What’s Really Driving the Herbalife Surge? (Hint: Forget About Value Investing)
Billionaires, corrupt auditors, short selling, a Congressional inquiry; the market really can’t get any worse than this. Or can it?
Recent share price volatility for Herbalife is a potent example of how big share gains and losses are less, these days, about the financial information a company discloses and whether you can trust it and more about who’s willing to place a bet, for how long, and for how much.
In the last two years, Herbalife Ltd. (HLF: NYSE) shares have had more spine-tingling ascents and chilling free-falls than Cedar Point’s Top Thrill Dragster roller coaster.
Last Monday, legendary hedge fund investor George Soros made a big “long” or buy bet on Herbalife, joining the iconic Carl Icahn. Soros and Icahn can’t possibly justify these investments based on a thorough vetting of the company’s financial disclosures. Why not?
Icahn’s and Soros’ trades aren’t driven by real audited numbers. Herbalife’s numbers for the last three years and the most recent 10-Qs are now unreviewed and unaudited by an independent certified public accounting firm after the scandalous resignation of auditor KPMG in April because of insider trading by its partner in charge. In other words, all bets on financial reporting integrity and completeness are off. Icahn and Soros are simply swinging big sticks to move the market their way.
Maybe Soros and Icahn just want to bet against William Ackman, the head of hedge fund Pershing Square who holds a 20 million shares short position. That’s primal enough. Ackman’s trade, a gutsy move too, required selling borrowed shares on the expectation that the price would fall and the borrowed shares could be repaid with cheaper ones. That’s a $1 billion bet that is based on fundamental beliefs— Ackman feels strongly that Herbalife is a pyramid scheme, a fraud that investors will soon abandon and regulators will eventually shut down. Herbalife says it spent approximately $15.1 million after-tax in the first six months of 2013 to respond to Ackman’s allegations.
In the meantime, Icahn’s and now Soros’ investment pushed the stock price higher and made it hundreds of millions more expensive for Ackman to unwind his trade, assuming he has not already begun to reverse course.
Herbalife is “unable, without unreasonable effort or expense”, to file a complete Form 10-Q for the quarter ending June 30, 2013 with the Securities and Exchange Commission. Herbalife is “deficient” according to the SEC because it is not filing timely financial information that has been reviewed by a certified public accountant. Herbalife’s auditors KPMG resigned on April 8, 2013 because the firm was no longer independent. KPMG former partner Scott London, who until April 5, 2013 was the KPMG engagement partner in charge of the Herbalife audit, plead guilty to criminal charges of passing confidential information to a friend about Herbalife, Skechers, and three other clients .
The kicker for Herbalife, and anyone who counts on some integrity in Herbalife’s financial information and disclosures, is that when KPMG was forced to withdraw its audit reports and opinions the auditor said those reports should no longer be relied by investors.
Herbalife’s CEO and CFO told analysts and investors on its most recent earnings call that the second quarter 10Q was filed without new auditor PwC’s review and without therequired Sarbanes-Oxley Section 906 certification of all financial disclosures.
PwC has to re-audit three prior years and review all the 10-Qs before the SEC or investors have financial information that can be trusted again. Herbalife expects that to happen by the end of the year. Of course, Herbalife executives and its audit committee, the one that hired and was supposed to be keeping an eye on KPMG inside trader Scott London, assure you that “the financial statements covering the referenced periods fairly present in all material respects the financial condition and results of operations of the company as of the end of and for the reference period, and they continue to be relied upon, and that the company’s internal controls over financial reporting was effective during these periods.”
Herbalife is confident of its ability to put together its financial information without new auditor PwC’s review, even after finding out its prior auditor was corrupt and even though a successful investor has made serious accusations about its business model being a fraud. Herbalife went ahead and prepared the 10Q and, for kicks, even did a “revision” restatement to correct some “errors” in the prior three years of balance sheets. A “revision restatement”, according to research firm Audit Analytics, is one that’s included in a periodic report without a prior disclosure in Item 4.02 of an 8-K. Thus, it doesn’t undermine reliance on past financial statements and is less disruptive, meaning the stock price doesn’t suddenly and precipitously drop because you’ve admitted that prior financials were all wrong perhaps due to a big error or accounting manipulation.
In early July the SEC announced the reestablishment of an Accounting Fraud Task Force that would focus specifically on, “identifying and exploring areas susceptible to fraudulent financial reporting, including on-going review of financial statement restatements and revisions…” Former SEC Director of Enforcement Robert Khuzami claimed to me, in my November Forbes magazine article, that fewer restatements meant less accounting fraud and, therefore, less need to prosecute audit firms and auditors. However, Audit Analytics wrote that “revision restatements” were 64.69% of the restatements disclosed in 2012. This figure is the highest percentage since 2005 (the first full year the 8-K disclosure requirement was in effect).”
Herbalife fixed $20 million of “errors” worth the company says relate to income tax expenses calculated on intercompany inventory transactions. The “errors” affected the interim period ended June 30, 2013 and the interim periods within and annual periods ended December 31, 2012, 2011 and 2010. Can a company be wrong about classifying such adjustments as “errors” rather than admitting they’re something more serious?
In 2010 Green Mountain, which sells Keurig brewers and K-Cups, found an “immaterial accounting error” in the “inter-company markup in its K-Cup inventory balance” that was fixed with a “revision” in one quarter. Auditor PwC agreed with that approach. Then the SEC raised questions and Green Mountain had to restate earnings from 2007 through the third quarter of fiscal 2010 to address that and more errors. PwC retroactively cited a material weaknesses in Green Mountain’s internal controls but then said they had already been fixed. The SEC is still investigating.
According to the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School, early in the twentieth century investors were guided mostly by speculation and insider information. Professor Benjamin Graham and Professor David Dodd believed, however, that “the true value of a stock could be determined through research.” Graham and Dodd gave the world a rational way to invest.
In June the Wall Street Journal’s MoneyBeat reminded us of a comment from D.A. Davidson analyst Tim Ramey from January. According to Ramey, it may have been the “mother of all short squeezes”, not fundamentals, fueling Herbalife Ltd.’s bounce off its Christmas Eve low. Ramey believed that “the short thesis has been thoroughly discredited” as a result. “Even on a day such as today, when a congresswoman asks the FTC to investigate Herbalife as a pyramid scheme, the shares are up.”
In the latest Herbalife short-squeeze, Soros’ investment pushed the stock up more than 9% in one day and up 99% for 2013, more than 170% since its bottom on Christmas Eve.
Graham and Dodd must be turning in their graves.
