ITEM 1. BUSINESS
BACKGROUND AND CORPORATE ORGANIZATION
GENERAL
Herbalife International, Inc. (the "Company") markets weight management products, food and dietary supplements and a line of personal care products worldwide through a network marketing system. The Company emphasizes the herbs and other natural ingredients in its 77 products in order to appeal to consumer demand for products including such ingredients. As of February 28, 1997, the Company conducts business in 34 countries located in The Americas, Europe and Asia/Pacific Rim. Retail sales derived from The Americas, Europe and Asia/Pacific Rim represented 32.5%, 35.9% and 31.6%, respectively, of the Company's total retail sales for the year ended December 31, 1996.
The Company has experienced substantial growth in retail sales and net income in recent years. From 1992 to 1996, the Company's retail sales grew from $405.1 million to $1,200.1 million, representing a compound annual growth rate of 31.2%, and the Company's net income grew from $20.1 million to $44.8 million, representing a compound annual growth rate of 22.2%.
The Company's products are marketed exclusively through a network marketing system. This system enables the Company's independent distributors to earn profits by selling Herbalife products to retail consumers or other distributors. Distributors may also develop their own distributor organizations by sponsoring other distributors to do business in any market where the Company operates, entitling the sponsors to receive royalties and bonuses on product sales within their downline organizations.
Management believes that Herbalife's network marketing system is ideally suited to its products, which emphasize a healthy lifestyle, because sales of such products are strengthened by ongoing personal contact between retail consumers and distributors, many of whom use the Company's products themselves. The Company's network marketing system appeals to a broad cross-section of people throughout the world, particularly those seeking to supplement family income, start a home business or pursue employment opportunities other than conventional, full-time employment.
HISTORY AND ORGANIZATION
The Company began operations in February 1980 as a California limited partnership and operated in that form through December 1985, with the exception of an interim period from October 1981 through August 1983 when the business was operated through a California corporation. In January 1986, the Company's business was transferred from the California limited partnership to its corporate general partner, Herbalife International of America, Inc. ("Herbalife of America"). In November 1986, Herbalife of America was acquired in a stock-for-stock reorganization by Sage Court Ventures, Inc. ("Sage Court"). As a result of the acquisition, Herbalife of America became a wholly-owned subsidiary of Sage Court and the former stockholders of Herbalife of America acquired a controlling interest in Sage Court. Sage Court's name was formally changed to Herbalife International, Inc. in December 1986.
In October 1993, the Company and certain selling stockholders sold a total of 6,047,000 shares of Common Stock in a Public Offering (the "1993 Offering"). The Company issued and sold 2,647,000 shares as part of this transaction.
Herbalife International, Inc. operates through 39 wholly-owned domestic and foreign subsidiaries. Except as the context otherwise requires, references to "Herbalife" and the "Company" include Herbalife International, Inc. and its operating subsidiaries.
EXECUTIVE OFFICES
The Company's executive offices are located at 1800 Century Park East, Los Angeles, California 90067. The Company's telephone number is (310) 410-9600.
GROWTH STRATEGY
The Company's strategy for growth consists of the following three principal elements:
EXPAND INTO NEW MARKETS. The opening of new markets is an essential component of the Company's business strategy. From January 1, 1992 through December 31, 1996, the Company has commenced operations in 24 new countries, consisting of four in The Americas, 15 in Europe and five in Asia/Pacific Rim. During 1996, these countries contributed $771.8 million of retail sales, representing 64.3% of the Company's total retail sales. The Company believes there are numerous additional markets in which its network marketing system and products should prove successful. The Company plans to open several new markets in 1997 and in 1998.
EXPAND PRODUCT OFFERINGS. The Company is committed to expanding its product line by developing and offering new products and introducing existing products into markets where they are not currently offered. Expansion of product offerings is designed to create enthusiasm among distributors and serve as a promotional tool in selling other products. During 1997, the Company intends to introduce several new products, including a new weight management program and new personal care products. In addition, the Company will continue its strategy of systematically introducing its most popular existing products into markets where they are not currently offered (subject to its ability to reformulate its products as necessary to obtain required regulatory approvals).
ENHANCE SALES IN CERTAIN EXISTING MARKETS. Management will continue to seek to enhance sales in the Company's existing markets. The Company intends to focus initially on the United States and certain other markets, such as France, Germany, Italy and Spain, where the Company has experienced a sales trend characterized by an initial period of rapid sales growth followed by a decline in sales. See "--Geographic Areas of Operations." Initiatives designed to enhance sales in these markets will include the creation of new regional strategy and planning groups, regular Company-sponsored and country-specific training and motivational events and teleconferences, the hiring of additional distributor support representatives, the introduction in each targeted international market of up to five additional products not previously offered, and the opening of new, more convenient distributor service centers in the targeted international markets.
PRODUCT OVERVIEW
The Company's products include weight management products, food and dietary supplements, personal care products and educational and promotional materials. The Company currently markets 77 products, exclusive of variations in product flavors, reformulations of products to satisfy regulatory requirements within a particular country or similar variations of the Company's basic product line. A limited number of the Company's personal care products are classified in the U.S. as Over the Counter ("OTC") drugs.
The following chart summarizes the number of products offered by the Company in its principal product categories as of December 31, 1996 and retail sales information by product category during the indicated periods.
PRODUCT SALES BY CATEGORY (Dollars in Thousands)
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* Includes a limited number of products that are classified in the U.S. as OTC drugs.
** Includes distributor kits and other educational and promotional materials. Such materials are regularly developed and enhanced by the Company and, as a result, the number of such materials is not presented.
The following chart sets forth the number of the Company's products available as of December 31, 1996 by category in each of the Company's markets as of that date.
NUMBER OF PRODUCTS OFFERED BY CATEGORY (AS OF DECEMBER 31, 1996)
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(1) Throughout the Report, "entering", "opening", "commencing operations" or "doing business" in a market or country means that the Company has obtained either regulatory approval of, or the favorable opinion of local legal counsel with respect to, its network marketing system, has obtained all requisite regulatory approvals of at least one product and has commenced sales and shipment of that product within the market or country. With respect to Japan, from 1989 through 1992, the Company operated under a licensing arrangement in Japan and reported license fees with respect thereto as revenue. Subsequently, in 1993, the Company formed a new Japanese subsidiary whose revenues were then included in the Company's results of operations. Accordingly, the Company considers Japan to have been "opened" in 1993.
WEIGHT MANAGEMENT PRODUCTS. A majority of the Company's sales are derived from the 14 weight management products that the Company markets as the Thermojetics-Registered Trademark- Weight-Management System. These weight management products include the following: (i) Formula 1, a protein powder in four different flavors designed as a meal replacement, (ii) the four Thermojetics-Registered Trademark- weight management tablets (original green, green, beige and yellow), (iii) Thermojetics-Registered Trademark- Herbal Concentrate, an herbal beverage blended from five natural botanicals, and (iv) a variety of other nutritional products, such as Cell-U-Loss-Registered Trademark-, Activated Fiber, N.R.G. (Nature's Raw Guarana), Thermo-bond-Registered Trademark- and Aminogen-Registered Trademark-.
FOOD AND DIETARY SUPPLEMENTS. The Company's food and dietary supplements include a variety of products, each containing herbs, vitamins, minerals and other natural ingredients. Such products are sold under various names, including Herbal-Aloe, Florafiber, Xtra-Cal, Herbalifeline, Tang Kuei Plus, Male Factor 1000, Schizandra Plus and A.M. Replenishing and P.M. Cleansing formula. In addition, in 1996, the Company launched its Health & Fitness Program and Bulk & Muscle Program, together with a Longetics Program designed for the needs of mature adults, which offer various products consisting of a protein drink mix, a multivitamin, mineral and herbal tablet and Cell Activator. In 1996, the Company supplemented its products to meet the nutritional needs of children. These products now consist of Kindermins-Registered Trademark-, a liquid multivitamin/herbal formula, and Dinomins-Registered Trademark-, a chewable vitamin tablet.
PERSONAL CARE PRODUCTS. The Company's entire personal care product line is marketed under the name Dermajetics-Registered Trademark-, which was initially launched in 1995. Currently, the Dermajetics-Registered Trademark- product line consists of the following products: The Skin Survival Kit, consisting of a day and night moisturizer, a deep cleaning facial mask and a hydrating eye gel, all packaged in a cosmetic bag; Parfums Vitessence-TM-, consisting of six eau de toilettes, three for men and three for women; Nature's Mirror-TM-, consisting of a cleanser, toner and moisturizer for each of three different skin types; Good Hair Day, consisting of seven hair care products; Ocean Currents, consisting of three bath products; Aroma Vie, consisting of nine aromatic soaps and oils; and other specialty personal care products, including Herbal Aloe Gel, Super APR (Arthritis Pain Relief) and Body Toning Cream.
EDUCATIONAL AND PROMOTIONAL MATERIALS. The Company also sells distributor kits, which an individual must purchase (at a worldwide average cost of approximately $89 per kit) in order to become a distributor of the Company, as well as other educational and promotional materials. Such materials include sales aids, informational videotapes and cassette recordings. Sales of distributor kits are not subject to distributor allowances (i.e., the Company receives the entire retail sales amount from the sale of distributor kits).
PRODUCT MANUFACTURING AND DEVELOPMENT. The Company expands its product line through the development of new products. New product ideas are derived from a number of sources, including trade publications, scientific and health journals, the Company's executives and consultants and outside parties. In advance of introducing products into its markets, local counsel and other representatives retained by the Company investigate product formulation matters as they relate to regulatory compliance and other issues. The Company's products are then reformulated to suit both the regulatory and marketing requirements of the particular market. See "--Regulation."
All of the Company's weight management products and food and dietary supplements are manufactured by outside companies. Raven Industries, Inc. ("Raven") manufactures the Company's powder products, and D&F Industries, Inc. ("D&F") manufactures substantially all of the Company's tablet and capsule products, including Activated Fiber-TM-, one of the Company's tablet products, pursuant to a license agreement with Dynamic Products, Inc. ("Dynamic"). Except with respect to certain research and development related to its personal care product line, the Company does not currently maintain its own product research, development and formulation staff and relies on Raven, D&F and other outside manufacturers for the development of such products. When the Company, one of its consultants or another party (including, in many instances, Raven or D&F) identifies a new product concept or when an existing product must be reformulated for introduction into a new or existing market, the new product concept or reformulation project is generally submitted to D&F or Raven for technological development and implementation.
D&F and Raven have granted the Company the exclusive right to market any product which the Company purchases from these suppliers. In addition, the Company has obtained or has applications pending for trademark registration of certain of its tradenames in certain jurisdictions. See "--Trademarks." However, there can be no assurance that another company will not replicate one of the Company's products.
The Company's business relationship with Raven and D&F represents an important source of income to these manufacturers, as sales to the Company comprise a substantial portion of the total sales of Raven and D&F. In May 1993, the Company entered into requirements contracts with Raven, D&F and Dynamic. Pursuant to these contracts, each manufacturer has agreed, among other things, not to sell the products sold to the Company to third parties, and the Company has agreed to purchase all of its requirements for powder products from Raven and all of its requirements for tablet, capsule, liquid, cream and lotion products from D&F or Dynamic, to the extent each such manufacturer is capable or becomes capable of manufacturing such products. The manufacturers have waived that requirement as it relates to certain personal care products. The contracts also provide Raven, D&F and Dynamic a right of first refusal to establish any manufacturing facility outside of North America that the Company proposes to develop or acquire and the right to receive certain royalty payments in the event that such a manufacturing facility were constructed or acquired and the right of first refusal were not exercised.
The Company's contracts with Raven, D&F and Dynamic are due to expire in January 1998, subject to automatic extension on the same terms for a period of five years unless notice to the contrary is provided by either party no later than six months prior to expiration. The Company is currently negotiating new contracts with Raven, D&F and Dynamic. However, there can be no assurance that Raven and D&F will continue to provide the product manufacturing, research, development and formulation services that they have in the past. Further, the Company currently anticipates that, even assuming new contracts with Raven, D&F and Dynamic are entered into, such contracts will not be exclusive requirements contracts as in the past. As a result, the Company believes that, under any circumstances, it will be required to arrange for alternative sources of supply for products within each of its product categories. The Company interacts regularly with outside third party suppliers (E.G., with respect to the personal care line) regarding product manufacturing. As a result, and based upon progress to date, the Company believes that it has or can obtain in a timely manner alternative sources of supply for substantially all of its weight management products and food and dietary supplements. The Company has commenced the process of identifying and evaluating alternative sources of supply for weight management products and food and dietary supplements in order to supplement or replace, as necessary, the manufacturing and related services currently provided by Raven, D&F and Dynamic.
Two individuals (not affiliates of the Company) are the principal stockholders of each of Raven, D&F and Dynamic. Mark Hughes, the Company's principal stockholder, Chairman of the Board, Chief Executive Officer and President, owns a one-third ownership interest in Raven and a one-fifth ownership interest in Dynamic.
The Company maintains a staff for the research and development of new personal care products. Information and specifications with respect to products currently in the personal care product line are made available to outside manufacturers on a confidential basis and for the limited purpose of manufacturing these products for the Company. Manufacturers of certain of the Company's personal care products include the European companies BCM Cosmetiques S.A., formerly Croda Cosmetique France S.A., and Abodino S.A. and the U.S. company Thibiant International Inc. The European manufacturers are supplied components by Herbalife at no charge, then procure the raw materials, compound the products and fill the supplied components. The U.S. manufacturer procures the raw materials and the components, compounds the product and fills the components. The Company's arrangement with the manufacturers can be terminated by either party upon the completion of any outstanding purchase orders.
