10-Q 1 gnc10-q3q2016.htm 10-Q Document

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, 2016
 
 
[     ]
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:  001-35113
 
GNC Holdings, Inc.
(Exact name of registrant as specified in its charter)
 
Delaware
20-8536244
(State or other jurisdiction of
(I.R.S. Employer
Incorporation or organization)
Identification No.)
 
 
300 Sixth Avenue
15222
Pittsburgh, Pennsylvania
(Zip Code)
(Address of principal executive offices)
 
 
Registrant’s telephone number, including area code:  (412) 288-4600
 
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.     [ X ] Yes [    ] No
 
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). 
X  ] Yes [    ] 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:
 
Large accelerated filer [X]
Accelerated filer [   ]
Non-accelerated filer [   ]
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
[ X ] No
 
As of October 25, 2016, there were 68,399,989 outstanding shares of Class A common stock, par value $0.001 per share (the “common stock”), of GNC Holdings, Inc.




TABLE OF CONTENTS
 
 
 
 
 
PAGE
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 




PART I - FINANCIAL INFORMATION

Item 1. Financial Statements
 
GNC HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Balance Sheets    
(unaudited)
(in thousands)

 
September 30, 2016
 
December 31, 2015
Current assets:
 
 
 
Cash and cash equivalents
$
37,203


$
56,462

Receivables, net
143,494


142,486

Inventory (Note 3)
621,865


555,885

Deferred income taxes
10,925


10,916

Prepaid and other current assets
32,553


27,114

Total current assets
846,040

 
792,863

Long-term assets:
 

 
 

Goodwill (Note 5)
647,806


649,892

Brands (Note 5)
720,000


720,000

Other intangible assets, net (Note 5)
113,197


119,204

Property, plant and equipment, net (Note 5)
221,775


230,535

Deferred income taxes
3,358


3,358

Other long-term assets
32,472


38,555

Total long-term assets
1,738,608

 
1,761,544

Total assets
$
2,584,648

 
$
2,554,407

Current liabilities:
 

 
 

Accounts payable
$
185,286


$
152,099

Current portion of long-term debt (Note 6)
4,550


4,550

Deferred revenue and other current liabilities
133,023


121,062

Total current liabilities
322,859

 
277,711

Long-term liabilities:
 

 
 

Long-term debt (Note 6)
1,544,038


1,444,628

Deferred income taxes
307,921


304,491

Other long-term liabilities
57,251


59,016

Total long-term liabilities
1,909,210

 
1,808,135

Total liabilities
2,232,069

 
2,085,846

Contingencies (Note 8)


 


Stockholders’ equity:
 

 
 

Common stock
114

 
114

Additional paid-in capital
921,794


916,128

Retained earnings
1,163,406


1,058,148

Treasury stock, at cost
(1,725,349
)

(1,496,180
)
Accumulated other comprehensive loss
(7,386
)

(9,649
)
Total stockholders’ equity
352,579

 
468,561

Total liabilities and stockholders’ equity
$
2,584,648

 
$
2,554,407

 
The accompanying notes are an integral part of the consolidated financial statements.

1


GNC HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Statements of Income
(unaudited)
(in thousands, except per share amounts)

 
Three months ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
2016
 
2015
Revenue
$
627,964

 
$
683,358

 
$
1,970,087

 
$
2,054,187

Cost of sales, including warehousing, distribution and occupancy

412,556

 
432,714

 
1,280,136

 
1,297,778

Gross profit
215,408

 
250,644

 
689,951

 
756,409

Selling, general, and administrative
148,392

 
141,155

 
430,448

 
421,013

Gains on refranchising (Note 4)
(383
)
 
(945
)
 
(18,283
)
 
(2,436
)
Long-lived asset impairments (Note 5)
3,045

 
28,333

 
3,045

 
28,333

Other (income) loss, net
(539
)
 
(49
)
 
(441
)
 
106

Operating income
64,893

 
82,150

 
275,182

 
309,393

Interest expense, net (Note 6)
15,360

 
13,753

 
45,078

 
36,912

Income before income taxes
49,533

 
68,397

 
230,104

 
272,481

Income tax expense (Note 12)
17,179

 
22,647

 
82,907

 
96,104

Net income
$
32,354

 
$
45,750

 
$
147,197

 
$
176,377

Earnings per share (Note 9):
 

 
 

 
 
 
 
Basic
$
0.47

 
$
0.55

 
$
2.11

 
$
2.06

Diluted
$
0.47

 
$
0.54

 
$
2.10

 
$
2.05

Weighted average common shares outstanding (Note 9):
 

 
 

 
 
 
 
Basic
68,190

 
83,669

 
69,808

 
85,663

Diluted
68,315

 
83,958

 
69,939

 
85,930

Dividends declared per share
$
0.20

 
$
0.18

 
$
0.60

 
$
0.54

 
The accompanying notes are an integral part of the consolidated financial statements.


2


GNC HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
(unaudited)
(in thousands)
 
 
Three months ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
2016
 
2015
Net income
$
32,354

 
$
45,750

 
$
147,197

 
$
176,377

Other comprehensive (loss) income:
 

 
 

 
 
 
 
Foreign currency translation (loss) gain
(592
)
 
(3,406
)
 
2,263

 
(6,568
)
Comprehensive income
$
31,762

 
$
42,344

 
$
149,460

 
$
169,809

 
The accompanying notes are an integral part of the consolidated financial statements.


3


GNC HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Statements of Stockholders’ Equity
(unaudited)
(in thousands)

 
Common Stock
 
Treasury Stock
 
Paid-in
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders’
Equity
 
Class A
 
 
 
 
 
 
Shares
 
Dollars
 
 
 
 
 
Balance at December 31, 2015
76,276

 
$
114

 
$
(1,496,180
)
 
$
916,128

 
$
1,058,148

 
$
(9,649
)
 
$
468,561

Comprehensive income

 

 

 

 
147,197

 
2,263

 
149,460

Purchase of treasury stock
(7,926
)
 

 
(229,169
)
 

 

 

 
(229,169
)
Dividends declared

 

 

 

 
(41,939
)
 

 
(41,939
)
Exercise of stock options
23

 

 

 
343

 

 

 
343

Restricted stock awards
72

 

 

 

 

 

 

Minimum tax withholding requirements
(47
)
 

 

 
(1,126
)
 

 

 
(1,126
)
Net excess tax benefits from stock-based compensation

 

 

 
(742
)
 

 

 
(742
)
Stock-based compensation

 

 

 
7,191

 

 

 
7,191

Balance at September 30, 2016
68,398

 
$
114

 
$
(1,725,349
)
 
$
921,794

 
$
1,163,406

 
$
(7,386
)
 
$
352,579

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2014
88,335

 
$
113

 
$
(1,016,381
)
 
$
877,566

 
$
898,574

 
$
(3,829
)
 
$
756,043

Comprehensive income (loss)

 

 

 

 
176,377

 
(6,568
)
 
169,809

Purchase of treasury stock
(6,012
)
 

 
(279,798
)
 

 

 

 
(279,798
)
Dividends declared

 

 

 

 
(45,986
)
 

 
(45,986
)
Exercise of stock options
71

 
1

 

 
1,597

 

 

 
1,598

Restricted stock awards
239

 

 

 

 

 

 

Minimum tax withholding requirements
(7
)
 

 

 
(381
)
 

 

 
(381
)
Net excess tax benefits from stock-based compensation

 

 

 
597

 

 

 
597

Stock-based compensation

 

 

 
4,747

 

 

 
4,747

Issuance of convertible notes, net (Note 6)

 

 

 
30,509

 

 

 
30,509

Balance at September 30, 2015
82,626

 
$
114

 
$
(1,296,179
)
 
$
914,635

 
$
1,028,965

 
$
(10,397
)
 
$
637,138

 
The accompanying notes are an integral part of the consolidated financial statements.


4


GNC HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(unaudited)
(in thousands)

 
Nine months ended September 30,
 
2016
 
2015
Cash flows from operating activities:
 


 

Net income
$
147,197


$
176,377

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


 

Depreciation and amortization expense
43,547


43,100

Amortization of debt costs
9,419


3,538

Stock-based compensation
7,191


4,747

Long-lived asset impairments
3,045

 
28,333

Gains on refranchising
(18,283
)

(2,436
)
Changes in assets and liabilities:





Decrease (increase) in receivables
3,519


(6,275
)
(Increase) decrease in inventory
(71,760
)

12,037

(Increase) in prepaid and other current assets
(5,342
)

(9,084
)
Increase in accounts payable
35,700


14,691

Increase in deferred revenue and accrued liabilities
13,515


11,635

Other operating activities
1,999


(1,924
)
Net cash provided by operating activities
169,747


274,739







Cash flows from investing activities:
 


 

Capital expenditures
(35,368
)

(30,432
)
Refranchising proceeds
30,306


1,888

Store acquisition costs
(1,918
)

(2,607
)
Net cash used in investing activities
(6,980
)

(31,151
)






Cash flows from financing activities:
 


 

Borrowings under revolving credit facility
197,000



Payments on revolving credit facility
(103,000
)


Payments on term loan facility
(3,412
)
 
(167,901
)
Proceeds from issuance of convertible senior notes

 
287,500

Debt issuance costs
(1,712
)

(8,225
)
Proceeds from exercise of stock options
343


1,597

Gross excess tax benefits from stock-based compensation
162


597

Minimum tax withholding requirements
(1,126
)

(381
)
Cash paid for treasury stock
(229,169
)

(279,798
)
Dividends paid to shareholders
(41,613
)

(45,904
)
Net cash used in financing activities
(182,527
)

(212,515
)






Effect of exchange rate changes on cash and cash equivalents
501


(833
)
Net (decrease) increase in cash and cash equivalents
(19,259
)

30,240

Beginning balance, cash and cash equivalents
56,462


133,834

Ending balance, cash and cash equivalents
$
37,203


$
164,074

 
The accompanying notes are an integral part of the consolidated financial statements.


5


GNC HOLDINGS, INC. AND SUBSIDIARIES
Supplemental Cash Flow Information
(unaudited)
(in thousands)



 
As of September 30,
 
2016
 
2015
Non-cash investing activities:
 
 
 
Accrued capital expenditures
$
3,432

 
$
2,117


The accompanying notes are an integral part of the consolidated financial statements.


6


GNC HOLDINGS, INC. AND SUBSIDIARIES
Condensed Notes to the Unaudited Consolidated Financial Statements


NOTE 1.  NATURE OF BUSINESS
 
GNC Holdings, Inc., a Delaware corporation (“Holdings,” and collectively with its subsidiaries and, unless the context requires otherwise, its and their respective predecessors, the “Company”), is a global specialty retailer of health, wellness and performance products, including protein, performance supplements, weight management supplements, vitamins, herbs and greens, wellness supplements, health and beauty, food and drink and other general merchandise.

The Company is vertically integrated as its operations consist of purchasing raw materials, formulating and manufacturing products and selling the finished products through its three reportable segments, which effective in the second quarter of 2016 include U.S. and Canada, International, and Manufacturing / Wholesale (refer to Note 11, "Segments" for more information). Corporate retail store operations are located in the United States, Canada, Puerto Rico, China and, beginning with the acquisition of THSD d/b/a The Health Store ("The Health Store") in 2014, Ireland. In addition, the Company offers products on the Internet through its websites, GNC.com and LuckyVitamin.com. The Company also offered product on the Internet through its 2013 acquisition of A1 Sports Limited d/b/a Discount Supplements (“Discount Supplements”) up to and including December 31, 2015 when the assets of Discount Supplements were sold and operations were ceased. Franchise locations exist in the United States and approximately 50 other countries. The Company operates its primary manufacturing facilities in South Carolina and distribution centers in Arizona, Indiana, Pennsylvania and South Carolina. The Company manufactures the majority of its branded products, but also merchandises various third-party products. Additionally, the Company licenses the use of its trademarks and trade names.
 
