Notorious PwC: Herba-Life After Death

Much has been recently said about the possibility that Herbalife will come in with fully audited financials either when they report Q3 earnings, or possibly before that. To be sure, this will be a seminal moment for Herbalife investors (long or short). 

One aspect of their re-audit that has been the subject of much discussion is the possibility that they will restate earnings. I think a minor restatement which is not material to Herbalife's earnings certainly may be a possibility given the change in auditors, but even if this were the case, I am doubtful that  if a minor restatement does occur that it will have any material impact on the company's future, or more acutely on the company's stock. Although I can't ignore the potential for a restatement I view it to be unlikely. The possibility of a restatement has been raised by Francine McKenna and reiterated by Ackman in letters to his investors as well as his 52 page book report he sent to PwC. Although you can't discount this possibility in its entirety, those that believe a material restatement is on the way are failing to take a very important piece of information into consideration: functionally speaking, PwC reviewed Herbalife's Q2 earnings in full prior to its release. 

Let me be absolutely clear on this point to avoid any confusion because the word "review" carries a lot of weight here. I am not saying that Herbalife filed a 10Q with PwC's SAS 100 compliant review and report (because they did not). Herbalife specifically said on their conference call that they filed "without the (SAS) 100 review and therefore, without the required stocks 906 certifications. The 10Q is complete in all other respects including SOX 302, CEO, CFO Certifications as to the accuracy of financial information." What I am saying though is that functionally speaking PwC actually reviewed the financials as part of their responsibilities as Herbalife's accountants otherwise Michael Johnson and John DeSimone would not have signed off on SOX 302 certification which requires interaction between Herbalife and PwC. In providing SOX 302, Johnson and DeSimone provided certification that:

1. They have read the report filed with the SEC,
2. The report does not contain untrue statements or omit statements of a material nature,
3. Statements made in the reports are not misleading,
4. Financial conditions and operations of the company are fairly represented by the report,
5. Internal controls of the company are their responsibility and the internal controls are designed in such a way that material information is communicated to them in a timely manner,
6. Internal controls within the company are assessed for operating effectiveness within 90 days of the certification and the conclusions on effectiveness have been included in the report,
7. Significant deficiencies in design or operation of internal controls that could impact the ability to record, process, summarize, and report financial information have been communicated to the company's independent auditors and the audit committee of the Board of Directors,
8. Material weaknesses in internal controls have been communicated to the company's independent auditors,
9. They have disclosed any fraud by senior management or other employees who have a significant role in internal controls (materiality is not a consideration with fraud), and
10. Whether there have been significant changes or corrective actions with regard to significant deficiencies and material weaknesses in internal controls or other factors subsequent to the date of the original evaluation of controls.

Johnson's and DeSimone's willingness to certify under section 302 clearly demonstrates that their report is accurate and not misleading and further leads me to believe PwC is very familiar with Herbalife's past and current accounting procedures.  

Furthermore, for all that has been made out of PwC not auditing Herbalife's latest financial results, but that other auditors have failed to share, is that under SAS 100 guidelines it states:

•  "In other situations, the accountant may determine it appropriate to issue a written report to address the risk that a user of interim financial information may associate the accountant with the interim financial information and, in the absence of a review report, inappropriately assume a higher level of assurance than that obtained."

PwC was clearly referenced in Herbalife's unaudited 10Q as being Herbalife's accountants performing the reaudits, yet PwC wrote no report stating that Herbalife's financials were unreliable in any way, although SAS 100 guidelines indicate they should do so if they felt otherwise. In the absence of such a report, I am left to believe that PwC takes no issues with Herbalife's accounting practices.

In another section of SAS 100 guidelines it also states that  "Communications Between Predecessor and Successor Auditors, requires a successor auditor to contact the entity's predecessor auditor and make inquiries of the predecessor auditor in deciding whether to accept appointment as an entity's independent auditor. Such inquiries should be completed before accepting an engagement to perform an initial review of an entity's interim financial information." This is just yet more evidence that PwC is on board with Herbalife's accounting and KPMG's prior audits. I mean, if I'm the guy that is thinking about asking out my buddy's ex-girlfriend, you better believe I'm going to ask him if he gave her the herpes I know he has, or if she really just has a cold sore. I can only think that if there was anything material to Herbalife's accounting, that it would have come up in those required inquiries, yet PwC accepted the engagement and since being engaged has issued no reports to contradict Herbalife's financials. I think that when we look at Herbalife's audited numbers, we're going to see Abreva and not Valtrex.

So what gives with 906's noticeable absence? Nothing as sexy or revealing as you'd imagine, just simply that section 906 specifies that the certification must state that the periodic report fully complies with the requirements of Exchange Act Sections 13(a) and 15(d) and Herbalife can't fully comply because their financial statements are not yet audited by an independent auditor. Even if Johnson and DeSimone wanted to furnish 906 certificates, they couldn't because by doing so they would be certifying compliance when it does not exist, and thus go to jail. Once PwC SAS 100 compliant review is complete, Johnson can put on his gear and go on a triathalon-like SOX 906 signing binge from his pool or his bike or his running shoes.

This leads to our next, but perhaps most fundamental question: Why was PwC unable to complete their audit? There must be some nefarious secrets and information lurking in the shadows at the Herbalife Headquarters, right? If you look at Herbalife's latest 10Q you'll see that is not from lack of trying as they spent $3.5 million in re-audit fees just in Q3. To put that in context, Herbalife paid KPMG $4.3M and $4.8M for all accountant services  in 2011 & 2012, respectively. The answer it turns out is yet again, pretty simple and not so interesting: the current audit will rely on auditing all prior quarterly filings and annual filings. In other words, they have to start at the beginning. In a very simple, but relevant analogy, how could PwC sign off on current carryforwards, without having fully reviewed the previously reported carryforwards or circumstances that caused them to arise?

And this brings us to the final question of the day: Why is it at all important? Well it's important for two main reasons:

1. It sets the baseline for what we can expect from PwC with respect to accounting treatments in all of the re-audits. I would be very surprised if PwC's accounting treatments for Q3, or for all prior re-audits, were to deviate from the treatments shown to us in Q2 because PwC is obviously comfortable with Herbalife's most recent accounting.
2. It also informs us as to why the Q2 financials were not provided with PwC's stamp of approval, or the company's 906 certification and why they are deficient in their filings. 

In closing, I have to remind myself that if you are an analyst reading this, you probably don't give a shit because you've got 30 models open in Excel right now, and you're going to back everything out to non-GAAP topline data anyway and see yet again that Herbalife is growing quarter to quarter, year to year. What is probably most likely is that you don't give a shit because you're not reading this at all, analyst or otherswise. Either way, as boring and unexciting as discussing the causes and implications of Herbalife's lack of audited financials may be, delivery of those audited financials may just kick in the door on the shorts.

So...

This goes out to you

This goes out to you, and you, and you, and you

This goes out to you

This goes out to you

This goes out to you, and you, and you