UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

 

 

 

Commission file number: 1-32381

 

 

 

 

HERBALIFE LTD.

(Exact name of registrant as specified in its charter)

 

 

P.O. Box 309GT

Ugland House, South Church Street

Grand Cayman, Cayman Islands

(Address of principal executive offices) (Zip code)

 

(310) 410-9600*

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

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

Large accelerated filer o      Accelerated filer þ     Non-accelerated filer o

 

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

 

Number of shares of registrant’s common shares outstanding as of April 27, 2006 was 70,197,359.

 

 

 

HERBALIFE LTD.

 

Index to Financial Statements and Exhibits

Filed with the Quarterly Report of the Company on Form 10-Q

For the Three Months ended March 31, 2006

 

HERBALIFE LTD.

 

CONSOLIDATED BALANCE SHEETS

 

 

See the accompanying notes to consolidated financial statements

HERBALIFE LTD.

 

CONSOLIDATED STATEMENTS OF INCOME

 

 

See the accompanying notes to consolidated financial statements

HERBALIFE, LTD.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

See the accompanying notes to consolidated financial statements

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

Herbalife Ltd., a Cayman Islands exempted limited liability company (“Herbalife” or the “Company”), incorporated on April 4, 2002, and its direct and indirect wholly-owned subsidiaries, WH Intermediate Holdings Ltd., a Cayman Islands company (“WH Intermediate”), WH Luxembourg Holdings S.à.R.L., a Luxembourg unipersonal limited liability company (“Lux Holdings”), WH Luxembourg CM S.à.R.L., a Luxembourg unipersonal limited liability company, and WH Acquisition Corp., a Nevada corporation (“WH Acquisition”), were formed on behalf of Whitney & Co., LLC (“Whitney”) and Golden Gate Private Equity, Inc. (“Golden Gate”), in order to acquire Herbalife International, Inc., a Nevada corporation, and its subsidiaries (“Herbalife International”) on July 31, 2002 (the “Acquisition”). Herbalife and its subsidiaries are referred to collectively herein as the Company.

 

IPO Recapitalization

 

On December 16, 2004, Herbalife completed an initial public offering of its common shares (the “IPO”), as part of a series of recapitalization transactions, including:

 

 

As a planned continuation of the IPO recapitalization, Herbalife exercised a contract provision in December 2004 to redeem 40%, or $110.0 million principal value (excluding a premium of $10.5 million), of the 91/2% notes due 2011, (the “91/2% Notes”). After the required notice period, this redemption was completed on February 4, 2005. The redemption premium of $10.5 million and the write-off of deferred financing fees of $3.7 million associated with this redemption are included in interest expense in the first quarter of 2005.

 

In connection with the IPO and the recapitalization, the Company incurred $24.7 million in fees and expenses of which $19.8 million were associated with the IPO (included in equity) and $4.9 million were associated with the establishment of the new credit facility (included in deferred financing costs).

 

Secondary Offering

 

On December 19, 2005, Herbalife completed a secondary public offering of 13 million common shares held by certain existing shareholders. The selling shareholders received all net proceeds from the sale of common shares sold in this offering. Accordingly, Herbalife did not receive any proceeds from the sale of common shares.

 

 

The unaudited interim financial information of the Company has been prepared in accordance with Article 10 of the Securities and Exchange Commission’s Regulation S-X. Accordingly, it does not include all of the information required by generally accepted accounting principles for complete financial statements. The Company’s financial statements as of and for the three months ended March 31, 2006 include Herbalife and all of its direct and indirect subsidiaries. In the opinion of management, the accompanying financial information contains all adjustments, consisting of normal recurring adjustments, necessary to present fairly the Company’s financial

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

statements as of March 31, 2006 and for the three months ended March 31, 2005 and March 31, 2006. Operating results for the three months ended March 31, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.

 

New Accounting Pronouncements

 

Effective January 1, 2006, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment (“SFAS No. 123R”), which generally requires, among other things, that all employee share-based compensation be measured using a fair value method and that the resulting compensation cost be recognized in the financial statements. The Company selected the modified prospective method of adoption. Under this method, compensation expense that the Company recognized for the three months ended March 31, 2006 included: (a) compensation expense for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”), and (b) compensation expense for all share-based payments granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R. Results for prior periods were not restated. See Note 8 to the consolidated financial statements for more details on stock based compensation.

 

Reclassifications

 

Certain reclassifications were made to the prior period financial statements to conform to current period presentation.

 

 

In 2004, Whitney acquired a 50 percent indirect ownership interest in Shuster Laboratories, Inc. (“Shuster”), a provider of product testing and formula development for Herbalife. Herbalife’s total purchases from Shuster for the three months ended March 31, 2005 and 2006 were $17,000 and $0, respectively.

 

In 2004, Whitney acquired a 50 percent indirect ownership interest in TBA Entertainment (“TBA”), a provider of creative services to Herbalife. For the three months ended March 31, 2005 a payment of $4,577,000 was made to TBA for services relating to the 25th Anniversary Extravaganza, of which the majority were reimbursements of Extravaganza expenses paid to third parties. For the three months ended March 31, 2006, no payments were made to TBA.

 

In 2004, Golden Gate acquired a 47 percent ownership interest in Leiner Health Products Inc. (“Leiner”), a nutritional manufacturer and supplier of certain Herbalife products. Total purchases by Herbalife from Leiner during the three months ended March 31, 2005 and 2006 were $111,000 and $0, respectively.

 

In January 2005, Whitney, together with its affiliates, acquired a 77 percent ownership interest in Stauber Performance Ingredients (“Stauber”), a value-added distributor of bulk specialty nutraceutical ingredients. Total purchases by Herbalife from Stauber for the three months ended March 31, 2005 and 2006 were $100,000 and $3,000, respectively.

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Long-term debt consists of the following:

 

 

In March 2006, the Company made a prepayment to the term loan borrowings under the senior credit facility of $9.8 million. Consequently, the Company expensed $0.2 million of related unamortized deferred financing costs in the first quarter of 2006.

 

 

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

 

Herbalife International and certain of its independent distributors have been named as defendants in a purported class action lawsuit filed February 17, 2005, in the Superior Court of California, County of San Francisco, and served on Herbalife International on March 14, 2005 (Minton v. Herbalife International, et al). The case has been transferred to the Los Angeles County Superior Court. The plaintiff is challenging the marketing practices of certain Herbalife International independent distributors and Herbalife International under various state laws prohibiting “endless chain schemes,” insufficient disclosure in assisted marketing plans, unfair and deceptive business practices, and fraud and deceit. The plaintiff alleges that the Freedom Group system operated by certain independent distributors of Herbalife International products places too much emphasis on recruiting and encourages excessively large purchases of product and promotional materials by distributors. The plaintiff also alleges that Freedom Group pressured distributors to disseminate misleading promotional materials. The plaintiff seeks to hold Herbalife International vicariously liable for the actions of its independent distributors and is seeking damages and injunctive relief. The Company believes that it has meritorious defenses to the suit.

