3 Reason's Herbalife Ltd.'s Stock Could Rise

Herbalife shares could be poised for a rally if any of these three things occur.

Aug 19, 2014 at 9:35AM

Under siege from activist hedge fund manager Bill Ackman, multi-level marketing giant Herbalife (NYSE:HLF) has been an immensely volatile stock over the last two years. Ackman's periodic accusations of fraud have, from time to time, sent Herbalife cratering, while strong earnings reports and analyst notes have occasionally buoyed shares.

Although Ackman insists that the company is destined to collapse, other investors are more bullish. Below I offer three reasons as to why Herbalife shares could rally. Of course, it's important to note that even if all possibilities break Herbalife's way, there's no guarantee that the stock will rise. A more general stock market downturn, other threats to the business, or just plain random chance could keep things from turning out well for Herbalife investors. With that in mind, let's get started.

Herbalife is hit with only modest infractions -- or even none
Ackman's ongoing crusade against Herbalife has drawn the attention of several government regulators, most notably the Federal Trade Commission. The FTC has a track record of bringing down pyramid schemes masquerading as legitimate multi-level marketing firms, including Fortune Hi-Tech Marketing and BurnLounge.

Herbalife could be the next firm to fall victim to the FTC's wrath, or at least, that's what Herbalife bears are betting on. If the FTC does charge Herbalife's management with operating an illegal pyramid scheme, the resulting impact on shares is likely to be catastrophic.

However, the inverse is equally true. That is to say, if the FTC were to conclude its formal inquiry with only modest action -- perhaps a small fine or slap on the wrist -- or even none, Herbalife shares could surge to the upside, as the likelihood of a government seizure or shutdown evaporates. Herbalife could continue to operate its business, and though its results could be dampened by any FTC action, the threat of a looming binary event would effectively vanish.

More bullish would be the FTC ending its formal inquiry and taking no action whatsoever. Although other government agencies (including the SEC, several state attorneys general, and perhaps the FBI) are also looking into Herbalife, the FTC has a history of leading the charge when it comes to prosecuting pyramid schemes.

If the FTC found Herbalife to be operating within the limits of the law, the bear case would effectively vanish. The ongoing regulatory threat would dissipate, and Herbalife shares would likely be revalued, gaining a multiple commensurate with the broader market.

A short squeeze is triggered in Herbalife shares
That surge to the upside could be prompted, partly, by a wave of investors rushing to purchase shares of an extraordinarily cheap stock (currently trading with a price-to-earnings ratio near 11). But more significant could be the buying by those investors who had been short shares of Herbalife.

As of this writing, about one-third of Herbalife's outstanding shares have been bet against -- making it one of the most heavily shorted stocks in the market. To stop potentially unlimited losses, short sellers could turn into buyers if Herbalife shares begin to move to the upside.

Even if the FTC's ongoing investigation is not resolved, a short squeeze could still occur. Herbalife's management has undertaken a strategy that has seen it aggressively repurchase its own shares this year. In February, it issued $1 billion in convertible senior notes to expand its buyback program, and in April, it stopped paying a dividend in order to finance more share repurchases. As my Foolish colleague Jim Royal points out, borrowing additional money to buy back even more stock could raise the short interest to untenable levels, prompting a major short squeeze on the slightest positive headline.

Herbalife's rapid growth could resume
The possibility of regulatory action (or inaction) is likely to dominate the Herbalife trade in the near-term. Yet, operational improvements could have a modestly positive affect on Herbalife shares.

Last month, Herbalife disappointed shareholders when it delivered an earnings report that came in short of analysts' expectations. Although Herbalife's adjusted EPS increased 10% from the same period last year, analysts had been expecting better results. Not surprisingly, Herbalife shares declined on the report.

A reversal in fortune, and a string of strong earnings reports could produce the opposite effect. Assuming that Herbalife is, as it says, not a fraudulent company, the market for its weight-loss shakes appears to be expanding. Earlier this year, researchers found that worldwide obesity rates had risen sharply over the last three decades: In the U.S., as many as a third of the population is now obese, and Australia and the U.K. are not far behind.

A special situation
Still, unlike other stocks, which may move on the basis of the underlying company's ability to bring desired products to market, Herbalife is truly a special situation.

At least in the near term, the return on Herbalife shares is likely to be related more to the outcome of ongoing investigations than the business itself. For Herbalife shares to head higher, investors should look for the FTC to end its inquiry with only modest penalties (or no penalties whatsoever). That, in turn, could prompt a short squeeze, and send shares trading significantly higher.

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Sam Mattera owns put options on Herbalife. 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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