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 July 28, 2006 was 71,165,066.

 

 

 

 

HERBALIFE LTD.

 

Index to Financial Statements and Exhibits
Filed with the Quarterly Report of the Company on Form 10-Q
For the Three and Six Months ended June 30, 2006

 

 

HERBALIFE LTD.

 

 

See the accompanying notes to consolidated financial statements

HERBALIFE LTD.

 

 

See the accompanying notes to consolidated financial statements

HERBALIFE, LTD.

 

 

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 and the 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 accounting principles generally accepted in the United States of America for complete financial statements. The Company’s financial statements as of and for the three and six months ended June 30, 2005 and June 30, 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

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

adjustments, necessary to present fairly the Company’s financial statements as of and for the three and six months ended June 30, 2005 and June 30, 2006. Operating results for the three and six months ended June 30, 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 and six months ended June 30, 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.

 

As of June 30, 2006, FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes was issued in its final version. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition effective for fiscal years beginning after December 15, 2006. Earlier application of the provisions of FIN 48 is encouraged if the enterprise has not yet issued financial statements, including interim financial statements, in the period FIN 48 is adopted. Herbalife’s accounting for its income tax contingency reserves are not based on the provisions of FIN 48 because its financial statements for the six months ended June 30, 2006 have been issued without the early adoption of the provisions of the Interpretation. Management is currently evaluating the impact of adopting FIN 48.

 

In June 2006, the FASB ratified the consensuses of Emerging Issues Task Force (“EITF”) Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF 06-3”). EITF 06-3 clarifies that the scope of this Issue includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer and indicates that the income statement presentation on either a gross basis or a net basis of the taxes within the scope of the Issue is an accounting policy decision that should be disclosed. Furthermore, for taxes reported on a gross basis, an enterprise should disclose the amounts of those taxes in interim and annual financial statements for each period for which an income statement is presented. The consensus is effective, through retrospective application, for periods beginning after December 15, 2006. Management is currently evaluating the impact of adopting EITF 06-3.

 

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. For the three and six months ended June 30, 2005, total purchases from Shuster, were zero and $0.02 million, respectively. For the three and six months ended June 30, 2006, there were no purchases from Shuster.

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

In 2004, Whitney acquired a 50 percent indirect ownership interest in TBA Entertainment (“TBA”), a provider of creative services to Herbalife. For the three and six months ended June 30, 2005 payments of $1.11 million and $5.70 million were 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 and six months ended June 30, 2006, payments to TBA were $0.10 million.

 

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. For the three and six months ended June 30, 2005, total purchases from Leiner were $0.03 million and $0.14 million, respectively. For the three and six months ended June 30, 2006, there were no purchases from Leiner.

 

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. For the three and six months ended June 30, 2005, total purchases from Stauber were $0.36 million and $0.46 million, respectively. For the three and six months ended June 30, 2006, total purchases from Stauber were $0.18 million and $0.19 million, respectively.

 

 

Long-term debt consists of the following:

 

 

During 2005 we prepaid approximately $109.0 million of our senior credit facility resulting in approximately $2.2 million additional interest expense from write-off of unamortized deferred financing costs. 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.

 

 

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

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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 these 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.

 

 

 

 

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,

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

“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 are the same as reported in the geographic operating information.

 

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 was intended to replace the Management Plan and the Independent Directors Plan and after the adoption thereof, no additional awards were 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 at the time of the adoption of the 2005 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 June 30, 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 and second quarters of 2006 include (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 and six months ended June 30, 2006, stock-based compensation expense was included in Selling, General & Administrative Expenses in the amount of $3.1 million and $5.5 million, respectively, as well as related income tax benefits recognized in earnings in the amount of $1.2 million and $2.2 million, respectively.

 

As of June 30, 2006, the total unrecognized compensation cost related to nonvested stock awards was $31.1 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 and six months ended June 30, 2006 was $1.5 million and $2.8 million lower, respectively, 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 June 30, 2006 were both negatively impacted by the change in accounting method by $0.02 per share. The negative impact on both basic and diluted net earnings per common share for the six months ended June 30, 2006 was $0.04 per share. 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 and six months ended June 30, 2006, tax benefits of $12.5 million and $14.2 million, respectively, 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 and six months ended June 30, 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.

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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 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 and six months ended June 30, 2005 and 2006.

 

 

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following tables summarize the activity under the stock-based compensation plans for the six months ended June 30, 2006:

 

 

 

The weighted-average grant date fair value of stock awards granted during the three and six months ended June 30, 2006 was $18.46 and $17.39, respectively. The total intrinsic value of stock awards exercised during the three and six months ended June 30, 2006 was $36.9 million and $41.2 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 June 30, 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 June 30, 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 June 30, 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 $0.4 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

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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.

