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 90067

(Address of principal executive offices) (Zip code)

 

(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 þ          Accelerated filer o          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 25, 2007 was 71,843,113.

 

 

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, 2007

 

 

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. (and together with its subsidiaries, the “Company”) is a leading global network marketing company that sells weight management, nutritional supplement and personal care products through a network of over 1.5 million independent distributors except in China, where the company currently sells the products through retail stores and an employed sales force. The Company reports revenue from seven geographic units: North America, which consists of the U.S., Canada, Jamaica and the Dominican Republic; Mexico and Central America, which consists of Mexico, Costa Rica and Panama; Brazil; South America and Southeast Asia, which includes New Zealand and Australia and excludes Brazil; EMEA, which consists of Europe, the Middle East and Africa; and Greater China, which consists of China, Taiwan and Hong Kong.

 

 

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 U.S. for complete financial statements. The Company’s unaudited consolidated financial statements as of and for the three months ended March 31, 2007 include Herbalife and all of its direct and indirect subsidiaries. In the opinion of management, the accompanying financial information contains all adjustments, consisting of normal recurring adjustments, necessary to present fairly the Company’s unaudited consolidated financial statements as of March 31, 2007 and for the three months ended March 31, 2006 and March 31, 2007. Operating results for the three months ended March 31, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007.

 

New Accounting Pronouncements

 

In February 2007, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, or SFAS No. 159, which permits entities to choose to measure many financial instruments, and certain other items, at fair value. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 applies to reporting periods beginning after November 15, 2007. The Company is currently evaluating the impact, if any, of adopting SFAS No. 159.

 

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurement, or SFAS No. 157, which defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. The provisions of SFAS No. 157 are effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact, if any, of adopting SFAS No. 157.

 

Reclassifications

 

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

 

 

Whitney & Co., LLC, or Whitney, holds a 50 percent indirect ownership interest in TBA Entertainment, or TBA, a provider of creative services to the Company. For the three months ended March 31, 2006, no payments were made to TBA. For the three months ended March 31, 2007, payments to TBA were $0.8 million.

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Long-term debt consists of the following:

 

 

On July 21, 2006, the Company entered into a $300.0 million senior secured credit facility with a syndicate of financial institutions as lenders. The credit facility is comprised of a $200.0 million term loan and a $100.0 million revolving credit facility and replaced the $225.0 million senior secured credit facility, originally entered into on December 21, 2004. The term loan bears interest at LIBOR plus a margin of 1.5%, or the base rate plus a margin of 0.50%, and matures on July 21, 2013. The revolver bears interest at LIBOR plus a margin of 1.25%, or the base rate plus a margin of 0.25%, and is available until July 21, 2012. The Company incurred approximately $2.3 million of debt issuance costs in connection with entering into the new credit facility in July 2006 which are being amortized over the term of the debt. The Company repaid all amounts outstanding under the $225.0 million senior secured credit facility. Consequently, the Company expensed $1.7 million of unamortized deferred financing costs related to that credit facility. Also in July 2006, the Company redeemed the outstanding $0.1 million aggregate principal amount of its 113/4% Notes.

 

On August 23, 2006, the Company borrowed $200.0 million pursuant to the term loan under the new credit facility to fund the redemption of its 91/2% Notes due 2011. The total redemption price of the 91/2% Notes was $187.8 million and consisted of $165.0 million aggregate principal amount, $16.6 million purchase premium and $6.2 million accrued interest. The redemption premium of $16.6 million and the write-off of unamortized deferred financing costs and discounts of $4.6 million associated with the 91/2% Notes were included in interest expense in the third quarter of 2006.

 

In September 2006, the Company prepaid $20.0 million of its new term loan borrowings resulting in $0.1 million additional interest expense from the write-off of unamortized deferred financing costs. In March 2007, the Company made another prepayment of $29.5 million and the Company expensed approximately $0.2 million of related unamortized deferred financing costs.

 

No borrowings were outstanding under the revolver at March 31, 2007.

 

 

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

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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). 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 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, the Company has been and is currently subjected to various product liability claims. The effects of these claims to date have not been material to the Company, and the reasonably possible range of exposure on currently existing claims is not material to the Company. The Company believes that it has meritorious defenses to the allegations contained in the lawsuits. The Company currently maintains product liability insurance with an annual deductible of $10 million.

 

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.

 

 

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

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 No. 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 64 countries throughout the world and is organized and managed by geographic units. The Company aggregates 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 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.

 

Revenues reflect sales of products to distributors based on the distributors’ geographic location.

 

In July 2006, the Company changed its geographic units from four to seven as part of the Company’s on-going Realignment for Growth efforts. These changes were intended to create growth opportunities for distributors, support faster decision making across the organization by reducing the number of layers of management, improve the sharing of ideas and tools and accelerate growth in its high potential markets. Historical information presented related to the Company’s geographic units has been reclassified to conform to the current geographic presentation. The Company’s reporting segment’s operating information and sales by product line are as follows:

 

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

 

 

The Company has five stock-based compensation plans, the WH Holdings (Cayman Islands) Ltd. Stock Incentive Plan, or the Management Plan, the WH Holdings (Cayman Islands) Ltd. Independent Directors Stock Incentive Plan, or the Independent Directors Plan, the Herbalife Ltd. 2004 Stock Incentive Plan, or the 2004 Stock Incentive Plan, the Herbalife Ltd. 2005 Stock Incentive Plan, or the 2005 Stock Incentive Plan, and the Herbalife

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Ltd. Independent Directors Deferred Compensation and Stock Unit Plan, or the 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 replaced 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 terms of the 2005 Stock Incentive Plan are substantially similar to the terms of 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 remained available for issuance under the 2004 Stock Incentive Plan at the time of the adoption of the 2005 Stock Incentive Plan. 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, 2007 include stock options, stock appreciation rights, or SARS, and stock units.

