Sunday, April 27, 2014

The Going Concern Value of Herbalife (HLF)

For active participants in the financial markets, the saga of events surrounding Herbalife Ltd. (HLF) since the end of 2012 has been quite a rollercoaster ride. Small investors involved with the stock have been drawn to pick a side in an epic battle opposing on one side legendary investor Carl Icahn of Icahn Associates Corporation and on the other side hedge fund manager Bill Ackman of Pershing Square Capital Management.

For those unfamiliar with the company, it's description can be found here on Reuters website:
Herbalife Ltd., incorporated on April 04, 2002, is a global nutrition company. The Company sells weight management, healthy meals and snacks, sports and fitness, energy and targeted nutritional products as well as personal care products. It distributes and sells its products through a network of independent distributors, using the direct selling channel. The Company categorizes its science-based products into four principal groups: weight management, targeted nutrition, energy, sports & fitness and Outer Nutrition.
As of December 31, 2012, it sold its products in 88 countries to and through a network of approximately 3.2 million independent distributors. In China, in order to comply with local laws and regulations, it sells its products through, sales representatives, sales officers, independent service providers and in retail stores. On December 31, 2012, the Company acquired a manufacturing facility in Winston-Salem, North Carolina. The Company’s operating segments are based on geographical operations in six regions: North America, Mexico, South & Central America, EMEA (Europe, Middle East and Africa), Asia Pacific and China. As of December 31, 2012, we marketed and sold 140 products encompassing over 4,900 stock keeping units (SKUs).

For my part, I have been tempted to take Bill Ackman's side by taking a short position in medium term out of the money options after going through the Pershing Square presentations. Even if the stock has not moved so much, I am betting on an increase in volatility as investors fight to determine who is right or wrong. To estimate the downside risk of my position I conducted a fundamental analysis of the company in order to put myself in the shoes of investors like Carl Icahn who are on the long side of Herbalife Ltd and here are the findings.

Considering the current P/E ratio of 11.74, the present price of the stock assumes that the earnings of Herbalife Ltd. will grow by roughly 5% over the next 5 years, giving us a 2017 price of $. However, public information tells us that earnings have been growing at a little over 30.5% a year over the past 10 years. 

Using a rate of 2/3 of the recent years growth of about 20% we find ourselves with a 2017 price of 132$ per share with a P/E Ratio of 8.36, the lowest it has been over the last 5 years for the company. The earnings trend of the past 10 years can be seen here:

Also, Herbalife has managed to grow it's book value per share over the past 10 years at an average rate of slightly over 8% per year. Assuming the pace slows down to 5%, once again 2/3 of the 8.8% 10 year average, we end up with a book value of nearly 7.60$ per share in 2019. The current P/B Ratio stands at 10.6 so assuming it's stays flat, we get a stock price of 81$ in 2019. Here is how EPS and Book Value per Share have evolved over the past 10 years:

The previously raised assumptions are very optimistic, it seems at a first glance that the market has a biased bearish view on the long term prospects of Herbalife. The data displayed shows that Herbalife is undervalued based on fundamental grounds. The only drawback of this narrow point of view if that even if the company looks cheap, it doesn't keep the business model from being called into question. In time, the results of the investigations by the FTC and the FBI will confirm if the company stays in business or not. In the meantime, the stock of Herbalife Ltd. will keep behaving like a binary option, displaying high volatility until the allegations are invalidated or confirmed. This shall be beneficial for out of the money options until then.

If you chose a long position with Carl Icahn on this trade, the stock of Herbalife Ltd. will be worth somewhere between $81 and $142 by 2019, providing a 7% to 20% compounded annual return to investors. If you decide to side on a short position with Bill Ackman, the stock is going to 0$ as the company gets shut down by regulators.

Which side did you pick?

Disclosure: The author has a short position in HLF.