Shares in Herbalife (HLF) had a bad week. It started on a high note when the company released its earnings that soundly beat expectations, but the popup in a stock price lasted only 30 minutes. It was all downhill from there. Three factors contributed to this decline.
First, the audited financial statements have not been released. Herbalife hired PricewaterhouseCooper to re-audit its statements after its previous auditor KPMG had to resign in the wake of an insider-trading scandal. The company said back in July that it expects the process to be completed by the end of the year, but some analysts hoped that the results will be announced earlier. Now the company's CFO cautions investors that they may have to wait a bit longer:
Well it's our expectation that it will be complete by year end but it's not done till it's done.
It seems more and more likely that the re-audited financials will be released at the end of January, when the company reports its annual results. This delay is a cause of concern for investors, because Carl Icahn, who owns 16% of the company, has agreed not to sell any shares until the end of February 2014. Icahn is sitting on very substantial gains, and he may be tempted to realize his profits. The problem is that Icahn's stake is worth more than a billion dollars even after the stock price declined in October. Selling so many shares quickly without driving their price further down is nearly impossible - unless there is another large buyer willing to step in.
Icahn hoped, no doubt, that this buyer will be Pershing Square, a hedge fund with a massive short position in Herbalife shares, or the company itself. Pershing Square, however, replaced 40% of borrowed shares with long-term puts. This maneuver reduced the possibility of a short-squeeze - a situation when short-sellers are forced to buy shares on the market to cover their positions. Now a delay in the audit process leaves the company with a very narrow window to line up the financing for a share buyback before a standstill agreement with Icahn expires.
A clean bill of health from the auditors is a major hurdle that the company needs to clear before it can talk to bankers about borrowing $1-2 billion for share repurchases. There is a possibility that the company may be forced to restate its financials for the prior periods. Some investors, like Soros Fund Management that owns 5% of Herbalife, may decide to lock-in their profits before the audited results are released, and before Carl Icahn gets a chance to start selling his massive stake.
I believe that many investors overestimate the capacity of Herbalife to borrow money. The latest quarterly results did not change the situation much: the net tangible assets of the company increased only by $22 million, less than 0.35% of its market cap, after the company spent $110 million buying its own shares during the quarter. The company may continue to spend $100-120 million on share buybacks per quarter, but this is not enough to offset the selling pressure if Icahn and/or Soros decide to liquidate their positions soon. Note that, unlike Icahn, Soros is not required to report any sales of Herbalife stocks, so we do not know yet if Soros sold any shares in October.
The announcement by Bill Ackman, who runs Pershing Square hedge fund, was the second reason for the decline in Herbalife share price this week. Ackman promised to reveal more information on Herbalife during the investment conference on November 21-22. Some observers believe that Ackman did not disclose this information right away because it is not very damaging. Whether it is true or not, Ackman's move created additional uncertainty for Herbalife investors. Most investors sit on good paper profits and may decide to close or reduce their positions before the new information is released.
Finally, the results for the last quarter were not as impressive as they sound. Sales increased 22.2% and earnings grew by 26.8% compared to a year ago period. Sequentially, however, both sales and profits were slightly lower, and the consensus estimate for the next year now calls for a moderate 10% growth in revenues and earnings.
The company beat the expectations for the 19th time, which is statistically implausible. Most public companies in the U.S. try to "manage" expectations of analysts who follow their stocks. This is why companies beat estimates more often than they miss them. Herbalife brought this process to the whole new level: even if the probability of beating estimates in any quarter is 80% (higher than the average for S&P 500), the chances of doing it 19 times in a row are less than 1.5%. In other words, there is a 98.5% probability that either analysts following Herbalife are exceptionally gullible and incompetent, or the company complements managing expectations with the accounting tricks. For example, the latest results were helped by a significant reduction in the effective tax rate. Here is how the company explained it in the SEC filing:
The decrease in the effective tax rate for the three and nine months ended September 30, 2013, as compared to the same periods in 2012, was primarily due to an increase of net benefits from discrete events, principally related to the expiration of statute of limitations related to certain tax contingencies and tax planning items related to certain income tax return filings, partially offset by the impact of changes in the geographic mix of the Company's income.
Crystal clear, isn't it? As a side note, I might observe that the effective tax rate of 24% is unusually low for a company that has been consistently profitable for many years. Another observation is that the company needs to show maximum profits this year - it is a major metric that banks will look at when deciding on the size and terms of the debt they are willing to extend to Herbalife for share buybacks. I have no doubts that the company will find a way to beat the expectations for the fourth quarter as well - analysts barely moved their estimates after the company surprised them last Tuesday.
An unpleasant by-product of always beating the estimates is that no one cares anymore. It's stopped being news, and the stock responded accordingly.
I believe that the stock may continue to drift lower and sideways for the next few weeks. Ackman's presentation at the end of November may act as a catalyst for a significant price move, but it's hard to predict which way until we hear what Ackman has to say. We are likely to see an increased volatility in January. On the one hand, we may see investors reducing their exposure in case the audited results disappoint, taking profits in the new tax year, or trying to jump off the wagon before Carl Icahn. And, of course, the possibility of a government intervention continues to cast a shadow over the company. On the other hand, a pullback in prices may entice more investors to buy shares in anticipation of the promised buyback.
I continue to recommend that individual investors stay away from or reduce their exposure to Herbalife.
The stock fell more than 13% since I initiated my position, and put options delivered an even better performance. I see a good chance of further declines. The risks, however, are increasing for both long and short positions, and it is wise to book some profits now.