Don't You Dare Short this Company

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

I'm always shocked when I hear that short-sellers are betting against a highly profitable and fast-growing stock. I understand that the company could decline and the shorts could make a lot of money. However, I wouldn't make a bet where the maximum gain is 100% and the amount of loss is unlimited. Short-sellers are betting against Herbalife (NYSE: HLF), which came under attack when David Einhorn questioned the company's business model and financial reporting.

In a recent article on, Jeremy Bowman looked at both sides of the trade. In his piece  "Are the Shorts Killing These Stocks," he mentioned both the Einhorn connection, and the fact that this is a multilevel marketing company as reasons for short-sellers to bet against the stock. On a positive note, the company's business practices were questioned by the SEC and Jeremy believes they put any issues to rest. In theory, this should have caused a recovery in the shares, but they have barely recovered since their 30% drop. Short-sellers seem to have jumped the gun anticipating a large investor like David Einhorn would short the stock. However, Einhorn never actually took out a short position. As a contrarian at heart, I look for opportunities in situations that others would avoid, which is why I think Herbalife could be an attractive investment.  

For those who don't know the Herbalife story, the company operates similarly to other weight-lmanagement companies. It uses distributors to sell its weight-loss  products, nutritional supplements, and personal care products. This puts the success of the company in the hands of its individual distributors. Since these distributors make more money as they move up the ladder, in theory this creates a virtuous cycle of growth. Of course, the weight-loss industry is rife with competition, and the largest player is Weight Watchers International (NYSE: WTW).

Weight Watchers' business model is somewhat different from Herbalife's. The company opens centers for in-person support, and provides on-line help, but does not focus on person-to-person sales. By at least three different measures, Herbalife seems like a better value than Weight Watchers. The company's dividend yield of 2.6% is exactly double that of Weight Watchers at 1.3%. Second, the company's P/E ratio on 2012 earnings is 11.51, versus Weight Watchers, which trades for nearly 13 times its anticipated earnings. Last but not least, analysts expect Herbalife to grow earnings at almost 15%, versus Weight Watchers’ expected 11%. It appears Herbalife could be a better value, but we need to make sure the company's reported earnings support the growth analysts expect. Though the company reported earnings almost two months ago, its last release gives us an idea of the type of growth investors can expect.

According to Herbalife's July earnings report, sales increased 17%, and EPS was up 25%. These increases were driven by strong volume growth of 23%. Growth was strong across the company's operating segments with at least 13% volume growth in each of its regions. The standout areas were Asia-Pacific, South & Central America, and China, which all showed volume growth of at least 29%.

The company also took several steps to reward long-term investors. It initiated a new $1 billion share buyback program, and repurchased almost $240 million worth of shares during the current quarter. The company also generated significant free cash flow, and its dividend payout ratio was just 28.75%. This should give investors confidence that the company's dividend yield is well covered and could grow further. Herbalife's full-year outlook was also positive, with expected sales growth of 10% - 12%, and earnings per-share between $3.88 and $3.98.

The one concern I had with the company's earnings release was that Herbalife issued $300 million in long-term debt to repurchase around 5 million shares. While it's admirable that the company is so committed to the value of its stock, without these repurchases it still would have beaten earnings estimates. When a company issues debt to repurchase shares the company better be absolutely sure that its stock is a good value to leverage up its balance sheet. That being said, there just isn't anything about Herbalife that makes me believe the stock should be shorted.

Herbalife has good organic growth, 15% expected earnings growth, and a 2.6% yield. When you consider that Herbalife sells for less than its growth rate, this just doesn't sound like a company to be against. It seems pretty obvious that short-seller's wallets are going to lose weight on this trade.

MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.

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