The processing, formulation, packaging, labeling and advertising of the Company’s products are subject to regulation by various federal agencies, including the Food and Drug Administration, the Federal Trade Commission, the Consumer Product Safety Commission, the United States Department of Agriculture and the Environmental Protection Agency. These activities are also regulated by various agencies of the states and localities in which the Company’s products are sold.

NOTE 2.  BASIS OF PRESENTATION
 
The accompanying unaudited consolidated financial statements, which have been prepared in accordance with the applicable rules of the Securities and Exchange Commission, include all adjustments (consisting of a normal and recurring nature) that management considers necessary to fairly state the Company's results of operations, financial position and cash flows. The December 31, 2015 consolidated balance sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America (“U.S. GAAP”). These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company’s audited financial statements in its Annual Report on Form 10-K for the year ended December 31, 2015 ("2015 10-K"). Interim results are not necessarily indicative of the results that may be expected for the remainder of the year ending December 31, 2016.

Revision for Sublease Rent Income

The Company revised its presentation of sublease income received from its franchisees for prior year periods to conform to the current period’s presentation with no impact on previously reported gross profit, operating income, net income, shareholders’ equity or cash flow from operations. The Company is the primary obligor of the leases for the majority of its franchise store locations and makes rental payments directly to the landlord and separately bills the franchisee for reimbursement. Accordingly, beginning in the first quarter of 2016, sublease rental income received from franchisees is appropriately presented as “Revenue” compared with the previous presentation as a reduction to occupancy expense in “Cost of sales, including warehousing, distribution, and occupancy" on the consolidated statements of income. In addition, the deferred rent asset associated with recognizing sublease rental income for lease agreements that contain escalation clauses, which are fixed and determinable, on a straight-line basis is now appropriately presented in “Other long-term assets” compared with the previous presentation as a reduction to the deferred rent liability in “Other long-term liabilities" on the consolidated balance sheets. This revision is not material to prior periods.


7


The following table includes the revisions to the 2015 consolidated statements of income:

 
Three months ended September 30
 
Nine months ended September 30
Revenue:
(in thousands)
Prior to revision
$
672,244

 
$
2,021,011

Revision
11,114

 
33,176

As Revised
$
683,358

 
$
2,054,187

Cost of sales, including warehousing, distribution and occupancy:

 

Prior to revision
$
421,600

 
$
1,264,602

Revision
11,114

 
33,176

As Revised
$
432,714

 
$
1,297,778


The following table includes the revision to the consolidated balance sheet:
 
December 31, 2015
Other long-term assets:
(in thousands)
Prior to revision (*)
$
32,891

Revision
5,664

As Revised
$
38,555

Other long-term liabilities:
 
Prior to revision
$
53,352

Revision
5,664

As Revised
$
59,016


(*) Includes the adoption of ASU 2015-03 and 2015-15 relating to the presentation of deferred financing fees as described below, which reclassified $3.3 million of debt issuance costs from "Other long-term assets" to "Long-term debt" at December 31, 2015 on the consolidated balance sheet.

Correction of Prior Year Immaterial Error

During the quarter ended March 31, 2015, the Company identified a $2.8 million error relating to prior periods in the calculation of the portion of the accrued payroll liability relating to certain amounts paid to store employees. The impact of this error was not material to any prior period. Consequently, the Company corrected the error in the first quarter of 2015 by increasing "Selling, general and administrative" expense on the consolidated statement of income and "Deferred revenue and other current liabilities" on the consolidated balance sheet by $2.8 million. The impact to net income was a decrease of $1.8 million for the nine months ended September 30, 2015. This correction had no impact on cash flows from operations for the prior year nine-month period.

Recently Adopted Accounting Pronouncements

In April 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standard Update ("ASU") 2015-03, which requires an entity to present debt issuance costs related to a recognized debt liability as a direct
reduction from the carrying amount of that debt liability, consistent with the treatment of debt discounts. This standard does not affect the recognition and measurement guidance for debt issuance costs. In August 2015, the FASB subsequently issued ASU 2015-15, which clarifies that ASU 2015-03 does not address the presentation of debt issuance costs related to line-of-credit arrangements. This standard is effective for fiscal years beginning after December 15, 2015. Accordingly, the Company adopted these standards during the first quarter of fiscal 2016, with retrospective application. Net debt issuance costs in the amount of $3.3 million, which were previously classified as "Other long-term assets" at December 31, 2015, were reclassified as a reduction to "Long-term debt" on the Company's consolidated balance sheet to conform to the current year presentation.

8


Recently Issued Accounting Pronouncements
    
In March 2016, the FASB issued ASU 2016-09, which includes multiple provisions intended to simplify various aspects of accounting and reporting for share-based payments. Currently, the difference between the deduction for tax purposes and the compensation cost of a share-based payment award results in either an excess tax benefit or deficiency. These excess tax benefits are recognized in additional paid-in capital and tax deficiencies (to the extent there are previous tax benefits) are recognized as an offset to accumulated excess tax benefits. If no previous tax benefit exists, the deficiencies are recognized in the income statement. The changes require all excess tax benefits and tax deficiencies related to share-based payments be recognized as income tax expense or benefit in the income statement as opposed to equity. The excess tax benefit in the cash flow statement will also change from its current presentation as a financing activity to being classified with other income tax as an operating activity. This standard is effective for annual reporting periods, and interim periods therein, beginning after December 15, 2016. The Company does not expect the impact of this guidance to have a material impact on the consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, which requires lessees to recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments for all leases with a term greater than 12 months. This standard is effective for annual reporting periods, and interim periods therein, beginning after December 15, 2018 and is required to be applied using a modified retrospective approach for all leases existing at, or entered into after, the beginning of the earliest comparative period presented. The Company has a significant number of leases, and as a result, expects this guidance to have a material impact on its consolidated balance sheet, the impact of which is currently being evaluated.

In November 2015, the FASB issued ASU 2015-17, which requires an entity to classify deferred tax assets and liabilities as noncurrent on the balance sheet. This standard is effective for annual reporting periods, and interim periods therein, beginning after December 15, 2016. The Company does not believe the adoption of this guidance will have a material effect on the consolidated financial statements.

In July 2015, the FASB issued ASU 2015-11, which requires an entity that determines the cost of inventory by methods other than last-in, first-out and the retail inventory method to measure inventory at the lower of cost and net realizable value. This standard is effective for annual reporting periods, and interim periods therein, beginning after December 15, 2016. The Company does not believe the adoption of this guidance will have a material effect on the Company’s consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, which updates revenue recognition guidance relating to contracts with customers. This standard states that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In August 2015, the FASB subsequently issued ASU 2015-14, which approved a one year deferral of ASU 2014-09 for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. The Company is currently evaluating the impact this guidance will have on the consolidated financial statements.

Other Revisions

In addition to the sublease rent revision and the adoption of ASU 2015-03 as explained above, certain amounts in the consolidated financial statements for prior year periods have been revised to conform to the current period's presentation. The impact to prior periods of these revisions was not significant with no impact on previously reported operating income, net income, cash flows from operations or stockholders' equity.
 

9


NOTE 3.  INVENTORY
 
The net realizable value of inventory consisted of the following:
 
September 30, 2016
 
December 31, 2015
 
(in thousands)
 
 
 
 
Finished product ready for sale
$
557,076

 
$
487,075

Work-in-process, bulk product and raw materials
58,993

 
62,242

Packaging supplies
5,796

 
6,568

Total inventory
$
621,865

 
$
555,885

 
NOTE 4.  REFRANCHISING

Gains on Refranchising

The Company has begun to execute its previously announced refranchising strategy, which includes increasing the proportion of its domestic stores that are franchise locations. During the nine months ended September 30, 2016, the Company refranchised 96 of its company-owned stores, including six refranchised during the three months ended September 30, 2016 and recorded refranchising gains of $18.3 million, of which $0.4 million related to the current quarter. The Company refranchised five and 12 stores, respectively, during the three and nine months ended September 30, 2015 and recorded refranchising gains of $0.9 million and $2.4 million during the respective periods.

Refranchising gains are calculated by subtracting the carrying value of applicable assets disposed of from the sales proceeds. In addition, the initial franchise fee received is included in the gain along with any other costs incurred by the Company to get the underlying assets ready for sale. The Company recognizes gains on refranchising after the asset purchase agreement is signed, the franchisee has taken possession of the store and management is satisfied that the franchisee can meet its financial obligations.

During the nine months ended September 30, 2016, the Company completed the refranchising of 84 stores to one franchisee for $28.6 million of net proceeds resulting in a gain of $16.5 million. The Company provided a short term promissory note as bridge financing while the franchisee secured third party bank loans. The demand note of $23.0 million was paid in July 2016, and together with a $0.5 million deposit and $5.1 million primarily related to inventory, resulted in a $28.6 million investing cash inflow in the nine months ending September 30, 2016.

Held for Sale

The Company classifies assets as held for sale when it commits to a plan to dispose of the assets by refranchising specific stores in their current condition at a price that is reasonable and the Company believes completing the sale within one year is probable without significant changes.  Assets held for sale are recorded at the lower of their carrying value or fair value, less costs to sell and depreciation is ceased on assets at the time they are classified as held for sale. During the quarter ended September 30, 2016, the Company reclassified $1.8 million of the applicable assets of 10 company-owned stores previously presented as held for sale within “Prepaid and other current assets” to "Inventory," "Goodwill" and "Property, plant and equipment, net" in the accompanying consolidated balance sheet as the Company no longer expects to sell these assets during the next 12 months.

Goodwill

In connection with the Company's change in reportable segments described in Note 11, "Segments," the Company's Domestic Retail and Domestic Franchise reporting units were combined into one Domestic Stores reporting unit, consistent with how the segment manager now reviews this business effective in the second quarter of 2016. The amount of goodwill derecognized in a refranchising is determined by a fraction (the numerator of which is the fair value of the portion of the reporting unit being sold and the denominator of which is the fair value of the Domestic Stores reporting unit) that is applied to the total goodwill balance of the Domestic Stores reporting unit. The fair value of the portion of the reporting unit sold is determined by the sales price, which is generally based on the discounted future cash flows expected to be generated by the franchisee. Appropriate adjustments are made to the fair value determinations if such franchise agreement is determined to not be at prevailing market rates.  In connection with the

10


sale of 96 company-owned stores to franchisees during the nine months ended September 30, 2016, the Company derecognized $3.6 million of goodwill that was included in the carrying value of the assets sold.

