After correctly predicting the current stock price, corporate shakeup, and takeover offer for Avon Products (AVP), I believe that I have credibility in providing reality checks on direct selling companies. I provided one earlier here for Sirius XM (SIRI) when I stated that the stock could and should double - a claim that the market appears to increasingly agree with. My next reality check concerns Herbalife (HLF).
Herbalife is a direct selling company that uses distributor networks to market weight loss, nutritional, energy, sports, and fitness products. The stock has precipitously fallen since activist investor David Einhorn inquired about why the company stopped disclosing information about distributors at the first quarter earnings conference call. Ironically, it was actually an excellent quarter from an excellent company.
Now, Einhorn is an activist investor that has been successful in pointing questionable accounting methods in the past. But, in some instances, fear mongering has left firms like Green Mountain Coffee Roasters (GMCR) substantially undervalued. Herbalife is now near its 52-week low and 41.1% below its 52-week high. In this article, I will run you through my DCF model on the firm and then triangulate the result against a review of the fundamentals of Avon and Procter & Gamble (PG).
First, let's begin with an assumption about the top-line. Herbalife has had excellent momentum with 26.4% growth in FY211, an acceleration off of double-digit growth in the preceding year. I model 14.5% per annum growth over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods eating 20% of revenue versus 65% for SG&A and 2.6% for capex. Taxes are estimated at 23% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I model this figure hovering around 0.2% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 8.5% yields a fair value figure of $85.22, implying that the stock would roughly double. In any event, the company trades attractively at 10.7x my 2012 free cash flow estimate. The market seems to be factoring in a WACC of 14%.
But, wait, it gets better. You may have thought I was assuming too high of a per annum growth rate at 14.5%. So, let's bump that number down to 5% (a figure that only mature companies like Wal-Mart (WMT) are expected to have.) At this low growth, the market will fairly value the company at an aggressive WACC of 10%. A more reasonable WACC of 8.5% would imply that the company is still 25% undervalued!
The Street seems to be in agreement with my bullish sentiments and, accordingly, rates the stock a very "strong buy" (source: NASDAQ). By contrast, Avon and P&G are trading at around fair value. While Herbalife trades at a respective 12.3x and 10.1x past and forward earnings, comparative figures are 19.8x and 15.2x for P&G and 23.3x and 17.2x for Avon.
Consensus estimates for Avon's EPS forecast that it will decline by 37.2% to $1.03 in 2012 and then grow by 18.4% and 14.8% in the following two years. Assuming a multiple of 18x and a conservative 2013 EPS of $1.18, the stock would hit $21.24 for minimal upside. The Chairman has underperformed expectations and has been viewed as reckless in handling bribery charges. The stock currently offers a dividend yield of 4.4%, although some investors are questioning its long-term sustainability.
While P&G may not have attractive upside, it certainly is a sustainable business and led by top management. Consensus estimates for P&G's EPS forecast that it will fall by 2.3% to $3.86 in 2012 and then grow by 8.3% and 8.6% in the following two years. Assuming am multiple of 18x and a conservative 2013 EPS of $4.13, the stock would hit $74.34 for 16.9% upside. This is not typically viewed as a sizable discount but is reasonable in light of the company's 3.5% dividend yield and beta of 0.5. Thus, I recommend P&G only for risk-averse income investors.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.