 

Prior to January 1, 2006, the Company applied the intrinsic value method as outlined in Accounting Principles Board, or APB, Opinion No. 25, Accounting for Stock Issued to Employees, or APB 25, and related interpretations, in accounting for share-based awards made under the Company’s plans. Under the intrinsic value method, compensation expense is recorded on the date of grant to the extent that the 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, Accounting for Stock Based Compensation, 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 year 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 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 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, 2006 and 2007, stock-based compensation expense was included in Selling, General & Administrative Expenses in the amount of $2.4 million and $3.5 million, respectively, as well as related income tax benefits recognized in earnings in the amount of $1.0 million and $1.2 million, respectively.

 

As of March 31, 2007, the total unrecognized compensation cost related to nonvested stock awards was $28.6 million and the related weighted-average period over which it is expected to be recognized is approximately 2.2 years.

 

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 and 2007, tax benefits of $1.5 million and $1.3 million were generated from option exercises, respectively.

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The Company’s stock-based compensation plans provide for grants of stock options, SARS, 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, or 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, or 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, 2006 and 2007.

 

 

The following tables summarize the activity under the stock-based compensation plans for the three months ended March 31, 2007:

 

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The weighted-average grant date per share fair value of stock awards granted during the three months ended March 31, 2006 and 2007 was $17.06 and $32.01, respectively. The total intrinsic value of stock awards exercised during the three months ended March 31, 2006 and 2007 was $4.3 million and $3.9 million, respectively.

 

 

On January 1, 2007 the Company adopted the provisions of FIN 48, Accounting for Uncertainty in Income Taxes, an interpretation of FAS 109, Accounting for Income Taxes. At the date of adoption, the total amount of unrecognized tax benefits, including related interest and penalties, was $42.1 million. If the total amount of unrecognized tax benefits was recognized, $26.0 million of unrecognized tax benefits, $6.9 million of interest and $2.7 million of penalties, would impact the effective tax rate and $6.5 million would result in an increase to goodwill. The Company accounts for interest and penalties generated by tax contingencies as a component of income tax expense. Also, the adoption of FIN 48 does not have a material impact to the retained earnings.

 

The Company believes that it is reasonably possible that the amount of unrecognized tax benefits could increase or decrease within the next twelve months and that change could be significant because of uncertainties from international transfer pricing issues, the deductibility of certain operating expenses in various foreign jurisdictions, settlements in foreign tax audits and the expiration of the statute of limitation in several foreign jurisdictions. Because of the nature of these uncertainties, the Company is not able to estimate the range of reasonably possible changes to the amount of unrecognized tax benefits within the next twelve months.

 

At the adoption date, the Company’s tax filings are generally subject to examination in major tax jurisdictions for years ending on or after December 31, 2002.

 

 

The Company 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. For the outstanding cash flow hedges on interest rate exposures at December 31, 2006 and March 31, 2007, the maximum length of time over which the Company is hedging these exposures is approximately three years.

 

On July 21, 2006 the interest rate swap agreement, originally entered into on February 21, 2005, was terminated due to the Company’s debt refinancing and interest income of approximately $0.8 million was recorded in the Company’s consolidated statements of income during the quarter ended September 30, 2006. Under the new credit facility, the Company is obligated to enter into an interest rate hedge for up to 25% of the aggregate principal amount of the term loan for a minimum of three years. On August 23, 2006, the Company entered into a new interest rate swap agreement. The agreement provides for the Company to pay interest for a three-year period at a fixed rate of 6.76% on various notional amounts while receiving interest for the same period at the LIBOR rate on the same notional principal amounts. The swap was designated as a cash flow hedge against LIBOR interest rate movements on the new term loan. The Company formally assesses, both at inception and at least quarterly thereafter, whether the derivatives used in hedging transactions are effective in offsetting changes in cash flows of the hedged item. As

 

HERBALIFE LTD.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

of December 31, 2006 and March 31, 2007, the hedge relationship qualified as an effective hedge under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. Consequently, all changes in the fair value of the derivatives are deferred and recorded in other comprehensive income, or OCI, until the related forecasted transaction is recognized in the consolidated statements of income.

 

The Company also designates certain derivatives as free standing derivatives for which hedge accounting does not apply. The changes in the fair market value of these derivatives are included in Selling, General and Administrative Expense in the Company’s consolidated statements of income. The Company purchases average rate put options, as well as forward extra contracts (a combination of a foreign forward exchange contract and an option), to partially mitigate the impact if the foreign currency weakens beyond the strike rate. The Company also uses foreign currency forward and ratio forward contracts to hedge foreign-currency-denominated intercompany transactions. The fair values of the option and forward contracts are based on third-party bank quotes.

 

 

In July 2006, the Company initiated a realignment of its employee base as part of its Realignment for Growth plan. The Company recorded $3.0 million of professional fees, severance and related costs in the preparation stage of the realignment in the third quarter of 2006 and $7.5 million of severance and related costs, which was included in Selling, General and Administrative Expenses, related to this realignment in the fourth quarter of 2006.

