Herbalife: Will Icahn Cash Out Sooner Than Not?

If you've been following Herbalife's (HLF) share price lately you will notice the stock has traded into the $70s. D.A. Davidson Analyst Tim Ramey argues that he expects the company to release audited financials forthwith including the announcement of a leveraged share buyback that could total as much as $2 billion. At a price of $75 per share, HLF could theoretically retire 25 million shares on that basis or 25% of the float. This $2 billion program seems aggressive to me, but even if we assume $1 billion of buybacks the float drops materially.

In all likelihood, the company has resumed its buyback program since August 29th. CFO John Di Simone indicated that because the company had visibility on the release of its audited financials that they would be back in the market to the tune of $50 million de minimus. By the time Q3 data is released, HLF's share count could be trending towards 100 million outstanding fully diluted.

HLF's recent share price may have some interesting implications for investors, most notably Mr. Icahn.

Earlier this year, Carl Icahn secured 2 board seats on the Herbalife Board of Directors. In exchange for these seats, Herbalife and Icahn agreed to a standstill provision. The details of this provision were outlined in an 8-K filing and are as follows:

3. Sale Restriction . In consideration of the Company's agreement set forth herein, so long as the Company has complied and is complying with its obligations under the first and second paragraphs of Section 1(a), Sections 1(b), 1(c) and 1(d), and Section 7, and has otherwise materially complied and is materially complying with its other obligations set forth in this Agreement, the Icahn Parties agree that from the date hereof until February 28, 2014, the Icahn Parties shall not, and shall cause their controlled Affiliates not to, directly or indirectly, voluntarily sell any common shares of the Company (or Beneficial Ownership thereof) or any securities convertible or exchangeable into or exercisable for any common shares of the Company (or Beneficial Ownership thereof) (including, without limitation, any derivative securities or instruments having the right to acquire common shares of the Company) unless such sale involves a sale, transfer, tender or other disposition involving a tender or exchange offer (whether commenced by a third party or the Company), or a merger or other business combination transaction that is not in violation of Section 2 of this Agreement.

This Section 3 terminates and ceases to have any effect at such time as the VWAP for a share of the Company's common stock on the New York Stock Exchange (defined as dollars traded for each transaction ( i.e. , price multiplied by the number of shares traded) divided by total number of shares traded) for any five (5) consecutive trading day period is at least $73.00, as adjusted to account for any stock split or stock dividend.

Investors who follow Herbalife's recent stock price may have noticed that HLF has closed above $73 per share the last two trading days begging the question: "Will Icahn start to cash out?"

Q. What would you do?

There's a saying on Wall St. "Bulls can make money, Bears can make money but Pigs get slaughtered."

Q. Why look a gift horse in the mouth?

If you are long HLF one might assume that Mr. Icahn will continue to be along for the ride, that a leveraged recap is in the cards, that the demand for the company's common shares will skyrocket, and that Pershing Square will be forced to cover their short position unleashing the "mother of all short squeezes."

Alternatively, one could take the view that in all likelihood, Icahn's exit strategy will be to sell his 17% position into the bids the company will be making to retire its shares.

Icahn is "in the money" significantly on his long position in HLF. The rough total is likely $500 million, perhaps more.

HLF may generate $600 million in free cashflow next year. Alternatively, it may not. Recall, 2 million distributors are resigning every year. Last quarter, 700,000 resigned. Continued growth is no certainty.

Additionally, the waters may remain shark-infested if you are long. SEC, FTC, State AG's, Class Action Suits, etc. all have the potential to disrupt the long thesis in a heartbeat.

Does Mr. Icahn like the game of Russian Roulette or not?

If even one bullet in the gun is enough to get regulators to intervene in the HLF business model then HLF's equity could get wiped to $0 per share. This would be one tremendous giveback to make.

Q. If you were "in the money" $500 million, what would you do?

Over the next three trading sessions if HLF's share price closes above $73, Icahn could be a seller. He will be free from the shackles of his standstill provision to liquidate his long position into the marketplace. Alternatively he could, too, hedge his long position in the options market.

