Description

Herbalife Limited ("HLF") is simply too cheap at current trading levels.  The Company has minimal debt, produces copious cash flows, requires little/no capital to grow and has negative working capital.  In short, this business is and always has been a winner.  If you looked at the Company's financial characteristics and nothing else over a period of time, you would probably conclude that this stock should trade at a large premium to the market given its cash flow generating power and highly variable cost structure which allows the Company to generate significant cash flows even in difficult economic circumstances.  That is not how the market has historically valued this business, however, because Wall Street has always hated multi-level marketing as a business model.  I don't particularly love the model either and I wouldn't want to be in this business, but I'm happy to make money on the stock if nobody else wants to.  I don't expect to get multiple expansion vs. where the stock has previously traded, but I think the current free cash flow yield is really nice and supports a much higher stock price and as I outline below I think there is some additional upside that the market is ignoring with HLF.

Brief Business Description

The Company sells nutritional supplements through a network of 1.9 million distributors in 70 countries around the world.  The products range is pretty wide, but the biggest selling product category is weight management products (63% of sales).  The weight management products include shakes, protein bars, meal replacement snacks.  The bulk of the remainder of the product line is in vitamins and other nutritional supplements.  While the products are relatively mundane, the unique and controversial aspect of the Company is the MLM structure.  Here's how it works.  Generally speaking there are two classes of distributors: supervisors and distributors.  There are 1.9 million total distributors in HLF's network, 505,000 of whom are supervisors.  In order to qualify as a supervisor, a distributor must earn 4,000 points (a point is roughly equal to $1 of sales) in a single month or 2,500 points for two consecutive months.  From a practical perspective sales supervisors are involved with HLF as a business (perhaps as their sole occupation but more likely as a way to make some supplemental income on the side).  The other 75% are "distributors" in name, but are not engaged with the Company as a profitable venture, they become distributors in order to take advantage of preferable pricing on products that distributors receive.

Let's walk through a simple transaction to understand how it is reflected in HLF's financial statements.  Let's suppose a distributor sells $100 worth of product to an end user.  The Company will sell the product to the distributor for $50 and then the distributor will sell that product to the end user for $100.  The Company will record $50 of revenues on its income statement in this simple example - the Company also reports the gross retail sales which is a useful number to track, but it does not show up on the income statement.  More frequently, a distributor will be buying product, perhaps for his personal consumption.  Lets say that distributor was sponsored by another distributor within the network (perhaps a supervisor); in this case the transaction would be the same, but the sponsoring supervisor would also earn a royalty on the sale.  So the Company would book the same $50 in revenues but it would have an additional expense of call it $15 of "royalty overrides" hitting the income statement.  In some cases you will have multiple levels of sponsors within the network (this is referred to within the network as an "upline"), so it's possible that a simple transaction like this could generate royalty overrides to multiple parties within the network.    

The maximum levels of royalties/product discounts and how they show up in the financial statements is reflected below:

Hence, for every dollar of gross retail sales, it is possible that $.73 of that is paid out to distributors.

The LTM income statement for the Company is shown in the table below:

Perhaps something that can't be fully appreciated about this business in a writeup is the corporate culture at HLF.  It is frequently described as a "cult".  I spent some time recently at a major distributor event for the Company and while I think the word "cult" is a little bit of an exaggeration, its not too far off the mark.  I don't view this as a positive or a negative from an investment standpoint, I just thought Id mention it to give you a little more of a flavor of what you are investing in here.  You kind of need to see it to believe it to understand the culture - its pretty unique.  Everyone is in really good shape, super positive attitudes, lots of fake tans - you get the picture.  Like a room full of Tony Robbins. If you are thinking about investing in the business, Id suggest going to one of the big distributor meetings ("Extravaganzas" as they call them at HLF).  A big part of the Company revolves around maintaining this culture and keeping the distributor network pumped up.  The longer history of the Company if you dont already know it centers on the Company's founder, Mark Hughes, who was kind of a "religious" figure within HLF.  Mark Hughes died in 2000 in fairly controversial circumstances (possibly a drug overdose combined with excessive drinking).  The Company went through a period of significant instability after this event as you can imagine, with a few different people trying to step into Mark Hughes place, and then going private in 2002 in an LBO sponsored by Golden Gate and Whitney Capital.  One aspect of my thesis is actually the Company's ability to survive through that period of instability.  Lets be honest - this is a "confidence" business - it lives and dies based on the confidence of the people within the network.  That death of the founder / central figure of the Company was a FAR bigger threat to this business than any macroeconomic weakness we are currently going through.  So for me the challenges the business faces today are real, but nothing compared to some of the periods that the business has been through in the past.  

