Seeking Alpha
Special situations, growth at reasonable price, value, micro-cap
Profile| Send Message|
( followers)

Background: The two latest articles on this company on Seeking Alpha focus either on the issues of Herbalife (NYSE:HLF) as the subject of a possible short squeeze or on whether it runs an illegal pyramid scheme. These topics are what dominate the media coverage right now. I therefore thought it would be appropriate to discuss the company and its stock primarily as if HLF were just another equity to consider investing in. In order to make this article timely, I have written it as a general overview rather than as a detailed study of the company, its business practices, and its products.

I would hope this article is both accurate and even-handed, and would serve at least as a way for those unfamiliar with the company to begin to learn about it.

Note that I am not an expert on multi-level marketing companies, have no relationship to Herbalife in any way, and do not consider myself to be an expert on Herbalife as a company or on the stock. I am approaching HLF as if it were any other investment that I might have or be interested in possibly purchasing.

I am not attempting to influence anyone to purchase or sell HLF or any option related to it. I simply think that too often, it is assumed that people know the story of a company that the media grabs onto because of a dramatic situation. Perhaps this article can serve as an easy-to-read piece for those who do not know much about the corporation that is talked about a lot right now as billionaires take their positions in the stock, in reality or at least by rumor.

Introduction: Founded in 1980, the network marketing company Herbalife has become the subject of immense attention due primarily to the large short position of hedge fund Pershing Square, run by Bill Ackman. In response, Carl Icahn has taken a large position in the company, along with board representation. It has now been reported by CNBC that George Soros' organization has made HLF a significant position of its own, possibly in hopes of helping to create a situation in which Pershing Square and other short-sellers cover, rocketing the shares higher.

Underlying the above is an operating company with publicly-traded shares.

The company: HLF has described itself as a direct multi-level marketing ("MLM") company. It has been compared to the private company Amway and the public companies Tupperware (NYSE:TUP) and NuSkin (NYSE:NUS) in its business model. It is best known for weight loss products such as the Formula 1 protein shake and nutritional supplements. It also produces personal care products.

HLF went public in 1986, was taken private in 2002, and went public again in 2004 under new management including the current CEO. The stock is currently up by about 9X since its IPO. It pays a $1.20/year dividend and has paid dividends continuously since 2007. The company has also aggressively used free cash flow to shrink shares outstanding. Several members of the executive team had executive positions at Walt Disney Co. (NYSE:DIS).

Independent Reviews: Value Line (VL) covers HLF and gives it a somewhat better-than-average financial strength score of B++ and an average safety rating of #3. Not counting this week's earnings report, 5-year annual average sales growth has been 17%; earnings growth has been 27%; book value growth 20.5%.

VL rates HLF an above-average #2 for timeliness. Its "value line" for HLF is 12X cash flow. With cash flow perhaps reaching $6/share for the full year 2013, that would put VL's fair value estimate for the current year at $72 as of June 30, one month ago. VL also projects a 3-5 year price target for HLF of $75-110, in addition to dividends. Even from today's about $65/share price, the total return projected for HLF is modestly above that of the Value Line median.

Value Line's data and commentary suggests that HLF is a growth company for which a share price around $65 is quite reasonable, leaving reasonable total return upside. In fact, the stock reached $63.4 in 2011 and $73 last year, all before Pershing Square went public with its diatribe and case against HLF. EPS and sales are much higher now, though, with the company having raised its outlook three times in 2013 alone.

A different independent stock advisory and research organization, Standard & Poor's, also follows HLF. S&P now forecasts $5 EPS in 2013 and $5.50 next year. Its proprietary valuation model suggests a $93 fair value for HLF shares. It does rate the stock "high risk". It reviewed the controversy over KPMG's withdrawal as an auditor due to apparent insider trading in HLF by KPMG's auditor of the company. S&P was not especially suspicious of the circumstances attendant to the withdrawal of KPMG as auditor.

At least two other independent research firms, both quantitatively-oriented, rate HLF versus other firms. Thomson Reuters gives HLF an '8' on a 1-10 scale, in the top quartile of all firms. Verus Analytics rates it slightly above average at '6'.

All together, these independent rating services provide a margin of comfort that HLF is performing well and has good prospects. No guarantees, though!

it should be noted that in Belgium, one lower court decision in 2011 found the company guilty of violating Belgian law regarding pyramid operations. Herbalife disagrees; the case is on appeal. I am unaware of any other such judicial findings anywhere else. S&P, Carl Icahn, etc., are presumably very well aware of this case.

Operations and products: Herbalife is focused on the U.S. and global obesity "epidemic". Formula 1 shakes are its flagship product, sales of which grew 16% this past quarter. Q2 represented the 15th consecutive quarter of double digit topline growth. The company also reported that June was the highest volume month in Herbalife's history.

HLF's main business model involves selling directly to end users. It has been calling them "distributors", but is switching to the term "members". These customers may also sell to new users. Other sales derive from people who make a business, usually part-time, from marketing Herbalife products. These are called sales leaders.

