I find it increasingly difficult to work out Valeant's revenue numbers and their implications. Simple maths keeps bringing out astounding factoids. Again I am harping back to the sale of the Facial Injectables/Aesthetics franchise to Galderma. Again I am quoting Michael Pearson (the CEO) on the conference call:
On the aesthetics side, we recently sold certain facial injectable products to Galderma for approximately $1.4 billion, for a gain of over $300 million. We are pleased to report that under Valeant's ownership, we accelerated the sales performance of the Medicis aesthetics assets through Q1 of this year compared to the performance under previous Medicis ownership. In April, we announced our offer for Allergan and publicly stated that we would be divesting these aesthetics products.
As expected, the aesthetics business deteriorated in Q2. The physicians were confused as to what products we wanted them to buy: our legacy Medicis products or our soon-to-have Allergan products. The uncertain status of our MVP Program also created concern for the doctors. Our reps and management were focused on pleasing their new owners and holding back sales until they worked for the new company, and our competitors were discounting heavily and is proportionately trying to take a temporary share to demonstrate weakness in our business.
As a result, our sales dropped approximately 40% in Q2. Fortunately, these assets are now safely in Galderma's hands, and we can now focus on the rest of our business.
Okay, so what we are being told is that the Facial Injectables business had sales growth all the way through Q1 of 2014 - and presumably was also doing pretty well in the second quarter until Valeant announced that they were buying Allergan.
Then presumably they fell off further when they announced that they were selling the unit to Nestle/Galderma.
There is only one problem here: dates.
The (unsolicited) offer for Allergan almost a quarter of the way through the quarter. The deal selling the fillers business was announced two thirds of the way through the quarter.
If you assume the drop happened over these announcements the actual drop had to be enormous - well over fifty percent.
I see two possibilities.
(a) the procedures didn't happen, or
(b) the procedures happened but using some other company's fillers.
And for (a) to be true the doctors had to forgo the income and throughout America and Canada - women will have more wrinkles and less luscious lips because they suddenly stopped using Restylane, Perlane and Emervel injectable cosmetic treatments - and all because of the machinations in Corporate America.
And for (b) to be true doctors need to know and care who is the provider of the injectables they use. This seems unlikely because the websites (typical example linked) are labelled Medicis not Valeant and have been for some time.
Valeant states that the competitors discounted during the quarter. However the main competitor is Juvederm owned by Allergan - and they reported revenue growth driven by unit volume. There is no indication of discounting.
This is part ten of a long series on Valeant Pharmaceuticals - a major company in the speciality pharmaceutical space - and one that has cumulatively undertaken many billions in acquisitions.
The series was prompted by their biggest attempted acquisition to date - an unsolicited and ultimately hostile bid for Allergan - the maker of Botox.
In my last post on Valeant Pharmaceuticals I observed that the company had blamed its earnings miss on the sale of its Facial Injectables business to Galderma. Specifically they stated that [Valeant] had built into our previous guidance $230 million of revenue and $0.50 per share cash EPS for the second half of the year from the (now sold) injectables business.
I calculated that there were 340 million shares outstanding and so for six months they were forgoing 170 million of earnings by selling that business. This is 340 million annualized and the business was sold for $1400 million.
This meant the business was sold at roughly 4 times earnings.
Michael Pearson stated on the conference call that were able to "realize the full value for these products" and so I thought there must be an error. After all Michael Pearson [the CEO of Valeant] is a clever and rational man and he would not sell at so low a price.
The post-tax and fees sales price is considerably lower than $1400 million - and so the sale looks even more insane. The 10-Q declares that there were $50 million in selling costs associated with the asset:
Divestiture of Filler and Toxin Assets
On July 10, 2014, the Company sold all rights to Restylane®, Perlane®, Emervel®, Sculptra®, and Dysport® owned or held by the Company to Galderma for approximately $1.4 billion in cash. The assets were included primarily in the Company's Developed Markets segment. The carrying values of the assets sold, which includes $622.6 million of intangible assets, $16.1 million of inventory, and a $403.1 million allocation of goodwill, were classified within Assets held for sale in the consolidated balance sheet as of June 30, 2014. In addition, the royalty obligation on sales of Sculptra® owed to Galderma of $27.1 million was classified as a Liability held for sale in the consolidated balance sheet as of June 30, 2014. The costs to sell for this divestiture of approximately $50 million will be recognized in the third quarter of 2014. As this divestiture does not represent a strategic shift that has, or will have, a major effect on operations and financial results, a discontinued operations presentation was not appropriate"
And slide 165 of this presentation assumes that $170 million in tax will also be paid on the divestiture. The net proceeds were thus $1180 million and the implied price earnings ratio for the sale was 3.5 times.
--
This observation of mine caused a stir - because the guidance does not look plausible.
I guess several people have asked either analysts or the company because explanations are coming out.
JPMorgan - in a note dated 6 August 2014 gave an explanation. I quote:
Management provided additional clarity on aesthetic injectables divestment.
The EPS impact from the divestiture of Valeant’s injectable franchise has been a key point of controversy since 2Q results last week. Although the injectable franchise generated $280mm in sales in 2013, Valeant had doubled its sales force on these products in January and forecasted sales to increase to $400mm in 2014 (largely back half-weighted as the sales force ramped). Further, Valeant opted to retain much of its sales infrastructure after the divestiture and, as a result, incremental margins on 2H divested revenues were extremely high.
The key explanation - highlighted - is that Valeant opted to retain much of its sales infrastructure after the divestiture. If this is true then the earnings effect of lost sales would be particularly high.
It would be a good explanation. The only problem is that this explanation is in radical disagreement with statements by the management of Valeant.
