Despite Herbalife's (HLF) best efforts to quell the drama and allegations surrounding the company, it has been unable to put to rest allegations that it is a pyramid scheme. Shares of the company have been whipsawed since Bill Ackman's presentation outlining his short thesis on the company, ticking up and down with every minute development. On February 4, 2013, the latest development in the Herbalife saga injected even more volatility into the company's share price. A New York Post article detailing FTC complaints about Herbalife sent shares plunging in early trading, with the stock falling well over 10%, before rallying to close with gains of over 1%. Our analysis of this FTC data, as well as aggregated FTC complaint data shows that worries over these claims are unfounded.
192 Complaints in 7 Years: An Enviable Track Record
The New York Post, through a Freedom of Information Act request to the FTC, revealed that Herbalife has been the subject of 192 consumer complaints over the past 7 years (these complaints, totaling over 700 pages, are accessible here). The New York Post added further fuel to the fire by stating that Herbalife itself is the target of an FTC probe, something that the company denied later in the day, stating that it is "unaware of any other regulatory interest and/or investigation." The FTC issued a statement on February 4 that it misspoke in its response to the Post's request. Spokesman Frank Dorman told reporters that the FTC should have stated that it redacted certain parts of the released complaints because the agency is barred from disclosing complaints obtained from foreign sources if they request confidentiality. The FTC withdrew its earlier explanation for these redactions, which stated that the agency could exempt information gathered in the course of a law-enforcement investigation from Freedom of Information Act disclosures. While the presence of FTC complaints regarding Herbalife may appear to be cause for concern, the FTC's own data tells a different story.
Any company that is able to manage just 192 consumer complaints to a government agency in 7 years is to be admired. The Consumer Financial Protection Bureau, which has taken control of financially-related consumer complaints, received 2,700 complaints regarding Capital One (COF) in just 10 months (between July 2011 and May 2012). Even American Express (AXP), seen as the gold standard in customer service within the industry, logged 870 complaints. Herbalife, on the other hand, has received just 192 complaints over the course of 7 years, for an average of 27.43 claims per year, hardly a level that can be considered excessive. Considering that Herbalife has hundreds of thousands of distributors here in the United States, this is an impressive level of complaints. The mere presence of FTC complaints does not delegitimize a company. There is no company that can please 100% of its customers 100% of the time, if it claims to do so, that can be an indicator of fraud. The most that Herbalife, or any company for that matter, can do is try and please as many of its customers as possible, and find ways to optimize its business so that the number of complaints can be minimized.
Placing These Claims in Context
Let us assume, for a moment, that Herbalife is indeed a pyramid scheme. But not just any pyramid scheme; let us assume that Herbalife, over the course of 32 years in business, has become the largest and most insidious pyramid scheme in the history of the United States. Shouldn't complaints regarding Herbalife not only be flooding into the FTC, but also make up the majority of the complaints that the FTC receives regarding business opportunities (the FTC category for complaints involving franchising, distributorships, employment agencies, invention promotion, and work from home offers)? If Herbalife was the largest pyramid scheme in the history of the United States, logic suggests that this should be the case.
The FTC's own data tells a different story, however. In 2011 (2012 data is not yet available), the FTC received a total of 36,111 complaints regarding business opportunities, which represented 1.99% of the total number of complaints that the FTC received in 2011. Of these 36,111 complaints, 17,730 complaints involved employment agencies, job-counseling companies, or overseas work offers. Complaints covering business opportunities and work at home offers totaled 19,863 for 2011. It is important to remember that these thousands of complaints cover only 2011, whereas Herbalife has been the subject of 192 complaints over the course of 7 years. Herbalife constitutes a small minority of the claims the FTC receives regarding business development opportunities. Given that Herbalife, with sales of over $3 billion in the first 3 quarters of 2012, is one of the largest multi-level-marketing companies in the United States, it is only logical that if the company were a deceptive pyramid scheme, it would be the subject of the majority of the FTC's complaints in this category.
We are not arguing that Herbalife's FTC complaints should be completely ignored. But, basing investment decisions solely on these complaints is equivalent to basing an investment decision in American Express of Capital One based only on the amount of consumer complaints that the companies receives. Neither Herbalife nor any other company in the world can please all of its customers. There will always be some unhappy customers in any business; the best that Herbalife can do is work to ensure that the number of unhappy customers is as low as possible.
Financials, Buybacks, and the Short Squeeze
With over 33% of Herbalife's float sold short, due in large part to Bill Ackman's position, the potential for a shirt squeeze is large. And Herbalife itself has announced that it expects to begin repurchasing stock once it reports Q4 2012 earnings on February 19 (however, since the company announced preliminary results on January 17, there is little reason to wait for February 19). And Herbalife has ample room to buy back shares. The company ended Q3 2012 with $321.722 million in cash & equivalents. As of the end of Q3 2012, the company had debt of $500.437 million, in the form of an unsecured revolving credit facility due March 2016. Herbalife has borrowed $500 million from the facility, and has $200 million more in borrowing capacity. With Herbalife's operating cash flow set for continued growth in Q4 2012 and 2013, the company will have further room to buy back shares. Additionally, the company could suspend its quarterly dividend of 30 cents per share, which costs the company just over $32.4 million per quarter (for a yield of 3.37% at current levels), to make room for additional buybacks. In our view, Herbalife investors, including us, would prefer to see buybacks rather than dividend payments. Let us assume that Herbalife will draw down the remaining $200 million on its credit facility, as well as utilize $100 million in existing cash. Even if shares of Herbalife will rally to $40 on the back of an announcement of buybacks, Herbalife will still be able to repurchase 7.5 million shares, or 6.94% of its outstanding shares (which totaled 108,001,495 as of the end of Q3 2012). And analyst Linda Weiser of B. Riley notes that with an estimated $750 million in EBITDA in 2012, and debt of around $500 million, Herbalife can add up to $2 billion of debt onto its balance sheet to buy back a majority of its outstanding shares (the company's market capitalization is currently around $3.84 billion) and still maintain its loan covenants.
