This Just In: Upgrades and Downgrades


At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

What's the deal with Herbalife?
It has begun. Two days ago, famed "short" hedge fund manager Bill Ackman announced that he has taken an "enormous" (his word) short position in shares of nutritional supplement maker Herbalife , a company he describes as a being a plain-and-simple pyramid scheme. Within hours of the announcement, shares of the company had dropped 10%, adding to a 12% loss the day before ... and punctuating losses that continue today, as the stock continues to dive a further 6.5%.

Investors, to understate the point, are getting spooked, and already, the follow-on downgrades are beginning to roll in, with Argus Research leading the followers with a downgrade to hold yesterday. But is there anything really to this apparent panic?

At first glance, there doesn't appear to be. To the contrary, assuming you trust the financials that Herbalife files routinely with the SEC, this company looks to be an incredible value. Priced at a low, low 8.2 times earnings, pegged for annualized profits growth of more than 15% by most analysts on Wall Street, and paying a generous 3.2% dividend yield -- evidence that its profits are real, and can be paid out in the form of real, tangible dividend checks -- it's hard to see what Ackman, and now Argus, might have against the stock.

Digging into the story Thursday, Bloomberg Television invited Ackman on to talk about his short, and comment on some rather disturbing statements made by Herbalife's CEO in response to it. Suffice it to say, Ackman did not disappoint. Let's review.

On the true nature of Herbalife
"This is a company we started analyzing a year and a half ago. This is a company that we have done an enormous amount of work. ... I believe that it is a certainty that this company is a pyramid scheme. ... This is the highest conviction I have ever had about any investment I have ever made, full stop."

On the implication that Herbalife is "cooking the books"
"The highest ranks of the company precisely understand what they are up to."

On what Ackman's doing, in addition to talking, to help his "short" position along
"We have given the FTC a lot of information that they would like to see in getting a better understanding of this company ... [and] the new Consumer Financial Protection Bureau, what is it for if not to protect -- again, the target market here for Herbalife are those who could not have qualified for a subprime mortgage during the crisis and can't put up a deposit to buy a home."

On whether he's scared of Herbalife's lawyers
"We welcome their suing us. If they sue us, we get access to inside information on Herbalife that we can prove that we are telling the truth."

On whether he's scared of Herbalife's CEO
Responding to Ackman's short, Herbalife CEO Michael Johnson was recently quoted saying that "the world would be better off without Ackman."

To this, Ackman responded in kind: "It is a strange and scary thing to say for the CEO of a NYSE-listed legitimate company. I never had a company react -- even look at MBIA [a company, incidentally, that Ackman shorted during the financial crisis]. They were very professional ... [but when] the CEO of a public company makes threatening statements, you have to ask yourself, why would he possibly say something like that?"

Why indeed?
As I said, at first glance, the numbers at Herbalife look good enough -- on the surface -- that an investor might be tempted to ignore Ackman's convictions, and take advantage of the apparently incredible buying opportunity he has created in Herbalife stock. Before you go in whole hog, however, it's worth pointing out that there is at least one sign of trouble starting to show up in Herbalife's numbers.

Specifically, for the past several years, Herbalife's earned an admirable record of generating more free cash flow than its GAAP financials claimed for "net income." In this respect, the company has imitated rival "health foods" companies, including Hain Celestial , Nutraceutical , and even USANA -- although USANA has problems of its own lately ...

Herbalife, however, recently broke from this pack. According to its SEC filings, in fact, the past 12-month period was the first time since the "bad years" of the financial crisis in which Herbalife actually took in less free cash flow than it claimed to have earned under GAAP accounting standards. For now, the gap between GAAP and real cash profits in minimal -- a matter of some $37 million. It could be, however, the first sign we've seen in the company's public financials that clearly supports what Bill Ackman is now saying in warning about the company.

If the trend reverses -- all well and good. On the other hand, if in future quarters we see Herbalife's free cash flows begin to fall further and further behind its reported "net income" ... look out below.

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Fool contributor Rich Smith has no positions in the stocks mentioned above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 296 out of more than 180,000 members. The Motley Fool owns shares of Hain Celestial. Motley Fool newsletter services recommend Hain Celestial. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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