Humberto Antunes , CEO of Galderma, has embraced our commercial team and I know he will continue our efforts to build strong relationships with the healthcare leaders in this industry.
It sure sounds like the sales force went with Galderma with the products in direct contradiction of the JPMorgan broker article.
This impression is further enhanced in by Valeant's conference call where they blame a dramatic intra-quarter fall in the sales of Facial Injectable product on the sale. To quote:
As expected, the aesthetics business deteriorated in Q2. The physicians were confused as to what products we wanted them to buy: our legacy Medicis products or our soon-to-have Allergan products. The uncertain status of our MVP Program also created concern for the doctors. Our reps and management were focused on pleasing their new owners and holding back sales until they worked for the new company, and our competitors were discounting heavily and disproportionately trying to take a temporary share to demonstrate weakness in our business.
As a result, our sales dropped approximately 40% in Q2. Fortunately, these assets are now safely in Galderma's hands, and we can now focus on the rest of our business.
You see (as per the highlighted section) the injectables sales force were holding back sales, focused on pleasing their new owners. Which of course implied they had new owners.
Galderma's management are also clear that most of the sales infrastructure went with the products to Galderma. Galderma's press release states:
At Galderma people come first. We are thrilled to take on board the experienced teams from Valeant Aesthetics and, more than ever, our intent is to preserve the quality of the long-lasting relationship built with doctors.
The JPMorgan note quoted above explicitly states that the sales force stayed with Valeant. Michael Pearson however has repeatedly stated the sales infrastructure went with the new owners.
Just for kicks I have examined many profiles on LinkedIn.com - checking the movement with functions with the asset sale. It is pretty clear - the sales infrastructure went with the asset.
Analysts make mistakes (I do regularly).
I gave an early draft of this blog post to Chris Schott, Jessica Fye, Wendy Lin and Dana Flanders (the JPMorgan analysts) and expected them to come out with an explanation consistent with the statements of Valeant and Galderma management (or for that matter consistent with easily obtained data on LinkedIn).
I will print that explanation when it is forwarded to me. But without further explanation the guidance provided by Valeant continues to make no sense. And the implication is devastating. Either Valeant is just making up its guidance numbers or they sold a growing business at under four times earnings.
People with better knowledge of the details of Russia's sanctions seem to think that most Herbalife product will still get through - so Herbalife is not going to miss because of Russian sanctions. Further comment on the moral point of this post in the post-script.
Whilst nobody has said it yet this is almost certainly negative for Herbalife. Herbalife has a business in Russia and to the best of my knowledge has no manufacturing in Russia. Its not huge - Europe, Middle East and Africa is less than a sixth of Herbalife globally - and Russia is likely a very small part of that.
However I would be surprised if the EMEA segment did not shrink next quarter.
There are of course in Russia a bunch of distributors who have built businesses in Russia distributing protein shakes, running clubs and fitness businesses and the like. Their businesses will now fail - and it will not be the fault of Herbalife.
The miss will be of great benefit to Bill Ackman who is short this non-pyramid scheme and - at least on this trade - needs all the help he can get.
Bill Ackman will get some cheer from his new best friend Vladimir.
Sometimes the cards land right for a fund manager.
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There are big problems closing a successful and honest direct selling organization. Many people have built legitimate businesses selling the product. Vladimir has no moral scruples but Herbalife (despite their reputation) do.
Herbalife has distributors in Venezuela who have built successful businesses there. There are now very strict currency controls in place - Herbalife sells product into Venezuela but can't get the money out. The currency they do have devalues fast. If they buy any property with the money its likely to get nationalized.
As a shareholder I wish that Herbalife would simply stop sending their product to Venezuela. Anything they send there is frankly lost.
However Herbalife feels integrated with their distributors - and responsible for them. To abandon a country is (morally) hard for a direct selling organization and Herbalife has a hard time doing it.
Vladimir Putin not so much.
---
What Bill Ackman wants the FTC to do in America is destroy the business of tens of thousands of people.
I will let you judge the morality of that.
John
Post script. When I started on Herbalife I believed every word Bill Ackman said - and I told the world so. But I was happy to own Herbalife for the bounce. I have since become convinced that Bill Ackman is wrong on every substantive point. This is not a pyramid scheme - instead there are millions (maybe tens of millions) of genuine consumers - and tens of thousands (maybe hundreds of thousands) of people who have built legitimate businesses. I believe the short case is aiming to destroy these businesses to meet the fantasy of a narcissistic hedge fund manager and the shorts in this case are deeply immoral. Over time I have noticed the company being moral to a fault - most notably in Venezuela where they support the existing distributor base at substantial financial cost. It is about time the Herbalife longs spelled out what is happening here. People whose evidence is incomplete to the point of fabrication have grabbed the moral high-ground whilst they take an immoral argument. It will be okay in the end - the longs will make a fortune and the shorts will have their finances redistributed. However I am getting a little frustrated at people suggesting that I have the moral low ground. J
I was casually reading some "selected additional information" on the financial condition of African Minerals (a large iron ore mining company listed in London). [Hat tip to FT Alphaville.]
In explaining the abnormal charges from previous years there is the following explanation:
Fuel Misappropriation
Our best estimate for misappropriated fuel of $18.0 million was recorded in 2012 within the aggregated income statement. This estimate has been based on extrapolation procedures and has therefore involved the use of estimates. We have taken a number of measures to mitigate the risk of further such losses occurring, such as employing a specialized in-house fuel consumption control team. The investigation is ongoing, however in 2013 there have been no developments which have led to an amendment to our original estimate.
