Seeking Alpha
Long/short equity
Profile| Send Message|
( followers)  

Yesterday, Herbalife's (NYSE:HLF) auditor KPMG resigned due to an insider trading scandal. This raises a number of interesting questions for investors on a go-forward basis.

1. Who replaces KPMG? Herbalife not only has an issue on a go-forward basis, but now must also find an auditor who is willing to sign-off on its financials since 2010. Would you want this assignment? Ernst & Young, PriceWaterhouseCoopers and Deloitte are the other major accounting firms with sterling reputations. If you were the senior partner for these firms in the L.A. office, would you take on this client?

a) The company is allegedly a pyramid scheme.

b) The potential for additional reputational downside/guilt by association is material.

c) A lot could go wrong between signing an engagement letter and the completion of historical audits.

2. What happens to Carl Icahn's strategy? Carl Icahn has taken an activist position on the long side of Herbalife's equity with a view to a potential recapitalization or take-private transaction. What reputable fiduciary would now extend Herbalife's additional credit absent audited financials? How does Herbalife add additional financial leverage to its balance sheet under the current circumstances? What hedge fund, board of directors or other "interested party" would sign-off on an acquisition/recap of Herbalife, absent a seal of approval from a reputable accounting firm?

3. Are Herbalife's financials accurate? Pershing Square has raised questions about Herbalife's revenue recognition policies. Specifically, Pershing argues that some of Herbalife's distributors so-called wholesale profits should be counted as operating expenses in the company's financials. Will a new auditor agree with Pershing Square? Will a new auditor agree with KPMG? How do we know that the KPMG partner allegedly guilty of insider trading was not also guilty of other transgressions? Is it beyond the realm of reason?

4. What about analyst coverage? Herbalife's biggest cheerleader at D.A. Davidson downgraded the stock yesterday and cut its price target in half. What responsible sell-side analyst would encourage investors to speculate on Herbalife at this point?

5. What about buy-side portfolio managers? How can responsible fiduciaries on the buy side own this name in their portfolios? How can they argue to their clients that they have confidence in the company's financial results absent a solid audit opinion? Would you take on this kind of career risk? Would you want this name in your portfolio at the end of the quarter, absent an auditor?

The resignation of Herbalife's auditor is a material event because it places the company's counterparties and stakeholders into new and uncharted territory and raises a number of new questions for investors. It is important to recognize that most agents in the Capital Markets business have fiduciary obligations that may place additional selling pressure on Herbalife's stock in the days ahead.

Q. If you were representing a client or investor, would you assign capital to this investment?

Absent audited financial results, what compelling argument might you have to do so?

Herbalife is likely a pyramid scheme. The FTC, SEC are likely examining the company.

In the interim, investors can no longer rely upon the public disclosures of the company because it is no longer audited. The knock-on effects of this disclosure are significant.

Source: 5 New Questions For Herbalife Investors