NOTE 5. GOODWILL AND OTHER LONG-LIVED ASSETS
Interim Impairment Test
Based on the Company's continued decline in operating results coupled with the sustained decrease in share price through September 30, 2016, management concluded a triggering event occurred in the current quarter requiring an interim goodwill impairment test for all of its reporting units as of September 30, 2016. Based on the results of this interim test, management concluded that all of the Company's reporting units had fair values in excess of their respective carrying values. Approximately $12 million of goodwill associated with the Lucky Vitamin reporting unit had an estimated fair value that exceeded its carrying value by less than 15% consistent with the 2015 annual test performed. If actual market conditions are less favorable than those projected, or if events occur or circumstances change that would reduce the fair value of the Lucky Vitamin reporting unit below its carrying value, an impairment charge may be recognized in a future period. Management estimated the fair value of its reporting units using the discounted cash flow method (income approach). Management also performed a quantitative impairment test for its indefinite-lived brand intangible assets and concluded that the fair values were in excess of their respective carrying values. The relief from royalty method (income approach) was used to calculate the fair value of the Retail brand and the excess earnings method (income approach) was used to calculate the fair value of the Franchise brand.
Management also evaluated its definite-long-lived assets consisting of property, equipment and other intangible assets. This impairment test resulted in a $3.0 million charge related to certain of the Company's under-performing stores in the three months ended September 30, 2016 presented as "Long-lived asset impairments" in the accompanying statement of income within the U.S. and Canada segment. For individual under-performing stores and those stores with expected future losses, the impairment test was performed at the individual store level as this is the lowest level which identifiable cash flows are largely independent of other groups of assets and liabilities. This test was performed by comparing estimated future undiscounted cash flows expected to result from the long-lived assets to the carrying value of the asset group, consisting of fixed assets and inventory. Under-performing stores were generally defined as those with historical and expected future losses. If the undiscounted estimated cash flows are less than the carrying value of the asset group, an impairment charge is calculated by subtracting the estimated fair value of property and equipment from its carrying value. Fair value is estimated using a discounted cash flow method (income approach) utilizing the undiscounted cash flows computed in the first step of the test.
Discount Supplements
During the third quarter of 2015, due to the declining financial performance and the Company’s decision to review strategic options for the business a triggering event occurred requiring an interim goodwill impairment review of the Discount Supplements reporting unit as of September 30, 2015. The Company determined the fair value of the Discount Supplements reporting unit at September 30, 2015 using a discounted cash flow method (income approach).
As a result of the review, the Company concluded that the carrying value of the Discount Supplements reporting unit exceeded its fair value and proceeded to step two of the impairment analysis. Based on the results of step two, the Company concluded that this reporting unit was fully impaired; as a result, a goodwill impairment charge of $23.3 million was recorded in the third quarter of 2015.
As a result of the impairment indicators, the Company also performed an impairment analysis with respect to the definite-long-lived assets of Discount Supplements, consisting of trade name and website intangibles and property and equipment. The fair value of these assets were determined using various income approaches. Based on the results of the analyses, the Company recorded impairment charges of $4.4 million on the trade name and website intangible assets and $0.6 million on property and equipment. All of the aforementioned charges totaling $28.3 million were recorded in "Long-lived asset impairments" in the consolidated statement of income for the nine months ended September 30, 2015.
The Company sold Discount Supplements in the fourth quarter of 2015.



11


Goodwill
The following table summarizes the Company's goodwill activity:
 
U.S.
and
Canada
 
International
 
Manufacturing/
Wholesale
 
Total
 
(in thousands)
 
 
 
 
 
 
 
 
Balance at December 31, 2015
$
403,874

 
$
43,177

 
$
202,841

 
$
649,892

Acquired franchise stores
1,391

 

 

 
1,391

Translation effect of exchange rates
21

 
151

 

 
172

Franchise conversions
(3,649
)
 

 

 
(3,649
)
Balance at September 30, 2016
$
401,637

 
$
43,328

 
$
202,841

 
$
647,806


Intangible Assets

Intangible assets other than goodwill consisted of the following:
 
Retail
Brand
 
Franchise
Brand
 
Operating
Agreements
 
Other
Intangibles
 
Total
 
(in thousands)
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2015
$
500,000

 
$
220,000

 
$
112,359

 
$
6,845

 
$
839,204

Acquired franchise stores

 

 

 
280

 
280

Amortization expense

 

 
(4,990
)
 
(1,309
)
 
(6,299
)
Translation effect of exchange rates

 

 

 
12

 
12

Balance at September 30, 2016
$
500,000

 
$
220,000

 
$
107,369

 
$
5,828

 
$
833,197


The following table reflects the gross carrying amount and accumulated amortization for each major intangible asset:

 
Weighted-
Average
Life
 
September 30, 2016
 
December 31, 2015
 
 
Cost
 
Accumulated
Amortization
 
Carrying
Amount
 
Cost
 
Accumulated
Amortization
 
Carrying
Amount
 
 
 
(in thousands)
Brands - retail
Indefinite
 
$
500,000

 
$

 
$
500,000

 
$
500,000

 
$

 
$
500,000

Brands - franchise
Indefinite
 
220,000

 

 
220,000

 
220,000

 

 
220,000

Retail agreements
30.3
 
31,000

 
(10,197
)
 
20,803

 
31,000

 
(9,407
)
 
21,593

Franchise agreements
25.0
 
70,000

 
(26,717
)
 
43,283

 
70,000

 
(24,617
)
 
45,383

Manufacturing agreements
25.0
 
70,000

 
(26,717
)
 
43,283

 
70,000

 
(24,617
)
 
45,383

Other intangibles
11.8
 
10,239

 
(5,347
)
 
4,892

 
10,222

 
(4,560
)
 
5,662

Franchise rights
3.0
 
7,486

 
(6,550
)
 
936

 
7,206

 
(6,023
)
 
1,183

Total
 
 
$
908,725

 
$
(75,528
)
 
$
833,197

 
$
908,428

 
$
(69,224
)
 
$
839,204


    





12


The following table represents future estimated amortization expense of intangible assets with finite lives at September 30, 2016:
Years ending December 31,
 
Estimated
amortization
expense
 
 
(in thousands)
 
 
 
2016 (remainder)
 
$
1,946

2017
 
7,627

2018
 
7,426

2019
 
7,286

2020
 
7,223

Thereafter
 
81,689

Total
 
$
113,197


NOTE 6.  LONG-TERM DEBT
 
Long-term debt consisted of the following: 
 
September 30,
2016
 
December 31,
2015
 
(in thousands)
Term Loan Facility (net of $1.7 million and $2.2 million discount)
$
1,171,457

 
$
1,174,369

Revolving Credit Facility
137,000

 
43,000

Notes
242,675

 
235,085

Debt issuance costs
(2,544
)
 
(3,276
)
Total debt
1,548,588

 
1,449,178

Less: current maturities
(4,550
)
 
(4,550
)
Long-term debt
$
1,544,038

 
$
1,444,628

 
The Company maintains a $1.2 billion term loan facility (the “Term Loan Facility”) that matures in March 2019. The Company also maintains a $300.0 million revolving credit facility (the “Revolving Credit Facility” and, together with the Term Loan Facility, the “Senior Credit Facility”) that matures in September 2018 as described in more detail below.

At September 30, 2016 and December 31, 2015, the interest rate under the Term Loan Facility was 3.25%. The Revolving Credit Facility had a weighted average interest rate of 2.7% and 2.6% at September 30, 2016 and December 31, 2015, respectively. At September 30, 2016 and December 31, 2015, the commitment fee on the undrawn portion of the Revolving Credit Facility was 0.5%, and the fee on outstanding letters of credit was 2.50%.

Refinancing of Revolving Credit Facility

The Company amended the Revolving Credit Facility on March 4, 2016, to extend its maturity from March 2017 to September 2018 and increase total availability from $130.0 million to $300.0 million. In connection with this transaction, the Company incurred $1.7 million of costs, which were capitalized as deferred financing fees within "Other long-term assets" and will be amortized to interest expense over the new term of the Revolving Credit Facility. At September 30, 2016, the Company had $157.4 million available under the Revolving Credit Facility, after giving effect to $137.0 million of borrowings outstanding and $5.6 million utilized to secure letters of credit.

Convertible Debt
Summary of Terms. On August 10, 2015, the Company issued $287.5 million principal amount of 1.5% convertible senior notes due 2020 (the “Notes”) in a private offering. The Notes are governed by the terms of an indenture between the Company and BNY Mellon Trust Company, N.A., as the Trustee (the "Indenture"). The Notes will mature on August 15, 2020, unless earlier purchased by the Company or converted. The Notes will bear interest at a rate of 1.5% per annum, and additionally will be subject to special interest in connection with any failure of the Company to perform certain of its obligations under the Indenture.

13


The Notes are unsecured obligations and do not contain any financial covenants or restrictions on the payments of dividends, the incurrence of indebtedness or the issuance or repurchase of securities by the Company or any of its subsidiaries. Certain events are considered “events of default” under the Notes, which may result in the acceleration of the maturity of the Notes, as described in the indenture governing the Notes. The Notes are fully and unconditionally guaranteed by certain operating subsidiaries of the Company (“Subsidiary Guarantors”) and are subordinated to the Subsidiary Guarantors obligations from time to time with respect to the Senior Credit Facility and ranks equal in right of payment with respect to the Subsidiary Guarantor’s other obligations.
The initial conversion rate applicable to the Notes is 15.1156 shares of common stock per $1,000 principal amount of Notes, which is equivalent to an initial conversion price of approximately $66.16 per share. The conversion rate will be subject to adjustment upon the occurrence of certain specified events, but will not be adjusted for any accrued and unpaid special interest. In addition, upon the occurrence of a “make-whole fundamental change" as defined in the Indenture, the Company will, in certain circumstances, increase the conversion rate by a number of additional shares for a holder that elects to convert its Notes in connection with such make-whole fundamental change.
Prior to May 15, 2020, the Notes will be convertible only under the following circumstances: (1) during any calendar quarter commencing after September 30, 2015, if, for at least 20 trading days (whether or not consecutive) during the 30 consecutive trading day period ending on the last trading day of the immediately preceding calendar quarter, the last reported sale price of the Company’s common stock on such trading day is greater than or equal to 130% of the applicable conversion price on such trading day; (2) during the 5 consecutive business day period after any 10 consecutive trading day period in which, for each day of that period, the trading price per $1,000 principal amount of Notes for such trading day was less than 98% of the product of the last reported sale price of the Company’s common stock and the applicable conversion rate on such trading day; or (3) upon the occurrence of specified corporate transactions. On and after May 15, 2020, until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert all or a portion of their Notes at any time, regardless of the foregoing circumstances. Upon conversion, the Notes will be settled, at the Company’s election, in cash, shares of the Company’s common stock, or a combination of cash and shares of the Company’s common stock. If the Company has not delivered a notice of its election of settlement method prior to the final conversion period it will be deemed to have elected combination settlement with a dollar amount per note to be received upon conversion of $1,000.
The Notes consist of the following components:
 
September 30, 2016
 
December 31, 2015
 
(in thousands)
Liability component
 
 
 
Principal
$
287,500

 
$
287,500

Conversion feature
(39,493
)
 
(46,271
)
Discount related to debt issuance costs
(5,332
)
 
(6,144
)
Net carrying amount
$
242,675

 
$
235,085

 
 
 
 
Equity component


 
 
Conversion feature
$
49,680

 
$
49,680

Debt issuance costs
(1,421
)
 
(1,421
)
Deferred taxes
(17,750
)
 
(17,750
)
Net amount recorded in additional paid-in capital
$
30,509

 
$
30,509


14



Interest Expense

Interest expense consisted of the following:
 
Three months ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Senior Credit Facility:
 
 
 
 
 
 
 