I think the current management team is excellent and in many ways, the business has never been stronger.  CEO Michael Johnson, came to the Company from Disney in 2003.  He is the perfect CEO for this business - highly charismatic, energetic and I also believe highly ethical.  He is a triathlete and does a great job working the politics of this business and giving the Company a great image.  One of the things he does really well is he walks the fine line of playing this central leadership role in the Company but not trying to be a "replacement" for Mark Hughes - he sort of positions himself as the person carrying on the dream of Mark Hughes.  This is important within the organization because a lot of important distributors within Herbalife have been there since the Hughes era.  

One of the things that management has done a nice job on over the last few years is beefing up the science behind the Company's products and bringing a greater level of legitimacy to the health benefits behind Herbalife's products. The Company maintains a very strong R&D staff along with an advisory board that includes a number of leading scientists (including a Nobel Laureate in Medicine).  So, while the efficacy of the products may not be the most important driver of this business, the strength and quality of the product portfolio is probably in a much better place today relative to where it's been in the past.  As an aside, I personally use the products - at first I just wanted to order some stuff as a due diligence measure, but I actually started to really like using some of the products and continue to reorder (the Formula 1 shakes, protein bars and "Lift Off" are personal favorites). 

Investment Highlights

• Strong cash flow generation and low capital requirements:  As stated, this is a business that has always produced enormous amounts of cash and requires little capital.  Further, its a highly variable expense structure and will make significant amounts of money even if challenges on the sales front are more difficult than expected.  Without capital requirements, the Company has historically taken all this cash flow and sent it back to shareholders in the form of a nice recurring dividend and frequent stock buybacks. 
• The business is healthy:  As stated, I was at a distributor meeting quite recently.  There was absolutely zero sign of a loss of confidence.  There may be challenges - VAT in Mexico, currency fluctuations, tough macro - but this engine is firing on all cylinders operationally from products through to sales. This is a confidence business, and confidence is high.  Note that the business has survived past recessions and survived the death of Mark Hughes.  The challenges the business faces today are real, but the Company has been through much worse in a far more fragile state in the past.  
• Ability to perform in a weak economic environment:  While HLF is not recession proof by any means, people are going to be looking for ways to make supplemental income and HLF is well positioned in that regard.  I view this as a small incrementally positive factor in the Company's favor in the current environment. 
• Optionality in emerging countries: China has quietly become the 3rd largest country for HLF by revenues, representing 8% of sales in Q4.  The China business is still in nascent stages and there is enormous upside if the business really gets traction in China.  One interesting thing to note is that the Company's most successful major country as measured by per capita consumption is Taiwan, which consumes orders of magnitude more product per capital than other major countries including the US.  There is good precedent for this business and brand resonating in that part of the world.  China revenues were up over 50% in Q4 and if HLF gets real traction there, it would be transformational for the Company.    Korea is showing some really good trends as well.  Another one that could be interesting longer term is India - not even on the radar yet, but at the recent distributor meeting the Company noted that some really remarkable things were starting to happen there (small in scale, but still very positive).  Another takeaway from the distributor meeting was the number of Taiwanese who attending the meeting - really remarkable - these people are really "Herbalized" as the Company likes to say.
• Strong insider buying patterns:  CFO Rich Goudis has bought $1.5 million worth of stock in the past 6 months, $1mm of this was in early March after the Company reported Q4 earnings - 2/3 the way through Q1 at that point, how bad could the q1 numbers be?  Additionally in the past 6 months, the General Counsel bought $400,000 of stock, the SVP of Sales Des Walsh bought $200,000 of stock and director Leon Waisben bought $750,000 of stock.  Waisben is a former HLF distributor and knows the organization from the inside over a period of decades, so that buy is particularly encouraging. 
• Daily consumption: A key management strategy that shows some promise in the past few years is the "daily consumption" selling model.  This is a sales strategy that started in Mexico and now the Company is replicating the success in Mexico around the world.  Essentially, the concept is to inject a social aspect to the sales process - bringing people into nutrition clubs that meet every day, sponsoring weight loss challenges etc.  There is a learning curve to implementing the model in a given market, but there are a number of markets that have been transitioning to this business model and are at an inflection point of starting to get real traction. 