The company is geographically very well-diversified. From its press release July 29 announcing Q2 earnings:

Three Months Ended Six Months Ended
6/30/2013

6/30/2012 (2)

6/30/2013

6/30/2012 (2)

North America$247,564 $224,661 $469,037 $435,372
Mexico 145,638 119,449 278,527 236,558
South and Central America 222,362 152,583 441,877 318,054
EMEA 186,286 161,635 355,871 315,627
Asia Pacific 299,240 296,548 610,986 556,496
China 118,149 77,072 186,588 134,016
Worldwide net sales 1,219,239 1,031,948 2,342,886 1,996,123
Cost of Sales 247,224 203,737 473,201 399,881
Gross Profit 972,015 828,211 1,869,685 1,596,242
Royalty Overrides 379,551 335,195 743,580 652,728
SGA 400,107 306,310 764,827 602,703
Operating Income 192,357 186,706 361,278 340,811
Interest Expense - net 5,559 3,169 10,932 4,542
Income before income taxes 186,798 183,537 350,346 336,269
Income Taxes 43,636 51,586 88,311 96,387
Net Income 143,162 131,951 262,035 239,882
Basic Shares 102,993 116,557 103,551 116,376
Diluted Shares 107,083 121,482 107,589 122,182
Basic EPS$1.39 $1.13 $2.53 $2.06
Diluted EPS$1.34 $1.09 $

Herbalife continues to expand on multiple fronts, both geographically and with a growing product line.

The KPMG issue: After being hit late last year with a diatribe from noted short-seller Bill Ackman that collapsed the stock into the $20s, HLF suffered a double whammy when KPMG was suddenly forced to resign as auditor and withdraw its certification of the validity of Herbalife's books. Because this is such an important issue, I present the KPMG statement from its chairman and CEO in full regarding:

KPMG LLP Chairman and CEO John Veihmeyer issued the following statement upon reviewing the criminal complaint filed today against former partner Scott London. London was charged today in the Central District of California for conspiring to commit securities fraud through insider trading.

"I was appalled to learn of the additional details about Scott London's extraordinary breach of fiduciary duties to our clients, KPMG and the capital markets. We unequivocally condemn his actions, and deeply regret the impact that his violations of trust and the law have had on our clients and our people. KPMG will be bringing legal actions against London in the near future.

"As a result of his unlawful activities, it was clear that our independence had been impaired with respect to the two companies for which he served as lead partner, Herbalife and Skechers. Due to this impairment, we were professionally obligated to take the regrettable action to resign as the independent auditor for these two companies and withdraw our previously issued audit reports. The sole reason for these steps was the actions of our former partner and we have no reason to believe that their financial statements are materially misstated."

I hope that that's all there is to it and that the auditor did not go along with fraudulent accounting in order to engage in profitable insider trading. Bill Ackman has not to my knowledge charged the company with accounting fraud; HLF stands by its accounting. I would think that Carl Icahn and his team members on HLF's board would have satisfied themselves on this issue by now and that their silence suggests that they are comfortable about this issue.

Other points: Herbalife was founded by Mark Hughes, who died in 2000. He built a health-oriented marketing-focused company. This focus continues; sales are expanding at a double-digit volume pace. Profitability is good, with operating margins around 20-22% and net profit margins around 10%. The last quarter had some moving parts, but generally the company has had reasonably predictable earnings. Value Line puts its earnings predictability at the 80% percentile of the companies it follows. That this metric was so high surprised me.

No insider sales have occurred this year; officers and directors own about 4.7% of the stock. Carl Icahn may hold about 16% of the shares, and now it appears that George Soros' investment vehicle is a substantial holder as well. 93% of the outstanding shares are held by institutional and mutual fund holders. Sponsorship is good. As of 3/31, 19% of the shares were held by Morgan Stanley plus the Fidelity Growth Company Fund. These are sophisticated shareholders.

The above points suggest to me that a great deal of due diligence has been performed on this company. Given its market niche, which always raises suspicions, this is very important, though again, as a total outsider, I cannot be sure of anything.

Upside potential: Assuming HLF's business conditions are as the company has reported, then as a serial raiser of expectations, shareholders can hope for further upside sales and earnings surprises.

As of 7/15, 30% of the shares had been sold short, many by Pershing Square. If the stock continues to rise, some and perhaps many of those shares may be covered, providing fuel to the rise.

Risks: The nutritional business is highly competitive and lacks regulatory or patent protection. There are many challenges involved in running a company that is headed for $5 B in sales that operates globally. The high level of short selling historically suggests caution. My understanding is that historical research has shown that highly-shorted stocks tend to underperform. (Whether that research includes highly-shorted companies with the sponsorship of Carl Icahn and possibly George Soros, though, is in my mind doubtful.)

Another risk could be that Carl Icahn could in theory claim at any time that he no longer trusts management and his representatives have resigned from the board. I'm not aware of any hint that this would occur, but am simply pointing out that the future has not happened yet. Wall Street does not guarantee anyone a profit from purchasing a stock. And perhaps Mr. Soros is not a shareholder, after all; perhaps the "sources" are incorrect.

Allegations that Herbalife is an illegal or improper pyramid scheme pose another risk.

With a beta of 1.05, HLF is exposed to general stock market risks. In addition, of course, it is impossible to delineate all the risks attendant to investing in HLF.

Summary: Aside from the drama involving the hedge fund moguls, Herbalife presents itself as a dynamic, well-funded company driven by aggressive and successful marketing. It is demonstrating strong sales and profit momentum despite a generally-sluggish global economy. In addition, the company has a strong record of returning profits to shareholders both through buybacks that have greatly shrunk the count of outstanding shares, and through dividends.

Insiders have not been selling stock all year.

The auditor issue with KPMG remains an unfortunate background risk until Price Waterhouse says that the books have been properly audited.

Allegations that HLF is running either an illegal pyramid scheme or at least an inherently unstable one should in my view be considered by any HLF potential investor. One never knows when or if a governmental action will appear against the company.

All in all, HLF appears to be an interesting stock that remains off its all-time high despite record sales and earnings, with the possibility of a short squeeze as a potential catalyst to move the stock up rapidly. Downside risks of course exist, both of the "headline" type and fundamentally.

Disclosure: I am long HLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: Nothing in this article constitutes investment advice. I am not a registered investment adviser. Note the caveats in the article, as well. This particular stock is controversial.