Term Loan Facility coupon
$
9,753

 
$
10,390

 
$
29,076

 
$
32,366

Revolver
1,359

 
172

 
3,420

 
510

Amortization of discount and debt issuance costs
591

 
1,243

 
1,775

 
2,168

Total Senior Credit Facility
11,703

 
11,805

 
34,271

 
35,044

Notes:
 
 
 
 
 
 
 
Coupon
1,078

 
623

 
3,234

 
623

Amortization of conversion feature
2,294

 
1,218

 
6,778

 
1,218

Amortization of discount and debt issuance costs
290

 
147

 
845

 
147

Total Notes
3,662

 
1,988

 
10,857

 
1,988

Interest income and other
(5
)
 
(40
)
 
(50
)
 
(120
)
Interest expense, net
$
15,360

 
$
13,753

 
$
45,078

 
$
36,912


NOTE 7.  FAIR VALUE MEASUREMENTS AND FINANCIAL INSTRUMENTS
Accounting Standards Codification 820, Fair Value Measurements and Disclosures defines fair value as a market-based measurement that should be determined based on the assumptions that marketplace participants would use in pricing an asset or liability. As a basis for considering such assumptions, the standard establishes a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value as follows:
Level 1 — observable inputs such as quoted prices in active markets for identical assets and liabilities;
Level 2 — observable inputs such as 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, other inputs that are observable, or can be corroborated by observable market data; and
Level 3 — unobservable inputs for which there are little or no market data, which require the reporting entity to develop its own assumptions.
The carrying amounts of cash and cash equivalents, receivables, accounts payable, accrued liabilities and the Revolving Credit Facility approximate their respective fair values. Based on the interest rates currently available and their underlying risk, the carrying value of franchise notes receivable recorded in "Other long-term assets" approximates its fair value.
The carrying value and estimated fair value of the Term Loan Facility and Notes (excluding the equity component classified in stockholders' equity) were as follows:
 
September 30, 2016
 
December 31, 2015
 
Carrying
Amount
 
Fair
Value
 
Carrying
Amount
 
Fair
Value
 
(in thousands)
Term Loan Facility
$
1,171,457

 
$
1,172,921

 
$
1,174,369

 
$
1,145,010

Notes
242,675

 
213,491

 
235,085

 
188,940

The fair value of the Term Loan Facility was determined using the instrument’s trading value in markets that are not active, which are considered Level 2 inputs. The fair value of the Notes was determined based on quoted market prices and bond terms and conditions, which are considered Level 2 inputs. 

15


As described in Note 5, "Goodwill and Other Long-Lived Assets," the Company recorded asset impairments in the three months ended September 30, 2016 and 2015. This resulted in property and equipment at certain of the Company's corporate stores at September 30, 2016 and goodwill and definite-long-lived assets of Discount Supplements (which was sold in the fourth quarter of 2015) at September 30, 2015 being measured at fair value on a non-recurring basis using Level 3 inputs.
 
NOTE 8.  CONTINGENCIES

The Company is engaged in various legal actions, claims and proceedings arising in the normal course of business, including claims related to breach of contracts, product liabilities, intellectual property matters and employment-related matters resulting from the Company's business activities.

The Company records accruals for outstanding legal matters when it believes it is probable that a loss will be incurred and the amount of such loss can be reasonably estimated. The Company evaluates, on a quarterly basis, developments in legal matters that could affect the amount of any accrual and developments that would make a loss contingency both probable and reasonably estimable. If a loss contingency is not both probable and estimable, the Company does not establish an accrued liability. During the three months ended September 30, 2016, the Company recorded $5.1 million in legal-related charges associated with a Pennsylvania fluctuating workweek wage issue, the Jason Olive case and a government regulation matter, the amounts of which were individually immaterial. These items are explained in more detail below. If the Company ultimately is required to make additional payments in connection with an adverse outcome in any of the matters discussed below, it is possible that it could have a material adverse effect on the Company's business, financial condition, results of operations or cash flows.

The Company's contingencies are subject to substantial uncertainties, including for each such contingency the following, among other factors: (i) the procedural status of the case; (ii) whether the case has or may be certified as a class action suit; (iii) the outcome of preliminary motions; (iv) the impact of discovery; (v) whether there are significant factual issues to be determined or resolved; (vi) whether the proceedings involve a large number of parties and/or parties and claims in multiple jurisdictions or jurisdictions in which the relevant laws are complex or unclear; (vii) the extent of potential damages, which are often unspecified or indeterminate; and (viii) the status of settlement discussions, if any, and the settlement posture of the parties. Consequently, except as otherwise noted below with regard to a particular matter, the Company cannot predict with any reasonable certainty the timing or outcome of the legal matters described below, and the Company is unable to estimate a possible loss or range of loss.

As a manufacturer and retailer of nutritional supplements and other consumer products that are ingested by consumers or applied to their bodies, the Company has been and is currently subjected to various product liability claims. Although the effects of these claims to date have not been material to the Company, it is possible that current and future product liability claims could have a material adverse effect on its business or financial condition, results of operations or cash flows. The Company currently maintains product liability insurance with a deductible/retention of $4.0 million per claim with an aggregate cap on retained loss of $10.0 million. The Company typically seeks and has obtained contractual indemnification from most parties that supply raw materials for its products or that manufacture or market products it sells. The Company also typically seeks to be added, and has been added, as an additional insured under most of such parties’ insurance policies.  The Company is also entitled to indemnification by Numico for certain losses arising from claims related to products containing ephedra or Kava Kava sold prior to December 5, 2003. However, any such indemnification or insurance is limited by its terms and any such indemnification, as a practical matter, is limited to the creditworthiness of the indemnifying party and its insurer, and the absence of significant defenses by the insurers. Consequently, the Company may incur material product liability claims, which could increase its costs and adversely affect its reputation, revenue and operating income.

Litigation
 
DMAA / Aegeline Claims.  Prior to December 2013, the Company sold products manufactured by third parties that contained derivatives from geranium known as 1.3-dimethylpentylamine/dimethylamylamine/13-dimethylamylamine, or "DMAA," which were recalled from the Company's stores in November 2013, and/or Aegeline, a compound extracted from bael trees. As of September 30, 2016, the Company was named in 30 personal injury lawsuits involving products containing DMAA and/or Aegeline.
As a general matter, the proceedings associated with these personal injury cases, which generally seek indeterminate money damages, are in the early stages, and any losses that may arise from these matters are not probable or reasonably estimable at this time.

16


The Company is contractually entitled to indemnification by its third-party vendors with regard to these matters, although the Company’s ability to obtain full recovery in respect of any such claims against it is dependent upon the creditworthiness of the vendors and/or their insurance coverage and the absence of any significant defenses available to its insurer.
California Wage and Break Claims. In July 2011, Charles Brewer, on behalf of himself and all others similarly situated, sued General Nutrition Corporation in federal court, alleging state and federal wage and hour claims. In October 2011, plaintiff filed an eight-count amended complaint alleging, among other matters, meal, rest break and overtime violations on behalf of sales associates and store managers. In January 2013, the Court conditionally certified a Fair Labor Standards Act ("FLSA") class with respect to one of Plaintiff's claims, and in November 2014, the Court granted in part and denied in part the plaintiff's motion to certify a California class and granted the Company's motion for decertification of the FLSA class. In May 2015, plaintiffs filed a motion for partial summary judgment as to the Company's alleged liability for non-compliant wage statements, which was granted in part and denied in part in September 2015. On February 5, 2016, the Company and attorneys representing the putative class agreed to class-wide settlements of the Brewer case and an additional, immaterial case raising similar claims, pursuant to which the Company agreed to pay up to $9.5 million in the aggregate, including attorneys’ fees and costs. Following a hearing on August 23, 2016, the Court approved the settlement agreement and dismissed the case with prejudice. As a result of this settlement, the Company recorded a charge of $6.3 million in the fourth quarter of 2015, in addition to $3.2 million previously accrued in the first quarter of 2015.
On February 29, 2012, former Senior Store Manager, Elizabeth Naranjo, individually and on behalf of all others similarly situated, sued General Nutrition Corporation in the Superior Court of the State of California for the County of Alameda. The complaint contains eight causes of action, alleging, among other matters, meal, rest break and overtime violations. As of September 30, 2016, an immaterial liability has been accrued in the accompanying financial statements.
Pennsylvania Fluctuating Workweek. On September 18, 2013, Tawny Chevalier and Andrew Hiller commenced a class action in the Court of Common Pleas of Allegheny County, Pennsylvania. Plaintiff asserted a claim against the Company for a purported violation of the Pennsylvania Minimum Wage Act (PMWA), challenging the Company’s utilization of the “fluctuating workweek” method to calculate overtime compensation, on behalf of all employees who worked for the Company in Pennsylvania and who were paid according to the fluctuating workweek method. In October 2014, the Court entered an order holding that the use of the fluctuating workweek method violated the PMWA. In September 2016, the Court entered judgment in favor of Plaintiffs and the class in an immaterial amount, which has been recorded as a charge in the quarter ended September 30, 2016 in the accompanying consolidated financial statements. Plaintiffs subsequently filed a petition for an award of attorney’s fees, costs and incentive payments; that petition is pending. The Company appealed from the adverse judgment; the appeal is pending.

Jason Olive v. General Nutrition Corp. In April 2012, Jason Olive filed a complaint in the Superior Court of California, County of Los Angeles, for misappropriation of likeness in which he alleges that the Company continued to use his image in stores after the expiration of the license to do so in violation of common law and California statutes. Mr. Olive is seeking compensatory, punitive and statutory damages and attorneys’ fees and costs. The trial in this matter began on July 20, 2016 and concluded on August 8, 2016. The jury awarded plaintiff immaterial amounts for actual damages and emotional distress damages, which are accrued in the Company's accompanying financial statements.  The jury refused to award plaintiff any of the profits he sought to disgorge, or punitive damages. The court has not yet entered judgment in the case.  In addition to the verdict, the Company expects Mr. Olive to seek attorneys’ fees and other costs in a total amount as yet unknown to the Company; because this amount cannot be reasonably estimated at this time, no amount has been accrued in the financial statements.

Oregon Attorney General. On October 22, 2015, the Attorney General for the State of Oregon sued General Nutrition Corporation in Multnomah County Circuit Court for alleged violations of Oregon’s Unlawful Trade Practices Act, in connection with its sale in Oregon of certain third-party products, which was amended on September 19, 2016 to add allegations related to products containing DMAA and oxilofrine.  The Company intends to continue to vigorously defend against all of these allegations. As any losses that may arise from this matter are not probable or reasonably estimable at this time, no liability has been accrued in the accompanying interim consolidated financial statements. Moreover, the Company does not anticipate that any such losses are likely to have a material impact on the Company, its business or results of operations. The Company is contractually entitled to indemnification and defense by its third-party vendors. Ultimately, however, the Company's ability to obtain full recovery in respect of any such claims against it is dependent upon the creditworthiness of its vendors and/or their insurance coverage and the absence of any significant defenses available to their insurers.


17


Government Regulation

In November 2013, the Company received a subpoena from the U.S. Department of Justice (“DOJ”) for information related to its investigation of a third party product vendor, USP Labs, LLC.  GNC fully cooperated with the investigation of the vendor and the related products, all of which were discontinued by GNC in 2013.  In October 2016, the Company reached agreement in principle with DOJ in connection with the Company’s cooperation; which agreement would acknowledge GNC relied on the representations and written guarantees of USP Labs and GNC’s representation that it did not knowingly sell products not in compliance with the FDCA. Under the agreement, which would include an immaterial payment to the federal government, GNC will take a number of actions to broaden industry-wide knowledge of prohibited ingredients and improve compliance by vendors of third party products. These actions are in keeping with the leadership role GNC has taken in setting industry quality and compliance standards, and GNC’s commitment over the course of the agreement (60 months) to support a combination of GNC and industry initiatives.