Overall, you have to give Mr. Icahn credit where credit is due. If regulatory intervention is a 1 year to 2 year process including investigation, he has arbitraged this time value extraordinarily well in the interim while placing Pershing Square in an uncomfortable headlock in the process.

Does pride go before a fall or not?

Why tempt fate any further?

Why not collect the spoils of this bold maneuver and get out of dodge while the getting is good?

I remain convinced that HLF is a pyramid scheme. It has all the Hallmarks of a pyramid scheme including:

Overpriced ProductsUsurious Gross MarginsExaggerated Earnings ClaimsHigh Distributor TurnoverNo Direct Evidence of Legitimate Retail SalesA Compensation Scheme that encourages Inventory LoadingThe Lion's Share of Earnings going to the top 10% of DistributorsHigh levels of Internal ConsumptionOpaque Disclosures andMisleading Accounting

Most participants lose money.

I am confident that an independent assessment of HLF's compensation model by FTC or SEC experts will conclude that the company is a deceptive marketer that markets a business opportunity to participants that is, in practice, a rigged game. What I don't know is "When".

At a bare minimum I do not think any rational investor can handicap the notion that HLF is not a pyramid scheme to 0%. At best, such a conclusion seems like speculation.

If you are long HLF, it may be irrational, too, to assume that Mr. Icahn will remain your silent partner for much longer.

$73 x 5 days in a row is the magic number to watch. After that, Uncle Carl may "hit the bid" and ride off into the sunset.

Dan Leob sung a beautiful song about how HLF was a "serial compounder". Investors who read his letter might have assumed that he was going to own HLF long-term. As it turned out, he took his money and ran.

Nobody ever lost money making money which is why odds may be that Mr. Icahn will be gone soon too.

Mr. Ackman remains convinced that HLF is pyramid scheme. He has not covered a single share of the stock he is short. We are told he has reason to believe that "aggressive, regulatory intervention" may be imminent.

Might it be conceivable that both Mr. Icahn and Mr. Ackman make money on their thesis? That all seems to depend upon who cashes out and at what price.

Disclosure: I am 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. (More...)

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Is It A Good Time To Buy Herbalife?

With the beginning of the current decade, a rapid change was witnessed in the global sports nutrition and meal replacement market. Historically, only a selected few groups, which included those actively involved in sports or dedicated bodybuilders, were the primary consumers of these products. Now, with the heightened awareness of health issues along with the move towards a healthy life style, an increasing number of regular people have started consuming nutritional meals and supplements. The availability of various nutritional products in different forms such as beverages and replacement meals, which were previously only available in the form of medicine, further supported the shifting trend.

The United States, a country reported to have one of the highest obesity rates in the world, has seen attractive growth in its supplements market. The market size reached $30 billion in 2011, exhibiting a growth of approximately 6.8 percent, from the previous year. The sports nutrition and meal replacement market accounted for 22 percent of the total market and this sector, in particular, has experienced high growth in demand due to the rising health concerns of an average person.

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In the area of nutrition and weight management, Herbalife (HLF) has emerged as the new market leader in the US with a market share of approximately 19 percent. The company has been consistently registering high growth in its top and bottom line through geographic expansion and the promotion of daily consumption. Although Herbalife faced some hiccups with the implementation of its strategy, the company was successful in the end and its success is reflected in its stock price, which has risen by more than 85%, since the start of the season.

Historic Success

The company has generally outperformed itself year on year, with constant improvements in its revenues, earnings and operating margins. However, the revenue base experienced a decline in the fiscal year 2009 primarily due to the unfavorable currency fluctuations. When measured in the local currency, net sales of Herbalife actually increased by more than 5 percent in 2009. The highest growth of 26 percent in revenues was achieved in 2011. Over the last 5 years, the company has registered a CAGR of approximately 13.7 percent in its revenues. The total revenues in 2012 crossed the $4 billion mark. In terms of its local currency, the company achieved an average annual growth of approximately 16.2 percent in its revenues. Hence, it is clearly evident that the adverse currency movement has significantly affected the company's results.

