Herbalife (NYSE:HLF) has gotten knocked around hard lately, as well-known investor David Einhorn has apparently taken some interest in the company and asked some fairly pointed questions. Although I don't agree with those who have interpreted his questions as implying that there is any sort of pyramid scheme at work, that doesn't mean that there aren't inherent issues with the Herbalife model. While there is likely to be sustained ongoing demand for the sort of supplements that Herbalife sells, I wonder whether Herbalife's model takes too much of the company's growth potential out of its own hands.
SEE: What is a Pyramid Scheme?
Growth Doesn't Look Like a Problem so Far
Even as shoppers look to save money by switching to private label brands and patronizing Quick Service Restaurant (QSR) value menus, it doesn't seem that the demand for products believed to enhance healthier living is flagging. Sales growth at store-based retailers like GNC (NYSE:GNC) and Vitamin Shoppe (NYSE:VSI) has stayed healthy, and Herbalife and peer Medifast (NYSE:MED) are delivering solid-looking growth as well.
For Herbalife, that meant about 21% reported growth in the last quarter, and organic and volume growth of about 24%, with U.S. growth even stronger at 26%. Even Mexico, which hasn't been having the best of economic times lately, is continuing to show revenue growth. At the same time, margins continue to improve and Herbalife posted 25% operating income growth.
But What About Controlling the Message Long Term?
There have been a lot of questions, worries, and allegations about the Herbalife business model over the years. One of the relatively frequent accusations is that distributors, which are "regular people" who sell products in a model similar to that pioneered by Avon (NYSE:AVP) or Tupperware (NYSE:TUP), look to "game" the system by buying excessive amounts of product to qualify for the royalty program. And then signing up other people to become distributors as well. It's a problem inherent to multi-level marketing companies, and skeptics fear that there's a lot of unsold product floating around.
That's not my concern. I'm not saying that people won't or don't do that, but I don't see it as the biggest threat to the model. Likewise, while I do believe that some people sign up as distributors primarily to take advantage of the wholesale pricing, which isn't my primary concern, either.
My bigger concern is the extent to which Herbalife's growth is in the hands of its distributors. Unlike Medifast, Herbalife distributors make a lot of their earnings on the wholesale-retail spread and are expected to actively build their own business and promote Herbalife's products. While it's not as though Herbalife spends no money on advertising or brand-building, I worry that too much of the company's image and brand is in the hands of people who may not have the resources, motivation or ability to really build the business.
Are FDA-Approved Products a Threat?
It's also worth asking whether the expected FDA approval of new weight-loss drugs from Vivus (Nasdaq:VVUS) and Arena Pharmaceuticals (Nasdaq:ARNA) will have a meaningful impact on Herbalife's model. Weight loss/weight management products represent a large share of Herbalife's sales and it's not entirely ridiculous to think that FDA-approved pills could be a threat - particularly if private insurance companies grant adequate reimbursement.
On one hand, I'm inclined to think that proven clinical efficacy is a meaningful advantage for the drug companies. That said, there are very real side effects to these drugs and even if Herbalife's products are not particularly effective, they don't do much (if any) harm.
SEE: Evaluating Pharmaceutical Companies
The Bottom Line
Historically, I've had issues with Herbalife's valuation, as I thought the company's probable free cash flow trajectory didn't justify the premium in the market. With the stock being clobbered, that's really not a major problem now.
SEE: Equity Valuation in Good Times and Bad
I'm sure Herbalife bulls will howl in protest that I see less than 10% compound free cash flow growth over the next decade, but so be it. Being conservative with growth projections has generally helped me avoid blow-ups. Moreover, a high single-digit free cash flow growth rate is sufficient to produce a fair value target in the high $50s. While I do have questions as to whether Herbalife's distributor-based model takes too much brand-building power away from management, Herbalife is far from a new kid on the block and the stock is cheap enough to at least merit further due diligence for risk-tolerant investors.
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.
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