Wholesale fuel prices are less than $1000 per tonne. Even by the time you get it to Sierra Leone the price is likely to be less than $1500 per tonne.
The amount of fuel stolen is likely to be over 10 thousand tonnes.
A quite large tanker truck contains 35 tonnes of fuel.
So this is 285 tanker trucks. Probably more as I have rounded down the amount of fuel and up the size of a tanker truck.
One per working day.
I wonder how they didn't notice them driving away.
Herbalife has 3.7 million distributors. There is very fast turnover amongst the lower-tiers of the distributor tree.
The core bear case for Herbalife is that these distributors are deceived - and that there are not huge numbers of real sales - and that the bulk of the sales are to people who are buying it for the business opportunity rather than to consume the product in its own right.
Indeed for this to be a pyramid at law the company needs to be selling the majority of its product to distributors who are not buying this for deliberate personal consumption but rather for the business opportunity.
If the majority of sales are to people who are not active distributors there is simply no way that this is a pyramid. A reasonable summary of the pre-Burn Lounge law from an anti-Herbalife slant is given by Dan McCrum at the FT.
Even he would concede that if a majority of sales were to people who were not active distributors with a valid distribution contract then Herbalife is not a pyramid scheme.
There are several steps to the argument.
Size of Herbalife sales
A large number of people on Wall Street have positions on Herbalife without having thought clearly about its size. It doesn't appear much in their social circles so it must be small.
Bill Ackman sneers at them when they say their competitor is McDonalds.
So lets detail it accurately.
Herbalife's main product is Formula 1. It is a protein shake powder used in meal replacement mostly for weight loss. According to the annual filings weight loss products (which are mostly Formula 1 and meal-replacement protein bars) are 63.5 percent of all product. Some of this is diet-suppressing herbal teas - but meal replacements alone are probably 58 percent of all sales - completely led by Formula 1.
Here is an image of several 750 gram packets of Formula 1:
This is the product - above all others - that is associated with Herbalife.
Here is the label which gives a suggested meal-replacement size of 50 grams:
This is a multi-level marketing company. You qualify for various tiers of the distributorship by selling a certain number of volume points in a given time. [For example 4000 or 5000 volume points will qualify you for "supervisor" status depending on how fast you sell them.]
For all Herbalife product the price changes by country - but the number of volume points does not. So whatever country you are in a packet of Formula 1 counts as 23.95 volume points.
During the last quarter Herbalife sold 1.4 billion volume points of product. I have used this slide before showing volume points by region:
1.431 billion volume points would be the equivalent of 59.7 million tins of Formula 1 powder.
Each packet contains 15 fifty gram meal replacements (see the label above). So if it were all meal replacement there would be 896.2 million meals replaced per quarter.
That would be 3584.7 million meals annually.
Not all of this is meal replacement though. My guess [explained above] is that only 58 percent of sales are meal replacement.
That would suggestion 2079.1 million actual meals annually.
Mr Ackman sneers when the company compares itself to McDonalds. But hey - I want to.
Here is the comparison: based on number of meals served Herbalife is about 8 percent of the size of McDonalds. [For comparison Herbalife is about 5 percent of the market cap of McDonalds. It does not make sense to compare revenue because McDonalds has a lot of franchise revenue - but it is - for completeness - roughly 18 percent of the revenue of McDonalds.]
These sales numbers are growing by 5 percent annually although that growth rate is slowing.
Herbalife sales per distributor
The number of sales leaders in the company (again according to the above table) is about 340 thousand. To make the numbers work the average sales leader or their down-line is selling 6100 meals per sales leader per year.
If they can get their average customer to consume 200 meals per year [that is replace four meals per week] then they have about 30 regular customers each - and the total number of Herbalife customers is about 10.4 million.
The total number of distributors of Herbalife is 3.7 million many of whom sign up for their own consumption. [The proportion who sign up for their own consumption rather than for the business opportunity is a very big item of contention. Suffice to say that there are a reasonable number of both...]
This number is increased considerably from when Mr Ackman did his original presentation. The 2011 annual report listed 2.7 million independent distributors.
Now here is a big observation: My calculation - there is enough Herbalife sold so that 10 million people globally replace 200 meals a year with Herbalife product.
But there are only 3.7 million people with an active distribution agreement.
We have three choices here. Either:
(a). The sales/revenue numbers cited above are completely fabricated, or
(b). The majority of Herbalife product is consumed by people who are not distributors or
(c). There are massive piles of inventory around not consumed.
I think we can reject hypothesis (a) very easily. The company generates huge amounts of cash and was buying back stock rapidly before Bill Ackman came along without blowing the debt out unreasonably. [They have bought even larger amounts more stock since Bill Ackman and the net debt has now risen sharply.] They would not have had the cash to buy back stock if the revenue numbers were falsified.
And I think we can reject (c) above pretty easily too. I have spent considerable time looking for the inventory and I can't find it. It is not on Ebay or Craigs list (as per this post). Besides you can now return it for a full refund - so having unsold inventory sitting in the garage is stupid and unlikely.
So we are left with the middle choice - the majority of Herbalife product is consumed by people who are not distributors.
Bluntly: there goes the bear case.
The FTC will - after examining all the documents - come to the same conclusion. And at that point I would not want to be short this company.
John
Corrections and amplifications:
There are two amendments that need to be made to this post. The first is that I got the volume points wrong.
The 550 gram packet is 23.95 volume points. The 750 gram packet is 32.75 volume points. This would make my comparison less extreme and serves to undermine the argument above.
However the labels (and considerable practice) suggest that the way that this is consumed is mixed with skim milk and some fruit and blended - with the dose being 25 grams not 50 grams.
