Next Herbalife Selloff - Delayed By Earnings

| About: Herbalife Ltd. (HLF)

Summary

October marks the beginning of HLF’s bear season.

For HLF's long-term game, the overall picture is dismal.

For now, we play the seasonality, the fact that HLF has likely hit a top, and the “smart money” price, which lies $10 below us.

As much as I love the idea of supporting a company that gives otherwise contributing members of society false dreams and hopes, leading them slowly to drag their friends and family down with lies, financial problems, and passing on the hilarious meme that is multi-level marketing (MLM), I have to be short on Herbalife (NYSE:HLF) here guys.

If we all invested with our hearts, I would be 100% long alcohol, big banks, and the North Korea ETF, if it is ever made. And of course, I would be short social media, progressive technology, and China - because you gotta be hedged, right?

But instead, I place my money where statistics, logic, and seasonality tell me to. And now, they are telling me to short HLF. I have actually been eyeing for a while Herbalife, so this short position is almost overdue.

Except it's not. The seasonality here shows now as being just about the right time to be short HLF. Herbalife differs from most stocks, which show chaotic seasonal patterns that vary by the month and are highly affected by seasonal earnings; here we see Facebook (NASDAQ:FB), which is an example of the chaos that would have us selling four times per year, if we were to make trades based 100% on seasonal patterns:

October marks the beginning of HLF's bear season. HLF has an interesting seasonality. Unlike most stocks, HLF's bull and bear seasonality occur in phases with no real discrepancies:

The data show negative Sharpe ratios from here till February. We also have the largest drawdown in October, before the green/red ratio turns red in the winter. It also appears that HLF is likely to make its yearly tops in the summer and pull back in the winter.

This year has matched the implication quite well, with the recent peak in late July/early August. (Yes, this year's data is included in the analysis, making inferences about this year seemingly cyclic, but the trend holds when removing this year's data from the analysis.) And with the stochastics telling us that the stock is overbought for the first time since that peak, I jumped on the opportunity to run a further analysis on HLF's current status to see whether it is a legitimate short opportunity:

Click to enlarge

We have a reliable bearish trend that begins in October and ends in February, when HLF begins its bullish phase. Thus, as a seasonal play, shorting HLF from Oct to the end of Jan pays off in the long run, year after year. This is my aim, as well.

One con of this trade is that a long position covering the bearish season will also cover earnings. The upcoming earnings for HLF looks like it might spark a rally. My preliminary earnings analysis for HLF shows this through several indicators - probability models, drift, call buying, etc. If you want a more in-depth analysis on HLF's earnings and while it is likely to beat and rally on earnings, please request the analysis in Exposing Earnings.

For now, let's assume the worst: HLF rallies on earnings. Thus, we must decide whether to exit before earnings and re-enter afterward or to hold over earnings. One good thing about earnings is that HLF's earnings rallies have become increasingly weaker, but this does not mean we should willingly be short on HLF into an earnings rally.

A more useful fact is that HLF almost always sells off after an earnings spike, meaning if we enter after an earnings beat, we can exit, taking profit, and re-enter our short position at a higher point. I like this idea and will purposefully avoid earnings, reopening a safe short afterward.

Why" safe?" I believe the short is safe for more than seasonal reasons. We have downward pressure on the price from a fundamental standpoint, as "smart money" has already made a bid for Icahn' s position, offering to buy him out at the highest bid of $51.50. It doesn't require advanced math to see that smart money points to HLF being overvalued in the eyes of the big players.

Thus, $63.50 is a speculative price - speculating on Icahn holding to his position and possibly taking the company private. But the smart money has already made public their true valuation of HLF, upping the difficulty of the mental gymnastics involved in adding to a HLF long position. This also gives us an idea of a top, especially as we see HLF as overbought but after only climbing a few dollars back from the selloff from the summer.

Then we have financial factors pointing to a weakening company. My favorite fundamental indicator - because of its statistical correlation to future stock price - is EBITDA/EV. When plotted with stock, its movements often precede stock price movements, meaning that jumps in EBITDA/EV should encourage investors to add/reduce their positions.

For HLF, the picture is dismal. Note that EBITDA/EV spiked right before HLF's epic rally. It dropped before HLF's fall to $35:

Now, the ratio is on the rise again, but not even close to previous levels. The rise in the stock is better explained by speculation and activist investor bolstering than fundamentals, from this standpoint. I don' t like to bet against a rising EBITDA/EV, but I also don't take HLF's tiny increase in this ratio as bullish, especially in light of where it lies in the overall picture.

Then we have HLF's growth, which is the go-to to many permabulls. HLF's primary growth is in China - as is all MLM's. Nothing wrong with further warping the Chinese concept of capitalism via MLM meme contagion, in my opinion, but the spread of the MLM infection already peaked in 2014:

I've seen this peak many times, and it's generally before - not after - the peak you want to go long on a stock, unless the company transitions from growth to value or dividends. But you already knew that. And that's why you're at least not buying at a top, right?

"But Damon, you said HLF will rally at earnings!"

Yes, but it' s not because the company is in great shape. An earnings rally combines three main factors:

  1. Actual earnings.
  2. Investor expectations.
  3. Forward guidance.

The first is not exactly great:

However, expectations are low. And the management of the company always has a rosy outlook for the future. Much like the members of HLF, the management will likely be optimistic as the ship sinks and their bank accounts hit zero - oh wait, management holds limited liability, so they'll be fine… unlike the members…

Anyway, the upcoming earnings report should look good for HLF longs not because of earnings growth but because of low expectations. If it can get at least half the population through life, it can certainly get HLF's investors through earnings. But afterward, I suggest you return to this article and consider a short position.

You might wait until after earnings to open a position. Or you can short before earnings, as I expect a pullback - even a slight one - before then. As a freebee for you guys, here' s my play, as sent out through Copy My Trades:

We play the seasonality, the fact that HLF has likely hit a top, and the "smart money" price, which lies $10 below us. The fact that HLF is overbought according to the stochastics bolsters the current choice of entry time. Here is my options play:

  1. Sell HLF Oct14 $64 Call
  2. Buy HLF Oct14 $67 Call
  3. Buy HLF Jan $60 Put

The first two options use weekly options. This credit spread should be rolled over every week, bringing in $50 per contract. After eight weeks, the Jan put has been fully funded, and we are even on our position.

Afterward, if HLF falls, we can see the Jan put increase in price and possibly walk away with significant gains. We will sell the strategy and re-open before and after earnings to increase the probability of profitability. If we need to hold through all of January, we can exercise the puts, buy protective calls, and run synthetic puts for the remainder of the month.

… but that' s a few months from now. So, for now, open the above strategy and aim to close at the beginning of November to avoid earnings. We will reopen in mid-Nov.

Notes:

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Note2: All unlabeled figures were created by me from data pulled from Yahoo and ADVN through R. Charts with blue backgrounds are from E-trade Pro.

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Exposing Earnings - my earnings prediction newsletter - is now live, here on Seeking Alpha. In this newsletter, we employ both fundamental and pattern analyses to predict price movements of specific companies after specific earnings. I offer specific strategies for playing those earnings reports. To-date, we are 94% accurate on earnings report predictions.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in HLF over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.