Sunshine is the best disinfectant.
- Justice Louis Brandeis
And it’s on that note that Pershing Square Capital Management ended its presentation on why Herbalife is a pyramid scheme titled “Who Wants to Be a Millionaire?” Given this forum’s devotion to financial reporting transparency and ethical reporting, how could you expect me NOT to weigh in on Herbalife’s disclosures, particularly given the recent televised fight between Bill Ackman and Carl Icahn. So, exactly what do the Company’s financial statements tell us?
Incentives and Reporting
My review of Herbalife’s most recently audited 10-K (fiscal year ended December 31, 2011) yielded some interesting points both positive and negative in terms of openness and transparency. As usual, I began by evaluating the Company’s possible incentives to misreport (e.g., overstate operating performance). Yes, Herbalife suffers from the usual performance pressures to meet operating targets imposed by debt contracts (see covenants in 2011 10-K, page 40). And the fact that the Company’s five year total return has greatly exceeded that of its peer group and the S&P 500 index the past several years no doubt creates market expectations and performance pressures. Yet, Herbalife didn’t play any of the traditional pro-forma reporting games (i.e., adjusted EBITDA) in its 2011 10-K. It didn’t need to given its steadily improving gross profits, contribution margins, operating and net income (10-K, page 57). However, the Company does report extensively using a non-GAAP “retail sales” metric which it touts as playing a “fundamental role in our compensations systems, internal controls and operations (10-K, page 55).” In short, there do not appear to be significant performance pressures which might prompt aggressive financial reporting behaviors.
Next, I read the 10-K looking for any management and control red flags that might suggest an environment ripe for aggressive reporting. Yes, management wealth is tied to company performance via stock-based compensation, but the amounts are not deemed excessive. Also, according to Audit Analytics, an independent research provider, Herbalife’s internal controls over financial reporting were considered effective each year from 2004 through 2011. Moreover, the Company did not restate its financial statements to correct any reporting errors during the same time period. On a totally unrelated note, it was quite refreshing to see Herbalife actually admit that debt is being used to fund share repurchases and dividends (10-K, page 71). While often true, most companies do not put this in print. So, there is little to suggest that management and internal control factors might promote aggressive reporting.
Finally, I searched the 2011 10-K for any industry or market structure factors that might affect the quality of Herbalife’s financial reporting. But frankly, there just weren’t any of the usual suspects (e.g., rapid or declining industry changes, new technologies or accounting, etc.). The only industry factor of any consequence noted was not a surprise. Herbalife disclosed its regulatory risks associated with running a network marketing program, specifically mentioning “pyramid” or “chain sale” schemes (10-K, page 32). It just doesn’t get any clearer than this:
The failure of our network marketing program to comply with current or newly adopted regulations could negatively impact our business in a particular market or in general.
In summary, I just didn’t find that many performance, management control, or industry pressures that might prompt the Company to misreport. That being said, I actually started to crunch a few numbers to validate my observations.
Risk Model Analysis
I began with an old grumpy favorite, the Beneish Model, to detect any signs of possible earnings manipulation. Despite the Company’s asset and sales growth, the model did not signal earnings manipulation, yielding probabilities of less than two percent for financial statement years 2008 through 2011.
Next, I ran a panel of five other tests (the quality of earnings and revenues ratios, the Sloan accrual measure, the excess cash margin metric, and the conservatism ratio) in a search for possible red flags. Again, the tests proved negative. Simply put, the financial statements do not signal accounting problems related to revenue recognition (e.g., accruals, etc.), nor do they suggest any cash reporting issues. And while I’m on the topic of cash, I was pleasantly surprised by Herbalife’s cash disclosures (10-K, page 101). Herbalife gets a star in my book for reporting credit card receivables as actual receivables, and NOT as cash, like so many other companies are doing today (see What’s Up With Cash Balances). Also, the Company should be commended for reporting any cash overdrafts as financing activities, rather than operating activities. But enough with the complements, nobody is perfect!
Financial Statement Issues
With almost three weeks left until Herbalife reports its full-year, audited results for FYE 2012 (see press release dated January 17, 2013), here are a few things the Company and its auditors might want to consider.
