Herbalife (NYSE:HLF) changed the exchange rate at which it values its Bolivar-denominated assets and liabilities from 6.3x to 10.7x on 3/31/14. Unfortunately, a better proxy for the fair value of Bolivars per US dollar is 50x, as demonstrated by Brazil's central bank's website. (And even this might be a generous assumption).
It appears Herbalife is holding out hope that 10.7x might one day be a real fair value exchange rate, despite:
- The fact that SICAD II is 50x as of April 28th
- The company exchanged 5.3mm Bolivars for $0.1mm in Q1 (a 56.2x exchange rate), and
- Inflation is Venezuela remains rampant
Notably, had Herbalife marked its Bolivars to the SICAD II rate for its March 31st books, GAAP EPS in Q1 would have been ~ZERO.
The math on that is:
$74.6mm of GAAP net income
LESS: $99.3mm incremental EBIT loss at SICAD II (per the 10-Q)
PLUS: $25.2mm tax benefit associated with the Venezuela loss (a 25.4% effective tax rate, which is consistent with the VZ-specific tax rate in the Q1 press release)
EQUALS: $0.5mm (effectively, zero)
According to the 10-Q, the company's effective tax rate increased in Q1 "primarily due to the inability to fully realize a tax benefit relating to Herbalife Venezuela's foreign exchange losses." That makes sense, but I'd argue that assuming a 25.4% tax benefit on the Venezuela loss is too optimistic.
Why? In Q1, the company reported that net sales in Venezuela increased 5.4% on the heels of a 123% price increase. The math on that suggests that volume declined 53% in Venezuela in Q1. That doesn't bode well for Herbalife's ability to utilize tax benefits in Venezuela going forward.
Had Herbalife assumed a lower tax benefit associated with its Venezuelan currency losses and marked its Venezuela assets to a more realistic proxy of fair market value (SICAD II), Herbalife's reported Q1 GAAP EPS would have been negative.
Herbalife's Reported Cash Flow
According to the Q1 press release, "the company generated cash flow from operations of $190.6 million, an increase of 39% compared to 2013."
However, this doesn't adjust for that pesky "EFFECT OF EXCHANGE RATE CHANGES ON CASH" below-the-line entry on Herbalife's cash flow statement. Below-the-line, in-the-line, above-the-line, it's a real adjustment, and it has a real impact on the reported cash on the company's balance sheet.
Most of this adjustment relates to the devaluation of the Venezuelan currency in Q1. If this were a one-time adjustment, the comparison of the $191mm to $138mm of cash flow in Q1'14 vs. Q1'13 might be appropriate.
Another way to look at it would be to assume the devaluations that occurred in Q1'13 and in Q1'14 are recurring adjustments. This is because the 3/31/14 exchange rate used to mark Herbalife's books of 10.7x is still nearly 80% below fair market value (as measured by SICAD II). There was an adjustment in Q1'13, there was an adjustment in Q1'14, and there will be more adjustments going forward.
With this perspective, comparing Q1'14 to Q1'13 cash flow from operations (and adjusting for exchange rate changes) suggests Herbalife's cash flow declined from $121mm to $90mm, or a decrease of 25%.
Herbalife Cancels its Dividend
You have to give the company credit, only a Herbalife press release would spin the cancellation of a dividend as a positive for shareholders.
If you look at the change in Herbalife's cash at its parent and US subs (where cash needs to be domiciled for the company to repurchase shares / issue dividends), it increased in Q1'14 in lock-step with reported cash flows from financing activities (i.e. debt issuance net of dividends / repurchases)
- Net cash provided by financing activities was $260.3mm in Q1'14
- Cash at Herbalife's parent and US subs increased $259.1mm in Q1'14 ($664.7mm as of 3/31/14 less $405.6mm as of 12/31/13)
This suggests that the cash flow the company generated from operations and investing occurred outside of Herbalife's US subsidiaries in Q1.
Doing some math on the parent company / US subs' obligations for the remainder of 2014 provides a counter-perspective on why Herbalife cancelled its dividend:
$665mm of cash as of 3/31
LESS: $255 of April share repurchases already consummated
LESS: $60mm of remaining April share repurchases
LESS: $50mm of remaining share repurchases per the company's previous guidance
LESS: $126mm of remaining capex (per the midpoint of the company's guidance, this capex primarily relates to the Winston-Salem facility)
Had the company retained its prior dividend policy, it would have needed $216mm to fund its quarterly cash dividends over the next eight quarters (as noted in the Q1 press release).
