2023-06-15 13:03:50 ET
Summary
- Herbalife is a controversial business with a fair share of risks associated with its operations.
- The recent post-covid sell-off has been excessive, leading to a deep-value opportunity.
- A 65% undervaluation has created a real opportunity for a mid-term intrinsic value play.
- 2023/2024 returns should be more positive and return the company to greater profitability.
Investment Thesis
Herbalife ( HLF ) is a controversial company whose shares have endured a difficult history over the last two years.
Strong returns during the COVID-19 pandemic resulted in investor expectations exceeding what the company was ultimately capable of returning in the long-run.
This mismatch gave way to a huge market sell-off which has resulted in shares now being 65% materially undervalued.
I believe the company should see a return to stronger growth figures in 2023/34 which should pave the way for further increased returns for shareholders.
Company Background
Herbalife is a global nutrition company that provides health and wellness products to consumers primarily through their direct-selling business. The firm’s products are primarily distributed across the weight management, sports nutrition and targeted nutrition segments.
The “direct selling” model Herbalife refers to as their primary sales medium is simply a Multilevel Marketing ((MLM)) network. This practice involves independent members of Herbalife acting as product distributors and resellers. These members also try to get new customers to become members (or sales agents) to further grow the distribution and sales of Herbalife’s products.
Members are incentivized to attract more people into the selling network through financial bonuses.
While Herbalife’s MLM sales model is considered by some to be quite controversial (myself included), their strong 43-year history and continued growth combined with a unique suitability of this sales medium for their products is difficult to ignore.
While recent results have been less than inspiring with revenues, net incomes and sales dropping since 2022, a turnaround may be on the horizon for Herbalife.
Therefore, a fundamental company analysis combined with an intrinsic and absolute valuation is necessary to better understand what value may lie for value-oriented investors in Herbalife’s shares.
Economic Moat – In Depth Analysis
Herbalife’s economic moat is primarily driven by the extensive networking effect derived from the direct-selling sales channel. Some moatiness is also derived from the more recognized and enduring image the company holds.
While their nutrition products are generally some of the most widely known and accepted in the market, particularly in the U.S., the high levels of competition in the supplements and sports nutrition environment makes true product differentiation difficult.
While it is arguable that Herbalife has achieved a certain level of differentiation by focusing primarily on weight-loss supplements, assigning any real economic moat to these products is difficult.
Nonetheless, Herbalife’s extensive advertising campaigns and high-profile brand ambassador signings such as Cristiano Ronaldo and the LA Galaxy MLS soccer team continue to drive the brands reputation in the public eye.
While these brand deals do little to directly create a long-lasting and tangible economic moat, I believe the positive publicity this brings the company is critical.
By showing consumers that professional athletes are willing to trust Herbalife to be their exclusive nutritional partner, it creates an image of trustworthiness and quality among potential customers.
This increased reputation undoubtedly increases the propensity for a consumer in the market to choose Herbalife products over the competition and even become a member of the direct selling system.
Herbalife’s relatively well-known reputation and high-profile brand ambassadors earn the company some moatiness and help slightly differentiate themselves in a highly competitive market.
Herbalife.ie | Start Your Business
The greatest source of moatiness for the company has without question stems from their direct selling network. As of 2022, Herbalife had over 6.2 million members including 2.9 million preferred members and 2 million distributors.
By getting members to directly sell Herbalife products to their friends, family and other consumers in general, Herbalife achieves an almost unprecedented level of customer interaction in their sales mediums.
By having individuals sell their products, Herbalife is able to increase the reliability and trustworthiness qualities in their sales channel as potential customers most likely know the member attempting to make the sale.
This familiarity can make people significantly more likely to purchase Herbalife products.
Herbalife.ie | Start Your Business
Furthermore, Herbalife provides members with a certain level of freedom when it comes to marketing their products and services. This provides many members with a critical level of autonomy which allows for entrepreneurial spirit to be applied.
This freedom to market and sell the products as they please can motivate many sellers who psychologically may see themselves as small-business owners. The benefit to Herbalife is that many direct selling members invent innovative and community-oriented marketing solutions such as the “Nutrition Clubs” marketing technique used by members in Mexico.
The key revenue driver for Herbalife is that many of these direct-sellers target consumers on a “daily consumption” basis. This means customers may only purchase one or two products at a time, but do so at highly frequent intervals.
