May 26, 2015 - 5:30pm EST by
2015 2016
Price: 51.08 EPS 4.55 5.03
Shares Out. (in M): 92 P/E 0 0
Market Cap (in $M): 4,720 P/FCF 0 0
Net Debt (in $M): 1,013 EBIT 0 0
TEV (in $M): 5,733 TEV/EBIT 0 0

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  • Bill Ackman (Pershing Square)
  • Pyramid Scheme
  • MLM


Herbalife (HLF) may be the most controversial name in investing today, but I believe
that the stock has nearly 3x upside in the next 12-18 months.
Herbalife is not a pyramid scheme & will be cleared by the FTC.
A recent change in business model has led to a temporary sales decline but will
lead to a large acceleration in growth by year end that is not appreciated by the
Herbalife is trading under 9x earnings power.
Strong & extremely hard catalysts coming in 2H.
Herbalife is not a pyramid scheme & will be cleared by the FTC
The bear thesis against Herbalife pushed by William Ackman is that it is a pyramid
scheme that will one day be shut down in the U.S. (under 20% of sales), forcing other
countries to follow suit and, regardless of regulatory action, the scheme will implode and
collapse on itself. I encourage all not familiar with the bear case to check out Mr.
Ackman’s dedicated website http://www.factsaboutherbalife.com/.
Herbalife has been in business for 32 years, has $7.5bn of retail sales, and in many
countries, including Mexico and South Korea, has been operating at high levels of
penetration for many years. Since pyramid schemes by their very nature collapse once
they run out of new naïve victims, it is unlikely that one could be so big or survive for so
long. Additionally, Herbalife has been operating in 90 countries, most for many years.
For Ackman to be right, the relevant agencies in each of these countries must have
missed this large and ongoing fraud for decades. Therefore, HLF is unlikely to be a
pyramid scheme since no multilevel marketing firm remotely close to Herbalife’s
size or age has ever been found to be operating an illegal pyramid scheme.
Part of what confuses investors with regards to Herbalife is that a large portion of the
product is consumed participants in the plan as opposed to sold to non-plan
participants. Most of Herbalife’s distributors are actually discount buyers who join
Herbalife to be able to order directly from the company and to benefit from discounts.
Given this structure/behavior, it is neither surprising nor alarming that sales within the
network would be significantly larger than sales to those who are not in the Herbalife
organization. I would note that, though a sales person will get less commission by
converting a client to a distributor, he will no longer have to deal with the hassle of
taking his order, will likely get a more committed durable customer, and will have the
opportunity to participate in any sales this person makes. To anyone looking to run an
HLF business or to anyone who values their time, the conversion from customer to
distributer is a no-brainer.
The FTC has provided some guidelines for assessing whether a multi-level marketing
organization is an illegal pyramid scheme, and they are very precise on the issue of
“internal consumption”, or sales to individuals who are distributors.
“Much has been made of the personal, or internal consumption issue in recent years. In
fact, the amount of internal consumption in any multi-level compensation business does
not determine whether or not the FTC will consider the plan a pyramid scheme. The
critical question for the FTC is whether the revenues that primarily support the
commission paid to all participants are generated from purchases of goods and services
that are not simply incidental to the purchase of the right to participate in the money
making venture.”
-FTC Staff Advisory Opinion January 2004
Using the language of the FTC guidance, in order for Herbalife to be a pyramid scheme,
the purchase of Herbalife’s product must be “incidental to the purchase of the right to
participate in the money making venture.” Who the ultimate users are and whether they
are inside or outside the program is not relevant. According to the FTC (and other
relevant case law), the multi-level marketing program is a pyramid scheme if the
purchase and sale of goods is merely a cover for the transfer of money.
Herbalife’s distributors, in aggregate, purchase an enormous amount of product. In
2013, the company sold product with a retail value of $7.5bn. To put this in perspective,
if all these sales were made up of the company’s leading product, a weight loss
supplement called Formula One, then the amount of product sold globally in 2013
would weigh more than the combined weight of the 1.54 million residents of
If the bear thesis is correct, these billions of dollars and millions of pounds of product
were purchased incidentally to buying into the Herbalife business opportunity. The
purchase of the product was merely a cover to buy into the pyramid scheme. The
buyers did not want the product and had no ability to resell the product to final
consumers. If this is the case, these millions of pounds of product, once purchased, sit
unwanted in people garages before eventually being trashed.
