Short Herbalife. Poor Guidance, Tender Completed, And Regulators Satisfied. Now It Is Time To Focus On The Numbers

| About: Herbalife Ltd. (HLF)

Summary

Herbalife has serious strategy issues to address.

HLF has poor margins, low owner earnings, and not meeting its cost of capital.

There is a tangible hole in its balance sheet.

Unique EVA valuation analysis indicates HLF is overvalued.

With the settlement and tender offer completed, it is time to focus on the poor financial performance ahead.

Decision: Short Sell

Countless articles, analysis, and evaluations already exist about Herbalife (NYSE:HLF). The Herbalife investment story has for years been a soap opera, pitting two Wall Street titans against each other like never before. To better understand the investment risks from a strategy and regulatory aspect, please read a broad amount of material and perspectives. This analysis will provide a different financial analysis than others.

Business Strategy and Challenges

Herbalife sells nutritional and supplemental products through a direct, multi-level marketing organization. The business practice requires representatives to purchase the goods and then resell them at an MSRP, capturing the discount between the two prices as the representative's earnings. Representatives can also earn income from recruiting others to join the organization and resell the products. While MLM business models can function, and there are enduring examples, there are specific concerns relating to Herbalife.

First, the practice of purchasing the goods ahead of resale instead of on consignment can create resale discounts below the MSRP and exacerbate financial issues for unprofitable representatives. Stella & Dot is a new breed of direct representative sales while still an MLM business. An important difference is that Stella & Dot's representatives have their own website, code, etc. and sell on a consignment or referral method where Stella & Dot provides direct fulfillment. An MLM should work well without needing to drive most of the representatives' earnings from recruitment of others.

Second, if Herbalife's reputation suffers from negative publicity and the number of failed representatives grows, Herbalife's recruitment and end sales could suffer. The Company does not offer sufficient resources for coaching or has grown too aggressively to sustain its representatives given the high churn of representatives. A strong MLM business should more closely resemble a franchise model where the long-term success and incentives are more closely aligned between the parties.

The preceding is not an exhaustive list but strategy changes to improve this business. Even with recent (and future) settlements and agreements, I doubt Herbalife will be able to change its compensation structure, culture, and practices to be the strategy I see as needed for its long-term vitality and success.

Market Capitalization Overview

11/16/17

Market Price

$65.65

Shares *

72.9

Dilutive Effect

3.4

FD Shares

76.3

Market Cap

$5,007

Enterprise Value

$6,109

* One financial presentation challenge is understanding the Company's share count. The number on the cover of its SEC filings includes shares that are legally outstanding, but were repurchased via a forward agreement in 2014 and will be retired in 2019, unless there is a change of control. To estimate the diluted share count, I have taken the basic shares outstanding from the 9/30 quarterly income statement and reduced them by the 7.6 million the Company repurchased during the tender offer, plus the approximation of the diluted effect from the most recent quarter.

Recent Financial Results

The Company promotes an adjusted diluted EPS that has many charges that I see as recurring given the pressure from outsiders to reform its business, the potential for future legal settlements and penalties from governments and class action suits. I will rely instead on the diluted GAAP EPS, as well as owner earnings, defined as GAAP net income + depreciation - CAPEX, and alternatively adding back stock-based compensation, and evaluated on a diluted per share basis.

FY 2017 GAAP diluted EPS guidance is $4.00 (midpoint of $3.90 and $4.10), including the fourth-quarter guidance of $0.74 (midpoint of $0.64 and $0.84). FY 2018 is essentially flat with the guidance of $4.02 (midpoint of $3.82 and $4.22). Guidance for FY 2017 at the beginning of the year was $2.95-3.35; so the Company remains on track to under promise and over deliver. The Company's CAPEX and depreciation and amortization are fairly close, so it can be said they cancel each other out.

Tying these financial metrics with the strategy, we can re-examine the common size income statement. Generally, the cost of goods sold is 19%, and royalties are 29%, leaving 52% of what HLF calls contribution margin. With SG&A about 39%, that leaves an operating margin of 13%. Below is a summary of the ranges and averages for these costs in the last year. But if you were to consider the royalties and SG&A as one, this is about 68%! What business has this high a percentage of revenue as sales and administrative expenses? There is little spent on R&D. If one were to argue that the royalties are in place of a retail presence that may be argued. But then the corporate SG&A remains at 39%, either an indication of poor management or that despite $4 billion in sales, this is a sales machine, not a vendor of healthy meal replacements and supplements.