 

Herbalife International and certain of its distributors have been named as defendants in a class action lawsuit filed July 16, 2003, in the Circuit Court of Ohio County in the State of West Virginia (Mey v. Herbalife International, Inc., et al). On April 21, 2006, the court granted plaintiff’s motion for class certification in West Virginia. The complaint alleges that certain telemarketing practices of certain Herbalife International distributors violate the Telephone Consumer Protection Act, or TCPA, and seeks to hold Herbalife International vicariously liable for the practices of its distributors. More specifically, the plaintiffs’ complaint alleges that several of Herbalife International’s distributors used pre-recorded telephone messages and autodialers to contact prospective customers in violation of the TCPA’s prohibition of such practices. Herbalife International’s distributors are independent contractors and if any such distributors in fact violated the TCPA they also violated Herbalife’s policies, which

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

require its distributors to comply with all applicable federal, state and local laws. The Company believes that it has meritorious defenses to the suit.

 

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

 

Certain of the Company’s subsidiaries have been subject to tax audits by governmental authorities in their respective countries. In certain of these tax audits, governmental authorities are proposing that significant amounts of additional taxes and related interest and penalties are due. The Company and its tax advisors believe that there are substantial defenses to their allegations that additional taxes are owed, and the Company is vigorously contesting the additional proposed taxes and related charges.

 

These matters may take several years to resolve, and the Company cannot be sure of their ultimate resolution. However, it is the opinion of management that adverse outcomes, if any, will not likely result in a material adverse effect on our financial condition and operating results. This opinion is based on the belief that any losses suffered in excess of amounts reserved would not be material, and that the Company has meritorious defenses. Although the Company has reserved an amount that the Company believes represents the most likely outcome of the resolution of these disputes, if the Company is incorrect in the assessment the Company may have to record additional expenses.

 

 

 

 

The Company is a network marketing company that sells a wide range of weight management products, nutritional supplements and personal care products within one industry segment as defined under SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” The Company’s products are manufactured by third party providers and then sold to independent distributors who sell Herbalife products to retail consumers or other distributors.

 

The Company sells products in 62 countries throughout the world and is organized and managed by geographic region. The Company elected to aggregate its operating segments into one reporting segment, as management believes that the Company’s operating segments have similar operating characteristics and similar long term operating performance. In making this determination, management believes that the operating segments are similar with regard to the nature of the products sold, the product acquisition process, the types of customers products are sold to, the methods used to distribute the products, and the nature of the regulatory environment.

 

Revenues reflect sales of products to distributors based on the distributors’ geographic location. Sales attributed to the United States is the same as reported in the geographic operating information.

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The Company’s geographic operating information and sales by product line are as follows:

 

 

 

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

The Company has six stock-based compensation plans which are the WH Holdings (Cayman Islands) Ltd. Stock Incentive Plan (“Management Plan”), the WH Holdings (Cayman Islands) Ltd. Independent Directors Stock Incentive Plan (“Independent Directors Plan”), the Herbalife Ltd. 2004 Incentive Plan (“2004 Stock Incentive Plan”), the 2005 Stock Incentive Plan (“2005 Stock Incentive Plan”), the Herbalife Ltd. Executive Incentive Plan (“Executive Incentive Plan”) and the Herbalife Ltd. Independent Directors Deferred Compensation and Stock Unit Plan (“Independent Director Stock Unit Plan”). The Management Plan provides for the grant of options to purchase common shares of Herbalife to members of the Company’s management. The Independent Directors Plan provides for the grant of options to purchase common shares of Herbalife to the Company’s independent directors. The 2004 Stock Incentive Plan is intended to replace the Management Plan and the Independent Directors Plan. No additional awards will be made under either the Management Plan or the Independent Directors Plan. However, the shares remaining available for issuance under these plans were absorbed by and became available for issuance under the 2004 Stock Incentive Plan. The 2005 Stock Incentive Plan authorizes the issuance of 4,000,000 common shares pursuant to awards, plus any shares that remain available for issuance under the 2004 Stock Incentive Plan. The terms of the 2005 Stock Incentive Plan are substantially similar to the terms of the 2004 Stock Incentive Plan. The purpose of the Executive Incentive Plan is to govern the award and payment of annual bonuses to certain company executives. The purpose of the Independent Directors Stock Unit Plan is to facilitate equity ownership in the Company by its independent directors through the award of stock units and to allow for deferral by the independent directors of compensation realized in connection with such stock units. The Company’s stock compensation awards outstanding as of March 31, 2006 include stock options, stock appreciation rights (“SARS”) and stock units.

 

Prior to January 1, 2006, the Company applied the intrinsic value method as outlined in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations, in accounting for share-based awards made under these plans. Under the intrinsic value method, compensation expense is recorded on the date of grant to the extent the then current market price of the underlying stock exceeds the exercise price. On January 1, 2006, the Company adopted SFAS No. 123R. This statement replaces SFAS No. 123 and supersedes APB 25. SFAS No. 123R requires that all share-based compensation be recognized as an expense in the financial statements and that such cost be measured based on the fair value of the awards granted. The Company adopted SFAS No. 123R using the modified prospective transition method which requires the recognition of compensation expense on a prospective basis only. Accordingly, prior period financial statements have not been restated. Under this transition method, stock-based compensation cost for the first quarter of 2006 includes (a) compensation cost for all share-based awards granted prior to, but not yet vested as of, January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123; and (b) compensation cost for all share-based awards granted subsequent to January 1, 2006 based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R.

 

SFAS No. 123R also requires the Company to estimate forfeitures in calculating the expense relating to share-based compensation as opposed to recognizing forfeitures as an expense reduction as they occur. The adjustment to

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

apply estimated forfeitures to previously recognized share-based compensation was considered immaterial and as such was not classified as a cumulative effect of a change of in accounting principle.

 

The Company records compensation expense over the requisite service period which is equal to the vesting period. For awards granted prior to January 1, 2006, compensation expense is recognized on a graded-vesting basis over the vesting term. For awards granted on or after January 1, 2006, compensation expense is recognized on a straight-line basis over the vesting term. For the three months ended March 31, 2005 and 2006, stock-based compensation expense was included in selling, general and administrative expenses in the amount of $1.8 million and $2.4 million, respectively, as well as related income tax benefits recognized in earnings in the amount of $0.7 million and $1.0 million, respectively.

 

As of March 31, 2006, the total unrecognized compensation cost related to nonvested stock awards was $28.2 million and the related weighted-average period over which it is expected to be recognized is approximately 2.3 years.

 

As a result of the adoption of SFAS No. 123R, the Company’s net income for the three months ended March 31, 2006 was $1.3 million lower than it would have been under the Company’s previous accounting method for share-based compensation. Basic and diluted net earnings per common share for the three months ended March 31, 2006 were negatively impacted by the change in accounting method by $0.02 and $0.01 per share, respectively. Prior to the Company’s adoption of SFAS No. 123R, benefits of tax deductions in excess of recognized compensation costs were reported as operating cash inflows. SFAS No. 123R requires that these excess tax benefits be recorded as a financing cash inflow rather than as a reduction of taxes paid. For the three months ended March 31, 2006, tax benefits of $1.7 million were generated from option exercises.