 

In the first quarter of 2007, the Company recorded severance and related costs of $1.5 million, which was included in Selling, General and Administrative Expenses, related to the realignment. The Company expects to complete the realignment during 2007 and recognize an additional $0.3 million of related costs by the end of 2007.

 

The following table summarizes the components of this reserve during fiscal 2007:

 

 

 

On February 2, 2007, the Company’s Board of Directors received a proposal from Whitney V L.P. and its affiliates to acquire all of the Company’s outstanding common shares for $38.00 per share in cash. The Company’s Board of Directors established a special committee consisting solely of independent directors to review the proposal. On March 30, 2007, the special committee of the Board of Directors rejected the offer from Whitney V L.P. and thereafter, the Board of Directors disbanded the special committee.

 

 

On April 18, 2007, the Company announced that its Board of Directors has authorized a program for the company to repurchase up to $300 million of Herbalife common stock during the next two years, at such times and prices as determined by company management, as market conditions warrant. Additionally, the company’s Board of Directors adopted a regular quarterly cash dividend program. As part of this program, the company announced a $0.20 per share cash dividend for the first quarter 2007, payable on May 15, 2007 to shareholders of record on April 30, 2007.

 

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 their customers who seek a healthy lifestyle. We are one of the largest network marketing companies in the world with net sales of approximately $1.9 billion for the year ended December 31, 2006. We sell our products in 64 countries through a network of over 1.5 million independent distributors except in China, where we sell our products through retail stores and an employed sales force. 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 27-year operating history.

 

We offer products in three principal categories: weight management products, nutritional supplements which we refer to as “Targeted 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 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: retailing of our products, recruitment and retention of distributors and improving distributor productivity, new markets, further penetrating existing markets including China, globalizing successful distributor methods of operation (such as Nutrition Clubs), introducing new products, developing niche market segments and further investing in our infrastructure.

 

In July 2006, we changed our geographic units from four to seven units as part of our on-going realignment for growth efforts. These changes are intended to create growth opportunities for our distributors, support faster decision making across the organization by reducing layers of management, improve the sharing of ideas and tools and accelerate growth in our high potential markets. Under the new geographic units we report revenue from:

 

 

Historical information presented related to our geographic units has been reclassified to conform to our current geographic presentation.

 

A key non-financial measure we focus on is Volume Points on a Royalty Basis, or 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 group or country directionally indicates an increase in local currency net sales.

 

Volume Points by Geographic Unit

 

 

Number of New Supervisors by Geographic Unit as of Reporting Period

 

Another key non-financial measure on which we focus is the number of distributors qualified as new supervisors under our compensation system. Distributors qualify for supervisor status based on their Volume Points. The growth in the number of new supervisors is a general indicator of the level of distributor recruitment, which generally drives net sales in a particular country or group.

 

Number of Supervisors and Retention Rates by Geographic Unit as of
Requalification Period

 

Our compensation system requires each supervisor to re-qualify for such status each year, prior to February. In February of each year, we delete from the rank of supervisor those distributors who did not satisfy the supervisor qualification requirements during the preceding twelve months. Distributors who meet the supervisor requirements at any time during the year are promoted to supervisor status at that time, including any supervisors who were deleted, but who subsequently requalified.

 

 

Supervisors must re-qualify annually. The requalification period covers the twelve months starting in February and ending the following January. The number of supervisors by geographic unit as of the reporting dates will normally be higher than the number of supervisors by geographic unit 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 the following February. For the latest twelve month re-qualification period ending January 2007, approximately 42.5 percent of our supervisors re-qualified. 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 units.

 

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, represent what we collect and recognize 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, it is used as the basis for certain information included in daily and monthly reports reviewed by our management. However, such a measure is not in accordance with Generally Accepted Accounting Principles in the U.S., or GAAP. You should not consider Retail

Sales in isolation from, nor as 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 under “Results of Operations. “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 36% 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. Due to 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. Because of local country regulatory constraints, we may be required to modify our typical distributor incentive plans as described above. 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.

 

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, 2007, net sales increased 11.5% to $508.1 million from $455.8 million for the three months ended March 31, 2006. The increase reflects the continued retailing success from distributors using the Nutrition Club operating method in Mexico and the U.S. The growth in the two markets accounted for 55.1% of the overall increase in net sales. Venezuela and certain other South American countries also experienced significant sales growth due in part to the opening of Peru during the first quarter of 2007, while net sales in Brazil declined. Net sales for the three months ended March 31, 2007 in EMEA and North Asia, were flat when compared to the same period in 2006.

 

Net income increased for the three months ended March 31, 2007 to $41.2 million, or $0.55 per diluted share, from $38.7 million, or $0.53 per diluted share for the same period in 2006. The net income increase was driven by revenue growth primarily in Mexico and the U.S. markets and lower interest expense following a debt refinancing in July 2006. Net income for the three months ended March 31, 2007 included a $1.0 million unfavorable after tax impact in connection with the Realignment for Growth plan and a $3.6 million charge for an increase in tax reserve. Net income for the three months ended March 31, 2006 included the impact of a $3.7 million tax benefit resulting from an international income tax settlement.

