What Should You Do With This Hedge Fund Battleground Stock?

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

Can a company widely considered to be a pyramid scheme survive when big name hedge fund operators like Bill Ackman and David Einhorn bet against its stock? That’s the question posed by network marketer Herbalife International (NYSE: HLF).

Herbalife is a multi-level marketing scheme much like Amway Corp. Just like Amway, Herbalife sells its products through direct marketers and takes fees from its marketers. Ackman has taken an enormous short position against the company, and he went to the trouble of giving a 342-slide PowerPoint presentation designed to expose Herbalife as a pyramid scam that preys on the poor.

The interesting thing is that Herbalife has managed to rebound after Ackman’s assault. The company’s shares took a slide to a price of $26.06 on Dec. 26 after Ackman’s presentation started circulating online. Yet they had climbed back to a price of $40.04 by Jan. 9. The main reason Herbalife rebounded was that another big-time hedge fund operator, Dan Loeb of Third Point LLC, disclosed that he had bought 8.9% of Herbalife’s shares.

So which hedge fund star is right here: Loeb or Ackman? If you look at the main financial numbers, Loeb seems to be right; Herbalife posted a diluted quarterly earnings per share year to year growth figure of 19.54%. Also, on Jan. 9 Herbalife had a PE ratio of 10.47 which can hardly be seen as a high flying valuation.  That ratio fell from nearly 20 in 2012 after shorts by Ackman.

Herbalife bulls will note that the company has been through a similar situation recently and survived it. Einhorn executed a  large short position in May after Herbalife's shares hit a high of $70 a share in April 2012. After the news and presentations by Einhorn, the stock was knocked down to around $44 a share, a range it stayed in until Ackman launched his attack in December.

Avon Products (NYSE: AVP) also hire agents to sell its products to the agent’s social networks.  Avon, however, specializes in make-up and other beauty products.  The Avon brand has a following much stronger than the Herbalife brand following.  On top of this, Avon’s products are low cost relative to most competitors unlike Herbalife as we will see below. Another competitor, the much-maligned Amway, is privately held. No comparable multi-level marketer is traded on any of the major U.S. stock exchanges. Being unique isn’t bad, but it can make it hard to evaluate a company. So how do you classify Herbalife for purposes of analysis? Herbalife claims to be a consumer products company like Procter & Gamble, yet Ackman contends that it makes its money by selling business opportunities not manufacturing consumer products. In his PowerPoint, Ackman makes a good case that Herbalife’s products are neither original nor competitively priced. Instead, Ackman proves that Herbalife is basically a retailer; a retailer that makes its money by overpricing its products.

How can Herbalife compete with Wal-Mart?

That means Herbalife’s real competitors are other retail stores selling nutritional products such as Wal-Mart Stores (NYSE: WMT), Target Corporation, Costco Wholesale Corporation, and other big retailers. How are working class people working out of their homes supposed to compete with Wal-Mart and Target? Equivalents to all of Herbalife’s products can be found on the shelves at the retail giants at lower prices.

Herbalife does not list the prices of products at its website instead it tells consumers to contact a distributor. However, when you look at distributor’s websites, prices are far more expensive than other online retailers like walmart.com or target.com.  For example, on one distributor’s website a 273 gram container of protein mix is $27, but if you look at Walmart’s website, you can find similar product for $9.92.  Target is a little more expensive; it offers a range of shakes starting at $8.44. These are just the prices listed on Wal-Mart and Target’s websites. Prices in the stores are presumably cheaper than Herbalife prices too and consumers don’t have to deal with a “distributor” to get the products.

The picture is fairly clear there is no way Herbalife can offer competitive prices to major retailers such as Target, Wal-Mart, Amazon.com and Costco. The reason Herbalife doesn’t list prices on its website is that it knows the prices are so high they’ll scare customers away. Legitimate retailers openly list prices to attract business.

A quick look at the retail sector shows that there is no way that Herbalife can realistically compete with organizations such as Wal-Mart and Costco. Instead, Ackman ably demonstrates that it makes its money by charging “fees” to distributors.

The games hedge funds play

Loeb could just be betting on a short-term price boost for Herbalife then when Herbalife hits the price he wants, he could sell, and its share value will drop like a rock. The best advice for average investors is to stay away from Herbalife. The games the hedge fund operators are playing with its stock make it too great a risk for small investors.  It will be very hard to find an edge that will give you a better idea of the stock’s worth than these hedge fund giants.

mthiessen has no position in any stocks mentioned. The Motley Fool has the following options: Long Jan 2014 $50 Calls on Herbalife Ltd.. 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