Environmental Compliance
 
In March 2008, the South Carolina Department of Health and Environmental Control (the "DHEC") requested that the Company investigate contamination associated with historical activities at its South Carolina facility. These investigations have identified chlorinated solvent impacts in soils and groundwater that extend offsite from the facility. The Company entered into a Voluntary Cleanup Contract with the DHEC regarding the matter on September 24, 2012. Pursuant to such contract, the Company is completing additional investigations with the DHEC's approval. The Company installed and began operating a pilot vapor extraction system under a portion of the facility in the second half of 2016, which was an immaterial cost to the Company, with DHEC’s approval to assess the effectiveness of such a remedial system. At this stage of the investigation, however, it is not possible to estimate the timing and extent of any additional remedial action that may be required, the ultimate cost of remediation, or the amount of the Company's potential liability, therefore no liability is recorded. 

In addition to the foregoing, the Company is subject to numerous federal, state, local and foreign environmental and health and safety laws and regulations governing its operations, including the handling, transportation and disposal of the Company's non-hazardous and hazardous substances and wastes, as well as emissions and discharges from its operations into the environment, including discharges to air, surface water and groundwater. Failure to comply with such laws and regulations could result in costs for remedial actions, penalties or the imposition of other liabilities. New laws, changes in existing laws or the interpretation thereof, or the development of new facts or changes in their processes could also cause the Company to incur additional capital and operating expenditures to maintain compliance with environmental laws and regulations and environmental permits. The Company is also subject to laws and regulations that impose liability and cleanup responsibility for releases of hazardous substances into the environment without regard to fault or knowledge about the condition or action causing the liability. Under certain of these laws and regulations, such liabilities can be imposed for cleanup of previously owned or operated properties, or for properties to which substances or wastes that were sent in connection with current or former operations at its facilities. The presence of contamination from such substances or wastes could also adversely affect the Company's ability to sell or lease its properties, or to use them as collateral for financing. From time to time, the Company has incurred costs and obligations for correcting environmental and health and safety noncompliance matters and for remediation at or relating to certain of the Company's properties or properties at which the Company's waste has been disposed. However, compliance with the provisions of national, state and local environmental laws and regulations has not had a material effect upon the Company's capital expenditures, earnings, financial position, liquidity or competitive position. The Company believes it has complied with, and is currently complying with, its environmental obligations pursuant to environmental and health and safety laws and regulations and that any liabilities for noncompliance will not have a material adverse effect on its business, financial performance or cash flows. However, it is difficult to predict future liabilities and obligations, which could be material. 












18


NOTE 9. EARNINGS PER SHARE
The following table represents the Company's basic and dilutive weighted-average shares:
 
Three months ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Basic weighted-average shares
68,190

 
83,669

 
69,808

 
85,663

Effect of dilutive stock-based awards
125

 
289

 
131

 
267

Diluted weighted-average shares
68,315

 
83,958

 
69,939

 
85,930

The following awards were not included in the computation of diluted EPS because the impact of applying the treasury stock method was antidilutive or because certain conditions have not been met with respect to the Company's performance-based and market-based awards.
 
Three months ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Antidilutive:
 
Time-based
1,120

 
176

 
1,011

 
159

Market-based

 

 
56

 

Contingently issuable:
 
 
 
 
 
 
 
Performance-based
130

 
139

 
133

 
138

Market-based
167

 

 
112

 

Total stock-based awards
1,417

 
315

 
1,312

 
297

The Company has the intent and ability to settle the principal portion of its Notes in cash, and as such, has applied the treasury stock method, which has resulted in all underlying convertible shares being anti-dilutive as the Company's average stock price in the current quarter is less than the conversion price. Refer to Note 6, "Long-term debt" for more information on the Notes.

NOTE 10.  STOCK-BASED COMPENSATION PLANS AND SHARE REPURCHASE PROGRAM
 
Stock and Incentive Plans

The Company has outstanding stock-based compensation awards that were granted by the Compensation and Organizational Development Committee (the “Compensation Committee”) of Holdings’ board of directors (the "Board") under the following two stock-based employee compensation plans:

the GNC Holdings, Inc. 2015 Stock and Incentive Plan (the "2015 Stock Plan") amended and adopted in May 2015, formerly the GNC Holdings, Inc. 2011 Stock and Incentive Plan (the “2011 Stock Plan”) adopted in March 2011; and
the GNC Acquisition Holdings Inc. 2007 Stock Incentive Plan adopted in March 2007 (as amended, the “2007 Stock Plan”).

Both plans have provisions allowing for the granting of stock options, restricted stock and other stock-based awards and are available to eligible employees, directors, consultants or advisers as determined by the Compensation Committee. The Company will not grant any additional awards under the 2007 Stock Plan. Up to 11.5 million shares of common stock may be issued under the 2015 Stock plan (subject to adjustment to reflect certain transactions and events specified in the 2015 Stock Plan for any award grant), of which 7.2 million shares remain available for issuance as of September 30, 2016.

19


The following table sets forth a summary of all stock-based compensation awards outstanding under all plans:
 
September 30, 2016
 
December 31, 2015
 
(in thousands)
Time-based stock options
1,153

 
688

Time-based restricted stock awards
310

 
194

Performance-based restricted stock awards
138

 
141

Market-based restricted stock awards
169

 

Total
1,770

 
1,023


Stock-Based Compensation Activity

During the nine months ended September 30, 2016, the Company granted the following stock-based compensation awards:
 
(in thousands)
Time-based stock options
644

Time-based restricted stock awards
278

Market-based restricted stock awards
171

Total
1,093

    

Time-based stock options vest 25% per year over a period of four years and the fair value was determined using the Black-Scholes model. Key assumptions used for the options granted during the current year period include a dividend yield between 2.31% and 3.80%, an expected term of 6.3 years, volatility between 30.1% and 30.7%, and a risk-free rate between 1.27% and 1.90%. Time-based restricted stock awards vest one-third per year over a period of three years.

Market-based awards vest at the end of a three-year period based upon total shareholder return compared with that of a selected group of peer companies. Total shareholder return is defined as share price appreciation plus the value of dividends paid during the three-year vesting period. Fair value of these awards was determined using a Monte Carlo simulation, which requires various inputs and assumptions, including the Company's common stock price. Compensation cost for these awards is recognized regardless of whether the market condition is achieved. Vested shares may range from 0% to 200% of the original target. Key assumptions used in the Monte Carlo simulation for the awards granted during the year include peer group volatility of 34.2% and a risk-free rate of 0.89%.

The above awards granted during the nine months ended September 30, 2016 will result in compensation expense of $13.7 million, net of expected forfeitures, over the service period from the applicable grant date through the date of vesting.

The Company recognized $4.2 million and $1.7 million of total non-cash stock-based compensation expense for the three months ended September 30, 2016 and 2015, respectively and $7.2 million and $4.7 million for the nine months ended September 30, 2016 and 2015. At September 30, 2016, there was approximately $13.0 million of total unrecognized compensation cost related to non-vested stock-based compensation, net of expected forfeitures, for all awards previously made that are expected to be recognized over a weighted-average period of approximately 1.6 years.

On July 28, 2016, the Company announced the departure from the Company and resignation from the Board of Michael G. Archbold, its former Chief Executive Officer, effective July 27, 2016. During the three months ended September 30, 2016 in connection with Mr. Archbold's departure, the Company recognized $4.5 million in severance expense of which $2.3 million relates to the acceleration of non-cash stock-based compensation.





20


Share Repurchase Program

In August 2015, the Board approved a $500.0 million multi-year repurchase program in addition to the $500.0 million multi-year program approved in August 2014, bringing the aggregate share repurchase program to $1.0 billion of Holdings' common stock. Holdings repurchased $229.2 million of common stock during the nine months ended September 30, 2016 and has utilized $802.2 million of the current repurchase program. As of September 30, 2016, $197.8 million remains available for purchase under the program.   

NOTE 11.  SEGMENTS
 
The Company’s refranchising strategy, which is increasing the proportion of domestic stores that are franchise locations in 2016 and beyond, has resulted in a change in the Company’s organizational structure and the financial reporting utilized by the Company’s chief operating decision maker (its chief executive officer) to assess performance and allocate resources; as a result, the Company's reportable segments have changed effective in the second quarter of 2016.  The Company believes that the new segments better present management’s new view of the business.     

The Company aggregates its operating segments into three reportable segments, which effective in the second quarter of 2016, include U.S. and Canada, International and Manufacturing / Wholesale. In connection with the change in the Company's segment reporting, warehousing and distribution costs have been allocated to each reportable segment, as appropriate. The Company's chief operating decision maker evaluates segment operating results based primarily on performance indicators, including revenue and operating income. Operating income of each reportable segment excludes certain items that are managed at the consolidated level, such as corporate costs. The Manufacturing / Wholesale segment manufactures and sells product to the U.S. and Canada and International segments at cost with a markup, which is eliminated at consolidation. The following table shows the new reportable segments compared with the previous reporting structure.
Old
 
New
Segment: Retail                                                                   Includes: Company-owned stores in the U.S., Puerto Rico and Canada, The Health Store and e-commerce including Discount Supplements, which was sold in the fourth quarter of 2015
 
Segment: U.S. and Canada
Includes: Company-owned stores in the U.S., Puerto Rico and Canada, franchise stores in the U.S. and e-commerce
 
 
 
Segment: Franchise
Includes: Domestic and international franchise locations and China operations
 
Segment: International
Includes: Franchise locations in approximately 50 countries, The Health Store and China operations
 
 
 
Segment: Manufacturing / Wholesale
Includes: Manufactured product sold to our other segments, third-party contract manufacturing and sales to wholesale partners
 
Segment: Manufacturing / Wholesale
Includes: Manufactured product sold to our other segments, third-party contract manufacturing and sales to wholesale partners (no change from old)
 
 
 
 
 
Other
Includes: Discount Supplements, an e-commerce business which was sold in the fourth quarter of 2015

21


The following table represents key financial information for each of the Company's reportable segments. Refer to Note 2, "Basis of Presentation" for a description of the prior period revision associated with sublease rent income.

 
Three months ended September 30,
 
Nine months ended September 30,
 
2016
 
2015 (*)
 
2016
 
2015 (*)
 
(in thousands)
Revenue:
 

 
 

 
 
 
 
U.S. and Canada
$
525,505


$
565,252


$
1,671,048


$
1,726,774

International
41,118


50,568


121,037


134,351

Manufacturing / Wholesale:






 



Intersegment revenues
53,016


67,511


172,603


206,749

Third-party
61,341


61,620


178,002


173,377

Subtotal Manufacturing / Wholesale
114,357


129,131


350,605


380,126

Total reportable segment revenues
680,980


744,951


2,142,690


2,241,251

Other


5,918




19,685

Elimination of intersegment revenues
(53,016
)

(67,511
)

(172,603
)

(206,749
)
Total revenue
$
627,964


$
683,358


$
1,970,087


$
2,054,187

Operating income:
 

 
 

 
 
 
 
U.S. and Canada
$
65,292


$
93,745


$
256,142


$
299,818

International
14,676


16,118


41,428


48,025

Manufacturing / Wholesale
17,395


22,521


53,719


63,589

Total reportable segment operating income
97,363


132,384


351,289


411,432

Unallocated corporate and other costs:






 



Corporate costs
(33,161
)

(20,643
)

(76,787
)

(69,967
)
Other
691


(29,591
)

680


(32,072
)
Subtotal unallocated corporate and other costs
(32,470
)

(50,234
)

(76,107
)

(102,039
)
Total operating income
64,893


82,150


275,182


309,393

Interest expense, net
15,360

 
13,753

 
45,078

 
36,912

Income before income taxes
$
49,533

 
$
68,397

 
$
230,104

 
$
272,481


(*) Prior periods have been revised to present the Company's new reportable segments.