 

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, 2007 compared to three months ended March 31, 2006

 

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 and retention of our distributor force, retailing of our products, 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 distributor marketing program coupled with educational and motivational tools and promotions to incentivize distributors to increase recruiting, retention and retailing, which in turn affect net sales. Such tools include company sponsored sales events such as 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 distributors and supervisors who continually build, educate and motivate their respective distribution and sales organizations. We also use event and non-event product promotions to motivate distributors to increase recruiting, retention and retailing activities. These promotions have prizes ranging from qualifying for events to product prizes and vacations. The costs of these promotions are included in Selling, General & Administrative Expenses.

 

The factors described above have helped distributors increase their business, which in turn has driven growth in our business. The following net sales by geographic unit discussion further details some of the above factors and describes unique growth factors specific to certain major countries. We believe that the correct business foundation, coupled with ongoing training and promotional initiatives, is required to increase recruiting and retention of distributors and retailing of our products. The correct business foundation includes strong country management that works closely with the distributor leadership, unified distributor leadership, a broad product line that appeals to local consumer needs, a favorable regulatory environment, a scalable and stable technology platform and an attractive distributor marketing plan. Initiatives such as Success Training Seminars, 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.

 

Our strategy will continue to include creating and maintaining growth within existing markets while expanding into new markets. We expect to increase our spending in Selling, General & Administrative Expenses to maintain or stimulate sales growth, while making strategic investments in new initiatives and in new markets. In

addition, new ideas and distributor business methods, or DMO’s, 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, The Wellness Coach in France, The Sampling Program in the U.S., and Generation Herbalife, or GenH, in many of our markets, as described under “Net Sales” below. Management’s strategy is to review the applicability of expanding successful country initiatives throughout a region and where appropriate, financially support the globalization of these initiatives.

 

North America

 

Net sales in North America increased $17.4 million, or 20.0%, for the three months ended March 31, 2007, as compared to the same period of 2006. In local currency, net sales increased 20.2% for the three months ended March 31, 2007, as compared to the same period of 2006. The fluctuation of foreign currency rates had an unfavorable impact of $0.1 million on net sales for the three months ended March 31, 2007. The overall increase was a result of net sales growth in the U.S. of $18.3 million or 22.5% for the three months ended March 31, 2007, as compared to the same period of 2006. In the U.S., we expanded our branding efforts with AEG by entering into an exclusive sponsorship agreement with the LA Galaxy soccer team. We also agreed to a major sponsorship agreement with an AVP Volleyball tour athlete, Karch Kiraly.

 

The increase in net sales in the U.S. was a result of a number of factors, including supervisor growth, up 19.7% at March 31, 2007, as compared to the same period of 2006, the continued strong relationship between the U.S. country management team and the distributor leadership, continued branding efforts such as sponsorship of the 2007 Amgen Tour of California bicycle race and the growth of the Nutrition Club DMO amongst our Latino distributors. To further support the retailing and recruiting efforts of our distributors, we opened a new sales center in Phoenix, Arizona in April 2007 and introduced a new flavor, Pina Colada, into our top selling Formula 1 shake line in the U.S. In January 2007, our Kickoff Supervisor Trainings attracted over 6,700 Distributors across 16 cities.

 

We believe that 2007 net sales in North America should continue to show positive year over year growth primarily as a result of the expected continuation of strong momentum in the U.S., the continued success and expansion of the Nutrition Club concept and increased focus on the Lead Generation/Sampling.

 

Mexico and Central America

 

Net sales in Mexico and Central America for the three months ended March 31, 2007 increased $11.9 million, or 14.2%, as compared to the same period of 2006. In local currency, net sales for the three months ended March 31, 2007 increased 18.6%, as compared to the same period of 2006. The fluctuation of foreign currency rates had an unfavorable impact of $3.8 million on net sales for the three months ended March 31, 2007. The overall increase was primarily a result of net sales growth in Mexico of $10.5 million or 12.6% for the three months ended March 31, 2007.

 

The increase in net sales in Mexico was primarily driven by very strong sales in the re-qualification month of January 2007 and strong supervisor growth, up 56.2% at March 31, 2007, as compared to March 31, 2006. The 2007 retention rate was 55.1%, as compared to the prior year of 57.5%, reflecting infrastructure and distributor training issues which have affected overall sales growth in Mexico. During the first quarter we expanded two existing sales centers in Leon and Tijuana and opened two new third party operations. In addition, we relocated and expanded our Mexico City South sales center. All of these moves were designed to improve our infrastructure and provide additional distributor access points to support the expansion of our business. In January 2007, we held a President’s Team Tour and a life style day in 8 different cities attracting over 10,000 attendees. In March 2007, 21 Supervisor Training School meetings were held in various cities attracting 11,300 attendees. In Central America, El Salvador was opened in February 2007, becoming our 64^th country.

 

We believe that 2007 net sales in Mexico and Central America will be flat to slightly positive as compared to 2006 net sales levels as first quarter sequential sales growth in Mexico was up less than 1% compared to the fourth quarter of 2006. We believe that we have made significant progress in addressing the root causes for the slow down in Mexico by making changes in the infrastructure, training and distributor business practice issues. In addition to the sales centers opened in the first quarter, we plan to open four additional facilities in the second quarter designed

to improve our product availability throughout Mexico. We have developed a comprehensive training plan with our Mexican distributor leadership and are currently implementing an extensive training and compliance auditing program targeting our Nutrition Club DMO to promote distributor best practices that we believe will accelerate our Nutrition Club growth. On the business practice front, we have hired a new Ethics and Business Practices director and have 25 inspectors in the field conducting Nutrition Club visits and audits in 17 cities. In addition, TAB Team members have been asked to perform inspections of Nutrition Clubs operating in their organization and report their findings back to the Company in April 2007. All of these efforts should be largely completed by the end of the second quarter, at which time we believe that we will have successfully addressed and resolved the major issues.

