus 1.50% to 2.50%, fixing the Company’s weighted average effective rate on the notional amounts at 4.28% to 5.28%. There was no hedge ineffectiveness recorded as result of this refinancing event.

 

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The Company assesses hedge effectiveness and measures hedge ineffectiveness at least quarterly. During the three and nine months ended September 30, 2013 and 2012, the ineffective portion relating to these hedges was immaterial and the hedges remained effective until their expiration in July 2013 and as of December 31, 2012. Consequently, all changes in the fair value of the derivatives were deferred and recorded in other comprehensive income (loss) until the related forecasted transactions were recognized in the condensed consolidated statements of income. The fair value of the interest rate swap agreements were based on third-party quotes. At December 31, 2012, the Company recorded the interest rate swaps as liabilities at their fair value of $2.0 million. No amount was recorded as of September 30, 2013 because the interest rate swaps had expired.

Foreign Currency Instruments

The Company also designates certain foreign currency derivatives, such as certain foreign currency forward and option contracts, as freestanding derivatives for which hedge accounting does not apply. The changes in the fair market value of these freestanding derivatives are included in selling, general and administrative expenses in the Company’s condensed consolidated statements of income. The Company uses foreign currency forward contracts to hedge foreign-currency-denominated intercompany transactions and to partially mitigate the impact of foreign currency fluctuations. The Company also uses foreign currency option contracts to partially mitigate the impact of foreign currency fluctuations. The fair value of the forward and option contracts are based on third-party quotes. The Company’s foreign currency derivative contracts are generally executed on a monthly basis.

The Company designates as cash-flow hedges those foreign currency forward contracts it enters into to hedge forecasted inventory purchases and intercompany management fees that are subject to foreign currency exposures. Forward contracts are used to hedge forecasted inventory purchases over specific months. Changes in the fair value of these forward contracts, excluding forward points, designated as cash-flow hedges are recorded as a component of accumulated other comprehensive income (loss) within shareholders’ equity, and are recognized in cost of sales in the condensed consolidated statement of income during the period which approximates the time the hedged inventory is sold. The Company also hedges forecasted intercompany management fees over specific months. These contracts allow the Company to sell Euros in exchange for U.S. dollars at specified contract rates. Changes in the fair value of these forward contracts designated as cash flow hedges are recorded as a component of accumulated other comprehensive income (loss) within shareholders’ equity, and are recognized in selling, general and administrative expenses in the condensed consolidated statement of income during the period when the hedged item and underlying transaction affect earnings.

As of September 30, 2013 and December 31, 2012, the aggregate notional amounts of all foreign currency contracts outstanding designated as cash flow hedges were approximately $243.2 million and $256.9 million, respectively. At September 30, 2013, these outstanding contracts were expected to mature over the next twelve months. The Company’s derivative financial instruments are recorded on the condensed consolidated balance sheet at fair value based on third-party quotes. As of September 30, 2013, the Company recorded assets at fair value of $5.6 million and liabilities at fair value of $4.2 million relating to all outstanding foreign currency contracts designated as cash-flow hedges. As of December 31, 2012, the Company recorded assets at fair value of $0.5 million and liabilities at fair value of $3.3 million relating to all outstanding foreign currency contracts designated as cash-flow hedges. The Company assesses hedge effectiveness and measures hedge ineffectiveness at least quarterly. During the three and nine months ended September 30, 2013 and 2012, the ineffective portion relating to these hedges was immaterial and the hedges remained effective as of September 30, 2013 and December 31, 2012.

As of both September 30, 2013 and December 31, 2012, the majority of the Company’s outstanding foreign currency forward contracts had maturity dates of less than twelve months, with the majority of freestanding derivatives expiring within one month. There were no foreign currency option contracts outstanding as of September 30, 2013 and December 31, 2012. See Part I, Item 3 — Quantitative and Qualitative Disclosures About Market Risk in this Quarterly Report on Form 10-Q for foreign currency instruments outstanding as of September 30, 2013, where the Company had aggregate notional amounts of approximately $630.6 million of foreign currency contracts, inclusive of freestanding contracts and contracts designated as cash flow hedges.

Gains and Losses on Derivative Instruments

The following table summarizes gains (losses) relating to derivative instruments recorded in other comprehensive income (loss) during the three and nine months ended September 30, 2013 and 2012:

 

     Amount of Gain (Loss) Recognized
in Other Comprehensive Income (Loss)
 
     For the Three Months Ended     For the Nine Months Ended  
     September 30, 2013      September 30, 2012     September 30, 2013      September 30, 2012  
     (In millions)  

Derivatives designated as hedging instruments:

          

Foreign exchange currency contracts relating to inventory and intercompany management fee hedges

   $ 0.2       $ (2.8   $ 3.2       $ (3.0

Interest rate swaps

     —         $ (0.2     —         $ (0.6

 

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The following table summarizes gains (losses) relating to derivative instruments recorded to income during the three and nine months ended September 30, 2013 and 2012:

 

    Location of  Gain
(Loss)
Recognized in Income
  Amount of Gain (Loss)
Recognized in Income
 
      For the Three Months Ended     For the Nine Months Ended  
      September 30, 2013     September 30, 2012     September 30, 2013     September 30, 2012  
        (In millions)  

Derivatives designated as hedging instruments:

         

Foreign exchange currency contracts relating to inventory hedges and intercompany management fee
hedges(1)

  Selling, general and

administrative expenses

  $ (1.4   $ (0.7   $ (4.0   $ (0.6

Derivatives not designated as hedging instruments:

         

Foreign exchange currency contracts

  Selling, general and

administrative expenses

  $ 8.8      $ (0.8   $ 3.6      $ (11.6

 

(1) For foreign exchange contracts designated as hedging instruments, the amounts recognized in income (loss) represent the amounts excluded from the assessment of hedge effectiveness. There were no ineffective amounts recorded for derivatives designated as hedging instruments.

The following table summarizes gains (losses) relating to derivative instruments reclassified from accumulated other comprehensive loss into income during the three and nine months ended September 30, 2013 and 2012:

 

     Location of  Gain
(Loss)
Reclassified
from  Accumulated
Other Comprehensive
Loss into Income
(Effective Portion)
   Amount of Gain (Loss) Reclassified
from Accumulated
Other Comprehensive
Loss into Income
 
        For the Three Months Ended     For the Nine Months Ended  
        September 30, 2013     September 30, 2012     September 30, 2013     September 30, 2012  
          (In millions)  

Derivatives designated as hedging instruments:

           

Foreign exchange currency contracts relating to inventory hedges

   Cost of sales    $ (1.1   $ 0.2      $ (3.2   $ 0.4   

Foreign exchange currency contracts relating to intercompany management fee hedges

   Selling, general and

administrative expenses

   $ (0.2   $ 1.5      $ (0.3   $ 4.0   

Interest rate swaps

   Interest expense, net    $ (0.2   $ (0.9   $ (2.0   $ (2.7

The Company reports its derivatives at fair value as either assets or liabilities within its condensed consolidated balance sheet. See Note 12, Fair Value Measurements, for information on derivative fair values and their condensed consolidated balance sheet location as of September 30, 2013 and December 31, 2012.

10. Shareholders’ Equity

Dividends

The declaration of future dividends is subject to the discretion of the Company’s board of directors and will depend upon various factors, including its earnings, financial condition, restrictions imposed by the Credit Facility and the terms of any other indebtedness that may be outstanding, cash requirements, future prospects and other factors deemed relevant by its board of directors. The Credit Facility permits payments of dividends as long as no default or event of default exists and the consolidated leverage ratio specified in the Credit Facility is not exceeded.

On February 19, 2013, the Company announced that its board of directors approved a cash dividend of $0.30 per common share in an aggregate amount of $30.9 million that was paid to shareholders on March 19, 2013. On April 29, 2013, the Company announced that its board of directors approved a cash dividend of $0.30 per common share in an aggregate amount of $30.9 million that was paid to shareholders on May 28, 2013. On July 29, 2013, the Company announced that its board of directors approved a cash dividend of $0.30 per common share in an aggregate amount of $30.8 million that was paid to shareholders on August 27, 2013.

The aggregate amounts of dividends declared and paid during the three months ended September 30, 2013 and 2012 were $30.8 million and $32.4 million, respectively. The aggregate amount of dividends declared and paid during the nine months ended September 30, 2013 and 2012 were $92.6 million and $102.7 million, respectively.

 

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Share Repurchases

On July 30, 2012, the Company announced that its board of directors authorized a new $1 billion share repurchase program that will expire on June 30, 2017. This share repurchase program allows the Company to repurchase its common shares, at such times and prices as determined by the Company’s management as market conditions warrant, and to the extent Herbalife Ltd.’s distributable reserves are available under Cayman Islands law. The Credit Facility permits the Company to repurchase its common shares as long as no default or event of default exists and the consolidated leverage ratio specified in the Credit Facility is not exceeded.

During the three months ended March 31, 2013, the Company repurchased approximately 4.0 million of its common shares through open market purchases at an aggregate cost of approximately $162.4 million or an average cost of $40.61 per share. The Company did not repurchase any common shares in the open market during the three months ended June 30, 2013. During the three months ended September 30, 2013, the Company repurchased approximately 1.7 million of its common shares through open market purchases at an aggregate cost of approximately $110.0 million or an average cost of $63.85 per share. As of September 30, 2013, the remaining authorized capacity under the Company’s share repurchase program was $677.6 million.

The Company reflects the aggregate purchase price of its common shares repurchased as a reduction to shareholders’ equity. The Company allocated the purchase price of the repurchased shares as a reduction to retained earnings, common shares and additional paid-in-capital.

The number of shares issued upon vesting or exercise for certain restricted stock units and SARs granted pursuant to the Company’s share-based compensation plans is net of the minimum statutory withholding requirements that the Company pays on behalf of its employees. Although shares withheld are not issued, they are treated as common share repurchases in the Company’s consolidated financial statements, as they reduce the number of shares that would have been issued upon vesting. These shares do not count against the authorized capacity under the Company’s share repurchase program described above.

Accumulated Other Comprehensive Income (Loss)

The following table summarizes changes in accumulated other comprehensive income (loss) during the nine months ended September 30, 2013:

 

     Changes in Accumulated Other Comprehensive
Income (Loss) by Component
Nine Months Ended September 30, 2013
 
     Foreign
Currency
Translation
Adjustments
    Unrealized
Gain (Loss)  on
Derivatives
    Total  
     (In millions)  

Beginning Balance

   $ (28.8   $ (2.9   $ (31.7
  

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss) before reclassifications, net of tax

     (2.9     2.5        (0.4

Amounts reclassified from accumulated other comprehensive income (loss) to income, net of tax(1)

     —         4.7        4.7   
  

 

 

   

 

 

   

 

 

 

Total other comprehensive income (loss), net of reclassifications

     (2.9     7.2        4.3   
  

 

 

   

 

 

   

 

 

 

Ending balance

   $ (31.7   $ 4.3      $ (27.4
  

 

 

   

 

 

   

 

 

 

 

(1) See Note 9, Derivative Instruments and Hedging Activities, for information regarding the location in the condensed consolidated statements of income of gains (losses) reclassified from accumulated other comprehensive income (loss) into income during the three and nine months ended September 30, 2013.

Other comprehensive income (loss) before reclassifications was net of tax benefits of $3.6 million and tax expense of $0.7 million for foreign currency translation adjustments and unrealized gain (loss) on derivatives, respectively, for the nine months ended September 30, 2013. Amounts reclassified from accumulated other comprehensive income (loss) to income was net of tax expense of $0.8 million for unrealized gain (loss) on derivatives for the nine months ended September 30, 2013.

11. Earnings Per Share

Basic earnings per share represents net income for the period common shares were outstanding, divided by the weighted average number of common shares outstanding for the period. Diluted earnings per share represents net income divided by the weighted average number of common shares outstanding, inclusive of the effect of dilutive securities such as outstanding stock options, SARs, stock units and warrants.

 

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The following are the common share amounts used to compute the basic and diluted earnings per share for each period:

 

     For the Three  Months
Ended September 30,
     For the Nine Months
Ended September 30,
 
     2013      2012      2013      2012  
     (in thousands)  

Weighted average shares used in basic computations

     102,200         108,816         103,096         113,838   

Dilutive effect of exercise of equity grants outstanding

     5,577         4,830         4,663         5,485   

Dilutive effect of warrants

     —          —          —          53   
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average shares used in diluted computations

     107,777         113,646         107,759         119,376   
  

 

 

    

 

 

    

 

 

    

 

 

 

There were an aggregate of 0.9 million and 3.6 million of equity grants that were outstanding during the three and nine months ended September 30, 2013, respectively, and an aggregate of 4.0 million and 2.6 million of equity grants that were outstanding during the three and nine months ended September 30, 2012, respectively, consisting of stock options, SARs, and stock units, but were not included in the computation of diluted earnings per share because their effect would be anti-dilutive or the market condition for the award has not been satisfied.

12. Fair Value Measurements

The Company applies the provisions of FASB ASC Topic 820, Fair Value Measurements and Disclosures, or ASC 820, for its financial and non-financial assets and liabilities. ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 establishes a fair value hierarchy, which prioritizes the inputs used in measuring fair value into three broad levels as follows:

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2 inputs include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability and inputs that are derived principally from or corroborated by observable market data by correlation or other means.

Level 3 inputs are unobservable inputs for the asset or liability.

The Company measures certain assets and liabilities at fair value as discussed throughout the notes to its consolidated financial statements. Foreign exchange currency contracts and interest rate swaps are valued using standard calculations and models. Foreign exchange currency contracts are valued primarily based on inputs such as observable forward rates, spot rates and foreign currency exchange rates at the reporting period ended date. Interest rate swaps are valued primarily based on inputs such as LIBOR and swap yield curves at the reporting period ended date. Assets or liabilities that have recurring measurements and are measured at fair value consisted of Level 2 derivatives and are shown below at their gross values at September 30, 2013, and December 31, 2012:

Fair Value Measurements at Reporting Date

 

     Derivative Balance
Sheet
Location
   Significant
Other
Observable
Inputs
(Level 2)
Fair Value at
September 30,
2013
     Significant
Other
Observable
Inputs
(Level 2)
Fair Value at
December 31,
2012
 
          (in millions)  

ASSETS:

        

Derivatives designated as cash flow hedging instruments:

        

Foreign exchange currency contracts relating to inventory and intercompany management fee hedges

   Prepaid expenses and other

current assets

   $ 5.6       $ 0.5   

Derivatives not designated as cash flow hedging instruments:

        

Foreign exchange currency contracts

   Prepaid expenses and other

current assets

   $ 4.9       $ 0.7   
     

 

 

    

 

 

 
      $ 10.5       $ 1.2   
     

 

 

    

 

 

 

 

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     Derivative Balance
Sheet
Location
     Significant
Other
Observable
Inputs
(Level 2)
Fair Value at
September 30,
2013
     Significant
Other
Observable
Inputs
(Level 2)
Fair Value at
December 31,
2012
 
            (in millions)  

LIABILITIES:

        

Derivatives designated as cash flow hedging instruments:

        

Foreign exchange currency contracts relating to inventory and intercompany management fee hedges

     Accrued expenses       $ 4.2       $ 3.3   

Interest rate swaps

     Accrued expenses         —         $ 2.0   

Derivatives not designated as hedging instruments:

        

Foreign exchange currency contracts

     Accrued expenses       $ 0.5       $ 1.3   
     

 

 

    

 

 

 
      $ 4.7       $ 6.6   
     

 

 

    

 

 

 

The Company’s deferred compensation plan assets consist of Company owned life insurance policies. As these policies are recorded at their cash surrender value, they are not required to be included in the fair value table above. See Note 6, Employee Compensation Plans, to the Company’s 2012 10-K for a further description of its deferred compensation plan assets.

The following tables summarize the offsetting of the fair values of the Company’s derivative assets and derivative liabilities for presentation in the Company’s condensed consolidated balance sheet at September 30, 2013 and December 31, 2012:

 

     Offsetting of Derivative Assets  
     Gross
Amounts of
Recognized
Assets
     Gross
Amounts
Offset in the
Balance Sheet
    Net Amounts
of Assets
Presented in
the Balance
Sheet
 
     (In millions)  

September 30, 2013

       

Foreign exchange currency contracts

   $ 10.5       $ (4.2   $ 6.3   
  

 

 

    

 

 

   

 

 

 

Total

   $ 10.5       $ (4.2   $ 6.3   
  

 

 

    

 

 

   

 

 

 

December 31, 2012

       

Foreign exchange currency contracts

   $ 1.2       $ (1.2     —    
  

 

 

    

 

 

   

 

 

 

Total

   $ 1.2       $ (1.2     —    
  

 

 

    

 

 

   

 

 

 

 

     Offsetting of Derivative Liabilities  
     Gross
Amounts of
Recognized
Liabilities
     Gross
Amounts
Offset in the
Balance Sheet
    Net Amounts
of  Liabilities
Presented in
the  Balance
Sheet
 
     (In millions)  

September 30, 2013

       

Foreign exchange currency contracts

   $ 4.7       $ (4.2   $ 0.5   
  

 

 

    

 

 

   

 

 

 

Total

   $ 4.7       $ (4.2   $ 0.5   
  

 

 

    

 

 

   

 

 

 

December 31, 2012

       

Foreign exchange currency contracts

   $ 4.6       $ (1.2   $ 3.4   

Interest rate swaps

     2.0         —         2.0   
  

 

 

    

 

 

   

 

 

 

Total

   $ 6.6       $ (1.2   $ 5.4   
  

 

 

    

 

 

   

 

 

 

The Company offsets all of its derivative assets and derivative liabilities in its condensed consolidated balance sheet to the extent it maintains master netting arrangements with related financial institutions. As of September 30, 2013 and December 31, 2012, all of the Company’s derivatives were subject to master netting arrangements and no collateralization was required for the Company’s derivative assets and derivative liabilities.

 

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13. Professional Fees and Other Expenses

In late 2012, a hedge fund manager publicly raised allegations regarding the legality of the Company’s network marketing program and announced that the hedge fund manager had taken a significant short position regarding the Company’s common shares, leading to intense public scrutiny and significant stock price volatility. The Company believes that the hedge fund manager’s allegations are inaccurate and misleading. The Company has engaged legal and advisory firms to assist with responding to the allegations and to perform other related services in connection to these recent events. The Company recognizes the related expenses as a part of selling, general & administrative expenses within its consolidated statement of income. For the three and nine months ended September 30, 2013, the Company recorded approximately $6.3 million and $23.8 million, respectively, of professional fees and other expenses related to this matter.

Of the approximately $6.3 million and $23.8 million in expenses incurred during the three and nine months ended September 30, 2013, respectively, discussed above, approximately $1.5 million and $4.5 million, respectively, were recognized for advisory retainer fees. The minimum guaranteed retainer fees were approximately $5.5 million as of September 30, 2013 and the expense recognition of these fees could accelerate based on certain conditions.

The Company also had a cash settlement liability award, or the Liability Award, outstanding as of September 30, 2013, which is tied to the Company’s stock price and which only vests if certain conditions are met relating to the above matter. The fair value of the Liability Award will be revalued each quarter until settlement and the Company will recognize and adjust the expense over the expected requisite service period. The expense recognized during the three and nine months ended September 30, 2013, relating to the Liability Award was approximately $1.0 million and $2.3 million, respectively, and are included in the approximately $6.3 million and $23.8 million expense described above. The remaining unrecognized expense relating to the Liability Award was approximately $3.6 million as of September 30, 2013, based on the fair value of the Liability Award as of that date. The recognition of the unrecognized expense relating to the Liability Award could accelerate and change based on certain conditions.