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The geographic expansion and the changes in the company's business model were the major contributors of the spurring growth of the company over the years. By 2012, the company had expanded its operations in 88 countries as compared to 70 countries in 2008.

The company has adopted several business practices, such as the introduction of Nutrition Clubs, Lifestyle Centers/Offices, Weight Loss challenges and Roadshows, which were collectively named as the distributor daily method of operations "DMO". This has significantly helped the company in increasing the effectiveness and productivity of its distribution networks. The company's increased spending on events and promotions, both in terms of absolute dollars and as a percentage of sales, has helped the company penetrate deeper in the markets of various regions. It has also helped in the establishment of a recurring customer base.

The company's earnings and margins have also improved over the years, with the latter rising from 14.1 percent in 2008 to 16.22 percent in 2012. The company's EPS has more than doubled since 2008. While maintaining a fairly stable gross margin, the company has improved its operational efficiency primarily through controlling selling, general and administrative expenses. They have been reduced to 30.9 percent of net sales in 2012 as compared to 32.7 percent of net sales in 2008. The high growth in revenues in the latter part of the examined period has also helped in improving the operating margin of the company. Apart from these factors, the expenses reported in 2008 and 2009 included severance payments amounting to $1.3 million and $6.7 million respectively, a payout required by the restructuring program conducted by the company.

Regional Expansion

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Out of the various regions that the company operates in, Asia Pacific (excluding China) has been the fastest growing region in terms of net sales. In 2012, approximately 28 percent of the company's total net sales came from this region, which comprises of 14 countries. Over the last 5 years, the region has achieved a CAGR of approximately 24.7 percent in net sales. However, in terms of the local currency, the region has registered an average annual growth of more than 31 percent over the same period. Within this region, South Korea currently has the largest market for Herbalife's products while India has the fastest growing market with net sales growing at an average annual rate of 94.5 percent, in terms of local currency, over the last 4 years.

In terms of the number of countries, Europe, Middle East and Africa (EMEA) is the largest region with the company operating in 50 countries. The region contributed approximately 15.4 percent of the company's total net sales. It is the fourth largest market of the company, after Asia Pacific, North America and South and Central America. However, it is the slowest growing region and registered a CAGR of only 2 percent in net sales over the last 5 years. In terms of local currency, the region has exhibited an annual average growth of approximately 7.6 percent in net sales. Within this region, the company's net sales in major economies such as Italy and France have declined over the years. However, Russia and Spain have witnessed positive growth in its net sales which was backed by the company's affiliation with football clubs, such as FC Barcelona and FC Spartak Moscow. To sum up, the company is currently in the process of changing its existing business model in Italy and it expects that the country will register positive growth once again when the DMO model is completely implemented.

North America including the US, which is the largest market for supplements and nutrition, has recorded a CAGR of 13.9 percent over the years in its net sales and an average annual growth of 14.2 percent in terms of the local currency. The US market, in particular, posted an average annual growth of 14.5 percent and had the highest daily consumption revenues as compared to the other regions. Despite the current high penetration level of the company in the US market, I strongly believe that the increasing health consciousness and the rising obesity problem in the US still provide growth opportunities for the company. Herbalife can achieve growth by expanding their network as well as increase daily consumption by increasing the frequency of its nutrition clubs attendance. The US market is also the fastest growing market, in absolute terms, with an increase of $140 million in net sales in 2012.

Central and South America is the third largest market for the company which posted a CAGR of 17 percent in net sales over the last 5 years. The region showed an average annual growth of 19.1 percent in its revenues in terms of the local currency. Brazil and Venezuela are the largest markets within this region but the growth achieved in both these countries have been derived from different sources. Brazil, the largest economy in this region, achieved a growth of 3 percent in revenues in terms of dollars in 2012. The growth was approximately 19.8 percent in terms of the local currency. The successful adoption of DMOs was driving factor behind this double-digit growth. Due to the controlled exchange rate policy adopted by the Venezuelan government, currency fluctuation has little effect on the net sales. However, the high inflation prevailing in the country has prompted the company to frequently change prices which has been the significant growth driver for the company. Despite the general stable exchange rate of Venezuela, the government does alter its exchange rate from time to time and this may result in a sudden decline in the revenues and margins of the company, as witnessed in 2010. In 2010, the Venezuelan Bolivar (VEB) depreciated by approximately 63 percent which translated into a 51 percent decline in revenues coming from this country despite the fact that net sales had actually gone up by 29 percent in the local currency. Thus, any further alteration in the currency exchange rate may result in similar repercussions.