22


NOTE 12.  INCOME TAXES
 
The Company recognized $17.2 million of income tax expense (or 34.7% of pre-tax income) during the three months ended September 30, 2016 compared with $22.6 million (or 33.1% of pre-tax income) in the prior year quarter. The Company recognized $82.9 million of income tax expense (or 36.0% of pre-tax income) during the nine months ended September 30, 2016 compared with $96.1 million (or 35.3% of pre-tax income) for the same period in 2015. The Company's tax rate is based on income, statutory tax rates and tax planning opportunities available in the jurisdictions in which it operates.

As described in Note 5, "Goodwill and Other Long-Lived Assets, Net," the Company recorded a $28.3 million long-lived asset impairment in the prior year quarter related to the Discount Supplements business. The Company fully reduced the deferred income tax assets relating to net operating loss carryforwards of Discount Supplements by a valuation allowance the result of which was not material to the prior quarter results. The Company recorded a discrete tax benefit of $11.6 million in the prior year quarter due to the effect of an anticipated worthless stock deduction resulting from excess tax basis in the common shares of Discount Supplements.
 
At September 30, 2016 and December 31, 2015, the Company had $6.4 million and $7.3 million of unrecognized tax benefits, respectively, excluding interest and penalties, which if recognized, would affect the effective tax rate. The Company's liability for uncertain tax positions decreased by $3.1 million during the three month period ended September 30, 2015 due in part to the expiration of certain statutes of limitation with respect to the 2011 fiscal year. The Company recognizes accrued interest and penalties related to unrecognized tax benefits in income tax expense. The Company accrued $2.3 million and $1.8 million at September 30, 2016 and December 31, 2015, respectively, for potential interest and penalties associated with uncertain tax positions. To the extent interest and penalties are not assessed with respect to the ultimate settlement of uncertain tax positions, amounts previously accrued will be reversed as a reduction to income tax expense.

Holdings files a consolidated federal tax return and various consolidated and separate tax returns as prescribed by the tax laws of the state, local and international jurisdictions in which it and its subsidiaries operate. The statutes of limitation for the Company’s U.S. federal income tax returns are closed for years through 2011. The Company's 2010 and 2011 federal income tax returns have been examined by the Internal Revenue Service. The Internal Revenue Service closed the examination without making any material adjustments to the returns. The Company has various state and local jurisdiction tax years open to possible examination (the earliest open period is generally 2011), and the Company also has certain state and local tax filings currently under audit.

NOTE 13. SUBSEQUENT EVENTS
 
On October 21, 2016, the Company announced that its Board authorized and declared a cash dividend for the fourth quarter of 2016 of $0.20 per share of common stock, payable on or about December 30, 2016 to stockholders of record as of the close of business on December 16, 2016.





23


Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with Item 1, “Financial Statements” of this Quarterly Report on Form 10-Q. The following information presented for the three and nine months ended September 30, 2016 and 2015 was prepared by management, is unaudited, and was derived from our unaudited consolidated financial statements and accompanying notes. In the opinion of management, all adjustments necessary for a fair statement of our financial position and operating results for such periods and as of such dates have been included. Effective in the second quarter of 2016, we changed our reportable segments as described in more detail under "Change in Reportable Segments" below.

Forward-Looking Statements
 
This Quarterly Report on Form 10-Q and any documents incorporated by reference herein or therein include forward-looking statements within the meaning of federal securities laws.  Forward-looking statements include statements that may relate to our plans, objectives, goals, strategies, future events, future revenues or performance, capital expenditures, financing needs and other information that is not historical information.  Forward-looking statements can often be identified by the use of terminology such as “subject to,” “believe,” “anticipate,” “plan,” “potential,” “predict,” “expect,” “intend,” “estimate,” “project,” “may,” “will,” “should,” “would,” “continue,” “seek,” “could,” “can,” “think,” the negatives thereof, variations thereon and similar expressions, or by discussions of strategy.
 
All forward-looking statements, including, without limitation, our examination of historical operating trends, are based upon our current expectations and various assumptions. We believe there is a reasonable basis for our expectations and beliefs, but they are inherently uncertain. We may not realize our expectations, and our beliefs may not prove correct. Actual results could differ materially from those described or implied by such forward-looking statements. The following uncertainties and factors, among others including, but not limited to, those we describe under the caption “Risk Factors” in this Quarterly Report on Form 10-Q and our 2015 10-K, could affect future performance and cause actual results to differ materially from those matters expressed in or implied by forward-looking statements:

significant and growing competition in our industry;
unfavorable publicity or consumer perception of our industry or products, as well as general changes in consumer behaviors and trends;
increases in the cost of borrowings and limitations on availability of additional debt or equity capital;
our debt levels and restrictions in our debt agreements;
incurrence of material product liability and product recall costs;
loss or retirement of key members of management;
costs of compliance or any failure on our part to comply with new and existing governmental regulations governing our products, including, but not limited to, proposed dietary supplement legislation and regulations;
changes in our tax obligations;
costs of litigation or investigations involving our company and any failure to successfully defend lawsuits and other claims against us;
failure of our franchisees to conduct their operations profitably and limitations on our ability to terminate or replace under-performing franchisees;
economic, political and other risks associated with our international operations, including fluctuations in foreign exchange rates relative to the U.S. dollar;
failure to keep pace with the demands of our customers for new products and services;
limitations of or disruptions in our manufacturing system or losses of manufacturing certifications;
limitations of or disruptions in our distribution network;

24


lack of long-term experience with human consumption of ingredients in some of our products;
increases in the frequency and severity of insurance claims, particularly claims for which we are self-insured;
failure to adequately protect or enforce our intellectual property rights against competitors;
changes in raw material costs and pricing of our products;
failure to successfully execute our growth strategy, including any inability to successfully launch our revised pricing strategy and enhance our customer loyalty program, any delays in our planned future growth, any inability to expand our franchise operations or attract new franchisees, any inability to expand our company-owned retail operations, any inability to grow our international footprint, or any inability to expand our e-commerce business;
any failure by our current marketing initiatives to timely produce the results that we anticipate;
changes in applicable laws relating to our franchise operations;
damage or interruption to our information systems;
risks and costs associated with data loss, credit card fraud and identity theft;
impact of current economic conditions on our business;
unusually adverse weather conditions;
natural disasters, pandemic outbreaks, boycotts, and geo-political events; and
failure to maintain effective internal controls.
Consequently, forward-looking statements should be regarded solely as our current plans, estimates and beliefs. You should not place undue reliance on forward-looking statements. We cannot guarantee future results, events, levels of activity, performance or achievements. We do not undertake and specifically decline any obligation to update, republish or revise forward-looking statements to reflect future events or circumstances or to reflect the occurrences of unanticipated events.

Business Overview
 
We are a global specialty retailer of health, wellness and performance products, including protein, performance supplements, weight management supplements, vitamins, herbs and greens, wellness supplements, health and beauty, food and drink and other general merchandise. We derive our revenues principally from: product sales through our company-owned stores; the Internet through our websites, GNC.com and LuckyVitamin.com; domestic and international franchise activities; and sales of products manufactured in our facilities to third parties. We sell products through a worldwide network of more than 9,000 locations operating under the GNC brand name.
Despite recent significant challenges explained below under "Executive Overview," we benefit from several competitive strengths that we believe position us to drive our business, including our:
well-recognized brand;
stable base of long-term customers;
highly leveragable business model;
unique product offerings and innovation capabilities;
geographically diverse store base;
vertically integrated operations;
differentiated service model designed to enhance the customer experience; and
highly experienced management team.

25


Executive Overview
 
Foundationally, we remain focused on a customer-centric evolution of our brand and culture defined by core principles that we believe enable GNC to foster one-to-one customer engagement and encourages our sales associates to become trusted advisors to their customers. These principles include development of:

meaningful, long-term connections with our customers;
deep expertise in health, wellness and performance;
solutions tailored to meet our customers’ unique goals;
a best-in-class shopping experience; and
customer-driven decision making and rigorous quality standards.
While our business remains profitable and we continue to recognize strong cash flow, with approximately 95% of our company-owned stores' cash flow exceeding our weighted-average cost of capital, we also have faced recent challenges to our business, including: increased competition; intensified regulatory and other governmental scrutiny, including inquiries from state attorneys general, and negative media coverage of our industry; year-over-year declines in same store sales; and consequently, heightened volatility in the trading price of our common stock.
In an attempt to reverse adverse trends that our business is currently experiencing and improve traffic to our stores, we are focused on the following:
Pricing and loyalty programs. the launch of a pilot program centered on single-tier pricing and a free loyalty program which we anticipate expanding system wide in the U.S. by 2017, which includes the following;
Implementing a revised pricing strategy. Early in 2016, we launched an intensive effort to develop and implement an improved pricing strategy in our domestic stores. In the third quarter of 2016, we launched a pilot of a single-tier pricing model thereby eliminating the multi-tiered pricing which we believe was causing confusion in the marketplace. We expect the results of this initiative to be evident in 2017 and beyond. In addition, in the third quarter of 2016, we aligned pricing and promotions on GNC.com to our stores, eliminated web-only promotions and eliminated the ability to make bulk purchases from our website. Although these changes had a significant impact on same store sales, we believe they are essential to improving the overall strength of our business; and
Enhancing our customer loyalty program. Historically GNC’s Gold Card loyalty program was intricately tied to the company’s multi-tiered pricing strategy. In the third quarter of 2016, we also launched a pilot of a new, free loyalty program, effectively decoupling the loyalty program from product pricing. Following extensive customer research during 2015, we believe that a free loyalty program focused on the accumulation of points is an important step for building a more regular and meaningful connection with our customers. We expect the results of this initiative to be evident in 2017 and beyond;
Marketing effectiveness. continued development of a precise plan on marketing spend across channels to improve the overall effectiveness in capturing the customers we are seeking, as well as improving our call to action messages designed to increase traffic and visits by new and existing customers;
Product innovation. increasing our flow of new, innovative GNC branded and third party products that attract new customers; and
Improving the customer experience. improvement in product availability and in-store elements of differentiation for the consumer that could include faster transaction times, more knowledgeable associates and an improved omni-channel availability for the consumer.
In addition to the above, we continue to focus on our other strategic initiatives, which remain the following:
Raising industry standards through the creation of an industry-wide coalition. We remain focused, together with other industry leaders and industry trade associations, on initiatives begun in 2015 to build an industry-led coalition aimed at raising the bar for quality and compliance throughout the dietary supplement industry. Coalition initiatives include: developing standardized raw material “good manufacturing practices” (“GMPs”), including “farm to factory” traceability standards; creating a product-registry database accessible to industry participants, consumers and the FDA; establishing minimum certification standards for manufacturing facilities, including an annual facility inspection process and product quality seals, and providing media support for a