PRODUCT RETURN AND BUY-BACK POLICIES. Generally, the Company's products include a customer satisfaction guarantee. Within thirty days of purchase, any customer who is not satisfied with an Herbalife product for any reason may return it or any unused portion to the distributor from whom it was purchased for a full refund from the distributor or credit toward purchase of another Herbalife product. Distributors may obtain replacements from the Company for products returned to them by consumers if they return such products to the Company on a timely basis. In addition, in most jurisdictions, the Company maintains a buy-back program pursuant to which it will repurchase products sold to a distributor provided that the distributor resigns from the Company, returns the product in marketable condition within twelve months of original purchase and meets certain documentation and other requirements. The Company believes this buy-back policy addresses a number of the regulatory compliance issues pertaining to network marketing systems. See "Regulation--Network Marketing System." Historically, product returns and buy-backs have not been significant, averaging 0.7% of annual retail sales during the last five years.
RECENT REGULATORY DEVELOPMENTS. The development and marketing of the Thermojetics-Registered Trademark- weight management tablets (original green, green, beige and yellow) and other products in the Thermojetics-Registered Trademark- line have contributed significantly to the Company's retail sales. One of the ingredients in the Thermojetics-Registered Trademark- original green herbal tablet is a Chinese herb, Ma Huang, which contains naturally-occurring ephedrine in small quantities. Ephedrine products have been the subject of adverse publicity in the United States and other countries relating to alleged harmful effects, including the deaths of several individuals. Currently, the Company offers the Thermojetics-Registered Trademark- original green herbal tablet only in the United States (except in certain states in which regulations may prohibit or restrict the sale of such product). On April 10, 1996, the FDA issued a statement warning consumers not to purchase or ingest dietary supplements containing natural sources of ephedrine that are claimed to produce certain effects (none of which are claimed by the Company's products), and the FDA stated that it intended to issue a proposed regulation regarding ephedrine-containing products by December 31, 1996. However, no proposal has been issued to date. There can be no assurance that the FDA will not seek to impose additional regulations, possibly prohibiting, limiting
potencies or placing other restrictions on the sale of such products. In addition, during the third quarter of 1995, the Company received inquiries from certain governmental agencies within Germany and Portugal relating to the Company's product, Thermojetics-Registered Trademark- Instant Herbal Beverage, which does not contain Ma Huang. The inquiries related to the caffeine content of the product and the status of the product as an "instant tea," which was disfavored by the regulators, versus a "beverage." The sale of this product in these countries was subsequently suspended by the Company at the request of the regulators. The Company may in the future attempt to reintroduce the product as a "beverage" in one or both of these markets.
NETWORK MARKETING SYSTEM
The Company's products are distributed exclusively through a network marketing system consisting of an extensive network of distributors. Distributors are generally independent contractors who purchase products directly from the Company or from other distributors for resale to retail consumers and other distributors. Distributors may elect to work on a full-time or part-time basis. The Company believes that its network marketing system appeals to a broad cross-section of people worldwide, particularly those seeking to supplement family income, start a home business or pursue employment opportunities other than conventional, full-time employment, and that a majority of its distributors therefore work on a part-time basis. The Company believes that its network marketing system is ideally suited to marketing its products because sales of such products are strengthened by ongoing personal contact between retail consumers and distributors, many of whom use the Company's products themselves. The Company encourages its distributors to use the Company's products and to communicate the results of their use of such products to their retail customers.
Distributors' earnings are derived from several sources. First, distributors may earn profits by purchasing the Company's products at wholesale prices (which are discounted 25% to 50% from suggested retail prices depending on the distributor's level within the Company's distributor network and whether the distributor has registered for Herbalife Advantage Program purchases) and selling the Company's products to retail customers at retail prices. Second, distributors may earn profits by selling products to other distributors who do not qualify for the same level of discount as the selling distributor. Third, distributors who sponsor other distributors and establish their own distributor organizations may earn royalties of 5% to 15% on product sales up to three levels down within their distributor organization and production bonuses of 2% to 6% on product sales within their downline organizations (except with respect to sales generated by distributors who have reached the "Global Expansion Team" level or higher). Combining these sources of earnings and including participation in the President's Team bonus (as described below), the Company's total "pay-out" on products subject to distributor royalties and overrides is approximately 68% of the Company's suggested retail sale price (i.e. 50% distributor allowance plus up to 22% of suggested retail sales prices in royalty overrides and similar bonuses, less a handling fee charged to distributors by the Company).
Distributors earn the right to receive royalties and production bonuses upon attaining the level of supervisor and above. Once a distributor becomes a supervisor, he or she has an incentive to qualify (by earning specified amounts of royalties) as a member of the Global Expansion Team, the Millionaire Team or the President's Team and thereby receive higher production bonuses (2%, 4% and 6%, respectively). The Company believes that the right of distributors to earn royalties and production bonuses contributes significantly to the Company's ability to retain its most productive distributors.
To become a distributor, a person must be sponsored by an existing distributor and must purchase a distributor kit from the Company (except in South Korea, where there is no charge for a distributor kit). To become a supervisor or qualify for a higher level, distributors must purchase a certain amount of the Company's products or earn certain amounts of royalties during specified time periods and must re-qualify for such levels once each year. To attain supervisor status, generally, a distributor must purchase, either from the Company or other distributors, products representing at least 4,000 volume points in one month or 2,500 volume points in two consecutive months (volume points are point values assigned to each of the Company's products that are equal in all countries and are based on the suggested retail price of U.S. products). Supervisors may then attain higher levels (I.E., the Global Expansion Team, the Millionaire Team or the President's Team) by earning increasing amounts of royalties based on purchases by distributors within their organizations. Supervisors contribute significantly to the Company's sales and certain key supervisors who have attained the highest levels within the Company's distributor network are responsible for generating a substantial portion of the Company's sales and for recruiting a substantial number of the Company's distributors. The following table sets forth the approximate number of the Company's supervisors at the dates indicated:
- ---------- * Every February 28th (which is the end of the first supervisor qualification period of each year), the Company deletes from the rank of supervisor those supervisors 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 such time (including any supervisors who were deleted on February 28th but who subsequently requalified). The Company relies on distributors' certifications as to the amount and source of their product purchases from other distributors. Although the Company applies certain review procedures with respect to such certifications, they are not directly verifiable by the Company.
The Company also has two compensation and incentive programs designed to motivate distributors at both the most senior and junior levels within the Company's distributor network. The Company's most senior distributors consist of approximately 260 distributors (as of December 31, 1996) who comprise the President's Team and who work closely with Mark Hughes to develop and implement new initiatives and strategies for increasing sales and distributor productivity throughout the Company's entire distributor organization. Qualifying President Team members have the opportunity to participate in the President's Bonus, which for 1996 consisted of a total available awards package of one percent of the Company's total product retail sales, or approximately $12 million. The distribution of the President's Bonus is determined by Mark Hughes and is based in part upon each President Team member's participation in corporate-sponsored training and motivational events. In this manner, the Company attempts to involve its most senior distributors in the development and growth of the Company in order to support the sales, training, motivation and strategic planning efforts of Mark Hughes.
For the Company's most junior distributors, those who have not yet attained supervisor status, the Company instituted a "Success Builder" program. This program permits a distributor who purchases products representing 1,000 volume points in one month to obtain a 42% distributor allowance from suggested retail prices on the Company's products, rather than the standard 25%. In addition, in 1996, the Company introduced the Herbalife Advantage Program ("HAP"), which uses a product brochure that enables the Company's junior distributors to obtain an extra 10% distributor allowance over the standard 25% and to order products by individual unit (rather than by cases) to better suit their inventory and usage needs. The Success Builder and HAP programs are designed to provide incentives to distributors who are in the initial stages of building distributor organizations and to encourage them to reach supervisor status. In addition to these programs, the Company periodically offers a variety of special promotions related to particular products or sales periods, involving special cash bonuses and other awards, such as "Get-A-Way" vacations.
The Company seeks to expand its distributor base in each market by offering distributors attractive compensation opportunities. The Company believes its international sponsorship program provides a significant advantage to its distributors as compared with distributors in certain other network marketing organizations because the program permits distributors in any country to sponsor distributors in other countries (where the Company is licensed to do business and where the Company has obtained required product approvals) and to earn the same level of royalties and bonuses on sales by those distributors as if both distributors resided in the same country.
The Company maintains a computerized system for processing distributor orders and calculating distributor royalties and bonus payments which enables it to remit such payments promptly to distributors. The Company believes that prompt remittance of royalties is vital to maintaining a motivated network of distributors and that its distributors' loyalty to the Company has been enhanced by the Company's history of consistently making royalty and bonus payments on a scheduled basis.
GEOGRAPHIC AREAS OF OPERATIONS
The following chart sets forth the countries in which the Company currently operates, the year operations were commenced in each country and retail sales information by country during the past five years.
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(1) The Company records sales data based on the country from which distributor orders are shipped by the Company. Sales by distributors to other distributors or retail consumers may occur in other countries, although such sales generally violate geographic limitations imposed by the Company on product sales.
(2) Sales in the Dominican Republic are shipped from the United States.
(3) The Company initiated operations in Israel in 1989 through a licensing arrangement that was terminated in 1990. In 1991, the Company began operating in Israel through a wholly-owned subsidiary. Accordingly, sales data for Israel are reported only for 1991 and subsequent periods.
(4) The Company operates through various import/export companies located in Russia to conduct transactions in the Company's products with Russian distributors.
(5) Because sales in South Africa are not large enough to be treated as a separate segment, they are included with sales from the European region.
(6) In 1989 through 1992 the Company operated under a licensing arrangement in Japan and recorded license fees with respect thereto as revenue. A new Japanese subsidiary was formed in November 1993 whose results from that date are reported above. 93.0% of the outstanding capital stock of the Japanese subsidiary is owned by the Company, with the remainder owned by certain officers and directors of the Company. In addition, the Company has begun steps to pursue an initial public offering of shares of the Japanese subsidiary in Japan.
(7) The Company initiated operations in South Korea in the fourth quarter of 1996.
GEOGRAPHIC SALES TRENDS. The opening of new markets is an essential component of the Company's business strategy. From January 1, 1992 through December 31, 1996, the Company commenced operations in 24 new countries. During 1996, these countries contributed $771.8 million of retail sales, representing 64.3% of the Company's total retail sales. Consistent with its growth strategy, the Company currently plans to enter up to four new markets in 1997 and up to six new markets in 1998. Potential new markets currently include Chile, China, India, Indonesia, Malaysia, Thailand, Turkey and Ukraine.
After entering a new country, the Company has generally experienced an initial period of rapid growth in sales as new distributors were recruited, followed by a decline in sales. The Company believes that a significant factor affecting these markets has been the opening of other new markets within the same geographic region or with the same or similar language or cultural bases and the corresponding tendency of some distributors to focus their attention on the business opportunities provided by new markets instead of developing their established downline organizations in existing markets. Additionally, in certain instances, the Company has become aware that certain sales in certain existing markets were attributable to purchasers who distributed such product in countries which had not yet been opened. When these countries were opened, such sales in existing markets shifted to the newly opened markets, resulting in a decline in sales in the existing markets.
Another significant factor contributing to such sales declines is the adverse publicity that sometimes arises when the Company experiences rapid growth within a market, thus drawing the attention of the media and the Company's competitors. The Company believes such unfavorable press reports are generally based upon a lack of familiarity with the Company and its network marketing system and often originate from competitive forces in the local market. For instance, in France in late 1994 through 1995, certain reports erroneously alleged that the Company was in some manner affiliated with a disfavored religious group. In other cases, including a situation in France that resulted in the arrest of certain Herbalife distributors, adverse publicity has arisen from allegations of tax improprieties, which typically occur when a country applies its tax laws for the first time to a sales and distribution system that is relatively new to that country, as is often the case with the Company's network marketing system. See "--Regulation--Transfer Pricing and Similar Regulations." The effect of occasional adverse publicity has at times also led to increased regulatory scrutiny in certain countries, which may also have an adverse effect on sales. For example, during the third quarter of 1995, the Company received inquiries from certain governmental agencies within Germany and Portugal related to the Company's product, Thermojetics-Registered Trademark- Instant Herbal Beverage. The inquiries related to the caffeine content of the product and the status of the product as an "instant tea," which was disfavored by the regulators, versus a "beverage." The sale of this product in these countries was subsequently suspended by the Company at the request of the regulators. The Company may in the future attempt to reintroduce the product as a "beverage" in one or both of these markets.
In 1997, the Company intends to initiate new strategies designed to enhance sales in the countries in which the sales trend described above has occurred, initially focusing efforts on France, Germany, Italy and Spain, as well as in the United States. These strategies include the creation of regional strategy and planning groups, regular Company-sponsored and country-specific promotional events and teleconferences in order to provide additional training and motivational support, the hiring of additional distributor support representatives to support marketing efforts, the addition in each targeted international market of up to five products that were previously unavailable in such markets, and the opening of new, more
convenient distributor service centers in the targeted international markets in connection with the reconfiguration of the Company's European distribution infrastructure.
THE AMERICAS. Total retail sales in The Americas decreased $16.2 million or 4.0% in 1996 versus 1995. Brazil, which was opened in the fourth quarter of 1995, contributed $76.2 million of retail sales during 1996. Despite the increase in retail sales in Brazil relative to 1995, the Company has experienced declining quarter to quarter retail sales in Brazil during the course of 1996. Retail sales in the United States decreased 16.2% to $279.6 million during 1996 from $333.6 million in the comparable 1995 period. The Company believes that a portion of this decrease is attributable to the fact that, prior to the opening of Brazil and Russia, certain retail sales in the U.S. were for products purchased in the U.S. but re-directed to Brazil and Russia by distributors. Following the opening of these markets, such sales shifted to Brazil and Russia. The Company will seek to enhance U.S. sales during 1997 through the various initiatives described above. See "--Geographic Sales Trends."