 

Brazil

 

Net sales in Brazil decreased $2.2 million, or 6.2%, for the three months ended March 31, 2007, as compared to the same period of 2006. In local currency, net sales decreased 10.0% for the three months ended March 31, 2007, as compared to the same period of 2006. The fluctuation of foreign currency rates had a favorable impact of $1.3 million on net sales for the three months ended March 31, 2007.

 

The net sales decline in Brazil reflected the decrease in the recruiting rate of new supervisors and a more difficult than anticipated transition of existing distributors to the Customer Club DMO. Specifically, we have seen a decline in the business of those distributors who have recently adopted Customer Clubs as their primary method of operation. As these distributors become more familiar with the best practices associated with operating their Clubs and building a sustainable customer base, we expect their business to increase. Distributors operating clubs for over a year experienced a 15% increase in business during the quarter, compared to the same period in 2006. Also contributing to the sales decline was a drop in Outer Nutrition sales as distributors changed from the Daily Action Plan DMO to the adoption of other referral tools. In February we held an Extravaganza in Fortaleza Brazil which attracted 3,500 distributors and featured Customer Club training, re-launch and training for the Nourifusion skin care line and key Chairman’s Club and President’s Team training. We are also sponsoring the 2007 Trofeu Brasil de Triathlon championship with the first race in Santos held on March 18, 2007.

 

We believe that 2007 sales in Brazil will essentially be flat with 2006 as we continue to be challenged by many of the same issues we faced in the first quarter. In order to help mitigate these challenges, we will proactively address these issues with several initiatives including monthly conference calls with distributor leadership to strengthen current promotions and improve training for Customer Club concepts and rules, a new Nutrition Club manual incorporating new rules and procedures based on legal requirements in an effect to share best practices, Nutrition Club site visits and the introduction of audit processes and monitoring. We will also be launching a new product catalog and introducing new locally developed Outer Nutrition products at more affordable price points and providing NouriFusion samples as well as updating training materials for other commonly used DMO’s.

 

South America and Southeast Asia

 

Net sales in South America and Southeast Asia increased $12.3 million, or 28.3%, for the three months ended March 31, 2007, as compared to the same period of 2006. In local currency, net sales increased 23.6% for the three months ended March 31, 2007, as compared to the same period of 2006. The fluctuation of foreign currency rates had a favorable impact of $2.0 million on net sales for the three months ended March 31, 2007. The overall increase was attributable mainly to net sales increases in Colombia, Argentina, Venezuela, Thailand and Malaysia, and the opening of Peru in December 2006 as a new market. In the first quarter of 2007, we held an extravaganza for the South America region in Bogota, Columbia, which was attended by over 11,000 distributors from more than 20 countries.

 

Colombia, Argentina, Venezuela, Thailand and Malaysia experienced sales increases of 94.1%, 26.5%, 168.1%, 52.4% and 29.9%, respectively, for the quarter ended March 31, 2007, as compared to the same period of 2006. This growth was the result of new supervisor growth and positive momentum from local events, including monthly Supervisor Training Schools, Malaysia’s 1^st Anniversary, Chile’s 10th Anniversary celebrations, and Thailand’s Kick-off Spectacular; sponsored activities such as the Beach Volleyball Tour in Australia and New Zealand; and several new product launches, including Herbalifeline in Colombia and Nourifusion in Malaysia.

 

We believe the 2007 sales in South America and Southeast Asia should continue to show positive year over year growth primarily as a result of continued momentum in Argentina and Venezuela, the opening of Peru, the

planned opening of Paraguay in the fourth quarter of 2007, and the ability to respond more quickly to distributor and consumer needs as a result of the Realignment for Growth efforts.

 

EMEA

 

EMEA net sales increased $1.7 million, or 1.2%, for the three months ended March 31, 2007, as compared to the same period of 2006. In local currency, net sales decreased 5.5% for the three months ended March 31, 2007, as compared to the same period of 2006. The fluctuation of foreign currency rates had a favorable impact on net sales of $9.5 million for the three months ended March 31, 2007.

 

The net sales increase was primarily due to the favorable impact of foreign currency rates and continued growth in Portugal, Spain, France and Italy, which experienced sales increases of 37.3%, 18.1%, 8.4% and 6.9%, respectively. Germany and the Netherlands continued to experience decreases in net sales of 21.1% and 19.5%, respectively, for the quarter ended March 31, 2007, as compared to the same period of 2006.

 

The net sales increases in Portugal, Spain, France and Italy 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 various Lead Generation DMO’s. In addition, there has been an increasing emphasis on good health and nutrition in France and in Portugal, and leadership has restructured Distributor training to include DMOs such as Nutrition Clubs, Wellness Evaluation and Sampling activities.

 

The decline in Germany was primarily driven by the continued loss of momentum resulting in a decrease in supervisors, down 27.2% at March 31, 2007, as compared to the same period of 2006. In Germany, significant distributor training has been undertaken, concentrating on long term customers, Nutrition Clubs and wellness coaching DMO’s.