26


coordinated industry including positive messaging with accurate product information to help change the narrative around our industry. We believe that over time, these initiatives will prove beneficial for the industry, for the FDA and other regulators, and lead to substantial improvement in regulatory and consumer trust and confidence in our industry.
Executing our refranchising strategy. We have undertaken an accelerated drive to increase the proportion of our domestic stores that are franchise locations, which we expect to accomplish both by increasing the proportion of new stores that are franchise locations and by transitioning company-owned stores to franchise locations. We are currently targeting a balanced portfolio of domestic company-owned and franchise locations over the next three to four years, beginning in 2016. As part of this effort, we remain focused on creating and nurturing franchise partnerships that support our brand image. We believe that this strategy can result in significant value creation for our stockholders. During the nine months ended September 30, 2016, we refranchised 96 company-owned stores to franchisees.
We believe that our combined efforts on these fronts will enable us to better leverage the competitive strengths that remain at the core of our business and will drive future success.
Recent Trends and Uncertainties

The following trends and uncertainties in our industry could affect our operating performance as follows:
broader consumer awareness of health and wellness issues and rising healthcare costs may increase the use of the products we offer and positively affect our operating performance;
interest in, and demand for, condition-specific products based on scientific research may positively affect our operating performance if we can timely develop and offer such condition-specific products;
the effects of favorable and unfavorable publicity on consumer demand with respect to the products we offer may have similarly favorable or unfavorable effects on our operating performance;
a lack of long-term experience with human consumption of ingredients in some of our products could create uncertainties with respect to the health risks, if any, related to the consumption of such ingredients and negatively affect our operating performance;
increased costs and other demands associated with heightened regulatory scrutiny, including but not limited to complying with new and existing governmental regulation, and/or legal challenges associated with products that we sell may negatively affect our operating performance;
consolidation within our industry and increasing participation in our market by mass market and internet retailers and consumer product manufacturers could continue to intensify competition within our industry and could continue to negatively affect our market performance;
a decline in disposable income available to consumers may lead to a reduction in consumer spending and negatively affect our operating performance; and
an aging population in the United States may positively impact sales of some of the products that we offer. 
Key Indicators
 
We evaluate segment operating results based on several indicators. The primary key performance indicators are revenues and operating income for each segment. Revenues and operating income, as evaluated by our chief operating decision maker (our chief executive officer), exclude certain items that are managed at the consolidated level, such as corporate costs. The following discussion compares the revenues and the operating income by segment, as well as those items excluded from the segment totals.
Same store sales growth represents the percentage change in same store point-of-sale retail sales in the period presented compared with the prior year period. Same store sales are calculated on a daily basis for each store and exclude the net sales of a store for any period if the store was not open during the same period of the prior year. We include our internet sales of GNC.com in our domestic retail company-owned same store sales calculation and effective January 1, 2016 we are excluding Drugstore.com, which does not have a significant impact. When a store's square footage has been changed as a result of reconfiguration or relocation in the same mall or shopping center, the store continues to be treated as a same store. If, during the period presented, a store was closed, relocated to a different mall or shopping center, or converted to a franchise store or a company-owned store, sales from that store

27


up to and including the closing day or the day immediately preceding the relocation or conversion are included as same store sales as long as the store was open during the same period of the prior year. We exclude sales during the period presented that occurred on or after the date of relocation to a different mall or shopping center or the date of a conversion.

28


Results of Operations
 
(Expressed as a percentage of total consolidated revenue)
 
Three months ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
2016
 
2015
Revenues:
 
 
 
 
 
 
 
U.S. and Canada
83.7
 %
 
82.7
 %
 
84.8
 %
 
84.1
 %
International
6.5
 %
 
7.4
 %
 
6.1
 %
 
6.5
 %
Manufacturing / Wholesale:
 
 
 
 
 
 
 
Intersegment revenues
8.4
 %
 
9.9
 %
 
8.8
 %
 
10.1
 %
Third party
9.8
 %
 
9.0
 %
 
9.1
 %
 
8.4
 %
Subtotal Manufacturing / Wholesale
18.2
 %
 
18.9
 %
 
17.9
 %
 
18.5
 %
Other
 %
 
0.9
 %
 
 %
 
1.0
 %
Elimination of intersegment revenue
(8.4
)%
 
(9.9
)%
 
(8.8
)%
 
(10.1
)%
Total net revenues
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Operating expenses:
 
 
 
 
 
 
 
Cost of sales, including warehousing, distribution and occupancy
65.7
 %
 
63.3
 %
 
65.0
 %
 
63.2
 %
Gross profit
34.3
 %
 
36.7
 %
 
35.0
 %
 
36.8
 %
Selling, general and administrative
23.6
 %
 
20.7
 %
 
21.8
 %
 
20.5
 %
Gains on refranchising
(0.1
)%
 
(0.1
)%
 
(0.9
)%
 
(0.1
)%
Long-lived asset impairments
0.5
 %
 
4.1
 %
 
0.2
 %
 
1.4
 %
Other (income) loss, net
(0.1
)%
 
 %
 
 %
 
 %
Total operating expenses
89.6
 %
 
88.0
 %
 
86.1
 %
 
85.0
 %
Operating income:
 
 
 
 
 
 
 
U.S. and Canada
10.4
 %
 
13.7
 %
 
13.0
 %
 
14.6
 %
International
2.3
 %
 
2.4
 %
 
2.1
 %
 
2.3
 %
Manufacturing / Wholesale
2.8
 %
 
3.3
 %
 
2.8
 %
 
3.2
 %
Unallocated corporate and other costs:
 
 
 
 
 
 
 
Corporate costs
(5.3
)%
 
(3.0
)%
 
(3.9
)%
 
(3.4
)%
Other
0.1
 %
 
(4.4
)%
 
 %
 
(1.6
)%
Subtotal unallocated corporate and other costs
(5.2
)%
 
(7.4
)%
 
(3.9
)%
 
(5.0
)%
Total operating income
10.3
 %
 
12.0
 %
 
14.0
 %
 
15.1
 %
Interest expense, net
2.4
 %
 
2.0
 %
 
2.3
 %
 
1.8
 %
Income before income taxes
7.9
 %
 
10.0
 %
 
11.7
 %
 
13.3
 %
Income tax expense
2.7
 %
 
3.3
 %
 
4.2
 %
 
4.7
 %
Net income
5.2
 %
 
6.7
 %
 
7.5
 %
 
8.6
 %

Note: The presentation of certain immaterial amounts in our consolidated financial statements of prior periods have been revised to conform to the current periods presented. Specifically, sublease rental income received from franchisees is presented as “Revenue” compared with the previous presentation as a reduction to occupancy expense in “Cost of sales, including warehousing, distribution, and occupancy.” This revision has no impact on operating income. For additional information regarding this revision, see Item 1, "Financial Statements," Note 2, "Basis of Presentation" under "Revision for Sublease Rent Income."




29


The following table summarizes our stores for the periods indicated:
 
Nine months ended September 30,
 
2016
 
2015
U.S. & Canada
 
 
 
Company-owned(a):
 

 
 

Beginning of period balance
3,584

 
3,487

Store openings
46

 
64

Acquired franchise stores(b)
16

 
33

Franchise conversions(c)
(96
)
 
(12
)
Store closings
(38
)
 
(26
)
End of period balance
3,512

 
3,546

Domestic Franchise:
 
 
 
Beginning of period balance
1,084

 
1,070

Store openings
21

 
18

Acquired franchise stores(b)
(16
)
 
(33
)
Franchise conversions(c)
96

 
12

Store closings
(16
)
 
(5
)
End of period balance
1,169

 
1,062

International(d):
 
 
 
Beginning of period balance
2,095

 
2,150

Store openings
61

 
89

Store closings
(165
)
 
(124
)
End of period balance
1,991

 
2,115

Store-within-a-store (Rite Aid):
 

 
 

Beginning of period balance
2,327

 
2,269

Store openings
29

 
51

Store closings
(9
)
 
(1
)
End of period balance
2,347

 
2,319

Total Stores
9,019

 
9,042

_______________________________________________________________________________
(a) Includes Canada.
(b) Stores that were acquired from franchisees and subsequently converted into company-owned stores.
(c) Company-owned store locations sold to franchisees.
(d) Includes franchise locations in approximately 50 countries (including distribution centers where sales are made) and company-owned stores located in Ireland (The Health Store) and China.








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Comparison of the Three Months Ended September 30, 2016 (current quarter) and 2015 (prior year quarter)

Revenues
 
Our consolidated net revenues decreased $55.4 million, or 8.1%, to $628.0 million for the three months ended September 30, 2016 compared with $683.4 million for the same period in 2015. The decrease was the result of lower sales in all of our segments.
 
U.S. and Canada.  Revenues in our U.S. and Canada segment decreased $39.8 million, or 7.0%, to $525.5 million for the three months ended September 30, 2016 compared with $565.3 million in the prior year quarter. Negative domestic retail same store sales of 8.5%, which includes GNC.com, resulted in a $35.2 million decrease in revenue year-over-year. Negative same store sales were primarily due to lower sales in the protein, vitamins and food/drink categories and a significant decrease in our e-commerce sales due in part to better aligning our web promotions to our stores. E-commerce sales were 6.8% of consolidated revenue during the current quarter compared with 7.3% of consolidated revenue during the prior year quarter. In addition, our corporate stores decreased from 3,546 at September 30, 2015 to 3,512 at September 30, 2016 in connection with our refranchising strategy.

Domestic franchise revenue decreased $2.4 million to $85.8 million in the current quarter compared with $88.2 million in the prior year quarter primarily due to lower wholesale sales associated with lower retail same store sales of our franchisees as well as the earlier timing of our annual franchise convention, which resulted in $6.3 million of lower sales in the current quarter as compared with the prior year quarter. Partially offsetting the above was an increase in the number of franchise stores from 1,062 at September 30, 2015 to 1,169 at September 30, 2016. Our franchisees did not participate in all corporate promotions and our expanded assortment initiative has been adopted by slightly more than half of our franchise stores compared with the significant majority of our corporate stores as of September 30, 2016; as a result, our franchisees reported negative retail same store sales of 8.9% in the third quarter of 2016 as compared with negative 6.4% in our domestic corporate stores (excluding GNC.com).

International. Revenues in our International segment decreased $9.5 million, or 18.7%, to $41.1 million in the current quarter compared with $50.6 million in the prior year quarter. Despite our international franchisees reporting an increase in retail same store sales of 3.9% in the current quarter (excluding the impact of foreign exchange rate changes relative to the U.S. dollar), revenue from franchisees decreased $11.3 million primarily relating to challenges in Chile, Saudi Arabia and Mexico, the termination of our franchise agreement in Turkey, which resulted in the closing of 85 stores and the earlier timing of the annual franchise convention, which resulted in $4.0 million in lower sales in the current quarter compared with the prior year quarter. Partially offsetting the above decrease was an increase in revenue of $1.8 million associated with our China business.

    Manufacturing / Wholesale. Revenues in our Manufacturing / Wholesale segment, excluding intersegment sales, decreased $0.3 million, or 0.5%, to $61.3 million for the three months ended September 30, 2016 compared with $61.6 million in the prior year quarter. Third-party contract manufacturing sales increased $2.2 million, or 6.3%, to $36.6 million for the three months ended September 30, 2016 compared with $34.5 million in the prior year quarter. This increase was partially offset by a decrease in wholesale sales of $2.4 million, or 9.0% from $27.1 million in the prior year quarter to $24.7 million in the current quarter. Intersegment sales decreased $14.5 million from $67.5 million in the prior year quarter to $53.0 million in the current quarter primarily due to lower proprietary sales.