14. Subsequent Events

On October 28, 2013, the Company announced that its board of directors approved a cash dividend of $0.30 per common share, payable on November 26, 2013 to shareholders of record as of November 12, 2013.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We are a leading global nutrition company that sells weight management products, nutritional supplements, energy, sports & fitness products and personal care products utilizing network marketing distribution. As of September 30, 2013, we sold our products to and through a network of 3.6 million distributors, which include approximately 0.2 million China sales representatives, sales officers, and independent service providers, many of whom are simply discount customers. In China, we currently sell our products through retail stores, sales representatives, sales officers and independent service providers. The Company is in the process of changing its terminology to identify “distributors” as “members”, and those members who participate in the business opportunity our network marketing program presents, as “sales leaders”.

We pursue our mission of “changing people’s lives” by providing high quality, science-based products to distributors and their customers who seek a healthy lifestyle and we also offer a financially rewarding business opportunity to those distributors who seek part time or full time income. We believe the global obesity epidemic has made our quality products more relevant and the effectiveness of our distribution network, coupled with geographic expansion, have been the primary reasons for our success throughout our 33-year operating history. As of September 30, 2013, we sold our products in 88 countries.

Our products are grouped in four principal categories: weight management; targeted nutrition; energy, sports & fitness; and Outer Nutrition, along with literature and promotional items. Our products are often sold through a series of related products and literature designed to simplify weight management and nutrition for consumers and maximize our distributors’ cross-selling opportunities.

Industry-wide factors that affect us and our competitors include the global obesity epidemic and the aging of the worldwide population, which are driving demand for weight management, nutrition and wellness-related products along with the global increase in under employment and unemployment which can affect the recruitment and retention of distributors seeking part time or full time income opportunities.

While we continue to monitor the current global financial environment, we remain focused on the opportunities and challenges in retailing of our products, recruiting and retaining distributors, improving distributor productivity, opening new markets, further penetrating existing markets, globalizing successful Distributor Methods of Operation, or DMOs, such as Nutrition Clubs and Weight Loss Challenges, introducing new products and globalizing existing products, developing niche market segments and further investing in our infrastructure. Management also continues to monitor the Venezuelan market and especially the limited ability to repatriate cash.

We report revenue from our six regions:

 

   

North America;

 

   

Mexico;

 

   

South and Central America;

 

   

EMEA, which consists of Europe, the Middle East and Africa;

 

   

Asia Pacific (excluding China); and

 

   

China.

Volume Points by Geographic Region

A key non-financial measure we focus on is Volume Points on a Royalty Basis, or Volume Points, which is essentially our weighted average measure of product sales volume. Volume Points, which are unaffected by exchange rates or price changes, are used by management as a proxy for sales trends because in general, an increase in Volume Points in a particular geographic region or country indicates an increase in our local currency net sales while a decrease in Volume Points in a particular geographic region or country indicates a decrease in our local currency net sales.

We assign a Volume Point value to a product when it is first introduced into a market and the value is unaffected by subsequent exchange rate and price changes. The specific number of Volume Points assigned to a product, and generally consistent across all markets, is based on a Volume Point to suggested retail price ratio for similar products. If a product is available in different quantities, the various sizes will have different Volume Point values. In general, once assigned, a Volume Point value is consistent in each region and country and does not change from year to year. The reason Volume Points are used in the manner described above is that we use Volume Points for distributor qualification and recognition purposes and therefore we attempt to keep Volume Points for a similar or like product consistent on a global basis. However, because Volume Points are a function of value rather than product type or size, they are not a reliable measure for product mix. As an example, an increase in Volume Points in a specific country or region could mean a significant increase in sales of less expensive products or a marginal increase in sales of more expensive products.

 

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Table of Contents
     Three Months Ended September 30,     Nine Months Ended September 30,  
     2013      2012      % Change     2013      2012      % Change  
     (Volume Points in millions)  

North America

     314.0         287.4         9.3     963.0         890.8         8.1

Mexico

     219.4         211.2         3.9     645.6         606.5         6.4

South & Central America

     245.2         186.0         31.8     687.6         517.9         32.8

EMEA

     173.5         145.5         19.2     514.1         445.9         15.3

Asia Pacific (excluding China)

     296.2         305.6         (3.1 %)      933.0         893.2         4.5

China

     97.4         57.1         70.6     230.9         156.0         48.0
  

 

 

    

 

 

      

 

 

    

 

 

    

Worldwide

     1,345.7         1,192.8         12.8     3,974.2         3,510.3         13.2
  

 

 

    

 

 

      

 

 

    

 

 

    

Average Active Sales Leaders by Geographic Region

With the continued expansion of daily consumption DMOs in our different markets and our objective to improve distributor retention, we believe the Average Active Sales Leader is a useful metric. It represents the monthly average number of sales leaders that place an order, including orders of non-sales leader distributors in their downline sales organization, during a given period. We rely on this metric as an indication of the engagement level of sales leaders in a given region. Changes in the Average Active Sales Leader metric may be indicative of potential for changes in annual retention levels and future sales growth.

 

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2013      2012      % Change     2013      2012      % Change  

North America

     74,085         67,826         9.2     71,573         65,395         9.4

Mexico

     64,633         60,123         7.5     62,596         56,256         11.3

South & Central America

     60,007         46,466         29.1     55,557         43,015         29.2

EMEA

     50,720         44,861         13.1     48,274         43,055         12.1

Asia Pacific (excluding China)

     72,886         66,433         9.7     70,792         61,156         15.8

China

     15,882         12,692         25.1     13,939         11,391         22.4

Worldwide(1)

     326,797         288,397         13.3     311,739         270,230         15.4

 

(1) Worldwide average active sales leaders may not equal the sum of the average active sales leaders in each region due to the calculation being an average of sales leaders active in a period, not a summation, and the fact that some sales leaders are active in more than one region but are counted only once in the worldwide amount.

Number of Sales Leaders and Retention Rates by Geographic Region as of Re-qualification Period

Our compensation system requires each sales leader to re-qualify for such status each year, prior to February, in order to maintain their 50% discount on products and be eligible to receive royalty payments. In February of each year, we demote from the rank of sales leader those distributors who did not satisfy the re-qualification requirements during the preceding twelve months. The re-qualification requirement does not apply to new sales leaders (i.e. those who became sales leaders subsequent to the January re-qualification of the prior year).

 

Sales Leaders Statistics (Excluding China)

   2013     2012  
     (In thousands)  

January 1 total sales leaders

     583.1        501.3   

January & February new sales leaders

     37.1        34.8   

Demoted sales leaders (did not re-qualify)

     (182.8     (151.3

Other sales leaders (resigned, etc)

     (1.3     (0.8
  

 

 

   

 

 

 

End of February total sales leaders

     436.1        384.0   
  

 

 

   

 

 

 

The distributor statistics below further highlight the calculation for retention.

 

Sales Leaders Retention (Excluding China)

   2013     2012  
     (In thousands)  

Sales leaders needed to re-qualify

     379.6        314.9   

Demoted sales leaders (did not re-qualify)

     (182.8     (151.3
  

 

 

   

 

 

 

Total re-qualified

     196.8        163.6   
  

 

 

   

 

 

 

Retention rate

     51.8     52.0
  

 

 

   

 

 

 

 

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The table below reflects the number of sales leaders as of the end of February of the year indicated (subsequent to the annual re-qualification date) and sales leader retention rate by year and by region.

 

     Number of Sales Leaders      Sales Leaders Retention Rate  
     2013      2012      2013     2012  

North America

     86,469         79,150         54.7     51.1

Mexico

     78,453         67,959         57.6     59.2

South & Central America

     79,351         65,653         53.6     55.7

EMEA

     57,071         55,121         60.7     61.5

Asia Pacific (excluding China)

     134,714         116,158         40.1     40.2
  

 

 

    

 

 

      

Total Sales Leaders

     436,058         384,041         51.8     52.0

China

     30,304         26,262        
  

 

 

    

 

 

      

Worldwide Total Sales Leaders

     466,362         410,303        
  

 

 

    

 

 

      

Sales leaders purchase most of our products for resale to other distributors and consumers. The number of sales leaders by geographic region as of the quarterly reporting dates will normally be higher than the number of sales leaders by geographic region as of the re-qualification period because sales leaders who do not re-qualify during the relevant twelve-month period will be removed from the rank of sales leader the following February. Comparisons of sales leader totals on a year-to-year basis are indicators of our recruitment and retention efforts in different geographic regions.

We provide distributors with products, support materials, training, special events and a competitive compensation program. If a distributor wants to pursue the Herbalife business opportunity, the distributor is responsible for growing his or her business and personally pays for the sales activities related to attracting new customers and recruiting distributors. Activities may include hosting events such as Herbalife Opportunity Meetings or Success Training Seminars; advertising Herbalife’s products; purchasing and using promotional materials such as t-shirts, buttons and caps; utilizing and paying for direct mail and print material such as brochures, flyers, catalogs, business cards, posters and banners and telephone book listings; purchasing inventory for sale or use as samples; and training and mentoring customers and recruits on how to use Herbalife products and/or pursue the Herbalife business opportunity.

Presentation

“Retail sales” represent the suggested retail price of products we sell to our distributors and is the gross sales amount reflected on our invoices. This is not the price paid to us by our distributors. Our distributors purchase product from us at a discount from the suggested retail price. We refer to these discounts as “Distributor Allowance”, and we refer to retail sales less distributor allowances as “Product Sales”.

Distributor allowances are stated percentages of up to 50% of suggested retail sales prices. Distributor allowances as a percentage of retail sales may vary by country depending upon regulatory restrictions that limit or otherwise restrict distributor allowances. We also offer reduced distributor allowances with respect to certain products worldwide. Each distributor’s level of discount is determined by qualification based on volume of purchases. In cases where a distributor has qualified for less than the maximum discount, the remaining discount, which we also refer to as a wholesale commission, is received by their sponsoring distributors. Therefore, product sales are recognized net of product returns and distributor allowances. See Critical Accounting Policies below for further discussion of product returns and distributor allowances.

“Net Sales” equal product sales plus “shipping and handling revenues”, and generally represents what we collect.

We do not have visibility to all of the sales from our independent distributors to their customers, but such a figure would differ from our reported “retail sales” by factors including (a) the amount of product purchased by our distributors for their own personal consumption and (b) prices charged by our distributors to their customers other than our suggested retail prices. We discuss retail sales because of its fundamental role in our systems, internal controls and operations, including its role as the basis upon which distributor discounts, royalties and bonuses are awarded. In addition, it is used as the basis for certain information included in daily and monthly reports reviewed by our management. However, such a measure is not in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. Retail sales should not be considered in isolation from, nor as a substitute for, net sales and other consolidated income or cash flow statement data prepared in accordance with U.S. GAAP, or as a measure of profitability or liquidity. A reconciliation of retail sales to net sales is presented below under Results of Operations.

Our international operations have provided and will continue to provide a significant portion of our total net sales. As a result, total net sales will continue to be affected by fluctuations in the U.S. dollar against foreign currencies. In order to provide a framework for assessing how our underlying businesses performed excluding the effect of foreign currency fluctuations, in addition to comparing the percent change in net sales from one period to another in U.S. dollars, we also compare the percent change in net sales from one period to another period using “net sales in local currency”. Net sales in local currency is not a U.S. GAAP financial measure. Net sales in local currency removes from net sales in U.S. dollars the impact of changes in exchange rates between the U.S. dollar and the

 

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functional currencies of our foreign subsidiaries, by translating the current period net sales into U.S. dollars using the same foreign currency exchange rates that were used to translate the net sales for the previous comparable period. We believe presenting net sales in local currency is useful to investors because it allows a meaningful comparison of net sales of our foreign operations from period to period. However, net sales in local currency measures should not be considered in isolation or as an alternative to net sales in U.S. dollars measures that reflect current period exchange rates, or to other financial measures calculated and presented in accordance with U.S. GAAP.

Our “gross profit” consists of net sales less “cost of sales,” which represents our manufacturing costs, the price we pay to our raw material suppliers and manufacturers of our products as well as shipping and handling costs including duties, tariffs, and similar expenses.

While all distributors can potentially profit from their activities by reselling our products for amounts greater than the prices they pay us, distributors that develop, retain, and manage other distributors can earn additional compensation for those activities, which we refer to as “Royalty overrides.” Royalty overrides are our most significant operating expense and consist of:

 

   

royalty overrides and production bonuses which total up to approximately 15% and 7%, respectively, of the retail sales of weight management, targeted nutrition, energy, sports & fitness, Outer Nutrition and promotional products;

 

   

the Mark Hughes bonus payable to some of our most senior distributors in the aggregate amount of up to 1% of retail sales of weight management, targeted nutrition, energy, sports & fitness, Outer Nutrition and promotional products; and

 

   

other discretionary incentive cash bonuses to qualifying distributors.

Royalty overrides provide potential earnings to distributors of up to 23% of retail sales or approximately up to 33% of our net sales. Royalty overrides are compensation to distributors for the development, retention and improved productivity of their sales organizations and are paid to several levels of distributors on each sale. Royalty overrides are compensation for services rendered to the Company and as such are recorded as an operating expense.

Due to restrictions on direct selling in China, our independent service providers in China are compensated with service fees instead of the distributor allowances and royalty overrides utilized in our traditional marketing program. Compensation to China independent service providers is included in selling, general and administrative expenses.

Because of local country regulatory constraints, we may be required to modify our distributor incentive plans as described above. We also pay reduced royalty overrides with respect to certain products worldwide. Consequently, the total royalty override percentage may vary over time and from the percentages noted above.

Royalty overrides together with distributor allowances of up to 50% of suggested retail sales prices represent the potential earnings to our distributors of up to approximately 73% of retail sales.

Our “contribution margins” consist of net sales less cost of sales and royalty overrides.

“Selling, general and administrative expenses” represent our operating expenses, which include labor and benefits, sales events, professional fees, travel and entertainment, distributor promotions, occupancy costs, communication costs, bank fees, depreciation and amortization, foreign exchange gains and losses and other miscellaneous operating expenses.

Most of our sales to distributors outside the United States are made in the respective local currencies. In preparing our financial statements, we translate revenues into U.S. dollars using average exchange rates. Additionally, the majority of our purchases from our suppliers generally are made in U.S. dollars. Consequently, a strengthening of the U.S. dollar versus a foreign currency can have a negative impact on our reported sales and contribution margins and can generate foreign currency losses on intercompany transactions. Foreign currency exchange rates can fluctuate significantly. From time to time, we enter into foreign exchange forward and option contracts to partially mitigate our foreign currency exchange risk as discussed in further detail in Part I, Item 3 — Quantitative and Qualitative Disclosures about Market Risk.

 

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Table of Contents

Summary Financial Results

Net sales for the three and nine months ended September 30, 2013 were $1,213.5 million and $3,556.4 million, respectively. Net sales increased $196.7 million, or 19.3%, and $543.4 million, or 18.0%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales for the three and nine months ended September 30, 2013 increased 20.5% and 18.5%, respectively, as compared to the same periods in 2012. The increase in net sales was primarily due to the continued successful adoption and operation of daily consumption DMOs; increased distributor engagement and an increase in average active sales leaders; branding activities; and increased distributor recruiting.

Net income for the three and nine months ended September 30, 2013 was $142.0 million, or $1.32 per diluted share, and $404.0 million, or $3.75 per diluted share, respectively. Net income increased $30.1 million, or 26.9%, and $52.2 million, or 14.8%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The increase for the three and nine months ended September 30, 2013 was primarily due to higher contribution margin driven by the sales growth discussed above partially offset by higher selling, general and administrative expenses to support the growth of our business and for the legal and advisory services described below and higher interest expense.

Net income for the three and nine months ended September 30, 2013 included approximately $6.3 million and $23.8 million, respectively, pre-tax unfavorable impact ($5.5 million and $20.6 million, respectively, post-tax) related to legal and advisory services and other expenses for the Company’s response to allegations and other negative information put forward in the marketplace by a hedge fund manager which started in late 2012 and approximately $6.2 million and $9.6 million, respectively, pre-tax unfavorable impact ($4.6 million and $7.3 million, respectively, post-tax) related to expenses for the re-audit of the Company’s 2010 to 2012 financial statements (See Selling, General and Administrative Expenses below for further discussion). Net income for the nine months ended September 30, 2013 also included a $15.1 million pre-tax unfavorable impact ($8.3 million post-tax) related to the Venezuela Bolivar devaluation (See Liquidity and Capital Resources — Working Capital and Operating Activities below for further discussion of currency exchange rate issues in Venezuela). The income tax impact of the expenses discussed above is based on forecasted items affecting the Company’s 2013 full year effective tax rate. Adjustments to forecasted items unrelated to these expenses may have an effect on the income tax impact of these items in subsequent periods.

Results of Operations

Our results of operations for the periods below are not necessarily indicative of results of operations for the full year or future periods, which depend upon numerous factors, including our ability to recruit new distributors and retain existing distributors, open new markets, further penetrate existing markets, introduce new products and programs that will help our distributors increase their retail efforts and develop niche market segments.

The following table sets forth selected results of our operations expressed as a percentage of net sales for the periods indicated:

 

     Three Months Ended     Nine Months Ended  
     September 30,
2013
    September 30,
2012
    September 30,
2013
    September 30,
2012
 

Operations:

        

Net sales

     100.0     100.0     100.0     100.0

Cost of sales

     19.6        19.8        20.0        20.0   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     80.4        80.2        80.0        80.0   

Royalty overrides(1)

     30.8        32.5        31.4        32.6   

Selling, general and administrative expenses(1)

     33.8        31.9        33.0        30.7   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating income

     15.8        15.8        15.6        16.7   

Interest expense, net

     0.4        0.3        0.4        0.3   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     15.4        15.5        15.2        16.4   

Income taxes

     3.7        4.5        3.8        4.7   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     11.7     11.0     11.4     11.7
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Service fees to our independent service providers in China are included in selling, general and administrative expenses while distributor compensation for all other countries is included in royalty overrides.

 

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Table of Contents

Net Sales

The following chart reconciles retail sales to net sales:

Sales by Geographic Region

 

    Three Months Ended September 30,        
    2013     2012        
    Retail
Sales
    Distributor
Allowance
    Product
Sales
    Shipping  &
Handling
Revenues
    Net
Sales
    Retail
Sales
    Distributor
Allowance
    Product
Sales
    Shipping  &
Handling
Revenues
    Net
Sales
    Change in
Net Sales
 
    (Dollars in millions)  

North America(1)

  $ 378.4      $ (172.2   $ 206.2      $ 22.5      $ 228.7      $ 331.9      $ (158.5   $ 173.4      $ 35.4      $ 208.8        9.5

Mexico(1)

    240.2        (111.5     128.7        12.5        141.2        206.0        (100.5     105.5        22.0        127.5        10.7

South & Central America

    375.7        (178.4     197.3        43.9        241.2        280.9        (137.5     143.4        24.1        167.5        44.0

EMEA

    293.5        (141.6     151.9        29.8        181.7        240.4        (116.8     123.6        23.9        147.5        23.2

Asia Pacific

    433.3        (191.0     242.3        41.7        284.0        449.5        (203.3     246.2        42.0        288.2        (1.5 )% 

China

    161.6        (25.0     136.6        0.1       136.7        92.8        (15.4     77.4        —         77.4        76.6
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

Worldwide

  $ 1,882.7      $ (819.7   $ 1,063.0      $ 150.5      $ 1,213.5      $ 1,601.5      $ (732.0   $ 869.5      $ 147.4      $ 1,016.9        19.3
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   
    Nine Months Ended September 30,        
    2013     2012        
    Retail
Sales
    Distributor
Allowance
    Product
Sales
    Shipping  &
Handling
Revenues
    Net
Sales
    Retail
Sales
    Distributor
Allowance
    Product
Sales
    Shipping  &
Handling
Revenues
    Net
Sales
    Change in
Net Sales
 
    (Dollars in millions)  

North America(1)

  $ 1,136.1      $ (526.3   $ 609.8      $ 87.8      $ 697.6      $ 1,021.4      $ (486.3   $ 535.1      $ 109.1      $ 644.2        8.3

Mexico(1)

    690.8        (331.8     359.0        60.8        419.8        588.4        (287.2     301.2        62.8        364.0        15.3

South & Central America

    1,068.3        (505.7     562.6        120.5        683.1        804.7        (388.2     416.5        69.1        485.6        40.7

EMEA

    868.0        (417.6     450.4        87.2        537.6        750.4        (362.8     387.6        75.5        463.1        16.1

Asia Pacific

    1,379.6        (614.8     764.8        130.2        895.0        1,319.8        (597.4     722.4        122.3        844.7        6.0

China

    381.6        (58.6     323.0        0.3        323.3        254.2        (42.8     211.4        —         211.4        52.9
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

Worldwide

  $ 5,524.4      $ (2,454.8   $ 3,069.6      $ 486.8      $ 3,556.4      $ 4,738.9      $ (2,164.7   $ 2,574.2      $ 438.8      $ 3,013.0        18.0
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

(1) During the second quarter of 2013 for the North America region and the third quarter of 2013 for the Mexico region, we simplified our pricing structure by increasing suggested retail prices and reducing total shipping and handling revenues by a similar amount, eliminating a “packaging and handling” line item from our invoices to distributors. We do not expect these changes to materially impact our consolidated net sales and profitability. We anticipate extending these changes to additional markets in future periods.