Putting those things together the calculations are more extreme, not less extreme than in the article above. [My guess - there are more than 15 million consumers who consume reasonable amounts of Herbalife product - meaning more than weekly.]
Bluntly there is too much Herbalife sold for a majority of sales to be internal to the distributor base. The sales must be external.
These numbers are utterly consistent with this press release (link) from Herbalife which suggests that 80 percent of sales are outside the network. In which case the FTC will go away.
Valeant missed analyst projections of revenue and guided down their so-called "cash EPS". Regular readers know that I don't hold much regard for Valeant's non-GAAP numbers (such as cash EPS) but for the moment lets consider them.
Valeant provided the following slide reconciling previous guidance to their new lower guidance. [The slide is number 28 in this linked document.]
Valeant announced the sale of the Facial Injectables (to Galderma) on 28 May 2014 - and according to the conference call the deal closed on 10 July.
To quote the conference call:
This past May, we announced that we were selling our injectable products to Galderma. By selling these assets early, we were able to clear the major FTC hurdle towards the June regulatory approval for Allergan and realize the full value for these products.
We closed the sale to Galderma on July 10. The $1.4 billion raised by this transaction will be used for Allergan -- for the Allergan transaction and/or other future business development opportunities.
Now according to the above table not owning the Facial Injectables business from July 10 to December 31 (ie for 174 days) will reduce annual revenue by $230 million and reduce cash EPS by 50c per share.
There are approximately 341.3 million diluted shares outstanding (as per the 10Q) so 50c per share is 170.65 million.
The implied margin after tax and all expenses for the injectable business is thus 170.65 million on the $230 million of revenue forgone - or 74.2 percent. If you allow that the business has a three percent tax rate (which is the rate that Valeant claims more generally) the margin on the business pre-tax is 76.5 percent.
There are other things you can work out. 230 million drop in revenue comes from not owning the business for 174 days of the year. If we assume no seasonality then the annual revenue of the business is = 230*365/174 = 482.4 million. And given the post tax margin is 74.2 percent the annualized forgone earnings are $358 million.*
Valeant sold this business for $1400 million - so the apparent PE ratio of the sale was - 3.9 times.
This is a very simple calculation from the guidance slide. Nestle/Galderma it seems have got a bargain. A true bargain - a business with sales growth, extraordinary margins and an unlevered price earnings ratio below four.
There is an implication here: Michael Pearson - the CEO of Valeant - let the business go for a startlingly cheap price.
That implication is clearly wrong. Michael Pearson is according to the people who know him - incandescently brilliant and in the conference call he stated that they were - and I am quoting again - able to "realize the full value for these products".
The alternative implication: the guidance slide is wrong.
I know I have put together presentations quickly - and mistakes do creep into them.
I bring this to public attention - and I await an amended corporate guidance. I will publish it when it comes.
John
*The way I have annualized this was roughly confirmed in the conference call. Howard Schiller - the CFO stated: "[Valeant] had built into our previous guidance $230 million of revenue and $0.50 per share cash EPS for the second half of the year." If we assume these numbers relate to only six months as per the call Valeant sold the business at 3.1 times earnings. Clearly silly. Something is wrong here.
Mr. Horsley agreed to pay $700,000 in the settlement, and is barred permanently from being a director or officer of a public company. Mr. Turner noted that Mr. Horsley also agreed to pay $5.6-million to settle shareholder lawsuits related to Sino-Forest’s collapse. He [the OSC chair] viewed that as an appropriate penalty, which is why he endorsed the relatively small OSC settlement.
Later the paper deadpans:
At its peak, Sino-Forest was the biggest forestry firm on the Toronto Stock Exchange, with a market value of more than $6-billion. It also raised a staggering $3-billion from investors between 2003 and 2010 before falling into creditor protection in 2012.
Simple question: Where did that $3 billion that was raised go?
Answer: Into someone's pocket.
Have you made a few billion dollars lately?
Repeat after me: the fraudsters have a better business model.
John
PS: There is out there a multi-billionaire fraudster who is completely absent from the Forbes list of global billionaires. Whatever: at a minimum the Forbes list is like Sino Forest: lacking credibility.
There are dozens of books on the financial crisis: I have read many of them and the Kindle samples for just about all of them. There are only two I would recommend: those are Bethany McLean and Joe Nocera’s excellent All the Devils are Here and the much more specifically detailed Fatal Risk from Roddy Boyd. Roddy's book is solely concerned with the failure of AIG.
Both books start without any strong ideological preconceptions and let the facts woven into a good story do the talking - and both wind up ambivalent about many of the major players - with many players having human weaknesses (gullibility, delusion, arrogance etc) but committing nothing that looks like a strong case for criminal prosecution. Reading these you can see why there are so few criminal prosecutions from the crisis. And you will also see just how extreme the human failings that caused the crisis are.
If you are not familiar with the saga that led up to the mortgage collapse, the rise of securitisation, the depth of the repo market, the lowering of credit standards start with the McLean/Nocera book. If you have to give a book as a gift to someone who is not a financial professional you could do little better. That is the best general book yet written on the crisis.
But for me (and because I was familiar with the broad details of the crisis anyway) the best book of the crisis is Roddy Boyd’s Fatal Risk. It is not a good first financial book to read and I had to think quite hard as to the details that Roddy glossed over - but that was because Roddy had to make a choice - was he writing for someone who vaguely knew what a credit default swap was or was he writing for someone who had actually read a “credit support annexe (a CSA)”.