EUROPE. Total retail sales in Europe increased $57.4 million or 15.4% in 1996 versus 1995. Sales increases in Austria, Finland, Norway, Poland, Russia, South Africa and Switzerland were offset in part by sales decreases in Germany and Israel of $61.2 million and $21.7 million, respectively, together with sales decreases in Belgium, Denmark, the Czech Republic, France, Italy, the Netherlands, Portugal, Spain, Sweden and the United Kingdom. In addition to the factors affecting sales in existing markets generally as discussed above, the Company believes the sales decreases in these countries were attributable to lengthy regulatory approval processes that have impeded the introduction of the Company's most popular existing products, the reduction in activity levels of certain key distributors in those markets and resistance to network marketing, which resistance appears to be particularly strong in Germany and France. In Russia, however, the Company has experienced significant retail sales increases, despite a difficult business environment as a result of the political, economic and social instability in that country. Thus far, the difficult business environment has prevented the Company from establishing a physical presence in Russia (through a sales or distribution center) and instead has required the Company to rely on various import/export companies located in Russia to conduct transactions in the Company's products with Russian distributors. As a result, the Company has been required to extend credit to certain import/export companies. The Company plans to closely monitor activities in Russia to determine the best means of conducting business with its Russian distributors as events unfold in that country.
ASIA/PACIFIC RIM. Total retail sales in Asia/Pacific Rim grew $235.3 million or 164.0% in 1996 versus 1995. This $235.3 million increase included retail sales increases of $229.4 million in Japan. The growth in Japan resulted from new products and marketing initiatives, and the Company believes that its success in Japan is attributable to the personal nature of retail sales in the Japanese market and the cultural acceptance of the Company's network marketing system in such an environment.
NEW MARKET EXPANSION PROGRAM. The Company engages in a structured and thorough analysis of potential new markets, including analysis of regulatory conditions, product approval procedures, competitive forces, synergies between new and existing countries and distributor presence or interest in new markets, before selecting markets to enter. When the Company decides to enter a new market, it first hires local legal counsel with expertise in the product approval process to help ensure that the Company's network marketing system and products comply with all applicable regulations and that the Company's profits may be expatriated. In addition, local counsel helps to establish favorable public relations in the new market by acting as an intermediary between the Company and local regulatory authorities, public officials and business people. Local counsel is also responsible for explaining the Company's products and product ingredients to appropriate regulators and, when necessary, arranging for local technicians to conduct required ingredient analysis tests of the Company's products. In recent years, the Company has expanded its hiring of local firms with experience in governmental relations and public relations prior to opening a market in order to ensure a more favorable business environment upon entering the market.
Where regulatory approval in a foreign market is required, the Company's local counsel work with regulatory agencies to confirm that all of the ingredients of the Company's products are permissible within the new market. During the regulatory compliance process, the Company may alter the formulation, packaging or labeling of its products to conform to applicable regulations as well as local variations in customs and consumer habits, and the Company may modify certain aspects of it network marketing system as necessary to comply with applicable regulations. Where reformulations of the Company's principal weight management products are required, the Company has historically found substitute or replacement ingredients to be readily available, although there can be no assurance in this regard in the future. Where regulatory approval in a foreign market is not required, the Company obtains the favorable opinion of local counsel as to compliance with all applicable regulations. See "--Regulation."
Following completion of the regulatory compliance phase, the Company undertakes the steps necessary to meet the operational requirements of the new market. The Company has recently developed a centralized distribution and telephone ordering system. In the majority of its new markets, the Company establishes a storefront sales center in one or more major
cities and provides for product purchases by telephone. Product is shipped to the purchaser from a warehouse located in the general geographic region. In addition, the Company initiates plans to satisfy the inventory, personnel and transportation requirements of the new market, and the Company modifies its distributor manuals, cassette recordings, video cassettes and other training materials as necessary to be suitable for the new market. In certain instances where the Company has achieved rapid sales growth in a new market, such as in Japan and Brazil, the Company has experienced inventory shortages as a result of the large demand for the Company's products.
Although the Company intends to expand into new markets, there can be no assurance that the Company can open markets on a timely basis or that such new markets will prove to be profitable. Significant regulatory and legal requirements must be satisfied before marketing can begin in any new market. In addition, expansion of the Company's operations into new markets entails substantial working capital and capital expenditure requirements associated with both the regulatory compliance and operations phases of the process. The lead-time and costs associated with opening anticipated new markets may significantly exceed those of entering new markets in the past due to greater regulatory requirements, the necessity of adapting to entirely new regulatory systems and problems related to entering new markets with different cultural bases and political systems from those encountered in the past. The lead-time necessary to open a new market is generally up to two years but may be more.
PRODUCT DISTRIBUTION
The Company's weight management products, food and dietary supplements and some personal care products are distributed to foreign markets either from the facilities of the Company's manufacturers or from the Company's Los Angeles distribution center. Products are distributed in the United States market from the Los Angeles distribution center or from the Company's Memphis distribution center. Products are generally transported by cargo ship or plane to the Company's international markets and are warehoused in either one of the Company's foreign distribution centers or a contracted third party warehouse and distribution center. After arrival of the products in a foreign market, distributors purchase the products from the local distribution center or the associated sales center. The Company's Dermajetics-Registered Trademark- personal care products are predominantly manufactured in France and the United States. The products manufactured in France are shipped to a third-party centralized warehouse facility in Strasbourg, from which delivery by ship or plane to other international markets occurs.
Beginning in 1996 and continuing in 1997, the Company has undertaken the process of reconfiguring its European product distribution system. As a part of this process, the Company has reduced the number of European warehousing facilities from nine to five and has opened new distribution sales centers. These sales service centers are conveniently located and attractively designed in order to encourage local distributors to meet and network with each other and learn more about Herbalife's products, marketing system and upcoming events. In addition, the Company has opened a central sales ordering facility in the United Kingdom for answering and processing telephone orders from throughout Europe. Operators at this center are capable of conversing in 17 different languages. As part of this reconfiguration, the Company also implemented a new inventory management system in the U.S., the U.K. and Japan. The new European system has resulted in improved inventory management and a reduction in distribution costs in 1996 as compared with 1995. Management anticipates that the reconfigured European distribution system, featuring centralized distribution and telephone ordering systems coupled with convenient storefront distributor service centers, will be the model for developing distribution and distributor service systems in other regions of the world.
MANAGEMENT INFORMATION AND TELECOMMUNICATIONS SYSTEMS
In order to facilitate its continued growth and support distributor activities, the Company continually upgrades its management information and telecommunications systems. These systems include, among other things: (i) a centralized host computer located in the Company's Inglewood, California Operations Center, which is linked to Herbalife's international markets through a dedicated wide area network that provides on-line, real-time computer connectivity and access; (ii) local area networks of personal computers within Herbalife's markets, serving the Company's regional administrative staffs; (iii) an international e-mail system through which Herbalife employees communicate; (iv) a standardized Northern Telecom Meridian telecommunications system connecting all of the Company's markets; and (v) a new inventory management system that has recently been installed in the U.S., the U.K. and Japan. These systems are designed to provide, among other things, financial and operating data for management, timely and accurate product ordering, royalty payment processing and inventory management and detailed distributor records. Over the last three years, the Company has invested approximately $11.2 million to enhance its computer and telecommunications systems.
REGULATION
In both its United States and foreign markets, the Company is subject to and affected by extensive laws, regulations, administrative determinations, court decisions and similar constraints (as applicable, at the federal, state and local levels) (hereinafter "regulations") including, among other things, regulations pertaining to (i) the formulation, manufacturing, packaging, labeling, distribution, importation, sale and storage of the Company's products, (ii) product claims and advertising (including direct claims and advertising by the Company as well as claims and advertising by distributors, for which the Company may be held responsible), (iii) the Company's network marketing system, (iv) transfer pricing and similar regulations that affect the level of foreign taxable income and customs duties, and (v) taxation of distributors, which in some instances may impose an obligation on the Company to collect the taxes and maintain appropriate records.
PRODUCTS. The formulation, manufacturing, packaging, storing, labeling, advertising, distribution and sale of the Company's products are subject to regulation by one or more governmental agencies, including the Food and Drug Administration ("FDA"), the Federal Trade Commission ("FTC"), the Consumer Product Safety Commission ("CPSC"), the United States Department of Agriculture ("USDA"), the Environmental Protection Agency ("EPA") and the United States Postal Service. The Company's activities are also regulated by various agencies of the states, localities and foreign countries in which the Company's products are manufactured, distributed and sold. The FDA, in particular, regulates the formulation, manufacture and labeling of foods, dietary supplements and OTC drugs, such as those distributed by the Company. FDA regulations require the Company and its suppliers to meet relevant good manufacturing practice ("GMP") regulations for the preparation, packing and storage of these products. GMP's for dietary supplements have yet to be promulgated but are expected to be proposed.
The 1994 Dietary Supplement Health and Education Act ("DSHEA") revises the provisions of the Federal Food, Drug and Cosmetic Act ("FFDCA") concerning the composition and labeling of dietary supplements and, the Company believes, is generally favorable to the dietary supplement industry. The legislation creates a new statutory class of "dietary supplements." This new class includes vitamins, minerals, herbs, amino acids and other dietary substances for human use to supplement the diet, and the legislation grandfathers, with certain limitations, dietary ingredients that were on the market before October 15, 1994. A dietary supplement which contains a new dietary ingredient (i.e., one not on the market before October 15, 1994) will require evidence of a history of use or other evidence of safety establishing that it is reasonably expected to be safe. Manufacturers of dietary supplements which make a "statement of nutritional support" must have substantiation that the statement is truthful and not misleading.
The majority of the products marketed by the Company are classified as dietary supplements under the FFDCA. The labeling requirements for dietary supplements have not been clearly established. In December 1995, the FDA issued proposed regulations which govern the labeling of dietary supplements, including how to declare nutritional information, how to make permissible "statements of nutritional support" and when additional, defined terminology may be used on dietary supplements. The proposed regulations were expected to become final at the end of 1996; as of this date, however, no final regulations have been issued. The proposed regulations would require the Company to revise a substantial number of its labels at an undetermined, but likely immaterial, expense to the Company. The FDA has informally stated that it will, subject to public comment, withhold enforcement of these regulations until January 1, 1998. Many states have also recently become active in the regulation of dietary supplement products and may require the Company to modify the labeling or formulation of certain products sold in those states.
All of the officers and directors of the Company are subject to a permanent injunction entered in October 1986 pursuant to the settlement of an action instituted by the California Attorney General, the State Health Director and the Santa Cruz County District Attorney. The Company consented to the entry of this injunction without in any way admitting the allegations of the complaint. The injunction prevents the Company and such officers and directors from making certain specified claims in future advertising of the Company's products and requires the Company to implement certain documentation systems with respect to payments to the Company's distributors. At the same time, the injunction does not prevent the Company from continuing to make certain specified claims concerning its products which have been and are being made, provided that it has a reasonable basis for making such claims.
As a marketer of food and dietary supplements and other products that are ingested by consumers, the Company is subject to the risk that one or more of the ingredients in its products may become the subject of adverse regulatory action. For example, one of the ingredients in the Thermojetics-Registered Trademark- original green herbal tablet is a Chinese herb, Ma Huang, which contains naturally-occurring ephedrine in small quantities. Ephedrine products have been the subject of adverse publicity in the United States and other countries relating to alleged harmful effects, including the deaths of several individuals. Currently,
the Company offers the Thermojetics-Registered Trademark- original green herbal tablet only in the United States (except in certain states in which regulations may prohibit or restrict the sale of such product). In response to potential federal regulatory proposals that may have affected the sale of the Thermojetics-Registered Trademark- original green tablets in the United States, the Company suspended sales of the product for approximately three months commencing in July 1995 and introduced a reformulated herbal green tablet that did not contain Ma Huang. When no such regulations were proposed or issued, the Company renewed sales of Thermojetics-Registered Trademark- original green herbal tablets in the United States in October 1995 (except in certain states in which regulations may prohibit or restrict the sale of such product). During the three-month suspension period, the Company did not experience a material change in the level of sales of the reformulated Thermojetics-Registered Trademark- green tablets versus sales of the Thermojetics-Registered Trademark- original green tablets in the recently preceding months. However, it is possible that a longer suspension period could have resulted in a decrease in sales of the reformulated Thermojetics-Registered Trademark- green tablets or other products within the Thermojetics-Registered Trademark- Weight Management System (even though such products do not contain Ma Huang). The Thermojetics-Registered Trademark- green tablets accounted for 2.1% and 2.5% of retail sales in 1995 and 1996, respectively, although the marketing of the Thermojetics-Registered Trademark- weight management tablets (original green, green, beige and yellow) and other products in the Thermojetics-Registered Trademark- line have contributed significantly to the Company's retail sales. The Company also previously offered the Thermojetics-Registered Trademark- original green herbal tablet in Canada but, in response to Canadian marketing issues and regulatory concerns, suspended sales of the product in February 1994.
