Is it Time to Join the Bulls in Herbalife?

Beleaguered direct seller Herbalife confounded its critics in late April by posting better-than-expected profitability while simultaneously raising its guidance for the current fiscal year. Is it time for investors to tune out the noise and buy in?

Jun 2, 2014 at 9:10AM

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Shareholders in direct-selling giant Herbalife (NYSE:HLF) have been enduring a soap opera lately as management jousts with activist investor William Ackman, whose Pershing Square hedge fund has a well-publicized short position on the company. The noted investor's latest volley was a documentary film which chronicled the experiences of former Herbalife distributors that depicted the company as more interested in finding new recruits than in selling products, a charge that also dogs competitors like Nu Skin Enterprises (NYSE:NUS).

Naturally, Herbalife also has its roster of supporters. This includes famed investor Carl Icahn, who holds a major stake through his holding company and recently upped his representation on Herbalife's board to five members. No doubt Mr. Icahn and company were pleased when the company reported better-than-expected results in its latest financial update in late April. So with the battle lines drawn, is Herbalife a good bet at current prices?

What's the value?
Herbalife has found great success in the direct-selling business by focusing on only a few product areas, led by its Formula 1 brand in the weight-management category which singlehandedly accounts for almost a third of its total sales.  Profit from the Formula 1 brand has allowed the company to build out a more well-rounded portfolio of products, which includes recent forays into the fitness and skin-care arenas through its Herbalife 24 and Herbalife Skin brands.  The company has also benefited from an increase in spending on health and wellness products by more affluent, aging populations in key markets like China, which has led to consistent profit growth for Herbalife over the past five years.

In its latest fiscal year, Herbalife reported a double-digit top-line gain that was a function of a larger base of distributors as well as an uptick in its distributors' productivity.  While the company's operating margin was hurt by ongoing litigation costs, its operating cash flow remained strong during the period.  The net result for Herbalife was an ability to fund a larger manufacturing footprint while returning capital to shareholders, primarily through stock repurchases.

That being said, the attention surrounding the company and its media-savvy detractors have undoubtedly hurt Herbalife's growth trajectory, which is evidenced by a top-line gain in its fiscal first quarter that was below its performance in the prior-year period. More notably, Herbalife's operating margin was hit hard because the company had to defend itself as it is under investigation by the Federal Trade Commission, and this led to a double-digit decline in its operating income.

Birds of a feather
Of course, Herbalife isn't the only direct seller with image problems. Competitor Nu Skin has had recent entanglements with Chinese authorities, who were investigating allegations that the company had violated China's direct-selling laws. Like Herbalife, Nu Skin primarily sells its products through retail shops in China, complemented by an independent direct-selling force in areas where it has obtained the necessary licenses. While Nu Skin emerged from the aforementioned situation with a relatively meager fine and an agreement to improve its business practices, it has clearly lost some momentum in China, a key geography that already accounts for almost half of its total sales.

A better way to go
Herbalife is certainly an intriguing story, and more so given its P/E multiple of roughly 14 and support from institutional investors; this list includes Mr. Icahn as well as hedge-fund managers George Soros and Kyle Bass. However, given the ongoing government investigation into the company's business dealings, investors should probably look for a lower-risk way to play the health and wellness opportunity like GNC Holdings (NYSE:GNC).

The company is the undisputed king of the health-food store segment as it operates more than 8,600 stores around the world. While its top-line growth has slipped a bit lately, highlighted by lower comparable-store sales in its fiscal first quarter, GNC's operating profitability has remained at a solid, double-digit level. This is thanks in part to its ability to leverage the sales infrastructures of its retail partners, most notably drugstore-giant Rite Aid.The net result for GNC has been a continuation of strong operating cash flow that has fueled the continued expansion of its franchise in existing and new markets.

The bottom line
The final chapter in the Herbalife vs. Ackman story has yet to be written, but prudent investors should probably avoid the obvious risk. GNC would be a better bet, especially since its recent sharp decline makes it a cheap way to play the likely future growth of global health and wellness spending.

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Robert Hanley owns shares of GNC HOLDINGS INC COM, Nu Skin, and Rite Aid. 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.

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