 

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provision of SFAS No. 123 to options granted under the Company’s stock-based compensation plans for the three months ended March 31, 2005. For purposes of this pro forma disclosure, the value of the options is estimated using the Black-Scholes-Merton option-pricing model and amortized to expense using a graded vesting schedule with forfeitures recognized as they occur.

 

 

The Company’s stock-based compensation plans provide for grants of stock options, stock appreciation rights, restricted stock and stock units (collectively called the “awards”). Stock options typically vest quarterly over a five-year period beginning on the grant date, and certain stock option grants vest over a period of less than five years. SARS vest quarterly over a five-year period beginning on the grant date. The contractual term of stock options and SARS is ten years. Stock unit awards under the 2005 Incentive Plan (“Incentive Plan Stock Units”) vest annually over a three year period which is equal to the contractual term. Stock unit awards under the Independent Directors

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Stock Unit Plan (“Independent Director Stock Units”) vest at a 25% rate on each of April 15, July 15 and October 15 of the calendar year in which the award is granted and January 15 of the calendar year following the year in which the award is granted. Unless otherwise determined at the time of grant, the value of each stock unit shall be equal to one common share of Herbalife.

 

The fair value of each award is estimated on the date of grant using the Black-Scholes-Merton option-pricing model based on the assumptions in the following tables. The expected term of the award is based on observed historical exercise patterns. Because of the very limited historical data all groups of employees have been determined to have similar historical exercise patterns for valuation purposes. The expected volatility of stock awards is primarily based upon on the historical volatility of the Company’s common stock and, due to the limited period of public trading data for its common stock, it is also validated against the volatility rates of a peer group of companies. The risk free interest rate is based on the implied yield on a U.S. Treasury zero-coupon issue with a remaining term equal to the expected term of the award. The dividend yield reflects that the Company has not paid any cash dividends since inception. The following table summarizes the weighted average assumptions used in the calculation of fair market value for the three months ended March 31, 2005 and 2006.

 

 

The following tables summarize the activity under the stock-based compensation plans for the three months ended March 31, 2006:

 

 

The weighted-average grant date fair value of stock awards granted during the three months ended March 31, 2005 and 2006 was $6.41 and $17.06, respectively. The total intrinsic value of stock awards exercised during the three months ended March 31, 2005 and 2006 was $0.4 million and $4.3 million, respectively.

 

 

The Company designates certain derivatives as cash flow hedges. The Company engages in a foreign exchange hedging strategy for which the hedged transactions are forecasted foreign currency denominated intercompany transactions. The hedged risk is the variability of the forecasted foreign currency cash flows where the hedging strategy involves the purchase of average rate options. The Company also engages in an interest rate hedging strategy for which the hedged transactions are forecasted interest payments on the Company’s variable rate term loan. The hedged risk is the variability of forecasted interest rate cash flows, where the hedging strategy involves the purchase of interest rate swaps. As of December 31, 2005, and March 31, 2006, the Company did not have any outstanding cash flow hedges on foreign exchange exposure. For the outstanding cash flow hedges on interest rate exposures at December 31, 2005 and March 31, 2006, the maximum length of time over which the Company is hedging these exposures is approximately three years. The interest rate swap outstanding as of December 31, 2005, and March 31, 2006 was accounted for under the shortcut method, as defined by SFAS No. 133, which assumes the hedge to be perfectly effective. Consequently, all changes in the fair value of the derivative are deferred and recorded in other comprehensive income (“OCI”) until the related forecasted transaction is recognized in the consolidated statements of income. The estimated net amount of existing gains expected to be reclassified into earnings over the next three years, which related to cash flow hedge, is $0.1 million.

 

The Company designates certain derivatives as free standing derivatives for which hedge accounting does not apply. The changes in the fair market value of the derivatives are recorded in the Company’s statements of income. The Company purchases average rate put options, which give the Company the right, but not the obligation, to sell foreign currency at a specified exchange rate (“strike rate”). These contracts provide protection in the event the foreign currency weakens beyond the strike rate. The Company also uses foreign currency forward contracts, which give the Company the obligation to buy or sell foreign currency at a specified time and rate. The contracts are used to protect against changes in the functional currency equivalent value of inter-company or third party nonfunctional currency payables and receivables. In December of 2005, the Company entered into a short term interest rate cap agreement, which is not designated under hedge accounting. The cap provides protection in the event the three month LIBOR rate were to increase beyond 4.75%, and is in place, along with the interest rate swap, to fulfill the Company’s obligation to hedge at least 25% of the term debt notional amount. The fair values of the option, forward contracts and interest rate cap are based on third-party bank quotes.

 

Overview

 

We are a global network marketing company that sells weight management, nutritional supplement and personal care products. We pursue our mission of “changing people’s lives” by providing a financially rewarding business opportunity to distributors and quality products to distributors and customers who seek a healthy lifestyle. We are one of the largest network marketing companies in the world with net sales of approximately $1.6 billion for the year ended December 31, 2005. We sell our products in 62 countries through a network of over one million independent distributors except in China, where we currently use a retail business model with employed sales representatives because of regulatory restrictions on direct selling. We believe the quality of our products and the effectiveness of our distribution network, coupled with geographic expansion, have been the primary reasons for our success throughout our 26-year operating history.

 

We offer products in three principal categories: weight management products, nutritional supplements which we refer to as “inner nutrition” and personal care products which we refer to as “Outer Nutrition^®”. Our products are often sold in programs, which are comprised of a series of related products designed to simplify weight management and nutrition for our consumers and maximize our distributors’ cross-selling opportunities.

Industry-wide factors that affect us and our competitors include the increasing prevalence of obesity and the aging of the worldwide population, which are driving demand for nutrition and wellness-related products and the recruitment and retention of distributors.

 

The opportunities and challenges upon which we are most focused are driving retailing of our product, recruitment and retention of distributors and improving distributor productivity, entering new markets, further penetrating existing markets, pursuing local distributor initiatives, introducing new products, developing niche market segments and further investing in our infrastructure.

 

A key non-financial measure we focus on is Volume Points on a Royalty Basis (hereafter “Volume Points”), which is essentially our weighted unit measure of product sales volume. It is a useful measure for us, as it excludes the impact of foreign currency fluctuations and ignores the differences generated by varying retail pricing across geographic markets. In general, an increase in Volume Points in a particular region or country directionally indicates an increase in local currency net sales.

 

Volume Points by Geographic Region

 

 

Another key non-financial measure on which we focus on is the number of distributors qualified as supervisors under our compensation system. Distributors qualify for supervisor status based on their Volume Points.

 

The growth in the number of supervisors is a general indicator of the level of distributor recruitment, which generally drives net sales in a particular country or region. Our compensation system requires each supervisor to re-qualify for such status each year, prior to February. There is significant variation in the number of supervisors from the fourth quarter to the first quarter of any given year due to the timing of the re-qualification process. This fluctuation is normal and consistent, does not reflect a dramatic underlying change in the business in comparing these two sequential quarters, and will become more meaningful period to period throughout the year.

