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Herbalife – Bull of the Year

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Herbalife International (HLF) – a weight management, nutrition, fitness, and skin care company – has been consistently in the news ever since activist investor Bill Ackman accused the company of being a pyramid scheme.

However, the company has held its own against Ackman – refusing to go down without a fight, and even turning the tables by attempting to dissuade investors in Ackman’s hedge fund. Herbalife’s stance was bolstered after a PWC re-audit of the company’s financials proved that the company complied fully with Generally Accepted Accounting Practices. The company has reported a strong performance every quarter since, and its management’s upbeat guidance has helped push the company’s stock higher and higher.

Herbalife stock is currently changing hands for $67, or nearly 11.4 times its forward earnings. From our analysis, we feel the stock is quite undervalued, given analysts’ projections of high earnings growth moving forward.

Introduction

Herbalife divides its products into five broad categories, namely: Weight Management; Targeted Nutrition; Energy, Sports & Fitness; Other Nutrition; and Literature, Promotional, and Other Products. The company sells products through a multi-tiered marketing network, and generates the bulk of its revenues (63%) from its Weight Management segment. The Targeted Nutrition category, on the other hand, contributes 23% to its topline, while Energy, Sports, and Fitness, Outer Nutrition, and Literature, Promotional, and Other Products combined contribute the remaining 14%.

Many investors, including Ackman, believe that Herbalife does not merit a market capitalization of $7 billion.  They are skeptical of how Herbalife has catapulted to success, and believe its business model is not sustainable enough to last – hence, accusations of the company being a pyramid scheme.

But the company has shown no signs of slowing down. It has reported an average growth of around 20.5% in annual revenues over the last three years, with four of its five segments reporting double-digit revenue growth, and Weight Management – the company’s largest segment by revenues – growing 20.4% each year over the same time frame.

We believe that demand for the company’s products will continue to rise as health-consciousness continues to spread. The ‘healthy living’ trend is expected to benefit the company’s Energy, Sports & Fitness segment the most.

High Growth Regions

The company operates in six geographical regions based out of the Cayman Islands. These include North America, Mexico, South and Central America, Europe, Middle East and Africa (EMEA), the Asia Pacific, and China. Among these, the Asia Pacific region contributed 28% of the company’s revenues in fiscal year 2012 (FY12) – the most among any geographic segment.

The Asia Pacific (excluding China) is not only the company’s largest geographical segment by revenues, but also its fastest growing one. This is attributable mainly to Herbalife’s business model, which is based on the performance of its sales associates and the availability of cheap labor. The Asia Pacific offers both these things, allowing the company to continue expanding in the region at low costs.

Stock Price Volatility

Herbalife’s stock price has fluctuated widely (currently, the stock has a beta of 1.7) ever since Ackman’s December 2012 announcement that he had shorted almost a billion dollars worth of Herbalife stock.

Ackman has been very critical of the company, and has gone on the record to say that the company will eventually go bankrupt. Ackman accused the company of being a pyramid scheme in December 2012, and has subsequently pushed regulatory bodies to investigate the business. Although Ackman has since reduced his short position in the company by nearly 40%, replacing it with put options to prevent mark-to-market losses to his fund, he remains bearish on the company.

On the other hand, Carl Icahn’s dramatic arrival onto the scene with his acquisition of a 16.5% stake in the company has added fuel to the fire. Ackman and Icahn have been feuding for years, and it is unclear whether Icahn really believes in the company or is just investing in it to get back at Ackman. So far, Icahn has gained much from his investment: Herbalife’s share price has risen from a low of $25 a share, to over $80 ever since he bought into the company.

While Icahn’s investment in Herbalife has partly contributed towards the increase in share price, we cannot take away the due credit the company’s management deserves for coming up with a strong defense plan in the face of Ackman’s continued allegations.

The company has fully cooperated with PricewaterhouseCoopers (PWC), who re-audited Herbalife when the company’s previous auditor resigned in April last year when it found out that one of its partners had leaked inside information about the company to a third party, who had then used it to trade Herbalife stock.

Herbalife then appointed PWC to audit its financial records, and because of the accusations levied, went ahead with a three-year evaluation of all its financials. This raised bearish sentiments in the market; many investors were of the view that the re-audit would reveal the weaknesses in the company’s business model.

