Herbalife Ltd. (NYSE:HLF) reported another very strong quarter of results, surpassing consensus EPS estimates by $0.23.  The upside was driven mostly by better-than-expected global revenues, with most regions beating expectations; Asia/Pac was the lone exception.  Concerns last quarter about the slowdown in trends in North America should be put to rest as volume points returned to double-digit growth.  HLF also increased its FY13 guidance significantly.  The EPS guidance for 3Q13 is slightly below consensus estimates, though recently the company has been guiding conservatively and then handily beating those estimates.

Herbalife Kerrisdale

But Bill Ackman is not satisfied and thinks there are many questions ahead of the earnings call. Below is a press release just issued by Pershing Square with some questions to Herbalife Ltd. (NYSE:HLF).

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

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

  • Why is the Company’s operating earnings growth so weak?  Is the Company “buying” revenue growth at the expense of operating income?

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

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

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

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

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

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

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

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

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

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

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

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

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

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