 

The following tables show trends in the number of supervisors over the reporting period by region, and fluctuations within each notable country are discussed in the appropriate net sales section below where pertinent.

 

Number of Supervisors by Geographic Region as of Reporting Period

 

Number of Supervisors by Geographic Region as of Requalification Period

 

 

Supervisors must re-qualify annually. The requalification period covers the twelve months starting in February and ending the following January. For the twelve month requalification period ended January 2006, 41.5% of our supervisors requalified, up from 39.7% a year ago. The number of supervisors by geographic region as of the reporting dates will normally be higher than the number of supervisors by geographic region as of the requalification period because supervisors who do not re-qualify during the relevant twelve-month period will be dropped from the rank of supervisor in February. Since supervisors purchase most of our products for resale to other distributors and consumers, comparisons of supervisor totals on a year-to-year, same period basis are good indicators of our recruitment and retention efforts in different geographic regions.

 

The value of the average monthly purchase of Herbalife products by our supervisors has remained relatively constant over time. Consequently, increases in our sales are driven primarily by our retention of supervisors and by our recruitment and retention of distributors, rather than through increases in the productivity of our overall supervisor base.

 

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

 

Presentation

 

“Retail Sales” represent the gross sales amounts on our invoices to distributors before distributor allowances (as defined below), and “net sales”, which reflects distribution allowances and handling and freight income, is what the Company collects and recognizes as net sales in its financial statements. We discuss Retail Sales because of its fundamental role in our compensation systems, internal controls and operations, including its role as the basis upon which distributor discounts, royalties and bonuses are awarded. In addition, information in daily and monthly reports reviewed by our management relies on Retail Sales data. However, such a measure is not in accordance with Generally Accepted Accounting Principles in the U.S. (“GAAP”). You should not consider Retail Sales in isolation from, nor is it a substitute for, net sales and other consolidated income or cash flow statement data prepared in accordance with GAAP, or as a measure of profitability or liquidity. A reconciliation of net sales to Retail Sales is presented below. “Product sales” represent the actual product purchase price paid to us by our distributors, after giving effect to distributor discounts referred to as “distributor allowances,” which approximate 50% of retail sales prices. Distributor allowances as a percentage of sales may vary by country depending upon regulatory restrictions that limit or otherwise restrict distributor allowances.

 

Our “gross profit” consists of net sales less “cost of sales,” which represents the prices we pay to our raw material suppliers and manufacturers of our products as well as costs related to product shipments, duties and tariffs, freight expenses relating to shipment of products to distributors and importers and similar expenses.

“Royalty Overrides” are our most significant expense and consist of:

 

 

Royalty Overrides are generally earned based on Retail Sales, and approximate in the aggregate about 22% of Retail Sales or approximately 35% of our net sales. Royalty Overrides together with distributor allowances represent the potential earnings to distributors of up to approximately 73% of Retail Sales. The compensation to distributors is generally for the development, retention and improved productivity of their distributor sales organizations and is paid to several levels of distributors on each sale. Because of local country regulatory constraints, we may be required to modify our typical distributor incentive plans as described above. Because of restrictions on direct selling in China, our full-time employed sales representatives in China are compensated with wages, bonuses and benefits instead of the distributors earnings — distributor allowances and royalty overrides. Consequently, the total distributor discount percentage may vary over time. We also offer reduced distributor allowances and pay reduced royalty overrides with respect to certain products worldwide.

 

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

 

“Selling, General and Administrative Expenses” represent our operating expenses, components of which include labor and benefits, sales events, professional fees, travel and entertainment, distributor marketing, occupancy costs, communication costs, bank fees, depreciation and amortization, foreign exchange gains and losses and other miscellaneous operating expenses.

 

“113/4% Notes” refers to Herbalife International’s 113/4% senior subordinated notes due 2010. “91/2% Notes” refers to our 91/2% notes due 2011.

 

Most of our sales to distributors outside the United States are made in the respective local currencies. In preparing our financial statements, we translate revenues into U.S. dollars using average exchange rates. Additionally, the majority of our purchases from our suppliers generally are made in U.S. dollars. Consequently, a strengthening of the U.S. dollar versus a foreign currency can have a negative impact on our reported sales and operating margins and can generate transaction losses on intercompany transactions. Throughout the last five years, foreign currency exchange rates have fluctuated significantly. From time to time, we enter into foreign exchange forward contracts and option contracts to mitigate our foreign currency exchange risk.

 

Summary Financial Results

 

For the three months ended March 31, 2006, net sales increased by 22.5% as compared to the same period in 2005, primarily driven by increases in the Americas and Asia/Pacific Rim, partially offset by decreases in Japan and Europe. The increased sales in the first quarter of 2006 reflected the continued sales momentum generated from the successful promotions in 2005 and the enthusiasm and unity within our distributor organization.

 

Net income increased for the three months ended March 31, 2006 to $38.7 million, or $0.53 per diluted share, from $13.3 million, or $0.19 per diluted share for the same period in 2005. Excluding the impact of a $3.7 million tax benefit resulting from an international income tax settlement in the first quarter of 2006 and $14.2 million of recapitalization expenses incurred in the first quarter of 2005 associated with the $110.0 million clawback of our 91/2% Notes, net income increased 27.3%. The net income increase was due to net sales growth, lower interest and income tax expense, partially offset by higher labor, promotional and professional fee expenses. Overall, the appreciation of foreign currencies had a $2.2 million favorable impact on net results for the three months ended March 31, 2006.

Results of Operations

 

Our results of operations for the periods described below are not necessarily indicative of results of operations for future periods, which depend upon numerous factors, including our ability to recruit and retain new distributors, open new markets and further penetrate existing markets and introduce new products and develop niche market segments.

 

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

 

 

Three months ended March 31, 2006 compared to three months ended March 31, 2005

 

Net Sales

 

The following chart reconciles Retail Sales to net sales:

 

Sales by Geographic Region

 

 

Changes in net sales are directly associated with the recruiting, retention and retailing of our distributor force, the quality and completeness of the product offerings that the distributor force has to sell and the number of countries in which we operate. Management’s role, both in-country and at the corporate level is to provide distributors with a competitive and broad product line, encourage strong teamwork and leadership among the Chairman’s Club and President’s Team distributors and offer leading edge business tools to make doing business with Herbalife simple. Management uses the marketing program coupled with educational and motivational tools to incentivize distributors to drive recruiting, retention and retailing which in turn affect net sales. Such tools include corporate sales events — Extravaganzas and World Team Schools — where large groups of distributors gather, thus

allowing them to network with other distributors, learn recruiting, retention and retailing techniques from our leading distributors, and become more familiar with how to market and sell our products and business opportunities. Accordingly, management believes that these development and motivation programs can increase the productivity of the supervisor network. The expenses for such programs are included in selling, general & administrative expenses. Sales are driven by several factors including the number and productivity of distributor leaders who continually build, educate and motivate their respective distribution and sales organizations. We also use product event and non-event promotions to motivate distributors to increase recruiting, retention and retailing activities. These promotions have ranged from our 2003 laptop computer promotion to vacations or other qualifying events for distributors that meet certain selling and recruiting goals. The costs of these promotions are included in selling, general, & administrative expenses.

