Tuesday, 8 May 2012

How to play Herbalife`s sell off

I am not one with a good history of calling market tops or bottoms, and frankly speaking, I think it is close to impossible to do so. That being said, an investor should focus on asymmetric trading or investment opportunities, which have a much higher risk adjusted expected return than the expected market return. One of this opportunities presented itself in regards to Herbalife stock, which experienced a massive sell-off, after trading in the 70`s a week ago, it is now close to $48. The panic run was generated by an inquiry made by the hedge fund manager David Einhorn on the distribution policy of Herbalife. I consider the worries unwarranted.


Herbalife is a multi-level marketing company focused on the distribution of weight management, nutritional supplements, energy, sports and personal care products. It distributes its products using a multi-level marketing model, by offering discounts to sales leaders. The most notable exception to its independent distributors business model is China, where the company operates a chain of retail stores. As of 31st of March 2011 it has a notable presence in 75 states throughout the world.  


The company has a market capitalisation of $5.49 billion and it sported net sales of $964.2 million in the first quarter of this year according to the most recent company statement. It increased the volume of worldwide sales by 24% in the first quarter, with growth in sales in all of its six regions. The company announced a net income of $108 million, or $0.88 per diluted share, 22% more than in Q1 of 2011.

The operational cash flow generated was $120.4 million, which was used towards the payment of $35.2 million in dividends, $24.9 in capital expenditures and $50 million in share repurchases. While the stock provided generous returns in the past three years, the panic run erased the gains of 2012 and half of 2011. It is in my view an exaggerated response to David Einhorn`s due diligence.

David Einhorn and the recent sell-off

The company experienced a massive sell-off as a result of David Einhorn`s questioning of the accuracy of Herbalife`s company disclosures and its multi-level-marketing strategy and pointing out on the difficulty of discerning which percentage of sales come from distributors and what percentage of sales are towards consumers. In multilevel marketing, the distributor is usually the customer. What happens is that many users ultimately become distributors, and as they find that it is no route to instant riches and requires selling skills to succeed, they end up buying only for their own consumption at a discount. This is not a major problem, because the amount of discount is related to sales volume, and his upline continues to receive commissions on their consumed products.

Stocking the distributors so it would look like the company has a high growth in sales, has been a big problem in MLM companies, but Herbalife has included a contractual obligation to buy back the unsold stock left with its distributors, and it discloses the number regularly: most recent figure is 0.4% of sales. That being said, I`m positive that the 30% drop in prices is unwarranted and the questions posed by hedge fund manager David Einhorn are only part of a so called "reputation trade".

The management announced on the 3rd of May a share repurchase agreement with Merrill Lynch in value of $427.9 million which would complete the company`s 1 billion share buy back authorisation. The programme is expected to be completed no later than July 2012 and they would retire the shares afterwards. To be clear about it, Herbalife announced a definite share buy-back schedule, not like a share repurchase announcement which may lead or may not lead to any actual buy-backs. It signals that management has confidence in the company`s results and considers the shares undervalued.

If the company purchases the shares at an average price of $50 per share, the buy-back would add 15c to the forecasted EPS for 2013, reaching approximately $4.30 per share. At the current price, Herbalife is trading 11x the forward earnings. It was trading at 20x forward earnings before the sell-off.

Investment strategy

Although I am not myself a consumer, nor am I a retailer of Herbalife products, my opinion is that the business model is viable and pre-sell off growth projections are attainable. Apart from buying June 15 $47.5 calls which are currently trading at $4. Or, purchase 70% of the maximum position you would be willing to risk and 30% after the 16th of May Ira Sohn investment research conference, at which David Einhorn will be a guest-speaker. He is expected to make a case against the multi-level marketing business model and try to take down Herbalife in process. Let`s see if his mile-long deck of slides will impress investors in any way.

Charts from Financial Times.

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