(QTR’s note: I’m publishing this article here for Anthony Canalungo, who I’ve occasionally chatted up about Herbalife over the past 18 months. Anthony is an 18 year old college student and young investor that has been following the Herbalife story since 2012. He’s been a follower of Benjamin Graham since the age of 15 and describes himself predominantly as a value investor. He’s a founding member of a non-profit in his community. You can follow him on Twitter @canalungo. We are both short Herbalife.)
“Herbalife in Venezuela: The Forest and the Trees” by Anthony Canalungo
- CFO John DeSimone accuses Bill Ackman of not being able to “see the forest through the trees.”
- Herbalife refuses to admit the impracticality of the SICAD 1 exchange rate.
- According to DeSimone, Herbalife’s accounting decisions are based on facts and circumstances.
In this interview with Stephanie Ruhle on Bloomberg TV, Herbalife (HLF) CFO John DeSimone makes the assertion that:
“there’s an element of Bill not being able to see the forest through the trees, I think he misinterprets what he sees…”
Generally, this means that someone is too caught up in the more granular details to see the overall picture in regard to a given situation.
Here lies the answer as to how Herbalife has stuck around for 34 years, become a publicly traded company two times over, and been exported into 91 countries. The reason no one had questioned the company’s business practices in such a detailed and public manner as Bill Ackman and Pershing Square first did is precisely because they had been convinced, one way or another, to step back from examining the most important of details. Either that, or they were just negligent.
They saw the “forest” as presented by Herbalife.
But in those important details lies the truth.
Of course, this comment was made in the context of a discussion about the legitimacy of nutrition clubs, but as the interview goes on to cover DeSimone’s view on the Venezuelan exchange mechanisms:
“Ruhle: You’ve seen Avon, Tupperware, and the street say the exchange simply isn’t 10 to 1. Are you considering changing that view?
“DeSimone: Yeah, it’s facts and circumstances by company”
A bit later….
“Ruhle: Who makes those decisions?”
“DeSimone: It’s an accounting decision, based on facts and circumstances”
I find his position on the Venezuelan currency situation, still choosing to use the 10.6 to 1 exchange rate, analogous to the comments he made about the “forest” and the “trees” a bit earlier.
Let’s take a deeper look into the “forest” of Venezuela from a currency perspective to see what exactly the facts and circumstances are, what might be fabrication, and how it all applies to Herbalife.
History of the Exchange Mechanisms
There is not just one, singular exchange mechanism in Venezuela. There are currently three legal exchange mechanisms being maintained by the Venezuelan government:
- CENCOEX (Official exchange): 6.3 BsF/USD
- SICAD 1: 10.6 BsF/USD
- SICAD 2: 49.9 BsF/USD
The CENCOEX exchange (formerly CADIVI) has been in existence since February 2003, when it was implemented in the aftermath of a two-month oil strike in Venezuela, in an attempt to limit capital flight from the country. It granted a very limited amount of dollars to citizens at the official rate for specific economic activities, including health emergencies, out-of-country education, and, most importantly, for travel abroad.
This bottle-necking of the amount of dollars that could be obtained by citizens and businesses alike caused inflation rates of up to 50%+ and led to the advent of a black market for dollars, where they’ve been known to fetch more than 10 times the official published rate.
The popularity of the black market among the middle and upper classes in Venezuela coupled with spiraling inflation gave rise to a technique commonly called “scraping.” Basically how this worked was a Venezuelan citizen with foreign connections would claim their limited amount of dollars, which would be given to them on a credit card, fly to another country, and charge that credit card (at the official rate, keep in mind) for cash in U.S. dollars. They would then fly back to Venezuela, sell the dollars for bolivars on the black market, and effectively print their own money!
Quite the arbitrage opportunity, right?
Needless to say, the Venezuelan government wasn’t too thrilled about the exchange mechanism being taken advantage of. The government announced the new Complementary System for the Administration of Foreign Currency, or SICAD in Spanish, in March 2013.
Things start to get a little complicated from here, but it becomes clearer as to how everything applies to Herbalife’s accounting.
The original SICAD mechanism was designed as an auction process, held weekly, where eligible companies from various industries would be invited to submit bids to purchase dollars for bolivars. The amount of U.S. dollars available to buyers in the weekly auction process was initially set at $100mm/week.
