Every time I read a penny stock dismantling by someone like Alan Brochstein or Ashraf Eassa, there's many common factors that I can synthesize with how Herbalife (HLF) seems to be conducting its day-to-day operations in the midst of the battle the company is in. In yet another effort to share with investors exactly what creeps me out about Herbalife, I went down the list and found 5 ways that Herbalife reminds me of a shoddy penny stock operation.
1. A Flurry of Fluffy Press Releases, Potentially to Focus on Recruiters from Certain Areas
Lots of penny stocks that SA contributors point out are fueled by press releases that don't hold any material information - they're simply promotional. The stock is driven by press releases, versus being driven by company fundamentals.
Herbalife has put out a number of press releases over the last 6 months that hold no major fundamental value to the underlying aspects of the business or allegations that the company is a pyramid scheme. If my company was accused of being a scheme, the only thing I would focus on would be proving the allegations false through fundamentals and metrics.
Not only does Herbalife's litany of PRs not have anything to do with answering fundamental business questions regarding potentially being a pyramid scheme, it's a direct nod to all of the communities & countries that the company is trying to recruit from:
Herbalife's press releases go to show exactly how much focus the company has on expansion into other countries. Why? That's where "the rest" of the people are. After all, this is the company trying to sell weight loss products in Cambodia!
Ever ask yourself: why are all the nutritional weight loss clubs going in across the street from soup kitchens?
2. Hiding Extremely Important Fundamentals
Penny stocks rarely give the fundamentals that they don't want to hand out until it's quarterly report time. Many shady penny stocks boost business by pushing everything but the fundamentals and hiding as much behind the scenes as possible. Less transparency, less chance for people to catch on.
If Herbalife was a legitimate company, there would be one business metric, where if answered truthfully and honestly, would almost completely disprove Bill Ackman's thesis and validate all of Herbalife. That business metric is the amount of Herbalife product sold within distributorships versus the amount sold to retail that are not distributors, "members", or whatever Herbalife's filings are calling their salespeople this quarter.
It's actually really simple.
If Herbalife sells more to in-network people than outside, it's a pyramid scheme. If not, Herbalife receives validation.
Over a year since Ackman's original thesis pointed this out, and Herbalife has done well to give investors everything - from major investors, to a buyback, to audited financials - that is everything but the answer to this extremely important and relevant question.
So, where's the beef?
Let's see what I've pointed out in some past articles about what the company has publicly said with regards to these metrics.
This was the original inquiry from David Einhorn that took place almost two years ago now and the company's corresponding response:
We have no freaking idea, but we hope to god it's more than 70%.
As Ackman pointed out in his last presentation in November, companies like Tupperware have extremely firm grasps on these numbers with Tupperware's COO reporting them to management weekly. Herbalife, however, not only doesn't have the data, but seems to be dancing around a finite answer for the company with regards to this question.
This is when Herbalife changed Des Walsh's answer for the public filing - which in and of itself is a shady move worthy of a penny scam:
After Ackman's original thesis in December 2012, CEO Michael Johnson, sounding like he was phoning in while running the New York marathon, flailed aimlessly while CNBC bounced questions off of him on live TV with regards to this. At a later date, Johnson would say he was "hyped up" that day. To me, he just sounded furious - with no one to blame for this line of questioning but his own company.
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And then, in true boner fashion, Johnson comes back onto CNBC 22 days later to amend his previous answer, now saying 90% of distributors are buying the product for themselves, which is almost the complete opposite of selling 90% "outside that distribution network".
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Why now, when this has been a point of contention for years, can we still not get an answer to this question? Originally raised in May of 2012, and we are now into February 2014 without any additional information on this absolutely crucial company metric that - read this slowly - has the potential to make or break the shorts argument against the company.
Don't you think if Herbalife had the "right" answer, they'd be screaming it from rooftops? Instead, we've gotten everything but this answer.
3. Herbalife Attacking Shorts/Critics
One thing you often see penny stocks do is go after people that speak critically about the company. Sometimes they send C&D letters, SLAPP lawsuits, or suits alleging libel. The reason is because most penny stock companies are more focused on their image than they are their fundamentals. They're driven by the perception of their business, versus the actual fundamentals of their business.
Most big board companies with major short interests simply let their business execution do the talking.
Herbalife seems scared of shorts - so they attack. Bank of America is a perfect example of this. Someone was just pointing this out, but I can't remember where I read it. Bank of America CEO Brian Moynihan stayed on Q&A during a recent conference call answering from all analysts - bearish and bullish - for two hours, until the queue was empty. Herbalife, since the Einhorn incident, doesn't let bears like Ackman or those of the like on the call. Bank of America isn't afraid of questions - why is Herbalife? What are they afraid someone might ask?