 

The net sales decline in the Netherlands was primarily driven by lower recruiting of new distributors. A major media campaign was conducted in January 2007, including radio, newsprint, flyers and other advertising materials in conjunction with the Distributors to further support the market.

 

While progress is being made, the turnaround is expected to be slow in Germany and the Netherlands and net sales for 2007 are expected to be below the 2006 level for these countries.

 

We expect 2007 net sales in EMEA to be essentially flat when compared to 2006. We have identified several high-potential markets such as Russia and Poland for which we are developing initiatives along with our distributors to grow sales and we are increasing local branding activities. Throughout EMEA the local branding activities include sponsoring the London Triathlon, the Lisbon triathlon and Beach Volleyball World Tour in Portugal, the French Ironman Triathlon, the Madrid Triathlon and the Moscow Marathon, which are intended to continually improve our corporate and brand reputation in these markets. We are also enhancing distributor communication processes and training, and continuing to launch our newer products into more markets, most notably Liftoff^tm, which was introduced in 20 markets in EMEA in 2006 and the first quarter of 2007, and Cookies & Cream flavor of our top selling Formula 1 shake line.

 

Greater China

 

Greater China net sales increased $12.1 million, or 42.3%, for the three months ended March 31, 2007, as compared to the same period of 2006. In local currency, net sales increased 42.7% for the three months ended March 31, 2007, as compared to the same period of 2006. The fluctuation of foreign currency rates had an unfavorable impact of $0.1 million on net sales for the three months ended March 31, 2007. The overall increase in net sales was attributable to the sales increases in China and Taiwan, while Hong Kong continued to experience a decline in sales.

 

Net sales in China increased by $7.4 million, or 173.4%, for the three months ended March 31, 2007, as compared to the same period of 2006. Since March of 2005 we have opened 42 stores and 20 service centers in 31 provinces throughout China. On March 23, 2007, we received our Direct Sellers license for the cities of Suzhou and Nanjing in the Jiangsu province.

 

Net sales in Taiwan increased $5.9 million, or 28.5%, for the three months ended March 31, 2007, as compared to the same period of 2006. The increase in net sales is primarily attributable to the refocus of local distributor leadership and some of their key members whose attention had temporarily shifted to the opening of Malaysia in 2006 and the emerging business opportunity in China.

 

Net sales in Hong Kong decreased $1.1 million, or 29.0%, for the three months ended March 31, 2007, as compared to the same period of 2006. The decline in net sales was primarily the result of a loss of momentum, attributable to the focus on the emerging opportunity in China, resulting in a decrease in supervisors, down 32.2% at March 31, 2007, as compared to March 31, 2006.

 

We believe the 2007 sales in Greater China should continue its positive year over year growth primarily as a result of the continued growth in Taiwan along with expansion of our business in China. We believe that the Direct Sellers licenses received in China in the first quarter of 2007 will foster sales growth in China over the long term.

 

North Asia

 

North Asia net sales decreased $0.9 million, or 2.5%, for the three months ended March 31, 2007, as compared to the same period of 2006. In local currency, net sales decreased 3.0% for the three months ended March 31, 2007, as compared to the same period of 2006. The fluctuation of foreign currency rates had a favorable impact of $0.2 million on net sales for the three months ended March 31, 2007.

 

Net sales in Japan decreased $2.9 million, or 12.8%, for the three months ended March 31, 2007, as compared to the same period of 2006. Continued competitive pressures from new companies entering the market and a decline in the recruiting of new supervisors were the primary reasons for the decline in sales. Although the full year retention rate decreased slightly compared to prior year, 48.9% versus 50.9%, the number of re-qualified supervisors remained approximately equal. We are currently running a Singapore Challenge promotion aimed at creating distributor excitement for the Summer Extravaganza to be held in Singapore later this year. The promotion runs through June 2007. We also held a Supervisor Spectacular event at the end of February 2007 which attracted 2,500 supervisors. We continue to be a sponsor of the Toray Tennis Tournament which was held January 30, 2007 through February 4, 2007 and attracted over 53,000 spectators.

 

Net sales in Korea increased $2.0 million, or 14.6%, for the three months ended March 31, 2007, as compared to the same period of 2006. We believe that a portion of the sales increase in Korea was the result of distributors “buying ahead” of an April 1, 2007 price increase and this may adversely affect sales in the second quarter of 2007. A Lift-Off™ promotion which ran from January 2007 through March 2007 was held to create excitement for the launch of Lift-Off™ in April 2007. In addition, a Korea Spectacular event was held in January which attracted 1,200 attendees.

 

We believe the 2007 sales in North Asia will be flat to slightly positive when compared to 2006 driven primarily by growth in Korea and a modest improvement in the rate of decline in Japan. We believe the current promotion running in Japan will provide incremental sales and reinvigorate our distributor leadership there. Korea will be launching Lift-Off™ in April 2007 and will be hosting a Leadership Training event in June 2007.

