- Herbalife is an extremely controversial stock, but basic fundamental analysis can determine whether it is a Buy, Sell, or Hold at current levels.
- HLF screens as very cheap based on cash flow measures like dividend discount models, less so on balance sheet measures like EV/EBITDA.
- Fair value for HLF under DDM scenarios range from $15 - $57. More aggressive inputs could create an even higher target price.
- Fair value for HLF under P/E measures ranges from the low-$40's to the sell-side consensus of $90 and up. EV/EBIDTA valuation measures give a similar range.
If an angel got its wings every time there was another bullish or bearish argument for or against Herbalife (NYSE:HLF), we'd have more angels with wings than there are on grains of sands on all the ocean beaches.
I am reminded of that line from "It's A Wonderful Life" as I prepared this analysis on one of the most controversial stocks I have ever researched or followed in the financial press. There are much smarter people discussing the situation with Herbalife than Yours Truly: Bill Ackman, Carl Icahn, Seeking Alpha stars like Quoth The Raven, and other commentators on Herbalife. MBAs, CFAs, and quants who have spent months - or years - studying Herbalife certainly know more about the company's financials and inner-workings than what I can gather from a few weeks of cursory study. And as for the entire multi-marketing legal controversy, I am not a lawyer or expert on multi-level marketing or for that matter, Ponzi Schemes.
What I can do as a Chartered Financial Analyst is perform a basic comparative financial analysis of Herbalife and try and determine based on the current stock price and financials whether the stock is overvalued, fairly valued, or undervalued under various scenarios. More specifically, we can determine a best and worst-case analysis that assumes that short of a cataclysmic shutting down of the company (a scenario I believe is highly unlikely, as I explain later) what the company's stock price is worth.
Here is Barclay Capital's estimates representing the bullish side among the sell-side community. You see why bulls like Herbalife: 10% growth in top-line sales, EBITDA growth of mid-single digits, and 80% gross margins driving EPS growth into the low-teens:(click to enlarge)
Herbalife is forecast to grow her top-line by 10% a year through 2016, very impressive growth and normally deserving of a big multiple premium (think Netflix or Amazon.com). However, net income grows much slower (about 5% a year) and it takes big share buybacks to get the EPS needle to move at the high rate forecasted even with excellent cash flow growth. China saw excellent Q2 sales growth, an impressive 44%. Strong recruiting trends and increased penetration of daily consumption programs continue to be the key driver for growth in this market, which now accounts for 13% of total sales.
With a starting stock price of approximately $51 when it was run, we see that with a long-term growth rate of 16%, EPS estimates in-line with the sell-side analysts, and a dividend payout ratio that likely approximates free cash flow being deployed to a 45% dividend or share buyback ratio, a fair price based on the inputs above produces a DDM price of $57. So Herbalife is basically fairly valued or a bit cheap at today's prices in the low-$50's.
Let's see what happens assuming EPS are cut in half and future growth slows to 8% under a situation where Herbalife's business model is attacked in both the U.S. (bulk of existing earnings) and China (future growth):(click to enlarge)
As you can see the fair DDM price falls drastically to the $15 range. Herbalife bulls love the free cash flow the company can generate but if that is cut substantially the valuation collapses.
Let's take a look at a P/E valuation model. Analysts are using 13-15x as the norm, hence price targets as high as $94 from The Street based on 2014 or 2015 EPS. But these analysts also note that their bear market forecasts generally incorporate a P/E multiple of about 7x EPS of about $6 in 2015, for price targets in the low-$40's. So while they are including a multiple collapse they are NOT including an EPS collapse. Collapsing both the multiple and EPS should give us a worst-case scenario.
Herbalife has traded at P/E multiple of about 15x since going public in 2004; the P/E the last 4+ years since 2010 has been closer to 14.5x. If we take the consensus EPS of $6.25 and $7.20 for 2014 and 2015, respectively, we can come up with the bullish price targets of $87 - $100. That assumes a near-normal multiple on 2014 and 2015 EPS. Using consensus EPS for 2014 or 2015 and a low-to-mid teens multiple, you get a stock price substantially higher than today's level.
