It has been almost a year since Mr. Ackman made his (in)famous 300 slides presentation on Herbalife (HLF) being a pyramid scheme. As investment community now brace for his 600 slide presentation at Robin Hood Conference this month, I believe it is the time to dispel some of the myths bears continue to spread about Herbalife and look at the company's prospects in greater detail. Through this and subsequent articles, I intend to address some of the key concerns investment community might still have on Herbalife.
Myth I: Mr. Ackman has got something on Herbalife
Herbalife continues to trade at a significant discount to its peers Nuskin (NUS) and USANA (USNA) despite of the fact that it has a better business model as well as good long term prospects. While Herbalife is trading at 10.94x forward consensus estimates, Nuskin is trading at 16.18x and USANA at 12.11x. The reason, of course, is the belief that Mr. Ackman has got something specific on Herbalife. This is far from truth.
Mr. Ackman has himself admitted that he hasn't studied the overall MLM industry in detail before shorting Herbalife. When asked last December if he has looked into other companies in MLM industry like Avon or Amway and believe if they were genuine, he answered:
"No, I haven't studied carefully Amway or Avon but I think they are legitimate multilevel marketing scheme."
Source: CNBC interview
Strange as it may sound, but the development of last one year strongly supports that Mr. Ackman erred on the due diligence needed to make such a big investment for his concentrated portfolio. If he would have done his due diligence properly there was no way he/or anyone else would have chosen Herbalife with far superior model than its peers as a potential short.
Now why is Herbalife's model superior? More than half of Herbalife's revenues come from daily consumption at nutrition clubs. One of the key determinants of whether a MLM company is a pyramid scheme is if its product is actually getting consumed or ending up in garages of the distributors. Daily consumption leaves little scope of inventory loading and is a very strong indicator of end market demand. So, clearly targeting a company like Herbalife and saying that its distributors end up with inventory is unfair. In fact, if we go by latest development in MLM space other companies are trying to copy Herbalife's daily consumption model which results in better retention rates among distributors as well as increased customer satisfaction.
In addition to better business model, Herbalife has several key growth drivers like global obesity epidemic working in its favor. Many of the company's successful distributors are transforming home based nutritional club to commercial nutrition club which will continue to drive sales for the next several years to come. So, there are several secular growth drivers in place which are and will help Herbalife grow it sales across the geographies.
Coming back to the point, it has been over a year and Mr. Ackman have not come up with anything specific or substantial on Herbalife to prove that it is an illegitimate pyramid scheme. Will he present something at the upcoming conference which will be substantial or specific? Unlikely, in my opinion, because Herbalife is operating perfectly legitimate MLM Company under the US laws and its business practices are far superior to its peers.
Myth II: Herbalife is similar to FHTM or Your TravelBiz.com which were shut down by FTC
One of the key tactics which many bears routinely use to create fears among Herbalife investors is by comparing it to pyramid schemes which were closed by FTC. In doing so, they often present incomplete information intentionally trying to mislead the investment community. A couple of days, fellow SA author Robert FitzPatrick gave example of YourTravelBiz.com. Before that Mr. Ackman presented side by side comparison of FHTM and Herbalife. While giving these examples bears chose not to give actual reasons on why these companies were prosecuted. Here's a look at both these cases.
YourTravelBiz.com enabled its member to set up a travel website and earn commissions on the bookings through their website. The company used to charge a fixed monthly fee from its members for the "internet business center" it provided. The following is the revenue distribution of Your TravelBiz.com in 2007 and 2008. One can clearly see that Travel commission and services which was supposed to be the main business of the company was only a small part of its total revenue. Most of the revenue it generated was from the sales of "internet business center" and the monthly fees users paid to be in the scheme.
Source: YourTravelBiz.com SEC filing
Same was the case with FHTM which also significantly depended of the Independent Representative (IR) joining and renewal fees for its operation.
IR & IR Renewal Fees
Source: FHTM Case Documents
Herbalife's, on the other hand, does not have any renewal fees and even the cost of startup kit is fully refundable if any new member want to leave the organization within three months (he/she is not even required to return the start up kit).
One can clearly see the heavy dependence of FHTM and YourTravelBiz.com on renewal fees unrelated to the sales of actual products. These are the typical pyramid schemes FTC has been targeting for the last several years. Herbalife is no way comparable to these companies and bear argument that Herbalife can be closed just like YourTravelBiz.com or FHTM is without merit.
Other Myths: There are several other myth perpetrated by bears including deliberate misrepresentation to suggest that override commissions are the main source of income for Herbalife distributors and a couple of hundred dollars a month from retail sales does not matter. I would request them to open their Bloomberg terminal and look at GDP per capita of countries outside the US. Herbalife drives significant amount of its sales from developing countries and what appears a small amount in the US is not necessarily small outside the country. For example, per capita GDP of India is $1440 per annum. Clearly a couple of extra hundred dollars a month is not something negligible for most of the population. I intend to address further myths in my upcoming articles.
Looking forward, I expect the next few weeks will be interesting ones for Herbalife bulls as there are significant catalysts pending for Herbalife. They are:
- Completion of audit by PWC and subsequent leveraged share buyback announcement
- Low trading volumes in December which makes stock susceptible for a short covering rally (Remember how Mr. Ackman timed his presentations towards mid December last year to take advantage of low trading volumes, this year he will likely be at a receiving end)
- More information regarding damages which Herbalife negotiates with KPMG
- Mr. Ackman's presentation at Robin Hood Conference. The valuation gap between Herbalife and its peers like Nuskin may close if Mr. Ackman is still not able to put across why specifically, among all MLM companies, is Herbalife a short candidate. If Herbalife was to get a similar multiple as Nuskin, it would mean ~50% upside for the stock from the current levels.
To sum up, I believe Herbalife's valuation's discount to its peers is not justified and the stock should trade at a premium to its peer group given its daily consumption model which discourages inventory stocking. Without indulging in a verbal duel, the company management has taken several steps over the past year to increase transparency and the company deserves to trade at a better multiple. Given the above mentioned catalysts, I believe the stock can see substantial upside in the near term.