Bears Should Be Wary Short Selling Herbalife

Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When a stock plunges in a very short amount of time, it can be like giving candy to value investors. Sometimes, a disappointment in earnings results in a sell-off in shares, creating a discount to its intrinsic value. Other times, fears in accounting, a bad takeover, or a legal dispute will cause the company’s share to decline in a single day.

In December, Herbalife (NYSE: HLF) dropped over 40%, but has since recovered. Herbalife shares fell after Bill Ackman, founder of Pershing Square, created a website to illustrate why he assessed the company as a pyramid scheme. The document, titled “Who Wants to Be a Millionaire” was posted here. Since Dec. 19, shares declined rapidly, finding a bottom on Dec. 24. Even Whitney Tilson joined in adding a short-selling position in the company.

Upside

With heavy coverage throughout the media outlets, investors should note the kind of comments being posted in response to the story. Users relate the pyramid scheme allegation to other companies working in a similar, alleged way. The assertion of the scheme from user comments is not directed towards Herbalife itself. Ackman is convinced that the stock will collapse.

To reverse the momentum in negative sentiment, investors should expect the company to take steps to restore confidence. It could buy back its shares, which implies a higher stock price in the short term. Another possibility that would realize shareholder value is a takeover of Herbalife. In the short term a short squeeze could lift shares back to $45, its pre-selloff price.

One firm recently disagreed with Ackman’s assessment for the company, and set a target of $72. The firm believes that long-term, the company is worth $120. The firm believes the company will return 200% in 2013 and 330% in the long term.

Downside

Ackman cites such things as litigation activities against the company, marketing methods, and top compensation, to characterize the alleged pyramid scheme. For example, active leaders earned between just $901 (83.9% of active leaders) to $514,638 (0.6% of active leaders):

Avg Compensation

% Active Leaders

$514,638

0.60%

$100,195

1.70%

$22,766

6.50%

$6,224

7.30%

$901

83.90%

Valuation

Assessing the valuation of a company has much less importance if a company’s reputation is tarnished and day-to-day business impacted, its business model broken, or there are accounting irregularities. In this case, Herbalife’s reputation on the stock market is under attack, but not completely lost.

The company has:

  • $1.2 billion liabilities against $1.6 billion total assets (77% leverage)
  • Dividend per share of $1.20 or 3.73% yield
  • Price to Earnings of 8.4x
  • Forward Price of Profit of 8x
  • Price to Book Ratio of 10.6x

Only the price to book ratio is of concern. The retail/wholesaler has very little in the way of product on its book. Over the last four years, however, inventory increased:

 

12/31/2008

12/31/2009

12/31/2010

12/31/2011

Inventory

134.39

145.96

182.46

247.69

values in millions USD; Data Source: Kapitall.com

On the cash flow statement, financing activities increased, but is normal, as the company expands its business in new geographic markets:

 

12/31/2008

12/31/2009

12/31/2010

12/31/2011

Issuance Equity Shares

-119.41

-66.75

-144.69

-299.37

Net Cash From Financing Activities

-205.06

-213.32

-254.48

-337.79

values in millions USD; Data Source: Kapitall.com

Annual expenses are manageable. Administrative expenses are matched with changes in revenue.

 

12/31/2008

12/31/2009

12/31/2010

12/31/2011

Selling General Admin Expense

1,568.56

1,535.41

1,787.90

2,212.18

% Change:

 

-2.1%

16.4%

23.7%

Net Sales or Revenues

2,359.21

2,324.57

2,734.22

3,454.53

% Change:

 

-1.5%

17.6%

26.3%

Gross Profit

1,900.81

1,831.44

2,175.41

2,774.45

% Change:

 

-3.6%

18.8%

27.5%

values in millions USD; Data Source: Kapitall.com

Conclusion

Speculators should expect Herbalife shares to continue to rise, due mostly to a short squeeze. In the long run, the value of the company will depend on actions taken by the company to defend its reputation. Herbalife must first prove that it is not a pyramid scheme, even though the company was established in 1980. Ultimately, the process for setting up product distributors must be shown to be sustainable. While the compensation model appears to look like a pyramid scheme, top sellers in any business will command the largest share of income and will represent the smallest percentage of sellers.

For now, short sellers hold the greatest risk. Herbalife’s valuation is just 8x. Investors interested in a long position for this company should do so in increments. This would limit losses if the accusations prove true, but will reward investors who enter the stock at its current price.


chrispycrunch has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus

Compare Brokers

Fool Disclosure