Fortunately for most people he does not want to assume you have actually read a CSA (although I have). But less forgivingly Roddy does not feel the need to define an Alt-A mortgage or a repo line. This is a fabulous book – but it deals with complex subjects without shying away from their complexity and it assumes you have enough knowledge and intelligence to cope.
Truths, generalities and people
Underlying Roddy’s books are a few financial truths that bear repeating. Firstly anything that has any chance of going wrong if done for long enough will go wrong. It doesn’t matter if your model tells you that you will be fine in any mortgage default environment short of the great depression: if you continue to bet on that model you will lose. Maybe not next year. Maybe not in ten years but you will eventually lose.
Likewise if you write large quantities of out-of-the-money puts you will eventually lose a lot of money.
Likewise if your model assumes that there is always going to be a deep liquid market in any security (with the possible exception of a Treasury bond) then one day you will wake up and the buyers will have scampered like antelopes from a waterhole at first sight of a lion. Any business that has to roll a large amount of debt at regular intervals is dangerous.
Ignore these truths and you take a risk. Ignore them on a grand enough scale and the risk will be fatal.
Whatever: if you ignore these truths you might become rich in the interim. Earnings and growth might be fine. You might even look like a genius. Maybe a “legendary CEO”.
So Roddy’s book starts a long time ago - the 1970s and 1980s when AIG did not forget those truths - and it talks about AIG as a superlative risk management machine. The first section of the book is a repeat of the AIG legend - a legend of superlative risk management mostly in the head of one man: Hank Greenberg. It is a legend that might be overstated but that doesn’t mean that it is not mostly true. Hank really did work absurd hours, pick at steamed fish and vegetables and ask sophisticated questions to six people at once. Hank knew to really understand what was going on you had to go three to four levels deep in an organisation and ask the right questions of assorted lower/mid ranked officers. They would answer truthfully because of a desire to impress or fear or even that (unlike many senior managers) they were not accustomed to spinning. He would get the raw data. He would make the assessment.
There were two things however that Hank did not assess properly: his own mortality and his declining skill in old age. There is no question of declining skill. It is very hard to imagine the Hank Greenberg of 1975 falling for China Media Express - but the Hank Greenberg of 2010 was suckered. As for mortality he had no plans.
He also did not plan for Eliot Spitzer.
By 2000 Hank was extremely concerned about what Wall Street thought of his stock. That is no surprise - AIG was the most highly valued large financial firm in the world (I remember being startled that its PE was three times Wells Fargo). And - unstated by Boyd - Hank liked that a lot because he used AIGs stock as currency to do acquisitions. He was - much to the chagrin of many investment bankers - very selective as to the acquisitions he would do (he knew acquisitions were fraught with risk) but he did some mighty big ones including the purchase of Sun America. I remember that one - and thought (correctly in hindsight) that it probably made sense primarily because AIG was paying with inflated stock.
So by the year 2000 Hank was - apart from running the business - actively manipulating the earnings of the business. As far as I can tell he ran the business particularly well (the legend of AIG was not false) but he also played Wall Street like a fiddle and gave them the numbers they wanted even if they were massaged a little (or maybe a lot).
Moreover - and this is critical for the story - AIG had no overarching operating system. It was a bunch of fiefdoms all reporting to Hank. This meant that AIG could not produce earnings results until the very last day they were legally allowed to file them. It meant Hank could personally massage earnings. At many financial institutions some approximation of earnings are known every month. At AIG there was no system they could query and ask for their aggregate Alt-A mortgage exposure. Hank might have known - indeed almost certainly would have known - but the system is Hank and Hank being removed or dying would be disastrous for AIG.
And then along comes Spitzer. Spitzer discovers a relatively minor finite insurance transaction between AIG and General Re. (Believe me it was minor - I know of plenty of nastier transactions than that... many of which were never prosecuted.*) However it is a clear attempt to fudge the numbers - Spitzer really is onto something. And with bombast and the power of the Attorney General he makes Hank Greenberg’s world fall apart. Spitzer fights dirty (and it is no surprise that several Spitzer prosecutions later failed because of prosecutorial misconduct) but Spitzer has his clear piece of fakery and he wants and gets his pound of flesh.
Hank is forced out - which is the equivalent to AIG of his sudden death. Worse because AIG went on to repudiate many things Hank stood for including many of his risk-control edicts. If he had died the hero CEO it might have been marginally better for AIG.
The minor nature of the AIG-Gen Re transaction is laid clear when Roddy suggests that there is an “excellent chance that Greenberg gave the Gen Re issues - which cost him his job, his honor, his status and perhaps over a billion dollars in personal wealth - all of five minutes of consideration.”
Still AIG-Gen Re was a transaction designed to massage (ie fake) the numbers - and thus speaks to a relationship with Wall Street and a concern to stock price that is unhealthy.
Unstated by Roddy: Hank had forgotten a cardinal rule of risk management: you do that sort of thing for long enough then one day you will find your Eliot Spitzer. This is just as sure as the statement that if you write put options long enough you will one day get your comeuppance.
The new CEO
The new CEO - Martin Sullivan - was the best salesman AIG had. Joe Cassano (who ran the disastrous AIG Financial Products) observed that he never saw Sullivan ask a single penetrating financial question. It's a telling observation.
The place I used to work had a boss who was very suspicious of financial product salesmen because inevitably they wanted to produce what the market (ie the crowd) wanted. And in financial services if you run with the crowd you can get your comeuppance delivered abnormally sharply.
To be fair, there are financial service companies that require salesmen even as leaders. Insurance brokers spring to mind.
AIG however was not one of those companies. It was global, complicated and pervasive and it had no overarching risk management system now that Hank was gone. To replace a control freak they needed another control freak at least until they built control systems. They never got that - and only at the very end (in Willumstead) did they get a CEO that even understood there was a problem.
