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Herbalife's a Double (at Least) and I'm Buying

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.

The business
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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Read/Post Comments (24) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 12, 2014, at 12:20 PM, drewtheglue wrote:

    HA! Laughable! You're joking right? You are selling the same snake oil HLF sells...

    You EXPECT A DOUBLE EH? So everyone should buy then right? The only thing that will double is the BS about the positives on this company.

    They spent all their cash on hand buying back worthless shares. If you believe in your company, you don't sacrifice a long term plan for a short term perspective. Not only that, if this were a double, why didnt the CEO hang on to his converted options? He could hold all those shares... but, he chose to DUMP THEM.

    ABANDON SHIP... I expect a HALF before a DOUBLE.

  • Report this Comment On May 12, 2014, at 12:21 PM, Zarthegreat wrote:

    So, there's no way in your mind that Herbalife could be acting immorally/illegally? There's no way that the federal agencies will find a flaw or miss conduct on behalf of Herbalife and its business model?

    History is full of prominent investors who take large positions in companies only to then loose lage portions of their investments.

    Bill Ackman encountered a very similar situation when going against MBIA, and he rode the stock down very close to zero, are you so sure he won't do it again.

    Why do you believe that Herbalife will allowed to operate in other countries if its business or its executives are found to be acting illegally, irresponsibly, liable and etc.

    If a pyramid scheme is shut down, not only its U.S. business will get shutdown but the whole business as a whole will be brought down.

  • Report this Comment On May 12, 2014, at 12:24 PM, drewtheglue wrote:

    Great timing on this article too... keep pumping it... you had to throw THIS WILL DOUBLE into the headline to get some poor saps to buy this crap...

    The author is as PATHETIC as HLF.


  • Report this Comment On May 12, 2014, at 12:33 PM, drewtheglue wrote:

    Hey, Jimmy... since you disclosed YOU'RE BUYING... how much did you buy? Please, DISCLOSE FOR THE AUDIENCE THAT YOU ARE PEDALING TOO. Don't just try to convince us we should buy because you're telling us you are a buyer. Why not spit out how committed you are to your position and put your money where your mouth is? If you are going to write an article SCREAMING DOUBLE to any poor fool out there that would believe that, please tell us, HOW LARGE IS YOUR POSITION IN HLF? AFTER ALL, YOURE A BUYER JIMMY! If its going to double, and YOURE A BUYER, you probably backed up the truck and your wifes truck and you're whole family's truck and bought all you could (you're a daydream believer, Jimmy). After all, who wouldn't follow the leadership of Carl Icahn and George Soros... now there's two straight and honest business people with the interest of other investors in mind! HAHA!

    THIS ARTICLE IS A JOKE. Unfortunately, a lot of people are being sucked into this pathetic excuse for a business model.

  • Report this Comment On May 12, 2014, at 12:43 PM, drewtheglue wrote:

    Go see how HLF's largest target customer feels about the business... the Latino community... they are rising up in arms against this outfit because they feel they were targeted and bilked from their hard earned dollars by pie in the sky attitudes.

    If you can't find info, here's a link to help the wary investor:

    More than 60% of Herbalife’s U.S. distributors are Latino.

    If this were such an opportunity, why would HLF target a specific race of people? Are they under educated as a whole demographically? Easy pickings perhaps?

    88% of those who get involved with the company NEVER MAKE A CENT.

  • Report this Comment On May 12, 2014, at 1:15 PM, drewtheglue wrote:

    Jimmy... why wait on that option? Why wouldn't you buy it today... it's a double... why wait?!

    What price are you willing to pay for that option to capture your "investment?" Why buy options? Options aren't investments, theyre spec plays! You're such a believer, go buy the stock man! Options are for speculators, but, YOURE A BUYER! Buyers OWN stocks, they don't spout how it will double and then speculate in case it happens.

    YOUR ARTICLE IS 100% FOR BENDING PERCEPTIONS. I will follow you so I can find other manipulated stocks. Those have lots of volatility, and money is to be made in volatility.