 

 

On July 21, 2006 (the “Closing Date”), the Company entered into a $300.0 million senior secured credit facility (the “New Credit Facility”) with a syndicate of financial institutions as lenders. The New Credit Facility replaced the Company’s existing $225.0 million senior secured credit facility (the “Prior Credit Facility”), originally entered into on December 21, 2004. All commitments under the Prior Credit Facility were terminated effective on the Closing Date. The Company repaid all amounts outstanding under the Prior Credit Facility amounting to $79.6 million. Consequently, the Company will expense $1.4 million of unamortized deferred financing costs related to the Prior Credit Facility and will recognize $0.4 million, which was primarily related to cash flow hedges on interest rate exposures, from OCI into earnings in the third quarter of 2006.

 

Also on the Closing date, the Company issued a notice to the trustee for the 91/2% Notes to redeem the outstanding 91/2% Notes on August 23, 2006. The aggregate principal amount of the 91/2% Notes to be redeemed is $165.0 million. The 91/2% Notes will be redeemed at the mandatory redemption price of approximately $109.8 per $100 aggregate principal amount of the 91/2% Notes. Borrowings under the New Credit Facility will be used to redeem the 91/2% Notes. Upon redemption of the 91/2% Notes, the Company expects to incur an after-tax one-time charge of approximately $14.0 million, representing the call premium and the write-off of unamortized deferred financing costs.

 

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 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.

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 Re-qualification Period

 

 

Supervisors must re-qualify annually. The re-qualification period covers the twelve months starting in February and ending the following January. For the twelve month re-qualification period ended January 2006, 41.5% of our supervisors re-qualified, 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 re-qualification 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.

 

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 distributor 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 prices 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 & 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 are generally 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 and six months ended June 30, 2006, net sales increased by 21.1% and 21.8%, respectively, as compared to the same periods in 2005, primarily driven by increases in the Americas and Asia/Pacific Rim. Net sales in Europe increased 2.4% for the three months ended June 30, 2006 and were flat for the six months ended June 30, 2006 when compared to the same periods of 2005. Partially offsetting the growth in these regions was a decline in Japan net sales. The overall increase in net sales for the three and six months ended June 30, 2006 reflected the continued sales momentum generated from the successful promotions in 2005 and 2006 and the enthusiasm and unity within our distributor organization.

Net income increased for the three months ended June 30, 2006 to $36.3 million, or $0.49 per diluted share, from $22.8 million or $0.32 per diluted share, for the same period in 2005. Net income increased for the six months ended June 30, 2006 to $75.0 million, or $1.01 per diluted share, from $36.1 million or $0.50 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 41.9% for the six months ended June 30, 2006. The net income increase was due to net sales growth, lower interest expense and a lower effective tax rate, partially offset by higher labor, promotional and professional fee expenses. Overall, the appreciation of foreign currencies had a $0.4 million and a $2.6 million favorable impact on net results for the three and six months ended June 30, 2006, respectively.

 

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.

 

 

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 2005 worldwide cup 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, 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 $65.4 million and $148.9 million, or 39.2% and 48.4%, respectively, for the three and six months ended June 30, 2006, as compared to the same periods of 2005. In local currency, net sales increased by 37.4% and 44.0%, respectively, for the three and six months ended June 30, 2006, as compared to the

same periods of 2005. The fluctuation of foreign currency rates had a favorable impact of $3.0 million and $13.5 million, respectively, on net sales for the three and six months ended June 30, 2006. The overall increase was a result of net sales growth in Mexico, Brazil and the U.S. of $43.1 million, $6.6 million and $4.5 million, respectively, or 86.0%, 27.1% and 5.7%, respectively, for the quarter ended June 30, 2006.

 

The net sales growth trend in Mexico reflects strong supervisor growth, up 100.7% at June 30, 2006, as compared to June 30, 2005, and the continued expansion of our Nutrition Clubs. We estimate that distributors are operating approximately 33,000 Nutrition Clubs in Mexico. During the first six months of 2006 we opened an additional sales center in Mexico City, held a Presidents Team Tour attended by approximately 9,000 distributors and held two Active Supervisor Schools, which approximately 4,300 distributors attended. Additionally, we relocated our Mexico headquarters and main warehouse in Guadalajara and plan to open two distribution centers in key cities across the market to better support the increased sales.

 

The net sales growth trend in Brazil is a result of strong supervisor growth, up 23.0% at June 30, 2006, as compared to June 30, 2005, strong distributor leadership and a highly effective country management team. In addition, expansion of the Total Plan lead generation method has been a key catalyst for growth. During the year we held a World Team School attended by over 4,500 distributors and launched the NouriFusion basic line in individual use packets.

 

Net sales growth in the U.S. is primarily a result of strong supervisor growth, up 12.4% at June 30, 2006, as compared to June 30, 2005; the establishment of a dedicated U.S. country management team; continued branding efforts such as sponsorship of the AVP Volleyball Tour, the Bay to Breakers Run 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. To further support the retailing and recruiting efforts of our distributors, we 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. Additionally, we introduced in July 2006 at our North American Extravaganza a water mixable version of our top selling Formula 1 shake, a reformulated version of our Garden 7 product and NouriFusion in individual use packets.

 

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 key markets.