There is a truism about financial product salespeople: if you put a salesman in charge of a financial institution with large reach and allow him to operate with thin risk control then your earnings will go up. And up. And up. At least until they don’t. Martin Sullivan proves that truism.
Under Sullivan some small businesses were allowed to expand in new ways until they became big businesses - ones big enough to threaten AIG and indeed the world. A decent example of the Martin management style comes from a small part of AIG - United Guaranty. United Guaranty was a mortgage insurer - at least for a while the best mortgage insurer on the Street. (I remember thinking that a couple of other players, notably PMI and MGIC were much riskier.)
The right thing to do with a mortgage insurer was stop writing business about 2005 - and certainly by 2006. [Or you could sell it as GE did.] Margins were collapsing and the risk of the loans was rising fast. The independent companies couldn’t really stop because that was their only business. AIG was under no such constraint - United Guaranty was a tiny part of AIG and stopping would not have affected the stock price. It might have even been seen by some (myself included) as a sign of discipline. Here is the quote from an AIG unit chiefs meeting in mid-2007.
As UGC posted its first losses, about $100 million, Nutt was explaining to Martin Sullivan and other senior management that while they hit a rough patch, they were writing excellent new business, and, at any rate, the competition was getting killed. Sullivan smilingly told Nutt that even if he didn’t write another dollar in business for a few months, “We would still love him”. AIG staffers had a phrase for this sort of response: “classic Martin”. It was a decent word or gesture, directed at a manager who was clearly fumbling, both publicly and on the job. But it also carried a serious message: better to be safe than sorry. The trouble is that the time for this was two to three years earlier.
To not realize that a mortgage insurance business in mid 2007 was problematic was seriously inept. UCG has now booked $3.9 billion in losses. Hank would have been on top of this at least a year earlier. Whether he would have been on top of it two years earlier is more dubious. One year earlier and UCG would still have had substantial losses. But they might have been absorbed by profits in an otherwise functioning AIG.
The two businesses that blew up AIG
There were problems all over AIG (and there were good bits too where individual managers saw the mess coming and ducked for cover). But two businesses stand out for the sheer destruction that they wrought. The better known was AIG Financial Products (FP) credit guarantee business. The less well known was Win Neuger’s securities lending business.
The credit guarantee business for thin fees guaranteed securitisation deals - usually very high grade paper or just as often resecuritisations of high grade paper. These were deals that would be fine in any credit event less bad than the great depression. In other words they were “great depression puts” and FP was writing puts. You should know the truism by now.
But worse the credit default swaps had a credit support annexe (CSA) attached. This made it mandatory for the parent company of AIG to collateralize the deals (ie put up hard cash to guarantee payment) under certain events. Senior management of AIG did not even know of the existence of the CSA until the company was at death’s door. They believed until very nearly the end that mark-to-market did not threaten liquidity.
I understand how a salesman (Sullivan) missed the CSA. If you followed the credit enhancement business you would know - by law - that the monoline insurers were not allowed to collateralize their obligations. Why of course should AIG be any different? But even that cursory “knowledge” could be dangerous. Both AIG and Ambac had CSAs attached to their guaranteed investment contract business (a business that was run by parent companies). I did not know of these until a well known hedge fund manager sent me a copy and even read it over the phone to me.
But that is a thin defence of AIG. The above mentioned hedge fund manager knew of the CSAs at Ambac and MBIA a couple of years before the disaster - and he had to look and find it. AIGs senior management should have just asked. Their risk management department should have been over every material contract - and believe me these were material contracts. This was an epic failure.
Win Neuger’s business was similarly destructive. What he did was [get the parent company to] borrow high grade securities from the life insurance companies, repo them, buy lower grade securities and pledge those back to the life companies to secure parent company obligations to the life companies.
Two things went wrong. The life company management (and later regulators) got mighty jacked when the life companies had lent their good securities and were holding trash security. They required hard capital injections from the parent company to solve this - and along the way AIG kicked in $5 billion. At the end the Texas Insurance Commissioner was going to confiscate four insurance companies (which would have collapsed AIG).
The second thing that went wrong is the counter-parties to the repo loans just wanted cash their back. They wanted it now. To get it though the parent company would need to get back the trashy (and hence heavily discounted) security from the life company, sell them, top up the (now large) shortfall and pay the investment bank on the repo line. This turned marks on the low-grade securities into an immediate liquidity drain on the parent. That is truly ugly.
How they got there too was a story of failure to consider fat tail risks. It is the main story of the book.
Liquidity versus solvency
At the height of the crisis it was very difficult to see whether AIG was a liquidity problem or a solvency problem. If it is a liquidity problem then bailouts don’t cost much -indeed structured right they are profitable. If it was solvency then a bailout will be very costly and in extrema (such as Ireland) can bankrupt the nation.
There are a couple of lessons here: sophisticated observers (if I am a sophisticated observer) can’t tell the difference between liquidity and solvency in a crisis. The second lesson is that any contract that can cause a liquidity problem will - if repeated long enough - actually cause a liquidity problem. Modelling solvency does not cut it... if you run a financial institution you better model liquidity as well – and better be ready for the closure of debt markets.
The AIG people after the failure
There is a lot of anger in the broad community about the people at AIG especially as none of them - those that caused the largest bailout of the crisis - were ever charged criminally. Roddy does not share the anger about the lack of criminal charges but he is angry about the sheer recklessness of some AIG people. This quote was revealing:
Al Frost’s [a key salesperson for AIG FP] job was to drum up deals and revenue from the major investment banks and he did. Cassano’s job was to ensure that decisions made at FP were logical and made with all available information. He failed...