 

The factors described above have driven growth in our business. The following net sales by geographic region discussion further details some of the above factors and describes unique growth factors specific to certain major countries. The Company believes that the correct foundation, coupled with ongoing training and promotional initiatives is required to increase recruiting and retention of distributors and retailing of the product. The correct foundation includes strong country management that works closely with the distributor leadership, a broad product line that appeals to local consumer needs, a favorable regulatory environment, a scalable and stable technology platform and an attractive marketing plan. Initiatives such as Success Training Seminars, World Team Schools, Promotional Events and regional Extravaganzas are integral components of developing a highly motivated and educated distributor sales organization that will work toward increasing the recruitment and retention of distributors.

 

The Company’s strategy will continue to include generating and maintaining growth within existing markets. We expect to increase spending in selling, general & administrative expenses to maintain or stimulate sales growth, while making strategic investments in new initiatives. In addition, new ideas are being generated in our regional markets, either by distributors, country management or corporate management. Examples are the Nutrition Clubs in Mexico and the Total Plan in Brazil and GenerationH (“GenH”) in the U.S., as described in the net sales discussion below. Management’s strategy is to review the applicability of expanding successful country initiatives throughout a region and/or globally where appropriate and financially support the globalization of these initiatives.

 

The Americas

 

Net sales in The Americas increased $83.5 million, or 59.4%, for the three months ended March 31, 2006, as compared to 2005. In local currency, net sales increased by 51.6% for the three months ended March 31, 2006, as compared to 2005. The fluctuation of foreign currency rates had a favorable impact of $11.0 million on net sales for three months ended March 31, 2006. The overall increase was a result of net sales growth in Mexico, Brazil and U.S. of $46.1 million, $12.1 million and $14.4 million, respectively, or 123.2%, 51.8%, and 21.5%, respectively, for the three months ended March 31, 2006.

 

The net sales growth trend in Mexico reflects the continued emphasis on distributor and customer retention programs such as the Nutrition Clubs, which are an innovative way by which distributors are retailing our products to new customers, some of whom may eventually become distributors of our products. The costs to set up a Nutrition Club are generally nominal, and are borne solely by the distributor. Our distributors are operating over 25,000 Nutrition Clubs in Mexico. During the first quarter we opened an additional sales center in Mexico City and held a Presidents Team Tour attended by approximately 9,000 distributors. In the second quarter of 2006 we plan to move our local headquarter and main warehouse to a new location to better support the increased sales. In connection with the relocation we expect to invest approximately $2.4 million in leasehold improvements, equipment and technology hardware.

 

The net sales growth trend in Brazil is a result of the expansion of the Total Plan, strong distributor leadership, a highly effective country management team and a good product portfolio. The Total Plan is a low cost lead generating method where distributors use our personal care line of products and offer consultations to obtain referrals. This concept specifically supports our retailing and recruiting initiatives and has been a catalyst for growth in Brazil. In December 2005, Brazil held its 10^th Anniversary Event, with over 10,000 distributors in attendance. At this event, new products (Firm Cell, Radiant C Scrub, Cleanser and Body Lotion) were launched that further support

the Total Plan, reinforcing our objective to increase the recruitment, retailing and retention by distributors. A demonstration of our online distributor tool, BizWorks, was also provided to highlight the benefits of real time organizational volume reports as a means to improve efficiency for distributors. The positive momentum from this event has continued into the first quarter of 2006.

 

Net sales growth in the U.S. is a result of the numerous steps taken in 2004, 2005 and the first quarter of 2006 to improve the business in the U.S., including the establishment of a dedicated U.S. country management team; branding efforts such as sponsorship of the JP Morgan Chase tennis tournament, the AVP Volleyball Tour, the Nautica Malibu Triathlon and the 2006 Amgen Tour of California bicycle race; various new promotions including the 2006 Active World Team promotion and the 2006 President Team Challenge; and various new product introductions in late 2005. These steps have helped maintain the positive net sales growth during the first quarter of 2006. It is our plan to open two new sales centers in the U.S. during the second half of 2006 to further support the overall sales growth and in particular to stimulate sales within the vicinity of the new sales centers.

 

We believe that 2006 sales in the Americas region should continue its positive year over year growth primarily as a result of the expected continuation of the strong momentum in Mexico, Brazil, and the U.S.

 

Europe

 

Net sales in Europe decreased $3.1 million, or 2.2%, for the three months ended March 31, 2006, as compared to 2005. In local currency, net sales increased 5.5% for the three months ended March 31, 2006, as compared to 2005. The fluctuation of foreign currency rates had an unfavorable impact on net sales of $11.1 million for the three months ended March 31, 2006. Germany, Netherlands and Switzerland continue to experience sales declines of 20.8%, 23.8% and 25.0%, respectively, while France and Italy increased net sales by 29.6% and 8.0%, respectively, for the three months ended March 31, 2006, as compared to 2005. During the quarter we re-located our call centers to Italy, France and the Netherlands in an effort to improve service and support to distributors, who previously were serviced out of the United Kingdom. During this process we also opened our first sales center in the Netherlands.

 

The decline in the Netherlands has been primarily driven by lower recruiting of new distributors. A reconstituted distributor strategy group, working closely with regional management is focused on initiatives to reverse that trend. New distributor business tools and the sponsorship of the Rotterdam Marathon are direct results of these efforts.

 

In Germany and Switzerland, a newly constituted strategy group is focusing on turnaround initiatives, both on business activity as well as brand building. Recent in-country trainings by top distributors on key initiatives such as the Total Plan have evolved from this group.

 

While progress is being made, the turnaround is expected to be slow in all three of the above markets, and net sales for 2006 are expected to be slightly below the level of 2005 for these countries.

 

The net sales increases in Italy and France are primarily due to a well balanced performance across distributor retailing, recruiting and retention efforts, a united distributor leadership working closely with the local management, and a program focus on the Total Plan as referred to above. In addition, in France there is an increasing emphasis on good health and nutrition, which is supported and promoted by local nutritionists.

 

We believe that 2006 sales in Europe should continue the positive year over year growth as measured in local currencies, partly due to our global and local branding initiatives, such as sponsoring the London Triathlon, the Belgium Gezond Wandeldag Fun Run and the Madrid Triathlon, which are intended to continually improve our corporate and brand reputation in the market and our introduction of new products into the region, such as Liftoff^tm, scheduled for launch during the second and third quarters of 2006. In addition, with the recent changes to our management teams, both regionally and locally, we expect to formulate and implement a new strategy to improve the declining markets in Europe and continue positive growth trends in others.

 

Asia/Pacific Rim

 

Net sales in Asia/Pacific Rim increased $8.0 million, or 13.3%, for the three months ended March 31, 2006, as compared to 2005. In local currency, net sales increased 13.6% for the three months ended March 31, 2006, as

compared to 2005. The fluctuation of foreign currency rates had a $0.2 million unfavorable impact on net sales for the three months ended March 31, 2006. The overall increase was attributable mainly to increases in South Korea, China and the opening of Malaysia in February 2006.

