Herbalife Company Report

2016

Valid business model supported by retail demand for products. buy on Resilient U.S. sales in q3Jack Brady

Balyasny Asset Management L.P.

Herbalife, Ltd.

Herbalife, Ltd.

Key Points:

1. Herbalife’s business model, and particularly its North American business, is valid. Furthermore, this business is sufficiently retail oriented to document the FTC-mandated 80% retail/acceptable personal consumption levels on U.S. sales.

2. Recent improvements to the sustainability of Herbalife’s business model, such as the 12-month qualification period for Sales Leaders, provide the company with a long-term growth runway.

3. Long term trends of rising global obesity and preventative nutrition bode well for core business’s earnings potential.

4. Herbalife’s model of distributors serving as nutritional consultants and lifestyle coaches for customers insulates Herbalife from retail and internet based competition.

5. Stock price fluctuations caused by Investor Carl Icahn and activist short seller Bill Ackman may provide attractive entry and exit points, as large price movements driven by their exchanges do not reflect any change in company fundamentals. Low probability either man will exit his position in the next 4 quarters given their strong convictions and considerable liquidity in the near term.

6. Valuation of Herbalife depends largely on North American Sales performance during the next four quarters. If sales fail to drop-off precipitously due to new FTC regulations, the “pyramid scheme” argument upon which the bear case is built will fall apart. This should then result in the company being revalued to a level consistent with its non-MLM peers.

7. With a current short float of 38%, Herbalife has the potential to benefit from a short-squeeze if it is indeed revalued to the upside. That said, the possibility of a short squeeze has not been built into my model and should not be a factor when considering an investment in Herbalife.

8. Recommendation: Wait-and-see what North American volume results look like in the third quarter. If they indicate resilient U.S. sales figures (which I believe they will), stock should revalue to a level consistent with non-MLM packaged goods retailers1 over the following three quarters. (See “Catalyst Pathway”, p. 7)

1 I used Packaged Goods as comparable companies because, while they are not MLM’s, they sell similar products to Herbalife. Weight loss products such as Herbalife’s Formula One Protein Shake and protein-rich soups make up almost 65% of net sales and are Herbalife’s main product category.

Key Metrics:Price: $61.17

52-Week Range: $42.26 – $72.22

Price Target: $91.00

Risk/Reward: 1.6x

EBIT (M): 2015A 2016E 2017E

Sales: (M) 2015A 2016E 2017E

$4,469 $4,624 $4,945

FYE Dec 2015A 2016E 2017E

(Curr) (Curr) (Curr)

EPS ($):

Q1 (Mar) 1.29 1.35 1.40

Q2 (Jun) 1.24 1.29 1.26

Q3 (Sept) 1.29 1.24 1.41

Q4 (Dec) 1.19 1.20 1.24

FY EPS 5.00 5.09 5.31

Herbalife, Ltd.

Herbalife’s Business Model:My belief in the validity of Herbalife’s business model stems from a combination of both primary and secondary research. In my analysis I emphasized primary research because, for a hotly debated stock like Herbalife, there are sound arguments from both the Bull and Bear camps relating to the feasibility (or lack thereof) of Herbalife’s business model. At the end of the day, biased arguments founded on carefully curated evidence can only go so far when it comes to determining the business practices of a company like Herbalife. While it is important to understand the theoretical underpinnings of Herbalife’s business model and interpret all available member metrics and company policies, I found it necessary to also interact with Herbalife’s distributors directly.

My primary research consisted of visits to two Herbalife Distributors near my home, posing as a potential customer. While I had many questions I wanted to answer while speaking with these distributors, the most important was this: are there legitimate retail sales being made by Herbalife distributors, or are distributors merely focused on recruiting others into the business?