But Cassano did not fail in a vacuum....
That Martin Sullivan and Steve Bessinger did nothing is now well established. But neither did Financial Services chief Bill Dooley, his CFO Elias Habayeb, Risk Management Chief Bob Lewis and his head of credit-risk Kevin McGinn. Anastasia Kelly’s legal department was similarly silent. These people saw everything AIG FP did in real time and had plenty of authority to force at least a reevaluation. It was, in fact, their job to do this...
Save for Anastasia Kelly (who retired) every other person in the line of oversight of the FP swaps book is now gainfully employed as an officer at a publicly traded company with as much or more responsibility than they had previously.
Roddy is right. The fact that the failure of these people was not criminal does not excuse it. These people were paid big multiples of average earnings and demonstrated that they can’t do their job. So they are still paid big multiples of average earnings.
Along this line special scorn needs to be reserved for Win Neuger. He ran AIGs internal asset management business - especially the securities lending business which in itself was big enough to destroy AIG.
He now runs an asset management company with over $80 billion under management.
Where else - except Wall Street - can you be that well rewarded for failure?
Recommendation
I don’t want to give too much away. This is the best book yet written about any specific episode of the crisis. I just think you should buy it. Buy multiple copies. Give them to your friends. They will be grateful too.
John
*Hint to the regulators: try and work out the large finite transaction between Unum Provident and Berkshire Hathaway. There lies a can of worms...
Herbalife's streak of beating earnings guidance every quarter since 2008 is over. They missed this quarter - not by much - but it is a miss for a company that seems to grow like topsy.
The shorts on Twitter/Seeking Alpha having spent some time saying that the numbers don't matter (just the business model) are now claiming some victory on numbers. Herb Greenberg (the only regular short I really have a lot of time for) stated that he thought the numbers don't matter but he now wants to assert meaning in the numbers.
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But lets examine them dispassionately.
Short-sellers in this stock (particularly Bill Ackman) have a thesis that the company is a con - a scam which requires endless new victims to sign up and buy a whole lot of inventory in the promise of getting rich. They assert that there are very few real customers. [In Bill Ackman's first presentation one of his staff suggested it was possible that there were no real customers.]
They want government intervention to shut the company down - but if it is a pyramid as such it will collapse on its own. New victims can't be found forever. In other words the shorts would like government intervention but they are not dependent on it.
My view (and the long view generally) is that there is a huge amount of real consumption and real consumption is easily visible. Go to a few Herbalife distributors and you will see daily consumption. Lots of it. (I have visited Herbalife distributors in multiple countries and spoken to many more and I have yet to visit a Herbalife distributor consistent with the Ackman thesis).
What you find is a sort of cult of weight loss. If you drink protein shakes and diet suppressing teas daily you will lose weight. The only problem is sticking to that diet. Enter Herbalife who provide a (for profit) community to help you to stick to that diet. The community combined with the shakes is the product.
Visit Herbalife distributors and what you see is very large numbers of people who have entered or aspire to enter a routine of "daily consumption".
You see repeat customers.
Repeat customers are central to the bull case. If you get more of them earnings can grow for a very long time. Moreover it is very hard (nay impossible) to argue that someone who buys $100 worth of product, then in two months buys $100 more, and two months later buys some more and so on for years is scammed in the Bill Ackman sense. They know what they are getting. They are not deceived.
In my view the network recruits vast numbers of people to the diet-cult. Most fail consistent with most diets. A small number become daily consumers and this tribe of daily consumers grows nearly continuously. Most of the sales of Herbalife are to the tribe of daily consumers - the sales to new recruits whilst important don't actually drive current quarter sales. [Some of these new recruits however will become daily consumers and drive sales for years.]
The bull case - and it is a very strong bull case indeed - is that the daily-consumption tribe will continue to grow at mid-single digit for a very long time. You could wake up in ten years and earnings be $30 a share and the stock (say) $600.
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The problem with endless growth stories
Imagine a company growing 10 percent per annum with a very high return on equity (so little capital is needed for additional sales).
Moreover assume that the discount rate is 7 percent.
Then try doing a discounted cash flow analysis.
If you assume that the growth goes forever then the value of the company is infinite.
So you must quite reasonably assume that the growth stops at some point. And the value of the company depends critically on when the growth slows. If it slows in 30 years it makes sense to pay a very big PE ratio for the company now.
If it slows next year you will get crushed buying at a high price.
Herbalife has grown fast enough since 2008 that you can engage in fantasies as to its ultimate valuation. Revenue in 2008 was $2.3 billion. It is now over $5 billion. And until the first quarter of this year it was growing uninterrupted in every geography. And the growth was volume growth - not just revenue.
Moreover the potential market is huge: fat people. This company sells roughly 10 percent of the number of "meals" as McDonalds but it sells then to far fewer people (mostly daily consumers). The potential number of daily consumers is a large multiple of the current number.
The enormous growth does enable fantasies. This stock could be very good indeed.
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Alas - the slowing down of Herbalife growth
Herbalife was growing, quite fast, in all jurisdictions in all quarters until very recently.
One year ago they published their volume growth and sales leaders numbers and they looked as follows:
Volume growth was 11 percent in North America, 16 percent in Europe, Middle East and Africa, 33 percent in South and Central America and 49 percent in China. It was 1 percent in Asia Pacific - which mostly means Malaysia. But that was after years of torrid growth.
Jokingly I suggest: try putting those numbers into your discounted cash flow analysis.