Avg

Min

Max

COGS

19.1%

18.6%

19.8%

Royalties

28.5%

27.8%

29.1%

Contribution Margin

52.5%

51.6%

53.1%

SG&A

39.0%

35.3%

42.4%

Adjusted SG&A

67.5%

63.1%

70.8%

Operating Margin

13.4%

10.2%

17.9%

Net Margin

8.0%

5.0%

12.0%

Now, this operating margin will be eroded by another 3% for interest, which will then be taxed at about 25%, leaving a net margin of about 8%, but as low as 5% in the most recent quarter.

Owner Earnings

In thousands except per share data

FY 2016

1Q 2017

2Q 2017

3Q 2017

4Q 2017*

FY 2017*

FY 2018*

Owner Earnings

214.9

85.2

140.3

57.7

48.9

332.1

271.6

Owner Earnings per Share

$2.50

$0.98

$1.64

$0.70

$0.64

$4.01

$3.56

Owner Earnings w SBC

255.1

96.5

151.7

67.6

59.7

375.5

316.6

Owner Earnings w SBC per Share

$2.96

$1.11

$1.78

$0.81

$0.78

$4.53

$4.15

* These are estimates based on HLF management guidance and Clarendon Capital Management estimates.

Earnings and Owner Earnings Yield

FY 2016

LTM

FY 2017

FY 2018

Earnings Yield

5.2%

7.5%

6.6%

6.1%

FY Owner Earnings (Basic)

4.5%

7.9%

6.9%

5.7%

Balance Sheet

The balance sheet is primarily accounts and has accounts that I feel confident using book value given their proximity to economic value. The following table shows the accounts I give credit to Herbalife in my analysis. Conspicuously absent is $354 million in the most recent quarter's inventory. It is a perishable that could not be liquidated if there was scrutiny on the business. This is the account that could be materially different than liquidation value. The business has an abundance of cash, $1.2 billion as of September 30, 2017, adjusted for the subsequent tender offer.

Account

9/30/17

Significant Changes Since 12/31/16

Cash

$1,179

$ 335

AR

95

Prepaids

188

PP&E

375

Total

$1,837

Accounts Payable

$61

Royalty Overrides

267

Other Current Liabs

427

Other Non-Current Liabs

175

LT Debt (incl Current)

2,281

833

Total

$ 3,211

Balance Sheet "Hole"

$ (1,374)

Inventory

354

The debt to market cap ratio is about 46%, though the net debt to market capitalization is a more conservative 22% at current share levels. During fiscal 2017, Herbalife has $833 million in new debt but has only $335 million in cash on the balance sheet - so its net debt position worsened by about $0.5 billion.

Capital Allocation

The Company has been repurchasing shares and issuing debt in the last year. However, it is hoarding $1.2 billion or about 24% of its market capitalization. Herbalife chooses the more tax efficient method of share repurchases rather than dividends to return capital to shareholders, though the price paid is considered high by some (including me).

"Since February 2017, the Company has repurchased a total of approximately $757 million of common stock," per the most recent earnings release. Without being too precise, this is about 13% of the prior year basic shares outstanding. The majority of these repurchases occurred in October, $458 million, 6.7 million shares at $68/share via a Dutch tender offer. This most recent purchase price is consistent with the approximate $67.16 experienced this far in 2017. That is a pretty significant price support level. But the recent weakness in the share price may be an indication the Company's active and consistent buyer is no longer helping set the market price. Herbalife could arguably take on more debt given its EBITDA levels to continue buybacks; however, the tender offer drove equity capital negative.

With a profitable business, why would a company raise $833 million in debt in one year? I rhetorically think "probably to do something foolish with it."

Herbalife is not a capital-intensive business. PP&E accounts for just 7% of the total market cap. With the cash on hand, Herbalife could replace its PP&E 3x over.

I do not see many opportunities for organic investment in the business. The Company's presence is already global. There are no similar businesses of any size. And acquiring new brands or products does not seem to be a priority as it can rely on other producers and use white labeling.

Cost of Capital

One of the most difficult things to do as a long-term equity investor is to determine an appropriate discount rate or what should be the required return given the risk of an investment. Given our long-term outlook and position, we do not use CAPM, as Beta is not relevant method to us and a poor risk measure, but instead use a build-up method, though admittedly this is some guess-work to be about right rather than precisely wrong.