 

Sales by Product Category

 

Our increased emphasis on the science of weight management and nutrition during the past two years has resulted in product introductions such as Niteworks^tm and Garden 7 ^tm, Best Defense^tm and the introduction of ShapeWorks^tm, a personalized meal replacement program. Due to the launch of these new products together with the continued positive sales momentum discussed above, net sales of weight management products and targeted nutrition products increased. The change of product mix due to various DMO’s, as well as the change in country mix, resulted in a decrease in the sales of Outer Nutrition^® products. With the introduction of new outer nutrition products like NouriFusion, and the increased use of the Total Plan by distributors in Brazil and worldwide, which uses outer nutrition^® products as its foundation, we anticipate moderate sales growth in 2007. We expect growth rates within these categories will vary from time to time as we launch new products.

 

Gross Profit

 

Gross profit was $400.8 million for the three months ended March 31, 2007, as compared to $364.4 million in the same period of 2006. As a percentage of net sales, gross profit for the three months ended March 31, 2007 decreased slightly from 79.9% to 78.9%, as compared to the same period in 2006. The decrease in gross profit percentage in the first quarter of 2007 was primarily due to changes in country mix, foreign exchange fluctuations and higher freight and excise tax in certain countries. For the changes in country mix, there was an unfavorable impact to the overall gross profit percentage related to the increase in North America sales, which has a lower gross profit margin, as a percent of worldwide sales, and the decrease in EMEA sales, which has a higher gross profit margin, as a percent of worldwide sales. Generally, gross profit percentages do not vary significantly as a percentage of sales other than due to product or country mix, ongoing cost reduction initiatives and provisions for slow moving and obsolete inventory. Additionally, we believe that we have the ability to mitigate ingredient and manufacturing cost increases from our suppliers 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 35.5% for the three months ended March 31, 2007, as compared to 36.3% in the same period of 2006. The decrease for the quarter ended March 31, 2007 was primarily due to changes in the mix of products and countries, a lower Active World Team bonus and the increase in sales in China where compensation to our full-time sales representatives was included in Selling, General & Administrative Expenses instead of Royalty Overrides. 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% and 29.4% for the three months ended March 31, 2006 and March 31, 2007, respectively.

 

For the three months ended March 31, 2007, Selling, General & Administrative expenses increased $14.4 million to $149.4 million, from $135.0 million in the same period of 2006. The increase included $7.8 million in higher salaries and benefits due primarily to normal merit increases, severance related to the realignment for growth plan (discussed in Note 11 to our consolidated financial statements) and higher compensation costs associated with employee sales representatives in China; $1.9 million in higher expenses related to sales events and promotions; and $1.2 million in higher depreciation and amortization related mostly to expansion and relocation to new facilities. The increases were partially offset by $2.3 million in lower legal and litigations expenses and lower professional fees related to IT infrastructure development.

 

We expect 2007 Selling, General & Administrative expenses to increase in absolute dollars over 2006 levels reflecting general salary merit increases, continued investments in China and various sales growth initiatives including sales events and promotions, partially offset by labor savings in 2007, resulting from our Realignment for Growth plan initiated in 2006. As a result of these initiatives, we believe that Selling General & Administrative Expenses as a percentage of net sales should improve compared to 2006 levels.

 

Net Interest Expense

 

Net interest expense was $2.2 million for the three months ended March 31, 2007, as compared to $6.0 million for the same period of 2006. The lower interest expense in 2007 was primarily due to the redemption in August 2006 of the outstanding $165.0 million aggregate principal amount of our 91/2% Notes due 2011, which bears a higher interest rate, and the lower balance of total long term borrowings.

 

Income Taxes

 

Income taxes were $27.7 million for the three months ended March 31, 2007, as compared to $19.4 million in the same period of 2006. As a percentage of pre-tax income, the effective income tax rate was 40.2% for the three months ended March 31, 2007, as compared to 33.4% in the same period of 2006. The increase in the effective tax rate for the three months ended March 31, 2007, as compared to the same period of 2006, was caused primarily by an increase in unrecognized tax benefits, i.e. income tax reserves, that are not related to the adoption of FIN 48 and the favorable settlement of the international tax audits in the first quarter of 2006, and was partially offset by a decrease in the operating effective tax rate in the first quarter of 2007, as compared to the same period in 2006. Excluding the effect of the increase in prior year unrecognized tax benefits, the effective tax rate would have been approximately 35.1% for the three months ended March 31, 2007.

 

Restructuring Reserve

 

In July 2006, we initiated a realignment of our employee base as part of our Realignment for Growth plan. We recorded $3.0 million of professional fees, severance and related costs in the preparation stage of the plan in the third quarter of 2006, $7.5 million of severance and related costs in the fourth quarter of 2006 and $1.5 million of severance and related costs in the first quarter of 2007. We expect to complete the realignment during 2007 and recognize an additional $0.3 million of related costs by the end of 2007.

 

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, 2007, we generated $46.1 million from operating cash flows, as compared to $43.7 million for the same period of 2006. The increase in cash generated from operations reflected an increase in operating income of $7.0 million, which was primarily driven by 11.5% growth in net sales, partially offset by higher royalty overrides and Selling, General and Administrative expenses.

 

Capital expenditures, including capital leases, for the three months ended March 31, 2007 were $9.1 million, as compared to $12.2 million for the same period in 2006. The majority of these expenditures represented investments in management information systems, the development of our direct-to-consumer platform, and the expansion of our facilities in China, Peru and Mexico. We expect to incur capital expenditures of up to $45.0 million in 2007.

