John Hempton wrote on his blog this past week that Herbalife (NYSE:HLF) common could be worth $100 or $200 per share.
Meredith Adler at Barclays thinks the common equity is worth $94 with an upside to $114
Meanwhile, the buy side of the street has haircut the price of the equity to sub $53. By the way, if Herbalife common were to trade at an Enterprise Value to Revenue Ratio of 1:1 the common would trade for roughly $45.
Even though over 24 million shares are closely held by Mr. Icahn and Mr. Stiritz, even though the company has repurchased millions upon millions of shares, still investors are dumping Herbalife's equity.
Nature is a wonderful thing to study and a powerful if not ruthless force. One of the more interesting things about nature is the fact that different species have different life-cycles. Many people know that a Mayfly has a lifecycle of less than 24 hours. (Candidly, some days I wish I was a Mayfly). Worker Bees have a lifecycle of roughly 4 weeks. It seems that servicing the needs of the hive has its costs. Dragonflies live less than six months. Most Herbalife distributors live for less than a year.
Investors who own Herbalife common on the long side should contemplate the opening line of the following children's poem.
Mary, Mary quite contrary, how does your garden grow?
Q. How does Herbalife grow?
A. It recruits new Mayflies, Worker Bees and Dragonflies at a faster pace than those who have gone before them are dying.
Using 2013 and 2014 results let's examine this dynamic in more detail.
In the first 4 quarters of 2013 Herbalife recruiters recruited:
- Q1 - 491k people
- Q2 - 553k people
- Q3 - 569k people
- Q4 - 552k people
Here is another way to think about this data. These recruits form the pipeline for Herbalife's attrition data. We know, categorically because the company tells us that most "Members" quit in less than a year.
Q. Do we see evidence that last year's recruits match with this lifecycle?
At the end of 2013 Herbalife had 3.7 million total "Members".
- In Q1 2014 Herbalife recruited 599k new members. Total Membership grew to 3.9 million. Solving for X 400k resigned. Put another way, 400k of the 491k people who signed up a year ago quit.
- In Q2 2014 Herbalife recruited 586k new members. Total Membership flatlined at 3.9 million. Solving for X, 586k people resigned. Put another way, 586k people resigned v. the 553k people recruited in the year ago period.
- To summarize, in Q1 & Q2 1 million people quit Herbalife (died). In Q1 and Q2 of last year 1.04 million people were recruited.
Q. What is the key insight here?
A. The more successful Herbalife is recruiting today the more successful the company's recruiting efforts need to be one year into the future.
In Q1 and Q2 of this year, Herbalife recruited 599k + 586k new members. By the one year anniversary date of their registrations a similar number of these recruits will die. So, next year just to sustain the size of the Membership base Herbalife must find 1.2 million new people. If it does not, the company simply will not grow.
Sequentially, this is probably the data point that frightened most buyside investors this past earnings report. Sequentially, the size of Herbalife's pyramid is stalling out.
Q. What impact does this have upon efforts to value the company?
A. The impact is material. Here's why.
Most analysts use some sort of discounted cashflow analysis to value a stock. Intellectually lazy analysts take forward cashflows or earnings and simply capitalize them. Even sillier analysts calibrate risk by measuring the spread v. the risk free rate to determine if they are getting paid a premium to hold the security.
One way to think about DCF is at a granular level. Every single customer a company has produces a cashflow output. Some customers will be worth more than others to be sure, still, the aggregate DCF for a firm is simple to articulate.
Cashflow from Existing Customers + Cashflow from Future Customers - Cashflow from Retiring Customers
Businesses with steady cashflow streams at the customer level are worth their weight in gold. Businesses like funeral homes or high-school graduation swag sellers only seem to get one shot at a transaction per customer during the customer's life-cycle. These kinds of business rely upon the successful acquisition of new cashflow streams in order to survive.
Put another way, the quality of the earnings produced by a company like Coca-Cola (NYSE:KO) is much higher than the earnings produced by Herbalife. Ergo: Coke deserves a higher earnings multiple than HLF at a customer level.
Here's another way to think about this variable. If I asked you this question, what would you say.
Q. I just signed up a new Herbalife Member. I would like to sell this customer to you. How much would you like to pay for him/her?