First, the percentage of the allowance for bad debts to gross receivables has declined from almost 5 percent in 2009 to 2.45 percent in 2011. Although I am not particularly happy about this, it could be due to the percentage of credit card receivables increasing from 53.62 to 70.83 percent during the same period. Then, there is inventory which grew significantly in 2011 by 35.7 percent. Unfortunately, inventory turnover slowed from 9.173 in 2008 to 8.117 in 2011. Complicating the analysis is that Herbalife for some reason stopped reporting data on reserves for inventory obsolescence in 2011, as it did in prior years (see 10-K’s for FYE 2007 and FYE 2010).
The assets causing me most concern are Herbalife’s intangibles: goodwill and marketing related intangibles. These assets in total comprise almost 29 percent of the Company’s balance sheet at FYE 2011. It is noteworthy that the reported asset values have remained relatively unchanged since they were first reported in FYE 2004. FYE 2011 disclosures provide absolutely no insight as to what these assets represent, or when these intangibles originated. Only a review of the FYE 2004 10-K tells us that the bulk of the intangibles originated with the 2002 merger of WH Acquisition into Herbalife International. But still, there is no information on exactly what the sizable marketing intangible represents. Also, in its FYE 2011 10-0K, the Company doesn’t even bother with a specific intangible asset note, preferring instead to discuss intangibles within its accounting policy notes…interesting. Why do I care about this? Intangible impairment may be lurking.
Some of you will no doubt argue that net earnings and operating cash flows are strong and increasing, as are market capitalization, and the related market to book ratios. Nothing there signals impairment, right? Well, here are a few things to consider. First, Herbalife freely acknowledges a relatively high turnover in its distributor customers (e.g., sale leader retention rates of approximately 50 percent, FYE 2011 10-K, page 54). Additionally, and more problematic, is what the Company’s “pop and drop” business model might tell us about the value of reported intangibles. Slides 251 through 256, as well as slide 260 of the “Who Wants to Be a Millionaire?” presentation appear to confirm a lack of customer loyalty and/or marketing effectiveness in mature markets. So, given the documented “pop and drop” cycles of Herbalife’s business model, isn’t it likely that the intangible assets recorded in 2004 should have been written off in the subsequent three to five year period? Recent earnings and cash flows might simply reflect the “pop” provided by new markets, rather than revenue and cash streams related to the 2004 intangibles. This grumpy old accountant sees a problem here, and the paucity of intangible asset disclosures raises some red flags in my book.
And then there are the leases…the off-balance sheet financing! Herbalife reports that it leases ALL physical properties on page 45 of the FYE 2011 10-K. Of course you remember how the grumpies feel about lease accounting. See CVS Caremark: Why Operating Leases Must Be Capitalized. So, using the data in note 5 of the FYE 2011 10K, I made the following assumptions to estimate Herbalife’s off-balance sheet lease liability:
- Discount rate of 5 percent based on an approximation of Herbalife’s borrowing cost.
- Thereafter lease obligations occur equally over the remaining 5 years.
- Tax effects are ignored.
Even with these “crude” assumptions, the Company’s estimated unrecorded lease liability approximates $140 million, which represents 9.7 percent of total assets at FYE 2011. And the liability to assets ratio jumps from 61.3 to 70.9 percent when the unrecorded lease obligations are considered. But GAAP is what it is…and, if anything, Herbalife is GAAP compliant when it comes to leases.
Finally, I do have a couple of complaints about Herbalife’s income statement presentations. Yes, I have the usual issues about “cash flow hedge” accounting and other comprehensive income reporting. But what troubles me more is the Company’s highly aggregated income statement. Financial reporting transparency would be improved if revenues were disaggregated to highlight product returns, distributor allowances, shipping and handling revenues, and product returns and allowances. Additionally, there is little or no detail on Selling, General, and Administrative expenses in the income statement or notes. And as pointed out by Pershing Square Capital Management on slide 301 of its presentation, the Company no longer reports shipping and handling costs (in FYE 2011), despite reporting them for 2008 through 2010.
So, is Herbalife a pyramid scheme? Well, if it is, the GAAP financials don’t really appear to signal it, nor does the auditor. This suggests to me that the recent uproar in the markets may be less about the Company’s financial condition, and more about Herbalife’s business model, not to mention the ego. If I were the Company’s financial physician, I would tell it:
You look healthy, but I don’t necessarily agree with your life style.
And by the way, In Herbalife’s case, the financial statements may be masking some longer-term health risks, particularly if regulatory authorities make the Company re-engineer its way of doing business.
This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.