The weekly auctions began in October 2013, but the government didn’t actually begin publishing the average exchange rate (around 11 to 1) until December 2013. Around the same time, those looking for color on what exactly “eligible companies” meant were given it when the Venezuelan central bank published Exchange Agreement #24. In accordance with the agreement, the only companies allowed to access the auctions at that time were those in the oil and gas industry and those supplying the central bank with gold.
Important to remember that at this point, the majority of companies were still using the official exchange rate to mark their books.
In January 2014, the government expanded the use of SICAD and issued Exchange Agreement #25, saying that the 11 to 1 rate would also be applied to the following businesses and transactions:
- Cash for traveling abroad
- Remittances to relatives domiciled abroad
- The aviation industry
- Leasing and service agreements, contracts for the use and exploitation of patents, trademarks, licenses and franchises, as well as for the import of intangible assets, payment of rental contracts for networks, installation, repair and maintenance of imported machinery, software or equipment corresponding to the telecommunications sector
- The insurance industry
- Foreign investments and payment of royalties, use and exploitation of patents, trademarks and franchises, as well as technology import and technical assistance agreements
The government also expressed that the official rate of 6.3 to 1 would increasingly be reserved only for the settlement of obligations related to purchases of “essential goods and services” such as critical food items and medicine. Contrary to the absurd marketing claims that have been thrown around carelessly by Herbalife distributors, I wouldn’t consider Formula 1 an “essential good.” But, seeing as Herbalife marks at the 10.6 to 1 rate, they realize this as well.
Back to SICAD 1.
The day following the SICAD 1 expansion, PricewaterhouseCoopers, Herbalife’s own auditors, released a letter to clients in regard to the recent changes to the exchange mechanism. They highlighted some structural issues:
“.6 While the SICAD mechanism is described as an auction, it has several attributes that are inconsistent with a free market auction. For example, participation in the SICAD mechanism is controlled by the Venezuelan government. For each auction the government indicates which sectors or products are allowed to participate. Further, the highest bidder is not necessarily the winner of an auction, and even when a bid is accepted the winner typically is not awarded the entire amount bid.”
“Entities can assert they have the intent to utilize the SICAD mechanism when offered. However, due to the issues described above in paragraph .6 it would be extremely difficult for an entity that follows US GAAP to assert that it has the ability to use the SICAD mechanism to settle its BsF denominated monetary balances…”
They also point out:
“.7 When invited to participate, an entity must submit documentation that supports it has a qualifying US$ liability related to a prospective import transaction. By definition, liabilities related to past import transactions are not eligible to be settled through SICAD.”
Translation: they’re stuck.
Because documentation of a prospective future import transaction is necessary to participate in the auction, it will always be a zero-sum game when using SICAD 1. An attempt to repatriate any of the $152.6mm cash balance held in Venezuela would require the sinking of an equivalent amount of inventory into a highly inflationary economy incapable of handling it.
Have you been to Venezuela recently? Many people there, unfortunately, are struggling to find food and toilet paper. Formula 1 shake mix is the last thing on their shopping list.
So where does that leave us?
The SICAD 2 exchange mechanism was implemented by the government in February 2014, and began operating in March 2014. It is the most practical rate left standing for Herbalife. The mechanism represents the closest thing Venezuela has had to a free-market currency exchange in over a decade, and in accordance with Exchange Agreement #27, will allow any entity domiciled in Venezuela to exchange currency for any purpose.
The current exchange rate stands at ~50 to 1.
Previous Bolivar Transactions
So what kind of success has Herbalife had exchanging currency at the different rates recently?
When asked about this in the interview, DeSimone said:
“We have actually had more SICAD 1 dollars received over the last 12 months than SICAD 2”
Obviously, as stated above, we’ve already seen why the SICAD 1 mechanism is impractical for Herbalife, but he makes a seemingly compelling case for the legitimacy of Herbalife’s decision to continue using the SICAD 1 rate.
