The role of short sellers in the market has been debated for some time. For some, they are seen as vultures, manipulating the market and spreading vicious rumors for their personal gains. And for others, short sellers are a necessary part of the markets, taking on the challenge of ensuring corporate transparency in an age where many believe securities regulators have become far too lax. While we believe that short selling does have a role to play in the markets, it is possible for it to be excessive. And that is precisely what is going on with shares of Herbalife (HLF), which has come under fire from Bill Ackman of Pershing Square Capital. In our view, Ackman's attack on Herbalife is excessive, and with shares of Herbalife down almost 28% over the past 5 days, long-term investors have been handed a buying opportunity. In this article, we will defend Herbalife, and attempt to explain to readers and investors why Ackman's charges are illogical and inconsistent with the financial results at Herbalife.
Setting the Stage
On Wednesday, December 19th, Herbalife shares plunged following a CNBC report that Bill Ackman of Pershing Square Capital was shorting Herbalife and was set to make a presentation regarding the company on Thursday, December 20. Ackman accused Herbalife of being a pyramid scheme, and that the company was ripe for a collapse. Herbalife CEO Michael Johnson issued a stirring rebuttal in an interview with CNBC, accusing Ackman of manipulating the markets, noting that an extraordinarily large number of put options, expiring on December 22, were purchased in recent days. Ackman, in his presentation on the 20th, said that he does not own put options on the stock, and then proceeded to explain his short thesis (which can be examined in detail here). The core of his thesis, however, is that Herbalife is a pyramid scheme, one that exploits vulnerable people, such as college students and stay-at-home-moms in order to line its own pockets. Herbalife's shares fell 9.75% on December 20, even as analysts defended the company, arguing that Ackman's research was flawed (we will discuss analyst reactions a bit later). We agree with this assessment. There are several flaws in the theory that Herbalife is a pyramid scheme, and in this article, we will explore 3 of the reasons that we believe the short thesis regarding Herbalife is flawed:
- Growing sales in the United States.
- Insider & Institutional Ownership.
Growing US Sales: How Do You Con People in the World's Largest Economy for 3 Decades?
Herbalife was founded in 1980, and went public in 2004. Naturally, the United States was Herbalife's first market, and the company has been operating here in the United States for 32 years. In our view, the question to ask therefore is this: how can a pyramid scheme operate for 32 years, and consistently grow its sales? Growth at Herbalife has been fueled in large part by the company's international expansion, and the company now has operations in over 80 countries. A pillar of Ackman's thesis is that the company has hidden the inherent weakness in its business by continuously expanding to new countries, something that cannot go on forever. However, an analysis of Herbalife's financial data shows that this argument is flawed.
If Herbalife is indeed a pyramid scheme, it stands to reason that sooner or later, sales in each of its markets will begin to fall, as people who join the Herbalife "community" realize that this is nothing more than a scheme designed to enrich the company and its executives at their expense. Therefore, shouldn't sales in the United States be declining? After all, if Herbalife is a pyramid scheme, how can the company continue selling products here in the United States for over 3 decades? In Q3 2004 (Herbalife's first third quarter as a public company), the company's net sales in the United States totaled $68.1 million. In Q3 2012, the company's net sales in the United States totaled $202.9 million. That equates to a compound annual growth rate of 14.62% over those 8 years. We fail to see how a pyramid scheme can sustain such a growth rate over 8 years, much less sustain itself over the course of over 3 decades. How can Herbalife continue to grow its American business if it is all a pyramid scheme? If Herbalife is only growing its sales and profits by expanding into new countries (thereby masking collapses in older markets), shouldn't there be a collapse in the United States, the oldest market of them all? And yet, Herbalife has been consistently growing its business here in the United States. In our view, the reason why is simple: Herbalife is a legitimate business, and while not everyone can become successful as a Herbalife distributor, we doubt that the company would be able to operate for over 3 decades if its business model was not proven.
Insider (and Institutional) Ownership: If You Run the Scheme, Why Own a Piece of It?
Let us assume, for a moment, that Herbalife is indeed a pyramid scheme. If this is the case, it means that someone is benefiting at the expense of others. In this case, Herbalife's management team and board of directors are lining their own pockets at the expense of the company's distributors and customers, and by extension, the company's investors. If Herbalife is a pyramid scheme, it means that the company's stock is a terrible investment, given the fact that the entire business model is built on a fraud. Therefore, the company's management has no reason to own its stock. After all, they are fully aware that this is a pyramid scheme. Why would they risk their ill-gotten gains by holding millions of shares of Herbalife stock?
