Herbalife: Buy The Drop

Jul.29.14 | About: Herbalife Ltd. (HLF)

Summary

Herbalife reported quarterly results that missed expectations but were up year over year thanks mainly to a fantastic performance in China.

Herbalife continues to aggressively buy back stock, and I expect it to repurchase 10% of shares in 12 months thanks to strong cash flow and a good balance sheet.

Shares dropped 11% on weak revenue guidance, but EPS guidance was strong. At 9.5x earnings, I would buy the drop.

Over the past 18 months, Herbalife (NYSE:HLF) has been one of the most controversial stocks around. Bill Ackman and others have essentially argued the company is a scam, nothing more than a pyramid scheme. Ackman argues that at its core Herbalife makes money by getting distributors to sign more distributors than by actually selling products. While Ackman has found individual distributors who have had dubious records, he has yet to provide a smoking gun. On the other side, famed investors like Carl Icahn have amassed significant stakes, noting HLF's cheap valuation and massive cash flow generation. Since launching his short, Ackman has spoken with much bravado but has been unable to land a knock-out blow, and he seems to be letting his emotions get in the way of his investing, crying during last week's presentation (you can look through Ackman's findings here). After examining HLF's earnings on Monday afternoon, I continue to believe HLF is a very cheap stock, and investors should bet with Icahn not Ackman.

In the second quarter, Herbalife earned $1.55 on revenue of $1.31 billion compared to expectations of $1.56 on sales of $1.35 billion (financial and operating data available here). While both lines did miss expectations, EPS was up 10% year over year while revenue increased 7%. While Wall Street wanted more, Herbalife continues to grow despite the massive PR assault Ackman has launched against the company. The company also continues to be a free cash flow machine, generating $117.3 million in free cash flow. During the quarter, HLF spent $581 million to repurchase 9.8 million shares. There is another $233 million remaining on its buyback authorization. Over the past year, HLF has cut its share count by 15%.

Herbalife also has the potential to continue buying back stock at a brisk pace. It only carries about $1.1 billion in net debt and should generate at least $600 million in operating cash flow this year. HLF can use cash flow to continue buying back at least $100 million in stock per quarter, or given low interest rates, it could certainly add some leverage to its capital structure to accelerate the buyback. With Carl Icahn involved, I would expect significant buybacks to continue, and these purchases will help to further squeeze the shorts and perhaps even force them to cover en masse, sending shares higher.

While investors were hoping for more growth, Herbalife showed growth around the world. North America revenue was up 1% despite being the center of the PR battle while Mexico and Asia Pacific were up 2%. Europe, the Middle East, and Africa jumped 22% to $227 million. The real story though was in China where revenue soared an amazing 44% to $170 million. With a rising middle class, China is becoming increasingly health conscious, and Herbalife is exploiting this trend extremely well. In 2-3 years, China will likely be the company's largest market. While North America was a little weaker than I hoped, China was a major positive in this report.

Now despite these positive, shares dropped over 11% after-hours because of lackluster guidance. Herbalife now expects sales growth of 8.5-10.5% compared to previous guidance of 10-12% on lower volume growth of 6-8%. Despite revenue being revised lower, Herbalife actually raised its EPS guidance to $6.17-$6.32 from $6.10-$6.30. At the end of the day, investors buy stocks to get a share of earnings and cash flow, not sales. I believe this drop is a massive reaction to decent guidance that included a raised EPS estimate. Now since Ackman's hyped presentation last week, HLF had rallied 22%. I suspect many investors are using in-line results as an excuse to take profits after a great run, which is understandable.

Still, slightly slower sales growth is not too alarming to me. Given a massive PR campaign waged by a hedge fund titan that has garnered significant media coverage, it is unsurprising some consumers and potential distributors are avoiding its products. The fact Herbalife is still growing nearly double-digits and over 40% in China is a testament to the quality of its products. After dropping 11%, HLF is only trading 9.6x earnings. I also expect HLF to repurchase at least 10% of outstanding shares over the next twelve months. With this combination, I think HLF has tremendous upside and even at 15x earnings, HLF has 50% of upside. If a short squeeze were to materialize, shares could rally briskly in a hurry as they did last week. Investing requires buying when others are fearful, and now is one of those times.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in HLF over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.