Investment Risks

• Political / regulatory / public attacks:  This is a Company and a business model that is an easy target for public criticisms - these criticisms typically range from claims that HLF is a ponzi scheme to claims that HLFs products cause health problems.  Most of these attacks are the real frauds, coming from people who are looking to profit from being short the stock (the "Fraud Discovery Institute" for instance) or by suing the Company.  The important fact though, is not the validity of the criticisms, but the fact that they exist regardless of accuracy and the impact that could have on the business.  The attacks are nothing new and something you probably have to live with forever as a shareholder.  To the extent it ever evolves into something that fundamentally damages the business - e.g. being shut out of a country by the govt. - is a real risk that you have to live with. The Company fights this by doing the right things - making good products and doing their best to operate in an ethical manner.  Unfortunately, there will always be some rotten apples in the organization - distributors who use unethical sales tactics, make false claims about the Company's products etc.  They will never be able to eliminate that completely, but I am pretty comfortable that at the corporate level, these guys are trying to do the right things.  Take for instance the Herbalife Family Foundation, which provides for the nutritional needs of at risk children through 40 Casa Herbalife programs around the world.  The Company also maintains relationships with athletes and political figures around the world (recently Madeleine Albright became a consultant to the Company) in order to bolster its image.  
• Consumer spending:  ultimately, this is a consumer stock.  Like anything else, sales will be challenged.  The Company tries to tout the low cost of its products on a per unit consumed basis, but ultimately consumer spending is going to be a challenge.
• Loss of confidence causes a ripple effect through the network.  As previously mentioned, I believe confidence is possibly the most important aspect of this business operating successfully.  In that regard, things are looking fine for HLF right now.  If there are any signs of the opposite, it will be time to exit.  Think about management changes, regulatory issues, product issues in this regard.
• Currency:  the Company deals in a lot of different currencies, many of which are related to emerging markets or volatile currencies.  The value of the peso is probably the biggest one to watch here in terms of financial impact.

Valuation

The table below shows HLF's current enterprise value.  Pretty conservative capital structure and mgmt is guiding to $3 of earnings this year.  On an $18 stock price, I'm looking to collect $3 of earnings this year which will be about the same as free cash flow.  If they miss the number by a bit, I'm not too concerned.  I think there is plenty of margin for error.  I think 6x forward cash earnings for a business with no debt is really attractive right now.

I'm not going to put a "price target" on this stock, its pretty simple in my book - you're buying a lot of cash earnings power per share of stock price and I think there is upside to that over time. I dont need a DCF to tell me that's a good buy.

Summary

This is a business that Wall Street has never cared for, despite continually proving the street wrong with cash earnings power.  They face some challenges in 2009, but the challenges are not as big as those that the Company has faced in the past.  They produce significant free cash flow and have a highly variable cost structure.  They have a culture of winning and have been doing so since the Company was started in 1980 - this culture is alive and well and is reinforced every day.  Management believes in the business and they prove it by buying stock in the open market.  I think this stock is going to "win ugly" in 2009 - going to be a tough year, but its going to make a ton of money regardless and people will wake up to the cheap stock price as cash starts to pile up on the balance sheet.  And look out for China - if they get that beast going, watch out!

And if the stock doesn't move, maybe Whitney Capital will come back for a 3^rd helping of HLF.  Apparently they liked the 2002 experience enough to try and buy the Company a 2^nd time in 2007 for $38/share (offer rejected). 

I look forward to your thoughts.

Catalyst

Eventually, some lowly analyst will notice a bunch of cash piling up on the balance sheet and alert his/her superiors.  That or the co. will raise the divvie or keep buying back stock until theres none left.  Or as noted above maybe if wall street keeps hating this company, private equity buyers dont seem to mind it so much.