As of the end of the third quarter of 2012, Herbalife has 108,001,495 outstanding shares. And Herbalife's management team and board of directors own over 2 million of those shares, with Chairman & CEO Michael Johnson holding over 1.1 million shares himself. We break down their holdings below.
Herbalife Insider Ownership
Managing Director, EMEA
Managing Director, North America
Chairman & CEO
Managing Director, Mexico
Richard P. Goudis
EVP, Sales & Marketing
Managing Director, Asia-Pacific
Collectively, Herbalife's directors and top executives own nearly 2% of the company (1.8731%), and we fail to understand why Herbalife's insiders would own over 2 million shares of the company if it were a pyramid scheme. While it is true that 2 of Herbalife's directors, and its managing director of the Asia-Pacific market do not hold any shares, Chairman & CEO Michael Johnson owns well over 1 million shares himself. Just exactly which directors or executives should own how much stock of a company has been debated for some time in the markets, but one thing is not up for debate in our view: the fact that a CEO who owns a decent-sized stake in his or her company should be seen as a vote of confidence. And so should entrenched institutional support.
Fidelity is Herbalife's largest single investor, with a stake of 15.24%. Vanguard and Morgan Stanley are the company's second and third largest investors, with stakes of around 6% each. Herbalife enjoys deep institutional support, with the company's 10 largest institutional investors owning 44.85% of its shares. We find it difficult to believe that Herbalife has been able to so consistently fool institutional investors such as Fidelity and Vanguard since it went public in 2004. These are not investors who buy shares of a company simply because they are infatuated with its business model. We doubt that a company such as Fidelity, which has a vast array of research capabilities, would find itself in control of over 15% of a pyramid scheme.
Time: Should it Take More Than Three Decades to Uncover a Pyramid Scheme?
As DA Davidson noted in its defense of Herbalife, perhaps the best argument in favor of the company is also the simplest. And that argument is time. Herbalife has been in business for 32 years, and in our view, it should not take three decades for regulators to uncover a pyramid scheme. Critics may argue that it is only a matter of time before the FTC and SEC come investigating Herbalife, and that the issue here is that regulators are too slow at catching under the radar schemes, not that Herbalife is innocent. We, however, do not think this is the case. Herbalife is not an under the radar "scheme," one that can operate for years before regulators are aware of what is going on. Herbalife is a company that posted over $3 billion in revenues in the first nine months of 2012 alone, with 3.1 million distributors around the world, and as of the end of 2011, the company had 5,100 employees (the number is likely to have grown since then). We find it difficult to believe that a scheme as large as this could go unnoticed by the FTC and SEC for over three decades. Critics will argue that Herbalife has already been ruled to be a pyramid scheme by a Belgian court. Shouldn't that mean that the company is in fact a pyramid scheme? Not necessarily. Herbalife operates in over 80 countries, and laws regarding multi-level marketing are different in each of those countries. The ruling in Belgium, which accounts for 0.65% of net sales at Herbalife, applies to Herbalife's Belgian operations, and the company is appealing the ruling.
The SEC, however, has taken a different view on Herbalife. The regulator began investigating Herbalife in October 2007 for possible insider trading violations (that issue has since been resolved), and a month later, informed the company that its investigation would be expanding to include an examination of Herbalife's business model. Specifically, the agency wanted to determine how much of the company's product was being personally consumed by Herbalife's distributors, and whether or not the company was withholding information from investors. However, the SEC closed the case in June 2008, and no charges or enforcement actions were brought against Herbalife or any of its executives. In 2012, the SEC once again began examining Herbalife's disclosure policies. However, in July, the SEC stated that it considered its examination of Herbalife to be over, following additional information provided by Herbalife. Critics who charge that regulators will soon be looking into Herbalife's business model should remember that they have already done so, and found no evidence of impropriety relating to the company's operations. The SEC has now examined Herbalife twice, and has closed its investigation both times, with no charges filed. In our view, it is highly unlikely that the SEC could miss evidence that Herbalife is a pyramid scheme twice within 5 years.