Other. Revenue decreased by $5.9 million due to the sale of Discount Supplements in the fourth quarter of 2015.
 
Cost of Sales and Gross Profit
 
Cost of sales, which includes product costs, warehousing, distribution and occupancy costs decreased $20.1 million to $412.6 million for the three months ended September 30, 2016 compared with $432.7 million in the prior year quarter. Gross profit decreased $35.2 million from $250.6 million in the prior year quarter to $215.4 million in the current quarter, and as a percentage of net revenue, decreased from 36.7% for the quarter ended September 30, 2015 to 34.3% in the current quarter. The decrease in gross profit rate was primarily due to occupancy expense deleverage associated with negative same store sales.
 

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Selling, General and Administrative (“SG&A”) Expense
 
SG&A expense, including compensation and related benefits, advertising and other expenses, increased $7.2 million, or 5.1%, from $141.2 million in the prior year quarter to $148.4 million in the current quarter. SG&A expense, as a percentage of net revenue, was 23.6% and 20.7% for the three months ended September 30, 2016 and 2015, respectively. During the current quarter, we recorded severance expense of $4.5 million associated with the departure of the former Chief Executive Officer and $5.1 million in legal-related charges. Excluding these charges, SG&A expense decreased $2.3 million or 1.6% primarily due to lower marketing expense and lower commissions associated with lower GNC.com and consignment sales, partially offset by higher salaries and benefits due in part to the prior year reduction to an incentive accrual.

Gains on Refranchising

Gains on refranchising, which represents gains on the sale of company-owned stores to franchisees were $0.4 million for the three months ended September 30, 2016 compared with $0.9 million in the prior year quarter. We sold six company-owned stores to franchisees in the current quarter compared with five company-owned stores in the prior year quarter.

Other Income, net

Other income, net, includes foreign currency gains of $0.5 million in the current quarter compared with $0.1 million in gains in the prior year quarter.

Long-lived asset impairments

We recorded a $3.0 million charge related to definite-lived assets in the three and nine months ended September 30, 2016 as future undiscounted cash flows could not support the carrying values of property and equipment at certain of our corporate stores. We recorded a $28.3 million charge in the three and nine months ended September 30, 2015 relating to our Discount Supplements business which was sold in the fourth quarter of 2015.
     
Operating Income
 
As a result of the foregoing, consolidated operating income decreased $17.3 million, or 21.0%, to $64.9 million for the three months ended September 30, 2016 compared with $82.2 million in the prior year quarter. Operating income, as a percentage of net revenue, was 10.3% and 12.0% for the three months ended September 30, 2016 and 2015, respectively. Operating income was impacted significantly by legal-related charges, severance expense and an impairment charge on property and equipment in the current quarter and an impairment charge in the prior year quarter.
 
U.S. and Canada. Operating income decreased $28.4 million, or 30.4%, to $65.3 million for the three months ended September 30, 2016 compared with $93.7 million for the same period in 2015. Operating income as a percentage of segment revenue was 12.4% in the current quarter compared with 16.6% in the prior year quarter. Gains on refranchising were $0.4 million and $0.9 million in the current quarter and prior year quarter, respectively, as explained above. Excluding these gains and the current quarter $3.0 million long-lived asset impairment charge, operating income decreased from 16.4% of segment revenue in the prior year quarter to 13.0% of segment revenue in the current quarter primarily due to expense deleverage in occupancy and salaries expense associated with negative same store sales.
     
International. Operating income decreased $1.4 million, or 8.9%, to $14.7 million for the three months ended September 30, 2016 compared with $16.1 million in the prior year quarter. Operating income was 35.7% of segment revenue in the current quarter compared with 31.9% in the prior year quarter. The increase in operating income percentage was primarily due to higher product margin rate as a result of a higher mix of proprietary sales.

Manufacturing / Wholesale. Operating income decreased $5.1 million, or 22.8%, to $17.4 million for the three months ended September 30, 2016 compared with $22.5 million in the prior year quarter.  Operating income as a percentage of segment revenue decreased from 17.4% in the prior year quarter to 15.2% in the current quarter primarily due to lower intersegment sales, which resulted in unfavorable manufacturing variances, and a higher mix of third-party contract manufacturing sales, which generally contribute lower margins.


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Other. Operating income increased by $30.3 million due to the comparative effect of the prior year quarter $28.3 million long-lived asset impairment charge relating to Discount Supplements, which was sold in the fourth quarter of 2015.
 
Corporate costs. Corporate overhead costs increased $12.6 million to $33.2 million for the three months ended September 30, 2016 compared with $20.6 million in the prior year quarter, primarily due to $5.1 million in legal-related charges, $4.5 million in severance expense associated with the departure of the former Chief Executive Officer and the comparative effect of the prior year reduction of an incentive accrual.

Interest Expense, net
 
Interest expense was $15.4 million in the three month period ended September 30, 2016 compared with $13.8 million in the three months ended September 30, 2015. The increase in interest expense was primarily due to the convertible debt issuance in August 2015 and amounts drawn under the Revolving Credit Facility, partially offset by a lower balance on the Term Loan Facility.
 
Income Tax Expense
 
We recognized $17.2 million of income tax expense (or 34.7% of pre-tax income) during the three months ended September 30, 2016 compared with $22.6 million (or 33.1% of pre-tax income) for the same period in 2015. The prior year quarter rate was impacted by a discrete tax benefit of $11.6 million due to the effect of an anticipated worthless stock deduction resulting from excess tax basis in the common shares of Discount Supplements and a decrease in the liability for uncertain tax positions of $3.1 million.

Net Income
 
As a result of the foregoing, consolidated net income decreased $13.4 million to $32.4 million for the three months ended September 30, 2016 compared with $45.8 million for the same period in 2015.

Diluted Earnings Per Share

Diluted earnings per share decreased 13.0% from $0.54 for the three months ended September 30, 2015 to $0.47 for the same period in 2016 due to a 29.3% decrease to net income, partially offset by a decrease in the weighted average diluted shares outstanding of 18.6% as a result of the share repurchase program.

Comparison of the Nine Months Ended September 30, 2016 (current year period) and 2015 (prior year period)

Revenues
 
Our consolidated net revenues decreased $84.1 million, or 4.1%, to $1,970.1 million for the nine months ended September 30, 2016 compared with $2,054.2 million for the same period in 2015. The decrease was the result of lower sales in the U.S. and Canada and International segments, partially offset by higher sales in our Manufacturing / Wholesale segment, excluding intersegment sales.
 
U.S. and Canada.  Revenues in our U.S. and Canada segment decreased $55.8 million, or 3.2%, to $1,671.0 million for the nine months ended September 30, 2016 compared with $1,726.8 million in the prior year period. Negative domestic retail same store sales of 4.9%, which includes GNC.com, resulted in a $63.0 million decrease in revenue year-over-year. Negative same store sales were primarily due to lower sales in the vitamin, food/drink and protein categories including the first quarter impact of deep discounts related to excess vitamin inventory nearing expiration, partially offset by improvement in the health and beauty and performance supplements categories. E-commerce sales were 7.6% of consolidated revenue in each of the current and prior year periods.

Domestic franchise revenue decreased $8.4 million to $254.1 million in the current year period compared with $262.5 million in the prior year period due to lower wholesale sales and royalties. Our franchisees did not participate in all corporate promotions and our expanded assortment initiative has been adopted by approximately half of our franchise stores compared with the significant majority of our corporate stores as of September 30, 2016; as a result, our franchisees reported lower retail same store sales as compared with our corporate stores or negative 7.0% in the current year period.


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Partially offsetting the above decreases was an increase of $9.4 million primarily due to a higher average company-owned store base and higher sales from Lucky Vitamin.

International. Revenues in our International segment decreased $13.4 million, or 9.9%, to $121.0 million in the current period compared with $134.4 million in the prior year period. Despite, our international franchisees reporting approximately flat retail same store sales of negative 0.5% in the current year period (excluding the impact of foreign exchange rate changes relative to the U.S. dollar), revenue from franchisees decreased $18.7 million primarily relating to challenges in Chile and Mexico and termination of our franchise agreements in Turkey and Australia. Partially offsetting the decrease was an increase in revenue of $5.3 million associated with our China business.

    Manufacturing / Wholesale. Revenues in our Manufacturing / Wholesale segment, excluding intersegment sales, increased $4.6 million, or 2.7%, to $178.0 million for the nine months ended September 30, 2016 compared with $173.4 million in the prior year period. Third-party contract manufacturing sales increased $13.1 million, or 14.9%, to $100.7 million for the nine months ended September 30, 2016 compared with $87.6 million in the prior year period. This increase was partially offset by a decrease in wholesale sales of $8.4 million, or 9.8% from $85.7 million in the prior year period to $77.3 million in the current year period. Intersegment sales decreased $34.1 million from $206.7 million in the prior year period to $172.6 million in the current year period primarily due to lower proprietary sales.

Other. Revenue decreased by $19.7 million due to the sale of Discount Supplements in the fourth quarter of 2015.

Cost of Sales and Gross Profit
 
Cost of sales decreased $17.7 million to $1,280.1 million for the nine months ended September 30, 2016 compared with $1,297.8 million in the prior year period. Gross profit decreased by $66.4 million from $756.4 million in the prior year period to $690.0 million in the current year period. Gross profit, as a percentage of net revenue, decreased from 36.8% for the nine months ended September 30, 2015 to 35.0% in the nine months ended September 30, 2016 primarily due to lower domestic retail product margin rate resulting from first quarter deep discounts on excess vitamin inventory nearing expiration, lower product margin rate in our GNC.com business and occupancy expense deleverage associated with negative same store sales.
 
SG&A Expense
 
SG&A expense increased $9.4 million, or 2.2%, to $430.4 million for the nine months ended September 30, 2016 compared with $421.0 million in the prior year period. SG&A expense, as a percentage of net revenue, was 21.8% and 20.5% for the nine months ended September 30, 2016 and 2015, respectively.

During the current year period, we recorded severance expense of $4.5 million associated with the departure of the former Chief Executive Officer and $5.1 million in legal-related charges. During the prior year period, we recorded an increase to a legal accrual and a decrease in bad debt expense associated with a reduction in the previously established allowance for certain of our international franchisees, based on cash collected. Together, these changes resulted in an increase in SG&A expense of $1.2 million. Also in the prior year period, SG&A expense increased by $2.8 million as a result of the correction of an immaterial error as further explained in Item 1, "Financial Statements," Note 2, "Basis of Presentation."

Excluding the above expenses, SG&A expense increased $3.8 million in the current year period. The increase in SG&A expense, excluding the charges noted above, was primarily due to an increase in salaries and related benefits related to supporting a higher average company-owned store base and the impact of the completion in early 2016 of our senior management team and higher marketing expense of $1.5 million partially offset by lower commissions associated with lower GNC.com and consignment sales and lower amortization expense associated with Discount Supplements, which was sold in the fourth quarter of 2015.

Gains on Refranchising

Gains on refranchising increased $15.9 million to $18.3 million for the nine months ended September 30, 2016 compared with $2.4 million in the prior year period. The increase was due to the sale of 96 company-owned stores in the current year period compared with 12 during the same prior year period.



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Other (Income) Lo