Changes in net sales are directly associated with the recruiting and retention of our distributor force, retailing of our products, the quality and completeness of our product offerings that the distributor force has to sell and the number of countries in which we operate. Management’s role, both in-country and at the region and corporate level, is to provide distributors with a competitive and broad product line, encourage strong teamwork and distributor leadership and offer leading edge business tools and technology services to make doing business with Herbalife simple. Management uses the distributor marketing program coupled with educational and motivational tools and promotions to encourage distributors to increase recruiting, retention and retailing, which in turn affect net sales. Such tools include Company sponsored sales events such as Extravaganzas, Leadership Development Weekends and World Team Schools where large groups of distributors gather, thus allowing them to network with other distributors, learn recruiting, retention and retailing techniques from our leading distributors and become more familiar with how to market and sell our products and business opportunities. Accordingly, management believes that these development and motivation programs increase the productivity of the sales leader network. The expenses for such programs are included in selling, general and administrative expenses. Sales are driven by several factors, including the number and productivity of distributors and sales leaders who continually build, educate and motivate their respective distribution and sales organizations. We also use event and non-event product promotions to motivate distributors to increase recruiting, retention and retailing activities. These promotions have prizes ranging from qualifying for events to product prizes and vacations. The costs of these promotions are included in selling, general and administrative expenses.

The factors described above have helped distributors increase their business, which in turn helps drive Volume Point growth in our business, and thus, net sales growth. The discussion below of net sales by geographic region further details some of the specific drivers of growth of our business and causes of sales fluctuations during the three and nine months ended September 30, 2013 as compared to the same periods in 2012, as well as the unique growth or contraction factors specific to certain geographic regions or

 

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significant countries within a region during these periods. We believe that the correct business foundation, coupled with ongoing training and promotional initiatives, is required to increase recruiting and retention of distributors and retailing of our products. The correct business foundation includes strong country management that works closely with the distributor leadership, actively engaged and unified distributor leadership, a broad product line that appeals to local consumer needs, a favorable regulatory environment, a scalable and stable technology platform and an attractive distributor marketing plan. Initiatives, such as Success Training Seminars, Leadership Development Weekends, Promotional Events and regional Extravaganzas are integral components of developing a highly motivated and educated distributor sales organization that will work toward increasing the recruitment and retention of distributors.

We anticipate that our strategy will continue to include creating and maintaining growth within existing markets while expanding into new markets. In addition, new ideas and DMOs are being generated in many of our markets and are globalized where applicable through the combined efforts of distributors, country management or regional and corporate management. While we support a number of different DMOs, one of the more popular DMOs is the daily consumption DMO. Under our traditional DMO, a distributor typically sells to its customers on a somewhat infrequent basis (e.g., monthly) which provides fewer opportunities for interaction with their customers. Under a daily consumption DMO, a distributor interacts with its customers on a more frequent basis which enables the distributor to better educate and advise customers about nutrition and the proper use of the products and helps promote daily usage as well, thereby helping the distributor grow his or her business. Specific examples of DMOs include the Club concept in Mexico, Premium Herbalife Opportunity Meetings in Korea, the Healthy Breakfast concept in Russia, and the Internet/Sampling and Weight Loss Challenge in the U.S. Management’s strategy is to review the applicability of expanding successful country initiatives throughout a region, and where appropriate, financially support the globalization of these initiatives.

North America

The North America region reported net sales of $228.7 million and $697.6 million for the three and nine months ended September 30, 2013, respectively. Net sales increased $19.9 million, or 9.5%, and $53.4 million, or 8.3%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales increased 9.6% and 8.3% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The overall increase in net sales in the region was a result of net sales growth in the U.S. of $20.6 million, or 10.2%, and $55.9 million, or 8.9%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012.

In the U.S. we continue to see success from consistent execution of daily consumption DMOs, especially the Nutrition Club model. The success of these DMOs has resulted in higher levels of distributor engagement and activity.

Average active sales leaders in the region increased 9.2% and 9.4% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. Average active sales leaders in the U.S. increased 9.3% and 9.4% for the three and nine months ended September 30, 2013, as compared to the same periods in 2012.

In July, the region hosted a series of General Market trainings in thirteen cities with a total of approximately 7,800 attendees.

Mexico

The Mexico region reported net sales of $141.2 million and $419.8 million for the three and nine months ended September 30, 2013, respectively. Net sales for the three and nine months ended September 30, 2013 increased $13.7 million, or 10.7%, and $55.8 million, or 15.3%, respectively, as compared to the same periods in 2012. In local currency, net sales for the three and nine months ended September 30, 2013 increased 8.7% and 10.5%, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had a favorable impact of $2.7 million and $17.6 million on net sales for the three and nine months ended September 30, 2013, respectively.

The growth in net sales is primarily the result of increased distributor engagement as well as the continued success of the Nutrition Club DMO. One of the recent growth drivers in Mexico has been the ongoing transition by many distributors from home clubs to commercial clubs, which are able to generate higher volumes of sales through the servicing of more customers and longer operating hours. Mexico also had 1% price increases in October 2012, December 2012, and February 2013 which contributed to the increase in net sales.

Average active sales leaders in Mexico increased 7.5% and 11.3% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012.

In September, the region hosted an Extravaganza in Mexico City and in Guadalajara with a total of approximately 28,300 attendees.

South and Central America

The South and Central America region reported net sales of $241.2 million and $683.1 million for the three and nine months ended September 30, 2013, respectively. Net sales increased $73.7 million, or 44.0%, and $197.5 million, or 40.7%, for the three and

 

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nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales increased 53.2% and 48.0% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had a $15.4 million and $35.5 million unfavorable impact on net sales for the three and nine months ended September 30, 2013, respectively. The increase in net sales for the three and nine months ended September 30, 2013 was due to growth in almost every country in the region led by Venezuela, Brazil, and Colombia. This growth was primarily driven by the adoption and expansion of the Nutrition Club and other daily consumption DMOs throughout the region. Net sales of the significant countries in the region are discussed below.

Net sales in Brazil increased $12.0 million, or 16.5%, and $49.3 million, or 21.8%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales increased 31.5% and 34.7% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had a $10.9 million and $29.0 million unfavorable impact on net sales in Brazil for the three and nine months ended September 30, 2013, respectively. The increase in local currency net sales was primarily the result of the successful ongoing adoption of Nutrition Clubs and other daily consumption DMOs. Brazil also had a price increase of approximately 4% in March 2013 which contributed to the increased sales.

Net sales in Venezuela increased $34.4 million, or 93.7%, and $82.8 million, or 91.7%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The overall sales growth was primarily due to increased distributor engagement and growth in the Nutrition Club DMO. Venezuela also had price increases of 15% in December 2012, 17% in April 2013, and 19% in July 2013, all of which contributed to the increase in sales. The rate for which we remeasure sales in Venezuela was officially devalued from 5.3 Venezuelan Bolivars per U.S. dollar to 6.3 Venezuelan Bolivars per U.S. dollar during February 2013, and had a $13.4 million and $29.0 million unfavorable impact on net sales in Venezuela for the three and nine months ended September 30, 2013, respectively. See Liquidity and Capital Resources — Working Capital and Operating Activities below for further discussion of currency exchange rate issues in Venezuela.

Average active sales leaders in the region increased 29.1% and 29.2% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012.

There were no major company sponsored events in the region during the quarter.

EMEA

The EMEA region reported net sales of $181.7 million and $537.6 million for the three and nine months ended September 30, 2013, respectively. Net sales increased $34.2 million, or 23.2%, and $74.5 million, or 16.1%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales increased 21.0% and 15.4% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had a $3.3 million and $3.0 million favorable impact on net sales for the three and nine months ended September 30, 2013. The increase in net sales for the three and nine months ended September 30, 2013 was primarily driven by the United Kingdom, Russia, Spain and Italy. Net sales of the significant countries in the region are discussed below.

Net sales in Russia increased $6.5 million, or 27.8%, and $18.9 million, or 27.0%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales increased 31.2% and 29.6% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had a $0.8 million and $1.8 million unfavorable impact on net sales in Russia for the three and nine months ended September 30, 2013, respectively. The increase in Russia was driven by the ongoing adoption of the Commercial Nutrition Club, additional sales centers which have increased access to our products and improving brand image including the sponsorship of FC Spartak Moscow football club.

Net sales in Italy increased $5.8 million, or 26.6%, and $7.9 million, or 10.7%, for the three and nine months ended September 30, 2013, respectively as compared to the same periods in 2012. In local currency, net sales increased 19.7% and 7.7% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had a $1.5 million and $2.2 million favorable impact on net sales in Italy for the three and nine months ended September 30, 2013, respectively. Italy has now had two consecutive quarters of positive year-over-year sales growth. Management believes this is a strong indication that the market is embracing the daily consumption DMO.

Net sales in Spain increased $3.9 million, or 26.9%, and $10.0 million, or 25.1%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales in Spain increased 19.9% and 21.5% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had a $1.0 million and $1.4 million favorable impact on net sales in Spain for the three and nine months ended September 30, 2013, respectively. The increase in Spain was mainly due to the positive effect of increased distributor engagement and recruitment.

 

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Net sales in the United Kingdom increased $7.9 million, or 93.4%, and $19.1 million, or 83.1%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales in the United Kingdom increased 97.2% and 87.1% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had a $0.3 million and $0.9 million unfavorable impact on net sales in the United Kingdom for the three and nine months ended September 30, 2013, respectively. The increase in the United Kingdom was primarily due to the successful adoption of Nutrition Clubs and Weight Loss Challenge DMO.

Average active sales leaders in the region increased 13.1% and 12.1% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012.

In September, the region hosted four Extravaganzas including two in Russia (St. Petersburg and Krasnoyarsk), one in Istanbul, Turkey, and one in Cologne, Germany. The Germany and Turkey events had approximately 15,000 and 3,900 attendees, respectively, while the Russia events had a total of approximately 8,100 attendees.

Asia Pacific

The Asia Pacific region, which excludes China, reported net sales of $284.0 million and $895.0 million for the three and nine months ended September 30, 2013, respectively. Net sales decreased $4.2 million, or 1.5%, and increased $50.3 million, or 6.0%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales increased 1.1% and 6.8% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had an unfavorable impact of $7.3 million and $7.5 million on net sales for the three and nine months ended September 30, 2013, respectively. The increase in local currency net sales for the three months ended September 30, 2013 was primarily driven by Indonesia and mostly offset by decreases in Taiwan and Malaysia. The increase in local currency net sales for the nine months ended September 30, 2013 reflected growth in several countries in the region led by Indonesia, South Korea, and Vietnam. Net sales of the significant countries in the region are discussed below.

Net sales in South Korea increased $2.1 million, or 1.9%, and $18.6 million, or 5.9%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales decreased 0.2% and increased 2.9% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had a favorable impact on net sales of $2.3 million and $9.6 million for the three and nine months ended September 30, 2013, respectively. The slight local currency decrease in net sales for the three months ended September 30, 2013 reflects a decline in the average productivity of existing Nutrition Clubs, somewhat offset by a modest increase in the number of Nutrition Clubs. The increase in net sales for the nine months ended September 30, 2013 continues to be driven by the successful adoption and operation of the Nutrition Club and other daily consumption DMOs along with the Mega and Premium Herbalife Opportunity Meetings.

Net sales in Taiwan decreased $7.8 million, or 19.6%, and $3.4 million, or 2.9%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales decreased 19.5% and 2.9% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates did not have a significant impact on net sales for the three and nine months ended September 30, 2013, respectively. Taiwan had their first price increase in almost three years in April and volume in subsequent months was lower than normal as a result. In addition, Taiwan is currently transitioning its focus towards more stable growth based on sales leader qualifications such as the 5,000 volume points in 12 months method, while placing less emphasis on shorter-term qualifications which also resulted in a temporarily decline in their sales during the transition period. Despite the decrease in net sales for the three months ended September 30, 2013, we believe the overall long trend is favorable and will be driven by the Nutrition Clubs DMO.

Net sales in India decreased $2.2 million, or 5.9%, and increased $2.8 million, or 2.7%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales increased 5.5% and 10.8% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had an unfavorable impact on net sales of $4.2 million and $8.4 million for the three and nine months ended September 30, 2013, respectively. The increase in local currency net sales for the three and nine months ended September 30, 2013 was primarily driven by increased product access and the successful adoption of the daily consumption DMOs, especially the Nutrition Club.

Net sales in Indonesia increased $8.8 million, or 44.1%, and $31.3 million, or 46.3%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales increased 60.6% and 57.5% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had an unfavorable impact on net sales of $3.3 million and $7.6 million for the three and nine months ended September 30, 2013, respectively. The primary catalyst driving the sales increase in Indonesia continues to be the growth in daily consumption DMOs, primarily Nutrition Clubs.

Net sales in Malaysia decreased $6.2 million, or 21.5%, and $3.1 million, or 3.5%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales decreased 18.8% and 2.7% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had an unfavorable impact on net sales of $0.8 million and $0.7 million for the three and nine months ended September 30, 2013, respectively. The decrease in net sales for the three months ended September 30, 2013 reflects, in part, the opening of a competitor in the country and the move of several distributors to the new company. We believe this is a short-term issue

 

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and that the impact on sales will be less going forward. In addition, during 2012 we saw tremendous growth in Nutrition Home Clubs. Some of these clubs received insufficient training and have declined in number and activity levels as a result. We are working with distributor leadership in Malaysia to address these training issues. We believe that the underlying DMO’s currently used by distributors in the country (Nutrition Clubs, Road Shows, and Mega Herbalife Opportunity Meetings) provide for a solid base of growth going forward.

Average active sales leaders in the region increased 9.7% and 15.8% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012.

There were no major company sponsored events in the region during the quarter.

China

Net sales in China were $136.7 million and $323.3 million for the three and nine months ended September 30, 2013, respectively. Net sales increased $59.3 million, or 76.6%, and $111.9 million, or 52.9%, for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. In local currency, net sales increased 70.3% and 48.6% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. The fluctuation of foreign currency rates had a favorable impact of $4.9 million and $9.1 million on net sales for the three and nine months ended September 30, 2013, respectively. The increase in net sales was driven by the continuing adoption and acculturation of daily consumption DMOs. In addition, sales have benefited from distributor acceptance of a trial Preferred Customer program which was launched earlier this year as well as on-line ordering.

Average active sales leaders in China increased 25.1% and 22.4% for the three and nine months ended September 30, 2013, respectively, as compared to the same periods in 2012. We believe that the increase in distributor engagement as reflected in the average active sales leader numbers is indicative of the market transitioning to daily consumption DMOs.

A Healthy & Activity Tour was held in five cities in July with a total of approximately 7,500 attendees.

As of September 30, 2013, we were operating 67 retail stores in 29 provinces in China. As of September 30, 2013, we had direct selling licenses for 25 out of the 29 provinces in which we were operating. We continue to seek additional provincial licenses where appropriate.

Sales by Product Category

 

    Three Months Ended September 30,        
    2013     2012        
    Retail
Sales
    Distributor
Allowance
    Product
Sales
    Shipping  &
Handling
Revenues
    Net
Sales
    Retail
Sales
    Distributor
Allowance
    Product
Sales
    Shipping  &
Handling
Revenues
    Net
Sales
    % Change in
Net Sales
 
    (In millions)  

Weight Management

  $ 1,224.9      $ (549.9   $ 675.0      $ 97.9      $ 772.9      $ 1,026.8      $ (485.4   $ 541.4      $ 94.5      $ 635.9        21.5

Targeted Nutrition

    444.9        (199.8     245.1        35.6        280.7        383.1        (181.0     202.1        35.3        237.4        18.2

Energy, Sports and Fitness

    103.8        (46.7     57.1        8.4        65.5        88.4        (41.7     46.7        8.1        54.8        19.5

Outer Nutrition

    57.7        (25.8     31.9        4.5        36.4        55.3        (26.2     29.1        5.1        34.2        6.4

Literature, Promotional and Other(1)

    51.4        2.5        53.9        4.1        58.0        47.9        2.3        50.2        4.4        54.6        6.2
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

Total

  $ 1,882.7      $ (819.7   $ 1,063.0      $ 150.5      $ 1,213.5      $ 1,601.5      $ (732.0   $ 869.5      $ 147.4      $ 1,016.9        19.3
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   
    Nine Months Ended September 30,        
    2013     2012        
    Retail
Sales
    Distributor
Allowance
    Product
Sales
    Shipping &
Handling
Revenues
    Net
Sales
    Retail
Sales
    Distributor
Allowance
    Product
Sales
    Shipping  &
Handling
Revenues
    Net
Sales
    % Change in
Net Sales
 
    (In millions)  

Weight Management

  $ 3,595.0      $ (1,649.1   $ 1,945.9      $ 316.8      $ 2,262.7      $ 3,038.7      $ (1,435.6   $ 1,603.1      $ 281.4      $ 1,884.5        20.1

Targeted Nutrition

    1,295.1        (594.1     701.0        114.1        815.1        1,134.0        (535.7     598.3        105.0        703.3        15.9

Energy, Sports and Fitness

    300.1        (137.7     162.4        26.5        188.9        250.5        (118.3     132.2        23.2        155.4        21.6

Outer Nutrition

    178.6        (81.9     96.7        15.7        112.4        175.2        (82.8     92.4        16.2        108.6        3.5

Literature, Promotional and Other(1)

    155.6        8.0        163.6        13.7        177.3        140.5        7.7        148.2        13.0        161.2        10.0
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

Total

  $ 5,524.4      $ (2,454.8   $ 3,069.6      $ 486.8      $ 3,556.4      $ 4,738.9      $ (2,164.7   $ 2,574.2      $ 438.8      $ 3,013.0        18.0
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

(1) Product buybacks and returns in all product categories are included in the literature, promotional and other category.

Net sales for all product categories increased for the three and nine months ended September 30, 2013 as compared to the same periods in 2012. The growth factors described in the above discussions of the individual geographic regions apply generally to all product categories.

