Herbalife (NYSE:HLF) offers one of the best chances for a double over the next couple of years, almost regardless of how the stock market performs. The stock has been unfairly beaten down as part of investor Bill Ackman's short-selling campaign, and now trades at 10 times this year's earnings -- very cheap for a company that's growing earnings per share as fast as it has. Even better, management has been very aggressive in its capital allocation, rapidly buying back shares in the face of a depressed stock price -- exactly the move that I want to see. So I'm buying a call on the stock.
I'm not going to spend much time on the business element here. Herbalife runs a multilevel marketing operation selling nutrition products in nearly 100 countries. Multilevel marketers are a legally recognized distribution technique and completely distinct from pyramid schemes. The hullabaloo around Herbalife concerns Ackman's allegation that Herbalife is running a pyramid scheme.
Bronte Capital's John Hempton came up with a simple test for determining whether Herbalife is a pyramid scheme, and it's a straightforward way to think about what's going on there. It's all about following the inventory. If you're not seeing these traits, there is only one possible alternative: The company runs a legitimate business selling real products to real consumers.
1. Are distributors being stuck with high sign-up fees? No, sign-up fees are under $100 and refundable.
2. Are distributors being stuffed with product? No, since Herbalife offers a full money-back return policy. Absolutely no pyramid scheme is offering its victims their money back. The first rule of cons is that money flows only one way, away from the mark.
3. Are Herbalife products being sold at cut-rate prices (i.e., on auction sites, Craigslist, etc.)? If distributors were stuck with inventory, you'd see that inventory leak out on the usual Internet commerce sites at extremely low prices. That's not happening.
If inventory is not being stuffed into distributors and they're not selling it at cut rates to get a few pennies back, then it must be being consumed. Importantly, if the above tests are true, it doesn't matter who is consuming Herbalife products, distributors or not. This issue of whether distributors are consuming the product is a red herring thrown out by bloggers, shorts that enjoy scaring the pants off everyone and driving the stock down to a bargain-basement 10 times forward earnings. And this for a business that has grown earnings per share at an average 24% annually over the last five years. Cheap.
So while some distributors or customers may have had a lousy time working with Herbalife or its many distributors (and their unctuous recruitment tactics), that does not make Herbalife a pyramid scheme.
While the ongoing FTC investigation may turn up some unsavory business practices, I expect those (if any) to all be at the margins of Herbalife's business model and not fundamental to its performance. The removal of uncertainty should rocket the stock much higher, and then Ackman's short case -- and those who followed him sheep-like into this short trade -- is done.
Management and buybacks
So Ackman's short thesis gave us the opportunity, and management has been very keen about seizing it to buy back stock in huge quantities. The company will have repurchased something like 20% of its share count by the end of June at very attractive prices. This will result in even further stock gains, coiling the spring when all this uncertainty is cleared.
I love the company's decision to cancel its dividend and accelerate its share repurchases for a couple of reasons. First, the repurchases are a better return of value, taxwise. The company did an excellent job of spinning this dividend cut and accelerating the repurchases, because it deflected attention from what, I suspect, is the true aim of cutting the dividend.
The second and more interesting reason for the dividend cut is that it frees up cash flow for another leveraged recap. The company had been paying out $120 million in cash as a dividend. That amount of cash flow -- or even just half -- would fund the interest on debt for a significant buyback. So, for example, if Herbalife borrowed a billion dollars at 6%, interest expense would total just $60 million. The dividend cut gives management the flexibility for a leveraged recap. This is something that various investors, including 17% owner Carl Icahn and 7% owner Bill Stiritz, have publicly suggested. Herbalife could be even more aggressive. And that all leads to the potential for a short squeeze.
So it's exciting to see a company actually use the finance side of its business to return value to shareholders.
Ackman couldn't care less if the stock goes to $0
One of the biggest parts of Ackman's bluster is that he's said the stock will go to $0. This is largely nonsense. Ackman would never stick around long enough for the stock to approach anywhere close to that level. Like a swan bowing out its wings or a bull stomping its hoof, Ackman must show supreme confidence in his position. He has to show the swagger. He's kept stringing out his line of supposedly "damning" evidence without ever really providing a "smoking gun," a sign that his case is weak.
And look closely at what he did when the stock went up late last year. He changed a huge portion of his short position to an options position. That's a tacit admission of partial defeat, though you wouldn't know that from his words -- more bluster -- after he revealed the move. He took money off the table and inherently reduced his downside if the stock were to continue to rise.
Here's another reason: Ackman is overplaying his hand. The U.S. comprises just 18% of Herbalife's sales and it's falling as sales in other countries rapidly increase. If Ackman thinks this stock is going to $0, he's going to have to fight this same battle in Herbalife's other markets for years and years. That's just not going to happen. And late last year, Belgium validated Herbalife's business model.
And that Belgium decision leads me to another point, on realpolitik. If Belgium -- in which Herbalife has little presence, jobs, investment, and political influence -- authorized the business model, how credible is it to believe that the U.S. government won't do so? Herbalife offers jobs, investment, and political influence, and its wealthy top distributors likely have some pull in the political arena. My best guess is that Herbalife gets what amounts to a slap on the wrist for mediocre distributor conduct.
Foolish bottom line
In any normal environment, this stock would trade for 20 times earnings, if not more. In other words, this is a $120 stock trading for half off.
So what's starting to become my biggest concern in buying Herbalife is the presence of large investors, such as Icahn and Stiritz, who could very well be interested in taking this company private. I suspect it could be purchased much too cheaply and spun back out later at a much higher price. We'll see. On the other hand, if these finance wizards can get the company to undertake leveraged recaps, as they have so far, then a take-private could be unnecessary and potentially even more painful for Ackman.
To take advantage of that price discrepancy, I'm going to use an option. So later this week, I'm buying a January 2016 $62.50 call on Herbalife.
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Jim Royal has no position in any stocks mentioned. The Motley Fool has the following options: long January 2016 $57 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.