3 Reasons Herbalife Ltd.'s Stock Could Fall

Herbalife shares could drop if any of these possible events occur.

Aug 20, 2014 at 11:42AM

Shares of Herbalife (NYSE:HLF) have nearly doubled in value since activist hedge fund manager Bill Ackman first targeted the company in December 2012. Accusing Herbalife's management of running a pyramid scheme, Ackman -- in a series of presentations -- has argued that the company is operating illegally and is destined to fail.

It's been 19 months and Herbalife is still standing, but shares could be poised to fall. Below, I offer three reasons why Herbalife shares could soon trade lower. Of course, it's important to note that there's no guarantee Herbalife shares will fall -- a general market rally, an upturn in the business, or just plain random chance could send shares surging to the upside. Nevertheless, investors should be mindful of the following possibilities.

Herbalife is forced to make significant changes to its business model
Several government regulators -- including the FTC and several state attorneys-general -- are currently investigating Herbalife. Action from one (or several) of these agencies could have a notable affect on Herbalife's business, making it difficult for the company to attract and retain its members.

Even if the government does not agree entirely with Ackman's reasoning, it could find some fault with the firm's current business practices. The FTC, for example, often charges businesses with wrongdoing, only to later settle after some changes in business model have been agreed to.

As a multi-level marketer, Herbalife relies on a network of distributors to sell its product. Turnover among its distributors runs high, and the vast majority do not make money selling Herbalife's products. Even if regulators find Herbalife's model to be, broadly speaking, legal, significant changes to the way in which Herbalife does business could weigh on its earnings: If Herbalife is hamstrung in its ability to recruit new members, its operating results could suffer.

Far more detrimental would be a shuttering of the company: if government regulators -- particularly the FTC -- find Ackman's case to have merit, they could conceivably shut down Herbalife at any moment.

Like Herbalife, Fortune Hi-Tech Marketing once claimed to be a multi-level marketing firm. The FTC, however, disagreed, and in January 2013, charged its owners with operating an illegal pyramid scheme. Though it never went to court, the settlement was disastrous for Fortune Hi-Tech, with assets seized and its management banned from the multi-level marketing industry.

If Fortune Hi-Tech had been a publicly traded company, its shareholders would've likely been wiped out. It may be unlikely, but if the FTC agrees with Ackman, the same could conceivably happen to Herbalife.

Herbalife's core business deteriorates
While regulatory intervention could cause a downturn in Herbalife's business, it may not be necessary: If very recent trends are any indication, Herbalife's underlying business could be deteriorating on its own.

When Herbalife reported earnings last month it disappointed investors, with its quarterly earnings falling short of analysts' expectations. Revenue grew, but less than Herbalife's management had expected, and Herbalife lowered its sales guidance for the full year. Certain regions were particularly hard-hit, with Herbalife's sales in South and Central America posting a decline.

To be fair, it's only one quarter, but the surprising miss on earnings and slowing revenue growth could be a sign of a struggling company.

Carl Icahn or Bill Stiritz sells their shares
Insider selling often weighs on stock prices, but Herbalife seems particularly exposed. Ackman's attacks on Herbalife might've carried more weight had it not been for the investments of Carl Icahn and Bill Stiritz.

As an activist investor, Icahn's track record is longer than Ackman's. Following Ackman's original presentation on Herbalife, Icahn began building a stake in the company, and currently owns nearly one-fifth of its shares. Bill Stiritz is not a famed investor, but as the CEO of Post Holdings, certainly understands business. He currently owns more than 5% of the company. Collectively, their stakes in Herbalife have lent it an air of legitimacy, and have served to undermine Ackman's credibility (if Icahn and Stiritz disagree, perhaps Ackman is wrong?).

But that legitimacy could quickly vanish if either one sells their stake, particularly if they do so before government regulators conclude their ongoing investigation. Although it's impossible to determine how significant the reaction would be, large stock sales from Icahn or Stiritz would suggest that they've changed their minds on the investment, and have become skeptical of Herbalife's underlying business.

The threat of regulatory intervention
Ultimately, the bear case for Herbalife is broadly built on the possibility of regulatory intervention. Admittedly, Herbalife's recent quarter suggests the bears could still profit even if the government takes no action. But to achieve his $0 price target, Ackman will likely require the help of government regulators.

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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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