The below document is a copy of a document, reproduced with permission, passed onto me this afternoon. But first, a little introduction.
It's a small world.
I know two geniuses named Matt from near Toronto, Ontario who are short Herbalife (NYSE:HLF). One is Matt Stewart, whom SA contributors likely know by now. Mr. Ackman echoed this sentiment in his last presentation calling Mr. Stewart a "genius" as well.
The second genius from Ontario, who I swore was Matt Stewart the first time he spoke to me, is named Matthew R. Handley. Matthew Handley is the Chief Investment Officer at a fund called Hummingbird Equity near Toronto.
QTR did not have anything to do with this analysis, but I found it extremely interesting. This document lays out a question of whether or not Herbalife has meaningfully overstated its revenues due to its new 90 day return policy.
Without further ado, I present to you Mr. Handley's document, "Are Herbalife Revenues Materially Overstated?"
Date: July 29, 2014
Author: Matthew R. Handley
1. Are Herbalife Revenues Materially Overstated?
2. Do Herbalife Financial Statements Require a Material Restatement by PWC?
3. Has Herbalife knowingly or inadvertently violated SEC Staff Accounting Bulletin 101/104 - Revenue Recognition?
Does Herbalife Revenue need to be materially adjusted to reflect the effect of Herbalife's Money Back Guarantee ("The Gold Standard Guarantees")
HERBALIFE - The Gold Standard Guarantees
Low Start-Up Cost
There are no minimum purchases required and there is a low cost for the Herbalife Member Pack.
There is a fully refundable, 90-day money-back guarantee for the cost of the Herbalife Member Pack if Membership is canceled for any reason. There is a 100% refund guarantee on product, plus return shipping costs for the return of all unsold products purchased in the prior 12 months if Membership is canceled for any reason.
Up-Front Business Opportunity Information
We provide clear, accurate, and timely disclosures to prospective Members regarding potential income in our Statement of Average Gross Compensation.
We require a new Member to acknowledge in writing that they are aware of each of these Gold Standard Guarantees before their Membership Application and Agreement is accepted.
Strong Product And Business Opportunity Claim Guidelines
We clearly define the benefit of each product and appropriate method of use directly on the product label so the right product is taken the right way to achieve the best results.
Approved product claims and product information can also be found in Books 2 and 4 of the Herbalife Member Pack, product brochures, other official literature, and MyHerbalife.com. We provide realistic expectations of the business opportunity and the effort required to succeed at all levels.
In 1999, the SEC released SAB 101, Revenue Recognition in Financial Statements. In 2003, the SEC revised that guidance in SAB 104. SABs 101 and 104 describe four criteria that must be met for the recording of revenue, they are as follows:
- Persuasive evidence of an arrangement exists;
- The price is fixed or determinable;
- Collectability is reasonably assured; and
- Delivery has occurred.
Recognizing that problems with revenue recognition arise where a right of return clearly exists, FASB issued SFAS 48, Revenue Recognition When Right of Return Exists. In this document, addressing specifically "Criteria for Recognizing Revenue When Right of Return Exists" it states:
In these situations, if an enterprise sells its product but gives the buyer the right to return the product, revenue from the sales transaction shall be recognized (per paragraph 6) at time of sale only if all of the following conditions are met:
- The seller's price to the buyer is substantially fixed or determinable at the date of sale.
- The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product.
- The buyer's obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product.
- The buyer acquiring the product for resale has economic substance apart from that provided by the seller. SFAS48, Footnote 2--This condition relates primarily to buyers that exist "on paper," that is, buyers that have little or no physical facilities or employees. It prevents enterprises from recognizing sales revenue on transactions with parties that the sellers have established primarily for the purpose of recognizing such sales revenue.
- The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer.
- The amount of future returns can be reasonably estimated
Sales revenue and cost of sales that are not recognized at time of sale because the foregoing conditions are not met shall be recognized either when the return privilege has substantially expired or if those conditions subsequently are met, whichever occurs first.