It didn’t take me very long to reach my conclusions that Herbalife distributors are focused primarily on retail sales. Given the sentiment surrounding Herbalife’s business model, I expected that the distributors would do their best to recruit me into the business opportunity, given my expressed interests in the product. They did not. I even brought up the business opportunity, hoping that they would jump at the opportunity to sign on another downline distributor to make a quick buck. Again, they did not. Both distributors indicated that their downline consisted of friends and family members who purchased mainly for personal consumption and sold a little on the side.

Rather than try to recruit me, these distributors provided me with a nutritional consultation that included free samples of various products, personal endorsements of various Herbalife products, and a thorough review of all the Herbalife products they believed would be of use to me.

Furthermore, when I asked these distributors what they thought of Herbalife as an organization, they both indicated that they were happy with their experiences as distributors (although one of them did say she preferred the original CEO, Mark Hughes, to Michael Johnson because he seemed friendlier).

And, importantly, neither of the distributors I spoke with had any intention of changing the way they conducted their business in light of the FTC-mandated rule changes.

The bottom line is that these distributors seemed, by all indications, to be retail oriented.

Two potential problems with this primary research is that I spoke with only two distributors and they were both middle class people who were selling Herbalife as a source of supplemental income. Whether or not Herbalife’s business model manifests itself in the same way among lower-income individuals for whom Herbalife distribution is a primary source of income is not definite. If I were covering Herbalife for a longer period of time, I would have continued this primary research before making a judgement, but nonetheless I feel confident in my assessment that Herbalife is not a pyramid scheme based on my primary research.

Herbalife, Ltd. Now onto the secondary research. Herbalife has several checks in place to prevent members from being forced to hold on to product they do not want or cannot sell, such as their 90-day 100% Money Back Guarantee which includes shipping expenses (this money-back guarantee has been extended to 12 months as a part of the FTC settlement). Over the past five years, less than 0.02% of products sold in the U.S. have been returned to the company, indicating that the vast majority of distributors are not purchasing more product than they can either sell or consume. Furthermore, Herbalife’s introduction of the 4K qualification system in 2014, which extends the Sales-Leader qualification period to 12 months from 3 months, allows distributors the opportunity to grow their business more slowly and methodically, further reducing the chances that distributors will participate in ill-advised inventory loading (a common practice in pyramid schemes that involves new distributors purchasing excessive amounts of product in order to obtain high-volume discounts).

The main area where Herbalife’s business model needs to improve is advertising. Because advertising the Herbalife business opportunity is a key component of recruiting new distributors and building out their sales force, Herbalife has historically participated in aggressive marketing campaigns. These campaigns, run primarily by high-level independent distributors, depict highly unrealistic earnings prospects in order to entice new distributors to join their downline. While these advertising campaigns technically aren’t lying (there are a handful of millionaires that have been minted by Herbalife’s business opportunity), they are clearly deceptive and have been banned in the U.S. by the FTC settlement. Critically, though, it isn’t likely this rule change will impact the fundamental earnings power of Herbalife, since the distributors who are “duped” into joining tend to be the ones whose involvement in the business is short lived, so Herbalife’s core distribution channels should not be materially impacted.

Therefore, I believe Herbalife’s business model to be valid, since it is primarily retail oriented and has legitimate demand for its products. The FTC settlement will force Herbalife to adopt more rigid ethical standards, and I believe they will be able to do so with little impact to their core business.

FTC Settlement:The most prominent and potentially crippling rule change stemming from the FTC settlement is that Herbalife must document at least 80% of sales as either retail sales or acceptable levels of personal consumption by distributors, or else reduce the multilevel compensation they pay to distributors. If documented sales were to fall below this 80% threshold, the reduction in earnings opportunities for distributors could substantially reduce their sales force in the U.S. as distributors begin to jump ship amid lower compensation levels.

