The nutrition company Herbalife has attracted a lot of controversies over the last few years. Most notable among these is the crusade of activist investor Bill Ackman against Herbalife, by far the biggest short position of his hedge fund Pershing Square. On the other hand, renowned investors Carl Icahn and George Soros both have long positions in Herbalife. This could mean that a clash of hedge fund titans is in the making. Meanwhile, Herbalife’s stock price has declined by more than 60% since last year. In this article I will analyse the business model of Herbalife and find out whether its stock price is poised to drop even further.
Herbalife is a global nutrition company founded in 1980 that sells weight management, healthy meals and snacks, fitness, energy and targeted nutritional products as well as personal care products. Herbalife sells its products through a multi-level marketing network of independent members and distributors. Approximately 3.7 million independent members sell Herbalife products, most of them being users of Herbalife products themselves. Members profit from selling Herbalife products, receiving discounts and earning royalty overrides on sales made by members whom they sponsor into their sales organization. The more products a member sells, the higher the rewards are they get through discounts and royalty overrides.
Herbalife’s financial performance
Currently Herbalife has an equity market value of $2.8 billion, which is down more than 60% from its high at the start of 2014. For the year 2014 total sales were $4,958 million, up 2.8% from 2013. This is a significant slowdown in revenue growth relative to the years before, in which it was normal for Herbalife to achieve more than 15% sales growth year-on-year. Although sales are still increasing, the sharp drop in sales growth signals an early stage of stagnation in the business of Herbalife. During the Q4 earnings presentation, Herbalife’s CEO stated that they expect a 6% to 9% decline of sales in 2015 mainly due to falling volume growth and projected earnings per share were cut back to $4.10 per share from $5.40 per share in 2015. Per share earnings in 2014 were $1.41, less than what was projected at the start of 2014.
The long-term debt position has exploded since 2010, as shown in the graph below. In 2014, long-term debt increased with 84%, while debt increased with 76% in 2013. These staggering amounts show that Herbalife needs more outside financing to maintain its business since operating cash flows are not sufficient anymore. This is also shown by the development of shareholder equity, which decreased about $800 million in 2014 to minus $334 million. Although Herbalife states it is still profitable, the underlying numbers clearly show that the underlying profitability is decreasing head over heels. These negative financial developments show that Herbalife’s business is heading to its demise.
Furthermore, production of Herbalife products takes place exclusively in the US while its products are sold in more than 90 countries, making it negatively influenced by the appreciating dollar. The negative currency effects will result in lower profits in US dollar, due to a relative increase in production costs as well as decreasing revenues. Especially the sales exposure to South-America will negatively influence income. The currencies of countries like Brazil and Venezuela, Herbalife’s most important South-American markets, have dropped in the past 6 months and are still depreciating.
Over the last ten years the gross margin of Herbalife has been around 80%, which is a huge number for a retail enterprise. The long-term gross margin as stated in its financial reports is much higher than those of other retailers like Costco (15%), Wal-Mart (25%) and Home Depot (35%). These companies are comparable in size, but are selling a more diverse range of products. This shows that Herbalife either has an incredibly cheap production process or it earns its revenues from other activities besides merely selling products. It is very questionable, given the developments of long-term debt and shareholder equity, whether these profit margins are accurate representations of the real situation.
In the meantime, the confidence of shareholders is falling. During the last quarter of 2014 three of the top 20 shareholders completely sold off their positions in Herbalife. In contrast, Soros Fund Management expanded its position with 80% at the end of last December. To keep up support for its stock price, Herbalife has terminated paying out cash dividends and started a stock buy-back program in 2012 amounting to $1.5 billion until the end of 2017. However, only $230 million of this provision remained at the end of 2014, which indicates that the end of their share repurchase program is near.
Why should Herbalife be considered a pyramid scheme?
The big problem with multi-level marketing networks is that only a small percentage of the so-called members make money on their investment. A staggering amount of 88% of all Herbalife participants makes no money at all from distributing products and more than 96% of its participants lose money on their investment, while they are promised a very lucrative deal. So far more than 9 million people are harmed by Herbalife and its false promises and this number keeps increasing.
The main difference between a legal multi-level marketing company and a pyramid scheme is whether revenues primarily come from selling goods or from recruitment. Sophisticated pyramid schemes treat internal demand from members as a legitimate source of sales, which makes it hard to determine the revenue from recruitment. This poses a lot of regulatory challenges in the process of dissolving pyramid schemes. Furthermore, pyramid schemes push members to actively recruit new participants to profit from royalty overrides and extra discounts or bonuses.
Herbalife charges participants a recurring fee for their membership to the Herbalife distribution network, which forces participants to actively recruit new members and aggressively sell the products. These mandatory fees help explain the incredibly high gross margin of Herbalife and are another tell-tale sign that the company’s main business is recruiting members instead of selling products.
Herbalife does not disclose the precise numbers behind their revenues in its financial statements, making it unclear whether the revenues come from selling products to customers or to participants in the marketing program. In a recent interview, the Herbalife CEO admitted that more than 90% of its sales come from members.
This quote is important, since it points out that Herbalife is almost fully reliant on internal sales and thus recruitment. Furthermore, the CEO does not want to disclose the exact numbers behind their revenues, which is odd. If Herbalife is not a pyramid scheme, disclosing the precise numbers would clear the fog on where Herbalife’s revenues do come from.
Former distributors have come forward saying that after leaving the Herbalife program they were left holding a lot of extra inventory that could not be sold anymore, leaving them with huge losses. This contradicts the promise that Herbalife will buy back part of the inventory if members decide to leave the program. As a result of these extra losses in the process of leaving the scheme, it is very difficult for unhappy participants to leave the program.
The Federal Trade Commission and the FBI are currently probing Herbalife as a result of the many allegations. The investigations are still in process, but the results of these investigations could be devastating for Herbalife. The worst case scenario would be a complete shutdown of Herbalife’s operations, while in the best case they are penalized for bad conduct, hurting their reputation even more.
What will happen to Herbalife in the coming months?
Herbalife will face a lot of tough challenges in the coming months. Revenues are hurt by the appreciating dollar, overall sales are slowing down and the long-term debt position is rapidly rising. These factors will result in negative pressures on the profits made by Herbalife. Furthermore, the increasingly negative publicity is hurting Herbalife more and more. Currently, the stock is sliding and there are no early signs of recovery in the short to medium term. Another scenario looming for Herbalife investors is a possible long squeeze. The top four shareholders hold over 50% of the outstanding Herbalife shares. In the last months, investment firms holding the stock have been liquidating their positions because of the worsening prospects of the company. If one of the biggest shareholders decides to sell their position there will be a high probability of a long squeeze occurring. In that situation a major shareholder decides to sell a falling stock to cut their losses. This downward pressure will lead to a further decline in stock price, incentivising other shareholders to sell their stock too, leading to a further decline in share price.
To conclude this article, it is evident that Herbalife is selling its deceiving business program to potential members instead of just selling nutrition products. Therefore, Herbalife is a pyramid scheme and in the long run will be dissolved by regulatory agencies, making investments in Herbalife stock worthless. In the meanwhile, hedge fund manager Bill Ackman stated that he will not stop with his crusade against Herbalife until the fraudulent company is out of business. With the FTC and FBI still investigating, Herbalife has manoeuvred itself in a tight spot with a very negative outlook and its stock price is expected to keep falling in the coming months.
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Jauke de Jong
Jauke is always looking for the hidden gems of the financial markets.