Today, Mr. Market values each one of Herbalife's 3.9 million members at around $1,500. Concurrently, Herbalife sells new Memberships for $50 to $100.Imagine for a moment that you could sell yourself to stock market participants. That would be one heck of an arbitrage opportunity. You could pay $100 to become a Member and then vend yourself to Mr. Icahn who is willing to value you at $1,500 (less whatever value you want to attach to future recruits).
Q. Why would stock market participants pay more for the value of a distributorship than what Herbalife sells them for in the open market?
As a short, the answer to this question clearly beats me.
Mathematically speaking, Herbalife distributorships have very little intrinsic value. If they did:
- They would produce more life-time free cashflow than they do
- The company would sell them for more than $100
- They would trade in the secondary market at a premium to their start-up costs
Q. Doesn't it seem absurd that Herbalife is perpetually diluting the value of incumbent distributorships with an endless chain of new recruits?
If you said "Yes, this idea is totally absurd!" then you are starting to get the mechanics of pyramid schemes.
Pyramid schemes are money transfer schemes. They thrive upon victimizing those who die at the bottom of the pyramid. Failure is not only a certainty, it is actually a desired goal of the rigged game. Absent the failure in the Membership base money could not be transferred to recruiters. New marks are then recruited to replace those who have gone before them. The entire business model thrives upon constantly pushing out the supply curve for distributors. A student of Econ 101 should easily be able to tell you what that does to prices and profits in the economy. Is it any wonder so many people fail?
Listening to a Herbalife conference call is like reading the Mad Hatter's Tea Party in Alice in Wonderland. The dialogue that occurs is pure and utter nonsense.
Investors in Herbalife own a company that functions in a very specific way. Like the Mayfly or the Dragonfly or the Worker Bee in nature, each and every Member is in some stage of dying. The statistical evidence of this reality is simply overwhelming.
If you own Herbalife, you own a company where 2 million of its Members will die this year alone. Next year, that number will likely climb to 2.2 million if not higher.
Q. How would you capitalize the cashflow stream for these people?
Adjusting for the obvious write-down of Herbalife's Venezuelan assets, Herbalife had net debt of roughly $1.2 billion.
91 million shares x 53 = 4.8 billion
Enterprise Value rounds out around $6 billion.
1x Recent quarterly sales annualized gives you a value of around $5 billion.
Q. Does Herbalife common have more downside to go? (At a ratio of 1:1 for EV to Revenue I get $45 per share for the common. This still looks rich considering all of the risks out there.)
I suppose the answer to that question depends upon the answers to the following questions?
- Will Herbalife be likely to be able to recruit more new Members annually at a geometric pace than those who naturally will resign every year?
- Is there any regulatory risk that you can think of on the horizon for this company considering no fewer than 7 state and federal regulators are investigating the company?
- Is Pershing Square likely to capitulate now that the growth story is in question or is it more likely that they will become more relentless in their pursuit of the short thesis?
- Does the mountain of debt the company has taken on represent refinancing risk and or interest rate risk if free cashflow deteriorates at all in the next year or two?
- If Mr. Market haircut HLF to 10x $6 even with Mr. Icahn and Stiritz on board, what multiple will be assigned of the Membership base actually begins to contract?
To close, the most important metric if you are still committed to the delusional long thesis is not found in the company's 10ks and 10Qs. Rather, it is found in a curious Appendix found at ir.herbalife.com called the "Regional Key Metrics" schedule. This document tells you how many new members get recruited every quarter. The 10K and 10Q tells you how many total Members there are in the pyramid. Solving for X, we have to calculate how many people resign every quarter because the company simply isn't honest enough to actually disclose its churn rates up front.
This might be a good reason not to listen to the company's management when analyzing this company.
As a quick reminder, 586k people quit Herbalife in Q2 alone. That is a run rate of roughly 2.4 million people. Each and every one of these "Members" who die will have to be replaced.
Q. for Mr. Hempton (with apologies to his investors).
How many new members will have to be recruited over the next ten years in your cashflow model for the equity to get to $200 per share?
Just wondering with the stock here at $53 ($200 - $53 = $147)
Alice in Wonderland
Disclosure: The author is short HLF. 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.