Herbalife Survives, But Concerns Linger - An Opportunity With Put Options

| About: Herbalife Ltd. (HLF)

Herbalife Ltd. (NYSE:HLF) got a pass at the Ira Sohn Investment Conference on Wednesday - famed short seller David Einhorn made no mention of the nutrition supplement marketer, causing shares of Herbalife to rally more than 17% during trading and another 3% after hours. It certainly seems as though traders have interpreted Mr. Einhorn's silence to mean two things: 1) Mr. Einhorn does not have a short position in the company and 2) there is nothing fundamentally wrong with Herbalife.

I would take issue with both contentions. First, Einhorn may well have a position in the stock - he could simply be keeping it hidden for the time being. It should also be noted here (and this should at least assuage some Herbalife shareholders and fans) that any position Mr. Einhorn may have in Herbalife could in fact be a long position - that is, he could have questioned the company's executives on May 1st because he is long the stock and wants to make sure everything is ok and, having been satisfied, all is well. However, what David Einhorn is or is not doing is really not the issue; the issue is with Herbalife, not Greenlight Capital.

That said, I believe the rally in Herbalife's shares Wednesday presents an excellent opportunity to bet against the stock at a cheaper price; puts on the company's shares are now significantly cheaper than they were on Tuesday. What follows is a list of reasons to be skeptical about Herbalife. Each has an link to the source of the information and all of which, while not in and of themselves that worrisome, together paint a rather disconcerting picture.

1) The Law Offices of Howard G. Smith have recently opened an investigation into potential claims against Herbalife related to the possibility that the company violated securities laws by making false and misleading statements. According to the press release,

the investigation relates to how Herbalife quantifies distributors, consumers and other clients, and its decision to stop disclosing the percentage breakdown among its distributors.

This is precisely the issue Mr. Einhorn questioned the firm about on May 1.

2) The company is incorporated in the Cayman Islands which, according to page 43 of Herbalife's most recent annual report (available from Herbalife at their investor relations page), makes it more difficult for common shareholders to protect their interests. Specifically, the company says that:

The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are not as clearly established as under statutes or judicial precedent in existence in jurisdictions in the United States. Therefore, shareholders may have more difficulty in protecting their interests in the face of actions by our management or board of directors than would shareholders of a corporation incorporated in a jurisdiction in the United States, due to the comparatively less developed nature of Cayman Islands law in this area...Shareholders of Cayman Islands exempted companies such as Herbalife have no general rights under Cayman Islands law to inspect corporate records and accounts or to obtain copies of lists of our shareholders. Our directors have discretion under our articles of association to determine whether or not, and under what conditions, our corporate records may be inspected by our shareholders, but are not obliged to make them available to our shareholders.

3) One product (the Formula 1 meal replacement) accounts for 30% of the company's sales, putting the company in a precarious position should the product suddenly become less popular. According to page 39 of its annual report,

If consumer demand for this product decreases significantly or we cease offering this product without a suitable replacement, then our financial condition and operating results would be harmed.

4) At least two academic journal articles have suggested that Herbalife's products are dangerous. In one article (from the Journal of Hepatology and available here from ScienceDirect), the authors found that 10 cases of toxic hepatitis "were sufficiently documented to permit causality analysis" implicating Herbalife products. In the other study (also from the Journal of Hepatology and available here from ScienceDirect) an "association" was observed between the consumption of Herbalife products and the development of acute hepatitis. Other studies have produced similar results. The point here is not to comment upon the safety of Herbalife products (I do not take them, nor am I a doctor), but to suggest that the fact that the products are implicated can and has (one example is State of California case BC392373, dept. 48) led to lawsuits, which, of course can damage the company's financial position.

5) Herbalife admits in its most recent annual report that it is subject to litigation risk regarding the legality of its business model. Specifically, the company notes (in its most recent annual report) that in Belgium, Herbalife was judged to be

in violation of the Belgian law on Unfair Commercial Practices by establishing, operating or promoting a pyramid scheme where a consumer gives consideration for the opportunity to receive compensation that is derived primarily from the introduction of other consumers into the scheme rather than from the sale or consumption of products.

The significance of this should not be overlooked: In Belgium, Herbalife was judged to be either operating or promoting a pyramid scheme. If you are unfamiliar with the difference between a pyramid scheme and legitimate multi-level marketing, consider

that the main difference between a legitimate multi-level marketing (MLM) business model and a pyramid scheme is that a legitimate MLM is focused on selling products, not recruiting more salespeople.

This is why Einhorn questioned who was buying the products. I have heard many people ask why it matters where the revenue comes from as long as it is there. This is why it matters: an operation wherein the emphasis is solely on recruiting more 'distributors' without adequate concern for selling products to traditional consumers who are not distributors, could be a pyramid scheme rather than a legal multi-level marketing organization.

Hence, it is extremely important that investors know what the breakdown is as far as who is buying the products - this is why it was so absurd for Herbalife to claim that the breakdown "wasn't valuable information...to investors." If you think this is not a red flag, consider the following observation made by the Director of the Bureau of Consumer Protection of the Federal Trade Commission as quoted originally in a CNBC article by Herb Greenberg: "it would be 'red flag' if a multi-level marketing company didn't keep track of unrelated customers."

6) Another worry is that if (notice I said "if" here) Herbalife sells most of its products to distributors (as Einhorn and others seem to be suggesting), those distributors better have an incentive to keep buying or the whole operation collapses on itself. A recent article in Barron's however, says that a

careful analysis of Herbalife... [shows] that over 90% of their U.S. distributors make no profit...[and although] international markets offer fresh prospects for the companies... Herbalife's filings show it has to replace more than half of its distributor ranks every year.

To put an exact figure on just how little the distributors make, Greenberg notes that the company's website says the average compensation for 'supervisors' is only $901 per year. Given this, it's no wonder the company experiences a high turnover rate. What happens if the company begins to have a hard time signing up salespeople?

While it is certainly unfortunate when bad things happen to good companies, sometimes there are simply too many issues to ignore even if every single one of them turns out to be meaningless as far as the company's integrity is concerned. What I am saying is this: sometimes stocks fall for the wrong reasons; however, if there is a laundry list of concerns about a company, you can bet that (eventually) one of those concerns will trigger a precipitous drop in the stock, whether the company deserves it or not.

The only question is, do you want to profit from it, or stay in the shares without buying any protection via put options and be left with nothing but the sound of your own complaining when the market unjustly punishes your company? I for one recommend buying puts on shares of Herbalife whether you own the stock or not.

This strategy seems like a fair and balanced win-win scenario for both Herbalife bulls and bears. If the bull case is correct and you buy puts, you were protected from the nasty effects of any vicious rumors while owning an otherwise fine stock. If the bear case is correct and one of the rumors turns out to be true, you don't get hurt so bad if the stock slides because your put protection cushions you from the fall. (Still) Long HLF puts.

Disclosure: I may initiate a short position in HLF over the next 72 hours.

Additional disclosure: Long HLF puts.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500. Become a contributor »
Tagged: , , Drug Related Products, Options
Problem with this article? Please tell us. Disagree with this article? .