 

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Gross Profit

Gross profit was $975.1 million and $2,844.8 million for the three and nine months ended September 30, 2013, respectively, as compared to $815.3 million and $2,411.5 million for the same periods in 2012. As a percentage of net sales, gross profit for the three months ended September 30, 2013 increased to 80.4% as compared to 80.2% for the same period in 2012 while gross profit for the nine months ended September 30, 2013 remained unchanged at 80.0% as compared to the same period in 2012. The 20 basis point net increase for the three months ended September 30, 2013, as compared to the same period in 2012, was primarily due to the favorable impact from retail price increases and country mix, partially offset by unfavorable inventory write-downs and higher other costs. For the nine months ended September 30, 2013 the favorable impact from retail price increases was primarily offset by the unfavorable impact of inventory write-downs and foreign currency fluctuations.

Royalty Overrides

Royalty overrides were $373.2 million and $1,116.8 million for the three and nine months ended September 30, 2013, respectively, as compared to $330.2 million and $983.0 million for the same periods in 2012. Royalty overrides as a percentage of net sales was 30.8% and 31.4% for the three and nine months ended September 30, 2013, respectively, as compared to 32.5% and 32.6% for the same periods in 2012. Generally, this ratio varies slightly from period to period due to changes in the mix of products and countries because full royalty overrides are not paid on certain products and in certain countries. Compensation to our independent service providers in China is included in selling, general and administrative expenses as opposed to royalty overrides where it is included for all other distributors under our worldwide marketing plan. We anticipate fluctuations in royalty overrides as a percentage of net sales reflecting the growth prospect of our China business relative to that of our worldwide business.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $409.7 million and $1,174.6 million for the three and nine months ended September 30, 2013, respectively, as compared to $324.2 million and $926.9 million for the same periods in 2012. Selling, general and administrative expenses as a percentage of net sales were 33.8% and 33.0% for the three and nine months ended September 30, 2013, respectively, as compared to 31.9% and 30.7% for and the same periods in 2012.

The increase in selling, general and administrative expenses for the three months ended September 30, 2013 included $20.5 million in higher salaries, bonuses and benefits; $6.3 million in expenses associated with our response to allegations and other negative information put forward by a hedge fund manager, as further discussed below; $6.2 million in expenses for the re-audit of our 2010 to 2012 financial statements; $26.6 million in higher expenses related to China independent service providers and $4.9 million in higher net foreign exchange loss.

The increase in selling, general and administrative expenses for the nine months ended September 30, 2013 included $56.3 million in higher salaries, bonuses and benefits; $23.8 million in expenses associated with our response to allegations and other negative information put forward by a hedge fund manager, as further discussed below; $9.6 million in expenses for the re-audit of our 2010 to 2012 financial statements; higher variable expenses related to sales growth including $25.0 million in higher distributor promotion, event costs, and advertising expense; $52.0 million in higher expenses related to China independent service providers; $11.4 million in higher non-income tax expenses such as value added tax and sales tax and $18.6 million in higher net foreign exchange loss, which included a $15.1 million net foreign exchange loss related to the remeasurement of the Company’s Bolivar denominated monetary assets and liabilities resulting from the Venezuela Bolivar devaluation (See Liquidity and Capital Resources — Working Capital and Operating Activities, for further discussion of currency exchange rate issues in Venezuela).

In late 2012, a hedge fund manager publicly raised allegations regarding the legality of the Company’s network marketing program and announced that the hedge fund manager had taken a significant short position regarding our common shares, leading to intense public scrutiny and significant stock price volatility. We have engaged legal and advisory services firms to assist with responding to the allegations and to perform other related services in connection to these events. For the three and nine months ended September 30, 2013, we recorded approximately $6.3 million and $23.8 million, respectively, of expenses related to this matter, and of which approximately $5.7 million and $21.2 million, respectively, were related to legal, advisory and other professional service fees. We expect to continue to incur expenses related to this matter over the next several periods and the expenses are expected to vary from period to period.

As discussed further in Item 1A, Risk Factors, on April 8, 2013, our former independent registered public accounting firm, KPMG, resigned and has withdrawn their audit opinions for the years ended December 31, 2012, 2011, and 2010. The Company engaged PricewaterhouseCoopers LLP, or PwC, as its new independent registered public accounting firm and is currently undergoing a re-audit of its prior years’ financial statements. For the three and nine months ended September 30, 2013, we recorded approximately $6.2 million and $9.6 million, respectively, in re-audit fees and expenses.

 

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Net Interest Expense

Net interest expense is as follows:

 

     Three Months Ended     Nine Months Ended  
     September 30,
2013
    September 30,
2012
    September 30,
2013
    September 30,
2012
 
     (Dollars in millions)  

Interest expense

     6.7        5.0        21.1        12.4   

Interest income

     (2.0     (1.5     (5.4     (4.3
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest expense

   $ 4.7      $ 3.5      $ 15.7      $ 8.1   
  

 

 

   

 

 

   

 

 

   

 

 

 

The increase in net interest expense for the three and nine months ended September 30, 2013, as compared to the same periods in 2012, was primarily due to higher outstanding balances on our Credit Facility discussed below.

Income Taxes

Income taxes were $45.5 million and $133.8 million for the three and nine months ended September 30, 2013, as compared to $45.4 million and $141.8 million for the same periods in 2012. The effective income tax rate was 24.3% and 24.9% for the three and nine months ended September 30, 2013, as compared to 28.9% and 28.7% for the same periods in 2012. The decrease in the effective tax rate for the three and nine months ended September 30, 2013, as compared to the same periods in 2012, was primarily due to an increase of net benefits from discrete events, principally related to the expiration of statute of limitations related to certain tax contingencies and tax planning items related to certain income tax return filings, partially offset by the impact of changes in the geographic mix of our income.

Liquidity and Capital Resources

We have historically met our working capital and capital expenditure requirements, including funding for expansion of operations, through net cash flows provided by operating activities. Variations in sales of our products would directly affect the availability of funds. There are no material contractual restrictions on the ability to transfer and remit funds among our international affiliated companies. However, there are foreign currency restrictions in certain countries, such as Venezuela as discussed below, which could reduce our ability to timely obtain U.S. dollars. Even with these restrictions, we believe we will have sufficient resources, including cash flow from operating activities, to meet debt service obligations in a timely manner and be able to continue to meet our objectives.

Our existing debt has not resulted from the need to fund our normal operations, but instead has resulted from our previous and ongoing share repurchase program. Since inception in 2007, total share repurchases amounted to approximately $1.8 billion. While a significant net sales decline could potentially affect the availability of funds, many of our largest expenses are variable in nature, which we believe protects our funding in all but a dramatic net sales downturn. Further, as discussed in greater detail below, we maintain the Credit Facility, executed on March 9, 2011 and amended on July 26, 2012, which had $198.1 million of undrawn capacity as of September 30, 2013. As discussed further below, on July 26, 2012, we amended the Credit Facility and entered into a $500.0 million term loan with a syndicate of financial institutions which matures in March 2016, or the Term Loan.

We utilized the majority of the proceeds from the Term Loan to pay down our outstanding balance on our revolving credit facility, which then provided us with additional undrawn capacity. This available undrawn capacity, in addition to cash flow from operations, can be used to support general corporate purposes, including, our future share repurchase programs, dividends, and strategic investment opportunities.

We also have a cash pooling arrangement with a financial institution for cash management purposes. This cash pooling arrangement allows certain of our participating subsidiaries to withdraw cash from this financial institution based upon our aggregate cash deposits held by subsidiaries who participate in the cash pooling arrangement. We did not owe any amounts to this financial institution under the pooling arrangement as of September 30, 2013 and December 31, 2012.

For the nine months ended September 30, 2013, we generated $577.0 million of operating cash flow, as compared to $399.9 million for the same period in 2012. The increase in cash generated from operations was primarily due to an increase in operating income of $51.8 million driven by a 18.0% growth in net sales for the nine months ended September 30, 2013 as compared to the same period in 2012.

Capital expenditures, including accrued capital expenditures, for the nine months ended September 30, 2013 and 2012 were $89.5 million and $59.9 million, respectively. The majority of these expenditures represented investments in technology infrastructure and initiatives to develop web-based distributor tools, and the expansion of our warehouses, sales centers and manufacturing facilities domestically and internationally. We expect to incur total capital expenditures of approximately $170 million to $180 million for the full year of 2013, which includes capital expenditures associated with the Herbalife Innovation and Manufacturing Winston-Salem, North Carolina facility that was acquired in December 2012.

 

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In March 2013, Herbalife hosted its annual global Herbalife Summit event in Paris, France where President Team members from around the world met and shared best practices, conducted leadership training and Herbalife management awarded distributors $61.7 million of Mark Hughes bonus payments related to 2012 performance.

On March 9, 2011, we entered into a $700 million senior secured revolving credit facility, or the Credit Facility, with a syndicate of financial institutions as lenders and terminated our prior senior secured credit facility, or the Prior Credit Facility. The Credit Facility has a five year maturity and expires on March 9, 2016. Based on our consolidated leverage ratio, U.S. dollar borrowings under the Credit Facility bear interest at either LIBOR plus the applicable margin between 1.50% and 2.50% or the base rate plus the applicable margin between 0.50% and 1.50%. The base rate under the Credit Facility represents the highest of the Federal Funds Rate plus 0.50%, one-month LIBOR plus 1.00%, and the prime rate offered by Bank of America. We, based on our consolidated leverage ratio, pay a commitment fee between 0.25% and 0.50% per annum on the unused portion of the Credit Facility. The Credit Facility also permits us to borrow limited amounts in Mexican Peso and Euro currencies based on variable rates.

In March 2011, we used $196.0 million in U.S. dollar borrowings under the Credit Facility to repay all amounts outstanding under the Prior Credit Facility. We incurred approximately $5.7 million of debt issuance costs in connection with the Credit Facility. These debt issuance costs were recorded as deferred financing costs on our consolidated balance sheet and are being amortized over the term of the Credit Facility.

On July 26, 2012, we amended the Credit Facility to include the Term Loan and used all $500.0 million of the borrowings under the Term Loan to pay down amounts outstanding under our revolving credit facility. The Term Loan is a part of the Credit Facility and is in addition to our current revolving credit facility. The Term Loan matures on March 9, 2016. We will make regular scheduled payments for the Term Loan consisting of both principal and interest components. Based on our consolidated leverage ratio, the Term Loan bears interest at either LIBOR plus the applicable margin between 1.50% and 2.50% or the base rate plus the applicable margin between 0.50% and 1.50%, which are the same terms as our revolving credit facility.

We incurred approximately $4.5 million of debt issuance costs in connection with the Term Loan. The debt issuance costs are recorded as deferred financing costs on our consolidated balance sheet and will be amortized over the life of the Term Loan. On September 30, 2013 and December 31, 2012, the weighted average interest rate for borrowings under the Credit Facility, including borrowings under the Term Loan, was 2.18% and 1.96%, respectively.

The Credit Facility requires us to comply with a leverage ratio and a coverage ratio. In addition, the Credit Facility contains customary covenants, including covenants that limit or restrict our ability to incur liens, incur indebtedness, make investments, dispose of assets, make certain restricted payments, pay dividends, repurchase our common shares, merge or consolidate and enter into certain transactions with affiliates. As of September 30, 2013 and December 31, 2012, we were in compliance with the debt covenants under the Credit Facility.

During the three months ended March 31, 2013, we borrowed $513.0 million and paid a total of $25.5 million under the Credit Facility. During the three months ended June 30, 2013, we paid a total of $12.5 million under the Credit Facility. We did not make any borrowings under the Credit Facility during the three months ended June 30, 2013. During the three months ended September 30, 2013, we borrowed $250.0 million and paid a total of $262.5 million under the Credit Facility. Our borrowings primarily related to the $272.4 million in repurchases of our common stock during the nine months ended September 30, 2013. The remaining outstanding borrowings have generated an increase in our cash and cash equivalents, which provides us with greater flexibility to execute strategic initiatives and to be opportunistically responsive to future events. As of September 30, 2013 and December 31, 2012, the U.S. dollar amount outstanding under the Credit Facility was $950.0 million and $487.5 million, respectively. Of the $950.0 million U.S. dollar amount outstanding under the Credit Facility as of September 30, 2013, $450.0 million was outstanding on the Term Loan and $500.0 million was outstanding on the revolving credit facility. The $487.5 million U.S. dollar amount outstanding under the Credit Facility as of December 31, 2012, related to the Term Loan and there were no amounts outstanding on the revolving credit facility. There were no outstanding foreign currency borrowings as of September 30, 2013 and December 31, 2012 under the Credit Facility.

We use our revolving credit facility to manage normal variations in cash created by significant cash items such as taxes, dividends, share repurchases, capital expenditures and other large cash flow items. Our revolving credit facility provides us with the ability to access significant funds on a timely basis. We repay outstanding balances from cash from operations.

As discussed further in Note 2, Significant Accounting Policies, to the Condensed Consolidated Financial Statements, our former independent registered public accounting firm, KPMG, resigned and has withdrawn their audit opinions for the years ended December 31, 2012, 2011 and 2010. Although our Credit Facility is currently not impacted, there is a possibility that this may impact our ability to obtain additional financing, if needed, from additional banks as audited financial statements are generally required in order to obtain additional financing. If we do obtain additional financing, the interest rates on those new borrowings could be higher than expected because of KPMG’s withdrawal of its audit opinions for the last three completed fiscal years. We believe we will have

 

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adequate cash flows from operations and continue to have access to our current Credit Facility in order to continue executing our current business objectives. We are assessing our current situation and our recently selected independent registered public accounting firm, PricewaterhouseCoopers LLP, is re-auditing our financial statements for the fiscal years ended December 31, 2012, 2011 and 2010.

Off-Balance Sheet Arrangements

At September 30, 2013 and December 31, 2012, we had no material off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K.

Dividends

The declaration of future dividends is subject to the discretion of our board of directors and will depend upon various factors, including our earnings, financial condition, restrictions imposed by the Credit Facility and the terms of any other indebtedness that may be outstanding, cash requirements, future prospects and other factors deemed relevant by our board of directors. The Credit Facility permits payments of dividends as long as no default or event of default exists and the consolidated leverage ratio specified in the Credit Facility is not exceeded.

On February 19, 2013, we announced that our board of directors approved a cash dividend of $0.30 per common share in an aggregate amount of $30.9 million that was paid to shareholders on March 19, 2013. On April 29, 2013, we announced that our board of directors approved a cash dividend of $0.30 per common share in an aggregate amount of $30.9 million that was paid to shareholders on May 28, 2013. On July 29, 2013, we announced that our board of directors approved a cash dividend of $0.30 per common share in an aggregate amount of $30.8 million that was paid to shareholders on August 27, 2013.

The aggregate amount of dividends declared and paid during the three months ended September 30, 2013 and 2012 were $30.8 million and $32.4 million, respectively. The aggregate amount of dividends declared and paid during the nine months ended September 30, 2013 and 2012 were $92.6 million and $102.7 million, respectively.

Share Repurchases

On July 30, 2012, we announced that our board of directors authorized a new $1 billion share repurchase program that will expire on June 30, 2017. This share repurchase program allows us to repurchase our common shares, at such times and prices as determined by our management as market conditions warrant, and to the extent Herbalife Ltd.’s distributable reserves are available under Cayman Islands law. The Credit Facility permits us to repurchase our common shares as long as no default or event of default exists and the consolidated leverage ratio specified in the Credit Facility is not exceeded.

During the three months ended March 31, 2013, we repurchased approximately 4.0 million of our common shares through open market purchases at an aggregate cost of approximately $162.4 million or an average cost of $40.61 per share. We did not repurchase any common shares in the open market during the three months ended June 30, 2013. During the three months ended September 30, 2013, we repurchased approximately 1.7 million of our common shares through open market purchases at an aggregate cost of approximately $110.0 million or an average cost of $63.85 per share. As of September 30, 2013, the remaining authorized capacity under our share repurchase program was $677.6 million.

Working Capital and Operating Activities

As of September 30, 2013 and December 31, 2012, we had positive working capital of $710.9 million and $221.7 million, respectively, or an increase of $489.2 million. This increase was primarily related to the increase in our cash and cash equivalents, the increase in our prepaid expenses and other current assets, the decrease in our income tax payable, partially offset by increases in our accrued expenses, advance sales deposits and current portion of long-term debt.

We expect that cash and funds provided from operations and available borrowings under the Credit Facility will provide sufficient working capital to operate our business, to make expected capital expenditures and to meet foreseeable liquidity requirements, including payment of amounts outstanding under the Credit Facility, for the next twelve months and thereafter.

The majority of our purchases from suppliers are generally made in U.S. dollars, while sales to our distributors generally are made in local currencies. Consequently, strengthening of the U.S. dollar versus a foreign currency can have a negative impact on net sales and contribution margins and can generate transaction losses on intercompany transactions. For discussion of our foreign exchange contracts and other hedging arrangements, see Part I, Item 3 — Quantitative and Qualitative Disclosures about Market Risk.

Venezuela

Currency Restrictions

Currency restrictions enacted by the Venezuelan government have become more restrictive and have impacted the ability of our subsidiary in Venezuela, Herbalife Venezuela, to timely obtain U.S. dollars in exchange for Venezuelan Bolivars, or Bolivars, at the

 

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official foreign exchange rate from the Venezuelan government and its foreign exchange commission, CADIVI. The application and approval process continue to be delayed and our ability to timely obtain U.S. dollars at the official exchange rate remains uncertain. In recent instances, we have been unsuccessful in obtaining U.S. dollars at the official rate and it remains uncertain whether our current pending applications and future anticipated applications will be approved.

In February 2013, the Venezuela government announced that it devalued its Bolivar currency and will eliminate the SITME regulated system. The SITME 5.3 Bolivars per U.S. dollar rate was eliminated and the CADIVI rate has been devalued from 4.3 Bolivars to 6.3 Bolivars per U.S. dollar. This new CADIVI rate is approximately 16% less favorable than the previously published 5.3 SITME rate. We recognized approximately $15.1 million of net foreign exchange losses within our consolidated statement of income during the first quarter of 2013, as a result of remeasuring our Bolivar denominated monetary assets and liabilities at this new CADIVI rate of 6.3 Bolivars per U.S. dollar. The majority of these foreign exchange losses related to the approximately $16.9 million devaluation of Herbalife Venezuela’s Bolivar denominated cash and cash equivalents. In March 2013, the Venezuelan government also announced they will introduce an additional complimentary exchange mechanism known as SICAD. It is currently unknown whether Herbalife Venezuela will be able to access this new exchange mechanism and the Company is currently assessing and monitoring the restrictions and exchange rates relating to this alternative mechanism.

During the nine months ended September 30, 2013, we also recognized $0.7 million of foreign exchange losses as a result of exchanging Bolivars for U.S. dollars using alternative legal exchange mechanisms that were approximately 75% less favorable than the new CADIVI rate. During the nine months ended September 30, 2013, we exchanged 5.6 million Bolivars for $0.2 million U.S. dollars using these alternative legal exchange mechanisms. We did not exchange Bolivars for U.S. dollars using these alternative legal exchange mechanisms during the three months ended June 30, 2013 or the three months ended September 30, 2013. As of September 30, 2013, Herbalife Venezuela’s net monetary assets and liabilities denominated in Bolivars were approximately $146.7 million, and included approximately $150.1 million in Bolivar denominated cash and cash equivalents. The majority of these Bolivar denominated assets and liabilities were remeasured at the CADIVI rate. We remeasure our Bolivars at the official published CADIVI rate given the limited availability of alternative exchange mechanisms and the uncertainty in the effective exchange rate for alternative exchange mechanisms. These remeasured amounts, including cash and cash equivalents, being reported on our condensed consolidated balance sheet using the published CADIVI rate may not accurately represent the amount of U.S. dollars that we could ultimately realize. While we continue to monitor the exchange mechanisms and restrictions under CADIVI, and assess and monitor the current economic and political environment in Venezuela, there is no assurance that we will be able to exchange Bolivars into U.S. dollars on a timely basis.