 

We terminated our $225.0 million senior secured credit facility in July 2006 in connection with the debt refinancing. We repaid all amounts outstanding under that credit facility amounting to $79.6 million. Interest expense in the third quarter of 2006 includes $1.7 million of write-off of deferred financing cost. We entered into a $300.0 million senior secured credit facility with a syndicate of financial institutions as lenders in August 2006. The new credit facility is comprised of a $200.0 million term loan and a revolving credit facility of $100.0 million. The term loan matures on July 21, 2013 and the revolving credit facility is available until July 21, 2012. The term loan bears interest at LIBOR plus a margin of 1.5% and the revolver bears interest at LIBOR plus a margin of 1.25%. We borrowed $200.0 million pursuant to the new term loan in August 2006 to fund the redemption of the outstanding $165.0 million aggregate principal amount of our 91/2% Notes due 2011. During 2006 we prepaid $20.0 million of our new term loan borrowings. In March 2007, we made another prepayment of $29.5 million. In July 2006, we also redeemed the outstanding $0.1 million principal amount of the 113/4% Notes due 2010.

 

The following summarizes our contractual obligations including interest at March 31, 2007 and the effect such obligations are expected to have on our liquidity and cash flows in future periods:

 

 

As of March 31, 2007, we had positive working capital of $151.0 million. Cash and cash equivalents were $162.2 million at March 31, 2007, compared to $154.3 million at December 31, 2006.

 

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 new term loan. There can be no assurance, however, that our business will service our debt 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.

 

Whitney Offer

 

On February 2, 2007, our Board of Directors received a proposal from Whitney V L.P. and its affiliates to acquire all of our outstanding common shares for $38.00 per share in cash. Our Board of Directors established a special committee consisting solely of independent directors to review the proposal. On March 30, 2007, the special committee of the Board of Directors rejected the offer from Whitney V L.P. and thereafter, the Board of Directors disbanded the special committee

 

Subsequent Events

 

On April 18, 2007, we announced that our Board of Directors has authorized a program for the Company to repurchase up to $300 million of our common shares during the next two years, at such times and prices as determined by our management, as market conditions warrant. Additionally, our Board of Directors adopted a regular quarterly cash dividend program. As part of this program, we announced a $0.20 per share cash dividend for the first quarter 2007, payable on May 15, 2007 to shareholders of record on April 30, 2007.

 

Contingencies

 

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

 

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). 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 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, the Company has been and is currently subjected to various product liability claims. The effects of these claims to date have not been material to the Company, and the reasonably possible range of exposure on currently existing claims is not material to the Company. The Company believes that it has meritorious defenses to the allegations contained in the lawsuits. The Company currently maintains product liability insurance with an annual deductible of $10 million.

 

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 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 effect on the Company’s 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 it believes represents the likely outcome of the resolution of these disputes, if the Company is incorrect in its assessment the Company 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 Statement of Financial Accounting Standards, or SFAS No. 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 64 countries throughout the world and we are 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 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, 2006 and 2007, respectively. No material changes in estimates have been recognized for the three months ended March 31, 2006 and 2007.

 

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 $11.4 million and $12.2 million as of December 31, 2006 and March 31, 2007, respectively.

 

In accordance with SFAS No. 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’s goodwill and other intangibles. As of March 31, 2007, we had goodwill of approximately $113.0 million, and marketing franchise of $311.0 million. No impairment was needed for the three months ended March 31, 2006 and 2007. Goodwill was reduced in 2006 by approximately $21.0 million due primarily to the effect of the settlement of an international tax audit related to the pre-acquisition period and the realization of pre-acquisition net operating losses. Goodwill was reduced by $0.3 million in the first quarter of 2007 due primarily to change in pre-acquisition income tax reserve.

 

Contingencies are accounted for in accordance with SFAS No. 5, Accounting for Contingencies. SFAS No. 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 requires us to use judgment. Many of these 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 our stock price volatility and employee stock award exercise behaviors. Our expected volatility is primarily based upon the historical volatility of Herbalife’s common stock and, 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 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.

 

We account for uncertain tax positions in accordance with FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, or FIN 48 — an interpretation of SFAS No. 109. FIN 48 addressed the determination of how tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, the Company must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution. The impact of the adoption of FIN 48 did not have a material impact on the results of operations, financial condition or liquidity.

 

New Accounting Pronouncements

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, or SFAS No. 159, which permits entities to choose to measure many financial instruments, and certain other items, at fair value. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 applies to reporting periods beginning after November 15, 2007. We are currently evaluating the impact, if any, of adopting SFAS No. 159.

 

In September 2006, the FASB issued No. 157, Fair Value Measurement, or SFAS No. 157, which defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. The provisions of SFAS No. 157 are effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact, if any, of adopting SFAS No. 157.

 

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, or 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 foreign denominated revenue. All of these foreign exchange contracts are designated as free standing derivatives for which hedge accounting does not apply.

 

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. We also enter into various forward extra contracts (a combination of a foreign forward exchange contract and an option), which provide protection against adverse market movement at a strike rate slightly worse than the forward and participate in favorable currency move up to a predetermined trigger level. We are only obliged to sell foreign currency at the strike rate when the spot exchange rate is traded at or above the trigger rate.

 

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

 

 

Foreign exchange forward contracts are used to hedge advances between subsidiaries. The objective of these contracts is to neutralize the impact of foreign currency movements on the subsidiary’s operating results. We also purchased ratio forward contract which protect against adverse market movement at a rate better than the current forward. The fair value of forward contracts is based on third-party bank quotes.

 

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