Thursday, February 21, 2013

Research: HLF Herbalife has surprisingly solid financials

I've heard about the billionaire battle over Herbalife between Icahn and Ackman too late. HLF hit a nice low in December and I only found out about it early February. This is mainly due to me not running my screeners, as this definitely satisfies the basic criteria of PE under 15, ROE / ROA > 20. When I first looked at the financials, I was extremely surprised. I've heard about Herbalife being some kind of pyramid scheme (oh sorry.... multilevel marketing), and I was pretty biased towards thinking that this company would be full of fraud. Here are the things that caught my eyes in the financials
  • Account receivables are a relatively small percentage of revenues
  • Enormous Free Cash Flow relative to Cash From Operating and Capital Expenditures
  • Net Income is in line with Free Cash Flow
  • Small amount of debt / liabilities relative to Free Cash Flow
  • Dividends
From the financial statements alone, HLF has what your poster child company should look like. I was certain that there must be something wrong in the 10-K. I take a pessimistic approach to investing. While most people are trying to find excuses for why they should buy terrible companies, I'm looking for reasons for ways a bad company can pretend to look like a good one. Here's what I found in the 10-K.
  • HLF does not use any capital leases. They only use operating leases. I believe at least some of these operating leases are improperly classified.
  • There are no off balance sheet arrangements.
  • HLF's revenues are the cash received by their clients, rather than the MSRP. This is the proper way of accounting, which makes their revenues look lower. In other words, this is more conservative vs using the MSRP for revenues and then increasing expenses in SGA or COGS to achieve the same net income.
  • HLF has (in retrospect) done some bad share repurchases. Who knew there would be a billionaire battle?
So out of what I found, the only bad thing I see here is perhaps some improper classification of capital leases as operating leases. But honestly, that's one of the smaller accounting evils that you can commit and it is also highly open to interpretation. I don't think the size of their leases are big enough to make this a showstopping factor. I was much more surprised at their choice of the more conservative choice of revenue recognition.

So now, for my own explanation on why they're so profitable. HLF operates by selling directly to customers. Customers in this case are direct users of the product, or people who call themselves distributors. Distributors resell the product to others. This is where the pyramid scheme comes in. There's this whole thing around how you can get better pricing on Herbalife products if you buy more from Herbalife (aka sell more to other people). Basically, the more you buy, the better a rate you can negotiate. And suddenly, this sounds not like a pyramid scheme, but every distribution system in business. Herbalife has an expense which basically shows how much the kickbacks are to the distributors. This as might as well have been part of SGA since Herbalife is basically paying people to sell the product. I'm willing to bet though, that this particular system pays out less in kickbacks than if they were to actually pay salesmen.

People "working" for themselves work harder. In the Herbalife system, the sellers effectively take losses if they do not sell enough. This results in lost time and labor which Herbalife would have had to pay for if they paid salesmen by the hour. If you think of it this way, Herbalife is basically saving money in every scenario where a distributor would have lost money. Therefore, Herbalife paying out kickbacks costs less than actually hiring a sales force, meaning their profit margins would be higher. The "pyramid" part of this scheme is really just the people who wasted their own time. Distributors who happen to own a store on the side can sell Herbalife products through their normal business operations. These are the big and real distributors, not the guy trying to sell 200 dollars worth of vitamins to friends and family.

Finally, for the valuation. Using the Discounted Cash Flow worksheet, a free cash flow value of 400 million, a 20% weight for goodwill and intangibles, a 20% haircut on non-cash assets, I got an intrinsic value of $25 to $27 per share. With hindsight being 20/20, it's a real shame that I missed out on the drop in December. This is the drive behind me building the automated system to download financial statements and market prices and constantly monitor all intrinsic values across the market!! Now that HLF is on my radar, I'll be watching for an opportunity to get it at a price at least near intrinsic.

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