Analyst Defenses, Herbalife's Financials, and its Valuation
Analysts that cover Herbalife have been united in their defense of the company. DA Davidson analyst Timothy Ramey stated that Ackman's presentation "gets an A for effort and style points" but that there is "not much substance" in his presentation. Ramey also added that, "[T]he central thesis seems to be that the compensation in royalties and overrides paid to the top distributors - which are very clearly linked to a volume point of product sales - is actually a payment for recruiting. We disagree and we suspect the company has multiple logical arguments should it ever need to defend itself to regulators." But perhaps the sharpest section of Ramey's latest research note on Herbalife was his commentary on the issues of class (and race) that are raised by Ackman's short thesis. Ramey writes that, "Ackman dismisses, at his own peril, the fact that Herbalife is a premium product that is consumed daily by a very loyal and growing population of people who are concerned about diet and healthy living. They may not look like the people Mr. Ackman knows in Chappaqua, but they are out there, and in growing numbers; weight loss is becoming a growing industry. The supposed pyramid will not collapse if there is real demand for the product - and we believe there is; Mr. Ackman seems to believe there is not." Chappaqua, where Ackman lives, is one of the wealthiest cities in the United States, with a median family income of $180,451. Chappaqua is rated as the 42nd wealthiest place in the United States. Ramey charges that Ackman's vision is clouded by the fact that he himself has never used Herbalife products, or knows people that sell them. And we do see the logic in this rebuttal. Many investors conflate their personal experiences with a company (or lack thereof) with its investment potential. Do investors avoid shares of Lockheed Martin (LMT) simply because they have never been inside an F-35 fighter? And do they buy shares of Procter & Gamble (PG) simply because Tide is their favorite detergent? Personal experience should have no role in making investment decisions. And it is possible that Bill Ackman has forgotten this essential investing rule.
B. Riley analyst Linda Weiser was also unimpressed with Ackman's thesis, and writes that the company has "potent buyback capabilities." Weiser stated in her latest report on Herbalife that,
"HLF has a clean, unleveraged balance sheet and has found a solution to the Grand Caymans incorporation issue (shareholders' equity cannot be negative for Grand Caymans companies), therefore HLF has the freedom to repurchase as much stock as it wants. With debt of about $500mm and 2012E EBITDA of about $750mm, HLF can easily add $2B of debt to its balance sheet to repurchase stock (it could potentially add even more debt). Our past discussions with management lead us to believe they would be willing to lever up the balance sheet to execute essentially a 'mini-LBO.'"
Herbalife ended Q3 2012 with $321.722 million in cash & equivalents on its balance sheet, versus debt of $500.437 million. Herbalife has ample room to buy back stock, and as the company's income and cash flow continues to grow, the company's balance sheet will continue to strengthen, giving it increased flexibility to buy back stock. And with over 19% of Herbalife's float sold short, an increase in the size of the company's buybacks is likely to have a disproportionate impact on its stock price (Herbalife bought back $506.331 million of stock in the first 9 months of 2012). While Herbalife's inventory has risen from $247.696 million at the end of 2011 to $311.283 million, this increase is not due to an inability to sell product. On the company's Q3 2012 conference call, CFO John DeSimone explained this rise in inventory, stating that the rise was due to
"product made at third parties. This investment in inventory has been necessary given the significant growth we are experiencing in markets with very long supply chain lead times, plus buffer inventory, necessitated by the execution of our vendor consolidation strategy to reduce the number of vendor partners to those that are capable of scaling with our growth."
While inventories are an issue that investors need to examine carefully over the course of the next several quarters, we believe that the company's present rise in inventory is not an issue, and that the company is overproducing to have a buffer as it moves forward with vendor consolidation.
As Herbalife's stock has continued to fall due to Ackman's disclosures that he is short the stock, the company's valuation has become more and more compelling.
(click to enlarge)Based on the company's December 20 closing price of $33.70, Herbalife trades at just 8.38x its estimated 2012 EPS, and 7.41x its estimates 2013 EPS (a growth rate of 13.18%). And should Herbalife increase its stock buybacks, the company's EPS estimates will rise further. Herbalife's recent slide has caused its yield to rise to 3.56%, and the company has the financial flexibility to raise its dividend even more (the company currently pays a quarterly dividend of 30 cents per share).
In our view, Bill Ackman's short thesis is flawed. Herbalife's sales in the United States are still growing, even after 32 years of business. The company's insiders own millions of shares, and Herbalife enjoys deep institutional support. And perhaps most important of all, it should not take 32 years to uncover a pyramid scheme. Herbalife has been investigated twice by the SEC, and in both instances, the SEC closed its investigation with no charges or enforcement actions brought against the company. Herbalife is a company that is misunderstood by many, and its recent selloff has created a buying opportunity for long-term investors. Herbalife is undervalued, has a solid dividend yield, and good global growth prospects. We believe that Herbalife's best days are ahead of it, and that the company will, in time, prove its critics wrong. We have added to our position in Herbalife on the back of this selloff, and believe that investors who add to or initiate positions in Herbalife will be rewarded for their conviction.