Not only does this allow the customers to try-out products before committing to a larger quantity, but such frequent, lower cost purchases often allow for increased cross-selling (the increased sale of auxiliary products which complement the core line-up).
Such low-volume, high frequency purchases can also significantly increase perceived customer satisfaction as the lower price-tag burdened by the consumer generally sets lower relative expectations for the product.
The direct-selling model also includes Herbalife selling their products to these seller members at wholesale prices so that these entrepreneurial individuals may then make a profit off their sales.
When combined with a volume incentivizing “Volume Points” performance measurement metric used by the company to assign a “Level” of each member in the context of their overall Market Plan, Herbalife is able to significantly drive the sale of their products.
The higher a level a member has, the larger the discount they then receive on further Herbalife product purchases. This creates a significant sell-motivation which drives sales both for members and for the company.
While the direct-selling business undoubtedly has a reputation of companies dumping products on sellers, Herbalife has recently become the leading firm when it comes to transparency in this process (following an FTC probe in 2016 leading to a restructuring of the business).
Herbalife accepts a full net-price buyback of unsold and unopened merchandise from its sellers for any goods purchased from the company over the TTM. This open approach allows sellers to be less burdened by a pressure to sell products which allows them to conduct business at a rate which best suits them.
This also increases the propensity for someone looking to enter the direct-selling business to choose Herbalife products and the company as their partner thanks to the more trusting relationship present at the firm.
Overall, Herbalife has mastered the direct-selling business model to ensure members are motivated to sell products and particularly, to sell at a total high volume while ensuring trust is present in the network.
When combined with the high-quality nature of their products and the high-profile ambassadors the company has for its nutritional range, Herbalife does manage to create a narrow yet tangible economic moat.
I believe this could earn the company a reasonable competitive advantage over other direct-selling and nutritional competitors for at least the next five years.
Financial Situation
Herbalife has had a relatively solid fiscal history since 2013 with the last couple of years being a little less than impressive. Their 5Y average ROTC is a healthy 18.89% with their ROA for the same period being 9.39%. Their 5Y gross, operating and net margins are 79.45%, 12.09% and 6.28% respectively.
These relatively strong 5Y operating indicators illustrate the fundamental profitability which exists at Herbalife. Unfortunately, the last couple of years have not been kind to the business with multiple headwinds leading to dropping profits despite reasonable revenue growth.
Net sales for FY22 decreased 11.7% YoY due primarily to a drop in sales volumes of almost 19.8% which was offset by an 8.5% favorable impact of price increases for sales.
While this sales drop is initially alarming, the COVID-19 Pandemic is largely the cause. Due to the restrictions placed by the pandemic on citizens across the globe, many individuals became seller members at Herbalife which drastically increased sales figures for these periods.
The ability to sell these products from home despite social distancing restrictions resulted in boosted sales figures and even more highly motivated sellers. This brought Herbalife strong revenues and net incomes for 2021. In 2022, as restrictions were eased and removed, some sellers departed the company which is primarily the reason net sales fell so drastically YoY.
This effect was particularly noticeable in China along with EMEA and North America.
In general, 2022 was quite lackluster compared to the strong FY21 and FY20 the company enjoyed. While net sales fell 11.7% YoY, the comparative increase in COGS as a percentage of net sales increased from 20.8% in FY20 to over 22.6% in FY22.
Selling, general and administrative expenses were maintained at around 35% of net sales which illustrates a highly efficient management of the company’s operations given the highly inflationary environment already encountered in FY22.
Overall, while FY22 was not great, the fundamental qualities of Herbalife’s business model have gone unharmed. The expectation for the firm to replicate the monster revenues of FY20/21 were excessive and a return to a more realistic scale has occurred.
When comparing on a longer timescale, Herbalife has still grown revenues by 8% since 2019 when compared to 2022 figures. This illustrates their consistent and well-paced expansion is still taking place which supports the thesis that core profitability is unharmed.
FY23 Q1 results have unfortunately not shown a marked improvement in sales with net figures dropping 6.3% YoY. While this decrease is only 2.6% on a constant currency basis, it is not the news many investors would have liked to see.
Net income was down 70% compared to Q1 FY22 to just $29.3M. While a $27M one-off pre-tax expense can be attributed to the costs relating to the company’s Transformation Program turnaround plan, even then net income still fell 42.7% YoY.