After an initial decline in 2009, Mexico's net sales have been increasing by more than 20 percent in terms of the local currency. This region accounted for 12.2 percent of the Herbalife's total net sales and has been one of the slowest growing markets, achieving a CAGR of 6 percent in terms of the US dollar. The slower growth has led to the declining share of the region in the company's total net revenue base. The company's performance in Mexico was severely hit by the Value Added Tax levied by the government on imports and resale of certain nutrition products which led to a decline of 25.3 percent in its reported revenues. However, after this the company was able to enhance its performance through the implementation of its DMO model and critical partnership with locals to enhance consumption and access. After 2009, the company's reported revenues have grown at an average annual rate of 23.8 percent and I expect the company to continue to register a double digit growth in this market for the next few years.

The company's operations are slightly different in China. In order to comply with Chinese regulations, the company uses direct selling and retail sales method rather than opting for distributors as is the case in other regions. The company has received a healthy response from the Chinese population and over the years, it has been able to expand its footprint in the Chinese market. The company has achieved a CAGR of nearly 30 percent in its reported revenues and an average annual growth rate of 15.5 percent in terms of the local currency. Herbalife currently operates 67 retail stores in China and has the approval to conduct its direct selling business in 24 out of 29 provinces in China. China is one of the key regions for the company and I expect this region to record healthy growth in the future.

Product Categories

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Weight management and meal replacement is the largest product category for the company and contributes more than 62 percent of the company's total net sales. The rising problem of obesity all over the world and the fast paced life has led to the rapid growth in this product category. Net sales of this product have increased at a CAGR of 14.5 percent over the last 5 years. As the company expands its geographical outreach, this particular category is expected to sustain this high growth level in the future as well.

Energy, sports and nutrition has been the fastest growing product line of the company. It has recorded a CAGR of more than 20 percent in its net sales over the last 5 years. The behavioral shift towards adopting a more active lifestyle and the resultantly increased participation in sports and physical activities have been the major driving factors for growth in this product line. Apart from this, the increasing association of the company with leading regional sports institutes, such as FC Barcelona, has also helped in boosting sales for this segment. I expect the company to continue its sponsorship programs for such institutes which will help in sustaining the growing demand for this product line in the upcoming years.

Future Outlook

Global nutrition market is expected to cross the $400 billion mark by 2014, with meal replacement dominating the industry. It is expected that US will continue to be the largest market served by the industry. However, the BRIC region is expected to be the fastest growing. Thus, the company would need to expand its footprint in all of the above markets for future growth.

As per the most recent results, the company's total net sales increased by $346.8 million for the six months. Out of the stated increase in net sales, 4 BRIC countries contributed 30.9 percent of the total change in net sales. The US market was still the largest market for the company and contributed 10.2 percent of the total change in net sales. Thus, total 5 countries contributed to more than 41 percent of the $346.8 million increase in net sales. This signifies the importance of these countries for the future growth of the company.

Individually, the net sales in US, Brazil, Russia, India and China rose by 8.4 percent, 24.4 percent, 26.7 percent, 7.4 percent and 39.3 percent respectively for the six months ended in June 2013. As shown above, the company has been aggressively growing in these markets in order to establish its strong market presence. I expect the company to be successful in gaining a substantial market share in these key markets and this will help Herbalife in gaining a large share of the expected fast paced growth in these markets. Thus, in my opinion, the company will continue posting high growth for at least the next two years.