However, seeing as the independent Lieberman Research investigation into Herbalife conducted in 2012 found that 56% of members joined solely for a discount on purchases and 73% joined primarily for discount on purchases, a large chunk of the 80% mandate will be easily documented as personal consumption by distributors and preferred members (the acceptable level of which is currently $125 per month per member). The remaining 15% or so will need come from retail sales in the field. And, seeing as I believe that Herbalife products have legitimate retail demand, documenting these purchases should be little more than a logistical issue for Herbalife. Their plans to release an app for tracking sales that will feed information directly into their own record system should solve this IT issue.

Herbalife, Ltd.

Valuation Analysis:Working under the assumption that Herbalife is a legitimate retailer, its stock is materially undervalued due to misplaced fear in the marketplace regarding pyramid scheme accusations. By looking at several earnings and valuation metrics, Herbalife appears to be attractively priced. Steady North American sales figures over the next four quarters will serve as the catalyst for Herbalife’s revaluation to the upside.

Price to Earnings Comps:

Relative to its non-MLM peers in the Packaged Food sector, on a Price to Earnings basis, Herbalife is very inexpensive. It trades at a current year P/E of 12.8, relative to the sub-sector median of 23.5. However, relative to its own 5 year average P/E of 11.8, it looks slightly expensive.

Herbalife P/E vs self over 5-year period

Enterprise Value to EBITDA Comps:

Relative to its non-MLM peers in the Packaged Food sector, on an EV/EBITDA basis, Herbalife is very inexpensive. It trades at a current year EV/EBITDA of 8.4, relative to the sub-sector median of 13.7. However, relative to its own 5 year average EV/EBITDA of 7.8, Herbalife looks slightly expensive.

Herbalife EV/EBITDA vs self over 5 year period

Synthesis:

Both of these comparative valuation metrics are telling the same story: Herbalife is currently trading cheaply relative to its peers who sell similar products through brick and mortar establishments, but it looks expensive relative to its own historical valuations.

Herbalife, Ltd. My interpretation of this pattern is that Herbalife, like most MLM companies, trades at a de-facto discount to its non-MLM peers due to concerns about the sustainability of its business model. That’s why its P/E and EV/EBITDA are substantially lower than these non MLM peers. However, Herbalife is trading at a premium to its own historical valuations because this “MLM discount” is beginning to shrink as the investing public slowly but surely comes to the conclusion that Herbalife is a genuine retailer with legitimate retail sales. This “MLM discount” has existed since May of 2012, when David Einhorn famously pressed management on an earnings call for details regarding the breakdown of the company’s retail sales. The discount fluctuated for a while after that initial emergence, but has been constant over the past 18 months since the jury is still out on whether or not Herbalife has a legitimate retail-oriented business model. By the time Q3 results are reported in 2017, I believe that this “MLM discount” will have disappeared as Herbalife gets revalued more along the lines of a traditional packaged foods company once pyramid-scheme related fears subside.

Furthermore, Herbalife has traded at a premium to its non-MLM peers in the past, when the market believed its business model was about to be proved legitimate and its earnings multiple was based solely on its strong fundamentals. (See below chart) So it’s not unrealistic from a historical perspective to expect that a scandal-free Herbalife is able to trade at these levels.

As you can see below, Herbalife began to revalue towards non-MLM peers in early 2013 when market sentiment shifted away from considering Herbalife to be a pyramid scheme. This revaluation was short lived, however, because there was no legal basis at the time for believing that Herbalife’s businesses model was legitimate; it was more speculation on the part of investors. This time around, however, the FTC has provided the legal basis that Herbalife needs to undergo a sustained revaluation: if Herbalife is able to comply with FTC mandates without a material impact on its business, then all concerns of Herbalife being an illegal pyramid scheme will be put to rest and a revaluation should ensue.

HLF P/E (White) vs Peer Average P/E (Orange). Difference reflects HLF’s “MLM Discount”

Herbalife, Ltd.

Managing “Pyramid Scheme” Risk:

I recommend a wait-and-see approach to trading Herbalife. While I believe the business model to be valid, the massive devaluation that would occur if Q3 2016 U.S. sales reported a steep selloff makes the risk/return of purchasing the stock before earnings unattractive.