Consolidation of Herbalife Venezuela

We plan to continue our operation in Venezuela and to import products into Venezuela despite the foreign currency constraints that exist in the country. Herbalife Venezuela will continue to apply for legal exchange mechanisms to convert its Bolivars to U.S. dollars. Despite the currency exchange restrictions in Venezuela, we continue to control Herbalife Venezuela and its operations. Therefore, we continue to consolidate Herbalife Venezuela in our consolidated financial statements.

We plan to utilize the CADIVI rate to the extent allowable under current restrictions in order to exchange Bolivars for U.S. dollars. We also plan to access government, PDVSA bond offerings, SICAD, and other alternative legal exchange mechanisms when they are made available to us. As discussed above, these alternative legal exchange mechanisms could cause us to recognize significant foreign exchange losses if they are less favorable than the CADIVI rate, which could also result in our Bolivar denominated cash and cash equivalents reported on our consolidated balance sheet being significantly reduced. To illustrate our sensitivity to potential future changes in the CADIVI rate or using unfavorable alternative legal exchange mechanisms to exchange Bolivars to U.S. dollars, if the exchange rate was approximately 75% less favorable than the current 6.3 CADIVI rate and this unfavorable exchange rate was used to convert our Bolivar denominated cash and cash equivalents as of September 30, 2013, our $150.1 million Bolivar denominated cash and cash equivalents as of September 30, 2013 would be reduced by $112.3 million and result in a corresponding foreign exchange loss to our operating profit. This 75% less favorable exchange rate is not necessarily representative of exchange rates which could be available to us for future exchanges, but is used for our sensitivity analysis above as it represents the actual weighted average rate that we received when using alternative exchange mechanisms during the nine months ended September 30, 2013. If Herbalife Venezuela’s ongoing operations were subject to the 75% less favorable exchange rate, Herbalife Venezuela would operate at a loss and this could have a significant negative impact to our consolidated financial statements. Our ability to access the CADIVI rate could impact what exchange rates will be used for remeasurement purposes in future periods. We continue to assess and monitor the current economic and political environment in Venezuela.

Herbalife Venezuela’s net sales represented approximately 5% and 3% of our consolidated net sales for the nine months ended September 30, 2013 and 2012, respectively, and its total assets represented approximately 9% and 7% of our consolidated total assets as of September 30, 2013 and December 31, 2012, respectively. As of September 30, 2013 and December 31, 2012, the majority of Herbalife Venezuela’s total assets consisted of Bolivar denominated cash and cash equivalents.

See the 2012 10-K for further information on Herbalife Venezuela and Venezuela’s highly inflationary economy.

 

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Subsequent Events

See Note 14, Subsequent Events, to the Condensed Consolidated Financial Statements included in Item 1 of Part I of this Quarterly Report on Form 10-Q, for information regarding subsequent events.

Contingencies

See Note 5, Contingencies, to the Condensed Consolidated Financial Statements included in Item 1 of Part I of this Quarterly Report on Form 10-Q, for information on our contingencies as of September 30, 2013.

Critical Accounting Policies

U.S. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the year. We regularly evaluate our estimates and assumptions related to revenue recognition, allowance for product returns, inventory, share-based compensation expense, goodwill and purchased intangible asset valuations, deferred income tax asset valuation allowances, uncertain tax positions, tax contingencies, and other loss contingencies. We base our estimates and assumptions on current facts, historical experience and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the recording of revenue, costs and expenses. Actual results could differ from those estimates. We consider the following policies to be most critical in understanding the judgments that are involved in preparing the financial statements and the uncertainties that could impact our operating results, financial condition and cash flows.

We are a nutrition company that sells a wide range of weight management products, nutritional supplements, energy, sports & fitness products and personal care products. Our products are manufactured by third party providers and in our Changsha, Hunan, China extraction facility, our Suzhou, China facility, and our Lake Forest, California facility, and then are sold to independent distributors who consume and sell Herbalife products to retail consumers or other distributors. As of September 30, 2013, we sold products in 88 countries throughout the world and we are organized and managed by geographic region. We have elected to aggregate our operating segments into one reporting segment, except China, as management believes that our operating segments have similar operating characteristics and similar long term operating performance. In making this determination, management believes that the operating segments are similar in the nature of the products sold, the product acquisition process, the types of customers to whom products are sold, the methods used to distribute the products, and the nature of the regulatory environment.

We generally recognize revenue upon delivery and when both the title and risk and rewards pass to the independent distributor or importer, or as products are sold in our retail stores in China or through our independent service providers in China. Net sales include product sales and shipping and handling revenues. Product sales are recognized net of product returns, and discounts referred to as “distributor allowances.” We generally receive the net sales price in cash or through credit card payments at the point of sale. Related royalty overrides and allowances for product returns are recorded when revenue is recognized.

Allowances for product returns, primarily in connection with our buyback program, are provided at the time the product is shipped. This accrual is based upon historical return rates for each country and the relevant return pattern, which reflects anticipated returns to be received over the buyback program period of up to 12 months following the original sale. The buyback program has certain terms and conditions that may vary by market, but generally permits the return of unopened and marketable condition products or sales materials purchased within the prior twelve month period, in exchange for a refund of the net price paid for the product. Historically, product returns and buybacks have not been significant. Product returns and buybacks were approximately 0.2% and 0.3% of product sales for the three and nine months ended September 30, 2013, respectively, as compared to 0.3% for both the same periods in 2012.

We adjust our inventories to lower of cost or market. Additionally, we adjust the carrying value of our inventory based on assumptions regarding future demand for our products and market conditions. If future demand and market conditions are less favorable than management’s assumptions, additional inventory write-downs could be required. Likewise, favorable future demand and market conditions could positively impact future operating results if previously written down inventories are sold. We have obsolete and slow moving inventories which have been adjusted downward $26.2 million and $18.0 million to present them at their lower of cost or market in our consolidated balance sheets as of September 30, 2013 and December 31, 2012, respectively.

Goodwill and marketing related intangible assets not subject to amortization are tested annually for impairment, and are tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. As discussed below, for goodwill impairment testing, we have the option to perform a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. If we conclude it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then there is no need to perform the two-step impairment test. Currently, we do not use this qualitative assessment option but we could in the future elect to use this option. For our marketing related intangible assets a similar qualitative option is also currently available. However, we currently use a discounted cash flow model, or the income approach, to determine the fair value of our marketing related intangible assets in order to confirm there is no impairment required. For our marketing related intangible assets, if we do not use this qualitative assessment option, we could still in the future elect to use this option.

 

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In order to estimate the fair value of goodwill, we also primarily use an income approach. The determination of impairment is made at the reporting unit level and consists of two steps. First, we determine the fair value of a reporting unit and compare it to its carrying amount. The determination of the fair value of the reporting units requires us to make significant estimates and assumptions. These estimates and assumptions include estimates of future revenues and expense growth rates, capital expenditures and the depreciation and amortization related to these capital expenditures, discount rates, and other inputs. Due to the inherent uncertainty involved in making these estimates, actual future results could differ. Changes in assumptions regarding future results or other underlying assumptions could have a significant impact on the fair value of the reporting unit. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill and other intangibles over the implied fair value as determined in Step 2 of the goodwill impairment test. Also, if during Step 1 of a goodwill impairment test we determine we have reporting units with zero or negative carrying amounts, then we perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. During Step 2 of a goodwill impairment test, the implied fair value of goodwill is determined in a similar manner as how the amount of goodwill recognized in a business combination is determined, in accordance with FASB ASC Topic 805, Business Combinations. We would assign the fair value of a reporting unit to all of the assets and liabilities of that reporting unit as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the price paid to acquire the reporting unit. The excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. As of both September 30, 2013 and December 31, 2012, we had goodwill of approximately $105.5 million and marketing related intangible assets of approximately $310.0 million. No marketing related intangibles or goodwill impairment was recorded during the three and nine months ended September 30, 2013 and 2012.

Contingencies are accounted for in accordance with the FASB ASC Topic 450, Contingencies, or ASC 450. ASC 450 requires that we record an estimated loss from a loss contingency when information available prior to issuance of our financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and the amount of the loss can be reasonably estimated. We also disclose material contingencies when we believe a loss is not probable but reasonably possible as required by ASC 450. Accounting for contingencies such as legal and non-income tax matters requires us to use judgment related to both the likelihood of a loss and the estimate of the amount or range of loss. Many of these legal and tax contingencies can take years to be resolved. Generally, as the time period increases over which the uncertainties are resolved, the likelihood of changes to the estimate of the ultimate outcome increases.

Deferred income tax assets have been established for net operating loss and interest carryforwards of certain foreign subsidiaries and have been reduced by a valuation allowance to reflect them at amounts estimated to be ultimately realized. Although realization is not assured, we believe it is more likely than not that the net carrying value will be realized. The amount of the carryforwards that is considered realizable, however, could change if estimates of future taxable income are adjusted. In the ordinary course of our business, there are many transactions and calculations where the tax law and ultimate tax determination is uncertain. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate prior to the completion and filing of tax returns for such periods. This process requires estimating both our geographic mix of income and our uncertain tax positions in each jurisdiction where we operate. These estimates involve complex issues and require us to make judgments about the likely application of the tax law to our situation, as well as with respect to other matters, such as anticipating the positions that we will take on tax returns prior to us actually preparing the returns and the outcomes of disputes with tax authorities. The ultimate resolution of these issues may take extended periods of time due to examinations by tax authorities and statutes of limitations. In addition, changes in our business, including acquisitions, changes in our international corporate structure, changes in the geographic location of business functions or assets, changes in the geographic mix and amount of income, as well as changes in our agreements with tax authorities, valuation allowances, applicable accounting rules, applicable tax laws and regulations, rulings and interpretations thereof, developments in tax audit and other matters, and variations in the estimated and actual level of annual pre-tax income can affect the overall effective income tax rate.

We account for uncertain income tax positions in accordance with the FASB ASC Topic 740, Income Taxes, or ASC 740, which provides guidance on the determination of how tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under ASC 740, we must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution.

We account for foreign currency transactions in accordance with ASC Topic 830, Foreign Currency Matters. In a majority of the countries where we operate, the functional currency is the local currency. Our foreign subsidiaries’ asset and liability accounts are translated for consolidated financial reporting purposes into U.S. dollar amounts at period-end exchange rates. Revenue and expense accounts are translated at the average rates during the year. Our foreign exchange translation adjustments are included in accumulated other comprehensive loss on our accompanying consolidated balance sheets. Foreign currency transaction gains and losses and foreign currency remeasurements are generally included in selling, general and administrative expenses in the accompanying consolidated statements of income.

 

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New Accounting Pronouncements

See discussion under Note 2, Significant Accounting Policies, to the Condensed Consolidated Financial Statements included in Item 1 of Part I of this Quarterly Report on Form 10-Q, for information on new accounting pronouncements.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to market risks, which arise during the normal course of business from changes in interest rates and foreign currency exchange rates. On a selected basis, we use derivative financial instruments to manage or hedge these risks. All hedging transactions are authorized and executed pursuant to written guidelines and procedures.

We apply FASB ASC Topic 815, Derivatives and Hedging, or ASC 815, which established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. If the derivative is designated as a fair-value hedge, the changes in the fair value of the derivative and the underlying hedged item are recognized concurrently in earnings. If the derivative is designated as a cash-flow hedge, changes in the fair value of the derivative are recorded in other comprehensive income (loss) and are recognized in the condensed consolidated statements of income when the hedged item affects earnings. ASC 815 defines the requirements for designation and documentation of hedging relationships as well as ongoing effectiveness assessments in order to use hedge accounting. For a derivative that does not qualify as a hedge, changes in fair value are recognized concurrently in earnings.

A discussion of our primary market risk exposures and derivatives is presented below.

Foreign Exchange Risk

We transact business globally and are subject to risks associated with changes in foreign exchange rates. Our objective is to minimize the impact to earnings and cash flow associated with foreign exchange rate fluctuations. We enter into foreign exchange derivatives in the ordinary course of business primarily to reduce exposure to currency fluctuations attributable to intercompany transactions, translation of local currency revenue, inventory purchases subject to foreign currency exposure, and to partially mitigate the impact of foreign currency rate fluctuations. Due to the volatility in foreign exchange markets, our current strategy, in general, is to hedge some of the significant exposures on a short-term basis. We will continue to monitor the foreign exchange markets and evaluate our hedging strategy accordingly. With the exception of our foreign exchange forward contracts relating to forecasted inventory purchases and intercompany management fees discussed below, all of our foreign exchange contracts are designated as free standing derivatives for which hedge accounting does not apply. The changes in the fair value of the derivatives not qualifying as cash flow hedges are included in selling, general and administrative expenses in our condensed consolidated statements of income.

The foreign exchange forward contracts designated as free standing derivatives are used to hedge advances between subsidiaries and to partially mitigate the impact of foreign currency fluctuations. Foreign exchange average rate option contracts are also used to mitigate the impact of foreign currency rate fluctuations. The objective of these contracts is to neutralize the impact of foreign currency movements on the operating results of our subsidiaries. The fair value of forward and option contracts is based on third-party quotes. Our foreign currency derivative contracts are generally executed on a monthly basis.

We also purchase foreign currency forward contracts in order to hedge forecasted inventory transactions and intercompany management fees that are designated as cash-flow hedges and are subject to foreign currency exposures. We applied the hedge accounting rules as required by ASC 815 for these hedges. These contracts allow us to buy and sell certain currencies at specified contract rates. As of September 30, 2013 and December 31, 2012, the aggregate notional amounts of these contracts outstanding were approximately $243.2 million and $256.9 million, respectively. At September 30, 2013, the outstanding contracts were expected to mature over the next twelve months. Our derivative financial instruments are recorded on the condensed consolidated balance sheet at fair value based on quoted market rates. For the forecasted inventory transactions, the forward contracts are used to hedge forecasted inventory transactions over specific months. Changes in the fair value of these forward contracts, excluding forward points, designated as cash-flow hedges are recorded as a component of accumulated other comprehensive income (loss) within shareholders’ equity, and are recognized in cost of sales in the condensed consolidated statement of income during the period which approximates the time the hedged inventory is sold. We also hedge forecasted intercompany management fees over specific months. Changes in the fair value of these forward contracts designated as cash flow hedges are recorded as a component of accumulated other comprehensive loss within shareholders’ equity, and are recognized in selling, general and administrative expenses in the condensed consolidated statement of income in the period when the hedged item and underlying transaction affects earnings. As of September 30, 2013, we recorded assets at fair value of $5.6 million and liabilities at fair value of $4.2 million relating to all outstanding foreign currency contracts designated as cash-flow hedges. As of December 31, 2012, we recorded assets at fair value of $0.5 million and liabilities at fair value of $3.3 million relating to all outstanding foreign currency contracts designated as cash-flow hedges. We assess hedge effectiveness and measure hedge ineffectiveness at least quarterly. During the three and nine months ended September 30, 2013 and 2012, the ineffective portion relating to these hedges was immaterial and the hedges remained effective as of September 30, 2013 and December 31, 2012.

 

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As of both September 30, 2013 and December 31, 2012, the majority of our outstanding foreign currency forward contracts had maturity dates of less than twelve months, with the majority of freestanding derivatives expiring within one month. There were no foreign currency option contracts outstanding as of September 30, 2013 and December 31, 2012.

The following table provides information about the details of our foreign exchange forward contracts:

 

Foreign Currency

   Average
Contract
Rate
     Notional
Amount
     Fair
Value
Gain (Loss)
 
            (In millions)      (In millions)  

At September 30, 2013

        

Buy Chinese yuan sell Euro

     8.18       $ 23.6       $ (0.4

Buy Euro sell Argentine peso

     8.70       $ 5.3         —    

Buy Euro sell Australian dollar

     1.44       $ 2.5         —    

Buy Euro sell Chilean peso

     675.00       $ 1.9         —    

Buy Euro sell Chinese yuan

     8.14       $ 23.7       $ 0.5   

Buy Euro sell Indonesian rupiah

     15,400.00       $ 7.7       $ 0.2   

Buy Euro sell Mexican peso

     17.15       $ 149.6       $ 6.2   

Buy Euro sell Malaysian ringgit

     4.35       $ 6.3       $ 0.1   

Buy Euro sell Peruvian nuevo sol

     3.74       $ 2.8         —    

Buy Euro sell Philippine peso

     58.45       $ 3.1         —    

Buy Euro sell Russian ruble

     43.24       $ 3.7       $ 0.1   

Buy Euro sell U.S. dollar

     1.34       $ 210.5       $ 1.8   

Buy British pound sell Euro

     1.18       $ 2.4         —    

Buy Japanese yen sell U.S. dollar

     98.96       $ 4.0         —    

Buy Malaysian ringgit sell U.S. dollar

     3.23       $ 5.4       $ (0.1

Buy New Taiwan dollar sell U.S. dollar

     29.69       $ 8.1       $ 0.1   

Buy U.S. dollar sell Brazilian real

     2.23       $ 5.4       $ 0.1   

Buy U.S. dollar sell Colombian peso

     1,897.00       $ 2.6         —    

Buy U.S. dollar sell Euro

     1.31       $ 126.6       $ (3.7

Buy U.S. dollar sell Indonesian rupiah

     11,245.00       $ 0.2         —    

Buy U.S. dollar sell South Korean won

     1,141.01       $ 34.1       $ 0.9   

Buy U.S. dollar sell New Taiwan dollar

     29.60       $ 1.1         —    
     

 

 

    

 

 

 

Total forward contracts

      $ 630.6       $ 5.8   
     

 

 

    

 

 

 

The majority of our foreign subsidiaries designate their local currencies as their functional currencies. At September 30, 2013 and December 31, 2012, the total amount of our foreign subsidiary cash and cash equivalents was $502.8 million and $321.3 million, respectively, of which $10.7 million and $6.9 million was invested in U.S. dollars as of September 30, 2013 and December 31, 2012, respectively. At September 30, 2013 and December 31, 2012, the total amount of cash and cash equivalents held by U.S. entities was $389.7 million and $12.2 million, respectively.

Currency restrictions enacted by the Venezuelan government continue to be restrictive and have impacted the ability of Herbalife Venezuela to obtain U.S. dollars in exchange for Bolivars at the official foreign exchange rates from the Venezuelan government. See Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations, for discussion on how the currency restrictions in Venezuela have impacted Herbalife Venezuela’s operations.

Interest Rate Risk

As of September 30, 2013, the aggregate annual maturities of the Credit Facility were expected to be $18.8 million for the remainder of 2013, $81.2 million for 2014, $100.0 million for 2015, and $750.0 million for 2016. The fair value of the outstanding borrowings on our revolving credit facility and Term Loan approximated their carrying values of $950.0 million as of September 30, 2013. The fair value of the outstanding borrowings on our revolving credit facility and Term Loan approximated their carrying values of $487.5 million as of December 31, 2012. The Credit Facility bears a variable interest rate, and on September 30, 2013 and December 31, 2012, the weighted average interest rate of the Credit Facility, including borrowings under the Term Loan, was 2.18% and 1.96%, respectively.

