Herbalife Asks Investors To Close Their Eyes And Imagine That It Did A Big Debt-Financed Stock Buyback

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A theme these days seems to be that if you can dream up a debt product, people will buy it, as long as the coupon is low enough. Take your pick of UBS's 7.625% 10-year coco that is in some loose sense junior to its common equity, 2013 looking like a record year for covenant-lite loans, the return of private-label RMBS with weak reps and warranties, or the fact that Rwanda recently issued a 6.875% 10-year bond. Here's something that won't fly though:

Herbalife Ltd. recently halted plans for a debt offering that would have raised cash for stock buybacks after auditor KPMG LLP resigned earlier this month, Chief Financial Officer John DeSimone said Tuesday.

The nutritional-supplements company was in the process of "putting together a meaningful new debt arrangement that if done would be used to buy back stock," Mr. DeSimone said on Herbalife's quarterly earnings call.

Those plans were put on hold after KPMG abruptly resigned as the company's auditor earlier in April following revelations that one of the accounting firm's former partners had divulged confidential information about his clients to a friend who used it to trade. The resignation left Herbalife without audited financial statements.

"We were going down that path, and that path has now been blocked," Mr. DeSimone said, adding that Herbalife is reviewing other options with banks.

Here is today's earnings call on which DeSimone said that, and here is Herbalife's sad 10-Q, with financial statements stamped "(Unaudited and Unreviewed)," which is ... I'm sure not unprecedented but not quite contemplated by the SEC's rules either.1 Perhaps it should be. Like, "if you're filing unreviewed financials, you should print them in a different font, Comic Sans or something."

What are the other options Herbalife is reviewing? One way to put it is: if, I don't know, Skechers2 was planning to do a big debt-financed stock buyback full of both bond-issuance and buyback economics for its banks, and all of a sudden lost its audited financials for insane turns-out-the-audit-partner-was-a-crook-on-the-side reasons, would the bank (and Skechers) still find a way to get the deal done without the audited financials? It's a genuine question, I don't know the answer, but I have this sneaking suspicion that it's yes. As far as I can tell you don't, like, technically need audited financials to sell debt,3 or to buy stock.4 It's just ... better.

My guess, and I'm probably wrong, is that a bank that really wanted to get this done could probably get it by their lawyers and committees.5 (And once you do that, you can obviously get it by investors. I mean, the stock is up since Herbalife lost its auditor.6) With one condition, that condition being something like "the committee and the deal team need to be really really really really really comfortable that everything in the financials is right and nothing will come back to bite/sue us." One can imagine the deal team, faced with more or less personally certifying the more or less most controversial set of public company financials in America,7 advising Herbalife that it makes more sense to go slow.

And I guess Herbalife didn't mind too much. They're still buying back stock, though more conservatively than they wanted to. And it's the thought that counts: Herbalife, which is up ~1.7% today, managed to get some of the warm glow of announcing a big debt-financed stock buyback, without actually spending the money.

Herbalife Dropped Debt-Offering Plan After KPMG Quit [WSJ]
Herbalife's CEO Discusses Q1 2013 Results - Earnings Call Transcript [Seeking Alpha]

1.As HLF's NT 10-Q helpfully explains:

Also, as a result of KPMG’s resignation, the unaudited interim financial information presented in the First Quarter 10-Q has not been reviewed by an outside independent accounting firm as required by the rules of the SEC. As a result, the First Quarter 10-Q is considered deficient and the Company is no longer considered to be timely or current in its filings under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). While the First Quarter 10-Q does not comply with the requirements of Regulation S-X, and should not be interpreted to be a substitute for the review that would normally occur by the Company’s independent registered public accounting firm, the Company’s Audit Committee and management believe that the interim financial information presented therein fairly presents, in all material respects, the financial condition and results of operations of the Company as of the end of and for the referenced periods and may be relied upon. Except for the absence of this review of the unaudited interim financial information discussed above, the First Quarter 10-Q fully complies with the requirements of the Exchange Act and the Company believes it is prudent to file the First Quarter 10-Q with the SEC in spite of the current circumstances to provide the financial and other information set forth therein to its shareholders and other interested parties. The Company plans to file an amendment to the First Quarter 10-Q as soon as practicable following the engagement of a successor independent registered public accounting firm and the firm’s review of the Company’s interim financial statements included therein.

2.Whom I obviously mention because the KPMG partner was insider trading on them as well as Herbalife, and so equally left them without an auditor. Until last week. When they hired one. BDO, but still. If I were Bill Ackman I'd have offered them like $10mm to hire a plausible new auditor before Herbalife announced Q1 earnings. Every day that Skechers has a decent auditor and Herbalife doesn't looks kinda bad for Herbalife, no? Here is a more sympathetic view of Herbalife's auditor-y plight and, yeah, fair enough, there really ought to be more than four-and-two-halves reputable auditing firms.

3.Since a whole lot of debt is done under Rule 144A, which requires that:

In the case of securities of an issuer that is neither subject to section 13 or 15(d) of the Exchange Act, nor exempt from reporting pursuant to Rule 12g3-2(b) under the Exchange Act, nor a foreign government as defined in Rule 405 eligible to register securities under Schedule B of the Act, the holder and a prospective purchaser designated by the holder have the right to obtain from the issuer, upon request of the holder, and the prospective purchaser has received from the issuer, the seller, or a person acting on either of their behalf, at or prior to the time of sale, upon such prospective purchaser's request to the holder or the issuer, the following information (which shall be reasonably current in relation to the date of resale under this section): a very brief statement of the nature of the business of the issuer and the products and services it offers; and the issuer's most recent balance sheet and profit and loss and retained earnings statements, and similar financial statements for such part of the two preceding fiscal years as the issuer has been in operation (the financial statements should be audited to the extent reasonably available).

So if they were a private company they could say "not reasonably available, working on it." But of course Herbalife is subject to sections 13 and 15(d), being a public company; it's just violating them. It's not entirely clear to me, though, that that would prevent it from doing a 144A debt deal?a Might be an oversight in the rules. In any case of course you can issue true-private-placement debt without it being 144A-eligible, it's just more annoying and less desirable for investors. But less desirable than what? Rwanda?

a.Well more technically a 144A offering is normally done by the issuer under the Reg D exemption - Rule 144A is for resales by QIB investors to each other - and Reg D requires that the company provide audited financials to non-accredited investors (see Rule 502(b)(1) & (b)(2)(ii)). But of course anyone buying in a 144A deal is a QIB and thus likely to be an accredited investor so, y'know, no problem.

4.Which Herbalife is still doing - as they said on their earnings call, "We will continue to repurchase stock on an opportunistic basis utilizing our strong cash flow from operations."

5.And if the bank's okay, Herbalife should be too, right? It's not like you incur more liability, as the company, from doing a private deal with wrong-and-unaudited financials than you do from doing a public deal with wrong-and-audited financials. And presumably you trust your own financials. The banks, who didn't prepare the financials and want to have a due diligence defense, should be more conservative than the company.

Oh incidentally I know I'm switching the thought experiment from Skechers to Herbalife here. It makes more sense for Skechers I guess but still.

6."Well but fixed income investors are more conservative than equity investors about this sort of thing," you say, but honestly, listen to yourself.

7.Are there other contenders? Is #2 JPMorgan? Discuss.