The company’s Transformation Program is a plan designed to help Herbalife achieve optimized global processes which will enable future growth. This turnaround program has a significant focus on digitization and modernization of Herbalife’s business model to ensure it remains relevant and applicable to today’s consumers and seller members.
The significant drop in net sales YoY was primarily due to weaker than anticipated performance in China and the United States. This was once more attributed to the total drop in seller members due to the return to pre-pandemic business practices.
However, the company did note that in Q1 FY23 a return to in-person events attracted more than 400,000 attendees across 700 different sales events. This should help drive further engagement from a seller member perspective which in-turn could enable better results for the remainder of the year.
For the first time in three years, Herbalife was able to organize an independent distributor leader meeting in Los Angeles which saw over 2,700 leading sellers gather together to observe a preview of the company’s long-term targets and growth objectives.
Furthermore, the company is on-track in their modernization process which includes launching new, more intuitive websites and a seller-wide e-commerce platform to increase the marketability and volume of sales.
I believe these critical improvements (part of the Transformation Program) should help Herbalife to become a more profitable and streamlined business fit for a post-covid consumer environment.
Seeking Alpha | HLF | Profitability
Seeking Alpha’s quant assigns Herbalife a " B +" profitability rating. I believe that this rating is a representative snapshot illustration of the company’s current profit generating abilities.
A critical element which impacts Herbalife’s potential for future profit generation is the prevailing trend of global macroeconomic conditions. The incredibly high probability for a recession to occur in H2 of 2023 could be a lucrative opportunity for the company to attract new sellers to their direct selling network.
As many lower-income consumers become increasingly exposed to inflationary pressures along with a more bearish job market, the opportunity Herbalife presents could become increasingly attractive.
Herbalife’s balance sheet looks to be in healthy shape too. The company currently has $1.32B in total current assets while total current liabilities only amount to just $1.23B.
This illustrates the relatively conservative fiscal strategy being pursued by management with regards to their expansion and acquisitions which is welcomed news for investors. Herbalife’s reasonable liquidity is further supported by the $508M the company has in cash.
Moody’s assesses Herbalife with a Ba3 CFR. They maintain that due to Herbalife’s controversial sales model and exposure to developing markets, the company must maintain stronger credit metrics than comparatively more securely footed piers.
The company has a debt/equity ratio of just 0.766x which again is reasonable. Their quick ratio (current assets minus inventory divided by current liabilities) is 0.44.
Herbalife has just recently upped its financial leverage from 3.75x to 4.50x effective December 31, 2023. This has been done through an amended Senior Secured Credit Facility. Planned step-downs to 4.25x and 4.00x are planned as of March 31, 2024.
While an increase in long-term debt leverage is not always welcomed news, this should provide the company with more financial flexibility to make investments in key initiatives especially related to the modernization of their business.
Herbalife is also known to engage in debt-financed share-buybacks which I believe the company will continue to do in the short- to mid-term future given the low price of their shares.
The company’s long-term debt consists of a $2.4B portion. While the majority of notes are due after 2025, the relatively high interest rates on some of these credit facilities is less than desirable.
Overall, it is clear that the management at Herbalife is aware of the factors that are hindering growth at the firm. The acknowledgment and creation of a plan aimed at modernizing the business is a positive step in the right direction which should help the company maximize their core profitability while continuing to grow in the future.
Valuation
Seeking Alpha | HLF | Valuation
Seeking Alpha’s Quant has assigned Herbalife with an “ A “ Valuation rating. I find this valuation to be an accurate overview of Herbalife's current valuation. I believe shares are currently trading at a reasonable discount compared to their future cash generation abilities.
The firm is currently trading at P/E GAAP FWD ratio of just 5.87x and a P/CF TTM ratio of only 4.60x. Their FWD EV/EBITDA of 6.31x is quite low in my opinion, along with their EV/Sales TTM of just 0.71x.
To emphasize, Herbalife is trading at only around 70% the value of their significantly hampered 2022 sales.
I believe these figures alone suggest that Herbalife could be trading at a pronounced undervaluation compared to the intrinsic and future value present in the firm.
Seeking Alpha | HLF | Summary Chart
From an absolute perspective, Herbalife shares are trading at their lowest price in years. Current prices of around $12.20 represents a 52-week low with prices last having reached these levels back in 2011.
Seeking Alpha | HLF | Earnings
By accomplishing a simple financial valuation based on the calculation below and using the estimated 2023 EPS of $2.59 a conservative r value of 0.03 (3%) and the current Moody’s Seasoned AAA Corporate Bond Yield, we can derive a base-case IV for Herbalife of $35.00.