Conclusion

I believe the high growth potential as well as an attractive dividend yield makes Herbalife one of the most attractive investment opportunities for any investor. In order to derive the return potential for the company, I have employed the modified dividend discount model due to the company's solid share repurchase and dividend history.

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Based on my projections, I expect the company to register high growth in its EPS over the next few years and then slow down, which is consistent with the relative estimates for this industry. I believe the company will continue with its high modified payout as it will sustain its share repurchase activity and sustain/increase its dividends payments. In the table above, the adjusted dividend growth reflects the growth in the payout of the company over the years and the annual share repurchase plan adopted by Herbalife. I expect the company to bring down its payout to a long term sustainable level and thus, an initial decline in payout is expected for the next year.

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Based on my valuation, the company upholds a large potential of generating returns which is consistent with its high beta and high debt profile. Even based on certain key multiples, the company is significantly undervalued. The market return assumed in the model is the annualized return of the S&P 500 index over the last 5 years.

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The sensitivity analysis has been performed by assuming various growth rates and required returns. Based on the sensitivity analysis, I can say that at this point in time the company provides a safe investment opportunity as it provides a minimum return of 1.63 percent in the worst case scenario and the highest possible return of 33.3 percent in the best case scenario. Thus, I will give a buy recommendation for this stock due to its current undervaluation and positive outlook.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. (More...)

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Herbalife Still Ascending Mount Everest - Look Out Below

The jury may still be out on whether or not Herbalife (HLF) is a pyramid scheme. Investors have placed their bets. Since the end of 2012 when Pershing Square revealed their allegation that HLF is a pyramid scheme much has changed and much has not.

This article offers a summary of some of the changes and some of the tactics that have been employed by the company in defence of the attack on its credibility.

At the end of 2012 Herbalife distributed its products in 88 countries through 3.2 million distributors. In the first two quarters of 2013 the company's distributors recruited another 1.076 million new distributors.

At the end of Q2 the company had 3.4 million distributors for a net gain of 200,000 distributors. Stated a different way, 876,000 distributors resigned from Herbalife in the first half of 2013. Herbalife has not entered any new countries since the start of the year.

The company's Book Value was $421 million at the end of 2012. The Book Value at the end of Q2 is $434 million. Herbalife is not a company that retains its earnings.

Where does the cash go?

Herbalife has generated in excess of $500 million of free cashflow on a trailing twelve month basis.

Herbalife's share count has dropped from 118 million shares to 107 million shares. The company repurchased $162.4 million worth of stock in Q1. This repurchase activity occurred on the heels of over $500 million worth of buybacks in 2012. Herbalife has a $1 billion repurchase program of which $787 million remains outstanding. Share repurchases have been suspended until the company's new auditor can sign-off on its historical financials.

The company also pays a dividend of 30 cents per share per quarter. Cash used to pay dividends has actually declined YOY due to the reduced share count.

The company also has capital expenditures of $60 million plus YTD. Last year the company spent $122 million on capital expenditures.

Has the Balance Sheet changed?

Even as Net Worth has not changed the following accounts have experienced material change since the end of 2012.

Long-Term Debt has increased from $431 million to $894 million. The company borrowed money to accelerate its share buybacks.

Cash on hand has also ballooned from $334 million to $850 million. This liquidity surplus becomes a powder keg for additional share repurchases once the audit trail is cleaned up. Alternatively balance sheet leverage could be reduced or dividends could be increased.

At today's Market Price of $64 per share Herbalife could retire 7.8 million shares with an additional $500 million worth of share repurchases. If the company were more aggressive in the debt markets, the company could theoretically retire an additional 10-15% of its float.

Hedge fund managers have taken the opposite side of Pershing Square. The combinant forces of Carl Icahn, Soros and Stiritz now own over 25% of the company. Icahn's 17% has a lock-up agreement in place until February of 2014. The incoming free cashflow, surplus liquidity and Pershing Square's 30 million share short position effectively act as a headlock (or is it a Full Nelson?) around the shorts/buoy the longs. With 25% of the shares in friendly hands and the company using most of its cashflow/leverage to repurchase shares, the avenues of escape for the shorts seem limited.

