Herbalife (HLF) is under siege by Pershing Square.
In 2012 the company generated in the neighborhood of $400 million of free cash flow (FCF). This morning the market cap is roughly $3.9 billion. The company's FCF yield is in excess of 10%. Longs argue that HLF should be buying back its stock.
Charlie Gasparino from Fox Business News tweeted yesterday:
FBN NEWS: HLF buying back stock since Jan 17; investors demand more aggressive program, source. Go-slow approach reflects long battle w Ackman
Herbalife's Board of Directors have an interesting capital allocation decision to make. Consider, free cash flow can be used in different ways:
- paid out as cash dividends
- reinvested in building the business
- to pay down debt
- to retire stock
Successful capital allocators manage the FCF mix to yield the best results for shareholders.
Q. If you had a seat on HLF's board, what would you do with a $1 of FCF?
Ostensibly, HLF's stock looks inexpensive. A 10% cash on cash return would favor an aggressive buyback program v. the alternatives.
Certainly if Herbalife's Board and management team have confidence in their business franchise, they should be buying as much stock as they can.
Historically, management has taken aggressive steps to reduce Herbalife's share count.
In July of 2012 Herbalife's Board approved the repurchase of up to $1 billion worth of stock with an expiry date of June 2017.
Q. How has the board done with share repurchases?
Any shares repurchased historically above today's stock price is a dilutive transaction for shareholders. Any shares repurchased below this price are, seemingly, accretive.
Here is a history of HLF's Share Repurchases since 2009
2009 - 4 million shares at $18.20
2010 - 5.7 million shares at $26.13
2011 - 5.5 million shares at $54.27
2012 Q1 - .7 million shares at $67.24
2012 Q2 - 5.3 million shares at $46.37
2012 Q3 - 3.9 million shares at $46.37
On a combined basis, since 2009 Herbalife has repurchased $1 billion worth of stock at an average price just shy of $40 per share.
Today HLF's stock is bid $35.00
As of today, HLF is underwater on its share repurchase program and so are its investors.
Q. Did the company borrow money to repurchase its shares?
From the company's most recent 10Q:
Our existing debt has not resulted from the need to fund our normal operations, but instead has effectively resulted from our share repurchase and dividend activities over recent years, which together, since the inception of these programs in 2007, amounted to approximately $1.9 billion.
Herbalife's business model has generated generous amounts of free cashflow. The company does not have material investments in Property, Plant nor Equipment. Most of its assets are Intangible and/or Inventory. Herbalife does not require long-term debt to finance capital purchases.
Nonetheless, Herbalife's balance sheet has $450 million worth of Long-Term debt as of the end of Q3, 2012.
In the summer of 2012, the company entered into an arrangement with Merrill Lynch to have Merrill repurchase $427.9 million worth of stock at an average price of $46.37.
Q. How did the company pay for it?
From the company's most recent 10Q:
As of September 30, 2012 the U.S. dollar amount outstanding under the Credit Facility was $500.0 million. As of September 30, 2012, the aggregate annual maturities, including interest, of the Credit Facility were expected to be $15.0 million for 2012, $154.9 million for 2013 and 2014, and $357.2 million for 2015 and 2016.
Q. How's that Merrill Lynch trade working out for HLF shareholders?
As I sit here right now, HLF stock is bid $35 in the market.
To summarize, HLF has borrowed a total of $500 million of capital with an interest expense of roughly 1.9% to acquire $427.9 million worth of shares from Merrill Lynch.
Today these 9.2 million shares would cost $322 million at a bid of $35.
Opportunity cost for shareholders?
What's $105 million between friends?
Borrowing money/employing financial leverage to buy back stock is a risky enterprise. If the transaction is accretive the rewards to shareholders can be compelling.
If, on the other hand, the trade works against you, shareholders get stuck with the bill twice.
- The equity account takes losses due to the collapse in share price.
- Shareholders still end-up having to assume the long-term liability from the debt incurred.
Longs who are pounding the table for Herbalife to buy-in more shares should think carefully about this enterprise.
Using the current stock price and the recent transaction with Merrill Lynch as an analog, Herbalife's board has diluted shareholder value with its most recent transactions.
The answer is obvious. The open market value of the stock is now lower than the price they paid to retire the shares.
Share buybacks are best employed when the following 3 scenarios are met:
- when the stock trades at a discount to its intrinsic value
- when the future cashflows the company generates are both steady and predictable
- when operating cashflow and not financial leverage is the key source of the cashflow used to refinance the purchases
Financial engineering often ends up as a "Fool's Errand" and share buybacks (unlike Dividends) are no guarantee of accretion.
Gearing a balance sheet to buy back stock for a company that has such a high rate of churn in its customer base seems equally cavalier.
Herbalife's Board of Director's track record with share repurchases is not exactly stellar.
Every single share repurchased since the end of 2010 has been a dilutive transaction.
Warning to HLF longs who want the company to continue to buy back stock:
Be careful what you wish for.
Maybe the more prudent move would be to pay-off some of that debt balance?
Certainly if I were Herbalife's banker I might be feeling a little queasy right now.