From the most recent 10-Q:
“During the fourth quarter of 2013, the Company received an approval through the SICAD mechanism for a bid of approximately 6.8 million Bolivars, or approximately $1.1 million U.S. dollars remeasured using the CADIVI rate, for a distribution of approximately $0.6 million in U.S. dollars, which resulted in a foreign exchange loss of approximately $0.5 million during the fourth quarter of 2013, or an effective exchange rate of 11.3 Bolivars per U.S. dollar.”
“During March 2014, the Company submitted a SICAD II bid to exchange its 5.3 million Bolivars for $0.1 million U.S. dollars which was approved and resulted in the Company recognizing a $0.7 million U.S. dollar foreign exchange loss at an effective exchange rate of approximately 56.2 Bolivars per U.S. dollar.”
For those keeping score at home, that’s $600,000 received at the SICAD 1 rate, and $100,000 received at the SICAD 2 rate, within the last 12 months. So the above statement by DeSimone is correct.
What he neglects to mention, however, is that these amounts are irrelevant compared to the total cash pile held in Venezuela.
To be rate-neutral, and to avoid confusion, let’s do the math in bolivars.
As stated in the company’s filings, the current amount of bolivar-denominated cash held on the balance sheet $152.6mm at the SICAD 1 rate (10.6 to 1). This means the total amount of cash in bolivars is equal to 152.6mmx10.6=1,617,560,000 bolivars.
The company exchanged 6.8mm bolivars at SICAD 1 in Q4 2013: 6.8mm/1.617B=0.4%
Then 5.3mm bolivars at SICAD 2 in March 2014: 5.3mm/1.617B=0.3%
These numbers are equivalent to 0.4% and 0.3% of total bolivars held. That’s nothing more than a rounding error. For all intents and purposes, the amount of cash Herbalife has taken out of Venezuela is not significant enough for DeSimone’s statement to hold any weight.
Even still, he stands firm and insists that 10.6 to 1 is the correct rate to use. Does anyone agree with him?
Peer Group Decisions
Maybe Herbalife will find some solidarity in their decisions with another company they consider themselves as competing with?
In their most recent proxy statement, the “Herbalife Peer Group,” used for comparisons of returns and compensation in order to make decisions regarding Herbalife’s executive compensation program, included the following companies:
- Avon Products, Inc.
- Church & Dwight
- Dr. Pepper Snapple Group
- Energizer Holdings
- The Hershey Company
- International Flavors & Fragrances
- Mead Johnson Nutrition
- McCormick & Co.
- Monster Beverage Corp.
- Nu Skin Enterprises
- J.M. Smucker Company
- Tupperware Brands
- Weight Watchers International
- GNC Holdings
The members of the peer group with significant businesses in Venezuela are Avon, Clorox, Energizer, Mead Johnson, Nu Skin, and Tupperware.
So what does the peer group have to say about their own facts and circumstances in regard to Venezuela?
First, from Avon’s Q1 2014 10-Q, after taking a $42mm loss after-tax:
“While liquidity may be limited through the SICAD II market, in comparison to the other available exchange rates, it represents the rate which better reflects the economics of Avon Venezuela’s business activity. Accordingly, we concluded that we should utilize the SICAD II exchange rate to remeasure our Venezuelan operations as of March 31, 2014.”
Next, from Nu Skin’s Q2 2014 10-Q, another MLM currently under scrutiny and the most relatable business to Herbalife, after taking a $25mm loss:
“As of June 30, 2014, the Company determined that it would be most appropriate for it to utilize the SICAD II rate, which was approximately 50 bolivars per U.S. dollar, as the Company had not been successful in getting approval under SICAD I and believed the SICAD II rate better reflects the rate at which the Company will be able to convert bolivars to U.S. dollars.”
Finally, from Tupperware’s Q2 2014 10-Q, after taking a $16mm loss:
“Based on these factors and its June 2014 evaluation of the restrictions and limitations affecting the availability of other, more favorable, exchange rates mechanisms, the Company has concluded that the SICAD 2 mechanism represents the most appropriate rate available as of the end of the second quarter. As a result, the Company remeasured the balance sheet at that exchange rate as of the end of the second quarter, recording a negative pretax impact of $15.8 million related to its net monetary assets.”
Interesting to see that every other MLM in the Herbalife peer group has already made the switch to the SICAD 2 rate. Looks like they’ve already “seen the forest through the trees.”
