A Growing Dividend Pick at Armageddon Prices

Why Herbalife's business may not collapse under FTC scrutiny, and how investors can profit by buying now.

Apr 2, 2014 at 1:23PM

Shares of Herbalife (NYSE:HLF) have been on the rise since last Monday when news came out that activist investor Carl Icahn had appointed three individuals from Icahn Enterprises (NASDAQ:IEP) to the company's board of directors.

The company, which manufactures weight loss and dietary supplements, had been under pressure after the announcement that the FTC would investigate allegations that the company was a large pyramid scheme. Hedge fund manager Bill Ackman had raised these concerns at the end of 2012 when he declared his massive billion-dollar short position and gave a 342 page presentation that explained why he bet against the company.

In spite of these pressures, however, Herbalife's fundamental business remains intact and the recent decline in share price may present investors with an opportunity to buy a stable, dividend-paying growth company at an extremely cheap valuation, albeit not without risk.

The battle in Washington
Bill Ackman has been lobbying to try to get Herbalife's business shut down, which is why last year Ackman spent $264,000 to hire lobbyists. Additionally Senator Ed Markey from Massachusetts had called on the SEC and FTC to investigate Herbalife after he received complaints from constituents.

While a lot of political money has gone into shutting down Herbalife's business, the company has used even more to fight back. Last year Herbalife spent $1.9 million on lobbying efforts, or over seven times that spent by Bill Ackman. This significantly tips the scales in Herbalife's favor.

A ponzi by any other name
Even if Bill Ackman turns out to be right and Herbalife is a de-facto pyramid scheme, the company and the stock could still do well if the company does not meet the legal definition of a pyramid scheme.

In order for the FTC to consider Herbalife a pyramid scheme the regulatory agency needs to show that the majority of Herbalife's business comes from recruiting new distributors rather than through sales of its products.

There are a couple of problems with this requirement.

The main problem is that many individuals sign up as distributors with no intention of selling the products so that they can receive discounts on products. According to the company 73% of those who sign up to become distributors do so to receive discounts on products that they personally consume. The burden of proof lies with the FTC to show that the company's distributors are not personally using the products, but rather keeping them as unsold inventory.

This is an uphill battle that the FTC has faced and lost before.

Amway precedent
In 1975 the FTC went after Amway because of complaints similar to those against Herbalife, but Amway eventually received a decision in its favor (93 F.T.C. 618).

Because Amway derived most of its revenue from product sales rather than the recruitment of new distributors, the decision deemed the company's distribution model legal.

Given this precedent it is likely that the FTC will drop its investigation of Herbalife.

The FTC, legislatures, and Bill Ackman face an uphill battle in trying to regulate or take down Herbalife's business. It is unlikely that the company's business model will be destroyed through a court order or significant regulation in the foreseeable future.

Investors also should not fear regulation in China
While investors have been terrified of the FTC taking action against Herbalife in the U.S., there has also been fear over the Chinese market.

Shares of multi-level marketing company Nu Skin (NYSE:NUS) fell precipitously in January after Chinese regulators announced that they would investigate the company for misleading advertising and business practices.

On Monday Nu Skin's shares retraced after Chinese regulators announced a relatively small fine for the company of $540,000, which alleviated worries that the government would go after the company with harsher penalties.

The Nu Skin fine should give Herbalife investors confidence that the Chinese government won't go after multi-level marketing companies with much force and that Herbalife's growth in China should remain stable.

Valuation
At $57 a share Herbalife currently trades at 11.6 times trailing-twelve-month earnings and at less than 9.5 times 2014 earnings. This is especially cheap when you consider that over the past five years the company has managed to grow its net income at an annual rate of 21.2%, decrease its share count by nearly 15%, and triple its dividend.

Herbalife looks likely to improve further in these areas going forward. The company is continuing to grow on both the top line and the bottom line. The board has increased their share buyback program to allow the company to repurchase up to $1.5 billion worth of shares. If the company continues to grow earnings as it has done in the past there is no reason to believe that it won't also increase its dividend at some point in the future.

Herbalife is priced for an Armageddon scenario that is unlikely to occur. If the FTC does not place any fines on the company and new regulations do not appear, then the share price should go up substantially. Even if minor fines and new regulations do affect the company, it should still do well.

Given Herbalife's low multiple to earnings, consistent growth rate, and habit of rewarding shareholders with stock buybacks and dividends, Herbalife may be one of the most undervalued companies on the market.

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Kyle Farrah owns shares of Nu Skin and Herbalife. The Motley Fool has the following options: long January 2015 $50 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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