Herbalife (NYSE:HLF) common has been decidedly volatile lately. The Market capitalization of the company's equity has been as low as $4.5 billion and as high as $6.3 billion in the past two weeks alone. So much for the efficient market hypothesis.
As I sit here today, HLF common trades for roughly $4.8 billion. I am using a share count of around 91 million to get to that number. The actual share count is likely lower. Net Debt adjusting for the nonsensical accounting treatment if HLF's Venezuelan operations comes in at around $1.2 billion give or take. So, Mr. Market is giving HLF an Enterprise Value of $6 Billion.
Q. Would you write a check for $6 billion to buy Herbalife today?
Q. Would you value each one of Herbalife 3.9 million members at $1,500 when the company sells new Memberships for $59?
Is it your expectation that Herbalife will be able to deliver the $4.8 billion in future cashflows promised to equity investors at $53 per share?
Dirty Harry captures the essence of a change in risk profile perfectly in this movie clip found here. One would hope that Mr. Stiritz is recalibrating his risk too now that he is underwater on a mark to market basis.
Right now, Herbalife's run rate for Free cashflow is around $600 million give or take. 10x Free Cashflow to EV is what market participants are paying for the common
Here are 10 reasons why this valuation is likely too optimistic.
1. In spite of the contraction in the multiple assigned to HLF's business model and that of other MLMs like Nu Skin (NYSE:NUS) over the past 6 months, longs remain undeterred. In the bull camp we still have Mr. Icahn and his 17 million shares, Mr. Stiritz and his 7 million shares, company management, a share buyback, John Hempton, Meredith Adler, etc.
Only when these longs finally throw in the towel or abandon their long thesis will Herbalife's intrinsic value be uncovered. In the interim, the fact that so many longs remain on one side of the boat, so to speak, creates opportunity for those with a contrarian view. Sell side analysts can be an investor's best friend. Turns out Mr. Ramey's uber bullish research at the beginning of 2013 was a great opportunity to get short. Equally so, I consider Mr. Icahn and Mr. Stiritz closely held positions as evidence that HLF common is at material risk of a long squeeze in future quarters.
2. Herbalife is running out of runway. After 34 years in business, the geographic opportunity set for the company's business plan is now limited. 91 countries have been penetrated including those with some of the lowest GDPs per capita in the world. The only reason to even try to penetrate markets like Vietnam or Burundi is because the opportunity set in mature markets is slowing.
3. The Life Time Value of a Customer is small. Even if you assume a highly benevolent life-time valuation of $500 per "Member" who (as the company tells us) "only buys for personal consumption and typically lasts less than a year" you get a Market Cap of $1.6 billion for Herbalife's 3.2 million Members. If you assume an NPV of $100 per Member that number collapses to $320 million. Effectively, what this means is that investors are paying between $4-$5 billion for the value of Herbalife's recruiting engine.
Put another way, most of the value in HLF common relates to "Members" the company has yet to acquire. Predicting what this cashflow stream might look like is definitely a crapshoot. De minimus, one should apply a higher discount rate to the range of potential outcomes Herbalife's recruiting engine might produce. 10x Cashflow might be just right if you think that HLF is a $600 million perpetuity. Then again, it could be way too optimistic if certain geographies continue to contract QOQ or YOY. My own view is that longs are not getting paid enough for the risks they are taking here. So, I am still short the common and own Puts.
4. Regulatory Risks are abundant. Herbalife common is likely one bad headline away from a material liquidation/revaluation. Here is a list of potential headlines that could hit the tape at any moment.
- Top Herbalife Recruiter Arrested for Wire Fraud
- FTC targets HLF For Anti-Trust Violations
- SEC charges HLF Execs with Misleading Investors
- Mexican Authorities Stop "Club Ciento" in Its Tracks
- FTC hammers HLF with List of Section 5 Violations
- Joint Task Force Prosecutes HLF as a Global Pyramid Scheme
- President's Team Whistle Blower Turns Against CEO
- FTC Injunction Freezes HLF Assets
I could go on. Any single one of these headlines could become reality at any given moment. Certainly, the probability that none of them come to pass is probably very low. Should any single one of these headlines materialize, this would be a huge tailwind for shorts.
5. The Law of Large Numbers. If HLF recruits 2 million people this year it must recruit the same number next year just to stay the same size. To grow it must recruit more than 2 million. Why? At today's run rate 2 million people are quitting annually. In an ironic outcome, the more successful Herbalife is today the more successful it has to be tomorrow. Trouble is, the higher you get up the mountain the thinner the air gets towards the top. Herbalife's entire business model is on a treadmill to hell. Once the recruiting apparatus fails to yield a net gain in new recruits, the valuation will collapse.
