Source: Seeking Alpha

Date: Dec 29, 2012

Shares of Herbalife (HLF) are down 44% year over year due to questionable accounting practices, and a publicly announced short-attack by Bill Ackman. To sum up this already well-publicized story, shares of Herbalife first plunged in May when David Einhorn, of Greenlight Capital, questioned how Herbalife quantifies distributors, consumers and other clients. The SEC followed suit, and in mid-August questioned Herbalife about its disclosures on sales by distributors. A formal SEC investigation appears likely sometime in 2013. Noted hedge-fund manager Bill Ackman subsequently announced a massive negative bet on shares of HLF, calling the company a ‘pyramid scheme’. As with all pyramid schemes, Ackman believes Herbalife will implode under its own weight, and HLF shares will eventually go to 0 sometime in the near future. Herbalife plans to respond publicly to these short attacks on January 10th, 2012, and defend their business model.

Despite these strong headwinds, a number of hedge-fund managers have publicly announced they are taking long positions in the stock, because shares of HLF are presently undervalued according to their estimates. In the end, these diametrically opposing views cannot be reconciled, and someone is going to lose. And lose big.

Interestingly enough, no one seems to be debating whether or not Herbalife is actually a pyramid scheme or not. The investment community appears to have accepted this as fact. By contrast, the argument centers around whether or not Herbalife has created the first-ever ‘sustainable pyramid scheme‘ that will continue to drive growth into the future, and thus represents an excellent value pick going forward. In this article, I evaluate these two opposing views (value-stock vs. short-candidate) on Herbalife.

Herbalife as a value-stock

Using the Benjamin Graham criteria for value investing, Herbalife barely receives a passing grade (57%).

SALES: [PASS]
The investor must select companies of “adequate size”. This includes companies with annual sales greater than $340 million. HLF’s sales of $3,897.6 million, based on trailing 12 month sales, pass this test.

CURRENT RATIO: [FAIL]
The current ratio must be greater than or equal to 2. Companies that meet this criterion are typically financially secure and defensive. HLF’s current ratio of 1.39 fails the test.

LONG-TERM DEBT IN RELATION TO NET CURRENT ASSETS: [FAIL]
For industrial companies, long-term debt must not exceed net current assets (current assets minus current liabilities). Companies that do not meet this criterion lack the financial stability that this methodology likes to see. The long-term debt for HLF is $450.1 million, while the net current assets are $261.2 million. HLF fails this test.

LONG-TERM EPS GROWTH: [PASS]
Companies must increase their EPS by at least 30% over a ten-year period and EPS must not have been negative for any year within the last 5 years. Companies with this type of growth tend to be financially secure and have proven themselves over time. HLF’s EPS growth over that period of 482.4% passes the EPS growth test.

P/E RATIO: [PASS]
The Price/Earnings (P/E) ratio, based on the greater of the current PE or the PE using average earnings over the last 3 fiscal years, must be “moderate”, which this methodology states is not greater than 15. Stocks with moderate P/Es are more defensive by nature. HLF’s P/E of 7.06(using the current PE) passes this test.

PRICE/BOOK RATIO: [FAIL]
The Price/Book ratio must also be reasonable. That is, the Price/Book multiplied by P/E cannot be greater than 22. HLF’s Price/Book ratio is 7.96, while the P/E is 0. HLF fails the Price/Book test.

Of these six criteria used in the Graham analysis, hedge-fund managers arguing for HLF as a value play have largely cited the stock’s low P/E ratio, and strong trailing 12 month sales. Even so, the company has considerable debt relative to current assets, and the short thesis directly attacks the company’s sustainability of sales going forward. Overall, the argument for HLF as a value pick at these levels is weak at best.

HLF as a short candidate

Bill Ackman has already laid out myriad reasons why he believes Herbalife is going to go down in flames, and hence the stock should be shorted (see link above). In fact, it’s one of the most impressive investor presentations I’ve ever seen, so there is little to add here. The question thus becomes, can Herbalife grow sales in a manner that does not trigger a massive implosion from within? A recent Seeking Alpha article noted that Herbalife’s true innovation for sustainability is its ability to grow geometrically, not exponentially. The problem with this argument is that the growth rate isn’t the underlying conundrum of pyramid schemes-it’s that they grow at all. Through any form of growth, direct-selling pyramid schemes begin to exhaust precious resources, namely their distributors, upon which the pyramid is built. Geometric versus exponential growth only determines the rate at which the resource is exhausted. At this point in time, heart-breaking testimonials from former Herbalife distributors are popping up all over the internet as a warning to would be distributors. One tasty excerpt from this collection that truly sums up Herbalife’s business model is the following: “Multiply the value of all of your assets by the value of all of your liabilities. Now double that figure. That is how much money you will owe when you file bankruptcy because you were a Herbalife distributor that swindled people into joining that organization.” This was a response to the question, “How much money do I need to give someone to sell Herbalife?”. With such negative sentiment growing among distributors, I see no way in which this model is sustainable. It is collapsing, and fast.

Conclusion

Herbalife’s stock is in deep trouble going forward, and does not represent a decent value pick. The company is unquestionably a pyramid scheme, and is rapidly exhausting its base of distributors through highly negative blogs popping up all over the internet. While the company may look undervalued from a P/E ratio perspective, I believe this is a false buying signal. The strong earnings of Herbalife will begin to dramatically sink once the pyramid scheme reaches critical mass, and implodes under its own weight. In my opinion, it’s time to hit the eject button if you are holding HLF, no matter what your losses are at this point. This stock is going much, much lower in 2013. In sum, HLF still represents an excellent short candidate, despite having already plunged more than 40% this year.

Additional disclosure: Research for this article was assisted by a Biotech Intern (YK) at Enhydris Private Equity, Inc.