With so much of Herbalife's float sold short, a sizeable buyback could induce a short squeeze into the stock, one that will drive EPS forecasts for 2013 and 2014 higher. The current consensus EPS forecasts call for 2013 EPS of $4.64 (growth of 14.85%), and 2014 EPS of $5.18 (growth of 11.64%). Based on Herbalife's February 4 closing price of $35.54, Herbalife currently trades at 7.66x estimated 2013 EPS, and 6.86x estimated 2014 EPS, which are levels we consider to be highly undervalued (for the record, the consensus price target for Herbalife is around $65).
Fortune Hi-Tech Marketing & FTC Action
We fully expect readers critical of Herbalife to bring up Fortune Hi-Tech Marketing, which was shut down by the FTC (in cooperation with the attorneys general of Kentucky, Illinois, and North Carolina) in late January. Fortune Hi-Tech, which was founded in 2001, was shut down for running an intricate pyramid scheme across the United States. Shares of Herbalife, which was not mentioned by the FTC or the 3 attorneys general during their press conference regarding Fortune Hi-Tech, fell one the back of this regulatory action, fueled in part by the fact that Simon Davies, Fortune's Chief Analytics Officer (and CFO from 2006-early 2012), held the position of Director of Internal Audit at Herbalife from 1994 until 2005. Critics of Herbalife seized on this, arguing that the only reason Mr. Davies was hired by Fortune was so that he could apply the expertise he gleamed from running Herbalife's pyramid scheme at Fortune. We think that such speculation is unwarranted. Because Fortune was a private company, we do not know the details of Mr. Davies' compensation package. Perhaps he was lured away from Herbalife by the promise of a larger salary. And in any case, 11 years is a long time to work in a senior management role without a promotion. Seeing as Fortune Hi-Tech offered him the post of CFO in January 2006, he felt that the time to make a move was at hand.
Setting aside the fact that Herbalife and Fortune Hi-Tech Marketing are 2 different companies, and that even Lou Abbot, a noted critic of many multi-level marketing companies, has said that Fortune operated in a "much grayer area than Herbalife and other multilevel marketing companies because so much of the income [earned by top-level distributors] was from signing up people," let us assume that the 2 companies are in fact connected, and the FTC's actions here are simply a prelude to its upcoming shutdown of Herbalife. Even if this were to happen, Herbalife will still survive, due to its legal structure and diverse international operations.
The FTC's authority is limited to the United States, and while Herbalife's operating headquarters are located in Los Angeles, the company is incorporated in the Cayman Islands, which is a British Overseas Territory, and therefore outside the FTC's jurisdiction. The FTC can only shut down Herbalife's U.S. operations (and seize its Los Angeles facilities), which in no way constitute Herbalife's only distribution centers. Herbalife maintains 300 distribution points across 88 countries, which can serve to limit the fallout from any potential shutdown of its Los Angeles facilities. In Q3 2012, the United States constituted 19.95% of Herbalife's sales, and 18.76% of its contribution margin. It is important to remember that even if Herbalife's U.S. operations are halted, the company will still have its diverse international business, which is subject to different laws and regulations than those of the United States. The laws and regulations governing multi-level-marketing companies are different in each of Herbalife's markets, and we do not believe that extrapolating any potential action taken by the FTC to Herbalife's international business is a prudent thing to do. Even if 20% of Herbalife's earnings were to disappear, the company's 2013 and 2014 EPS forecasts would fall to $3.71 (for a P/E of 9.58x) and $4.14 (for a P/E of 8.58x). Even without the company's United States operations, Herbalife's forward multiple is still in the single digits, and does not take into account the potential for an increase in EPS forecasts due to share buybacks.
In our view, long-term, patient investors should use the recent decline in shares of Herbalife to add to or initiate positions in the company. The FTC's own data reveals that Herbalife's complaints are quite small for a company of its size. We would expect more than 192 complaints over the last 7 years stemming from the largest and most intricate pyramid scheme in United States history, and believe that such a scheme should constitute a much larger proportion of total business development complaints that the FTC receives. Herbalife has the capacity to repurchase meaningful amounts of stock in the weeks and months to come, and its jurisdiction, as well as the diversity of its revenue base, can help shield the company from FTC action, something that we believe is unlikely. As Dan Loeb notes in his long thesis for Herbalife, "The short thesis rests on the notion that the FTC has been asleep at the switch, missed a massive fraud for over three decades, and will shortly awaken (at the behest of hedge fund short seller) to shut down the Company. We find this thesis to be preposterous, particularly since the FTC has been sensitive to frauds of this kind. Since 1997, the FTC has brought 13 separate cases against alleged pyramid schemes." We fully agree with this argument. Herbalife is not a mysterious company. It reports billions in revenues each year, and has millions of distributors around the world. Given that the FTC has not stood idly by when it comes to pyramid scheme, it is difficult to see how the agency could miss such a large pyramid scheme for over 3 decades. While the controversy surrounding Herbalife is unlikely to disappear soon, we believe that at these levels, shares of Herbalife are a compelling long-term investment for risk-tolerant investors.