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

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

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Published by Linette Lopez
Bill Ackman releases his thoughts on Herbalife's earnings call yesterday.
Bill Ackman releases his thoughts on Herbalife's earnings call yesterday.

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Published by: Linette Lopez on Jul 30, 2013
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Pershing Square Capital Management Raises Questions Regarding Herbalife’s 2Q Earnings
NEW YORK, July 30, 2013 //-
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, andregulator 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 –
themost 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). TheCompany has attempted to characterize $11.5mm of this large increase in SG&A as non-recurring; however, morethan two-thirds of the Q2 SG&A increase relates to: (i) higher salaries, bonuses and benefits ($22.0mm); (ii) higherdistributor promotion, event costs and advertising expense ($15.3mm); (iii) higher expenses related to Chinaindependent service providers ($19.7mm); and higher non-income tax expenses such as value added tax and salestax ($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 Q3’1
3 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.
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 6.3Bolivars to 1 U.S. dollar for the purpose of consolidating its Venezuelan operations and balance sheet
Herbalifehas been unable to convert Bolivars to U.S. dollars at this rate and has resorted to
“alternative legal exchanges” inwhich 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 ratecommensurate 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 thiscould 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 thanwhat can be achieved in the market? 
Why does management’s guidance for the balance of 2013 “assume a Venezeulan exchange rate of 10 to1” 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? 
Q3 2013 operating income calculated by using (i) the midpoint of the Company’s guidance for Diluted EPS of 
$1.11; multiplied by (ii) 107mm diluted shares outstanding; divided by (iii) 1
23.5% (midpoint of the effective taxrate guidance); plus $5.6mm of interest expense.
Herbalife’s Independent Auditor
When a public company files its Form 10-Q, it is customary for an independent auditor to review the filingbeforehand. Page 8 of the 10-
Q notes that “The unaudited interim financial in
formation presented in thisQuarterly 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 tha
t 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 f 
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
interimfinancial information presented in this Quarterly Report on Form 10-Q, prior period errors were identified whichaffected the interim period ended June 30, 2013, and the interim periods within and annual periods endedDecember 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
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. Inaddition, 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 liabi 
lity 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 wasmisstated 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 exceededconsensus 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 financialmeasures include add-backs for expenses associated with (1) the Venezuela devaluation impact, (2) expenses
incurred responding to attacks on the Company’s business model, and (3) expenses incurred for the re
-audit of 2010 to 2012 financial statements due to resignation of KPMG. The press release also notes that such Non-GAAP
adjustments are “unaudited and unreviewed.”
Page 16 of Herbalife’s Q2’13 10
Q notes that Herbalife’s effective tax rate decreased from 28.1% in Q2’12 to 23.4%in Q2’13 “
primarily due to an increase of net benefits from discrete events, principally related to favorable taxaudit settlements
, and the impact of changes in the geographic mix of the Company’s income. (emphasis added)”
Why does the Company add-back non-recurring expense items when calculating Adjusted EPS, but fail todeduct benefits such as the favorable settlement of tax audits that the Company itself describes as
“discrete events?” 
Given that the Company has been sued numerous times for being a pyramid scheme, and given that, in the
 past, other investors have raised allegations about Herbalife’s business model similar to those issuesraised by Pershing Square, why does Herbalife consider “expenses incurred responding to attacks on theCompany’s business model” a non
-recurring expense? 
Has PwC reviewed the Company’s Non
-GAAP adjustments and provided the Company with an opinion asto whether or not they are appropriate? 
Page 22 of Herbalife’s Q2’13 10
Q notes that “the Company recorded $8.1 million and $17.6 m
illion, respectively,
of professional fees and other expenses related to [expenses incurred responding to attacks on the Company’sbusiness model].” The 10
Q further notes that: included in these amounts are expenses related to “a cash
settlement liabilit
y award, or the Liability Award, outstanding as of June 30, 2013, which is tied to the Company’sstock price and which only vests if certain conditions are met relating to the above matter.”
Please provide a detailed breakdown of the $17.6 million of expenses relating to this matter.
Who is the beneficiary of this Liability Award and how is it determined? 
Senior Distributor Departure Disclosure
Herbalife’s SEC filings contain vague statements that Herbalife’s “sales leaders, together with their downline
organizations, account for substantially all of our revenues” and that “the loss of a group of leading sales leaders,
together with their downline sales organizations, or the loss of a significant number of distributors for any reason,could negatively impact sales of our products, impair our ability to attract new distributors and harm our financial
condition and operating results.” (HLF Q2 FY 2013 Report on Form 10
-Q, page 45)
Given that two very senior distributors, Anthony Powell and Shawn Dahl (one of 39 Chairman’s Clubmembers), have left Herbalife (Powell in Q1 ’13 and Dahl late in Q2 ’13), why isn’t the current and future
impact of the loss of these two senior distributors
quantified in any way, and disclosed in Herbalife’s
MD&A? Have other senior distributors departed, and what is the likelihood of more senior distributor departures in the future? 
When do you plan on reinstituting the Chairman’s Club website
(http://www.herbalife.com/chairmansclub) , which Des Walsh said on the last conference call is down for 
“scheduled maintenance”? Why does the scheduled maintenance of the website take months to
The Impact of Pricing Increases
Page 30 of Herbalife’s Q2’13 10
Q notes that net sales in Brazil increased 32.7% in Q2’13, partially due to “a priceincrease of approximately 4.0% in March 2013 which contributed to the increase in sales.” Similarly, net salesgrowth in Venezuela increased 73.1%, fueled, in part, by “price increases of 15% in December 2012 and 17% inApril 2013.”
However, page 31 of Herbalife’s Q2’13 10
Q explains the decrease of net sales in Malaysia by 20.1% in Q2’13 bysaying: “the decrease
in net sales for the three months ended June 30, 2013 was primarily due to a price increasethat took effect at the end of March 2013. As generally occurs, distributors reacted to the announcement of the

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