SFAS 48, further states at paragraph 7:
If sales revenue is recognized because the conditions of paragraph 6 are met, any costs or losses that may be expected in connection with any returns shall be accrued in accordance with FASB Statement No. 5, Accounting for Contingencies. Sales revenue and cost of sales reported in the income statement shall be reduced to reflect estimated returns.
Herbalife sells its products to Distributors and to Nutrition Clubs and now does so explicitly with their "Gold Standard Guarantees" attaching to same. The "Gold Standard Guarantee" is actively touted by Herbalife with tremendous effort being exerted to note:
"We require a new Member to acknowledge in writing that they are aware of each of these Gold Standard Guarantees before their Membership Application and Agreement is accepted"
When originally introduced, I viewed this guarantee simply as a defensive "gimic" aimed at countering the FTC's actions. Upon deeper reflection however, I now recognize that Herbalife may have made a critical mistake.
Specifically, what the "Money Back Guarantee" appears to have done is eliminate (or more accurately defer) the legal transfer of title to all the items Herbalife sells.
The Gold Standard Guarantee establishes a clear and definitive legal obligation upon Herbalife that requires they make certain repurchases, if required, within certain time frames, those being 90 days and 12 months respectively.
Accordingly, both Herbalife and PWC now have equally clear legal obligations to Herbalife Shareholders and the SEC to recognize the Revenues from sales only when earned and in complete compliance with SEC SAB 101/104 and the guidance outlines provided via SFAS 48.
To record Revenue without offsets, allowances, a definitive recording formula and or notes against such unearned revenue would appear to have the immediate effect of materially misstating (overstating) earnings. Specifically, Revenue recognized and booked today as earned may evaporate as returns under the money back guarantee program occur and/or accelerate. Until such time as the Buyer's right of return has expired, no Revenue should be recorded unless some definitive and clearly disclosed method for its calculation is established.
If left unaddressed, this matter presents a serious potential litigation risk for PWC as Auditor.
Additionally, I believe serious consideration should be given to delving into SFAS 48. I draw specific attention to item #4: "The buyer acquiring the product for resale has economic substance apart from that provided by the seller" and the related footnote attaching to same "FAS48, Footnote 2". Questions in particular, exist in my view, as to whether a Nutrition Club has such economic substance. Club 100 participants certainly would not and in light of the Club 100's apparent managed consumption, Nutrition Clubs may be more appropriately categorized as an agent of Herbalife, particularly those 37,000 or so in Mexico. Taking this view, and despite Herbalife agreements reflecting the relationship otherwise, it would appear that inventories held by the agent in these clubs could well be illusory and at a minimum items to be reserved against.
Finally, drawing attention to item #2 in SFAS 48 "The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product". It would appear that sales to both Distributors and Nutrition Clubs clearly violate this item. Specifically, while the sale to the Distributors and Nutrition Clubs appears facially non-contingent on resale of product, the reality is that the money back guarantee makes it entirely contingent, to the extent of the 12 month right of return at 100% of cost and shipping (again no risk? No transfer of title?). All appropriate things to consider, in my view, when assessing Herbalife's revenues.
I offer these observations personally and solely as an independent investor, short Herbalife via puts through my personal account.
I am not an Accountant or Lawyer and as such strongly encourage these observations be investigated by such qualified parties, there may be a simple explanation.
Revenue recognition, legal transfer of title and rights of return absent risk of loss are serious and sometimes complex matters.
In the event certain or partial revenues are deemed more appropriately classified as "unearned revenues" or "deferred revenues" this should be embraced by Herbalife, as it would only serve to provide business model and valuation clarity to all Herbalife shareholders.
[QTR'S] DISCLAIMER: Everything Matt just said, plus the fact that this document has been simply reproduced from exactly what Matt sent me today via e-mail. QTR has not published this document as a premium document and is not looking to make SA royalties from producing it. This is strictly to get this issue into the public discourse.
I am also short puts via my personal account.
Disclosure: The author is short HLF. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: QTR and Matt are both short Herbalife. This document is being produced simply to raise the question surrounding how revenues are booked.