Herbalife's cost of debt is approximately 6.7%, which is consistent with its new credit facilities per management. The 10-year is currently at 2.4%, so HLF's credit cost and risk is approximately 4.3%. I now must add an equity premium. Note, my build-up method is estimating the creditworthiness and some degree of risk that is company specific by using Herbalife's own cost of debt. I will add a 5% equity premium, in line with my return requirements for large-cap stocks, or requiring 11.7% return on my investment.

The Company's earnings yield in the last 12 months is 7.5% and 7.9% on an owner earnings yield basis. Herbalife is not covering its cost of equity capital.

Valuation

Alternative EVA Method

CCM Method

With BS Hole

No BS Hole

Owner Earnings Multiple

12.0x

18.4x

14.5x

FY 2017 Diluted Owner EPS

$4.53

$4.53

$4.53

POE Value

$54.41

$83.66

$65.65

Balance Sheet Hole

(1,373.6)

(1,373.6)

0

Balance Sheet Hole PS

(18.01)

(18.01)

0

Combined EVA

$36.40

$65.65

$65.65

Upside / (Downside)

(44.5%)

Given the hole in the balance sheet, I am using a modified approach to the Economic Value Added model and using owner earnings. Given the documented concerns and heavy liabilities, limited PP&E, I am applying a 12x multiple to the 2017 diluted owner earnings, but then deducting the estimated value of the deficiency in the balance sheet. Alternatively, I have presented this analysis without the deduction for the negative balance sheet value equating to an 18.4x multiple on owner earnings to match the current market price or a 14.5x multiple if the balance sheet deficiency is ignored.

With the current price market capitalization, I will compare my required cost of capital to the current estimates. With an 11.7% estimated cost of equity, the required owner earnings would be $7.68 per year, or about 85% higher than my estimate and management guidance for FY 2018 diluted owners earnings of $4.15. Herbalife has delivered beyond guidance and repurchased shares to help it given limited top-line growth, but I do not envision this Company being able to meet my requirements and estimate for profitability. A non-capital intensive business should be able to achieve higher gross margins and higher returns on equity.

My concerns

1) Herbalife has a smart and significant shareholder in Carl Icahn. Icahn's holdings are now approximately 31%, obviously significant. 2) This is not a new idea. Bill Ackman (head of Pershing Square) began his crusade years ago at the Sohn conference. He has delivered multiple PowerPoint presentations with hundreds of slides. He bankrolled a movie that is either a documentary and investigatory journalism or a "gotcha" piece that isn't altruistic but one more PR tactic to defame the Company. 3) The business strategy and MLM practices have been criticized for years, and per the recent settlement with the FTC, Herbalife's practices are being changed. As we learned from David Einhorn's long battle with Allied Capital, this type of short selling investment can take a long time to be recognized by accountants, regulators, and investors, if ever. It is unsure that there will be any further scrutiny and reform including possible penalties. This was a major catalyst Bill Ackman pointed to in his analysis and short position. 4) Per Morningstar, the number of investors (shares) who are short the stock has decreased significantly.

Shares Short Change (from 10/13/2017 to 11/13/2017)

-23.8%

The short story may have run its course and I am late to the party.

Conclusion

Why now? With the tender offer completed, there does not look to be much capital left to continue the high level of share buybacks without levering up further. I do not believe a company that fails to meet its cost of capital can remain overvalued indefinitely. The Company has provided a poor economic forecast (FY 2018 owner earnings). Herbalife has major flaws in its business strategy - the model does not fit the product nor do the high level of sales and administration. A regulatory risk may be removed, but the poor financial metrics, balance sheet, and strategy flaws should become the focus instead of the pyramid scheme practices the company was accused of. With the regulatory issues (potentially) behind Herbalife and the tender offer completed, now it is time for investors focus on the numbers and see if its strategy and new practices can deliver.

Disclosure: I am/we are short HLF.

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

Additional disclosure: This article is not a recommendation, solicitation or offer of any security. Investments are inherently risky and appropriate caution and diligence should be taken, particularly when short selling securities. Please conduct appropriate due diligence and consult a financial professional, attorney, CPA, and/or similar professional before making any investment decisions.

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