The FDA has on record a small number of reports of adverse reactions allegedly resulting from the ingestion of Ma Huang contained in the Company's Thermojetics-Registered Trademark- original green tablet. The Company has not received any communications from the FDA with respect to these reports. However, many other companies manufacture products containing various amounts of Ma Huang and the FDA has on record hundreds of reports of adverse reactions to these products. On April 10, 1996, the FDA issued a statement warning consumers not to purchase or ingest dietary supplements containing ephedrine that are claimed to produce such effects as euphoria, heightened awareness, increased sexual sensations or increased energy, because these products pose significant adverse health risks, including dizziness, headache, gastrointestinal distress, irregular heartbeat, heart palpitations, heart attack, strokes, seizures, psychosis and death. The Company markets its Ma Huang product as an aid in weight management, and not principally for any of their claims. The FDA stated that it intended to issue a proposed regulation regarding ephedrine-containing products by December 31, 1996; however, no proposal has been issued to date. There can be no assurance that the FDA will not seek to impose additional regulations, possibly prohibiting, limiting potencies or placing other restrictions on the sale of such products. In addition, several states either regulate or are considering regulating ephedrine-containing products as controlled substances or are prohibiting the sale of such products by persons other than licensed pharmacists.
There is a risk that the Company's product containing Ma Huang may become subject to further federal, state, local or foreign laws or regulations, which could require the Company to: (i) withdraw or reformulate its product with reduced ephedrine levels or with a substitute for Ma Huang and/or (ii) relabel its product with different warnings or revised directions for use and/or (iii) not make certain statements, possibly including weight loss, with respect to any product containing Ma Huang. Even in the absence of further laws or regulation, the Company may elect to reformulate and/or relabel its product containing Ma Huang. While the Company believes that its Ma Huang product could be reformulated and relabeled, there can be no assurance in that regard or that reformulation and/or relabeling would not have an adverse effect on sales of such product or related products within the Thermojetics-Registered Trademark- product line even though such products do not contain Ma Huang. It is a regular part of the Company's business to monitor regulatory developments of this sort in all of its markets and to determine the optimal strategy for the Company in each instance in which such a development arises.
Some of the products marketed by the Company are considered conventional foods and are currently labeled as such. Both this category of products and dietary supplements are subject to the Nutrition, Labeling and Education Act ("NLEA"), and regulations promulgated thereunder, which regulates health claims, ingredient labeling and nutrient content claims characterizing the level of a nutrient in the product.
A limited number of the products sold by the Company are labeled in the United States as OTC drugs as opposed to dietary supplements, conventional foods or personal care items. Many OTC drug products do not require pre-approval by the FDA, but must comply with applicable OTC monographs, which prescribe permissible ingredients and appropriate labeling language. In addition, either the Company or its supplier must register and file annual drug listing information with the FDA. Because the FDA could take the position that claims made with respect to any product of the Company fall within an OTC monograph, the regulatory status of some of the Company's products is or could become unclear. If any enforcement were undertaken, the Company could be required to relabel or reformulate such products, which the Company believes it could do without any material adverse effect on the Company or the sale of such products.
In foreign markets, prior to commencing operations and prior to making or permitting sales of its products in the market, the Company may be required to obtain an approval, license or certification from the country's ministry of health or comparable
agency. Where a formal approval, license or certification is not required, the Company nonetheless seeks a favorable opinion of counsel regarding the Company's compliance with applicable laws. Prior to entering a new market in which a formal approval, license or certificate is required, the Company works extensively with local authorities in order to obtain the requisite approvals. The approval process generally requires the Company to present each product and product ingredient to appropriate regulators and, in some instances, arrange for testing of products by local technicians for ingredient analysis. Such approvals may be conditioned on reformulation of the Company's products or may be unavailable with respect to certain products or certain ingredients. Product reformulation or the inability to introduce certain products or ingredients into a particular market may have an adverse effect on sales. The Company must also comply with product labeling and packaging regulations that vary from country to country. The Company's failure to comply with such regulations can result in, among other things, a product being removed from sale in a particular market, either temporarily or permanently.
The FTC, which exercises jurisdiction over the advertising of all the Company's products, has in the past several years instituted enforcement actions against several dietary supplement companies for false and misleading advertising of certain products. These enforcement actions have resulted in consent decrees and monetary payments by the companies involved. In addition, the FTC has increased its scrutiny of the use of testimonials, which are utilized by the Company. While the Company has not been the target of FTC enforcement action for the advertising of its products, there can be no assurance that the FTC will not question the Company's advertising or other operations in the future.
In certain countries, the Company may also be affected by regulations applicable to the activities of its distributors because in some countries the Company is, or regulators may assert that the Company is, responsible for its distributors' conduct, or such regulators may request or require that the Company take steps to ensure its distributors' compliance with regulations. The types of regulated conduct include, among other things, representations concerning the Company's products, income representations made by the Company and/or distributors, public media advertisements (which in foreign markets may require prior approval by regulators) and sales of products in markets in which such products have not been approved, licensed or certified for sale. In certain markets, it is possible that improper product claims by distributors could result in the Company's products being reviewed or re-reviewed by regulatory authorities and, as a result, being classified or placed into another category to which stricter regulations are applicable. In addition, certain labeling changes might be required.
Through its manuals, seminars and other training materials and programs, the Company attempts to educate its distributors as to the scope of permissible and impermissible activities in each market. The Company also investigates allegations of distributor misconduct. However, the Company's distributors are generally independent contractors, and the Company is not able to monitor directly all distributor activities. As a consequence, there can be no assurance that the Company's distributors comply with applicable regulations. Misconduct by distributors has in the past and could again have a material adverse effect on the Company in a particular market or in general.
The Company is unable to predict the nature of any future laws, regulations, interpretations or applications, nor can it predict what effect additional governmental regulations or administrative orders, when and if promulgated, would have on its business in the future. They could, however, require the reformulation of certain products not able to be reformulated, imposition of additional record keeping requirements, expanded documentation of the properties of certain products, expanded or different labeling and scientific substantiation regarding product ingredients, safety or usefulness. Any or all such requirements could have a material adverse effect on the Company's results of operations and financial condition.
NETWORK MARKETING SYSTEM. The Company's network marketing system is subject to a number of federal and state regulations administered by the FTC and various state agencies as well as regulations in foreign markets administered by foreign agencies. Regulations applicable to network marketing organizations are generally directed at ensuring that product sales are ultimately made to consumers (as opposed to other distributors) and that advancement within such organizations be based on sales of the organizations' products rather than investments in the organizations or other non-retail sales related criteria. For instance, in certain markets there are limits on the extent to which distributors may earn royalties on sales generated by distributors that were not directly sponsored by the distributor. Where required by law, the Company obtains regulatory approval of its network marketing system or, where such approval is not required, the favorable opinion of local counsel as to regulatory compliance. However, the Company remains subject to the risk that, in one or more of its markets, its marketing system could be found not to be in compliance with applicable regulations. Failure by the Company to comply with these regulations could have a material adverse effect on the Company in a particular market or in general. See "--Product Distribution."
The Company is also subject to the risk of challenges to the legality of its network marketing system. For example, in WEBSTER V. OMNITRITION INTERNATIONAL, INC., 79 F.3d 776 (9th Cir. 1996), the "multi-level marketing" program of Omnitrition International, Inc. ("Omnitrition") was challenged in a class action by certain Omnitrition distributors who alleged that Omnitrition was
operating an illegal "pyramid scheme" in violation of federal and state laws. The Company believes that its network marketing system would not be classified as an illegal marketing system under the standards set forth in the OMNITRITION case and other applicable statutes and caselaw, in part based upon significant differences between the Company's marketing system and that described in the OMNITRITION case. Further, it is an ongoing part of the Company's business to monitor and respond to regulatory and legal developments, including those that may affect its network marketing system. However, the regulatory requirements concerning network marketing systems do not include "bright line" rules and are inherently fact-based. An adverse judicial determination with respect to the Company's network marketing system could have a material adverse effect on the Company. Among other things, such a determination could require the Company to make modifications to its network marketing system, result in negative publicity or have a negative impact on distributor morale. In addition, further adverse rulings by the courts in the OMNITRITION litigation or other similar litigation could have a material adverse effect on the Company, even if the Company's network marketing system is not itself challenged.
TRANSFER PRICING AND SIMILAR REGULATIONS. In many foreign countries, the Company is subject to transfer pricing regulations, restrictions on management fees charged by the Company to its local subsidiary and similar regulations and restrictions designed to ensure that appropriate levels of income are reported as earned by the local subsidiary and taxed by the foreign governmental authorities. In addition, the Company's operations in foreign countries are subject to regulations designed to ensure that appropriate levels of customs duties are assessed on the importation of the Company's products.
While the Company believes it is in compliance with all applicable regulations and restrictions, it is subject to the risk that governmental authorities could audit its transfer pricing and related practices and assert that additional taxes are owed. For
example, the Company is currently subject to pending audits or proposed assessments in a number of foreign jurisdictions, including Italy, France and Germany, involving transfer pricing issues, income taxes, value added taxes, withholding taxes and related interest and penalties. In certain circumstances, additional taxes, interest and penalties have been assessed, and the Company will be required to litigate to reverse the assessments. In most instances, the Company and its tax advisors believe that the Company has substantial defenses, and the Company is vigorously contesting all material outstanding assessments.
In the event that such audits or assessments are concluded adversely to the Company, the Company believes that it could generally offset or mitigate the consolidated effect of foreign taxes required to be paid through the use of U.S. foreign tax credits. However, depending upon the years at issue, the Company might not be able to amend prior U.S. tax returns to obtain the benefit of such credits. Furthermore, to the extent that the Company's operations in high tax jurisdictions such as Japan grow disproportionately relative to the balance of Company's operations, the Company may be unable to fully utilize its foreign tax credits in the U.S., which could, accordingly, result in the Company paying a higher overall effective tax rate on its worldwide operations. Because the laws and regulations governing U.S. foreign tax credits are complex and depend, among other things, on tax treaties with foreign nations in addition to U.S. tax laws, there can be no assurance that the Company would in fact be able to take advantage of any tax credits.
OTHER REGULATIONS. The Company is also subject to a variety of other regulations in various foreign markets, including regulations pertaining to social security assessments and value added taxes, employment and severance pay requirements, import/export regulations and antitrust issues. As an example, in many markets, the Company is substantially restricted in the amount and types of rules and termination criteria that it can impose on distributors without causing social security assessments to be payable by the Company on behalf of such distributors and without incurring severance obligations to terminated distributors. In some countries, the Company may be subject to such obligations in any event.
Failure by the Company to comply with such regulations could have a material adverse effect on the Company in a particular market or in general. Such assertions or the effect of adverse regulations in one market could adversely affect the Company in other markets as well by causing increased regulatory scrutiny in those other markets or as a result of the negative publicity generated in those other markets.
COMPLIANCE PROCEDURES. As indicated above, the Company, its products and its network marketing system are subject, both directly and indirectly through distributors' conduct, to numerous federal, state and local regulations both in the United States and foreign markets. Beginning in 1985, the Company began to institute formal regulatory compliance measures by developing a system to identify specific complaints against distributors and to remedy any violations by distributors through appropriate sanctions, including warnings, suspensions and, when necessary, terminations. In its manuals, seminars and other training programs and materials, the Company emphasizes that distributors are prohibited from making therapeutic claims for the Company's products.
The Company's general policy regarding acceptance of distributor applications from individuals who do not reside in one of the Company's markets is to refuse to accept such individual's distributor application. From time to time, exceptions to the policy are made on a country-by-country basis.
In order to comply with regulations that apply to both the Company and its distributors, the Company conducts considerable research into the applicable regulatory framework (typically, with the assistance of local legal counsel and other representatives) prior to entering any new market to identify all necessary licenses and approvals and applicable limitations on the Company's operations in that market. The Company devotes substantial resources to obtaining such licenses and approvals and bringing its operations into compliance with such limitations. The Company also researches laws applicable to distributor operations and revises or alters its distributor manuals and other training materials and programs to provide distributors with guidelines for operating a business, marketing and distributing the Company's products and similar matters, as required by applicable regulations in each market. However, the Company is not able to monitor its supervisors and distributors effectively to ensure that they refrain from distributing the Company's products in countries where the Company has not commenced operations, and the Company does not devote significant resources to such monitoring.
In addition, regulations in existing and new markets are often ambiguous and subject to considerable interpretive and enforcement discretion by the responsible regulators. Moreover, even when the Company believes that it and its distributors are in compliance with all applicable regulations, new regulations are regularly being added and the interpretation of existing regulations is subject to change. Further, the content and impact of regulations to which the Company is subject may be influenced by public attention directed at the Company, its products or its network marketing system, so that extensive
adverse publicity about the Company, its products or its network marketing system may result in increased regulatory scrutiny.
It is an ongoing part of the Company's business to anticipate and respond to such new and changing regulations and make corresponding changes in the Company's operations to the extent practicable. In furtherance of these efforts, in 1994 the Company formed its Government Relations Group, currently consisting of eight employees, and in 1995 created the position of Chief International Counsel. These employees seek to establish relationships with regulators and community leaders in both new and existing markets and strive to ensure that the Company's products and network marketing system comply with regulatory requirements. However, while the Company devotes considerable resources to maintaining its compliance with regulatory constraints in each of its markets, there can be no assurance that the Company would be found to be in full compliance with applicable regulations in all of its markets at any given time or that the regulatory authorities in one or more markets will not assert, either retroactively or prospectively or both, that the Company's operations are not in full compliance. Such assertions or the effect of adverse regulations in one market could negatively affect the Company in other markets as well by causing increased regulatory scrutiny in those other markets or as a result of the negative publicity generated in those other markets. Such assertions could have a material adverse effect on the Company in a particular market or in general. Furthermore, depending upon the severity of regulatory changes in a particular market and the changes in the Company's operations that would be necessitated to maintain compliance, such changes could result in the Company experiencing a material reduction in sales in such market or determining to exit such market altogether. In such event, the Company would attempt to devote the resources previously devoted to such market to a new market or markets or other existing markets, but there can be no assurance that such transition would not have an adverse effect on the Company's business and results of operations either in the short or long term.