And while one would certainly miss some upside by waiting until after Q3 earnings, I expect Herbalife’s revaluation to take place primarily in the first half of 2017 as more post-FTC data becomes available, and therefore the risk/return improves drastically by waiting on Q3 results before initiating a position in Herbalife. Waiting allows you to avoid much of the risk while giving up a disproportionately small portion of the upside.

Another risk-mitigation measure one could take would be to would be to buy deep Out-of-the-Money puts on Herbalife in tandem with an outright long position in the stock. This could be an effective option (no pun intended) given the polarized sentiment surrounding Herbalife and its business model. For, if Herbalife were to begin reporting weak sales figures and the market determined it to be a pyramid scheme, the resulting devaluation would likely be large enough to make even deep OTM puts viable contracts (I would recommend a $40 strike price, given my Bear-Case estimate of a fair value of $42). However, because this strategy would add a negative-carry aspect to the trade and also because Herbalife options are fairly expensive right now (IVM almost 60 for $40 Feb17 contracts), waiting to see resilient Q3 U.S. sales seems to be the optimal risk-management strategy for this trade.

Catalyst Pathway:

In broad strokes, the major catalyst for Herbalife’s revaluation will be a change in market sentiment surrounding its business model. And, specifically, that change in market sentiment will be solidified, one way or the other, by the third quarter of 2017. If the FTC-mandated anti-pyramid scheme regulations crush Herbalife’s U.S. Sales, then it must be a pyramid scheme by definition. If Herbalife’s U.S. sales are resilient, then by definition it must be a valid retail-oriented business. My conviction is the latter.

Q3 2016: Sales figures will reflect any initial drop off in sales activity due to rule changes. While most measures will not yet be phased in completely, the impact of new marketing standards (the most problematic of the FTC mandates, in my opinion) will be evident in sales numbers. Steady sales from North American operations will cause the company’s revaluation to begin.

Q4 2016: Effectiveness of Herbalife’s retail sale documentation will start to become evident. Expected to be rolled out during Q4. If it turns out that documenting retail sales is merely an IT issue, Herbalife’s revaluation will continue.

Herbalife, Ltd. Q1 2017: The impact of changes to Herbalife’s Multilevel Compensation Program will be becoming evident. If Herbalife is able to retain its U.S. distribution network (and therefore report steady U.S. sales) under these new regulations, the validity of its business model is reinforced. Revaluation continues.

Q2 2017: The impact of all changes to Herbalife’s business model will become evident, since the 1-year implementation timeline will be up. The jury will be out on the validity of Herbalife’s business model, one way or another. Strong sales will accelerate Herbalife’s revaluation towards its non-MLM peers in the packaged foods industry. Revaluation should fully materialize shortly after Q2 earnings.

Conclusion:

At the end of the day, going either long or short Herbalife equates to taking a position on the validity of their business model. If Bill Ackman is right, Herbalife will lose a considerable amount of its value over the next 12 months. If Carl Icahn is right, the stock will perform very well over the next 12 months. Because of this, there is substantial risk associated with owning Herbalife at this point in time. The value of Herbalife’s stock is ultimately determined by one factor: whether or not it is a pyramid scheme.

To that end, the most important takeaway from this report is that I do not believe Herbalife to be a pyramid scheme, but rather to be a manufacturer and retailer of nutrition and weight loss products for which there is legitimate retail demand. I am confident in this conclusion, and I believe that if Q3 U.S. sales are resilient, entering a long position in Herbalife would be an intelligent trade. Furthermore, I think that liquidating the position after Herbalife’s revaluation is complete in the middle of 2017 would be the most prudent exit strategy, with the highest risk/reward. While I think Herbalife has bright long-term prospects, I see trading their revaluation, rather than buying and holding the stock, as the optimal investment strategy here.