However, PWC has cleared Herbalife of malpractices as regards to its financial statements, as announced by the company in December 2013. The news has given some confidence to investors concerned about manipulations and tampering in the company’s financials, who have rewarded the company, bidding its stock up 18% in the week following the announcement.

However, the good news was short-lived, with news out of China soon raining on the company’s parade.

The company’s share price dropped 10% on January 16, 2014 following news regarding an investigation into the business practices of Nu Skin (NUS)’s China division. Nu Skin is a company similar to Herbalife, and an investigation into its practices has given rise to speculations that soon Herbalife may meet a similar fate in China.

Herbalife’s stock price dropped a further 3% on January 28, 2013 following news that one of the top consumer regulators in Canada had launched a formal inquiry into Herbalife to investigate if it is a pyramid scheme or not.

But soon after, the company’s share price swung again on positive news out of China: on January 30th, China’s Ministry of Commerce allowed Nu Skin to participate in the 2014 EXPO in Shanghai – a signal that Nu Skin had been more or less cleared of the charges levied against it.

So far, Canada’s investigations into Herbalife’s business practices have not been made public.

Aside from Icahn, Fidelity Investments (FMR LLC) also holds about a 13% stake in Herbalife, which has sent positive signals to the market.

William Stiritz Increasing Stake

William Stiritz, the 77-year old packaged foods veteran, paid scant attention to Herbalife till the televised smack down between two billionaire hedge fund activists, Icahn and Ackman, got him to take a closer look. The chief executive of cereals manufacturing company Post Holdings has since increased his investments in Herbalife, and is now one of the largest shareholders of the company, for he believes that Herbalife is a ‘national treasure’ and that Ackman is out to destroy it. Stiritz, who has a 54-year history in the food industry, now wants to help the company undergo a leveraged buyout (LBO).

Bill hired Jim Tamey, an analyst most bullish on Herbalife, as the Director of Strategic Ventures in Post Holdings. Tamey’s hiring signals the possibility that Bill may be looking to buy out Herbalife. The move also supports the argument that the company’s business model is ethical and it is not a pyramid scheme.

Financial Position

Herbalife’s cash flows from operations (CFOs) increased from around $273 million in fiscal ‘08 (FY08) to $745 million in FY13. The company has continued to use its free cash flows to benefit shareholders by buying back shares, repurchasing around $187 million worth during the third quarter (3Q) of FY13 (around 2.9% of its market cap). The company has recently announced that it will be issuing convertible notes to raise $1 billion, and has plans to use a major part of it to fund its buyback program. This will help the company increase the available balance of share repurchases to around $1.5 billion, from an existing $653 million.

Although the company’s debt-to-equity ratio of 209% is very high, it should not raise concerns regarding the company’s liquidity position because Herbalife is sitting on a cash pile of $893 million and generates enough cash flows to keep meeting its debt obligations.

For a detailed analysis of the company’s cash flows and its solvency position, read “Herbalife – The Grass is Greener on the Buyer’s Side”.

Revised Outlook

Herbalife announced its earnings for 4QFY13 on February 3, 2013, revealing it had beat both earnings and revenue estimates. The company’s stock price jumped around 7% following the announcement.

Herbalife also issued guidance for the ongoing quarter: the company guided adjusted EPS to $1.24-1.28 for 1QFY14, lower than the Street’s estimate of $1.40. The company is accounting for a negative impact of $0.2 to its topline from expected foreign exchange fluctuations.

Ackman also renewed his attack on Herbalife the same day the company released its earnings, charging that former Herbalife distributor, Shawn Dahl, had used false promises and unethical practices to convince people into becoming the company’s distributors. The stock price took a tumble during trading hours because of Ackman’s accusations, but steadied soon enough to close up 7%.

Conclusion

We believe that the company’s stock is undervalued considering its growth potential and strong liquidity position. At a forward price-to-earnings (P/E) multiple of 11.4x, the company’s shares are currently trading at a discount of 19% to the S&P 500 Index (SPX).

Bidness Etc believes that the company deserves a higher valuation as its projected annual earnings growth of around 13% in 2014 is higher compared to the average 11% projected for companies in the S&P 500 index.

Furthermore, the company’s initiatives to make its business model more understandable and transparent will eventually ease investors’ concerns and result in an expansion in Herbalife’s valuation multiples. If the company trades at a forward multiple of 13x, which is its five-year average for S&P 500 index, its stock price should rise to $76 (taking FY14 EPS estimates of $5.86). We recommend the stock as a Buy.

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