TRADEMARKS
The Company uses the umbrella trademarks Herbalife-Registered Trademark-, Thermojetics-Registered Trademark-, Dermajetics-Registered Trademark- and several other trademarks and tradenames in connection with its products and operations. Trademark registrations are either issued or pending in the United States Patent and Trademark Office and in comparable agencies in many other countries. The Company considers its trademarks and tradenames to be an important factor in its business. The Company's product formulations are not protected by patents and are generally not patentable.
COMPETITION
The Company is subject to significant competition for the recruitment of distributors from other network marketing organizations, including those that market weight management products, food and dietary supplements and personal care products, as well as other types of products. Some of the Company's competitors are substantially larger and have available considerably greater financial resources than the Company. The Company's ability to remain competitive depends, in significant part, on the Company's success in recruiting and retaining distributors through an attractive compensation plan and other incentives. The Company believes that its production bonus program, international sponsorship program and other compensation and incentive programs provide its distributors with significant earning potential. However, there can be no assurance that the Company's programs for recruitment and retention of distributors will be successful.
In addition, the business of marketing weight management, food and dietary supplement and personal care products is highly competitive. This market segment includes numerous manufacturers, distributors, marketers, retailers and physicians that actively compete for the business of consumers both in the United States and abroad. The market is highly sensitive to the introduction of new products or weight management plans (including various prescription drugs) that may rapidly capture a significant share of the market. As a result, the Company's ability to remain competitive depends in part upon the successful introduction of new products.
EMPLOYEES
As of December 31, 1995 and 1996, the Company had 1,060 and 1,180 full-time employees, respectively. These numbers do not include the Company's distributors, who are generally independent contractors rather than employees of the Company. The Company considers its employee relationships to be satisfactory. Except for certain employees in Mexico, none of the Company's employees is a member of any labor union, and the Company has never experienced any business interruption as a result of any labor disputes.
ITEM 2.

ITEM 2. PROPERTIES
The Company leases all of its physical properties located in the United States. The Company's executive offices, re-located to Century City, California in February 1996, include approximately 81,000 square feet of general office space under a lease that expires in January 2006. The Company leases an aggregate of approximately 78,000 square feet of office space, computer facilities and conference rooms at the Operations Center in Inglewood, California, under a lease that expires in October 2006, and approximately 146,000 square feet of warehouse space in two separate facilities located in Los Angeles and Memphis. The Los Angeles and Memphis agreements have terms through May 2001 and August 2006, respectively. The Company also leases warehouse and office space in a majority of its other geographic areas of operations. The Company believes that its existing facilities are adequate to meet its current requirements and that comparable space is readily available at each of these locations.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
The Company is from time to time engaged in routine litigation incident to the conduct of its business. The Company regularly reviews all pending litigation matters in which it is involved and establishes reserves deemed appropriate by management for such litigation matters. The Company believes that no litigation currently pending against it will have a material adverse effect on its consolidated financial position and results of operations. See "Regulation--Transfer Pricing and Similar Regulations" for a discussion of certain pending tax matters.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock has been quoted on the National Market System of the National Association of Securities Dealers Automated Quotation System ("NASDAQ-NMS") under the symbol "HERB" since April 21, 1992. The table below sets forth, for the periods indicated, the high and low closing bid prices of the Common Stock, as reported on NASDAQ-NMS.
BID/CLOSING PRICES* ------------------- HIGH LOW ---- --- First Quarter $17 3/4 $10 1/4 Second Quarter 13 1/4 10 1/8 Third Quarter 15 1/2 9 3/4 Fourth Quarter 9 7/8 6 3/4
First Quarter $12 $9 3/8 Second Quarter 16 1/4 10 1/8 Third Quarter 15 7/8 12 5/8 Fourth Quarter 32 5/8 15 3/4
___________ *The bid/closing prices in the table were taken from a written summary provided to the Company by NASDAQ. Prices reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.
At February 28, 1997, 30,230,738 shares of the Company's Common Stock were issued and outstanding, and were held by 1,114 stockholders of record.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data set forth below for each of the years in the five-year period ended December 31, 1996 are derived from the audited consolidated financial statements of the Company. The selected financial and operating data should be read in conjunction with Management's Discussion and Analysis of Results of Operations and Financial Condition and the consolidated financial statements and related notes.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RECENT DEVELOPMENTS AND OUTLOOK
The Company utilizes a worldwide network marketing system to market weight management products, food and dietary supplements and personal care products. As of December 31, 1996, the Company conducted business in 34 countries located throughout The Americas, Europe and Asia/Pacific Rim.
The Company has reported increased annual retail sales and net sales in each year since 1988 and has reported profits for each year since 1990. See "--Presentation of Retail Sales." In the last five years, retail sales increased from $405.1 million in 1992 to $1,200.1 million in 1996, representing a compound annual growth rate of 31.2%, and net income increased from $20.1 million in 1992 to $44.8 million in 1996, representing a compound annual growth rate of 22.2%. In 1996, retail sales and net income increased by $276.5 million or 29.9% and $25.1 million or 127.0%, respectively, compared to 1995. The increase was primarily due to an expansion of operations into Japan, Russia and Brazil.
The Company markets its products globally. For 1996, 76.7% of retail sales were attributable to markets located outside of the United States. The following summarizes the Company's retail sales by region for the time periods indicated.
In 1996, a relatively small number of countries accounted for a large proportion of the $276.5 million increase in retail sales. Of the 34 countries in which the Company operated during 1996, 14 countries experienced an aggregate increase in retail sales of $480.4 million as compared with 1995. Japan, Russia and Brazil accounted for 82.0% of this increase. The growth in these 14 countries was offset by a $203.9 million aggregate decrease in retail sales in the remaining 20 countries in which the Company operated. As part of its growth strategy, management has recently implemented a plan to revitalize sales in countries where the Company has experienced a loss of retail sales. See "Business--Growth Strategy." The concentration of increased retail sales in a small number of countries is expected to make the Company's earnings in future periods more susceptible to various risks relating to dependency on foreign operations.
Subsequent to commencement of operations in 1980, the Company's network of independent distributors has grown substantially to include 115,000 supervisors as of February 28, 1997 and a much larger number of distributors. Although the number of supervisors continued to grow during 1996, the Company has experienced a decline in the addition of new supervisors during certain periods in 1996 in several of its major markets. The addition of new supervisors declined in Japan and Russia over the course of the three months ended December 31, 1996 and in Brazil over the course of the nine months ended September 30, 1996 (with a moderate increase in Brazil during the fourth quarter of 1996), and sales of distributor kits declined in Russia over the course of the three months ended December 31, 1996 and in Brazil over the course of 1996. Furthermore, despite the substantial growth in Japan, Russia and Brazil in 1996, the rate of growth of retail sales declined in Japan and Russia over the course of the three months ended December 31, 1996, and retail sales generally declined in Brazil over the course of the year ended December 31, 1996.
PRESENTATION OF RETAIL SALES
Throughout this report "retail sales" are determined as the gross sales amounts reflected on the Company's invoices to its distributors. The Company does not receive the amount reported as "retail sales", and the Company does not monitor the actual retail prices charged for the Company's products. "Net sales" represent the actual purchase prices paid to the Company by its distributors, after giving effect to distributor discounts (referred to as "distributor allowances"), which total approximately 50% of suggested retail sales prices. The Company receives its net sales price in cash or through credit card
payments upon receipt of orders from distributors. The Company's "gross profit" consists of net sales less (i) "cost of sales," consisting of the prices paid by the Company to its manufacturers for products and costs related to product shipments, foreign duties and tariffs and similar expenses, and (ii) "royalty overrides," currently consisting of (a) royalties (5% to 15%) and bonuses (up to 6%) on the suggested retail sales prices of products earned by qualifying distributors on the sales of other distributors within their distributor organizations, and (b) the President's Team Bonus payable to certain of the Company's most senior distributors in the aggregate amount of up to an additional 1% of product retail sales. Royalty overrides as reported in the Consolidated Statements of Income are net of a handling fee (6% of retail sales effective April 1, 1994, previously 5%) charged by the Company to its distributors on purchases of products from the Company. The Company's "income from operations" consists of income before interest income and income taxes.
The Company's use of "retail sales" in reporting financial and operating data reflects the fundamental role of "retail sales" in the Company's accounting systems, internal controls and operations, including the basis upon which distributor bonuses are paid. The retail sales price of the Company's products is reflected in distributor invoices as the price charged to distributors together with, in most cases, a deduction for the corresponding distributor allowance. The retail sales price is used by the Company to calculate, among other things, royalty overrides and "volume points" earned by distributors. Volume points are point values assigned to each of the Company's products that are equal in all countries, and are used as a supervisor qualification criteria. In addition, management relies upon "retail sales" data reflected in daily sales reports to monitor results of operations in each of the Company's markets.
The significance of the Company's "net sales" is to reflect, generally, the prices actually received by the Company after deducting the basic distributor allowance, but before deducting royalty overrides and bonuses. The ratio of the Company's "retail sales" to "net sales" is relatively constant because distributor allowances historically total approximately 50% of suggested retail sales prices. Accordingly, factors that affect "retail sales" generally have a corresponding and proportionate effect on "net sales." To the extent the ratio of "retail sales" to "net sales" varies from period to period, such variances have resulted principally from sales of the Company's distributor kits and other educational and promotional materials, for which there are no distributor allowances. Sales of such items initially decreased and thereafter stabilized as a percentage of total retail sales since 1991, but such decreases have not had a material impact on the ratio of the Company's "retail sales" to "net sales" or on the Company's operating margin.
The Company's 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 the Company's ability in the future to enter new markets and introduce additional and new products into its markets.
1996 COMPARED TO 1995
Retail sales increased 29.9% to $1,200.1 million in 1996 from $923.6 million in 1995. The increase was primarily due to the year to year aggregate sales growth of $480.4 million in 14 countries (including two countries which opened in 1996): 82.0% of this increase was derived from sales in three countries: Japan, Russia and Brazil. This increase was partially offset by an aggregate $203.9 million sales decline in the remaining 20 countries in which the Company operates.
Regionally, retail sales for 1996 as compared to 1995 increased 164.0% in Asia/Pacific Rim, 15.4% in Europe and declined 4.0% in The Americas. In Asia/Pacific Rim, combined retail sales of $378.8 million increased by $235.3 million compared with 1995. The increase was due to a significant growth in sales in Japan which contributed retail sales of $311.1 million in 1996 as compared to $81.7 million in 1995. The increase in sales in Japan is in part attributable to the introduction of new products and expansion of existing product lines and the growth in the distributor network in Japan. In Europe, combined retail sales for 1996 of $431.3 million increased by $57.4 million compared to 1995. This increase was due to a full year operation in Russia which opened during 1995 and contributed retail sales of $142.1 million in 1996 as compared to $29.6 million in 1995. The most significant decline in Europe was in Germany with 1996 retail sales of $54.3 million compared to $115.6 million in 1995. The decrease was due in part to the July 1995 suspension of sales of Thermojetics-Registered Trademark- Instant Herbal Beverage in that country and the adverse publicity stemming from the suspension.
In The Americas, combined retail sales in 1996 of $390.0 million decreased by $16.2 million as compared to 1995. The decrease was due to a decline in sales in the United States and several South American countries, partially offset by Brazil which opened in the fourth quarter of 1995. The reduction in U.S. retail sales is attributable in part to the Company's commencement of operations in Brazil and the continuing effect of the commencement of operations in Russia in July 1995. The Company is aware that, prior to the opening of Brazil and Russia, some retail sales in the U.S. were for products purchased in the U.S. but re-directed to Brazil or Russia by distributors. The Company expects that U.S. retail sales may continue to be impacted as the expansion of operations into international markets continues.
The Company's gross profit increased to $278.8 million for 1996 from $206.5 million in 1995. As a percentage of retail sales, the gross profit was 23.2% in 1996 as compared with 22.4% in 1995. This is primarily attributable to higher sales in Japan where the gross profit is higher due to higher retail selling prices.
Marketing, distribution and administrative expenses for 1996 increased to $210.1 million from $176.0 million in 1995. As a percentage of retail sales, these expenses were 17.5% in 1996 as compared to 19.1% in 1995. The increase in these expenses is attributable to higher in-country distribution center costs directly related to sales volume, particularly in Japan and Brazil. In addition, administrative expenses increased as a result of a continued emphasis and increased costs of strengthening government and media relations, increased compensation related to staff additions and incentive compensation awards. Such increases were partially offset by a decrease in sales promotion expenses in 1996 as compared to 1995. Foreign exchange losses were $3.0 million in 1996 as compared to losses of $2.6 million in 1995.
Income taxes of $28.0 million in 1996 increased from $11.8 million in 1995. As a percentage of income before income taxes, the income tax rate increased from 37.5% for 1995 to 38.5% for 1996. The increase is due in part to an increased proportion of profits in countries which have a higher effective tax rate.
Net income for 1996 increased to $44.8 million from $19.7 million in 1995 because of the factors discussed above.
1995 COMPARED TO 1994
Retail sales increased 4.5% to $923.6 million in 1995 from $884.1 million in 1994. Contributing to 1995 consolidated retail sales was the introduction of the first three phases of products in the Company's new line of personal care products, the Skin Survival Kit in January 1995, the fragrances, Parfums Vitessence-TM-, in April 1995 and the facial products, Nature's Mirror-TM-, in October 1995. The new products accounted for $107.4 million of consolidated retail sales in 1995. The products were introduced extensively in Europe and The Americas where they accounted for $49.2 million and $50.7 million, or 13.2% and 12.5%, of those regions' retail sales in 1995, respectively.