  • Report this Comment On May 12, 2014, at 1:30 PM, drewtheglue wrote:

    I am learning how you manage this pump and dump scheme... first, you write an article creating a perception ... "its a double" is like saying, "this thing is going way up from here" ... then, they move the price up illogically, because it's not the huge buy volume moving it up , that's for sure, it's just people you are sucking into the price movement who are believers, Jimmy.

    Look at the volume and price since January. Pretty much capitulation! ALL LONG RED BARS for VOLUME. Looks like the market doesn't feel as strongly as you about the chances here for a double.... you might as well make it a quadruple, Jimmy... because when you are selling ice cream to eskimos, you got to make it convincing!

    I would say its closer to 52 than 62 by the end of the week. If it's such a double, why did the CEO dump his long position?! He already made a mint from 7.75 to 61 on his option, but, he could have carried that profit a lot further according to you. And, who would be better in the know than the CEO?!?! If it was such a double, why did he DUMP his shares?!

  • Report this Comment On May 12, 2014, at 2:22 PM, powershake wrote:

    Don't you know that Michael O. Johnson the CEO is HOLDING 1.1 MILLION share of stock worth around $60 million?

    CEO sold 10 year old option expiring this year. He needed to sell without being involved with insider trading. This decision and appropriate paparwork was probably done months or even years ago.

  • Report this Comment On May 12, 2014, at 2:40 PM, powershake wrote:

    Don't you know that Michael O. Johnson the CEO is HOLDING 1.1 MILLION shares of stock worth around $60 million right now?

    CEO sold 10 year old option expiring this year. He needed to sell without being involved with insider trading. This decision and appropriate paperwork was probably done months or even years ago.

  • Report this Comment On May 12, 2014, at 2:41 PM, earlcarroll wrote:

    I expect it to be range bound for year or so between 50 and I am selling puts and have been for over 9 months...will double within 90 days of when investigation is over but that is slow as hell especially with 5 different investigations going on at one time.

  • Report this Comment On May 12, 2014, at 2:57 PM, mjmny wrote:

    I would advise some respectful and factual discussion here, not mudslinging.


  • Report this Comment On May 12, 2014, at 3:38 PM, earlcarroll wrote:

    meanwhile back at the ranch THE STOCK IS UP THIS MONTH.....bill stiritz, carl Icahn, George soros and several other billionaires who are long the stock and selling puts have done their own investigation...this group of billionaires have a lot better investigators, lawyers, and analysts than the government could ever hire.. do you think Icahn would have put so many on the hlf board if he had not done a thorough investigation...DUE is what these billionaires do and they do it very well, ackman on the other hand NOT SO MUCH I use j c penny , target. and now hlf as my examples...these billionaires just keep selling puts and the puts just keep expiring worthless.. and once these investigations end and hlf gets a fine and a slap on the wrist the stock goes to 100 bucks a share and all the shorts will be SQUEEEEEZED like volkswagon was..this is going to make a great movie once it is more thing...only 18 percent of hlf sales are in the united states so WHAT IS THE WORST POSSIBLE OUTCOME?? they lose 18 percent of there sales...IT IS NOT POSSIBLE FOR IT TO GO TO ZERO...

  • Report this Comment On May 12, 2014, at 4:03 PM, powershake wrote:

    HLF stands with the Latino community & takes pride in the fact that 85% of Latino customers rate HLF as good, very good or excellent!

  • Report this Comment On May 12, 2014, at 4:52 PM, earlcarroll wrote:

    ackman covered half his short position about a year ago at 62 bucks a share and bought puts....he must not believe his own research or he would have doubled down rather than cover...actions speak louder than his words or research...hlf will be over 100 within 90 days from the time these investigations are over..meanwhile the most money to be made is in selling puts

  • Report this Comment On May 12, 2014, at 5:04 PM, Zarthegreat wrote:

    It's time to put this pyramid scheme out of business. An MLM in which 88% of the distributors make nothing cannot be considered anything other than a scam. I find it mind boggling that so many people support this company, are they brainwashed zombies who believe that eventually they will get rich? I think so, its amazing how MLMs can have such an effect on a human psyche. But if you sit back and look at the situation logically, one can see that this is nothing short of a scam and should not be permitted to continue operating legally in the U.S. or in any place for that matter.

