With the beginning of the current decade, a rapid change was witnessed in the global sports nutrition and meal replacement market. Historically, only a selected few groups, which included those actively involved in sports or dedicated bodybuilders, were the primary consumers of these products. Now, with the heightened awareness of health issues along with the move towards a healthy life style, an increasing number of regular people have started consuming nutritional meals and supplements. The availability of various nutritional products in different forms such as beverages and replacement meals, which were previously only available in the form of medicine, further supported the shifting trend.
The United States, a country reported to have one of the highest obesity rates in the world, has seen attractive growth in its supplements market. The market size reached $30 billion in 2011, exhibiting a growth of approximately 6.8 percent, from the previous year. The sports nutrition and meal replacement market accounted for 22 percent of the total market and this sector, in particular, has experienced high growth in demand due to the rising health concerns of an average person.
In the area of nutrition and weight management, Herbalife (HLF) has emerged as the new market leader in the US with a market share of approximately 19 percent. The company has been consistently registering high growth in its top and bottom line through geographic expansion and the promotion of daily consumption. Although Herbalife faced some hiccups with the implementation of its strategy, the company was successful in the end and its success is reflected in its stock price, which has risen by more than 85%, since the start of the season.
The company has generally outperformed itself year on year, with constant improvements in its revenues, earnings and operating margins. However, the revenue base experienced a decline in the fiscal year 2009 primarily due to the unfavorable currency fluctuations. When measured in the local currency, net sales of Herbalife actually increased by more than 5 percent in 2009. The highest growth of 26 percent in revenues was achieved in 2011. Over the last 5 years, the company has registered a CAGR of approximately 13.7 percent in its revenues. The total revenues in 2012 crossed the $4 billion mark. In terms of its local currency, the company achieved an average annual growth of approximately 16.2 percent in its revenues. Hence, it is clearly evident that the adverse currency movement has significantly affected the company's results.
The geographic expansion and the changes in the company's business model were the major contributors of the spurring growth of the company over the years. By 2012, the company had expanded its operations in 88 countries as compared to 70 countries in 2008.
The company has adopted several business practices, such as the introduction of Nutrition Clubs, Lifestyle Centers/Offices, Weight Loss challenges and Roadshows, which were collectively named as the distributor daily method of operations "DMO". This has significantly helped the company in increasing the effectiveness and productivity of its distribution networks. The company's increased spending on events and promotions, both in terms of absolute dollars and as a percentage of sales, has helped the company penetrate deeper in the markets of various regions. It has also helped in the establishment of a recurring customer base.
The company's earnings and margins have also improved over the years, with the latter rising from 14.1 percent in 2008 to 16.22 percent in 2012. The company's EPS has more than doubled since 2008. While maintaining a fairly stable gross margin, the company has improved its operational efficiency primarily through controlling selling, general and administrative expenses. They have been reduced to 30.9 percent of net sales in 2012 as compared to 32.7 percent of net sales in 2008. The high growth in revenues in the latter part of the examined period has also helped in improving the operating margin of the company. Apart from these factors, the expenses reported in 2008 and 2009 included severance payments amounting to $1.3 million and $6.7 million respectively, a payout required by the restructuring program conducted by the company.
Out of the various regions that the company operates in, Asia Pacific (excluding China) has been the fastest growing region in terms of net sales. In 2012, approximately 28 percent of the company's total net sales came from this region, which comprises of 14 countries. Over the last 5 years, the region has achieved a CAGR of approximately 24.7 percent in net sales. However, in terms of the local currency, the region has registered an average annual growth of more than 31 percent over the same period. Within this region, South Korea currently has the largest market for Herbalife's products while India has the fastest growing market with net sales growing at an average annual rate of 94.5 percent, in terms of local currency, over the last 4 years.
In terms of the number of countries, Europe, Middle East and Africa (EMEA) is the largest region with the company operating in 50 countries. The region contributed approximately 15.4 percent of the company's total net sales. It is the fourth largest market of the company, after Asia Pacific, North America and South and Central America. However, it is the slowest growing region and registered a CAGR of only 2 percent in net sales over the last 5 years. In terms of local currency, the region has exhibited an annual average growth of approximately 7.6 percent in net sales. Within this region, the company's net sales in major economies such as Italy and France have declined over the years. However, Russia and Spain have witnessed positive growth in its net sales which was backed by the company's affiliation with football clubs, such as FC Barcelona and FC Spartak Moscow. To sum up, the company is currently in the process of changing its existing business model in Italy and it expects that the country will register positive growth once again when the DMO model is completely implemented.
North America including the US, which is the largest market for supplements and nutrition, has recorded a CAGR of 13.9 percent over the years in its net sales and an average annual growth of 14.2 percent in terms of the local currency. The US market, in particular, posted an average annual growth of 14.5 percent and had the highest daily consumption revenues as compared to the other regions. Despite the current high penetration level of the company in the US market, I strongly believe that the increasing health consciousness and the rising obesity problem in the US still provide growth opportunities for the company. Herbalife can achieve growth by expanding their network as well as increase daily consumption by increasing the frequency of its nutrition clubs attendance. The US market is also the fastest growing market, in absolute terms, with an increase of $140 million in net sales in 2012.
