Herbalife Nutrition: Controversial But Undervalued (NYSE:HLF) - Seeking Alpha

Mario Tama

By Antonio Velardo

Investment Thesis

We believe that this is a very compelling opportunity for several reasons.

First, the company has a strong brand name and loyal customer base, which can support long-term growth prospects for Herbalife Nutrition (NYSE:HLF). Second, their direct selling model involves giving personalized product recommendations and building a strong relationship with the customers, which can provide Herbalife with a competitive advantage over traditional retailers.

Third, Financials are improving with well-built revenue growth and profitability. Finally, the controversies surrounding Herbalife have led to an undervaluation, creating a potential buying opportunity. We believe that alongside lower P/E, the company is also trading below EPV.

Business Introduction

Herbalife is a multi-level marketing company that offers a variety of nutrition, weight management, personal care, and sports nutrition products. It was founded in 1980 and is headquartered in LA, California.

Herbalife has a network of independent distributors who are responsible for promoting and selling the products directly to customers. They also offer personalized weight management and nutrition plans. These distributors earn commissions on their own sales as well as on the sales made by the people they recruit into the network.

Their product line includes:

• Weight management products include meal replacement products, protein shakes, drink mixes, weight loss enhancers, and healthy snacks.
• Targeted nutrition products, comprising functional beverages, and dietary and nutritional supplements.
• Outer nutrition products, such as facial skin, body, and hair care products.
• Energy, sports, and fitness products, including N-R-G tea and energy drink products.

In addition to their product offerings, Herbalife also provides their distributors with relevant training and support materials. This includes business tools, resources, training courses, and access to a network of other distributors.

Although they have faced criticism and controversies over their business practices and marketing claims, the company maintains a strong presence in their industry and advocates how their business model provides a legitimate opportunity for people to start their businesses.

Billion Dollar Short on Herbalife

The research report on Herbalife will not be complete without the introduction of a huge short and controversy looming over several years.

In December 2012 hedge fund manager Bill Ackman disclosed his short position accusing them of being a pyramid scheme and advocated for their closure. Meanwhile, Carl Icahn, Founder of Icahn Enterprises L.P. a conglomerate holding company went long on Herbalife contending that it's not a pyramid scheme. This ignited a series of public feuds that spanned over several years of legal battles, resulting in a huge loss on Ackman's short position.

Ackman's belief was that the company is a pyramid scheme which is illicit and bound to fail either at the hands of the lawmakers or their own making. He shorted Herbalife in the mid-forties range and after his 300-slide presentation criticizing the company, the stock fell to the mid-twenties. He could have made 100s of millions at this stage but as he held on to the short, the value continued to decline until other investors started buying, contending it to be undervalued. Dan Loeb of third point and Carl Icahn started pushing the stock, resulting in a short squeeze for Ackman.

FTC ultimately decided not to close Herbalife on claims of it being a pyramid scheme and a settlement of $200m was announced which was to be returned to distributors claiming false damages.

Risks

Like any other business, Herbalife is exposed to a variety of different risks that can impact its operations, performance, and the share price. Some of the risks are mentioned below.

• Regulatory Risk: Herbalife operates in a highly regulated industry, and changes in the regulation can affect their operations. Like, increased scrutiny on their sales and marketing practices.
• Litigation Risk: Hardly a year goes by when we don't hear about Herbalife fighting some legal battles on different grounds. Future litigations can impact their performance and hence the stock price.
• Reputation Risk: They have faced criticism in the past on claims of false advertising and their business practices. Future such allegations or practices can further damage their brand image.
• Currency risk: They operate in a number of different countries and around the globe and are exposed to currency rate fluctuations.
• Supply chain risk: Herbalife sources ingredients from around the world, and disruptions in the supply chain can impact their ability to manufacture their products.

Valuation

HLF's last year guidance called for a 4%-10% decline in sales in 2022, but currencies weakened sales by 4.2% in Q4 2022. Additionally, the company got roughly 3% of its 2021 sales from Russia and 1% from Ukraine, both markets have been shut down. In addition to those two factors, last year we had the Chinese lockdowns. Lockdowns in other regions like Vietnam have also impacted the company. Lastly, as the company pointed out, the recent cohort added during the pandemic is churning off at a higher rate

HLF blames the weak cohort on a lack of in-person events from which previous cohorts benefitted. We think this cohort was always a little less committed given when it signed on. It's reasonable to think that the people who got their Peloton in April 2020 will be more likely to quit once gyms reopen, and there is a similar dynamic here. It's unclear how much this impacted HLF sales this year, but the company thinks this is the biggest factor and responsible for most of the change in guidance, so it's reasonable to assume this had at least a 6% impact on revenue.

The good news is that all these factors should resolve or reverse by 2024. So, I view HLF as a company whose true underlying growth rate is mid to high single digits, and we should start seeing that play out by the end of 2023.

Herbalife reported an impressive beat on the top and bottom-line front. EPS was $0.53 against the expectations of $0.34, a positive surprise of 57%. On the revenue front, the company reported $1.18b in sales against the expectations of $1.13b, beating the expectations by 4.5%.

Debt on Herbalife is a concern, Herbalife reported a reduction of $60m in Q4, closing the quarter at 3.47x gross debt over EBITDA which is over the management target of 3.0x, but management is poised to reduce it by emphasizing that the primary use of future cash flows will be to reduce the debt.

We deploy a very conservative EPV model to value Herbalife. We are using two scenarios with very conservative revenue of only $4.6b in column one and ten-year average in column two, which is also consistent with the analyst expectations for revenue in the current year.

Margins for HLF have been volatile over the last 10 years, so we have been very conservative on that front too, using 11-11.5% below the historic average of 13%.

In this approach, we normally add back the growth expenses to analyze what the stock is worth on the normalized earnings without any future growth. But with Herbalife, we want to be as conservative as we can to have a guess of what the stock would be worth. So, with zero in growth capex and taxes of 31%, we get a sustainable NOPAT of $333m and $387m.

With a current WACC of 6.88%, we are using a WACC of 7.0-7.5%. After adjusting for debt position the implied price that we get on our 1st scenario is not that far out to the current stock price but remember we added no growth expense which is very conservative and frankly not true, the company is spending on growth. We just decided to have a conservative view of the stock. In the 2nd column, we get an implied price of $31.56, with an average implied price of $26.

Moat Investing

Conclusion

Despite facing challenges and risks like litigation & Regulatory, 3.47x Debt/EBITDA, lack of growth, we conclude that the company is undervalued, and long-term catalysts make it an attractive stock to hold.

The CEO pledged to deliver growth, and management's prioritization of reducing debt gives us hope that Herbalife will continue towards normalization on the valuation front and shed this pessimistic investor sentiment around the stock. Furthermore, their continued expansion into emerging markets and their new product development are additional catalysts for Herbalife going forward.

We further believe as the overall picture around the demand of these products improves, and the markets such as China which is already in the reopening phase, and hopefully, Ukraine and Russia open in the future, as all these temporary shocks fade, we will start to see Herbalife growing and returning to its full potential and even going beyond our average valuation of $26.

In conclusion, I believe Herbalife represents a compelling investment opportunity for investors who are willing to look past the controversy and focus on the company's strong fundamentals. With a strong brand, loyal customer base, and direct selling model, Herbalife is well-positioned for long-term growth. Furthermore, the company's improving financials and undervalued stock create a potential buying opportunity for investors looking for a high-growth investment in the nutrition and weight management industry.