Many investors may not like the MLM business model, some agree with Ackman's thesis, and others just want to avoid the stock due to an FTC investigation. Regardless of the situation, Herbalife's (NYSE:HLF) stock is oversold and has become attractively undervalued. We've seen the stock fall by $10 twice and rise by over $10 all within the past month. All of the negative coverage surrounding the stock along with those investors who are ignoring the negativity has created this extreme volatility. With volatility, comes trading opportunities. Ultimately, I think that the stock can increase about 20% rather quickly off of the current oversold and undervalued level.
As far as defending the company for the longer term, here are the facts. The accusations that Herbalife is an illegal pyramid scheme are a stretch. Companies are considered illegal pyramid schemes if they award payments for the act of signing up or recruiting other participants. Herbalife pays its distributors based on the sale of product to be used by end users. Nothing is earned by Herbalife members for mere recruitment or for converting a customer to a member. Herbalife's CEO Michael Johnson stated in the Q2 report that 97% of the product sold in the U.S. is consumed by the end user. He also said that he was highly confident that the FTC investigation regarding Herbalife's business model will have a positive outcome. Now, I do understand that some investors are turned off by the MLM business model, and that's fine. They don't have to invest in the company. However, it is not necessary to call for the company's demise simply because you don't like the company's business model.
Even in the face of the negative news, Herbalife achieved a 15.8% increase in EBITDA in 2012 over 2011 and an 11.6% increase in EBITDA in 2013 over 2012. Revenue increased by an average of 20.1% for the past four years. Earnings increased by an average of 33% annually for the past five years. Just because the company missed its Q2 EPS by 2 cents doesn't mean that Herbalife is on a downward trajectory. The company was bound to have a miss eventually after exceeding estimates for 21 straight quarters.
Herbalife is a cash flow machine as it increased its free cash flow by an average of 30% annually over the past four years. The company brought in $773 million in operating cash flow and $626 million in free cash flow in 2013. This was achieved last year even after the negative news surrounding Ackman's presentation.
Herbalife has become extremely undervalued after the recent sell-off. The stock is trading at only 7 times analyst's expected EPS of $7.19 for 2015. The EV/EBITDA ratio is only 7.5, thus reinforcing the low valuation when taking the tax implications out of the equation. I typically like to see stocks trading with an EV/EBITDA under 10. As a comparison, the S&P 500 is trading at 16 times next year's expected earnings. Herbalife is trading at less than half of the market's valuation. Of course this undervaluation is due to the fear surrounding the FTC investigation. However, like I mentioned earlier, the company is confident that the investigation will have a positive outcome.
Looking forward, analysts are expecting Herbalife to grow earnings at 17% this year and 14% next year. This is above average growth as compared to the expected annual growth of the S&P 500 of 9% - 10%.
The Stock is Worth Much More if the Investigation has a Positive Outcome
The stock was trading at about $70 back in 2012 before Ackman's negative presentation was released. If the stock increased 13% in 2012 and 30% in 2013 in line with the S&P 500's gains, Herbalife would now be trading over $100. If Herbalife was trading in line with the market at 16X next year's expected earnings, the price would be $115.
Based on a cash flow basis, the company is worth much more. I performed a discounted cash flow analysis using a discount rate of 9%. If the company were able to grow its free cash flow at 20% annually, which is a lower growth rate than the 30% growth it achieved for the past four years, the stock is worth $426 today. I don't expect the stock to rise to that level any time soon even if the company has a positive outcome from the investigations. I just wanted to demonstrate what the company is worth on a projected free cash flow basis.
The short sellers are up against all of this plus the company's projections of buying back $50 million worth of stock per quarter as stated in the recent conference call. With the company's confidence in a positive outcome, an oversold condition, an undervaluation, strong fundamentals, and an ongoing stock repurchase program, the short sellers are likely to get squeezed.
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.