Herbalife, instead of focusing on business, went on the offensive and tried to get Ackman's clients to leave his fund. I wrote about this in a previous article, the day it was reported:
Certainly an interesting move, this is. However, it's not new territory for Bill Ackman who, when he was shorting MBIA was public enemy number one, and had to endure skeptics, lawyers, regulatory agency depositions, and all other types of pushback. With MBIA, it even got to the point where Ackman had to hire personal security.
In the spirit of being contrarian, this move from Herbalife seems like they may actually be tipping their hand a bit and acknowledging that things may not be going well under the surface.
Rather than waste time, money and resources "going on the offensive", why would they not implement the same type of aggression in:
- finalizing audited financial statements?
- implementing a retail sales tracking program?
- working on consistent IR/disclosures with regards to how they answer questions about retail sales?
- addressing the concerns of an open SEC Enforcement Division case?
The question remains: if Ackman isn't a threat to the company, is producing misleading information and Herbalife has nothing to worry about - why go after him? Why not simply conduct business as usual and let the cards fall as they may?
Herbalife's move was discussed on Bloomberg, and you can hear some of the excerpts from the analysts here.
Some of the quotes from the analysis:
- "It doesn't sit well with me...you have time to attack Ackman"
- "Earnings have slid down, they should have better things to do than harass [Ackman]"
- "They have a real credibility issue and they're not addressing that."
- "A move like this by Herbalife makes it feel like they're at war."
- "You've got a multi billion dollar company to run - why don't you go do that?"
4. No Access to Top Tier Financing
Lots of penny stocks don't have access to big time capital. They either don't have enough assets on their books to take on something secured or do a bond issue, or they don't have the fundamentals or clout necessary to warrant anything other than equity for a discount or convertibles, both leaving the financier an emergency exit in the deal if they short against their bet (or convert).
Matt Stewart raises some interesting questions in his last couple of articles. Namely, why didn't Herbalife have access to capital means that were a bit more top-tier than convertible debt? From Matt's most recent writeup on Herbalife:
Convertible debt gives bondholders a unique ability to hedge their position. Because of the conversion option embedded in the note, bondholders can immunize themselves against downside risk by shorting HLF common (in this case, by way of a forward contract/swap). It strikes me as obvious that HLF was unable to raise new debt without offering investors downside protection. Hence, the convertible.
Why would investors want downside protection against capital loss for a company that gushes so much cashflow?
Perhaps concerns over the legitimacy of Mr. Ackman's pyramid scheme thesis have some gravitas?
Consider too the additional expense of the conversion option. Notwithstanding the fact that this note has a 2% yield, there are extra costs layered into this deal. For starters, the capped call contracts are a cost, then there are the underwriting fees, and finally, there is the inevitable redilution to equity holders 5 years hence if the stock trades materially higher. As a short, of course, this does not worry me too much.
If you don't know anything about types of debt, just know that the last two major companies I've seen take on convertibles were J.C. Penney (JCP) and BlackBerry (BBRY) - two companies fighting for their lives.
Herb Greenberg (@herbgreenberg) seems to find Herbalife's recent financing just as interesting as Matt and I.
The consensus between myself, guys like Matt and CNBC's own Herb Greenberg is that no bank will lend Herbalife money without having a "quick exit" plan. Why?
Whether the market feels the same way, we'll see in the coming days.
5. Cult Like Support With No Grasp On Underlying Fundamentals
People that invest in penny stocks generally don't have much of a clue as to what they're doing. They don't grasp the fundamentals of how the market values the business, and they drink whatever "kool aid" the company is selling them.
In this case, Herbalife is like a penny stock too. The hoards of rabid longs seem to be so far on the other end of the scale and hell bent on vehemently defending the company - as you're likely to witness in the comments section of my articles and my Twitter account.
When Herbalife's model is questioned, the name calling and vitriol comes of our its supporters. I've recently written this approach is likely to signal that the shorts are onto something. The name calling, in my experience, comes out when there's no facts to back up the argument.
As someone that once wrote a thesis paper on religions and cults (which I won't get into in depth), there's some major similarities that both of these situations seem to share. Both sets of members seem:
- blind to the obvious - in this case, that it's a scheme.
- to have unconditional loyalty to the brand, regardless of what it provides them in return.
- not to notice that the guy in charge is the one making all of the "real" money (Herbalife insider selling by execs).
The conclusion here is that Herbalife continues to remain a risk, even after the recent news of its financing and buyback. The market seems to be understanding this - it's keeping Herbalife's valuation roped in today after the stock ran hard into close yesterday.
I covered my equity short yesterday, expecting to see Herbalife push through $70 today on the buyback news. Instead, the market is showing us that it's taking the news with a hint of skepticism on a day where the Dow is trying to bounce a bit from yesterday's shellacking. I added puts today again, and continue to be bearish long-term on Herbalife.
Best of luck to all investors.