Pershing Square Capital Management Raises Questions Regarding Herbalife's 2Q Earnings

NEW YORK, July 30, 2013 /PRNewswire/ -- In advance of Herbalife's earnings call for the second quarter of 2013, Pershing Square Capital Management, L.P. ("Pershing Square") has compiled a list of questions arising from Herbalife's recently published earnings release and second quarter 10-Q that we think any reasonable investor, analyst, and regulator would like answered.

Weak Reported Q2'13 Operating Income Growth
Despite 18% growth in Q2'13 net sales compared to the same time period in 2012, GAAP operating income – the most important measure of the core earnings power of the Company – grew by only 3% as a result of a 31% increase in SG&A expenses (See page 5 of the 10-Q, Condensed Consolidated Statements of Income). The Company has attempted to characterize $11.5mm of this large increase in SG&A as non-recurring; however, more than two-thirds of the Q2 SG&A increase relates to: (i) higher salaries, bonuses and benefits ($22.0mm); (ii) higher distributor promotion, event costs and advertising expense ($15.3mm); (iii) higher expenses related to China independent service providers ($19.7mm); and higher non-income tax expenses such as value added tax and sales tax ($6.8mm). 

• Why is the Company's operating earnings growth so weak?  Is the Company "buying" revenue growth at the expense of operating income?

Weak Implied Q3'13 Operating Income Growth
Herbalife's updated guidance for Q3'13 implies flat year-over-year operating income of approximately $161M, despite its guidance of net sales growth of 16.5% to 18.5% vs. 2012.^[1]

• Why does the Company have such meaningfully negative operating leverage in Q2 2013 and in its projections for 2013 full-year operating income? 

Herbalife's Continued Use of Exchange Rates that are Unavailable in the Venezuelan Market
According to the 10-Q on page 10, in the second quarter of 2013 Herbalife used the official CADIVI rate of 6.3 Bolivars to 1 U.S. dollar for the purpose of consolidating its Venezuelan operations and balance sheet.  Herbalife has been unable to convert Bolivars to U.S. dollars at this rate and has resorted to "alternative legal exchanges" in which the Company has only been able to convert a nominal amount of Bolivars at a rate "75% less favorable than the new CADIVI rate (10-Q p. 10)."  As highlighted in the 10Q on page 37, if the company used an exchange rate commensurate with the rates available in alternative legal exchanges, the company's reported cash and cash equivalents as of June 30, 2013 would decline by $93.2 million and it would incur a corresponding amount of foreign exchange loss to operating profit.  Furthermore, "Herbalife Venezuela would operate at a loss and this could have a significant negative impact to our consolidated financial statements."

• Why does the Company continue to use an exchange rate in Venezuela that is substantially better than what can be achieved in the market?
• Why does management's guidance for the balance of 2013 "assume a Venezuelan exchange rate of 10 to 1" if the Company is marking its Venezuelan assets and liabilities on its June 30, 2013 balance sheet at the CADIVI rate of 6.3 Bolivars per U.S. dollar?

Herbalife's Independent Auditor
When a public company files its Form 10-Q, it is customary for an independent auditor to review the filing beforehand.  Page 8 of the 10-Q notes that "The unaudited interim financial information presented in this Quarterly Report on Form 10-Q has not been reviewed by an independent registered public accounting firm as the Company's former independent registered public accounting firm resigned on April 8, 2013."

• In light of the fact that PwC was retained by Herbalife in May, why didn't it review the Company's Q2'13 Form 10-Q?
• When will PwC begin reviewing and auditing the Company's 10-Q and 10-K reports?
• When will PwC complete its auditing review of Herbalife's 2010 through 2012 public filings?

Prior Period Errors in Reported Income Tax Expenses
Page 9 of Herbalife's Q2'13 10-Q notes that "in connection with preparing the unaudited and unreviewed interim financial information presented in this Quarterly Report on Form 10-Q, prior period errors were identified which affected the interim period ended June 30, 2013, and the interim periods within and annual periods ended December 31, 2012, 2011 and 2010. These income tax errors primarily relate to income tax expenses calculated on intercompany inventory transactions and the Company's application of ASC 740-10-25-3(e)." The 10-Q continues: "The Company concluded that these errors were not material, individually or in the aggregate, to any of the prior reporting periods. (emphasis added)"

Pages 9 and 10 of Herbalife's 10-Q disclose that the impact of such "prior period errors" caused Herbalife's reported deferred tax liability as of December 31, 2012 to increase by 286%, from $15.9mm to $61.3mm. In addition, reported 2012 diluted earnings per share decreased approximately 3% from $4.05 to $3.94.