 

Net sales in South Korea increased $3.5 million, or 35.4%, for the three months ended March 31, 2006, as compared to 2005. This continued improvement in 2006 was a result of positive momentum from the local events including leadership weekends and a unified focus by Korea’s country and distributor leadership. Also, during the first quarter of 2006 we made some modifications to the local distributor compensation plan, which we expect to have a positive impact on recruiting in 2006.

 

Net sales in China increased $4.0 million to $4.3 million for the three months ended March 31, 2006, as compared to 2005. Since March of 2005 we have opened 19 retail stores in 9 provinces throughout China. We expect to increase the number of stores to cover approximately 20 provinces before the end of 2006.

 

Malaysia opened in February 2006 with over 10,000 attendees at various opening events. Net sales for the three months ended March 31, 2006 was $3.9 million.

 

Net sales in Taiwan decreased $3.5 million, or 14.7%, for the three months ended March 31, 2006, as compared to 2005. The decrease was primarily attributed to the local distributor leadership and some of their key members directed their focus on the opening of Malaysia and the emerging business opportunity in China.

 

Overall, we believe that additional promotions, various branding initiatives including the sponsorship of several healthy lifestyle events in the region, the opening of Malaysia, the further expansion into the Chinese market, the expansion of Nutrition Clubs within the region and new product introduction, should continue the region’s positive year over year growth.

 

Japan

 

Net sales in Japan decreased $4.7 million, or 17.5%, for the three months ended March 31, 2006, as compared to 2005. In local currency, net sales in Japan decreased 7.4% for the three months ended March 31, 2006, as compared to 2005. The fluctuation of foreign currency rates had an unfavorable $2.7 million impact on net sales for the three months ended March 31, 2006. After two consecutive quarters of year over year sales growth as measured in local currencies, the current quarter decline was primarily due to the introduction of Shapeworks^tm in the first quarter of 2005 and the timing of certain promotions. Such promotions and significant product introductions were not repeated in 2006. The number of new distributors and the supervisor retention rate are improving when compared to the same period last year. The improved retention rate was caused by a shift in distributors taking advantage of the modified re-qualification criteria, a criteria we believe will lead to increased future sales and exceed the immediate negative impact on sales.

 

Sales by Product Category

 

 

Our increased emphasis on the science of weight management and nutrition during the past two years, illustrated by our assembly of the Scientific Advisory Board and the Medical Advisory Board, has resulted in product introductions such as Niteworks^tm and Garden 7^tm and the introduction of ShapeWorks^tm, a personalized meal replacement program. Due to the launch these new products together with the continued positive sales

momentum discussed above, net sales of weight management products and Inner Nutrition^® products increased at a higher rate than net sales of inner nutrition products. Literature, Promotional and Other, which is net of product buy-backs and returns in all product categories, increased due to a decrease in returns and refunds. We expect shifts within these categories from time to time as we launch new products.

 

Gross Profit

 

Gross profit was $364.4 million for the three months ended March 31, 2006, as compared to $296.3 million in the same period of 2005. As a percentage of net sales, gross profit for the three months ended March 31, 2006 increased slightly from 79.6% to 80.0%, as compared to the same period of 2005. Generally, gross profit percentages do not vary significantly as a percentage of sales other than due to ongoing cost reduction initiatives and provisions for slow moving and obsolete inventory. Additionally, we believe that we have the ability to mitigate price increases by raising the prices of our products or shifting product sourcing to alternative manufacturers.

 

Royalty Overrides

 

Royalty Overrides as a percentage of net sales were 36.3% for the three months ended March 31, 2006 and March 31, 2005. Generally, this ratio varies slightly from period to period due to changes in the mix of products and countries because full Royalty Overrides are not paid on certain products or in certain countries. Due to the structure of our global compensation plan, we do not expect to see significant fluctuations in Royalty Overrides as a percent of net sales.

 

Selling, General, & Administrative Expenses

 

Selling, General, & Administrative expenses as a percentage of net sales were 29.6% for the three months ended March 31, 2006 and March 31, 2005, respectively.

 

For the three months ended March 31, 2006, Selling, General & Administrative expenses increased $25.0 million to $135.0 million from $110.0 million in the same period of 2005. The increase included $11.0 million in higher salaries and benefits, due primarily to normal merit increases, higher employee bonuses, higher stock based compensation expenses, increases related to the strengthening of the management team regionally and in the U.S.; higher compensation costs associated with employee sales representatives in China; and $5.6 million in additional professional fees primarily associated with our technology infrastructure and legal expenses; and $3.9 million in additional sales event expenses related primarily to the Chile Extravaganza and Herbalife Honors, our most prestigious award ceremony.

 

We expect 2006 Selling, General & Administrative expenses to increase over 2005 levels, reflecting general salary merit increases and the on-going investments in our five key strategies—distributor, direct-to-consumer, product development, China, and infrastructure strategies. Although as a percentage of net sales, these expenses should be slightly down from 2005 levels.

 

Net Interest Expense

 

Net interest expense was $6.0 million for the three months ended March 31, 2006, as compared to $22.2 million in the same period of 2005 reflecting the lower level of debt, from the redemption of 40% or $110 million principal amount of the 91/2% Notes completed in February 2005.

 

Income Taxes

 

Income taxes were $19.4 million for the three months ended March 31, 2006, as compared to $15.6 million in the same period of 2005. As a percentage of pre-tax income, the effective income tax rate was 33.4% for the three months ended March 31, 2006, as compared to 54.1% in the same period of 2005. The decrease in the effective tax rate for the three months ended March 31, 2006 as compared to 2005 was caused primarily by the higher pre-tax income, the impact of non-deductible recapitalization charges in the three months ended March 31, 2005 and the settlement of an international tax audit in the three months ended March 31, 2006. Excluding the impact of the

recapitalization expenses and the completion of the international tax audit, the effective tax rate would have been approximately 39.7% and 37% for the three months ended March 31, 2006 and March 31, 2005, respectively.

 

Foreign Currency Fluctuations

 

Currency fluctuations had a favorable impact of $2.2 million on net results for the three months ended March 31, 2006, when compared to what current year net results would have been using last year’s foreign exchange rates. For the three months ended March 31, 2006, the regional effects of currency fluctuations were an unfavorable impact of $1.4 million in Europe, an unfavorable impact of $0.2 million in Asia/Pacific Rim, a favorable impact of $3.1 million in The Americas, and a favorable impact of $0.7 million in Japan.

 

Net Results

 

Net income for the three months ended March 31, 2006 was $38.7 million, or $0.53 per diluted share, up from $13.3 million, or $0.19 per diluted share for the same period of 2005. Excluding the impact of a $3.7 million tax benefit resulting from an international income tax settlement in the first quarter of 2006 and $14.2 million of recapitalization expenses incurred in the first quarter of 2005 associated with the $110.0 million clawback of our 91/2% Notes, net income increased 27.3%. The increase in net income was due to the net sales growth, lower interest and income tax expense, partially offset by higher labor, promotional and professional fee expenses. Overall, the appreciation of foreign currencies had a $2.2 million favorable impact on net results for the three months ended March 31, 2006.

