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Summary

  • Since Bill Ackman launched his campaign against Herbalife shares have underperformed the S&P 500 by 1300 basis points.
  • Herbalife trades at a multiple of just over 7x 2015 expected EPS (roughly equivalent to free cash flow per share).
  • Herbalife is using all of its free cash flow to repurchase stock. Continued repurchases at 7x earnings will lead to rapid EPS growth over the next several years.
  • Situation is reminiscent of tobacco company stocks during the 1990s- early 2000s. After several years of buying back stock at 6-7x earnings, tobacco stocks had market leading returns.
  • Herbalife could potentially trade north of $200 by 2018/2019 if the taint persists (followed by a re-rating).

Regardless of what one thinks of Bill Ackman's campaign against Herbalife (NYSE:HLF), he has clearly had a negative impact on the share price. While the S&P 500 has risen nearly 37% since Ackman launched his assault on Herbalife, Herbalife shares have risen just 24%. Ackman's campaign has helped launch an FTC and DOJ investigation of the company while attracting many investors to follow him by shorting Herbalife shares (short interest is 28% of shares outstanding and nearly 38% of free float). Due to this negative publicity, Herbalife currently trades at just 8.3x and 7.3x consensus earnings estimates for 2014 and 2015 which is about a 50% discount to the 15x estimated 2015 earnings at which the S&P 500 trades despite having historically grown EPS faster than the S&P.

Since Ackman's assault on the company, Herbalife has directed over 100% of its free cash flow (over 100% by adding debt to the balance sheet to repurchase stock) to repurchasing shares. Based on recent management commentary, investors can reasonably expect that Herbalife will continue to devote most, if not all, of its free cash flow (which roughly approximates net income) to buying back stock. By repurchasing stock at such a low multiple of earnings (or free cash flow), Herbalife is able to dramatically shrink its share count, thereby boosting EPS (or free cash flow per share). The longer the "Ackman discount" persists, the greater the number of shares Herbalife will repurchase and the higher its EPS.

This situation reminds me of a phenomena once known as "the tobacco taint" whereby large tobacco companies like Altria (NYSE:MO) and Reynolds America (NYSE:RAI) traded at very low multiples in during the 1990s/ early 2000s on concerns about the liability owned to states for health costs incurred related to smoking related illness. While trading at 6-7x earnings (despite 7-10% operating income growth), these companies repurchased significant amounts of their outstanding shares and were fantastic investments. In fact, tobacco companies nearly always traded at a large discount to the market during the 1990s and early to mid 2000s despite strong operating income growth and free cash flow generation. With the benefit of accretive share buybacks, on a total return basis, tobacco stocks in general and Philip Morris in particular were the best performing category over a 45 year time horizon (from 1960 - 2005). There are very close similarities between the tobacco stocks of the 1990s and Herbalife today. Eventually, as greater certainty around the ultimate liabilities materialized, the tobacco stocks re-rated to roughly the market multiple.

Let's see what this could potentially mean for Herbalife shareholders - assuming that the "Ackman discount" persists through 2018:

2H14

2015

2016

2017

2018

Herbalife Free Cash Flow

300

630

667.8

687.834

708.469

assumed to grow at 6% per year

Share Price

52

57.2

62.9

69.2

76.1

assumed to grow at 10% per year

Shares repurchased (million)

5.77

11.01

10.62

9.94

9.31

assumes all free cash flow used

to repurchase shares

Total Shares (end of period)

93.2

82.2

71.6

61.7

52.4

FCF per share

7.66

9.33

11.16

13.53

roughly equivalent to EPS

The above model shows that assuming just 6% operating income growth (well below the double digit operating income CAGR of the past decade), and assuming all free cash flow is used for repurchases, Herbalife would compound its FCF per share (roughly equivalent to EPS) at a 21% rate between 2014 and 2018. Assuming that shares then reverted to a 15x P/E multiple (in-line with the market), investors could expect shares to trade at $203 in 2018 which implies a 41% compound annual return over four years.

To me this looks like an asymmetrically negative proposition for short-sellers. If Herbalife were able to grow operating income faster (say 10%), while keeping net debt to EBITDA constant (so increasing debt with operating income growth and buying back slightly more shares), EPS could be nearly $19 by 2018. Assuming reversion to a 15x multiple in 2018/19 implies a 50%+ annual return for equity holders.

Ultimately I think that the FTC will require Herbalife to make slight modifications to its business practices which will have minimal impact on the company's results. I expect that this will drive a re-rating of the shares. However, as a long term holder, I hope it takes years for this to resolve itself so that Herbalife can continue to gobble up cheap stock at a very cheap price.

Source: Bill Ackman's Campaign Is A Gift To The Long-Term Herbalife Shareholder