"If you're PriceWaterhouse and you're auditing the books of this company, this is a highly misleading presentation of the China business. In fact, it appears to me...they're trying to hide the fact that the China royalty expense moves in lock step with the sales in China"
-Bill Ackman, "Herbalife in China" webcast
As a disclosure right off the bat, I am not a CPA, nor am I an accounting expert. These conclusions are drawn from Herbalife's (NYSE:HLF) public filings in conjunction with Pershing Square's analysis of the company in China. I have checked and re-checked Pershing's work on this facet of the webcast and support the conclusions they've drawn wholeheartedly.
For most of this article, I'm going to be sourcing Pershing Square's recent "Herbalife in China" webcast/call from March of this year. You can view that webcast, in its entirety, by clicking here.
The presentation does well in and of itself to allege that Herbalife is definitely breaking MLM criminal laws in China.
So much of Herbalife's existence in China, which is a highly regulated MLM country, is derived on how it presents itself to the country. It presents itself not as a pure MLM model to skirt the rules, but it operates as a pure MLM model due to some cheeky financial engineering.
Inclusive of this engineering are the murky details behind how Herbalife derives its "hourly consulting pay" (hint: it's not based on hours, or consulting) and how it tucks its Chinese royalties into the company's SG&A, unlike the way it books it for every single other country. The question of whether or not Herbalife is committing accounting fraud boils down to these two items for me.
Hourly Consulting Pay
COO Rich Goudis once said that for competitive reasons, he "didn't want to disclose our compensation program" with regards to China.
Why could that be? As soon as we take a look at Hourly Consulting Pay, we start to see things that are questionable about this line item.
As I addressed in a previous article:
"Hourly Consulting Pay" is an Herbalife term, and it's the way Herbalife skirts the rules in China. It's not based on consulting, nor is it based on hours - interesting. HCP is based on commissions from downline sales and bonuses through downline sales.
By calling it "hourly consulting pay", it allows the company to publicly talk about its pay tiers without fear of recourse from the rules. HCP is a reverse engineered figure that is made up of fictional hours - it allows Herbalife to pay members for recruiting in a country that doesn't allow this by calling it something else.
Is it materially false and misleading to call this payment something that it clearly isn't and specifically for the potential purpose of eluding Chinese MLM laws?
Booking of Recruiting Rewards
Member compensation from all other countries is located in a line item called "contribution margin". For China - by itself - this number gets tucked into the SG&A for some reason.
That reason, seemingly, is to prevent people from noticing that it's moving as a fixed percentage of net sales. This is fine in other countries - it offers insight as to how much recruiting contributes to net sales. It's not illegal to post this number with regards to other countries. In China, however, this number can be reverse engineered to display that Herbalife's emphasis on recruiting falls well outside of the law in China.
Through Pershing Square's reverse engineering of how China deduces the above numbers, we find a clue that the China number is based on sales - instead of how it's purported to be based on hours worked or other parameters.
China's compensation plan doesn't seem to be any different than it is elsewhere in the world. The company seems to use the same percentages as it does in the rest of the world (royalty overrides, production bonuses, Mark Hughes Bonus, etc).
Herbalife seems to calculate China royalties as a percentage of retail sales - the same way it is doing it in the U.S. and other countries.
Herbalife is seemingly getting away with operating a pure, illegal MLM model in the country of China.
Is This Accounting Fraud?
It's certainly confusing, to begin with. Here's some questions I'll leave you with, to conclude:
- A lot of the question is to whether or not Herbalife is booking these royalties this way specifically with the intent to obfuscate. Certainly, the circumstantial evidence is pointing towards a resounding "yes".
- If Pershing can find these issues and PwC seemingly overlooked them or didn't have concern with them during the audit, what does that say about PwC's audit of the company?
- Where is PwC now that this information has come to light? These books need to be looked at again, a lot closer - PwC's reputation could potentially be at stake.
- Shouldn't the SEC be issuing a comment letter asking for a bit more information about why China expenses are booked in the manner that they are? I'd love to read Herbalife's response.
- Is the way these payouts are booked materially false and misleading?
As we move into another trading week with the news of the criminal investigation into Herbalife behind us, I encourage investors to look long and hard at Pershing's latest webcast on Herbalife's China business with regards to these allegations. It certainly left me with tons of questions I'd like to ask Herbalife.
With regards to accounting fraud, I'm going to leave that one up to the SEC - I'll be waiting with bated breath to hear whether or not they'll weigh in on this aspect of Herbalife's business.
Investment thesis: Yet more questions piling up about Herbalife as momentum is seemingly shifting towards the bears on this one - the evidence continues to be overwhelming. I continue to contend that Herbalife is a worldwide confidence game that will ultimately be shut down by regulators.
Disclosure: I am short HLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.