Or do they?

In order for the short thesis to pay off one of two things has to occur.

a) Herbalife's business fundamentals need to deteriorate.

b) Regulators need to intervene

As has been pointed out many times before, Herbalife's business model relies upon velocity. Specifically, the company must be successful recruiting new participants due to the annual exodus/short lifetime value of its existing customer base. To date, the HLF recruiting juggernaut has masked the churn inherent in the business model because it recruits more people annually than those who resign. However, it is apparent to anyone with a rudimentary understanding of mathematics that the more successful Herbalife is today, the more successful it needs to become tomorrow in order to continue to grow. Today's recruits become next year's resignations. If HLF recruits 2 million new distributors this year it must also find 2 million new recruits next year for the top-line to stay positive.

Already, HLF is teetering on the brink of net distributor attrition. From Q1 to Q2 the company actually saw its distributor base contract by 200,000 people. Whether or not this trend continues remains to be seen, but the toughest part of Mount Everest to climb is the last 1,000 feet. Most climbers actually die on the way back down from the summit. Once Herbalife's recruiting metrics turn negative, what will happen to the valuation of the equity? Will a 10 P/E become a stretch? Can management ethically continue to buy-back shares in the face of a shrinking customer base?

As for regulatory intervention, it strikes me that this outcome is analogous to a game of Russian Roulette. If you are long Herbalife you are speculating that regulators will not intervene. However, even if there is only one bullet in the chamber of the revolver - that bullet can kill you. The history of regulatory intervention in the U.S.A. is the confiscation of all of the company's assets and the immediate seizure of the operations in the event an investigation finds the enterprise to be a pyramid scheme. Under this scenario, HLF likely becomes a $0.

So - What's Next?

If you believe that HLF is a legitimate enterprise it becomes obvious that everything the management of the company is doing seems entirely rational. They are buying back shares at a discount to the market's multiple, they continue to pay dividends, they are borrowing money at an inexpensive rate to acquire equity in themselves at a high free cashflow yield. They believe in themselves. Ostensibly, it all looks good. Add-in the additional gravitas provided by Mr. Icahn and Mr. Stiritz and Mr. Soros and the short side of the trade still looks curious - at least on a near-term basis.

However, lurking in the wings if you are long remain the following untold stories:

What will the SEC conclude from its own objective investigation?

What will the FTC conclude from an equally arm's length review?

What will States AG's conclude?

What about the class action lawsuits?

And finally, where will the next 2 million plus new distributors the company needs to find come from? In 2012 & 2013 trend data HLF has signed-up over 4 million new distributors. Can they repeat this effort ad infinitum? Doubtful.

Pershing Square has been squeezed to be sure. The last 9 months have been painful on a mark to market basis. The market cap of HLF has more than doubled since the end of 2012. There are some reputable foes on the long side of the table.

Of course if the business model deteriorates and/or the regulators step-in, all of the share buybacks the company has done over the past 3 years will end-up a total waste of capital. Also, the balance sheet that is more levered today than it was when Mr. Ackman revealed his short position becomes a tailwind for shorts if the company's recruiting efforts start to slide into negative comps.

Lenders may also start to get antsy as the company has no real hard assets to offer as collateral.

Within a year investors will likely learn whether or not regulators find HLF's compensation scheme to be a pyramid scheme or endless chain.

Equally so, we will likely find out if the recruiting juggernaut continues to slip off the rails or not. Will "Pop & Drop" finally hit the mothership?

What is for certain is that both Mr. Ackman and Mr. Icahn will likely be along for the ride until at least February of 2014.

Will HLF be private by then?

Who knows?

I remain convinced that HLF is:

a) an Unsustainable business model and

b) an endless chain that victimizes unsophisticated individuals with an entrepreneurial dream.

At a market cap of $6.6 billion and Free cashflow of say $550 million you are getting a FCF yield of 8.3% on HLF equity v. 2.9% on a ten year treasury. The latter seems money good. As for the former?

At $64 a share the long bet seems increasingly perilous.

Disclosure: I am 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. (More...)

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