Herbalife (HLF 3.83%) is a multi-level marketer of various weight management and meal replacement products, including shakes and teas. The company was founded in 1980 and has grown to attain a market cap of over $6 billion. Since hedge fund manager Bill Ackman launched his short thesis and campaign against Herbalife in December of 2012, there has been a very contentious debate over the legitimacy and even legality of the company's business. Shares of the company have been very volatile since then, especially as major investors have taken an opposing view to Ackman and have gone long on the stock.
While some may have concerns over potential Federal action against the company resulting in severe penalties, I see this as a low probability event given the company's history successfully operating in the United States combined with the specifics of "pyramid" and "ponzi" schemes laws, which I will discuss later. However, given that Herbalife's compensation is based on actual product sales to consumers, both in their network and outside of it, it is hard to conceive a scenario where it could be found to be in violation of American "ponzi scheme" laws. As such, Herbalife is a strong business with operating leverage and momentum and is trading at rather inexpensive levels based upon the historic and forecasted earnings.
Herbalife: A Legally Compliant Multi-Level Marketing Company
Before I discuss my thoughts of Herbalife and applicable laws, I want to include a statement from Debra A. Valentine, former general counsel for the Federal Trade Commission or FTC during a 1998 speech titled, "International Monetary Funds Seminar on Current Legal Issues Affecting Central Banks:"
Some people confuse pyramid and Ponzi schemes with legitimate multilevel marketing. Multilevel marketing programs are known as MLM's, and unlike pyramid or Ponzi schemes, MLM's have a real product to sell. More importantly, MLM's actually sell their product to members of the general public, without requiring these consumers to pay anything extra or to join the MLM system. MLM's may pay commissions to a long string of distributors, but these commission (sic) are paid for real retail sales, not for new recruits.
I think that the above quote accurately represents the significant market misunderstanding currently experienced by many betting against Herbalife. Herbalife sells real and tangible products, and while they are sold through a non-traditional distribution technique this does not delegitimize the business. Additionally, compensation is based upon actual sales, not the simple recruitment of additional individuals into the program.
Back in October of last year, the Office of Investor Education and Advocacy within the Securities and Exchange Commission, or SEC, issued an investor alert titled, "Beware of Pyramid Schemes Posing as Multi-Level Marketing Programs," which issued a few red flags of attributes of illegal pyramid schemes to watch out for. They included the following advice:
When considering joining an MLM program, beware of these hallmarks of a pyramid scheme: No genuine product or service. MLM programs involve selling a genuine product or service to people who are not in the program. Exercise caution if there is no underlying product or service being sold to others, or if what is being sold is speculative or appears inappropriately priced.
Herbalife pays compensation to its distributors based upon sales of product, not for simply bringing in new members into the program. This is probably the most important distinction of the business and separates it from illegal pyramid schemes posing as multi-level marketing companies.
Herbalife: a cheap, growing and geographically diverse company
If investors were to focus on the strong fundamentals of the company, shares would likely trade significantly higher from where they are today. Shares currently trade for 10.2x 2014 earnings estimates and 9x 2015 earnings estimates. Nu Skin Enterprises (NUS 1.93%) and USANA Health Sciences (USNA 1.00%) are somewhat comparable multi-level marketing companies and the two trade for 11.8x and 12.8x 2014 earnings estimates, respectively. These multi-level marketing companies have been somewhat overlooked and misunderstood due to the perceived regulatory threat that they face.
Analysts are expecting Herbalife to grow EPS by a healthy rate of 15.5% from this year to next. The company grew adjusted EPS by 18% from Q1 2013 to Q1 2014 while also generating strong volume growth of 9% during the same period. The company has guided for 2014 diluted EPS to come in at a range between $6.10 and $6.30 and I have a large amount of confidence in their ability to execute on these goals.
Management has shown a very strong commitment to providing shareholder returns as they have been intently focused on returning value through share buybacks; they even terminated the dividend to focus on repurchasing shares instead. Since 2007, the company has bought back approximately $2.85 billion in shares. Additionally, Herbalife is geographically diversified with strong emerging market exposure. North American sales only represented slightly more than 20% of revenues in Q1 2014. Roughly 82% of the company's sales were outside of the United States in 2013. China has been an important growth driver in recent years, especially as sales grew over 95% from Q1 2013 to Q1 2014. This geographic diversity is important as any adverse legislation in one jurisdiction may not have a tremendously significant impact on the business as a whole.
HLF Average Diluted Shares Outstanding (Quarterly) data by YCharts
Herbalife remains an undervalued and misunderstood company
Herbalife does not appear to be in violation of applicable "ponzi" or "pyramid" scheme laws in the United States, however the perception of regulation risk has hurt investors' appetite for the company's shares. As a result the company trades for rather inexpensive valuation metrics despite strong operating momentum and management's commitment to providing returns for shareholders. As the risk of adverse regulatory action dissipates and the market realizes the minimized probability of this, shares could rally significantly.
