The share price of Herbalife Ltd. (HLF) has corrected ~30% from the all-time high it hit in April. It only needed three questions by David Einhorn (which he asked on the company's 1Q earnings conference call) to trigger a panic attack among the company's investors. The market responded frantically as a similar story of the demolition of Green Mountain Coffee Roasters, Inc. (GMCR) by the same man started playing on investors' minds. Einhorn had thrashed Green Mountain with a presentation questioning the company's financial health and accounting practices. The stock price of Green Mountain Coffee Roasters has corrected ~75% since his October 2011 presentation.
Despite of all this investor panic, Herbalife continues to report strong results. Last month, the company reported Q2 EPS of $1.1, beating the consensus estimates of $0.96 by a good margin. Under a tough macro backdrop, the company posted better-than-expected results in every aspect of the business. Given strong momentum across geographies, management upgraded FY12 revenue growth guidance to 15.0%-17.0% from 12.5%-14.5% and EPS guidance to $3.88-$3.98 from $3.58-$3.74. Despite a solid second quarter, the stock prices have failed to recover, as there is a fear that David Einhorn could present a well-crafted bear case on Herbalife.
The bearish thesis is based on the riskiness of the multi-level business model in general. The company's inventory levels have seen alarming growth in the last two years. The increasing presence of heavily discounted Herbalife products on eBay not only violates the person-to-person model of the business, but also indicates that the distributors are buying more than they can sell in order to uphold their "sales leader" status, and as a result are selling the products at a loss. Also, a lack of visibility into where a product goes after sale to a distributor suggests that it might be possible that the company has no real customers and its distributors are just buying for themselves - the long-term sustainability for which is questionable.
We believe that multi-level marketing is a legitimate business model if executed properly. The company's strong cash flow performance over a prolonged period suggests the same. Though the company has seen a 71% inventory growth over the last year period, we are not overly concerned as the company has also achieved a strong sales growth of 56% in the same time frame. As far as the online-presence of the company's product is concerned, we admit it violates the model, but in most cases, the online sellers are not distributors, but third-party vendors who are buying product from distributors.
Moreover, the management has pointed out that the online presence is insignificant relative to its sales base and is the lowest among the multi-level marketing companies. Now going into the concerns about real customers, it should be noted that the company's P&L ends where the distributor P&L starts. The distributors, who are just buying for themselves, can be perceived as discount customers and more often than not, eventually end up constructing a sales business once they see the opportunities ahead.
Thus, we believe the bearish thesis is overblown and the stock weakness offers a great opportunity to invest. The following are some other reasons that make us bullish on this stock.
- Rapidly growing Nutritional Supplement Market
Over the past decade, the worldwide supplement market has grown at 8-10% rate annually and now stands over $175 billion. We remain optimistic on the supplement industry's growth, given favorable macro factors like rising obesity rates and aging population. In addition, increasing acceptance of non‐traditional therapies and growing demand for lower-cost alternatives suggest that the nutritional supplement industry will continue to expand. Thus, we believe the company is well positioned with its portfolio of affordable products.
- Huge Growth Potential in China
We believe China will be an important growth driver for the company. Unlike its competitors, the company has limited penetration in China and represents the company's smallest region sales wise. We expect the company to continue its high growth in China (Q2 sales were up 50.5% and volumes were up 54%) and eventually scale up this business to surpass all other regions in sales.
- Geographic Diversity
Herbalife has a relatively less risky profile as compared to other global direct sellers like Nu Skin Enterprises Inc. (NUS) and Tupperware Brands Corporation (TUP). The company has its profits are well spread over different regions, whereas Nu Skin is largely dependent on Japan and Tupperware extracts a bulk of its profits from Europe. Thus, Herbalife remains relatively immune to global headwinds and has an attractive risk profile than its public global direct selling industry peers.
- $1 billion buyback program
The company completed its $428 million accelerated share repurchase program in July, buying back 9.2 million shares, or 7.5% of shares outstanding, for an average price of $46.37. The company continues to return its shareholders and has authorized a new 5-year, $1 billion buyback program.
Herbalife also has impressive return to equity of 104.97% and return to assets of 26.72%. According to Yahoo Finance, the consensus expects the company to post an annual growth of 14.10% over the next five years, which is in-line with The Hain Celestial Group, Inc.'s (HAIN) 14.85% annual growth over the next five years. However, the company is trading at a forward P/E of 10.74 as compared to Hain's 25.37. We, therefore, believe Herbalife is significantly undervalued. We believe the company will likely achieve its pre-'Einhorn effect' multiple of ~15x forward earnings, as investor concerns slowly wane and investors start focusing on the fundamentals. Thus we see 50% upside for the stock and would recommend buying it.