Regionally, retail sales in 1995 compared to 1994 increased 153.9% and 14.7% in Asia/Pacific Rim and The Americas, respectively, and decreased 21.0% in Europe. In The Americas, retail sales increased from $354.3 million in 1994 to $406.2 million in 1995. In Asia/Pacific Rim, retail sales increased from $56.5 million in 1994 to $143.5 million in 1995. In Europe, retail sales decreased from $473.2 million in 1994 to $373.9 million in 1995.
In The Americas, combined retail sales in 1995 increased $51.9 million, or 14.7%, when compared to 1994, which was due to (i) a sales increase in the U.S. of $38.6 million or 13.1% when compared to 1994, and (ii) the October 1995 opening of Brazil, which reported retail sales of $24.2 million. The increases were partly offset by a reduction in sales in Mexico resulting from devaluation of the Mexican peso and a decrease in retail sales in Argentina in part resulting from the opening of Brazil in 1995, as a result of which certain Argentina product sales were redirected to Brazil. Within The Americas, U.S. retail sales accounted for $333.6 million or 36.1% of total worldwide retail sales in 1995, compared to $295.0 million or 33.4% of total worldwide retail sales in 1994. The increase in U.S. retail sales as a percentage of worldwide retail sales resulted from increased U.S. sales and approximately constant foreign sales in 1995 as compared to 1994.
In the European region, the decrease in German sales of $43.9 million, together with sales decreases in the Czech Republic, France, Israel, Italy, Portugal, Spain and the U.K, were partially offset by sales in Belgium, Denmark, Poland and Sweden, all of which opened in the second half of 1994, and sales in Austria, Russia, South Africa and Switzerland, which opened in the second and third quarters of 1995. The decrease in sales in Germany was due in part to the suspension of sales of Thermojetics-Registered Trademark- Instant Herbal Beverage in that country in July 1995. The suspension led to an increase in product returns and distributor resignations, as well as a decline in sales of other products. In 1995, sales in France continued to be negatively impacted by an adverse business environment, including continued adverse publicity regarding certain of the Company's French distributors. See "Business--Geographic Areas of Operations." The Company believes that another significant factor affecting these markets has been the opening of other new markets within the same geographic region or with the same or similar language or cultural bases, and the inclination of some distributors to focus their attention on business opportunities provided by new markets, which can have a negative impact on existing markets.
The Asia/Pacific Rim growth was due to (i) sales increases in Japan of $63.0 million, or 335.7%, when compared to 1994, and (ii) the opening of the Philippines in December 1994 and Taiwan in July 1995, which reported combined retail sales of $17.6 million for 1995.
Gross profit decreased 1.8% to $206.5 million in 1995 from $210.4 million in 1994. As a percentage of retail sales, gross profit for 1995 decreased to 22.4% from 23.8% in 1994. The decreased gross profit was due to higher cost of sales and royalty overrides as a percentage of retail sales. The cost of sales percentage increased to 15.5% in 1995 from 14.8% in 1994. Such increase includes higher freight costs resulting from (i) redeployment of inventories to meet demand patterns and (ii) provisions made against slow moving inventory. In addition, royalty overrides as a percentage of retail sales increased to 15.0% in 1995 from 14.2% in 1994. This was the result of a modification to the marketing plan made in June 1995, which increased the royalties earned by distributors and increased bonuses payable to certain of the Company's senior distributors.
Marketing, distribution and administrative expenses increased 26.1% to $176.0 million in 1995 from $139.6 million in 1994. As a percentage of retail sales, these expenses increased to 19.1% in 1995 from 15.8% in 1994. Selling expenses increased $5.1 million, corporate expenses increased $18.6 million and distribution expenses increased $12.7 million. The increased selling expenses were instrumental in an effort to increase distributor kit sales, stimulate new distributor sponsoring rates and expand distributor training. The increase was also due to introductions of new technologies, such as International Satellite Supervisor Training and The Herbalife Broadcast Network, a home based satellite television program. The corporate expenses increased due to (i) initiatives taken in new product introductions and marketing activities, (ii) intensified government and media relations and other business related functions and (iii) foreign exchange losses which increased $2.5 million in 1995, when compared to 1994. The increase in distribution expense was due to new country openings and facility and staff expansions in Japan and Germany.
During 1995, the Company made a detailed study of its European warehousing and distribution systems to identify possible areas of cost savings. As a result, the Company planned to make a number of changes in its European infrastructure in order to enhance operating efficiencies. In connection with this change, the Company recorded a restructuring charge of $2.3 million, primarily relating to lease termination costs. The infrastructure modifications commenced in the second half of 1996.
Income taxes decreased to $11.8 million in 1995 from $27.6 million in 1994. As a percentage of pre-tax income, income taxes remained constant at 37.5%.
Net income decreased 57.1% to $19.7 million in 1995 from $46.0 million in 1994, as a result of the factors described above.
LIQUIDITY AND CAPITAL RESOURCES
The Company has historically met its working capital and capital expenditure requirements, including funding for expansion of operations, through net cash provided by operating activities.
In 1996, net cash provided by operating activities was $65.4 million, compared to $77.9 million in 1995. The decrease primarily resulted from (i) reductions in advanced sales deposits primarily resulting from timing differences, (ii) non-recurring 1995 inventory reductions as compared to an increase in 1996 inventory balances related to revenue growth, (iii) higher 1996 income taxes from increased income and a non-recurring tax refund received in 1995, and (iv) comparably higher receivable balances primarily resulting from new and existing country expansion. These reductions were partially offset by increased net income from expansion into new markets and additional liquidity provided by higher accrued expense balances.
For the year ended December 31, 1995, net cash provided by operating activities was $77.9 million, compared to $14.8 million for the year ended December 31, 1994. Although net income in 1995 decreased $26.3 million when compared to 1994, net cash provided by operating activities increased by $63.0 million. This increase resulted primarily from reductions in inventories, prepaid expenses and other current assets, increases in advanced sales deposits and royalty override accruals and reduced taxable income and the timing of income tax payments.
Capital expenditures in 1996 were $15.4 million compared to $7.2 million for the prior year. The majority of the 1996 expenditures resulted from the expansion of office and distribution facilities and additional costs incurred in connection with the implementation of management information systems. Capital expenditures for the year ended December 31, 1995 were $7.2 million compared to $8.6 million for the year ended December 31, 1994. The majority of the 1995 expenditures were made to upgrade computer and office equipment and to expand facilities to support growth. In connection with its entry into each new market, the Company funds inventory requirements and, in certain markets, establishes a distributor service center and/or a distribution facility. While the capital requirements associated with entry into new markets vary, the Company estimates that approximately $7 million will be required for pre-opening expenses and capital expenditures associated with its 1997 new market expansion activities.
Stockholders' equity increased $28.9 million to $138.5 million during 1996. In 1996, net income of $44.8 million and the issuance of capital stock, including related tax benefits on non-qualified stock option exercises, of $10.3 million were partially offset by $17.8 million of dividends declared and stock repurchases of $7.5 million. Stockholders' equity decreased $0.3 million to $109.5 million at December 31, 1995 from $109.8 million at December 31, 1994. In 1995, net income of $19.7 million was offset by $22.2 million of dividends declared. The dividend in the third and fourth quarters of 1995 was reduced to $0.15 per share from $0.22 per share in the prior four quarters. The payment of dividends is determined by the Board of Directors at its discretion and the amounts of dividends declared and paid in future quarters will depend, among other factors, on profitability, as well as other planned uses of the Company's cash resources. See "Dividend Policy."
On January 12, 1996, the Company announced that its Board of Directors had approved a share repurchase program pursuant to which up to $5 million could be expended to repurchase shares of the Company's Common Stock. On September 13, 1996, the Company announced that the Board of Directors had approved the extension of the share repurchase program, such that up to an aggregate of one million shares of the Company's Common Stock could be repurchased. As of February 28, 1997, the Company had expended $7.5 million to make repurchases of 574,500 shares in the public market.
In total, cash and cash equivalents increased to $87.5 million at December 31, 1996 compared to $69.2 million at December 31, 1995. At December 31, 1996, the Company's cash, cash equivalents and marketable securities aggregate balance was $131.0 million, which represents an $26.8 million increase from the balance as of December 31, 1995.
The Company has not been subjected to material price increases by its suppliers for several years. The Company believes that it has the ability to respond to a portion or possibly all of any price increases by raising the price of its products. Purchases by the Company from its suppliers are generally made in U.S. dollars, while sales to distributors are generally made in local currencies. Consequently, strengthening of the U.S. dollar versus a foreign currency can have a negative impact on the Company. The Company is authorized to enter into forward exchange contracts of up to $10 million to manage its foreign exchange risk. Foreign exchange transaction losses were $0.1 million, $2.6 million and $3.0 million in the years ended December 31, 1994, 1995 and 1996, respectively.
For a discussion of certain contingencies that may impact liquidity and capital resources, see "Note 9, Contingencies," in the Company's consolidated financial statements included herein.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements of the Company, together with the Report thereon of Deloitte & Touche LLP, independent auditors, are included elsewhere herein on pages 31 through 48.
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information called for by Item 10 of Part III is incorporated by reference to the Company's definitive Proxy Statement for the 1996 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 1996.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION
Information called for by Item 11 of Part III is incorporated by reference to the Company's definitive Proxy Statement for the 1996 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 1996.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information called for by Item 12 of Part III is incorporated by reference to the Company's definitive Proxy Statement for the 1996 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 1996.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information called for by Item 13 of Part III is incorporated by reference to the Company's definitive Proxy Statement for the 1996 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 1996.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
1. FINANCIAL STATEMENTS
The following financial statements of the Company are filed with this report and can be found on the pages indicated below:
2. FINANCIAL STATEMENT SCHEDULES
None.
3. EXHIBITS
(1) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1987.
(2) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1989.
(3) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.
(4) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.
(5) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.
(6) Incorporated by reference to the Company's definitive Proxy Statement relating to its annual meeting of shareholders held May 20, 1993.
(7) Incorporated by reference to the Company's Registration Statement on Form S-1 (No. 33-66576) declared effective by the Securities and Exchange Commission on October 8, 1993.
(8) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the three months ended June 30, 1994.
(9) Incorporated by reference to the Company's Definitive Proxy Statement relating to its 1994 Annual Meeting of Stockholders.
(10) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1994.
(11) Incorporated by reference to the company's annual Report on Form 10-K for the year ended December 31, 1995.
(12) Incorporated by reference to the Company's definitive Proxy Statement relating to its 1996 Annual Meeting of Stockholders.
(13) Filed herewith.
(b) REPORTS ON FORM 8-K:
None.
(c) OTHER EXHIBITS:
See "Item 14(a)3. Exhibits."
(d) OTHER FINANCIAL STATEMENT SCHEDULES:
None.
INDEPENDENT AUDITORS' REPORT
To the Stockholders of Herbalife International, Inc.:
We have audited the accompanying consolidated balance sheets of Herbalife International, Inc. and subsidiaries (the "Company") as of December 31, 1995 and 1996, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Herbalife International, Inc. and subsidiaries at December 31, 1995 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996 in conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP Los Angeles, California February 14, 1997
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1995 AND 1996
ASSETS
See the accompanying notes to consolidated financial statements
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1995 AND 1996
LIABILITIES AND STOCKHOLDERS' EQUITY
See the accompanying notes to consolidated financial statements
HERBALIFE INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
See the accompanying notes to consolidated financial statements
HERBALIFE INTERNATIONAL, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1994, 1995, AND 1996
See the accompanying notes to consolidated financial statements
HERBALIFE INTERNATIONAL, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
See the accompanying notes to consolidated financial statements
HERBALIFE INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. GENERAL
Herbalife International, Inc. and its subsidiaries (the Company) markets weight management products, other food and dietary supplements and personal care products worldwide. The Company's products, which consist of herbs and other natural ingredients, are marketed through a network marketing system in which "distributors" who are generally independent contractors purchase products for resale to retail consumers and other distributors. As of December 31, 1996, the Company conducted business in thirty-four countries located in the Americas, Europe and Asia/Pacific Rim. In the Company's foreign markets, distributors market the same, or essentially the same products, as those sold in the United States and in fundamentally the same manner.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION POLICY
The consolidated financial statements include the accounts of the Company and its subsidiaries; all significant intercompany transactions and accounts have been eliminated.
TRANSLATION OF FOREIGN CURRENCIES
Foreign subsidiary's asset and liability accounts are translated for consolidated financial reporting purposes into U.S. dollar amounts at year-end exchange rates. Revenue and expense accounts are translated at the average rates during the year. Foreign exchange translation adjustments are accumulated in a separate component of stockholders' equity. Transaction losses, which were $111,000, $2,573,000 and $3,013,000 in the years ending December 31, 1994, 1995 and 1996, respectively, are included in marketing, distribution and administrative expenses in the accompanying Consolidated Statements of Income.
FORWARD EXCHANGE CONTRACTS
The Company enters into forward exchange contracts in managing its foreign exchange risk on intercompany transactions and does not use the contracts for trading purposes. Gains and losses on forward exchange contracts are recorded when incurred. Premiums on such contracts are amortized into income over the life of the contracts.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. Cash and cash equivalents are comprised primarily of money market accounts, foreign and domestic bank accounts, and tax-exempt municipal bonds with short-term maturities. To reduce its credit risk, the Company monitors the credit standing of the financial institutions that hold the Company's cash and cash equivalents.
MARKETABLE SECURITIES
The Company's marketable securities are classified as "available for sale". Fluctuations in fair value are included in a separate component of stockholders' equity. Marketable securities are comprised primarily of tax-exempt municipal bonds with contractual maturities of up to three years.
