Herbalife's Earnings Report Is Virtually Meaningless

With the exception of the rare acquisition, there are no events more important to investors than earnings releases. Stock prices can be volatile, divorced from the fundamentals, often for long periods of time -- but ultimately, nothing matters more than a company's revenue and profit.

Unless that company is Herbalife (NYSE:HLF).

Herbalife's earnings report came in better than anticipated on Monday -- both the top and bottom lines exceeded analysts' expectations. It raised its guidance and boosted its share repurchase program. Normally, this would be fantastic -- all signs of a company firing on all cylinders.

But Herbalife isn't like any other company -- outside of for the shortest of short-term traders, Herbalife's earnings results are not of major importance.

A limited range of outcomes
If nothing else, Herbalife is a fascinating investment story. While other stocks may face a nearly limitless range of possible futures, Herbalife is a rare exception. For investors, there are really only three potential outcomes:

1. Herbalife is found to be operating an illegal pyramid scheme. Its assets are seized; its business is shuttered. Shares fall, nearly overnight, into the low single digits.
2. Herbalife is exonerated of all charges, or cleared of most, receiving just a minor slap on the wrist. Short-sellers, having bet on the firm's imminent shutdown, are forced to cover. The regulatory overhang on the stock vanishes -- Herbalife rallies sharply higher.
3. Herbalife isn't completely shut down, but isn't in the clear. It's forced to make some significant changes to its business model, but continues to operate.

The third option is most interesting, but impossible to judge: If Herbalife is forced to make significant changes to the way in which it recruits and pays its network of independent distributors, can it still post 18% annual earnings growth like it did this quarter? It's a question worth asking, but it cannot possibly be answered until the army of government agencies (FTC, SEC, FBI and several state attorneys general) currently questioning the company conclude their respective investigations.

Forget about the fundamentals
If hedge fund manager Bill Ackman wasn't convinced Herbalife's(NYSE:HLF) business model was illegal, he would own part of the company. In his own words:

If you closed your eyes and said this is not a pyramid scheme, and you looked at the economic performance of the business, this is a stock that [Pershing Square] would own. We love companies that generate a huge amount of cash, grow at a high rate, have no capex, 90% gross margins, huge operating margins, and management takes all that capital and returns it to shareholders. ... If Herbalife were a legitimate business, [Pershing Square] would own the stock.

In their earnings previews, Fools Joe Solitro and Dan Caplinger pointed out analysts' expectations for Herbalife's earnings heading into the quarter. Normally, these numbers are of the utmost importance to investors, but with all due respect to my colleagues, are basically irrelevant when it comes to Herbalife. The questions surrounding Herbalife do not concern its profitability -- even Bill Ackman, the company's most outspoken critic, agrees that Herbalife's business model is highly profitable.

Instead, the question facing investors is whether or not those profits are derived illegally. If not, the company -- trading with a below market multiple in spite of its consistent growth -- appears highly undervalued. But if Herbalife is operating an illegal pyramid scheme, shareholders are facing the possibility of a catastrophic loss of principal.

It's strange, but investors will get far more insight from watching Ackman's upcoming documentary (judging the relative strength or weakness of his case) than they would reading Herbalife's earnings release.

Herbalife is either a company about to get devastated by regulators, or one whose shares, by Ackman's own admission, are significantly undervalued. Everything else is just noise.