Herbalife in Lawmaker's Crosshairs

Now that Herbalife is attracting the scrutiny of a Senate lawmaker, what does it mean for the stock -- and for competitor NutriSystem?

Jan 24, 2014 at 5:42PM

Herbalife (NYSE:HLF), the nutritional-supplements company, already being targeted by a leading hedge fund manager, is now in the crosshairs of a Senate lawmaker. News broke this week that Senator Edward J. Markey, D-Mass., has asked the Securities and Exchange Commission and the Federal Trade Commission to examine the company's business practices. Senator Markey also wrote to Herbalife's chief executive in search of more information about the company.

The company's stock has tanked by more than 10% since the news surfaced.

The legal brief
Herbalife sells vitamins and drink mixes through a network of individual distributors. In 2012 William A. Ackman -- manager of Pershing Square Capital Management -- launched an attack against the company, claiming Herbalife was a pyramid scheme. Herbalife spent 2013 fending off the allegations.

Meanwhile, Herbalife's stock performed well in 2013 as Ackman took heavy losses by going short when other large investors bet against him. So the hedge fund manager began pressing regulators and lawmakers to shut down the company. According to The New York Times, Ackman reportedly met with members of the Senator's staff last fall.

In letters to the regulators dated Wednesday, Senator Markey said, "I have seen reports from Massachusetts residents that suggest Herbalife is a pyramid scheme."

A spokeswoman from the Los Angeles-based company reportedly said in a statement, "We received the letter from Senator Markey this morning and look forward to an opportunity to introduce the company to him and address his concerns at his earliest convenience."

The SEC and FTC declined to comment.

Why it matters
This case could adversely impact Herbalife's shares as the matter unfolds. However, the wheels of justice spin slowly, and it is far too early to predict what the outcome will be. If the agencies find the claims have merit, the SEC will issue what is called a "Wells Notice" notifying the company a formal probe is under way.

Depending on what the inquiry determines, this matter will be something for investors to watch closely. Keep in mind these are only allegations, and the company's stock may be in choppy waters as the case unfolds. This imbroglio could also end up being much ado about nothing -- and Ackman may come out with the short end of the herb stalk, so to speak.

In the meantime, competitors of Herbalife could be in a position to take advantage of this story. One such player is NutriSystem (NASDAQ:NTRI), even though the companies sell different types of products.

NutriSystem in a turnaround mode
NutriSystem is one of the most well-known brands in the weight-loss business. Its direct-marketing model allows the company to operate with little inventory while cost-effectively garnering customers and selling them ready-to-eat meals.

After a period of bumps and bruises, NutriSystem's stock climbed by more than 100% last year before some cooling off to open 2014. The company is strong in many ways. NutriSystem is now debt-free and has a long history of operating with a gross margin of more than 50%.

For the third quarter ending Sept. 30, the company announced revenue was $85.4 million, an increase of 5% from revenue of $81.3 million in the third quarter in the prior year. Adjusted net income was $4.3 million, or $0.15 per share, compared to $2.9 million, or $0.10 per share, in Q3 2012. Net income for the quarter was $356,000 or $0.01 per share.

Finally, the company has a lot of cash on its hands, with cash and short-term investments at more than $41 million. Most important, the company reported it had no borrowings outstanding under its bank facility.

The skinny
Since this is a hot news story, some investors in Herbalife might be inclined to exit quickly, and some speculators may be in the buy/sell mode as they try to make short-term gains. Then there are others who might keep their powder dry until all the cards are on the table.

NutriSystem might be a good alternative for those investors looking to hedge their bets. The company is poised to continue climbing -- provided, however, the management team is successful in making its diet products available to order on the Internet.

Finally, investors in Herbalife should mark their calendars for Feb. 18, when the company will release full-year 2013 results, and a conference call the following day may shed more light on this unfolding legal matter.

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Fool contributor Kyle Colona has no position in any stocks mentioned. The Motley Fool has the following options: long January 2015 $50 calls on Herbalife. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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