 

Liquidity and Capital Resources

 

We have historically met our working capital and capital expenditure requirements, including funding for expansion of operations, through net cash flows provided by operating activities. Our principal source of liquidity is our operating cash flows. Variations in sales of our products would directly affect the availability of funds. There are no material restrictions on the ability to transfer and remit funds among our international affiliated companies.

 

For the three months ended March 31, 2006, we generated $46.1 million from operating cash flows, as compared to $25.1 million for the three months ended March 31, 2005. The increase in cash generated from operations reflected an increase in net income of $25.4 million, which was primarily driven by a 22.5% growth in net sales and a decrease in interest paid of $13.2 million, partially offset by an increase in income taxes paid of $7.7 million and the timing of the Mark Hughes Bonus payment. In 2006, we made $24.6 million of Mark Hughes Bonus payments in March 2006. In 2005, the Mark Hughes Bonus payments were paid in April 2005.

 

Capital expenditures, including capital leases, for the three months ended March 31, 2006 were $12.2 million, as compared to $4.4 million for the same period in 2005. The majority of these expenditures represented investments in management information systems, the development of the Company’s direct-to-consumer platform, and the expansion of our facilities in China. We expect to incur capital expenditures of up to $45 million in 2006.

 

2005 and 2006 are investment years for us in China as we expand our business there. The operating loss in China for 2005 was $2.2 million and we currently anticipate to fund an operating loss of approximately $10.0 million in 2006, in addition to total capital expenditures and working capital of up to $15.0 million for the planned build-out of retail stores, our offices and the expansion of the capabilities of our manufacturing facility. In 2005 we invested approximately $4.5 million in capital expenditures in China.

 

In December 2004, Herbalife completed an initial public offering in connection with which several recapitalization transactions were completed, including the tender for all of the outstanding 113/4% Notes, of which 99.9% accepted the tender offer, and a replacement of the existing term loan and revolving credit facility with a new $225.0 million senior credit facility. In addition, we redeemed $110 million principal amount excluding discounts or 40% of our outstanding 91/2% Notes in February of 2005 for the cash amount of $124.1 million, including a premium of $10.5 million and accrued interest of $3.6 million. Interest expense in 2005 includes the redemption amount of $14.2 million, which represents $10.5 million of premium and $3.7 million of write off of deferred financing cost and discount.

The $225.0 million senior credit facility consists of a senior secured revolving credit facility with total availability of up to $25.0 million and a senior secured term loan facility in an aggregate principal amount of $200.0 million. The revolver is available until December 21, 2009. The revolver bears interest at LIBOR plus 2%. In April 2005 the senior credit facility was amended whereby the interest rate was reduced from LIBOR plus 21/4% to LIBOR plus 13/4%. In addition, the amount payable in connection with a partial or full refinancing of the loan within the first year of the amendment shall equal 101% of the principal amount. In August 2005, the senior credit facility was amended to permit the purchase, repurchase or redemption of up to $50.0 million aggregate principal amount of the 91/2% Notes due 2011. There were no repurchases of the 91/2% Notes in 2005 and 2006. In March 2006, we prepaid $9.8 million of our senior credit facility resulting in approximately $0.2 million additional interest expense from write-off of deferred financing fees. With regard to the term loan we are obligated to pay $0.2 million every quarter until September 30, 2010 and the remaining principal amount on December 21, 2010.

 

The senior credit facility and the 91/2% Notes include customary covenants that restrict, among other things, the ability to incur additional debt, pay dividends or make certain other restricted payments, incur liens, merge or sell all or substantially all of our assets, or enter into various transactions with affiliates. Additionally, the senior credit facility includes covenants relating to the maintenance of certain leverage, fixed charge coverage, and interest coverage ratios, and requirements to make early payments to the extent of excess cash flow, as defined therein.

 

The following summarizes our contractual obligations including interest at March 31, 2006 and the effect such obligations are expected to have on our liquidity and cash flows in future periods:

 

 

As of March 31, 2006, we had positive working capital of $43.2 million. Cash and cash equivalents were $109.2 million at March 31, 2006, compared to $88.2 million at December 31, 2005.

 

We expect that cash and funds provided from operations and available borrowings under our new revolving credit facility will provide sufficient working capital to operate our business, to make expected capital expenditures and to meet foreseeable liquidity requirements, including debt service on the 91/2% Notes and the new senior credit facility. There can be no assurance, however, that our business will service our debt, including our outstanding notes, or fund our other liquidity needs.

 

The majority of our purchases from suppliers are generally made in U.S. dollars, while sales to Herbalife distributors generally are made in local currencies. Consequently, strengthening of the U.S. dollar versus a foreign currency can have a negative impact on operating margins and can generate transaction losses on intercompany transactions. For discussion of our foreign exchange contracts and other hedging arrangements, see the quantitative and qualitative disclosures about market risks described below.

 

Contingencies

 

We are from time to time engaged in routine litigation. We regularly review all pending litigation matters in which we are involved and establish reserves deemed appropriate by management for these litigation matters when a probable loss estimate can be made.

 

Herbalife International and certain of its independent distributors have been named as defendants in a purported class action lawsuit filed February 17, 2005, in the Superior Court of California, County of San Francisco,

and served on Herbalife International on March 14, 2005 (Minton v. Herbalife International, et al). The case has been transferred to the Los Angeles County Superior Court. The plaintiff is challenging the marketing practices of certain Herbalife International independent distributors and Herbalife International under various state laws prohibiting “endless chain schemes,” insufficient disclosure in assisted marketing plans, unfair and deceptive business practices, and fraud and deceit. The plaintiff alleges that the Freedom Group system operated by certain independent distributors of Herbalife International products places too much emphasis on recruiting and encourages excessively large purchases of product and promotional materials by distributors. The plaintiff also alleges that Freedom Group pressured distributors to disseminate misleading promotional materials. The plaintiff seeks to hold Herbalife International vicariously liable for the actions of its independent distributors and is seeking damages and injunctive relief. The Company believes that it has meritorious defenses to the suit.

 

Herbalife International and certain of its distributors have been named as defendants in a class action lawsuit filed July 16, 2003, in the Circuit Court of Ohio County in the State of West Virginia (Mey v. Herbalife International, Inc., et al). On April 21, 2006, the court granted plaintiff’s motion for class certification in West Virginia. The complaint alleges that certain telemarketing practices of certain Herbalife International distributors violate the Telephone Consumer Protection Act, or TCPA, and seeks to hold Herbalife International vicariously liable for the practices of its distributors. More specifically, the plaintiffs’ complaint alleges that several of Herbalife International’s distributors used pre-recorded telephone messages and autodialers to contact prospective customers in violation of the TCPA’s prohibition of such practices. Herbalife International’s distributors are independent contractors and if any such distributors in fact violated the TCPA they also violated Herbalife’s policies, which require its distributors to comply with all applicable federal, state and local laws. The Company believes that it has meritorious defenses to the suit.