6. Three Words. Stinky Balance Sheet. Herbalife's Balance Sheet is now insolvent as the company has negative Book Value per share. This presents two potential problems if you are long over a 2-3 year horizon.
Interest rate risk is obvious for any future recapitalization.
a) the Fed may raise rates. Much of HLF's debt functions like an ARM. Rates would reset to the upside raising the company's interest expense.
b) a change in the risk profile of the cashflow stream would inevitably mean that banks and bondholders will require higher levels of compensation for the risks they are taking.
Q. If you were Herbalife and you were looking to refinance your debt today given the recent earnings miss, what would you expect your banker to say to you?
$1.7 billion of debt is no small amount to refinance. Any change in company fundamentals to the downside raises HLF's cost of capital and will haircut equity accordingly. Mr. Icahn's recapitalization is now a tailwind for shorts.
7. Bill Ackman. So far, short sellers like Whitney Tilson and alike have enjoyed the fruits of over $50 million spent by Pershing Square exposing Herbalife's business model. Mr. Ackman's relentless pursuit of this company will be unyielding. He has told us as much. If nothing else, this raises Herbalife's costs of doing business, keeps the company in the Headlines, and acts as a tailwind for short sellers. If you think Mr. Ackman is going to go away, think again.
8. Company Management. Herbalife's Quarterly Conference Calls make North Korea seem like it has a free press. Bullish Analysts hand-picked by the company for access to the calls lob softball questions at management. Management then lobs back softball answers. The whole enterprise unfolds like watching two marshmallows attack one another. Meredith Adler from Barclays seems to have stepped into Tim Ramey's shoes as the latest sell-side bull to find it unpalatable to accept the idea that management might just be misleading her. Amazingly not a single analyst asked a single question about Club 100 on the most recent call. Fear of ex-communication can be a powerful force no doubt. Here's the point. Anyone who actually listens to company management as if they are in the "No Spin Zone" will, in all likelihood, find their reputations churned along with their client's capital.
Company management has already seduced the likes of Tim Ramey and Mr. Stiritz and Mr. Icahn, etc. Meanwhile, they also have a long history of co-conspiring with Herbalife's Top Recruiters, turning a blind eye to obvious compliance infractions, paying out huge Mark Hughes bonuses at annual shin-digs, while jet-setting to Extravaganzas to "train" new victims how to succumb to the mathematics of their well-oiled pyramid scheme.
Company management is slick. Company management is talented. Company management is crafty, belligerent and evasive (couldn't you just tell us your churn data in the 10Qs?).
Company management is also crooked and has an answer for everything.
One has to wonder how they might answer this question in the future:
"How do you plead?"
9. Herbalife is still overvalued. 1x Revenues to Enterprise Value strikes me as an appropriate valuation for a company with a customer base on spin cycle. Best case, that gets you $45 per share. Then even if you layer in a 25% probability of regulatory intervention you get to $35 per share. Doesn't it seem obvious that the only thing that has been propping up the stock has been the company's buyback and Mr. Ichan's commitment?
Q. What would Herbalife be worth if Mr. Icahn hadn't wanted revenge v. Mr. Ackman?
10. Reputational Risk. At the end of the day, people who have a conscience don't want to be associated with confidence games. Whether or not Mr. Ackman's presentation on Club Ciento moved the stock, it certainly moved people emotionally. How sinister is a plot to have low-income people dressed in cap and gown pay for their "tuition" via "Consumos"? Is there anything more shady? Perhaps not.
Q. Isn't it funny how Michael Johnson has had absolutely nothing to say about "Club 100" at all? How's that for leadership?
Wouldn't a leader publish a press release immediately to say something like. "Mr. Ackman has uncovered evidence of a pyramid scheme in Herbalife's nutrition clubs that is completely at odds with company policy and our company's values. We will take whatever steps necessary to shut-down Club 100 across the world as soon as possible."
Don't hold your breath. "Club 100" pays for Mr. Johnson's private jet.
To close, Herbalife remains a massive risk if your are long here at anything north of $50 per share. I will grant the notion that $600 million or so of free cashflow may have some degree of visibility if you think the company may last another year. Any amount beyond that is just a roll of the dice or a flip of a coin.
Calibrating all of the risks, I might assign a best case value of $6 billion if the company is a valid going concern. $0 if it is a pyramid scheme. Somewhere between these two values lies an appropriate bid for HLF common.
To make it easy, how does $30 sound?
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.