During August 2009, we entered into four interest rate swap agreements with an effective date of December 31, 2009. The agreements collectively provided for us to pay interest for less than a four-year period at a weighted average fixed rate of 2.78% on notional amounts aggregating to $140.0 million while receiving interest for the same period at the one month LIBOR rate on the same notional amounts. These agreements expired in July 2013. These swaps at inception were designated as cash flow hedges against the variability in the LIBOR interest rate on our term loan under the Prior Credit Facility or against the variability in the LIBOR interest

 

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rate on the replacement debt. Our term loan under the Prior Credit Facility was terminated in March 2011 and refinanced with the Credit Facility as discussed further in Note 4, Long-Term Debt, to the Condensed Consolidated Financial Statements. Until their expiration in July 2013, the Company’s swaps were effective and were designated as cash flow hedges against the variability in certain LIBOR interest rate borrowings under the Credit Facility at LIBOR plus 1.50% to 2.50%, fixing the Company’s weighted average effective rate on the notional amounts at 4.28% to 5.28%. There was no hedge ineffectiveness recorded as result of this refinancing event.

We assess hedge effectiveness and measure hedge ineffectiveness at least quarterly. During the three and nine months ended September 30, 2013 and 2012, the ineffective portion relating to these hedges was immaterial and the hedges remained effective until their expiration in July 2013 and as of December 31, 2012. Consequently, all changes in the fair value of the derivatives were deferred and recorded in other comprehensive income (loss) until the related forecasted transactions were recognized in the condensed consolidated statements of income. The fair value of the interest rate swap agreements are based on third-party quotes. At December 31, 2012, we recorded the interest rate swaps as liabilities at their fair value of $2.0 million. No amount was recorded as of September 30, 2013 because the interest rate swaps had expired.

Item 4. Controls And Procedures

Evaluation of Disclosure Controls and Procedures. Our management, including our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on such evaluation, and notwithstanding the error disclosed in Note 2, Significant Accounting Policies, to the Condensed Consolidated Financial Statements, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of September 30, 2013.

Changes in Internal Control over Financial Reporting. There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

FORWARD-LOOKING STATEMENTS

This document contains “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 other than statements of historical fact are “forward-looking statements” for purposes of federal and state securities laws, including any projections of earnings, revenue or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning proposed new services or developments; any statements regarding future economic conditions or performance; any statements of belief; and any statements of assumptions underlying any of the foregoing. Forward-looking statements may include the words “may,” “will,” “estimate,” “intend,” “continue,” “believe,” “expect” or “anticipate” and any other similar words.

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 or incorporated by reference in our filings with the Securities and Exchange Commission. Important factors that could cause our actual results, performance and achievements, or industry results to differ materially from estimates or projections contained in our forward-looking statements include, among others, the following:

 

   

the resignation of our former independent registered public accounting firm, its withdrawal of its audit reports with respect to certain of our historical financial statements, any difficulties PricewaterhouseCoopers LLP, our successor accounting firm encounters in the re-audits of such relevant historical financial statements or any material modifications to such historical financial statements PricewaterhouseCoopers LLP believes should be made as a result of such re-audits;

 

   

any collateral impact resulting from the ongoing worldwide financial environment, including the availability of liquidity to us, our customers and our suppliers or the willingness of our customers to purchase products in a difficult economic environment;

 

   

our relationship with, and our ability to influence the actions of, our distributors;

 

   

improper action by our employees or distributors in violation of applicable law;

 

   

adverse publicity associated with our products or network marketing organization, including our ability to comfort the marketplace and regulators regarding our compliance with applicable laws;

 

   

changing consumer preferences and demands;

 

   

our reliance upon, or the loss or departure of any member of, our senior management team which could negatively impact our distributor relations and operating results;

 

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the competitive nature of our business;

 

   

regulatory matters governing our products, including potential governmental or regulatory actions concerning the safety or efficacy of our products and network marketing program, including the direct selling market in which we operate;

 

   

legal challenges to our network marketing program;

 

   

risks associated with operating internationally and the effect of economic factors, including foreign exchange, inflation, disruptions or conflicts with our third party importers, pricing and currency devaluation risks, especially in countries such as Venezuela;

 

   

uncertainties relating to the application of transfer pricing, duties, value added taxes, and other tax regulations, and changes thereto;

 

   

uncertainties relating to interpretation and enforcement of legislation in China governing direct selling;

 

   

uncertainties relating to the interpretation, enforcement or amendment of legislation in India governing direct selling;

 

   

our inability to obtain the necessary licenses to expand our direct selling business in China;

 

   

adverse changes in the Chinese economy, Chinese legal system or Chinese governmental policies;

 

   

our dependence on increased penetration of existing markets;

 

   

contractual limitations on our ability to expand our business;

 

   

our reliance on our information technology infrastructure and outside manufacturers;

 

   

the sufficiency of trademarks and other intellectual property rights;

 

   

product concentration;

 

   

changes in tax laws, treaties or regulations, or their interpretation;

 

   

taxation relating to our distributors;

 

   

product liability claims;

 

   

whether we will purchase any of our shares in the open markets or otherwise; and

 

   

share price volatility related to, among other things, speculative trading and certain traders shorting our common shares.

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 Condensed Consolidated 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 that are incorporated by reference speak only as of the date of those documents. We do 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.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

See discussion under Note 5, Contingencies, to the Condensed Consolidated Financial Statements included in Item 1 of Part I of this Quarterly Report on Form 10-Q, which is incorporated herein by reference.

From time to time, the Company is subject to inquiries from and investigations by various governmental and other regulatory authorities with respect to the legality of the Company’s network marketing program. Given the nature of recent allegations made by certain short sellers and related market events, the Company believes it may receive governmental inquiries (such as the previously disclosed SEC inquiry). To the extent any of these inquiries are or become material they will be disclosed individually. Consistent with its policies, the Company is and will fully cooperate with any inquiries and looks forward to resolving them in a timely manner.

Item 1A. Risk Factors

The resignation of our former independent registered public accounting firm, its withdrawal of its audit reports with respect to certain of our historical financial statements, any modifications to such historical financial statements our successor accounting firm believes should be made as a result of the re-audit thereof, any difficulties we or our successor accounting firm encounter moving forward and the costs related to the foregoing, may have a material adverse effect on us.

On April 8, 2013, KPMG notified us that KPMG was resigning, effective immediately, as our independent accountant. KPMG stated it had concluded it was not independent because of alleged insider trading in our securities by one of KPMG’s former partners who, until April 5, 2013, was the KPMG engagement partner on our audit. KPMG advised us it resigned as our independent accountant solely due to the impairment of KPMG’s independence resulting from its now former partner’s alleged unlawful activities

 

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and not for any reason related to our financial statements, our accounting practices, the integrity of our management or for any other reason. As a result of the alleged insider trading activity by its now former partner and KPMG’s resulting resignation, KPMG notified us that it had no option but to withdraw its audit reports regarding our financial statements for the fiscal years ended December 31, 2010, 2011 and 2012 and the effectiveness of internal control over financial reporting as of December 31, 2010, 2011 and 2012 and that such reports should no longer be relied upon as a result of KPMG’s lack of independence created by the circumstances described above. Our Audit Committee and management continue to believe that our financial statements covering the referenced periods, notwithstanding the revisions discussed in Note 2, Significant Accounting Policies, to the Condensed Consolidated Financial Statements included in Item 1 of Part I of this Quarterly Report on Form 10-Q under the heading Revision of Prior Period Financial Statements, fairly present, in all material respects, our financial condition and results of operations as of the end of and for the referenced periods and may continue to be relied upon and that our internal control over financial reporting was effective during these periods. See Note 2, Significant Accounting Policies, to the Condensed Consolidated Financial Statements for information on these matters.

The Audit Committee conducted a search for KPMG’s successor and, on May 21, 2013 engaged PricewaterhouseCoopers LLP, or PwC, as the Company’s new independent registered accounting firm. As a result of the engagement of PwC, we, members of management and our Audit Committee will be required to expend significant time, resources and capital in connection with the requisite re-audits, helping familiarize PwC and its personnel with our business and operations and other related matters.

As a result of KPMG’s resignation, we have suffered and will continue to suffer a number of difficulties in respect of our SEC filings and other matters. This Quarterly Report on Form 10-Q as well as the Quarterly Reports on Form 10-Q for the first and second quarters of 2013, filed with the SEC on April 29, 2013 and July 29, 2013, respectively, are technically considered deficient and we are no longer considered to be technically timely or current in our Exchange Act filings because the unaudited interim financial information presented herein and therein has not been reviewed by an independent registered accounting firm in accordance with Accounting Standards Board Statement on Accounting Standards 100, or SAS 100, as required by SEC rules. In addition, the absence of the SAS 100 reviews and KPMG’s withdrawal of its previous audit reports required us to suspend the effectiveness of our registration statements on Form S-8 related to our equity incentive plans and our employee stock purchase plan. The combination of these issues also renders us ineligible for the time being to use both shelf registration and “short-form” registration that allows us to incorporate our prior filings by reference. We will not be able to file in a timely manner Quarterly Reports on Form 10-Q with the SEC that contain financial statements that have been reviewed by, or Annual Reports on Form 10-K that contain financial statements that have been audited by, an independent registered public accounting firm until PwC completes its re-audits and its SAS 100 reviews of the applicable periods. If we are unable to do so, among other things, we will continue to be untimely in our filings under the Exchange Act and our ability to access the capital markets will be significantly limited. In addition, if PwC is unable to timely complete the re-audits of our historical financial statements for the fiscal years ended December 31, 2010, 2011 and 2012 as well as the audit of fiscal 2013, or if PwC believes that modifications should be made to our historical financial statements as a result of the re-audits thereof, we may encounter additional issues. The failure to deliver audited financial statements after 2013 year end could constitute an event of default under our Credit Facility and may lead the New York Stock Exchange to commence delisting procedures with respect to our common shares. While we do not believe these events will come to pass, there can be no assurances at this time.

To date we have incurred significant costs as a result of KPMG’s resignation in the form of legal and similar professional fees, in addition to the substantial diversion of the time and attention of our officers, directors and members of our accounting department. We have also seen added volatility in the trading price of our common shares. We expect to continue to suffer these additional costs, distractions and other issues, and we expect to continue to see greater volatility in the price of our common shares, until PwC has completed its re-audits of our financial statements for the fiscal years ended December 31, 2010, 2011 and 2012, its review of the three months ended March 31, 2013, the three and six months ended June 30, 2013, the three and nine months ended September 30, 2013, and any subsequent periods.

The worldwide financial and economic environment could negatively impact our access to credit and the sales of our products and could harm our financial condition and operating results.

We are closely monitoring various aspects of the current worldwide financial and economic “crisis” and its potential impact on us, our liquidity, our access to capital, our operations and our overall financial condition. While we have historically met our funding needs utilizing cash flow from operating activities and while we believe we will have sufficient resources to meet current debt service obligations in a timely manner, no assurances can be given that the current overall downturn in the world economy will not significantly adversely impact us and our business operations. We note economic and financial markets are fluid and we cannot ensure

 

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that there will not be in the near future a material adverse deterioration in our sales or liquidity. While our current senior secured variable credit facility can also be used to support our current liquidity requirements, increases in interest rates could negatively affect the cost of financing our operations if our future borrowings were to increase.

Our failure to establish and maintain distributor relationships for any reason could negatively impact sales of our products and harm our financial condition and operating results.

We distribute our products exclusively to and through approximately 3.6 million independent distributors, including 0.2 million in China, and we depend upon them directly for substantially all of our sales. To increase our revenue, we must increase the number of, or the productivity of, our distributors. Accordingly, our success depends in significant part upon our ability to recruit, retain and motivate a large base of distributors. The loss of a significant number of distributors for any reason could negatively impact sales of our products and could impair our ability to attract new distributors. In our efforts to attract and retain distributors, we compete with other network marketing organizations, including those in the weight management, dietary and nutritional supplement and personal care and cosmetic product industries. Our operating results could be harmed if our existing and new business opportunities and products do not generate sufficient interest to retain existing distributors and attract new distributors.

Our distributor organization has a high turnover rate, which is a common characteristic found in the direct selling industry. In light of this fact, we have our sales leaders re-qualify annually in order to maintain a more accurate count of their numbers. For the latest twelve month re-qualification period ending January 2013, approximately 51.8% of our sales leaders, excluding China, re-qualified. Distributors who purchase our product for personal consumption or for short-term income goals may stay with us for several months to one year. Sales leaders who have committed time and effort to build a sales organization will generally stay for longer periods. Distributors have highly variable levels of training, skills and capabilities. The turnover rate of our distributors, and our operating results, can be adversely impacted if we, and our senior distributor leadership, do not provide the necessary mentoring, training and business support tools for new distributors to become successful sales people.

We estimate that, of our approximately 3.6 million independent distributors, we had approximately 611,000 sales leaders as of September 30, 2013. These sales leaders, together with their downline sales organizations, account for substantially all of our revenues. Our distributors, including our sales leaders, may voluntarily terminate their distributor agreements with us at any time. The loss of a group of leading sales leaders, together with their downline sales organizations, or the loss of a significant number of distributors for any reason, could negatively impact sales of our products, impair our ability to attract new distributors and harm our financial condition and operating results.

Since we cannot exert the same level of influence or control over our independent distributors as we could were they our own employees, our distributors could fail to comply with applicable law or our distributor policies and procedures, which could result in claims against us that could harm our financial condition and operating results.

Our distributors are independent contractors and, accordingly, we are not in a position to directly provide the same direction, motivation and oversight as we would if distributors were our own employees. As a result, there can be no assurance that our distributors will participate in our marketing strategies or plans, accept our introduction of new products, or comply with our distributor policies and procedures.

Extensive federal, state and local laws regulate our business, products and network marketing program. Because we have expanded into foreign countries, our policies and procedures for our independent distributors differ due to the different legal requirements of each country in which we do business. While we have implemented distributor policies and procedures designed to govern distributor conduct and to protect the goodwill associated with Herbalife trademarks and tradenames, it can be difficult to enforce these policies and procedures because of the large number of distributors and their independent status. Violations by our independent distributors of applicable law or of our policies and procedures in dealing with customers could reflect negatively on our products and operations and harm our business reputation. In addition, it is possible that a court could hold us civilly or criminally accountable based on vicarious liability because of the actions of our independent distributors.

Adverse publicity associated with our products, ingredients or network marketing program, or those of similar companies, could harm our financial condition and operating results.

The size of our distribution force and the results of our operations may be significantly affected by the public’s perception of the Company and similar companies. This perception is dependent upon opinions concerning:

 

   

the safety and quality of our products and ingredients;

 

   

the safety and quality of similar products and ingredients distributed by other companies;

 

   

our distributors;

 

   

our network marketing program; and

 

   

the direct selling business generally.

 

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Adverse publicity concerning any actual or purported failure of our Company or our independent distributors to comply with applicable laws and regulations regarding product claims and advertising, good manufacturing practices, the regulation of our network marketing program, the licensing of our products for sale in our target markets or other aspects of our business, whether or not resulting in enforcement actions or the imposition of penalties, could have an adverse effect on the goodwill of our Company and could negatively affect our ability to attract, motivate and retain distributors, which would negatively impact our ability to generate revenue. We cannot ensure that all of our independent distributors will comply with applicable legal requirements relating to the advertising, labeling, licensing or distribution of our products.

In addition, our distributors’ and consumers’ perception of the safety and quality of our products and ingredients as well as similar products and ingredients distributed by other companies can be significantly influenced by media attention, publicized scientific research or findings, widespread product liability claims and other publicity concerning our products or ingredients or similar products and ingredients distributed by other companies. For example, in May 2008 public allegations were made that certain of our products contain excessive amounts of lead thereby triggering disclosure and labeling requirements under California Proposition 65. Following an investigation, these allegations were publicly withdrawn by the allegations initiator. While we have confidence in our products because they fall within FDA suggested guidelines as well as applicable state regulations for the amount of lead that consumers can safely ingest and do not believe they trigger disclosure or labeling requirements under California Proposition 65, negative publicity such as this can disrupt our business. Adverse publicity, whether or not accurate or resulting from consumers’ use or misuse of our products, that associates consumption of our products or ingredients or any similar products or ingredients with illness or other adverse effects, questions the benefits of our or similar products or claims that any such products are ineffective, inappropriately labeled or have inaccurate instructions as to their use, could lead to lawsuits or other legal challenges and could negatively impact our reputation, the market demand for our products, or our general business.

From time to time we receive inquiries from government agencies and third parties requesting information concerning our products. We fully cooperate with these inquiries including, when requested, by the submission of detailed technical dossiers addressing product composition, manufacturing, process control, quality assurance, and contaminant testing. Further, we periodically respond to requests from regulators for additional information regarding product-specific adverse events. We are confident in the safety of our products when used as directed. However, there can be no assurance that regulators in these or other markets will not take actions that might delay or prevent the introduction of new products, or require the reformulation or the temporary or permanent withdrawal of certain of our existing products from their markets.

Adverse publicity relating to us, our products or our operations, including our network marketing program or the attractiveness or viability of the financial opportunities provided thereby, has had, and could again have, a negative effect on our ability to attract, motivate and retain distributors, and it could also affect our share price. In the mid-1980’s, our products and marketing program became the subject of regulatory scrutiny in the United States, resulting in large part from claims and representations made about our products by our independent distributors, including impermissible therapeutic claims. The resulting adverse publicity caused a rapid, substantial loss of distributors in the United States and a corresponding reduction in sales beginning in 1985. In addition, in late 2012, a hedge fund manager publicly raised allegations regarding the legality of our network marketing program and announced that his fund had taken a significant short position regarding our common shares, leading to intense public scrutiny and significant stock price volatility. We expect that negative publicity will, from time to time, continue to negatively impact our business in particular markets and may adversely affect our share price.

Our failure to appropriately respond to changing consumer preferences and demand for new products or product enhancements could significantly harm our distributor and customer relationships and product sales and harm our financial condition and operating results.

Our business is subject to changing consumer trends and preferences, especially with respect to weight management products. Our continued success depends in part on our ability to anticipate and respond to these changes, and we may not respond in a timely or commercially appropriate manner to such changes. Furthermore, the nutritional supplement industry is characterized by rapid and frequent changes in demand for products and new product introductions and enhancements. Our failure to accurately predict these trends could negatively impact consumer opinion of our products, which in turn could harm our customer and distributor relationships and cause the loss of sales. The success of our new product offerings and enhancements depends upon a number of factors, including our ability to:

 

   

accurately anticipate customer needs;

 

   

innovate and develop new products or product enhancements that meet these needs;

 

   

successfully commercialize new products or product enhancements in a timely manner;

 

   

price our products competitively;

 

   

manufacture and deliver our products in sufficient volumes and in a timely manner; and

 

   

differentiate our product offerings from those of our competitors.

 

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If we do not introduce new products or make enhancements to meet the changing needs of our customers in a timely manner, some of our products could be rendered obsolete, which could negatively impact our revenues, financial condition and operating results.

Due to the high level of competition in our industry, we might fail to retain our customers and distributors, which would harm our financial condition and operating results.

The business of marketing weight management and nutrition products is highly competitive and sensitive to the introduction of new products or weight management plans, including various prescription drugs, which may rapidly capture a significant share of the market. These market segments include numerous manufacturers, distributors, marketers, retailers and physicians that actively compete for the business of consumers both in the United States and abroad. In addition, we anticipate that we will be subject to increasing competition in the future from sellers that utilize electronic commerce. Some of these competitors have longer operating histories, significantly greater financial, technical, product development, marketing and sales resources, greater name recognition, larger established customer bases and better-developed distribution channels than we do. Our present or future competitors may be able to develop products that are comparable or superior to those we offer, adapt more quickly than we do to new technologies, evolving industry trends and standards or customer requirements, or devote greater resources to the development, promotion and sale of their products than we do. For example, if our competitors develop other diet or weight management treatments that prove to be more effective than our products, demand for our products could be reduced. Accordingly, we may not be able to compete effectively in our markets and competition may intensify.