FAIR VALUE OF FINANCIAL INSTRUMENTS
Pursuant to SFAS No. 107, "Disclosure About Fair Value of Financial Instruments," the Company has estimated the fair value of its financial instruments using the following methods and assumptions: a) The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable and bank debt approximate fair value because of their short-term nature; and b) The fair values of short-term investments are based on quoted market prices.
INVENTORIES
Inventories are stated at lower of cost (on the first-in, first-out basis) or market.
ADVERTISING COSTS
The Company expenses advertising costs in the period incurred. Literature and promotional items are sold to distributors and are included in inventories and are charged to cost of sales as they are sold.
LONG-LIVED ASSETS
Depreciation of furniture, fixtures and other equipment is computed on a straight-line basis over the estimated useful lives of the related assets, which range from three to six years. Leasehold improvements are amortized on a straight-line basis over the life of the related asset or the term of the lease whichever is shorter.
Costs incurred in advance of commencing operations in a new country are capitalized. These costs are predominantly legal, accounting and other professional costs relating to the approval and registration of the Company's products in the new markets as well as professional expenses incurred in connection with the structuring, organization and formation of the entities through which the Company's business is conducted in a new Company. These costs are amortized over a period not exceeding twenty-four months.
Goodwill is being amortized over periods ranging from fifteen to forty years.
Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Impairment losses would be recognized if the carrying amount of the asset exceeds the fair value of the asset.
INCOME TAXES
Income tax expense includes income taxes payable for the current year and the change in deferred income tax assets and liabilities for the future tax consequences of events that have been recognized in the Company's financial statements or income tax returns. A valuation allowance is recognized to reduce the carrying value of deferred tax assets if it is more likely than not that a component of the deferred tax assets will not be realized.
ROYALTY OVERRIDES
An independent distributor may earn commissions called royalty overrides or production bonuses based on retail volume. Such commissions are based on the retail sales volume of certain other members of the independent sales force who are sponsored by the distributor.
MINORITY INTEREST
On December 30, 1996, the Company sold shares of Herbalife Japan to certain Company Directors, Executive Officers and Resident Managers of Herbalife Japan. The minority interest represents the minority stockholders 7% interest in the equity of Herbalife Japan.
REVENUE RECOGNITION
The Company records its retail sales based upon suggested retail prices as reflected on the Company's sales invoices to its distributors. The Company does not receive the amount reported as retail sales, but generally receives the net sales price in cash or through credit card payments upon receipt of orders from distributors. The net sales price is the suggested retail price less a distributor allowance approximating 50%. Sales and related royalty overrides are recorded when the merchandise is shipped. Advance sales deposits represent prepaid orders for which the Company has not shipped the merchandise.
SOURCES OF SUPPLY AND PRODUCT DEVELOPMENT
Substantially all the Company's weight management products, food and dietary supplement products are produced by two manufacturers, who also perform substantially all of the Company's research and development functions and own certain product formulations and manufacturing processes relating to the Company's products. The Company has requirement contracts with these companies that extend to January 1998, whereby the Company has agreed to purchase all of its requirements for these products from the manufacturers, and the manufacturers have agreed to sell these products only to the Company.
EARNINGS PER SHARE
Primary earnings per share are computed by dividing net income by the weighted average number of common and equivalent shares. Fully diluted earnings per share assumes the maximum dilutive effect of stock options.
STOCK COMPENSATION
Effective January 1, 1996, the Company adopted FAS No. 123, "Accounting for Stock-Based Compensation". This statement establishes financial accounting and reporting standards for stock-based employee compensation plans, such as stock purchase plans, stock options, restricted stock and stock appreciation rights as well as non-employee equity transactions. The Company has not changed the method of accounting for its employee stock compensation plans, but as permitted by this statement, has provided the fair value disclosure requirements in Footnote 10.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. Such estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
3. INVENTORIES
Inventories consist primarily of finished goods available for resale and can be categorized as follows:
December 31, --------------------------- 1995 1996 ----------- ----------- Product $35,099,000 $39,668,000 Literature 3,375,000 3,419,000 Promotional items 2,430,000 3,117,000 ----------- ----------- Total $40,904,000 $46,204,000 ----------- ----------- ----------- -----------
4. BANK LOANS AND CONTRACTS PAYABLE
Bank loans and contracts payable consist of the following:
December 31, --------------------------- 1995 1996 ----------- ----------- Capitalized leases, due in monthly installments through 2000 (Note 5) 2,398,000 3,536,000 Other 566,000 1,263,000 ----------- ----------- Total 2,964,000 4,799,000 Less current portion 1,185,000 2,493,000 ----------- ----------- Long-term portion $1,779,000 $2,306,000 ----------- ----------- ----------- -----------
Annual scheduled payments of bank loans and contracts payable are: $2,493,000 (1997), $886,000 (1998), $732,000 (1999), $477,000 (2000), and thereafter $211,000 (2001).
During 1996, the Company entered into a revolving bank credit facility in South Korea in the amount of $2,000,000. The credit facility will continue to be available until written notice from the borrower is provided. The credit facility provides for borrowings at local interest rates, set when borrowings are made. The borrowings are collateralized by cash investments on account with the bank. At December 31, 1996, there was $1,198,000 borrowed against this line of credit.
5. LEASE OBLIGATIONS
The Company has warehouse and office facilities, furniture and fixtures and equipment under leases which expire at various dates through 2009. Under the lease agreements, the Company is also obligated to pay property taxes, insurance, and maintenance costs. Certain of the leases contain renewal options. Future minimum rental commitments for non-cancelable operating leases and capital leases at December 31, 1996 were as follows:
Operating Capital ----------- ----------- 1997 8,360,000 1,437,000 1998 7,605,000 1,025,000 1999 5,415,000 826,000 2000 3,759,000 510,000 2001 3,528,000 220,000 Thereafter 11,541,000 ----------- ----------- Total $40,208,000 4,018,000 ----------- ----------- Less: Amounts included above representing interest 482,000 ----------- Present value of net minimum lease payments $3,536,000 -----------
Rental expense for the years ended December 31, 1994, 1995 and 1996 was $5,120,000, $7,126,000, and $9,434,000 respectively.
Property under capital leases is included in property in the accompanying balance sheets at December 31, 1995 and 1996 as follows:
1995 1996 ---------- ---------- Equipment $3,756,000 $5,575,000 Less: accumulated amortization 1,443,000 2,291,000 ---------- ---------- Total $2,313,000 $3,284,000 ---------- ---------- ---------- ----------
6. EMPLOYEE COMPENSATION PLANS
The Company has two incentive compensation plans: the 1992 Executive Incentive Compensation Plan (the "1992 Plan") and the 1994 Performance-Based Annual Incentive Compensation Plan (the "1994 Plan"). Under the 1992 plan, a target percentage of earnings before bonuses and income taxes may be awarded to Officers, Directors and Key Employees, as determined by the Chief Executive Officer and Compensation Committee, based on the attainment of certain corporate and business objectives. The expense under the 1992 Plan for 1994 and 1996 totaled $830,000 and $320,000, respectively. No bonuses were awarded under this plan for 1995.
The 1994 Plan provides additional compensation as an incentive to key executives and consultants to attain certain specified performance objectives of the Company. The amount of the available awards to individual participants and the aggregate amount to all participants is determined based upon objective performance goals as determined by the Compensation
Committee of the Board of Directors. The amounts awarded under the 1994 Plan for 1994 and 1996 totaled $3,160,000 and $5,850,000, respectively. No amounts were awarded under this plan for 1995.
In accordance with the 1994 Plan, the Company made advances of targeted performance bonus amounts during 1994 and 1996 to the participants. As of December 31, 1996, the remaining outstanding principal and accrued interest obligations were $3,968,000 (of which $607,000 is being forgiven pursuant to the consulting agreement as discussed in Note 7). Each advance is a full recourse obligation of the executive with a maturity date of two years following the date of the advance. In addition, the advances bear interest at the applicable federal rate (AFR) for two-year notes at the time of the advances. The rates for existing outstanding advances range from 5.31% to 7.93%. The remaining balance for Directors and Officers will be repaid prior to the end of the first quarter of 1997.
The Company also maintains a savings plan pursuant to Sections 401 (k) and (m) of the Internal Revenue Code. The plan is available to substantially all employees who meet length and service requirements. Employees may elect to contribute 2% to 15% of their compensation, and the Company will match a portion of the participant's contribution. Participants are partially vested in contributions, made on their behalf by the Company, after three years, and fully vested after seven years. Employer contributions were $203,000, $284,000 and $399,000 for the years ended December 31, 1994, 1995 and 1996, respectively.
In 1996, the Company implemented two non-qualified, unfunded, deferred compensation plans for select groups of management: the "Management Plan" and the "Senior Executive Plan". The Deferred Compensation Plans allow eligible employees to elect annually to defer up to fifty percent (50%) of their base annual salary and up to one hundred percent (100%) of their annual bonus for each calendar year (the "Annual Deferral Amount"). The Company makes matching contributions on behalf of each participant in the Senior Executive Plan of one hundred percent (100%) of the amount deferred by each participant up to ten percent (10%) of the participant's base annual salary. Each participant in either of the Deferred Compensation Plans has at all times a fully vested and non-forfeitable interest in each year's contribution, including interest credited thereto, and in any Company matching contributions, if applicable. In connection with a participant's election to defer an Annual Deferral Amount, the participant may also elect to receive a short-term payout, equal to the Annual Deferral Amount plus interest. Such amount is payable in five or more years from the first day of the year in which the Annual Deferral Amount is actually deferred. The deferred compensation expense was $2,826,000 for 1996.
7. TRANSACTIONS WITH RELATED PARTIES
The CEO and majority stockholder of the Company owns a one-third interest in Raven Industries, a major supplier of the Company's products, and a one-fifth interest in Dynamic Products, Inc., a supplier of one of the Company's products. An employee (former Director and Executive Officer) of the Company owns a five percent interest in Dynamic Products, Inc. Total purchases from Raven Industries were $41,801,000, $26,246,000 and $53,193,000 for the years ended December 31, 1994, 1995 and 1996, respectively. Total purchases from Dynamic Products, Inc. were $5,768,000, $3,094,000 and $3,181,000 for the years ended December 31, 1994, 1995 and 1996, respectively. At December 31, 1995 and 1996, the aggregate amounts payable to these suppliers were $971,000 and $1,339,000, respectively.
The Company engages Nutrient Research Consultants, Ltd., which is wholly owned by an employee (former Director and Executive Officer), to perform consulting services related to the formulation and testing of nutritional products. For the years ended December 31, 1994, 1995 and 1996, payments by the Company to this consulting firm amounted to $1,294,000, $1,003,000 and $230,000, respectively.
In January 1997, the Company entered into a consulting agreement with the former Chief Counsel of the Company (the "Consultant"). The agreement provides for the Consultant to provide consulting services, as requested by the Company, through the end of 1997 in connection with the business and operations of the Company. Pursuant to the agreement, the Consultant is entitled to receive, among other things, the following: (i) base monthly compensation at the rate of $700,000 per annum through the end of 1997; (ii) $1,000,000 payable on January 1, 1998; and (iii) forgiveness of $607,000 of the advances previously made to the Consultant. In addition, vesting of the Consultant's restricted shares and stock options, originally granted pursuant to his preexisting employment agreement, will continue to vest through the consulting period.
In December 1996, the Company sold an aggregate 7% interest in its Japanese subsidiary to certain Company Directors, Executive Officers and Resident managers of Herbalife Japan K.K.. The aggregate sales price was $4,620,000, $1,386,000 in
cash and $3,234,000 in full recourse interest bearing notes. The notes are receivable in five equal annual principal and interest installments, beginning in December 1997. The sales price of the shares was determined based upon a valuation performed by an independent investment banking firm. The profit recognized from the sale has been deferred until the interest ultimately is sold to a third party.
8. RESTRUCTURING EXPENSES
In connection with the Company's plan to modify its European infrastructure to enhance operating efficiencies, the Company recorded a restructuring charge of $2,300,000 in the year ended December 31, 1995. The restructuring charge included expected termination costs for certain leases and reductions in certain asset carrying values. The plan to modify the infrastructure was implemented in the second half of 1996. At December 31, 1996, the remaining liability of approximately $700,000 consists of lease obligations at closed facilities.
9. CONTINGENCIES
The Company is subject to transfer pricing regulations, restrictions on the management fees it charges to its worldwide subsidiaries and similar regulations and restrictions designed to ensure that appropriate levels of income are reported as earned by the local subsidiary and taxed by the appropriate governmental authorities. In addition, the Company's operations in foreign countries are subject to regulations designed to ensure that appropriate levels of customs duties are assessed on the importation of the Company's products.
While the Company believes it is in compliance with all applicable regulations and restrictions, it is subject to the risk that governmental authorities could audit its transfer pricing and related practices and assert that additional taxes are owed. For example, the Company is currently subject to pending audits or proposed assessments in a number of foreign jurisdictions, including Italy, France and Germany, involving transfer pricing issues, income taxes, value added taxes, withholding taxes, and related interest and penalties. In certain circumstances, significant additional taxes, interest and penalties have been assessed, and the Company will be required to litigate to reverse the assessments. In most instances, the Company and its tax advisors believe that the Company has substantial defenses, and the Company is vigorously contesting all material outstanding assessments. However, the ultimate resolution of these matters may take several years.
