Three months ago, I claimed that Herbalife's (HLF) valuation was "baseless" and that the "stock could double". This article was followed by two more: "Buy Herbalife, Avon Over Procter & Gamble" and "Herbalife: A $6B Scheme Or A Stock To Double?". Through it all, I employed a tactical gambit that would unearth the phony criticisms of the bears. The bears responded by evoking fears that have little basis in reality and are overly reliant on speculation. Needless to say, my point has thus far been confirmed by the market.
I first criticized that the critics would have you believe that Herbalife, which has beaten expectations time and time again, is a Ponzi scheme. To the extent that this is true, it has been more than factored into the stock price. On a May 1 conference call, short seller David Einhorn was questioned about how much sales came from "outside the network" versus "within the distributor base." In a matter of a few days, the stock went from $73 to $42.15 - a 42.3% decline. It was a weird overreaction, to say the least, and shares traded at a multiple of 13.1x past earnings for the end of June - below the 13.7x historical 5-year average.
Perhaps more importantly, I stressed to investors that it is much better to be long on the market versus short. The latter is a risky, although sometimes lucrative, bet that assumes a superior knowledge than the public market. In the context of an efficient market, stock prices reflect all publicly-available information and, according to some, insider information too. While empirical research has shown that value investing works because some stocks are overly discounted, the market is not terribly off either. And, at 11.8x forward earnings, with a relatively mild projection of 14.8% annual EPS growth over the next 5 years (annual average was 28% over the past 5), the stock is at a low. More on that below.
What's better, Herbalife's future growth is nowhere close to being fully appreciated, as evidenced by the 0.5 PEG ratio for Aug 13, 2012. If Herbalife was was such a shoddy company, then why did the firm generate $430.6M for the TTM ending 2Q12 versus $380.8M for 2Q11, $276.6M for 2Q10, $195.7M for 2Q09, and $206.3M for 2Q08? China, where multi-level marketing is not allowed, represented more than one-twentieth of the business and was one of four regions that exceeded 20% growth in the 4Q. If Herbalife engages, let alone succeeds, in a country that does not allow MLM marketing, how could it get away with being a Ponzi scheme abroad? Products that are successful in one market have translated well in others.
All told, FCF has had a CAGR of 15.9% over the past 5 years. Assuming FCF grows 590 bps less on an annual basis over the next 5 years, 2Q17 FCF for the TTM would come out to $693.5M. Assuming a multiple of 14x, the stock would be worth $86.12 by 2016. If EPS growth consensus is met, the stock would be worth $124.46 at a 14x multiple. Discounting that backwards by 10% yields a present value of $77.28, which means there is a ~50% margin of safety that the stock could more than double in value.
Since I first published my bullish thesis, the stock has been gone up 22.3% - nearly sextupling the return on the Dow Jones. The company was being investigated by the SEC, but now Herbalife spokeswoman says that:
The documents speak for the themselves, the matter's closed and there's no SEC investigation.
Apparently, I wasn't the only one that found the assertion that Herbalife was a Ponzi scheme to be overly hyperbolic.
It is interesting then, that peer firm Nu Skin Enterprises (NUS), a global direct selling firm, was accused by Citron Research of running a pyramid scheme in opposition to Chinese law. It should be noted that the stock has fallen by "only" around 10% since the report was made - less than a fourth of Herbalife's fall. Citron Research has produced great research in the past, but I respectfully disagree with their contentions on this one. While MLM compensation schemes are not allowed under Chinese law, carefully regulated "direct selling" is. Rated a "buy" on the Street according to data from FINVIZ.com, Nu Skin has the wind in its favor. It also trades at 12.1x forward earnings and 12.5x free cash flow, so the downside has been fairly limited at this point.
What I find most interesting about the bear thesis is how Citron Research frames the presentation of direct selling very similarly to how other critics do. The modus operandi is to make them sound shady. Citron Research argues that Nu Skin promises "massive personal wealth" and evokes a "cult-like behavior" like it is necessarily a bad thing. It's a "guilt through 'smell'" argument that direct selling businesses are used to. Google "direct selling" or "MLM marketing" and you will hear similar arguments being presented on ethics. While fear can cause short-term market disruptions, in the long term, the market corrects past mistakes and rationalizes more for the future.
Look no further than Avon Products (AVP), which is the world's largest direct seller. Avon has been charged with international bribery against US law and faced shareholder rebellion over corporate governance. I argued that the role of CEO & Chairman would be split and that the firm was an ideal takeover target. Like my position on Herbalife, both of my positions on Avon proved true.
Avon is worthy of a speculative buy at this point. Shares trade at 15x forward earnings but, then again, EPS is expected to be flat over the next 5 years. This sets the bar very low for high risk-adjusted returns. In the meanwhile, the stock offers a 5.8% dividend yield. Earnings have been far worse than expectations - an average miss of 22.7% - over the last five quarters, but the turnaround potential is huge. Avon has both the brand and economic moat necessary to ride a full recovery and outperform broader indices. It may not have as favorable risk/reward as Herbalife and Nu Skin, but it is still worthy of a buy.
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