 

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

 

Certain of our subsidiaries have been subject to tax audits by governmental authorities in their respective countries. In certain of these tax audits, governmental authorities are proposing that significant amounts of additional taxes and related interest and penalties are due. We and our tax advisors believe that there are substantial defenses to their allegations that additional taxes are owed, and we are vigorously contesting the additional proposed taxes and related charges.

 

These matters may take several years to resolve, and we cannot be sure of their ultimate resolution. However, it is the opinion of management that adverse outcomes, if any, will not likely result in a material effect on our financial condition and operating results. This opinion is based on our belief that any losses we suffer would not be material and that we have meritorious defenses. Although we have reserved an amount that we believe represents the likely outcome of the resolution of these disputes, if we are incorrect in our assessment we may have to record additional expenses.

 

Critical Accounting Policies

 

Our Consolidated Financial Statements are prepared in conformity with accounting principles generally accepted in the United States, which require us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the year. Actual results could differ from those estimates. We consider the following policies to be most critical in understanding the judgments that are involved in preparing the financial statements and the uncertainties that could impact our results of operations, financial condition and cash flows.

 

We are a network marketing company that sells a wide range of weight management products, nutritional supplements and personal care products within one industry segment as defined under SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” Our products are manufactured by third party providers and then sold to independent distributors who sell Herbalife products to retail consumers or other distributors.

We sell products in 62 countries throughout the world and is organized and managed by geographic region. In the first quarter of 2003, we elected to aggregate our operating segments into one reporting segment, as management believes that our operating segments have similar operating characteristics and similar long term operating performance. In making this determination, management believes that the operating segments are similar in the nature of the products sold, the product acquisition process, the types of customers products are sold to, the methods used to distribute the products, and the nature of the regulatory environment.

 

Revenue is recognized when products are shipped and title passes to the independent distributor or importer. Amounts billed for freight and handling costs are included in net sales. We generally receive the net sales price in cash or through credit card payments at the point of sale. Related royalty overrides and allowances for product returns are recorded when the merchandise is shipped.

 

Allowances for product returns primarily in connection with our buyback program are provided at the time the product is shipped. This accrual is based upon historic return rates for each country, which vary from zero to approximately 5.0% of retail sales, and the relevant return pattern, which reflects anticipated returns to be received over a period of up to 12 months following the original sale. Historically, product returns and buybacks have not been significant. Product returns and buybacks were approximately 0.9% and 0.9% for the three months ended March 31, 2005 and 2006 respectively. No material changes in estimates have been recognized for the three months ended March 31, 2005 and 2006.

 

We record reserves against our inventory to provide for estimated obsolete or unsalable inventory based on assumptions about future demand for our products and market conditions. If future demand and market conditions are less favorable than management’s assumptions, additional reserves could be required. Likewise, favorable future demand and market conditions could positively impact future operating results if previously reserved for inventory is sold. We reserved for obsolete and slow moving inventory totaling $8.0 million, and $9.6 million as of December 31, 2005 and March 31, 2006, respectively.

 

In accordance with Statement of Financial Accounting Standards (“SFAS”) 144, long-lived assets, such as property, plant, and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.

 

Goodwill and other intangibles not subject to amortization are tested annually for impairment, and are tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, the Company determines the fair value of a reporting unit and compares it to its carrying amount.

 

Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill and other intangibles over the implied fair value. The implied fair value is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with SFAS No. 141, Business Combinations. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill and other intangibles. As of March 31, 2006, we had goodwill of approximately $129.5 million, and marketing franchise of $310.0 million. No write-downs have been recognized for the three months ended March 31, 2005. For the three months ended March 31, 2006, goodwill was reduced by $4.7 million due primarily to the effect of the settlement of an international tax audit related to the pre-acquisition period.

 

Contingencies are accounted for in accordance with SFAS 5, “Accounting for Contingencies.” SFAS 5 requires that we record an estimated loss from a loss contingency when information available prior to issuance of our

financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and the amount of the loss can be reasonably estimated. Accounting for contingencies such as legal and income tax matters requires us to use judgment. Many of these legal and tax contingencies can take years to be resolved. Generally, as the time period increases over which the uncertainties are resolved, the likelihood of changes to the estimate of the ultimate outcome increases.

 

Deferred income tax assets have been established for net operating loss carryforwards of certain foreign subsidiaries and have been reduced by a valuation allowance to reflect them at amounts estimated to be ultimately recognized. The net operating loss carryforwards expire in varying amounts over a future period of time. Realization of the income tax carryforwards is dependent on generating sufficient taxable income prior to expiration of the carryforwards. Although realization is not assured, we believe it is more likely than not that the net carrying value of the income tax carryforwards will be realized. The amount of the income tax carryforwards that is considered realizable, however, could change if estimates of future taxable income during the carryforward period are adjusted.

 

We account for stock-based compensation in accordance with SFAS No. 123R, Share-Based Payment.  Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the vesting period. Determining the fair value of share-based awards at the grant date requires judgment, including estimating out stock price volatility and employee stock award exercise behaviors. Our expected volatility is primarily based upon on the historical volatility of Herbalife’s common stock and, but due to the limited period of public trading data for its common stock, it is also validated against the volatility of a company peer group. The expected life of awards is based on observed historical exercise patterns, which can vary over time. As stock-based compensation expense recognized in the Consolidated Statement of Income is based on awards ultimately expected to vest, the amount of expense has been reduced for estimated forfeitures. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on historical experience.

 

New Accounting Pronouncements

 

Effective January 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment (“SFAS No. 123R”), which generally requires, among other things, that all employee share-based compensation be measured using a fair value method and that the resulting compensation cost be recognized in the financial statements. We selected the modified prospective method of adoption. Under this method, compensation expense that we recognized for the three months ended March 31, 2006 included: (a) compensation expense for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation, and (b) compensation expense for all share-based payments granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R. Results for prior periods were not restated. See Note 8 to the consolidated financial statements for more details on stock based compensation.

 

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

 

We have adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133, as amended and interpreted, established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. If the derivative is designated as a fair-value hedge, the changes in the fair value of the derivative and the underlying hedged item are recognized concurrently in earnings. If the derivative is designated as a cash-flow hedge, changes in the fair value of the derivative are recorded in other comprehensive income (“OCI”) and are recognized in the

statement of operations when the hedged item affects earnings. SFAS No. 133 defined new requirements for designation and documentation of hedging relationships as well as ongoing effectiveness assessments in order to use hedge accounting. For a derivative that does not qualify as a hedge, changes in fair value are recognized concurrently in earnings.

 

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

 

Foreign Exchange Risk

 

We enter into foreign exchange derivatives in the ordinary course of business primarily to reduce exposure to currency fluctuations attributable to inter-company transactions and translation of local currency revenue. Most of these foreign exchange contracts are designated as cash flow hedges for forecasted transactions.

 

We purchase average rate put options, which give us the right, but not the obligation, to sell foreign currency at a specified exchange rate (“strike rate”). These contracts provide protection in the event that the foreign currency weakens beyond the option strike rate.

 

The following table provides information about the details of our option contracts: