On Monday, July 28, Herbalife (NYSE:HLF) reported its results for the second quarter of 2014, and may have self-inflicted more damage than Bill Ackman could have through any presentation. The company's financials tell the story of a company that is becoming increasingly dependent upon borrowed money and stock buybacks, which is a maneuver that will only work for so long. The time may be just about up.
Herbalife's results missed Wall Street estimates for the first time in over five years. Profit declined by 17 percent to $119.5 million, or $1.31 per share. During the quarter, Herbalife reported earning $157 million in cash from operations, which has been declining over the last three quarters, on revenue of about $1.3 billion. During the second quarter, the company repurchased $581 million in stock, or over three times as much money as the business earned through its operations.
Within the first half of 2014, Herbalife repurchased $1.3 billion in shares, which is significantly more than the $166 million it repurchased in the first half of 2013. With a market valuation of about $6.6 billion, at least before reporting earnings, it is hard to imagine that too many others were buying Herbalife shares in the first half of this year, or the $1.3 billion in share repurchasing would have yielded a better share performance.
One group of individuals that have certainly not bought shares alongside the company would be the insiders, who have sold shares by the bushel. For example, HLF's president, Michael Johnson, sold 250,000 shares in May, worth over $15 million. In fact, the only insider that purchased shares on the open market in 2014, rather than through stock options or as compensation, was Carl Icahn.
Herbalife managed to acquire many of its shares through clever financing associated with its convertible transaction. The company issued a one billion dollar convertible note in the first quarter in order to buy stock. The convertible was part of an arrangement its advisors, and possibly some of its newer major shareholders, suggested where Herbalife entered into prepaid forward contracts to buy back some of the shares underlying the convertible. In doing so, Herbalife essentially paid upfront for shares to be immediately removed from its share count, but it will not actually get those shares for around five years (with the convertible maturing in 2019). The company used the rest of the proceeds to buy shares during the second quarter.
This financial engineering has left Herbalife in a far less secure position. Essentially all the company's earnings plus $1 billion in new debt have gone towards nothing but supporting the share price, and earnings still declined on a per share basis. Now, even if the company uses all of its available income to continue repurchasing stock, it could only do so at a rate of about one-third it did in the first half of 2014, if not far less, before factoring the increased debt costs. Given the still ongoing government scrutiny, declining income and significant expansion to its outstanding debt over the last few quarters, it is unlikely that HLF will have the capacity to obtain similar capital again, or at least not at decent pricing, making another convertible or similar debt transaction unlikely.
Whether or not Bill Ackman's claims are true, it may certainly be the case that his crusade against the company has thwarted many would-be purchasers from becoming customers or independent distributors. If he is accurate, any such slowing of new blood may cause the whole system to fall apart. In the meanwhile, Herbalife has to wait for Ackman to make his next move, hoping it is as easily brushed off as his last one was. It is believed Ackman is shorting Herbalife with options that expire in early 2015, making it highly likely that he will again attempt to instigate a decline in share price.
Similarly, Herbalife must wait for the U.S. Federal Trade Commission to either make some determinations or subpoena more information. While the FTC may conclude the company is not a pyramid scheme, it could conclude otherwise or uncover some different issue. Nonetheless, since federal investigations tend to be long and excessively thorough, with this one starting in March of this year, it appears unlikely the FTC will make any announcement in the coming weeks, if not months.
Given that Herbalife's earnings report was not a catalyst for its shares and the company has already spent the bulk of its cash on share repurchases in the first half of 2014 (and probably purchased more in July), it appears highly unlikely that there will be any near term positive news coming from Herbalife. As a result, the next piece of news to affect Herbalife will likely be negative. Between now and then, shares appear highly speculative, if not downright dangerous.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within 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.