However, if we cut EPS to the level used in the bear-case DDM, we come up with a stock price much lower. Let's take the trough P/E multiple during recent Ackman Attacks. The stock collapsed to about 7-8x 2014 EPS. If that happens again AND the EPS are cut in half as per the DDM above, then you are looking at a stock price of $25-$30, consistent with the uber-bear scenarios that do not incorporate an FTC shut-down of the company. The combination of trough earnings and a trough P/E multiple is a double-whammy. We've had the trough multiple but earnings have not been impacted - yet.
HLF has shifted its business model from selling bulk orders sporadically to selling smaller ones more frequently. This shift has driven significant growth and analysts expect this momentum to continue. Q2 2014 saw tough comparisons as having been a bigger cause of a slowdown in volume points (VPs) in certain key markets, such as the US and China. HLF is making changes to enforce the rules about what distributors should not be saying to potential new members and this could be dampening sales, especially in the U.S. This should be remedied after a multi-city tour in the U.S. is completed later this year which should provide distributors with greater guidance on what they can or cannot say.
Let's move away from income statement measures like P/E and DDM and use one that incorporates the balance sheet. If we use EV/EBITDA, we can see a late-July comparison for some peer group comparables of Herbalife. Herbalife trades at a slight discount to her peer group on EV/EBITDA:(click to enlarge)
You can see how the P/E and EV/EBITDA have gotten cheaper compared to 2006, long before the controversy that envelops Herbalife today. Herbalife went from a 1.7x premium P/E to the peer group average (see below) to a 4x P/E discount (see above). EV/EBITDA went from about a 1x premium (below) to a 1x discount (above). If we assign a dirt-bottom EV/EBITDA multiple of 5x, then the fair price would be in the $42 range, consistent with the P/E valuation method:(click to enlarge)
As for the major controversy concerning Herbalife's sales practice, it is just my opinion but I find it hard to believe that the Federal Trade Commission would close a company after it has been in operation for 30+ years. It is simply too draconian, even if a start-up utilizing the practices outlined by Ackman would face more severe penalties or warnings today. The FTC may order corrective actions (hence my slashing of EPS by half in the DDM model above) but it is highly unlikely - again, my opinion - that they will suddenly decide that after 30 years they rise to the level of a full-fledged Ponzi Scheme.
Questionable sales tactics ? Hey, drug companies got nailed for that when they gave away pens and flashlights. The question will then be what will be the ultimate sales changes and what will be the impact on revenues, earnings, and cash flows. I believe that a 50% cut to EPS and a trough multiple give you a realistic 'worst-case' analysis for Herbalife, rather than assuming the company is shut down or that consumption of their products (I take no position on their usefulness or nutritional value) drops by 75-90%. That usually happens only when something is obsolete (8-track tapes) or replaced by a superior product (typewriters and Wang word processors eclipsed by Microsoft Word).
Herbalife does have a few levers to maintain EPS and cash flow even at reduced levels: gross margins near 80%, a lower tax rate as earnings ramp up from China; stock buybacks using free cash flow; and a depressed valuation (at current or lower levels) that may discount the worst. However, high debt levels may impinge on any fair value using any of the three methods I showed above as total debt has gone up 10-fold in only the last 4 years. Debt as share of total capital was under 10% before the Credit Crisis; today it is closer to 30%. Debt has kept EPS and the stock price up but the cost is less flexibility in the future.
I make no claims on the competing arguments of Herbalife bulls and the shorts, Carl Icahn vs. Bill Ackman, or the dueling legal and marketing experts arguments for-and-against the company. I simply wanted to take a step back and ask "what is this company worth?" under a range of plausible scenarios. Ultimately, the market - and the company, the FTC, the Department of Justice, and overseas governments - will determine the fate of the company and her share price.
And that will determine whether the longs or the shorts enjoy a wonderful life being long or short Herbalife shares.