In the event that such audits or assessments are concluded adversely to the Company, the Company believes that it could generally offset or mitigate the consolidated effect of foreign income taxes required to be paid through the use of U.S. foreign tax credits. However, depending upon the years at issue, the Company might not be able to amend prior U.S. tax returns to obtain the benefit of such credits. Furthermore, to the extent that the Company's operations in high tax jurisdictions such as Japan grow disproportionately relative to the balance of the Company's operations, the Company may be unable to fully utilize its foreign tax credits in the U.S., which could, accordingly, result in the Company paying a higher overall effective tax rate on its worldwide operations. Because the laws and regulations governing U.S. foreign tax credits are complex and depend, among other things, on tax treaties with foreign nations in addition to U.S. tax laws, there can be no assurance that the Company would in fact be able to take advantage of such additional tax credits.
Furthermore, the Company is from time to time engaged in routine litigation incident to the conduct of its business. The Company regularly reviews all pending litigation matters in which it is involved and, estimating the impact of such litigation matters, establishes reserves considered appropriate by management. The Company's estimates of the impact of these matters may change as the matters progress and are ultimately resolved.
10. STOCKHOLDERS' EQUITY
The Company's 1991 Stock Option Plan ("1991 Plan"), as amended, permits the granting of non-qualified stock options to key employees and consultants to purchase 5,400,000 shares of the Company's Common Stock at prices not less than 85% of the fair market value of such shares on the date the option is granted. All options outstanding at December 31, 1996 were granted at the fair market value of such shares on the grant date. The contractual life of the options are generally 10 years and vest ratably over a maximum of 5 years in minimum annual installments of 20%.
The Company's 1994 Plan allows for the granting of stock appreciation rights ("SAR's") and other forms of stock based performance awards authorized by the Compensation Committee of the board of Directors. Compensation costs for these awards are recorded based on the quoted market price of the Company's common stock at the end of the period in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. In 1992 and 1993, three key management employees were issued a total of 525,000 restricted shares of Common Stock in connection with their respective employment agreements. The employees are entitled to receive dividends, but assumption of full beneficial ownership vests ratably over five years and is contingent upon remaining in continuous employment for the vesting period. Paid-in Capital in Excess of Par Value and Unearned Compensation were recorded for the market value of the shares issued. Unearned Compensation is being amortized to compensation expense over the vesting period and is shown as a reduction of stockholders' equity. Stock based compensation costs included in the determination of income were $1.1 million, $.9 million and $4.8 million for the years ended 1994, 1995, and 1996, respectively.
The Company accounts for stock option grants in accordance with Accounting Principles Board Opinion No. 25. Had compensation cost for stock option grants been calculated using the fair value provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS 123), the Company's net earnings and earnings per share would have been reduced to the pro forma amounts indicated in the following table:
1995 1996 ----------- ----------- Net Income - as reported $19,728,000 $44,791,000 Net Income - pro forma $18,164,000 $42,054,000
Primary EPS - as reported $0.65 $1.43 Primary EPS - pro forma $0.60 $1.35
Fully Diluted EPS - as reported $0.65 $1.38 Fully Diluted EPS - pro forma $0.60 $1.30
During November, 1995, 1,460,000 options were repriced by the Company to reflect the then current stock price of $7.375. In accordance with the provisions of FAS 123, the fair value compensation cost of the vested portion of the repriced options was included in the determination of pro forma earnings for 1995. The pro forma effect on net income for 1995 and 1996 is not necessarily representative of the pro forma effect on net income for future years since the pro forma compensation costs relate only to stock options granted or repriced during 1995 and 1996.
The fair value of the stock options granted during 1995 and 1996 was determined using the Black-Scholes option pricing model and the following weighted average assumptions for 1995 and 1996, respectively: risk-free interest rates of 5.79% and 6.47%; expected option life of 3.5 years and 5.5 years; volatility of 70.52% and 77.68%; and dividend yields of 5.2%.
Summarized information related to the 1991 and 1994 Plan is as follows:
The following table summarizes information about fixed-price stock options at December 31, 1995 and 1996:
1995 1996 ------ ------ Outstanding at January 1, $12.95 $6.69 Granted $7.39 $14.96 Repriced $7.38 Exercised $2.19 $5.64 Surrendered for reprice $15.92 Canceled $14.59 $7.38 Outstanding at December 31, $6.69 $10.92
Option groups outstanding at December 31, 1996 and related option information follows:
11. OPERATIONS IN FOREIGN COUNTRIES
The following is a summary of the financial activity of the Company by geographical area:
The Company's "income from operations" consists of income before interest income and income taxes. Corporate assets consist principally of marketable securities.
12. INCOME TAXES
The components of income before income taxes were:
Year Ended December 31, -------------------------------------------------- 1994 1995 1996 ---------- ---------- ----------- Domestic $62,369,000 $29,735,000 $23,298,000 Foreign 11,275,000 1,830,000 49,533,000 ---------- ---------- ----------- $73,644,000 $31,565,000 $72,831,000 ---------- ---------- ----------- ---------- ---------- -----------
Income taxes are as follows:
Year Ended December 31, -------------------------------------------------- 1994 1995 1996 ---------- ---------- ----------- CURRENT: Foreign $4,950,000 $4,498,000 $26,349,000 Federal 25,951,000 937,000 8,774,000 State 2,167,000 29,000 2,600,000 DEFERRED: Foreign 350,000 (511,000) (3,367,000) Federal (6,007,000) 6,834,000 (5,589,000) State 205,000 50,000 (727,000) ---------- ---------- ----------- $27,616,000 $11,837,000 $28,040,000 ---------- ---------- ----------- ---------- ---------- -----------
The tax effects of temporary differences which gave rise to deferred income tax assets and liabilities are as follows:
Year Ended December 31, ------------------------------ 1995 1996 ---------- ----------- DEFERRED INCOME TAX ASSETS: Intercompany profit in inventory $4,373,000 $1,101,000 Accruals not currently deductible 3,662,000 10,909,000 Tax loss carryforwards of certain foreign subsidiaries 2,635,000 3,614,000 Deferred compensation plan 1,056,000 Less valuation allowance (2,232,000) (1,445,000) Accrued state income taxes 67,000 652,000 Other 831,000 1,532,000 ---------- ----------- $9,336,000 $17,419,000 ---------- ----------- DEFERRED INCOME TAX LIABILITIES: Depreciation/Amortization $2,031,000 $1,166,000 Payments to former partners 1,009,000 $962,000 Inventory deductibles 533,000 464,000 Deductible deferred costs 452,000 5,000 Other 215,000 43,000 ---------- ----------- $4,240,000 $2,640,000 ---------- -----------
NET $5,096,000 $14,779,000 ---------- ----------- ---------- -----------
At December 31, 1996, the Company's deferred income tax asset for tax loss carryforwards of certain foreign subsidiaries totaling $3,614,000 was reduced by a valuation allowance of $1,445,000. The tax loss carryforwards expire in varying amounts between 1997 and 2005. Realization of the tax loss carryforwards is dependent on generating sufficient taxable income prior to expiration of the loss carryforwards. Although realization is not assured, management believes it is more likely than not that the net carrying value of the tax loss carryforwards will be realized. The amount of the tax loss carryforwards that is considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced.
The tax expense differs from the "expected" income tax expense by applying the United States statutory rate of 35% as follows:
Cumulative undistributed earnings of foreign subsidiaries for which no deferred taxes have been provided approximated $16,934,000 at December 31, 1996. The additional taxes payable on the earnings of foreign subsidiaries, if remitted, would be substantially offset by U.S. tax credits for foreign taxes paid.
13. FINANCIAL INSTRUMENTS
The Company enters into forward exchange contracts in managing its foreign exchange risk on intercompany transactions and does not use the contracts for trading purposes. The Company's goal is to protect the Company from the risk that the eventual dollar net cash inflows from the intercompany transactions will be adversely affected by changes in exchange rates. At December 31, 1996, the Company had $4,000,000 in notional amounts of forward exchange contracts with short-term maturities through February 25, 1997. Gains and losses on the forward exchange contracts are recognized currently into income and, along with contract premiums, are included in marketing, distribution and administrative expenses. A summary of the forward exchange contracts as of December 31, 1996 is as follows:
The Company is exposed to credit losses in the event of nonperformance by counterparties to its foreign exchange contracts but has no off-balance-sheet credit risk of accounting loss. The Company anticipates, however, that the counterparties will be able to fully satisfy their obligations under the contracts. The Company does not obtain collateral or other security to support the foreign exchange contracts subject to credit risk but monitors the credit standing of the counterparties. The Company is required by the counterparty to provide $1,500,000 of collateral for the Company's obligations in the contracts.
14. QUARTERLY INFORMATION (UNAUDITED)
Quarterly information presented here is unaudited.
1995 1996 ------------ ------------ FIRST QUARTER ENDED MARCH 31 Retail sales $229,166,000 276,572,000 Net sales 121,613,000 146,223,000 Operating margin 52,449,000 62,539,000 Net income 6,301,000 9,220,000 Net income per common share 0.21 0.30 Dividends per share paid 0.22 0.15
SECOND QUARTER ENDED JUNE 30 Retail sales $235,396,000 $283,933,000 Net sales 124,827,000 150,255,000 Operating margin 53,499,000 65,312,000 Net income 8,055,000 10,401,000 Net income per common share 0.27 0.33 Dividends per share paid 0.22 0.15
THIRD QUARTER ENDED SEPTEMBER 30 Retail sales $201,661,000 $306,697,000 Net sales 107,257,000 160,741,000 Operating margin 45,774,000 71,363,000 Net income 335,000 11,339,000 Net income per common share 0.01 0.36 Dividends per share paid 0.15 0.15
FOURTH QUARTER ENDED DECEMBER 31 Retail sales $257,421,000 $332,941,000 Net sales 135,307,000 174,716,000 Operating margin 54,785,000 79,620,000 Net income 5,037,000 13,830,000 Net income per common share 0.17 0.42 Dividends per share paid 0.15 0.15
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized.
Dated: March 26, 1997 HERBALIFE INTERNATIONAL, INC.
TIM GERRITY By:_______________________________________ Tim Gerrity Executive Vice President, Chief Financial Officer (Principal Financial and Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
TITLE DATE
MARK HUGHES __________________________ Chairman of the Board and March 26, 1997 Mark Hughes President, Chief Executive Officer (Principal Executive Officer)
CHRISTOPHER PAIR ___________________________ Director and Executive Vice March 26, 1997 Christopher Pair President, Chief Operating Officer
MICHAEL E. ROSEN Director and Executive Vice March 26, 1997 ___________________________ President, Chief Executive, Michael E. Rosen Corporate Development/Marketing
EDWARD HALL ___________________________ Director March 26, 1997 Edward Hall
ALAN LIKER ___________________________ Director March 26, 1997 Alan Liker
CHRISTOPHER M. MINER ____________________________ Director March 26, 1997 Christopher M. Miner
HERBALIFE INTERNATIONAL, INC.
EXHIBITS TO ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED
DECEMBER 31, 1996
HERBALIFE INTERNATIONAL, INC. EXHIBIT INDEX
- -------------------------------------------------------------------------------- Exhibit Description Page Number No./(Footnote) - -------------------------------------------------------------------------------- 10.11 Amendment to Employment Agreement between the Company and David Addis dated June 29, 1993 (7) 10.12 Form of Letter Agreement between the Compensation Committee of the Board of Directors of the Company (7) and Mark Hughes 10.13 Form of Indemnity Agreement between the Company and certain officers and directors of the Company (7) 10.14 Trust Agreement among the Company, Citicorp Trust, N.A. and certain officers and directors of the (7) Company 10.15 Form of Stock Appreciation Rights Agreement between the Company and certain directors of the (7) Company 10.16 1994 Performance Based Annual Incentive (9), (12) Compensation Plan 10.17 Form of Promissory Note for Advances under the Company's 1994 Performance Based Annual Incentive (10) Compensation Plan 10.18 Employment Agreement between the Company and Chris Pair dated April 3, 1994 (8) 10.19 Deferred Compensation Agreement between the (10) Company and Michael Rosen 10.20 Office lease agreement between the Company and State Teacher's Retirement System, dated July 20, (11) 10.21 Form of stock appreciation rights agreements between the Company and certain directors of the (11) Company 10.22 The Company's Senior Executive Deferred Compensation Plan, effective January 1, 1996 (11) 10.23 The Company's Management Deferred Compensation Plan, effective January 1, 1996 (11) 10.24 Master Trust Agreement between the company and Imperial Trust Company, Inc., effective January 1, (11) 10.25 The Company's 401K Plan (11) 10.26 Agreement Concerning Share Allocation Plan for (13) Specific Directors of Herbalife of Japan K.K. dated December 30, 1996. 10.27 Consulting Agreement between David Addis and (13) Herbalife of America, Inc. Dated January 27, 1997. 21 List of subsidiaries of the Company (13) 23.1 Independent Auditors' Consent (13) 27 Financial Data Schedule (13) - -------------------------------------------------------------------------------- (1) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1987.
(2) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1989.
(3) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.
(4) ncorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.
(5) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.
(6) Incorporated by reference to the Company's definitive Proxy Statement relating to its annual meeting of shareholders held May 20, 1993.
(7) Incorporated by reference to the Company's Registration Statement on Form S-1 (No. 33-66576) declared effective by the Securities and Exchange Commission on October 8, 1993.
(8) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the three months ended June 30, 1994.
(9) Incorporated by reference to the Company's Definitive Proxy Statement relating to its 1994 Annual Meeting of Stockholders.
(10) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1994.
(11) Incorporated by reference to the company's annual Report on Form 10-K for the year ended December 31, 1995.
(12) Incorporated by reference to the Company's definitive Proxy Statement relating to its 1996 Annual Meeting of Stockholders.
(13) Filed herewith.