Herbalife: A Neutral View

May. 8.14 | About: Herbalife Ltd. (HLF)

Summary

Herbalife has been a controversial stock, but the bottom line is that it has delivered returns to investors.

Herbalife's business, valuation, and growth projections all appear to be going well, which might make it a good investment.

However, the allegations and probes against Herbalife are tough to ignore, and if they turn out to be true, then investors stand to lose a lot.

Herbalife (NYSE:HLF) has been mired in controversy as the company has been at the center of numerous allegations, especially from activist investor William Ackman. Ackman has directed numerous potshots at the nutrition and weight loss company, ranging from calling its business model a pyramid scheme to its breaking of laws in China.

But Ackman has his interests. He made a $1 billion bet against Herbalife shares in December 2012, believing that the stock is worth nothing. Since then, he has went on multiple tirades against the company in a bid to justify his position. But Herbalife shares have gained 34% since December 2012, so Ackman is at the losing end of this bet.

This has led me to think that there might be something that Herbalife could be doing right if the market has been rewarding the company so well. As such, I decided to take a closer look at what the company's management has been saying and how its financial performance has been.

A look at the business

Starting off with financial performance, the first quarter wasn't a good one for the company. Although its revenue was up 13% year over year, net income was down a whopping 37%. However, the company reported sales of $1.3 billion, driven by a volume increase of 9%. In fact, net sales in the U.S. increased 8% in the first quarter, and March was the largest sales month in Herbalife's U.S. history, driven by a record 83,000 new members. On a global basis, in the first quarter, there was a 11% increase in average active sales leaders and a 24% increase in the number of new members.

In 2013, Herbalife retained a record 216,459 of its sales leaders, as compared to 196,732 in the year 2012. In addition, the company is undertaking various initiatives such as regionalization, systemized training, sharing of daily consumption business practices among customers, along with city by city initiatives to drive its volume point per capita penetration.

The company further expects that daily consumption will accelerate on the back of its Nutrition Club activities in markets such as Korea and Mexico. The company has a total of 78,000 Nutrition Clubs across the world and these clubs are continuously engaged in integrating daily consumption business methods such as Fit Clubs to their core service offerings.

Herbalife is also seeing growing interest, dedication, and excitement among members across the world as evidenced by various events such as regional extravaganzas, summits, honors, and anniversary events. In 2013, Herbalife saw 200,000 members participating in these events, and it expects these numbers to grow substantially in the current fiscal.

Besides, the company introduced a new skincare line with 10 new paraben-free products. These products were launched in 2 extravaganzas held in Las Vegas and Los Angeles, with more than 10,000 members attending the events. Since Herbalife sells weight management, healthy meals and snacks, sports and fitness, energy and nutritional products, and personal care products globally, the company can benefit from the growing awareness regarding a healthy living through its strategies going forward.

Valuation appears to be solid

From a valuation point of view as well, Herbalife looks enticing. It trades at a trailing P/E of 13.59 and a forward P/E of 8.61. In addition, the PEG ratio is well below one at 0.50, reflecting steady and stable growth in the long run. Besides, the company has strong operating cash flow of $826 million and levered free cash flow of $486 million. Analysts also remain positive regarding Herbalife's prospects with an estimated earnings CAGR of 19% for the next five years.

Herbalife has raised its earnings estimate for the year, and now expects a profit between $6.10 and $6.30 a share, up from the prior forecast of $5.85 to $6.05. In addition, Michael O. Johnson, the Herbalife CEO, is of the opinion that Herbalife shares are undervalued due to allegations that it is an illegal pyramid scheme.

So, from an investment point of view, Herbalife looks interesting. However, the controversies and the troubles that surround the company cannot be ignored.

Things to watch out for

Herbalife is essentially a multi-level marketing (MLM) company. Its members are paid when they recruit new members, and the allegation is that the focus on the product is less. Ackman recently revealed further evidence through a 13-minute video that carried interviews with former distributors who stated that Herbalife victimized them.

According to CNNMoney --

"Ackman argues that Herbalife is a pyramid scheme because it makes more money by recruiting new distributors than it does selling products to consumers. He says the company deliberately targets Latinos and other vulnerable immigrant groups.

Herbalife disclosed in March that it is being investigated by the Federal Trade Commission. The company has said that it is cooperating with the inquiry and hopes that it will clear up "misinformation" in the market.

Federal law enforcement officials have confirmed to CNN that the FBI and U.S. Justice Department are also looking into Herbalife, though the company has not commented on any criminal investigation.

In the film, the former distributors describe how they lost tens of thousands of dollars after being led to believe they would be able to earn up to $10,000 a month selling Herbalife products from home.

The former members of Herbalife's vast direct sales network all said they were encouraged to bend the truth when presenting the "business opportunity" to potential new members of the system.

"It's really not about selling Herbalife," one says. "It's really about getting people's money by bringing them into the business."

Although Herbalife has dismissed these allegations as negative propaganda, investors who are considering an investment in the company based on its actual business and expected growth should beware.

Conclusion

Herbalife is a high-risk-high-return play. If Ackman is proved wrong, and the various probes that are troubling Herbalife are found to be incorrect, then the company could be a good investment. If they are right, then Herbalife could become a dead investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.