Herbalife: We Shall Overcome

| About: Herbalife Ltd. (HLF)

Summary

Preferred members increased by more than expected.

Separating preferred members from distributors has its benefits for Herbalife, such as the consumer data it gives the company.

Worries on China are slightly overblown.

"Look, I'm doing this for the good of the world, and I want to see sunshine on Herbalife."

- Carl Icahn

In February, I wrote an article explaining why I was changing my view on Herbalife (NYSE:HLF). In the article, I explained why the July FTC "win" presented management with an opportunity to restructure and turn around the firm. Weeks later, I wrote a follow-up article asking the shorts to take cover.

Last week, the company announced earnings. Revenue of $1.5 billion was in line with Wall Street consensus, while earnings beat by $0.03. Investors were, however, disappointed with the company's reduced guidance. Adjusted net sales are expected to increase 3.6% to 6.6%, down from the previously announced range of 3.9% to 6.9%. As shown below, the share price, which was in an upward trajectory, reversed course.

(Source: Investing.com)

In my previous articles, I have explained that while Herbalife is not cheap, the risks of shorting it are more than the opportunities. In this article, I will focus on the company's turnaround efforts, the growth of preferred members, and the current situation in China.

Preferred Members

To me, this was one of the most important parts of the company's conference call. The main argument among the shorts is that Herbalife sells a business opportunity, not its products.

Before the FTC ruling, this point was valid. In fact, at some point, Des Welsh, the company's president, did not know the ratio of products sold to customers versus those sold to distributors "because we don’t have visibility to that level of detail." In its ruling, the FTC asked Herbalife to start operating legitimately.

After the FTC ruling, the company has done a lot to create transparency and accountability. It has separated the distributors from the preferred customers. Distributors are people who buy the products to sell, while preferred customers are people who sign up to get the products at a discount.

Screen Clipping

(Source: Herbalife)

If Herbalife was junk, as many people think it is, then we would not see the number of preferred members increase. In the Q3 earnings call, which happened just a month after the company separated the two memberships, it had about 50,000 preferred members. In the Q4 conference call, it mentioned the number of members had risen to about 300,000. In terms of volume from the preferred customers, the company has already met the volume target it had set for May this year.

This growth happened when Herbalife was going through a tough period. John Oliver, the popular comedian, had just criticized the company in an episode that has now been viewed by more than 25 million people. At the same time, the hype surrounding the upcoming documentary "Betting on Zero" was on the rise. The company's CEO announced that he would step down, and an SEC investigation was announced.

In this regard, the surge in the number of preferred members is an indication that Herbalife has real customers who buy its nutritional products. Going forward, this is one of the numbers investors should keep their eye on.

Although separating the distributors and the preferred members is a regulatory requirement, it is also beneficial for the company, which collects useful data from its members. In the previous conference call, Michael Johnson said the following about the data.

The advances we are making in segmentation of our members, which clearly delineates discount product customers versus distributors. The introduction of the new technologies and the creation of smart customer data will provide us with further competitive advantage, enhanced visibility into consumer behavior and preference will be a huge advantage for us.

In addition to this, investors should not ignore Herbalife's efforts in improving transparency on the distributors' side. In the recent conference call, the company talked about its Point of Sale system, which is in beta. In January, the apps processed 196,000, a number which is expected to hit 2 million in May. Another initiative called the Loyal Customer Program is intended to improve communication between the distributors and their customers. I expect these initiatives will play an important role in adding more distributors, increasing volume, and attracting more customers.

China

China is one of the most important markets for Herbalife. As shown below, the country contributes a significant amount of revenue to the company. It is also the only country that has consistently increased revenues in the last three years.

Screen Clipping

(Source: Seeking Alpha)

The same is true when you look at China's volumes. As shown below, in the past three years, it has consistently increased volumes.

Screen Clipping

(Source: Seeking Alpha)

In terms of sales leaders, although it is slightly different from other regions, they have consistently increased over the past three years.

Screen Clipping

(Source: Seeking Alpha)

However, in the past two quarters, the Chinese market has been a bit challenging for the company. First, the volumes declined. In Q4, volumes declined by 11%. Management attributed this decline to the sales leaders' shift to social media at the expense of face-to-face meetings with the clients. This strategy had worked in well in Q1, and management said:

Our Herbalife China team integrated WeChat into our online product ordering, and into our nutrition education and communication to service providers and customers. Thanks to these and other customer focused initiatives our China business continues to grow as more consumer see Herbalife as a trusted, convenient, results driven nutrition brand.

At the time, the social media engagement had created excellent opportunities for Herbalife in terms of volumes and revenues. However, as the year went on, this changed, as the company explained in the last call.

But what we thought as we went through the year is that the stickiness of those customers was minimal compared to what we would experience in the clubs.

In the search for growth, it is acceptable for companies to make mistakes along the way. I expect Herbalife will continue to face challenges in China as it shifts from social media to the club-based model.

I always say the minute I stop making mistakes is the minute I stop learning and I've definitely learned a lot.

- Miley Cyrus

Early this year, Herbalife announced its joint partnership with Tasly, a Chinese company with more than 1,000 patents and one of the largest CPM exporters in China. While the details of the partnership are scant, I expect Herbalife will capitalize on Tasly's understanding of the Chinese market to improve its volumes in the country and globally. In the last call, the company said this about the venture:

The joint venture will develop and commercialize high-quality consumer health products based on Tasly's deep portfolio of proprietary formulations, patents and clinical studies by leveraging Herbalife scientific, regulatory and commercial development expertise to bring products to a global market through Herbalife's distributor network. The proposed joint venture furthers our business plan to expand our product range globally.

Herbalife is also under investigation by the SEC and DOJ in a corruption-related case. Having this type of investigation is not helpful for any company. However, going by the recent precedents, I believe the concerns are overblown. In a similar corruption case by Nu Skin (NYSE:NUS), the company agreed to pay less than a million dollars. This is coupled with Herbalife's Chinese compliance measures. It has six internal auditors and big four accounting firms to mitigate any compliance bleaches. While no one knows the verdict or its timeline, I believe it will not have the big impact shorts expect.

Final Thoughts

Herbalife has faced a number of challenges in the past five years, such as the FTC investigation, the attack by a famed short seller, and bad press. Many people have questioned the company's valuation and its international growth. Others, such as Ackman, believe the upcoming documentary will have serious implications. However, as I mentioned in my previous article, the documentary might not have the impact they are anticipating. In this article, I have shown that the company's preferred members in the United States are increasing faster than expected. I have also explained the situation in China and why I think the situation is overblown. As I mentioned in my previous article, HLF is not cheap. However, being short the company presents more risks than opportunities.

Disclosure: I am/we are long HLF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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