Shareholders of Hain Celestial (HAIN -3.99%) have endured a stomach-churning year. The company has failed to produce a quarterly report since May of 2016; there are no signs this will change any time soon.
The possible explanations for this run the gamut. Do we trust that CEO and founder Irwin Simon is simply running into some accounting errors created by underlings? Or are there much more serious problems afoot?
This article in no way can answer that question with 100% certainty. However, it provides a powerful framework from which to view the situation.
Image source: Getty Images.
Step 1: How proceed with so many unknowns
It has been over 250 days since Hain Celestial last reported earnings. But now, even those numbers are being put into question.
The officers at Hain clearly know more about what's going on at the company than individual investors. That's true with any company. But it's problematic when we don't know who to trust.
How do we deal with that? Here's what risk expert Nassim Taleb has to say:
About 3,800 years ago, Hammurabi's code specified that if a builder builds a house and the house collapses and causes the death of the owner of the house, that builder shall be put to death.
What the ancients understood very well was that the builder will always know more about the risks than the client, and can hide sources of fragility and improve his profitability by cutting corners ... The builder can also fool the inspector, for the person hiding risk has a large informational advantage over the one who has to find it.
Who knows more about hidden risks than anyone else at Hain? Irwin Simon -- the founder, CEO and Chairman of the company. So I went back to see how much skin Irwin has in the game.
What I found was disappointing: The total number of shares he owned peaked in 2003, and have fallen by 60% since then. At the same time, his compensation packages have ballooned -- from as little as $2 million in 2005 to as much as $26 million as recently as 2013.
Admittedly, there's overlap: Part of these compensation packages comes from options to buy the company's stock. But a clear trend has established itself.
Data source: A review of all publicly available DEF 14A filings with the SEC.
The red line represents the type of skin in the game that I -- as a shareholder -- want to see. Simon has downside exposure if there are risks that eventually come to light.
The green line largely represents only upside for Simon; while some of that compensation comes via equity rewards, many of those shares are sold, and still more is provided by cash bonuses for meeting certain criteria.
Step 2: Determine Simon's incentives
Simon has had several different compensation packages determined by meeting preset goals. The earlier agreements don't specify exact criteria, while the later ones -- thanks to demands for transparency in the Age of the Internet -- are much easier to parse out.
At its core, Simon was compensated for continually meeting growth goals for:
- Overall revenue
- Overall earnings per share
- Adjusted EBITDA
On the face of it, there's nothing wrong with these metrics. In fact, they're pretty solid. There's one problem, though: They are awful guidelines for a company like Hain Celestial.
That's because Hain has become a leader in natural/organic foods and personal care products by becoming a serial acquirer.
Image source: Getty Images.
The company has rolled up hundreds of smaller brand names that have made a name for themselves independently. By acquiring them, the thinking goes, Hain can inject the money and scale necessary to take them to the next level.
Except, that may not be what's happening at all. One 2015 review on Glassdoor.com stated: "Hain's current acquisition model essentially operates on limiting up-front costs ... they slim down an acquired brand's team to the bare minimum."
Similar reviews paint an equally unflattering picture.
This opens up the door for an alarming theory: Hain could have been continually buying up smaller players because it knew it would have an immediately positive impact on revenue. And by cutting the acquired brand's operations down to the bare bones, greater profitability could be eeked out.
While a great strategy for the short term -- and for meeting performance goals to maximize compensation -- this could be disastrous for shareholders over the long run.
Step 3: Identify the important metrics
Of course, one review from an anonymous employee should never inform an investing decision. There's got to be cold, hard, numbers in there, too. I would argue that organic revenue growth -- how much Hain was able to grow the brands it's already owned for a year -- would be a much better indicator for whether or not Hain is actually any good as a business.
Just don't tell that to management.
In 2008, a rather shocking confrontation happened during the company's conference call when analyst Daniel Khoshaba of KSA tried to get this critical number from Ira Lamel, Hain's CFO at the time. According to Seeking Alpha, here's how it went down:
Ira Lamel: "There is no way I am going to be able to give you what our organic growth at retail was on Celestial."
Daniel Khoshaba: "You don't have organic, well, how about organic growth for the company?"
Lamel: "We do not give organic growth for the company."
Khoshaba: "Why not?"
Lamel: "Because we don't give it."
Khoshaba: "I would think you would want to share it that with your shareholders?"
Lamel: "We don't give it. Can we move on to the next question?"
This sequence alone should be enough to give investors pause. Management is purposely obscuring one of the most important variables.
I say "purposely" because in future conference calls, several analysts -- especially Greg Badishkanian of Citigroup (C 1.00%) -- try to figure out what the organic growth rates are by doing some backwards math. Lamel and Irwin continually play a game of cat and mouse, telling the analyst if his guesses are getting warmer or colder.
The fact of the matter is that management knew very well what the number was. If they didn't, they wouldn't know if an analysts' guess was correct.
Alas, by the time 2013 rolled around, management had changed its tune. John Carroll, CEO of Hain Celestial's U.S. operations, had this to say at an investor conference, according to a Seeking Alpha transcript (emphasis added):
We will be able to ... focus on the brands that we've acquired and drive them organically because organic growth is the underpinning of the company.
That's what I call an about-face.
But even then, the company wasn't completely forthcoming. On the very next conference call, the most Simon would say about organic growth was that "it was around high single digits."
What does that mean?
Sure, "high single-digits" could be -- say -- 7% to 9%. But "around" that number? Do we go as low as 5%? Maybe 4%? Is this really a good way to report on what your executive claimed three months earlier to be "the underpinning of the company"?
The cat-and-mouse game continued -- at varying levels -- over the coming years. At times, very specific numbers were given. At others, they weren't.
But starting in November 2015, the results were getting ugly in the United States, where the company did about 40% of its business:
- November 2015: Simon says, "U.S. organic growth from the U.S. businesses were down."
- February 2016: Simon says (emphasis added), "Organic growth for all our businesses, excluding the U.S., was up high single-digits."
- May 2016: CFO Pasquale Conte says: "Our UK business delivered low-single-digit organic growth." No specifics were given for U.S. organic growth.
Combine this with slowdowns at some of Hain's biggest customers -- Whole Foods and United Natural Foods -- and it shouldn't be too surprising that growth started slowing.
The signal and the noise...
This brings us to the accounting scandal -- which initially started as a relatively benign investigation of revenue recognition on vendor concessions.
I spent so much time on incentives and skin in the game not to indict Simon or any other executives of purposeful misdeeds. Instead, it's to point out that they are only human, reacting to (admittedly terrible) incentives laid before them.
That's how we've arrived at where we are.
But the market is future-looking, and I don't think it looks bright for Hain. That's not because of the accounting scandal, but because of the narrowing moat for the company.
By far the most insightful commentary on the interplay between the company's long-term prospects and the scandal came from an August Fortune article by Shawn Tully:
Here's the looming threat. It's possible that all of this occurred because the distributors reckoned that the stores they're selling to would order a lot more organic products than they're ordering -- meaning customers at those stores are putting fewer Hain products in their shopping carts. If so, it's a signal that the hunger for Hain's brands, and maybe other organic brands, is fading.
For a stock trading at 21 times trailing free cash flow, I wouldn't want to pay the price for fading brands...or mis-incentivized executives.