So here we have three different MLM companies from the peer group in addition to Herbalife operating in Venezuela, with all except for Herbalife now using SICAD 2, and guess who is the independent registered accounting firm engaged with all four of them?
What in the world is going on here? Could we have a bit of corruption on our hands?
Just putting that question out there.
Now what about the others in the peer group? Clorox, Energizer Holdings, and Mead Johnson are all still either using the official rate or the SICAD 1 rate to mark their balance sheets and operating results.
While this may immediately look like it discredits the point I’m trying to make here, I beg to differ. Remember what the Venezuelan government said they’re now reserving the official CENCOEX exchange rate for? That would be “essential goods.” Let’s take a look at some of the products sold by Clorox, Energizer, and Mead Johnson, and throw in Herbalife as well for good measure since they’re also still marking at SICAD 1.
- Infant Formula
- Infant Care Products
- Shake Mix
- Herbal Tea
- Aloe Water
- “Business Opportunity”
Which of the above doesn’t belong with the others? It’s a very safe assumption to say that soap, infant formula, and batteries will be deemed “essential goods” by the Venezuelan government, thus giving them access to the official exchange rate when importing these products, and justifying the use of a rate other than SICAD 2 for balance sheet measurement.
But Formula 1? Will the Venezuelan government really consider Formula 1 an essential good?
Herbalife stands alone in its peer group as the only company still marking at a rate besides SICAD 2 without justification.
Impact on Financials
Since other companies in Herbalife’s peer group have already chosen to accept the markdown and subsequent hit to revenue and earnings resulting from switching to SICAD 2, what would Herbalife’s Venezuela revenue over the past few quarters have looked like translated at the SICAD 2 exchange rate?
Revenue (VZ only):
- Q2 2014 VZ Revenue at SICAD 1: $37.5mm, 24.8% decline YoY
- Q2 2014 VZ Revenue at SICAD 2: $7.9mm, 84.4% decline YoY
Keep in mind that until the end of the first quarter, Herbalife was still using the official rate.
- Q1 2014 VZ Revenue at CENCOEX: $54.8mm, 5.4% growth YoY
- Q1 2014 VZ Revenue at SICAD 1: $32.6mm, 37.4% decline YoY
- Q1 2014 VZ Revenue at SICAD 2: $6.8mm, 87.0% decline YoY
Not a very pleasant 6 months in Venezuela, was it?
Let’s look at earnings next, this time for the entire company when factoring in marking at SICAD 2.
Q2 2014 GAAP Net Income: $119.5mm, $1.31 EPS, 2.2% decline YoY
Less: $109.5mm foreign exchange loss to operating income
Plus: $27.8mm tax benefit (using 25.4% tax rate specific to Venezuela from the company’s filings)
Equals: $37.8mm, $0.41 EPS, 69.4% decline YoY
Now we see why Herbalife doesn’t want to make the switch. A 69.4% Year-over-Year decline in earnings per share would be more or less catastrophic at this point.
Also worth pointing out here that the bolivar-denominated cash, $152.6mm at SICAD 1, is equivalent to 19.7% of the company’s total cash and equivalents ($773.5mm). If they were to switch rates, $120.2mm or 15.5% of total cash would disappear, further reducing the already negative shareholders’ equity.
Here’s the really interesting part: if rampant inflation in Venezuela continues, even the SICAD 2 rate will be too generous after long enough.
So what’s wrong here? Why does Herbalife continue to resist this change that many of their peer companies have declared an unavoidable reality?
Maybe it’s because the company is a massive, 34-year old pyramid scheme which will do anything and everything in its power to keep its fraudulent business propped up for as long as possible.
They’re not doing anything about this right now because they’re not being forced to. Likely, their stance is to just leave the situation as is until their auditor or a regulator requires them to do otherwise.
And where in the world is PwC on this? When will they step in and bring about this change? How can they continue to accept Herbalife’s financial statements marked at a different rate than their closest peers, who are also clients, when the facts don’t differ at all between them?
With PwC’s approval, John DeSimone and Herbalife continue with their refusal to admit the impracticality of the SICAD 1 rate, saying that it remains practical, but I believe the facts and circumstances above suggest otherwise.
I don’t think Herbalife even wants to “see the forest through the trees” at this point.