The Value Corner
Even when using this conservative CAGR value for r, Herbalife appears to be undervalued by huge 65%.
When using a more optimistic CAGR value of 0.5 (5%), shares are valued at around the $45 mark, which would represent a present 73% undervaluation.
Therefore, I believe Herbalife as a company is currently trading safely in deep value territory. If the firm is able to put even 3-4% growth back on the cards in 2023/2024, I believe significant returns are on the horizon for investors.
I remain hesitant to consider the full 65% discount and cautiously apply a 20% margin of safety under the pretext of controversy hindering overall gains. Still, a 45% base-case safety margin applied undervaluation is very tempting.
In the short term (3-10 months) it is difficult to say exactly what the stock will do. Much depends on the prevailing macroeconomic conditions and how reluctant investor sentiment will be to realize the true fundamental profitability that lies at Herbalife.
In the long term (2-4 years) I expect their position as a market leading direct-selling business to become even stronger. Their extensive network of sellers and core product combine to create a relatively high-quality (if controversial) business.
I believe current share prices represent a classic lagging-sentiment mistake by Mr. Market. A base-case 65% undervaluation is simply too large to ignore.
Risks Facing Herbalife
Herbalife faces a multitude of risks. The most influential are its exposure to controversy, government regulation regarding MLM businesses, significant operations in developing markets along with the long-term risks associated with a reliance on seller member growth.
The direct-selling or MLM business model has long been criticized by a number of regulatory agencies due to the relative lack of profitability this model creates for the individual sellers. Many have criticized such structures as preying on vulnerable individuals who have few marketable skills by creating an alluring yet fragile image of small business entrepreneurship.
Furthermore, most individual sellers struggle to make profits. According to the FTC, a whopping 99% of MLM sellers fail to make a profit. While this data is very difficult to aggregate for Herbalife due to the individual nature of their 6.2 million sellers the holistic picture isn't very positive.
This has placed the sales model under intense scrutiny by many regulatory bodies and could mean that future anti-competitive action could be taken by the authorities to limit or band such activities in certain states, nations or regions.
Federal Trade Commission | Consumer Alert
Back in 2016 Herbalife was engaged in a significant controversy which resulted in the firm having to pay back member sellers who had lost money with the firm. This resulted in Herbalife restructuring their business model to focus on selling products rather than recruiting new sellers which ultimately was beneficial for the company’s profitability and reputation.
In the long-term such action could significantly harm Herbalife’s profitability and overall ability to generate meaningful returns for its shareholders.
Herbalife’s extensive operations in Asia and China also expose the company to significant developing market risk where frequent currency and market fluctuations could harm profitability and sales.
Their operations structures in these regions have for long benefitted from being robust and secure compared to the lack of infrastructure plaguing traditional sales mediums. However, as many of these fast-growing nations develop a larger middle class and more competitive market landscapes, Herbalife could find their market share and allure decreasing.
Finally, Herbalife ultimately relies on recruiting more and more sellers into their direct-selling network to ensure sales volumes and future revenues continue to grow. Given that such growth ultimately cannot be achieved indefinitely, it does place the longevity of this business under question.
Given the increasing focus many attribute to sustainability and conscious spending, such a model could prove unfit for the demands of future generations.
From an ESG perspective, the aforementioned risk of poor business ethics arise when discussing Herbalife’s extensive MLM structure.
Summary
Herbalife is a controversial direct-selling company which has had a tumultuous and complicated history. While profitability has endured throughout their over 40-year existence, the questions regarding business ethics and overall sustainability of their sales model remain.
Nonetheless, from a pure value perspective it is difficult to argue Herbalife being anything else than hugely undervalued. A base case 65% undervaluation is hard to ignore with future profitability looking more positive over the next two years.
While it may be difficult for the company to replicate its monster returns in 2020/2021, a potential recession in 2023 could prove beneficial for the company and in-turn for its shareholders.
I remain hesitant to consider the full 65% discount and cautiously apply a 20% buffer margin under the pretext of controversy hindering overall gains.
Nonetheless, given the huge discount and fundamentally undervalued nature of their shares, I rate Herbalife a Strong Buy. I try to keep in mind that one doesn’t have to buy the company’s products in order to benefit from a rise in share prices.
For further details see:
Herbalife: Questionable Business, Undeniably Good Value