 

Europe

 

Net sales in Europe increased $3.4 million and $0.3 million, or 2.4% and 0.1%, respectively, for the three and six months ended June 30, 2006, as compared to the same periods of 2005. In local currency, net sales increased 2.7% and 4.1%, respectively, for the three and six months ended June 30, 2006, as compared to the same periods of 2005. The fluctuation of foreign currency rates had an unfavorable impact on net sales of $0.5 million and $11.6 million for the three and six months ended June 30, 2006. Portugal, France, Italy and Spain continue to grow and experienced sales increases of 50.5%, 34.9%, 17.7% and 12.9%, respectively, while Germany and the Netherlands experienced decreases in net sales of 14.9% and 21.2%, respectively for the quarter ended June 30, 2006, as compared to 2005. During the first quarter we relocated 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 net sales increases in Portugal, France, Italy and Spain continued, 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. In addition, there has been an increasing emphasis on good health and nutrition in France, which is supported and promoted by local nutritionists.

 

In Germany, a recently constituted strategy group has focused on turnaround initiatives, both in business activity as well as brand building. Significant distributor training has been undertaken, concentrating on long term customers, nutrition clubs and wellness coaching. In addition, improved distributor communications has been a key focus and new online tools are being provided.

 

The decline in the Netherlands was 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.

These include a National Supervisor recruitment drive, the launch of Liftoff ^tm in June, a highly successful Spring Spectacular event and the appointment of a member of the Global Nutritional Advisory Board.

 

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

 

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. This includes sponsoring the London Triathlon, the Italian Beach Volleyball Championship, the Nice Ironman Triathlon and the Madrid Triathlon, which are intended to continually improve our corporate and brand reputation in the market. We are also enhancing distributor communication processes and training, and, in addition, we have the introduction of some new products into the region, most notably Liftoff^tm. Liftoff^tm was introduced in eight markets in the second quarter, and is scheduled for launch during the third quarter of 2006 in ten additional markets.

 

Asia/Pacific Rim

 

Net sales in Asia/Pacific Rim increased $13.8 million and $21.8 million, or 24.7% and 18.8%, for the three and six months ended June 30, 2006, respectively, as compared to the same periods of 2005. In local currency, net sales increased 22.9% and 18.1%, respectively for the three and six months ended June 30, 2006, as compared to the same periods of 2005. The fluctuation of foreign currency rates had a $1.0 million and $0.9 million favorable impact, respectively, on net sales for the three and six months ended June 30, 2006. The overall increase was attributable mainly to increases in South Korea, China and the opening of Malaysia in February 2006. During the quarter ended June 30, 2006, we held an extravaganza for the region in Bangkok, Thailand, which was attended by over 15,000 distributors from 13 countries.

 

Net sales in South Korea increased $2.3 million and $5.8 million, or 18.9% and 26.3%, respectively, for the three and six months ended June 30, 2006, as compared to 2005. This growth 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 by $5.5 million to $6.0 million and by $9.5 million to $10.2 million, respectively, for the three and six months ended June 30, 2006, as compared to the same periods of 2005. During the quarter ended June 30, 2006, approximately 1,300 distributors from China attended the Asia Pacific Extravaganza. Since March of 2005 we have opened 28 retail stores in 17 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 and six months ended June 30, 2006 was $7.4 million and $11.2 million, respectively.

 

Net sales in Taiwan decreased $0.9 million and $4.5 million, or 4.6% and 10.1%, respectively, for the three and six months ended June 30, 2006, as compared to the same periods of 2005. In local currency, net sales in Taiwan decreased 2.2% and 7.9% for the three and six months ended June 30, 2006, as compared to the same periods of 2005. The fluctuation of foreign currency rates had an unfavorable impact on net sales of $0.5 million and $0.9 million for the three and six months ended June 30, 2006. The decrease was primarily attributed to the local distributor leadership and some of their key members, whose attention was focused primarily 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 introductions should continue the region’s positive year over year growth.

 

Japan

 

Net sales in Japan decreased $1.3 million and $5.9 million, or 6.4% and 12.5%, respectively, for the three and six months ended June 30, 2006, as compared to the same periods of 2005. In local currency, net sales in Japan

decreased 0.4% and 4.4% for the three and six months ended June 30, 2006, as compared to the same periods of 2005. The fluctuation of foreign currency rates had an unfavorable $1.2 million and $3.9 million impact on net sales for the three and six months ended June 30, 2006. In spite of the decrease in net sales, 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 an increase in the number of distributors taking advantage of the modified re-qualification criteria. We believe the modified re-qualification criteria will lead to increased future sales. During the quarter ended June 30, 2006, approximately 1,200 distributors from the region attended the Asia Pacific Extravaganza in Bangkok and over 1,500 distributors attended nutrition club trainings hosted in three key cities. Additionally, Liftoff^tm and NouriFusion^tm skin whitening foundation were launched. During the second half of 2006, we will be launching several new products and promotions, which are expected to generate excitement among our distributors. Additionally, it is our plan to open another showroom and sales center in Osaka, which will operate seven days a week.

 

Sales by Product Category