• Who discovered these errors – was it the Company or PwC?
• Given that the Company's reported deferred tax liability increased 286%, why does the Company believe that "these errors were not material?"

Page 10 of the 10-Q further discloses that, of the $13.2mm tax expense adjustment in year 2012, $1.6mm was misstated in the first six months. Assuming the remainder of the restatement is split across the third and fourth quarters, this implies that Herbalife's Q4'12 diluted EPS results were overstated by five cents per share.

We note that Herbalife's Q4'12 results were the first period reported after Pershing Square's presentation entitled "Who wants to be a Millionaire?" on December 20, 2012. This was an important quarter for the Company to demonstrate EPS growth. During that quarter, the Company reported $1.05 of diluted EPS, which exceeded consensus EPS estimates by four cents per share.

• Had Herbalife correctly accounted for its income tax expense in Q4'12, would the Company's reported diluted EPS have been less than the consensus figure of $1.01? If so, does the Company still believe that  the restatement is not material?

Reconciliation of Non-GAAP Financial Measures
The Company's press release for Q2'13 notes $26.1mm of "Non-GAAP financial measures" net of taxes, which serve to make reported Adj. EPS for the first half of 2013 10% greater than GAAP diluted EPS. These financial measures include add-backs for expenses associated with (1) the Venezuela devaluation impact, (2) expenses incurred responding to attacks on the Company's business model, and (3) expenses incurred for the re-audit of 2010 to 2012 financial statements due to resignation of KPMG. The press release also notes that such Non-GAAP adjustments are "unaudited and unreviewed."

Page 16 of Herbalife's Q2'13 10-Q notes that Herbalife's effective tax rate decreased from 28.1% in Q2'12 to 23.4% in Q2'13 "primarily due to an increase of net benefits from discrete events, principally related to favorable tax audit settlements, and the impact of changes in the geographic mix of the Company's income. (emphasis added)"

• Why does the Company add-back non-recurring expense items when calculating Adjusted EPS, but fail to deduct benefits such as the favorable settlement of tax audits that the Company itself describes as "discrete events?"
• Given that the Company has been sued numerous times for being a pyramid scheme, and given that, in the past, other investors have raised allegations about Herbalife's business model similar to those issues raised by Pershing Square, why does Herbalife consider "expenses incurred responding to attacks on the Company's business model" a non-recurring expense?
• Has PwC reviewed the Company's Non-GAAP adjustments and provided the Company with an opinion as to whether or not they are appropriate?

Page 22 of Herbalife's Q2'13 10-Q notes that "the Company recorded $8.1 million and $17.6 million, respectively, of professional fees and other expenses related to [expenses incurred responding to attacks on the Company's business model]." The 10-Q further notes that:  included in these amounts are expenses related to "a cash settlement liability award, or the Liability Award, outstanding as of June 30, 2013, which is tied to the Company's stock price and which only vests if certain conditions are met relating to the above matter."

• Please provide a detailed breakdown of the $17.6 million of expenses relating to this matter.
• Who is the beneficiary of this Liability Award and how is it determined?

Senior Distributor Departure Disclosure
Herbalife's SEC filings contain vague statements that Herbalife's "sales leaders, together with their downline sales organizations, account for substantially all of our revenues" and that "the loss of a group of leading sales leaders, together with their downline sales organizations, or the loss of a significant number of distributors for any reason, could negatively impact sales of our products, impair our ability to attract new distributors and harm our financial condition and operating results." (HLF Q2 FY 2013 Report on Form 10-Q, page 45)

• Given that two very senior distributors, Anthony Powell and Shawn Dahl (one of 39 Chairman's Club members), have left Herbalife (Powell in Q1 '13 and Dahl late in Q2 '13), why isn't the current and future impact of the loss of these two senior distributors quantified in any way, and disclosed in Herbalife's MD&A? Have other senior distributors departed, and what is the likelihood of more senior distributor departures in the future? 
• When do you plan on reinstituting the Chairman's Club website (http://www.herbalife.com/chairmansclub), which Des Walsh said on the last conference call is down for "scheduled maintenance"?  Why does the scheduled maintenance of the website take months to complete?

The Impact of Pricing Increases
Page 30 of Herbalife's Q2'13 10-Q notes that net sales in Brazil increased 32.7% in Q2'13, partially due to "a price increase of approximately 4.0% in March 2013 which contributed to the increase in sales." Similarly, net sales growth in Venezuela increased 73.1%, fueled, in part, by "price increases of 15% in December 2012 and 17% in April 2013."

However, page 31 of Herbalife's Q2'13 10-Q explains the decrease of net sales in Malaysia by 20.1% in Q2'13 by saying: "the decrease in net sales for the three months ended June 30, 2013 was primarily due to a price increase that took effect at the end of March 2013. As generally occurs, distributors reacted to the announcement of the upcoming price increase by accelerating their purchases in advance of the price increase, which increased sales for the first quarter of 2013 but led to lower sales for the second quarter of 2013."

• Why do price increases lead to increased net sales in certain countries (i.e. Brazil and Venezuela) but cause decreased net sales in other countries (i.e. Malaysia)?

Amendment To The Agreements Of Distributorship
On July 18, 2002, the Company published a Notice To Distributors regarding Amendment To The Agreements Of Distributorship between Herbalife International, Inc. and Each Herbalife Distributor. As part of this agreement, "the Company may not, in countries where the Company is currently operating, materially change the relative relationship between the volume points, the adjusted retail price and/or the retail price of all products sold by the Company in the markets in which such products are being sold, unless such changes are made to convert adjusted retail prices up to a full retail price basis (i.e., one volume point per US $1.00 in the United States) or unless such changes are required by applicable law or are necessary in the Company's reasonable business judgment to account for specific local market conditions or local currency conditions to achieve a reasonable profit on operations in such respective market or markets."

We note that, since 2004, the ratio of "Retail Sales" to volume points in North America has increased from a ratio of 1.04x to 1.20x (as of Q2'13). This has the effect of increasing the price a distributor must pay to "buy" a volume point.

• Given that the ratio of retail sales to volume points has increased ~15% since 2004, why is the Company not in violation of the terms of the agreement it signed with its distributors in 2002?

Distributor Churn
Page 8 of Herbalife's Q1'13 10-Q stated that as of March 31, 2013, the Company had 3.6 million independent distributors, which included 0.2 million in China.  Page 8 of Herbalife's Q2'13 10-Q states that as of June 30, 2013, the Company had 3.4 million independent distributors, which includes 0.2 million in China. This implies non-China distributors decreased a net 0.2 million from Q1'13 to Q2'13.  We further note that Herbalife's Regional Key Metrics supplement shows that Herbalife gained 517,701 new distributors in Q2'13 (excluding China).

• Is it correct to assume that 717,701 distributors exited the business in Q2'13 (3.4mm + 0.518mm – 3.2mm = 0.718mm)?
• Given that the Company had 2.9mm non-sales leaders (excluding China) as of Q1'13, this implies a ~98% annual churn rate in the Company's non-sales leader distributor base (0.7mm / 2.9mm = 24.4% * 4 = 98%)?  Do you agree with this calculation?  If not, what is the annual churn rate for non-sales leader distributors?
• What is the reason for the wide variance in the implied non-sales leader distributor churn metric from Q1'13 to Q2'13?
• Why doesn't the Company provide new distributor numbers and non-sales leader churn metrics in its audited public filings, along with explanations for the change in the underlying churn rate?

Visit www.factsaboutherbalife.com  to view Pershing Square's presentation and to learn more about the company.

About Pershing Square Capital Management, L.P.
Pershing Square Capital Management, L.P. ("Pershing Square"), based in New York City, is a SEC-registered investment advisor to private investment funds.  Pershing Square manages funds that are in the business of trading — buying and selling — securities and other financial instruments.  Funds managed by Pershing Square are short the stock of Herbalife Ltd.  Pershing Square may increase, decrease, dispose of, or change the form of its investment in Herbalife for any or no reason, at any time.  Pershing Square may change its views about or its investment positions in Herbalife at any time, for any reason or no reason.  Pershing Square may buy, sell, cover or otherwise change the form or substance of its Herbalife investment.  Pershing Square disclaims any obligation to notify the market of any such changes.  Please see the full Disclaimer appearing on website www.factsaboutherbalife.com. 

[1] Q3 2013 operating income calculated by using (i) the midpoint of the Company's guidance for Diluted EPS of $1.11; multiplied by (ii) 107mm diluted shares outstanding; divided by (iii) 1 – 23.5% (midpoint of the effective tax rate guidance); plus $5.6mm of interest expense.

SOURCE Pershing Square Capital Management, L.P.

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