In other words, the company may have cut its dividend to ensure its parent company and US subs would have enough cash to meet pre-existing share repurchase guidance and US capex commitments without having to take on incremental debt or repatriating monies from Herbalife's foreign subsidiaries to fund its dividend.
It is also worth noting that as of 3/31/14, Herbalife's Tangible Book Value (TBV) went from positive to negative. Deducting $105mm of goodwill and $310mm of trademark from reported 3/31/14 shareholders' equity of $42mm results in a TBV of negative ($3.81) per share.
And adjusting Herbalife's 3/31/14 shareholders' equity for the $255mm share repurchase implies that Book Value is now negative as well.
According to the Company's 2013 10-K (emphasis added), "The declaration of future dividends is subject to the discretion of the Company's board of directors, and will depend on various factors, including its earnings, financial condition, Herbalife Ltd.'s available distributable reserves under Cayman Islands law, restrictions imposed by the Credit Facility and the terms of any other indebtedness that may be outstanding, cash requirements, future prospects and other factors deemed relevant by its board of directors."
Is it possible that, given that Herbalife now has negative book value, the company lacks sufficient "distributable reserves" to continue its dividend policy?
Various red flags in Herbalife's Q1'14 results suggest the business could be headed for a slowdown:
- Herbalife's reported retention rate in 2014 was 51.8%, which is flat with 2013 (ex China). However, the 10-Q also notes that "We chose not to require Venezuelan sales leaders to re-qualify in 2014 due to product supply limitation that may have prevented some sales leaders from re-qualifying." This suggests that had Herbalife's Venezuelan re-qualification not been 100%, the consolidated retention rate actually would have declined vs. 2013.
- New sales leaders in January & February declined 11.1% as compared to 2013 (37.1k in Jan/Feb 2013 vs. 33.0k in Jan/Feb 2014). New sales leaders are a critical leading indicator for Herbalife's future sales growth.
- Net sales decreased 16.8% in Taiwan in Q1'14 (constant currency). The company attributes part of this decrease to "a first order limitation rule which limits the amount of product a new Member may order after initially signing up" instituted by Taiwan in November 2013.
Investors should ask: why would a "first order" limitation impact sales so much? Isn't the majority of sales from pre-existing sales leaders / members who order the product on a recurring basis because they love it so much? What would happen to Herbalife's sales if other countries follow Taiwan's lead and implement similar policies?
- Net sales decreased 42.9% in Malaysia in Q1'14 (constant currency). The company attributes this decline to a new competitor who entered Malaysia in October of 2013. Investors should ask: How could a new competitor have such a drastic impact on Herbalife's business in such a short time frame? Who was this new competitor (was it another nutrition powder company like Slim-Fast, or was it an MLM)? What does a 43% sales decline say about the product loyalty of Herbalife's Malaysian customers? Given the lack of barriers of entry in this industry, is the company worried about a similar dynamic occurring in other markets?
- Herbalife is coming under increased tax scrutiny in foreign jurisdictions. Herbalife's 10-Q provides new disclosure that (i) the Mexican Tax Administration Service has requested information related to the Company's 2010 year, and (ii) the Federal Revenue Office of Brazil notified the company on March 6, 2014 that it will be performing a tax assessment related to the company's 2011 year. The amount of the Brazilian assessment for 2004 was only $3.8mm, but net sales in Brazil have increased from ~$12mm in 2006, to ~$65mm in 2011, to nearly $400mm in 2013. Therefore, any negative tax assessment precedent set in 2004 or 2011 could have significant implications if applied to other years. Herbalife has not reserved a loss related to these inquiries
- Herbalife's new statement of average gross compensation paid by Herbalife to US members in 2013 is now available. According to the statement, Herbalife had 122,043 US sales leaders in 2013 (73,428 with a downline and 48,615 without). Notably, the company's regional key metrics disclosure only shows 120,008 sales leaders in 2013 for all of North America. How could Herbalife have more sales leaders in the US than in all of North America combined? Is Herbalife inserting foreign distributors (presumably receiving above-average commissions) to overstate the commissions received by distributors in its US statement of average gross compensation?
This question is all the more relevant now that the US is only 94% of Herbalife's North American net sales (as of Q1'14) -- down from 98% in Q1'13. (Makes you wonder if the decline in US sales as a % of North America sales YoY is the result of a "pop" in Trinidad & Tobago, a North American market Herbalife entered in 2012).
Disclosure: I am short HLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am short HLF via my fund interests in Pershing Square. I wrote this article myself, and it expresses my own opinions. This article has not been reviewed by Pershing Square and should not be interpreted as expressing their opinions.