We are also subject to significant competition for the recruitment of distributors from other network marketing organizations, including those that market weight management products, dietary and nutritional supplements and personal care products as well as other types of products. We compete for global customers and distributors with regard to weight management, nutritional supplement and personal care products. Our competitors include both direct selling companies such as NuSkin Enterprises, Nature’s Sunshine, Alticor/Amway, Melaleuca, Avon Products, Oriflame, Omnilife, Tupperware and Mary Kay, as well as retail establishments such as Weight Watchers, Jenny Craig, General Nutrition Centers, Wal-Mart and retail pharmacies.

In addition, because the industry in which we operate is not particularly capital intensive or otherwise subject to high barriers to entry, it is relatively easy for new competitors to emerge who will compete with us for our distributors and customers. In addition, the fact that our distributors may easily enter and exit our network marketing program contributes to the level of competition that we face. For example, a distributor can enter or exit our network marketing system with relative ease at any time without facing a significant investment or loss of capital because (1) we have a low upfront financial cost to become a Herbalife distributor, (2) we do not require any specific amount of time to work as a distributor, (3) we do not insist on any special training to be a distributor and (4) we do not prohibit a new distributor from working with another company. Our ability to remain competitive therefore depends, in significant part, on our success in recruiting and retaining distributors through an attractive compensation plan, the maintenance of an attractive product portfolio and other incentives. We cannot ensure that our programs for recruitment and retention of distributors will be successful and if they are not, our financial condition and operating results would be harmed.

We are affected by extensive laws, governmental regulations, administrative determinations, court decisions and similar constraints both domestically and abroad, and our failure or our distributors’ failure to comply with these constraints could lead to the imposition of significant penalties or claims, which could harm our financial condition and operating results.

In both domestic and foreign markets, the formulation, manufacturing, packaging, labeling, distribution, advertising, importation, exportation, licensing, sale and storage of our products are affected by extensive laws, governmental regulations, administrative determinations, court decisions and similar constraints. Such laws, regulations and other constraints may exist at the federal, state or local levels in the United States and at all levels of government in foreign jurisdictions. There can be no assurance that we or our distributors are in compliance with all of these regulations. Our failure or our distributors’ failure to comply with these regulations or new regulations could disrupt our distributors’ sale of our products, or lead to the imposition of significant penalties or claims and could negatively impact our business. In addition, the adoption of new regulations or changes in the interpretations of existing regulations may result in significant compliance costs or discontinuation of product sales and may negatively impact the marketing of our products, resulting in significant loss of sales revenues.

The FTC revised its Guides Concerning the Use of Endorsements and Testimonials in Advertising, or Guides, which became effective on December 1, 2009. Although the Guides are not binding, they explain how the FTC interprets Section 5 of the FTC Act’s prohibition on unfair or deceptive acts or practices. Consequently, the FTC could bring a Section 5 enforcement action based on practices that are inconsistent with the Guides. Under the revised Guides, advertisements that feature a consumer and convey his or her atypical experience with a product or service are required to clearly disclose the results that consumers can generally expect. In contrast to the 1980 version of the Guides, which allowed advertisers to describe atypical results in a testimonial as long as they included a disclaimer such as “results not typical”, the revised Guides no longer contain such a safe harbor. The revised Guides also add new examples to illustrate the long-standing principle that “material connections” between advertisers and endorsers (such as payments or free products), connections that consumers might not expect, must be disclosed. Herbalife has revised its marketing materials to be compliant with the revised Guides. However, it is possible that our use, and that of our independent distributors, of testimonials in the advertising and promotion of our products, including but not limited to our weight management products and our income opportunity, will be significantly impacted and therefore might negatively impact our sales.

 

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Governmental regulations in countries where we plan to commence or expand operations may prevent or delay entry into those markets. In addition, our ability to sustain satisfactory levels of sales in our markets is dependent in significant part on our ability to introduce additional products into such markets. However, governmental regulations in our markets, both domestic and international, can delay or prevent the introduction, or require the reformulation or withdrawal, of certain of our products. Any such regulatory action, whether or not it results in a final determination adverse to us, could create negative publicity, with detrimental effects on the motivation and recruitment of distributors and, consequently, on sales.

We are subject to FDA rules for current good manufacturing practices, or cGMPs, for the manufacture, packing, labeling and holding of dietary supplements distributed in the United States. Herbalife has implemented a comprehensive quality assurance program that is designed to maintain compliance with the cGMPs for dietary supplements manufactured by or on behalf of Herbalife for distribution in the United States. However, if Herbalife should be found not to be in compliance with cGMPs for the products it self-manufactures it could negatively impact our reputation and ability to sell our products even after any such situation had been rectified. Further, if contract manufacturers whose products bear Herbalife labels fail to comply with the cGMPs, this could negatively impact Herbalife’s reputation and ability to sell its products even though Herbalife is not directly liable under the cGMPs for such compliance. In complying with the dietary supplement cGMPs, we have experienced increases in production costs as a result of the necessary increase in testing of raw ingredients, work in process and finished products.

From time to time, the Company is subject to inquiries from and investigations by various governmental and other regulatory authorities with respect to the legality of the Company’s network marketing program. Given the nature of recent allegations made by certain short sellers and related market events, the Company believes it may receive governmental inquiries (such as the previously disclosed SEC inquiry). To the extent any of these inquiries are or become material they will be disclosed individually. Consistent with its policies, the Company is and will fully cooperate with any inquiries and looks forward to resolving them in a timely manner.

Our network marketing program could be found to be not in compliance with current or newly adopted laws or regulations in one or more markets, which could prevent us from conducting our business in these markets and harm our financial condition and operating results.

Our network marketing program is subject to a number of federal and state regulations administered by the FTC and various state agencies in the United States as well as regulations on direct selling in foreign markets administered by foreign agencies. We are subject to the risk that, in one or more markets, our network marketing program could be found not to be in compliance with applicable law or regulations. Regulations applicable to network marketing organizations generally are directed at preventing fraudulent or deceptive schemes, often referred to as “pyramid” or “chain sales” schemes, by ensuring that product sales ultimately are made to consumers and that advancement within an organization is based on sales of the organization’s products rather than investments in the organization or other non-retail sales-related criteria. The regulatory requirements concerning network marketing programs do not include “bright line” rules and are inherently fact-based and, thus, we are subject to the risk that these laws or regulations or the enforcement or interpretation of these laws and regulations by governmental agencies or courts can change. The ambiguity surrounding these laws can also affect the public perception of our company. Specifically, in late 2012, a hedge fund manager publicly raised allegations regarding the legality of our network marketing program and announced that his fund had taken a significant short position regarding our common shares, leading to intense public scrutiny and significant stock price volatility. The failure of our network marketing program to comply with current or newly adopted regulations could negatively impact our business in a particular market or in general and may adversely affect our share price.

We are also subject to the risk of private party challenges to the legality of our network marketing program. Some multi-level marketing programs of other companies have been successfully challenged in the past, while other challenges to multi-level marketing programs of other companies have been defeated. In 2004 Test Ankoop-Test Achat, a Belgian consumer protection organization, sued Herbalife International Belgium, S.V., or HIB, challenging the legality of our network marketing program in Belgium. On November 23, 2011, the Brussels Commercial Court rendered a judgment that HIB is in violation of the Belgian law on Unfair Commercial Practices by establishing, operating or promoting a pyramid scheme where a consumer gives consideration for the opportunity to receive compensation that is derived primarily from the introduction of other consumers into the scheme rather than from the sale or consumption of products. The court ordered cessation of the violation, and a penalty payment of EUR 5,000 per infringement (limited to a total amount of penalty payments of EUR 250,000) starting two months from the official notification of the judgment. HIB has not yet been officially notified of the judgment and therefore the conditions for possible penalty payments have not been fulfilled. The Company believes the trial court’s judgment is flawed legally and factually and on March 8, 2012 filed an appeal of the judgment with the Court of Appeal of Brussels. A preliminary hearing was held on April 2, 2012 setting a briefing schedule. Since then Test Aankoop filed its reply on July 6, 2012 and Herbalife’s response was filed on September 28, 2012. Test Aankoop filed its final brief on February 12, 2013. The date for the oral hearing before the Court of Appeals of Brussels has been set for November 4, 2013. We believe that we have a meritorious basis to appeal this judgment. Nonetheless, the Company has implemented various relatively minor clarifications and changes which we believe are consistent with the trial court’s ruling pending the appeal procedure. This or other adverse judicial determinations with respect to our network marketing program, or in proceedings not

 

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involving us directly but which challenge the legality of multi-level marketing systems, in Belgium or in any other market in which we operate, could negatively impact our business. Additionally, Herbalife has been named as a defendant in a purported class action lawsuit filed April 8, 2013 in the U.S. District Court for the Central District of California (Bostick v. Herbalife International of America, Inc., et al) challenging the legality of our network marketing program under various state and federal laws. On May 30, 2013, we filed a motion to dismiss the lawsuit on a variety of grounds. On October 11, 2013, after plaintiff indicated his intention to dismiss certain claims brought under federal law, the Court denied our motion to dismiss the remaining state claims. We believe the suit is without merit and plan to defend the suit vigorously.

A substantial portion of our business is conducted in foreign markets, exposing us to the risks of trade or foreign exchange restrictions, increased tariffs, foreign currency fluctuations, disruptions or conflicts with our third party importers and similar risks associated with foreign operations.

Approximately 80% of our net sales for the year ended December 31, 2012, were generated outside the United States, exposing our business to risks associated with foreign operations. For example, a foreign government may impose trade or foreign exchange restrictions or increased tariffs, or otherwise limit or restrict our ability to import products into a country, any of which could negatively impact our operations. We are also exposed to risks associated with foreign currency fluctuations. For instance, purchases from suppliers are generally made in U.S. dollars while sales to distributors are generally made in local currencies. Accordingly, strengthening of the U.S. dollar versus a foreign currency could have a negative impact on us. Although we engage in transactions to protect against risks associated with foreign currency fluctuations, we cannot be certain any hedging activity will effectively reduce our exchange rate exposure. Additionally we may be negatively impacted by conflicts with or disruptions caused or faced by our third party importers, as well as conflicts between such importers and local governments or regulating agencies. Our operations in some markets also may be adversely affected by political, economic and social instability in foreign countries. As we continue to focus on expanding our existing international operations, these and other risks associated with international operations may increase, which could harm our financial condition and operating results.

Currency restrictions enacted by the Venezuelan government have become more restrictive and have impacted the ability of our subsidiary in Venezuela, or Herbalife Venezuela, to obtain U.S. dollars in exchange for Venezuelan Bolivars, or Bolivars, at the official foreign exchange rate from the Venezuelan government and its foreign exchange commission, CADIVI. The application and approval processes have been intermittently delayed and the timing and ability to obtain U.S. dollars at the official exchange rates remains uncertain. In certain instances, we have made appropriate applications through CADIVI for approval to obtain U.S. dollars so that Herbalife Venezuela can pay for imported products and an annual dividend, at the official exchange rate. In recent instances we have been unsuccessful in obtaining U.S. dollars at the official rate and it remains uncertain whether our current pending applications and future anticipated applications will be approved. As an alternative exchange mechanism, in prior years, we have also participated in certain bond offerings from the Venezuelan government and from Petróleos de Venezuela, S.A. or PDVSA, a Venezuelan state-owned petroleum company, where we effectively purchased bonds with our Bolivars and then sold the bonds for U.S. dollars. In other instances, we have also used other alternative legal exchange mechanisms for currency exchanges, such as the legal parallel market mechanism which was discontinued in May 2010.

In June 2010, the Venezuelan government introduced additional regulations under a newly regulated system, SITME, which was controlled by the Central Bank of Venezuela. SITME provided a mechanism to exchange Bolivars into U.S. dollars through the purchase and sale of U.S. dollar denominated bonds issued in Venezuela. However, SITME was only available in certain limited circumstances. Specifically, SITME could only be used for product purchases and it was not available for other matters such as the payment of dividends. Also, SITME could only be used for amounts of up to $50,000 per day and $350,000 per month and was generally only available to the extent that the applicant had not exchanged and received U.S. dollars via the CADIVI process within the previous 90 days. While we currently plan to continue to import products into Venezuela and exchange Bolivars for U.S. dollars based on the exchange mechanisms prescribed by the Venezuelan government, if the current currency restrictions are not lifted or eased, our product supplies in the Venezuelan market may be limited and we may make changes to Herbalife Venezuela’s operations each of which could negatively impact our business.

In February 2013, the Venezuela government announced it devalued its Bolivar currency and will eliminate the SITME regulated system. The SITME 5.3 Bolivars per U.S. dollar rate was eliminated and the CADIVI rate has been devalued from 4.3 Bolivars to 6.3 Bolivars per U.S. dollar. This new CADIVI rate is approximately 16% less favorable than the previously published 5.3 SITME rate. We recognized approximately $15.1 million of net foreign exchange losses within our condensed consolidated statements of income during the first quarter of 2013, as result of remeasuring our Bolivar denominated monetary assets and liabilities at this new CADIVI rate of 6.3 Bolivars per U.S. dollar. See Note 2, Significant Accounting Policies, to the Condensed Consolidated Financial Statements included in Item 1 of Part I of this Quarterly Report on Form 10-Q for further information on the Bolivar devaluation.

If the foreign currency restrictions in Venezuela intensify or do not improve, we may be required to deconsolidate Herbalife Venezuela for U.S. GAAP purposes and would be subject to the risk of impairment. In addition, if foreign currency restrictions do not improve, we may have to use alternative legal exchange mechanisms which are significantly less favorable than the official rate which could cause the Company to incur significant foreign exchange losses. Due to the current political and economic environment in Venezuela, there is also a risk that there could be additional foreign currency devaluations which could cause our cash and cash equivalents to decrease. If any of these events were to occur it could result in a significant negative impact to our consolidated earnings. See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, within our 2012 Annual Report on Form 10-K, for a further discussion on Venezuela.

 

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Our expansion in China is subject to general, as well as industry-specific, economic, political and legal developments and risks in China and requires that we utilize a different business model from that which we use elsewhere in the world.

Our expansion of operations into China is subject to risks and uncertainties related to general economic, political and legal developments in China, among other things. The Chinese government exercises significant control over the Chinese economy, including but not limited to controlling capital investments, allocating resources, setting monetary policy, controlling foreign exchange and monitoring foreign exchange rates, implementing and overseeing tax regulations, providing preferential treatment to certain industry segments or companies and issuing necessary licenses to conduct business. Accordingly, any adverse change in the Chinese economy, the Chinese legal system or Chinese governmental, economic or other policies could have a material adverse effect on our business in China and our prospects generally.

In 2005, China published regulations governing direct selling and prohibiting pyramid promotional schemes, and a number of administrative methods and proclamations were issued in 2005 and in 2006. These regulations require us to use a business model different from that which we offer in other markets. To allow us to operate under these regulations, we have created and introduced a model specifically for China. In China, we have Company-operated retail stores that can directly serve customers and preferred customers. We also have sales representatives who are permitted by the terms of our direct selling licenses to sell away from fixed retail locations in the provinces of Jiangsu, Guangdong, Shandong, Zhejiang, Guizhou, Beijing, Fujian, Sichuan, Hubei, Shanxi, Shanghai, Jiangxi, Liaoning, Jilin, Henan, Chongqing, Hebi, Shaanxi, Tianjin, Heilongjiang, Hunan, Guangxi, Hainan, Anhui and Yunnan.

We have also engaged independent service providers that meet both the requirements to operate their own business under Chinese law as well as the conditions set forth by Herbalife to sell products and provide marketing, sales and support services to Herbalife customers. These features are not common to the business model we employ elsewhere in the world, and based on the direct selling licenses we have received and the terms of those which we hope to receive in the future to conduct a direct selling enterprise in China, our business model in China will continue to incorporate some or all of these features. The direct selling regulations require us to apply for various approvals to conduct a direct selling enterprise in China. The process for obtaining the necessary licenses to conduct a direct selling business is protracted and cumbersome and involves multiple layers of Chinese governmental authorities and numerous governmental employees at each layer. While direct selling licenses are centrally issued, such licenses are generally valid only in the jurisdictions within which related approvals have been obtained. Such approvals are generally awarded on local and provincial bases, and the approval process requires involvement with multiple ministries at each level. Our participation and conduct during the approval process is guided not only by distinct Chinese practices and customs, but is also subject to applicable laws of China and the other jurisdictions in which we operate our business, including the U.S., as well as our internal code of ethics. There is always a risk that in attempting to comply with local customs and practices in China during the application process or otherwise, we will fail to comply with requirements applicable to us in China itself or in other jurisdictions, and any such failure to comply with applicable requirements could prevent us from obtaining the direct selling licenses or related local or provincial approvals. Furthermore, we rely on certain key personnel in China to assist us during the approval process, and the loss of any such key personnel could delay or hinder our ability to obtain licenses or related approvals. For all of the above reasons, there can be no assurance that we will obtain additional direct-selling licenses, or obtain related approvals to expand into any or all of the localities or provinces in China that are important to our business. Our inability to obtain, retain, or renew any or all of the licenses or related approvals that are required for us to operate in China could negatively impact our business.

Additionally, although certain regulations have been published with respect to obtaining and operating under such approvals and otherwise conducting business in China, other regulations are pending and there continues to be uncertainty regarding the interpretation and enforcement of Chinese regulations. The regulatory environment in China is evolving, and officials in the Chinese government exercise broad discretion in deciding how to interpret and apply regulations. We cannot be certain that our business model will continue to be deemed by national or local Chinese regulatory authorities to be compliant with any such regulations. The Chinese government rigorously monitors the direct selling market in China, and in the past has taken serious action against companies that the government believed were engaging in activities they regarded to be in violation of applicable law, including shutting down their businesses and imposing substantial fines. As a result, there can be no guarantee that the Chinese government’s current or future interpretation and application of the existing and new regulations will not negatively impact our business in China, result in regulatory investigations or lead to fines or penalties against us or our Chinese distributors.

Chinese regulations prevent persons who are not Chinese nationals from engaging in direct selling in China. We cannot guarantee that any of our distributors living outside of China or any of our sales representatives or independent service providers in China have not engaged or will not engage in activities that violate our policies in this market, or that violate Chinese law or other applicable law, and therefore result in regulatory action and adverse publicity.

China enacted a labor contract law which took effect January 1, 2008 and on September 18, 2008 an implementing regulation took effect. On October 28, 2010 China enacted a social insurance law that came into effect on July 1, 2011. We have reviewed our employment contracts and contractual relations with employees in China, which include certain of our employed sales personnel, and have transferred those employed sales personnel into independent service providers and have made such other changes as we believe to be necessary or appropriate to bring these contracts and contractual relations into compliance with these laws and their implementing regulations. In addition, we continue to monitor the situation to determine how these laws and regulations will be implemented in practice. There is no guarantee that these laws will not adversely impact us, cause us to change our operating plan for China or otherwise have an adverse impact on our business operations in China.

 

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If our operations in China are successful, we may experience rapid growth in China, and there can be no assurances that we will be able to successfully manage rapid expansion of manufacturing operations and a rapidly growing and dynamic sales force. If we are unable to effectively manage such growth and expansion of our retail stores and manufacturing operations, our government relations may be compromised and our operations in China may be harmed.

If we fail to further penetrate existing markets and expand our business into new markets, then the growth in sales of our products, along with our operating results, could be negatively impacted.

The success of our business is to a large extent contingent on our ability to further penetrate existing markets and to a much less extent enter into new markets. Our ability to further penetrate existing markets or to expand our business into additional countries in Eastern Europe, Southeast Asia, South America, Africa or elsewhere, to the extent we believe that we have identified attractive geographic expansion opportunities in the future, is subject to numerous factors, many of which are out of our control.