But the shorts would argue that the Chinese numbers are anomalous - they are just finding another billion people to scam. That seemed delusional. The sales growth in North America - the most mature market - and hence the one where the pyramid-style collapse should have already happened - was still double digit. [I concluded - and still believe - the shorts are slightly unhinged.]
Moreover the sales growth per active sales leader is increasing in many markets. This means that mid-level distributors are getting paid more. That makes for a happy network.
In the first quarter of this year Herbalife had its first slowdown of any kind. These numbers shocked me to the downside and my position has been smaller ever since.
Note the sales decline in Asia Pacific. This was the first sales decline in any region that I remember.
The point is that if sales are shrinking in one region they may in turn shrink in any region. It means the growth that seemed bullet-proof from 2008 to 2013 was no longer bullet proof.
Moreover the sales leaders grew faster than sales. This meant the income of mid-level distributors was starting to get pressured. This is not good news.
Still North American growth was high (9 percent, not double-digit) and China was off-the-scale good.
These are not the numbers of a stock trading at a 10 times forward price earnings multiple. But they are no-longer the numbers that allow me to indulge $1000 a share fantasies. To get to $1000 a share in any reasonable time-frame growth numbers have to be impregnable. They clearly showed some vulnerability.
The sales decline it appears was almost entirely in Malaysia where one explanation on the ground is that they had a new competitor. Malaysia was at the time the number one market in the world for Herbalife according to Google Trends. Trends in Malaysia had been unbelievably good.
Malaysia for the unaware (meaning most my readers) has a different typical Herbalife distributor to (say) New York. New York tends to have "nutrition clubs" which feel a bit like down-market coffee shops where people sit around and drink shakes.
Malaysia has boot camps.
The shtick is that you turn up in a public park on a weekend morning and you do fitness classes. The first class is typically free. They are hard work. Over time they sign you up for both paid fitness classes and Herbalife shakes.
There is a quid-pro-quo. The fitness classes also have evening social outings - dances which serve multiple functions: weight loss support, Herbalife cult-revival, matchmaking. There are several vidoes on YouTube of these.
The first is a picture of a (soft) exercise class in a park for overweight (mostly Muslim) Malays:
The second video shows something that I have never seen elsewhere - women in full Muslim dress dancing.
This is a different image of Herbalife: part bootcamp, part fitness club, part diet club, part dance party. There are many hundreds of people at some of these clubs. These are reasonable sized businesses.
There is one of these clubs in Sydney now - with a Malaysian upline. See the 24 Fit Club. It is clearly a Herbalife club - but the meal plan is only part of what they sell.
I always - and instinctively thought that the Malaysian model was better than the Latin American/New York model. Exercise plus diet shakes clearly works better than just diet shakes. [I have seen cycling groups associated with Herbalife clubs in Miami - so the models do change according to the skills and interests of the distributors.]
Anyway an ugly sales decline in Malaysia was a decent sized kick to the Herbalife fantasy. If sales declined sharply in one market because of competition - especially when the market looked so viable - they could decline everywhere. It was impossible to project growth forever.
The 2014 second quarter earnings miss
This quarter the sales growth by region does not look anywhere near as good as in the past.
Notably there was a sales decline year on year in North America. That is a first. And there was a sharp sales decline South and Central America. This is clearly evidence that growth at this company is no-longer a given. Fantasies of enormous stock prices become more difficult to support.
However the observant will notice that Asia Pacific grew quite substantially (6 percent) quarter on quarter even if the annual growth rate was only 1 percent.
According to the short thesis this is not meant to happen. These things are meant to implode like Ponzis, not stage resurgences.
The resurgence is particularly notable because it seems that the competitor did not gain traction: the network effects of Herbalife are particularly strong. That is bullish.
Moreover whilst Herbalife sales have some seasonality (people want to lose weight for summer because of bikinis and the like) Malaysia is - climate wise - probably the least seasonal market possible. It is just hot there. So there is not a seasonal driver here.
Volumes are essentially flat quarter on quarter in North America. Its annoying and a challenge to the bull thesis but it is not disastrous.
By contrast the quarter on quarter declines in South America were quite sharp. I am wondering whether this looks like Malaysia last quarter or whether something else is happening. Whatever: as a Herbalife bull it is not good news.
Valuation
This stock remains less than ten times forward earnings. Volumes are still growing 5 percent though that volume growth is down from 14 percent a year ago and the numbers no longer look impregnable. Incremental ROE is high - and there is a huge runway for growth in Asia and China.
They buy back their shares with their profits.
The management are focussed on returning profits to shareholders through buy-backs at least in part to drive out the shorts.
I can think of no other business with that sort of volume growth, such a high incremental ROE and equity shrink. This is a great stock.
Just not as great as it was before. The upside has shrunk. No question about it.
But I can imagine few worse shorts. I have visited many Herbalife distributors and the Ackman thesis is supported nowhere. And the shorts flit between the numbers not mattering and the numbers being critical.
The numbers do matter. They are not as good as they were. The upside is capped at a lower number but still closer to $200 a share than $100. I think I can wait. Just not as happily as before.
John
Disclosures: I purchased some in the morning of Ackman's speech. I turfed some later in the day (and I am not normally a day trader). I repurchased some of those in the after-market today. The core holding is much smaller than it was last year - but it is still meaningful and we intend to sit on it a very long time.
J
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Post-conference call comments: In the conference call they revealed that Venezuelan sales were down 40 percent. They had previously had trouble getting cash out of Venezuela and ran the risks of assets there being nationalized. This was a rational reduction in sales. Brazilian sales were down 1 percent - completely coincident with the World Cup. It seemed Brazilians wanted to party, not to diet. The rest of Latin America grew nicely.
The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.
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