Recovering from the Einhorn Effect
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
During the first half of May, shares of Herbalife (NYSE: HLF) suffered a dramatic fall, from an all-time high near $73 to a low of $42.15. The main reason for that fall was the presence of famous hedge fund manager David Einhorn in the company's earnings release press conference. Einhorn asked some questions regarding the difference between sales to end customers and distributors, hinting at the possibility of lack of transparency in the company’s report.
Herbalife is a network marketing company that sells weight management, nutritional supplement, energy, sports and fitness, and personal care products all over the world. The network marketing business model is working pretty well for the company; this structure provides high profit margins and low operational risk since it's a very flexible way to expand the business quickly and efficiently.
On the other hand, is not easy to tell if sales are done to final clients or distributors, and that means the industry is always under suspicion of building a pyramid scheme in which most of the buyers are the distributors instead of final consumers. Einhorn's questions were in fact pointing in that direction: So, what is the percentage that actually sold to consumers that are not distributors?
Einhorn didn't make any concrete accusations against the company, and after his comments in the press conference he didn't mention Herbalife again, not in his public appearances or in letters to investors in his fund. The company's management provided reasonable answers to Einhorn's questions, and even published extra disclosure material after the conference.
The reaction from the markets was fast and furious, perhaps because the memory of what happened to shares of Green Mountain Coffee Roasters (NASDAQ: GMCR) is still fresh on investors' minds.
David Einhorn delivered a big blow to Green Mountain last October when he went public with a presentation questioning the company's financial health and accounting practices. The shares were above $115 in September 2011 and are currently trading below the $18 level. With that precedent in mind, investors decided to sell Herbalife first and ask the questions later.
But that may have been a mistake. Shares of Herbalife started recovering as investors realized that there were no concrete accusations against the company, and they even saw a subsequent 6% rise when Herbalife reported better than expected results. The stock has now recovered a considerable portion of its fall due to “the Einhorn effect” trading in the $55 zone, but there is still some upside room until reaching its $70 price range prior to the fall.
The report was quite strong, with sales increasing at a 17% and the Asia Pacific region delivering an outstanding 25% growth rate. China in particular was very stimulating with a 50% increase in yearly sales. And this is not the first time that Herbalife delivered strong growth rates; the company has a very solid track record with earnings per share growing at a 28% on average over the last five years.
One important thing is still missing in this story, though. Herbalife should make a much bigger effort to bring transparency into the subject of consumers vs. distributors. It shouldn't be so difficult to quantify a few figures regarding sales in order to differentiate among its consumers.
The situation won't be clear enough until the company delivers more detailed information on these subjects, but a strong earnings report certainly helps at recovering trust from investors. Herbalife is not out of the woods yet, but if the company provides some extra information regarding sales figures, this stock should be able to quickly recover the $70 zone, where it was trading before it became a victim of the Einhorn effect.
acardenal has no positions in the stocks mentioned above. The Motley Fool has the following options: long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters and short DEC 2012 $21.00 calls on Green Mountain Coffee Roasters. Motley Fool newsletter services recommend Green Mountain Coffee Roasters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.