In addition, government regulations in both our domestic and international markets can delay or prevent the introduction, or require the reformulation or withdrawal, of some of our products, which could negatively impact our business, financial condition and results of operations. Also, our ability to increase market penetration in certain countries may be limited by the finite number of persons in a given country inclined to pursue a direct selling business opportunity or consumers willing to purchase Herbalife products. Moreover, our growth will depend upon improved training and other activities that enhance distributor retention in our markets. While we have recently experienced significant growth in certain of our markets, we cannot assure you that such growth levels will continue in the immediate or long term future. Furthermore, our efforts to support growth in such international markets could be hampered to the extent that our infrastructure in such markets is deficient when compared to our more developed markets, such as the U.S. Therefore, we cannot assure you that our general efforts to increase our market penetration and distributor retention in existing markets will be successful. If we are unable to continue to expand into new markets or further penetrate existing markets, our operating results could suffer.

Our contractual obligation to sell our products only through our Herbalife distributor network and to refrain from changing certain aspects of our marketing plan may limit our growth.

We are a party to an agreement with our distributors that provides assurances that we will not sell Herbalife products through any distribution channel other than our network of independent Herbalife distributors. Thus, we are contractually prohibited from expanding our business by selling Herbalife products through other distribution channels that may be available to our competitors, such as over the internet, through wholesale sales, by establishing retail stores or through mail order systems. Since this is an open-ended commitment, there can be no assurance that we will be able to take advantage of innovative new distribution channels that are developed in the future.

In addition, this agreement with our distributors provides that we will not change certain aspects of our marketing plan without the consent of a specified percentage of our distributors. For example, our agreement with our distributors provides that we may increase, but not decrease, the discount percentages available to our distributors for the purchase of products or the applicable royalty override percentages, including roll-ups, and production and other bonus percentages available to our distributors at various qualification levels within our distributor hierarchy. We may not modify the eligibility or qualification criteria for these discounts, royalty overrides and production and other bonuses unless we do so in a manner to make eligibility and/or qualification easier than under the applicable criteria in effect as of the date of the agreement. Our agreement with our distributors further provides that we may not vary the criteria for qualification for each distributor tier within our distributor hierarchy, unless we do so in such a way so as to make qualification easier.

Although we reserved the right to make these changes to our marketing plan without the consent of our distributors in the event that changes are required by applicable law or are necessary in our reasonable business judgment to account for specific local market or currency conditions to achieve a reasonable profit on operations, there can be no assurance that our agreement with our distributors will not restrict our ability to adapt our marketing plan to the evolving requirements of the markets in which we operate. As a result, our growth may be limited.

We depend on the integrity and reliability of our information technology infrastructure, and any related inadequacies may result in substantial interruptions to our business.

Our ability to provide products and services to our distributors depends on the performance and availability of our core transactional systems. We upgraded our back office systems globally to the Oracle Enterprise Suite which is supported by a robust hardware and network infrastructure. The Oracle Enterprise Suite is a scalable and stable solution that provides a solid foundation upon which we are building our next generation Distributor facing Internet toolset. While we continue to invest in our information technology infrastructure, there can be no assurance that there will not be any significant interruptions to such systems or that the systems will be adequate to meet all of our future business needs.

 

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The most important aspect of our information technology infrastructure is the system through which we record and track distributor sales, volume points, royalty overrides, bonuses and other incentives. We have encountered, and may encounter in the future, errors in our software or our enterprise network, or inadequacies in the software and services supplied by our vendors, although to date none of these errors or inadequacies has had a meaningful adverse impact on our business. Any such errors or inadequacies that we may encounter in the future may result in substantial interruptions to our services and may damage our relationships with, or cause us to lose, our distributors if the errors or inadequacies impair our ability to track sales and pay royalty overrides, bonuses and other incentives, which would harm our financial condition and operating results. Such errors may be expensive or difficult to correct in a timely manner, and we may have little or no control over whether any inadequacies in software or services supplied to us by third parties are corrected, if at all.

Our ability to effectively manage our network of independent distributors, and to ship products, and track royalty and bonus payments on a timely basis, depends significantly on our information systems. The failure of our information systems to operate effectively, or a breach in security of these systems, could adversely impact the promptness and accuracy of our product distribution and transaction processing. We could be required to make significant additional expenditures to remediate any such failure, problem or breach.

Anyone that is able to circumvent our security measures could misappropriate confidential or proprietary information, including that of third parties such as our independent distributors, cause interruption in our operations, damage our computers or otherwise damage our reputation and business. We may need to expend significant resources to protect against security breaches or to address problems caused by such breaches. Any actual security breaches could damage our reputation and expose us to a risk of loss or litigation and possible liability under various laws and regulations. In addition, employee error or malfeasance or other errors in the storage, use or transmission of any such information could result in a disclosure to third parties. If this should occur we could incur significant expenses addressing such problems. Since we collect and store distributor and vendor information, including credit card information, these risks are heightened.

Since we rely on independent third parties for the manufacture and supply of certain of our products, if these third parties fail to reliably supply products to us at required levels of quality and which are manufactured in compliance with applicable laws, including the dietary supplement cGMPs, then our financial condition and operating results would be harmed.

The majority of our products are manufactured at third party contract manufacturers, with the exception of our products sold in China, which are manufactured in our Suzhou China facility, and certain of our top selling products which are produced in our manufacturing facility located in Lake Forest, California. It is the Company’s intention to expand the capacity of its existing manufacturing facilities, and add additional facilities, to produce additional products for our North America and international markets. In December of 2012 we purchased a facility in Winston-Salem, North Carolina and are in the process of refurbishing this facility to become our largest finished goods manufacturing facility. We expect this facility to become operational in June 2014. We cannot assure you that our outside contract manufacturers will continue to reliably supply products to us at the levels of quality, or the quantities, we require, and in compliance with applicable laws, including under the FDA’s cGMP regulations and while efforts are being made to ensure a smooth transition we cannot assure you that the transition from our third party contract manufacturers to this new Herbalife facility will not result in possible inventory shortages. Additionally, while we are not presently aware of any current liquidity issues with our suppliers, we cannot assure you that they will not experience financial hardship as a result of the current global financial crisis.

For the portion of our product supply that is self-manufactured, we believe we have significantly lowered the product supply risk, as the risk factors of financial health, liquidity, capacity expansion, reliability and product quality are all within our control. However, a significant delay in completion of the Winston-Salem Facility, while unlikely, could hamper our ability to support the continued growth in net sales.

Our supply contracts generally have a two-year term. Except for force majeure events such as natural disasters and other acts of God, and non-performance by Herbalife, our manufacturers generally cannot unilaterally terminate these contracts. These contracts can generally be extended by us at the end of the relevant time period and we have exercised this right in the past. Globally we have approximately 40 suppliers of our products. For our major products, we typically have both primary and secondary suppliers. Our major suppliers include Fine Foods (Italy) for meal replacements, protein powders and nutritional supplements, Valentine Enterprises (U.S.) for meal replacements and protein powders, Nature’s Bounty (U.S.) for meal replacements and nutritional supplements, and PharmaChem Labs (U.S.) for teas and Niteworks®. Additionally we use contract manufacturers in India, Brazil, Korea, Japan, Taiwan and Germany to support our global business. In the event any of our contract manufacturers were to become unable or unwilling to continue to provide us with products in required volumes and at suitable quality levels, we would be required to identify and obtain acceptable replacement manufacturing sources. There is no assurance that we would be able to obtain alternative manufacturing sources on a timely basis. An extended interruption in the supply of products would result in the loss of sales. In addition, any actual or perceived degradation of product quality as a result of reliance on contract manufacturers may have an adverse effect on sales or result in increased product returns and buybacks. Also, as we experience ingredient and product price pressure in the areas of soy, fructose, dairy products, gums, plastics, and transportation reflecting global economic trends, we believe that we have the ability to mitigate some of these cost increases through improved optimization of our supply chain coupled with select increases in the retail prices of our products.

If we fail to protect our trademarks and tradenames, then our ability to compete could be negatively affected, which would harm our financial condition and operating results.

The market for our products depends to a significant extent upon the goodwill associated with our trademark and tradenames. We own, or have licenses to use, the material trademark and trade name rights used in connection with the packaging, marketing and

 

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distribution of our products in the markets where those products are sold. Therefore, trademark and trade name protection is important to our business. Although most of our trademarks are registered in the United States and in certain foreign countries in which we operate, we may not be successful in asserting trademark or trade name protection. In addition, the laws of certain foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States. The loss or infringement of our trademarks or tradenames could impair the goodwill associated with our brands and harm our reputation, which would harm our financial condition and operating results.

Unlike in most of the other markets in which we operate, limited protection of intellectual property is available under Chinese law. Accordingly, we face an increased risk in China that unauthorized parties may attempt to copy or otherwise obtain or use our trademarks, copyrights, product formulations or other intellectual property. Further, since Chinese commercial law is relatively undeveloped, we may have limited legal recourse in the event we encounter significant difficulties with intellectual property theft or infringement. As a result, we cannot assure you that we will be able to adequately protect our product formulations or other intellectual property.

We permit the limited use of our trademarks by our independent distributors to assist them in the marketing of our products. It is possible that doing so may increase the risk of unauthorized use or misuse of our trademarks in markets where their registration status differs from that asserted by our independent distributors, or they may be used in association with claims or products in a manner not permitted under applicable laws and regulations. Were this to occur it is possible that this could diminish the value of these marks or otherwise impair our further use of these marks.

If our distributors fail to comply with labeling laws, then our financial condition and operating results would be harmed.

Although the physical labeling of our products is not within the control of our independent distributors, our distributors must nevertheless advertise our products in compliance with the extensive regulations that exist in certain jurisdictions, such as the United States, which considers product advertising to be labeling for regulatory purposes.

Our products are sold principally as foods, dietary supplements and cosmetics and are subject to rigorous FDA and related legal regimens limiting the types of therapeutic claims that can be made for our products. The treatment or cure of disease, for example, is not a permitted claim for these products. While we train our distributors and attempt to monitor our distributors’ marketing materials, we cannot ensure that all such materials comply with applicable regulations, including bans on therapeutic claims. If our distributors fail to comply with these restrictions, then we and our distributors could be subjected to claims, financial penalties, mandatory product recalls or relabeling requirements, which could harm our financial condition and operating results. Although we expect that our responsibility for the actions of our independent distributors in such an instance would be dependent on a determination that we either controlled or condoned a noncompliant advertising practice, there can be no assurance that we could not be held vicariously liable for the actions of our independent distributors.

If our intellectual property is not adequate to provide us with a competitive advantage or to prevent competitors from replicating our products, or if we infringe the intellectual property rights of others, then our financial condition and operating results would be harmed.

Our future success and ability to compete depend upon our ability to timely produce innovative products and product enhancements that motivate our distributors and customers, which we attempt to protect under a combination of copyright, trademark and trade secret laws, confidentiality procedures and contractual provisions. However, our products are generally not patented domestically or abroad, and the legal protections afforded by common law and contractual proprietary rights in our products provide only limited protection and may be time-consuming and expensive to enforce and/or maintain. Further, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our proprietary rights or from independently developing non-infringing products that are competitive with, equivalent to and/or superior to our products.

Monitoring infringement and/or misappropriation of intellectual property can be difficult and expensive, and we may not be able to detect every infringement or misappropriation of our proprietary rights. Even if we do detect infringement or misappropriation of our proprietary rights, litigation to enforce these rights could cause us to divert financial and other resources away from our business operations. Further, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States.

Additionally, third parties may claim that products or marks that we have independently developed or which bear certain of our trademarks infringe upon their intellectual property rights and there can be no assurance that one or more of our products or marks will not be found to infringe upon third party intellectual property rights in the future.

 

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Since one of our products constitutes a significant portion of our retail sales, significant decreases in consumer demand for this product or our failure to produce a suitable replacement should we cease offering it would harm our financial condition and operating results.

Our Formula 1 meal replacement product constitutes a significant portion of our sales, accounting for approximately 29%, 29%, and 28% of net sales for the fiscal years ended December 31, 2012, 2011, and 2010, respectively. If consumer demand for this product decreases significantly or we cease offering this product without a suitable replacement, then our financial condition and operating results would be harmed.

If we lose the services of members of our senior management team, then our financial condition and operating results could be harmed.

We depend on the continued services of our Chairman and Chief Executive Officer, Michael O. Johnson, and our current senior management team as they work closely with the senior distributor leadership to create an environment of inspiration, motivation and entrepreneurial business success. Although we have entered into employment agreements with certain members of our senior management team, and do not believe that any of them are planning to leave or retire in the near term, we cannot assure you that our senior managers will remain with us. The loss or departure of any member of our senior management team could adversely impact our distributor relations and operating results. If any of these executives do not remain with us, our business could suffer. Also, the loss of key personnel, including our regional and country managers, could negatively impact our ability to implement our business strategy, and our continued success will also be dependent on our ability to retain existing, and attract additional, qualified personnel to meet our needs. We currently do not maintain “key person” life insurance with respect to our senior management team.

The covenants in our existing indebtedness limit our discretion with respect to certain business matters, which could limit our ability to pursue certain strategic objectives and in turn harm our financial condition and operating results.

Our credit facility contains financial and operating covenants that restrict our and our subsidiaries’ ability to, among other things:

 

   

pay dividends, redeem share capital or capital stock and make other restricted payments and investments;

 

   

incur or guarantee additional debt;

 

   

impose dividend or other distribution restrictions on our subsidiaries;

 

   

create liens on our and our subsidiaries’ assets;

 

   

engage in transactions with affiliates; and

 

   

merge, consolidate or sell all or substantially all of our assets and the assets of our subsidiaries.

In addition, our credit facility requires us to meet certain financial ratios and financial conditions. Our ability to comply with these covenants may be affected by events beyond our control, including prevailing economic, financial and industry conditions. Failure to comply with these covenants could result in a default causing all amounts to become due and payable under our credit facility, which is secured by substantially all of our domestic assets, against which the lenders thereunder could proceed to foreclose.

If we do not comply with transfer pricing, customs duties, VAT, and similar regulations, then we may be subjected to additional taxes, duties, interest and penalties in material amounts, which could harm our financial condition and operating results.

As a multinational corporation, in many countries including the United States we are subject to transfer pricing and other tax regulations designed to ensure that our intercompany transactions are consummated at prices that have not been manipulated to produce a desired tax result, that appropriate levels of income are reported as earned by our United States or local entities, and that we are taxed appropriately on such transactions. In addition, our operations are subject to regulations designed to ensure that appropriate levels of customs duties are assessed on the importation of our products. We are currently subject to pending or proposed audits that are at various levels of review, assessment or appeal in a number of jurisdictions involving transfer pricing issues, income taxes, customs duties, value added taxes, withholding taxes, sales and use and other taxes and related interest and penalties in material amounts. In some circumstances, additional taxes, interest and penalties have been assessed and we will be required to pay the assessments or post surety, in order to challenge the assessments.

The imposition of new taxes, even pass-through taxes such as VAT, could have an impact on our perceived product pricing and therefore a potential negative impact on our business. We have reserved in the consolidated financial statements an amount that we believe represents the most likely outcome of the resolution of these disputes, but if we are incorrect in our assessment we may have to pay the full amount asserted which could potentially be material. Ultimate resolution of these matters may take several years, and the outcome is uncertain. If the United States Internal Revenue Service or the taxing authorities of any other jurisdiction were to successfully challenge our transfer pricing practices or our positions regarding the payment of income taxes, customs duties, value added taxes, withholding taxes, sales and use, and other taxes, we could become subject to higher taxes and our revenue and earnings could be adversely affected.

On May 13, 2011, the Mexican Tax Administration Service issued a resolution nullifying a prior assessment in an amount equivalent to approximately $87 million, translated at the period ended spot rate, for various items, the majority of which was VAT allegedly owed on certain of our products imported into Mexico during years 2005 and 2006. Since, the Mexican Tax Administration Service can re-issue some or all of the original assessment, we commenced litigation in the Tax Court of Mexico in August 2011 to

 

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dispute the assertions made by the Mexican Tax Administration Service in the case. The Mexican Tax Administration Service filed a response which was received by us in April 2012. The response challenged the assertions that we made in our August 2011 filing. Litigation in this case is currently ongoing.

The Mexican Tax Administration Service commenced audits of our Mexican subsidiaries for the period from January to September 2007 and on May 10, 2013, we received an assessment of approximately $22 million, translated at the period ended spot rate, related to that period. On July 11, 2013 the Company filed an administrative appeal disputing the assessment.

The Mexican Tax Administration Service audited our Mexican subsidiaries for the 2011 year. The audit focused on importation and VAT issues. On June 25, 2013, the Mexican Tax Administration Service closed the audit of the 2011 year without any assessment.

We have not recognized a loss with respect to any of these Mexican matters as we, based on our analysis and guidance from our advisors, do not believe a loss is probable. Further, we are currently unable to reasonably estimate a possible loss or range of loss that could result from an unfavorable outcome if the assessment was re-issued or any additional assessments were to be issued for these or other periods. We believe that we have meritorious defenses if the assessment is re-issued or would have meritorious defenses if any additional assessment is issued. Any adverse outcomes in these matters could have a material impact on our financial condition and operating results.

We could become a “controlled foreign corporation” for U.S. federal income tax purposes.

We believe that we are currently not a “controlled foreign corporation” for U.S. federal income tax purposes. However, this conclusion depends upon the composition of shareholders who own 10% or more of our outstanding shares, applying special rules including constructive ownership rules (“10% shareholders”), and whether such 10% shareholders who are United States persons or entities own in the aggregate more than 50% of our outstanding shares. If we were to be or become a “controlled foreign corporation,” our 10% shareholders would be subject to special tax treatment. Any shareholders who contemplate owning 10% or more of our outstanding shares (taking into account the impact of any share repurchases we may undertake pursuant to share repurchase programs) are urged to consult with their tax advisors with respect to the special rules applicable to 10% shareholders of controlled foreign corporations.

Changes in tax laws, treaties or regulations, or their interpretation could adversely affect us.

A change in applicable tax laws, treaties or regulations or their interpretation could result in a higher effective tax rate on our worldwide earnings and such change could be significant to our financial results. Tax legislative proposals intending to eliminate some perceived tax advantages of companies that have legal domiciles outside the U.S. but have certain U.S. connections have repeatedly been introduced in the U.S. Congress. If these proposals are enacted, the result would increase our effective tax rate and could have a material adverse effect on the Company’s financial condition and results of operations.

We may be held responsible for certain taxes or assessments relating to the activities of our distributors, which could harm our financial condition and operating results.

Our distributors are subject to taxation, and in some instances, legislation or governmental agencies impose an obligation on us to collect taxes, such as value added taxes and social contributions, and to maintain appropriate records. In addition, we are subject to the risk in some jurisdictions of being responsible for social security, withholding or other taxes with respect to payments to our distributors. For example, in Spain, Brazil and Italy, the Company received tax assessments from the authorities for withholding taxes, social contributions, and related items in connection with payments made to distributors in those countries in prior periods. The Company has appealed the assessments. In the case of Spain substantially all the assessment was withdrawn and in the case of Italy the assessment is anticipated to be withdrawn. The Company believes it has meritorious defenses in other instances. In addition, in the event that local laws and regulations or the interpretation of local laws and regulations change to require us to treat our independent distributors as employees, or that our distributors are deemed by local regulatory authorities in one or more of the jurisdictions in which we operate to be our employees rather than independent contractors under existing laws and interpretations, we may be held responsible for social contributions, withholding and related taxes in those jurisdictions, plus any related assessments and penalties, which could harm our financial condition and operating results.

We may incur material product liability claims, which could increase our costs and harm our financial condition and operating results.

Our products consist of vitamins, minerals and botanicals and other ingredients that are classified as foods or dietary supplements and are not subject to pre-market regulatory approval in the United States. Our products could contain contaminated substances, and some of our products contain some ingredients that do not have long histories of human consumption. We