  • Report this Comment On May 12, 2014, at 5:05 PM, Zarthegreat wrote:

    HLF will be next to Zero once these investigations are over...

  • Report this Comment On May 12, 2014, at 5:34 PM, spectrum wrote:

    I find it highly amusing that those people negative towards HLF & the facts spelt out in detail by Jim Royal, are foaming at the mouths & almost suffocating in their own negativity. Why not go to your nearest nutrition club, it might help with the high blood pressure (whoops! almost forgot about the medical disclaimer!)

  • Report this Comment On May 12, 2014, at 7:52 PM, drewtheglue wrote:

    I will simply say, you can smell dishonesty a mile a way. Where there i smoke, there is fire. This headline, it seductive, its untruthful, the author doesnt even put his money where his mouth is. He will buy a 62.50 put at the end of the week? Hes not even an investor, hes a speculator. And his thesis is based on "if Carl and George drive over with Thelma and Louise... IM A BUYER!" haha! What a dolt.

    I love the fact that he said, "IM A BUYER" ... what an amateur. haha "Ok, Mr. Buyer... how many you want...?" It's a double... crap, everyone is looking for yield these days... this is a sure fire bet here, EH?! HAHA! Laughable!

    That's not mudslinging by the way, that's called POINTING OUT THE OBVIOUS AND MAKING LIGHT OF IT. Pull your pants up....

  • Report this Comment On May 13, 2014, at 11:08 AM, THETRUTHOFTHIS wrote:


  • Report this Comment On May 13, 2014, at 12:02 PM, THETRUTHOFTHIS wrote:

    The couple of shorts still existing seem to

    be extremely fearful for a good reason, they will get what they deserve.

    HERBALIFE stock price will fivefold within the next 6 years.

  • Report this Comment On May 13, 2014, at 1:12 PM, drewtheglue wrote:

    Hey Jimbo, did you pick up those Long Calls yet at 62.50? They are cheaper now than in the future, where you expect the price to be! haha! Why not buy now if you feel this is an easy double? Why wait for it to go up further? Don't spout off YOU'RE A BUYER unless you are actually A BUYER... the headline should say YOURE A BS'ER, not a BUYER

  • Report this Comment On May 13, 2014, at 1:14 PM, drewtheglue wrote:

    Did anyone catch this at the bottom of the article:

    "Jim Royal has no position in any stocks mentioned."

    HE JUST STATED IN THE HEADLINE HES A BUYER, or isnt he??? Is this more misleading information surrounding HERBALSTRIFE?

  • Report this Comment On May 13, 2014, at 10:03 PM, drewtheglue wrote:

    What other business can one get into where there is an 88% failure rate? Do 88% of gas stations fail? Do 88% of GM's vehicles fail? Does 88% of our votes for President fail? Does 88% of your laundry soap fail? Do you have 88% blockage of your arteries? Do you fail to remember your name 88% of the time? How many store you can think of that fail at selling 88% of their products? If you have an 88% failure rate, HOW CAN ONE BE ALLOWED TO SELL THIS AS AN OPPORTUNITY, KNOWING, WHAT IS BEING SOLD IS 88% BANKRUPTCY FROM THE GET GO? ALL THESE PEOPLE WILL FAIL and those above them are just sucking the life out of them like new blood to a vampire, silently screaming for more upline! to get a piece of the paltry earnings they might make after taxes and time invested. BOGUS It's no wonder Herbalife doesn't advertise! Living the dream under the radar! HELLO. If one can't see the smoke coming off this fire in every direction, THEYRE BLIND.

  • Report this Comment On January 07, 2015, at 8:53 AM, CindyGa wrote:

    I bookmarked this page more than six months ago waiting for the day Herbalife falls to half of what it was when you said it was a double.

    I've been short since it was in the 70s and will likely cover half of my position today below 30 although I am quite certain this is headed below 10.

    I am not trying to be flippant here, but I have to ask: if you thought this was an easy double eight months ago at 60, do you now see this as an easy quadruple from 30 over the coming four months?

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Jim Royal

Jim is a special-situations investor focusing on transactional events (such as spinoffs, recapitalizations, or reorganizations, among others) that create advantageous stock mispricings.

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