Central and South America is the third largest market for the company which posted a CAGR of 17 percent in net sales over the last 5 years. The region showed an average annual growth of 19.1 percent in its revenues in terms of the local currency. Brazil and Venezuela are the largest markets within this region but the growth achieved in both these countries have been derived from different sources. Brazil, the largest economy in this region, achieved a growth of 3 percent in revenues in terms of dollars in 2012. The growth was approximately 19.8 percent in terms of the local currency. The successful adoption of DMOs was driving factor behind this double-digit growth. Due to the controlled exchange rate policy adopted by the Venezuelan government, currency fluctuation has little effect on the net sales. However, the high inflation prevailing in the country has prompted the company to frequently change prices which has been the significant growth driver for the company. Despite the general stable exchange rate of Venezuela, the government does alter its exchange rate from time to time and this may result in a sudden decline in the revenues and margins of the company, as witnessed in 2010. In 2010, the Venezuelan Bolivar (VEB) depreciated by approximately 63 percent which translated into a 51 percent decline in revenues coming from this country despite the fact that net sales had actually gone up by 29 percent in the local currency. Thus, any further alteration in the currency exchange rate may result in similar repercussions.
After an initial decline in 2009, Mexico's net sales have been increasing by more than 20 percent in terms of the local currency. This region accounted for 12.2 percent of the Herbalife's total net sales and has been one of the slowest growing markets, achieving a CAGR of 6 percent in terms of the US dollar. The slower growth has led to the declining share of the region in the company's total net revenue base. The company's performance in Mexico was severely hit by the Value Added Tax levied by the government on imports and resale of certain nutrition products which led to a decline of 25.3 percent in its reported revenues. However, after this the company was able to enhance its performance through the implementation of its DMO model and critical partnership with locals to enhance consumption and access. After 2009, the company's reported revenues have grown at an average annual rate of 23.8 percent and I expect the company to continue to register a double digit growth in this market for the next few years.
The company's operations are slightly different in China. In order to comply with Chinese regulations, the company uses direct selling and retail sales method rather than opting for distributors as is the case in other regions. The company has received a healthy response from the Chinese population and over the years, it has been able to expand its footprint in the Chinese market. The company has achieved a CAGR of nearly 30 percent in its reported revenues and an average annual growth rate of 15.5 percent in terms of the local currency. Herbalife currently operates 67 retail stores in China and has the approval to conduct its direct selling business in 24 out of 29 provinces in China. China is one of the key regions for the company and I expect this region to record healthy growth in the future.
Weight management and meal replacement is the largest product category for the company and contributes more than 62 percent of the company's total net sales. The rising problem of obesity all over the world and the fast paced life has led to the rapid growth in this product category. Net sales of this product have increased at a CAGR of 14.5 percent over the last 5 years. As the company expands its geographical outreach, this particular category is expected to sustain this high growth level in the future as well.
Energy, sports and nutrition has been the fastest growing product line of the company. It has recorded a CAGR of more than 20 percent in its net sales over the last 5 years. The behavioral shift towards adopting a more active lifestyle and the resultantly increased participation in sports and physical activities have been the major driving factors for growth in this product line. Apart from this, the increasing association of the company with leading regional sports institutes, such as FC Barcelona, has also helped in boosting sales for this segment. I expect the company to continue its sponsorship programs for such institutes which will help in sustaining the growing demand for this product line in the upcoming years.
Global nutrition market is expected to cross the $400 billion mark by 2014, with meal replacement dominating the industry. It is expected that US will continue to be the largest market served by the industry. However, the BRIC region is expected to be the fastest growing. Thus, the company would need to expand its footprint in all of the above markets for future growth.
As per the most recent results, the company's total net sales increased by $346.8 million for the six months. Out of the stated increase in net sales, 4 BRIC countries contributed 30.9 percent of the total change in net sales. The US market was still the largest market for the company and contributed 10.2 percent of the total change in net sales. Thus, total 5 countries contributed to more than 41 percent of the $346.8 million increase in net sales. This signifies the importance of these countries for the future growth of the company.
Individually, the net sales in US, Brazil, Russia, India and China rose by 8.4 percent, 24.4 percent, 26.7 percent, 7.4 percent and 39.3 percent respectively for the six months ended in June 2013. As shown above, the company has been aggressively growing in these markets in order to establish its strong market presence. I expect the company to be successful in gaining a substantial market share in these key markets and this will help Herbalife in gaining a large share of the expected fast paced growth in these markets. Thus, in my opinion, the company will continue posting high growth for at least the next two years.
I believe the high growth potential as well as an attractive dividend yield makes Herbalife one of the most attractive investment opportunities for any investor. In order to derive the return potential for the company, I have employed the modified dividend discount model due to the company's solid share repurchase and dividend history.
Based on my projections, I expect the company to register high growth in its EPS over the next few years and then slow down, which is consistent with the relative estimates for this industry. I believe the company will continue with its high modified payout as it will sustain its share repurchase activity and sustain/increase its dividends payments. In the table above, the adjusted dividend growth reflects the growth in the payout of the company over the years and the annual share repurchase plan adopted by Herbalife. I expect the company to bring down its payout to a long term sustainable level and thus, an initial decline in payout is expected for the next year.
Based on my valuation, the company upholds a large potential of generating returns which is consistent with its high beta and high debt profile. Even based on certain key multiples, the company is significantly undervalued. The market return assumed in the model is the annualized return of the S&P 500 index over the last 5 years.
The sensitivity analysis has been performed by assuming various growth rates and required returns. Based on the sensitivity analysis, I can say that at this point in time the company provides a safe investment opportunity as it provides a minimum return of 1.63 percent in the worst case scenario and the highest possible return of 33.3 percent in the best case scenario. Thus, I will give a buy recommendation for this stock due to its current undervaluation and positive outlook.