On one side you have the bears who suggest that Herbalife (HLF) is no more than a giant $6B Ponzi scheme with a shaky accounting method. On the other side, you have the bulls who claim that the 27.2% price decline was out of touch with better-than-expected momentum and solid free cash flow generation. Before going on in this article, it is important to make no bones about where I stand: you can rank me solidly in the latter camp.
It is also worthy to mention that it is much easier to be long than short in a market. The practice of short selling is, in my view, more a strategy combating inertia than a means of adding accountability to the marketplace. To be fair, short selling helps achieve market equilibrium and thus adds efficiency, but that does not make it a winning investment strategy. As it stands, equities head up in the long-term and have done so since the records were first established. There are times when one might feel compelled to short a stock, but it's a risky gamble.
The American economy, thankfully, is built of optimism and fueled by natural growth. Especially under the assumption of the efficient markets hypothesis, short theses have to demonstrate almost "insider information" to have a reaction on valuation.
Unless, of course, you are David Einhorn. The legendary and successful short seller misled investors into associating Herbalife with a giant Ponzi scheme. It's not, and we need to stop pretending that it is. Frauds happen, but Herbalife has been around for years and operates in more than 79 countries under a variety of regulatory procedures. The association makes even less sense when you consider that the company has consistently increased dividend distributions over the years. It went from offering a 10 cents per share distribution in 2008 to 20 cents in 2010 and now 30 cents. Companies that run Ponzi schemes find it hard to distribute real money to shareholders in real bank accounts, let alone to increasingly distribute money.
Furthermore, Herbalife has been a free cash flow machine. Free cash flow, the source of value creation, has gone up consistently from $184M in 2008 to $418M last year. This means Herbalife trades at only 14x last year's free cash flow despite strong progress. In fact, over the last five quarters, the company has beaten expectations by an average of nearly 15%. Yes, the company may be valued at 14% more than its historical 5-year average PE multiple, but it merits that premium given how much of a growth play it is in an uncertain economy. By my estimates here, the stock will double in value.
That won't deter the bears. They will still linger like they are currently doing at Sirius XM (SIRI). Sirius has a virtual monopoly on the satellite radio market and has delivered better-than-expected performance time and time again. The company is currently worth less than liquidation value when you consider double-digit revenue growth and its billion of dollars in net operating loss carryforwards, which shelter future tax obligations.
In my DCF model, I assume (1) 19.8% per annum revenue growth and (2) 2.5% into perpetuity, (3) consistent operating metrics, and (4) a discount rate of 15%. Based on these assumptions, the firm should be worth $4.60 - more than double its current value. Yes, Liberty Media (LMCA) may take over the brand, but that just means that you should invest in Liberty, which is currently cheap with a "buy" rating on the Street according to FINVIZ.com.
As can be seen with Sirius and Herbalife, the bears have to work against inertia to see the fruits of their "stock picking prowess." In the instance of Sirius and Herbalife, the bears also have so much to prove and so little evidence to work with. Not surprisingly, the short theses commonly devolve into a "she said this, he said that" dialogue. Einhorn, of course, has no proof that the company is running a $6B Ponzi scheme, but that won't stop his dialogue. In my recent bullish piece on the company, one follower referenced a court opinion:
Also a California court said that HLF should be looked into as to whether it is a endless chain scheme:
"Moreover, in the Court's view, Herbalife's entire business model appears to incentivize primarily the payment of compensation that is 'facially unrelated to the sale of the product to ultimate users because it is paid based on the suggested retail price of the amount ordered from [Herbalife], rather than based on actual sales to consumers.'"
Ironically, that same court opinion goes onto denying the "endless-chain-scheme claim," which is logical because Herbalife makes its business by operating a network, not a pyramid scheme. The company is in the direct selling business, which is a legitimate business method to incentivize the supply-side but unfortunately all too commonly associated with Ponzi schemes. Again, the shorts are reduced to floating around supposed "secrets" to fool an efficient market. Herbalife is, after all, incorporated in the Caymans.
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.