Another claim against HLF is regarding the company’s return policy. The owners of
unwanted product are presumed to have failed at the business opportunity and should
be happy to part with their (unwanted) product in order to be reunited with their money.
So, if Herbalife were to offer a money back refund policy, there is little doubt that they
would be inundated with returns/demands for a refund, as millions of pounds of
products came pouring back to Herbalife and billions of dollars went pouring out.
Well, actually, Herbalife does offer a money back refund policy. To quote the website:
“There is a 100% refund guarantee on product, plus return shipping costs for the
return of all unsold products purchased in the prior 12 months if Membership is
canceled for any reason.“
- Herbalife Website
On return policy, Herbalife does not accept opened containers (so if you have a pack of
ten and you have opened two, you can only return eight). Herbalife requires the
distributor to complete a four page form which requires their name, identification
number, the product they wish to return, a couple of signatures, and the date. Herbalife
requires that the product be shipped back to the company or dropped off at a
distribution center. For distributors who have received royalty overrides or commissions
(something which can only happen if you have meaningful sales), Herbalife may audit
the distributor before providing the refund. Historically, and consistent with industry
practice, Herbalife used to charge a 10% restocking fee and did not refund shipping
charges, although both of these policies have been changed.
None of these requirements seem overly complex or onerous to me. I find the argument
that the vast majority of victims of the scheme would abandon their last $2,000 to avoid
certain (modest) administrative hassles hard to imagine.
For further proof, thousands of distributors took advantage of the policy, returning
product with a retail value of approximately $15 million, or 0.2% of Herbalife’s
shipments, in 2013.
The theory that distributors are unaware of the policy lacks credibility as well, since the
buyback policy and other protections are prominently displayed to new Herbalife
distributors multiple times as they sign up for their distributorship. They are simply
impossible to miss.
Assuming that Herbalife’s return policy is indeed unworkable still leaves the question of
the fate of the product. Presumably, disgruntled victims would find another avenue to
sell their product. It stands to reason that they might try to sell it online on a site such as
eBay. It turns out that over the past several years, an amount of product approximating
0.1% of Herbalife’s revenue has changed hands on eBay, and these transactions can
be instructive.
By way of background, Herbalife discourages its distributors from selling product on
This policy, just like policy prohibiting distributors from selling the product in stores, is
designed to protect the integrity of the person-to-person multi-level selling system. That
said, the harshest sanction Herbalife can apply to a distributor that violates its rules is to
terminate the distributor from the program. Termination hardly seems like a terrible
threat to a distributor who has given up on the business, has a costly supply of
unwanted product, and does not feel he can return the product to Herbalife.
If there is little real end demand, the products, once sold, cannot really be returned, and
the quantity of product shipped, we should expect that eBay would be populated with an
abundance of desperate sellers and a relative paucity of buyers. Under such market
conditions, we should expect the clearing price for Herbalife products to be a small
fraction of the purchase price to plan participants.
To the contrary, Herbalife product sells online for ~65% of MSRP (manufacturer’s
suggested retail price). 65% is actually the highest possible price that Herbalife
products could sell for online without creating arbitrage opportunities for entry level
distributors who purchase product for 58-75% of MSRP. At this ~65% of MSRP, entry
level distributors who resell their products online would expect to make a modest loss,
while supervisors who purchase product at 50% of MSRP would expect to make a
modest profit but are prohibited from doing so by Herbalife’s rules. If the price were
much higher, anyone could sign up with Herbalife, order product, resell it on eBay, and
turn a profit, an opportunity which would certainly be arbitraged.
Herbalife was recently involved in litigation in Belgium when a consumer group called
Test Aankoop sued Herbalife, claiming that it was operating an illegal pyramid scheme
in Belgium. In its ruling in favor of Herbalife (eviscerating the lower court’s opinion that
Herbalife operates an illegal pyramid scheme), the Belgian appeals court considered
the question of where the product goes. On the matter of returns, it said:
“That the product return rules are being applied correctly by Appellant [Herbalife] follows
among others from the fact that Respondent [Test Aankoop] is unable to present even
one complaint by a Belgian Herbalife customer who considers himself deceived in this
– Belgian Court of Appeals
On the question of where the product goes:
“it cannot be claimed that the system of Appellant allows for product to endlessly
wander within the system and never find its way to the consumer. All products
purchased by a distributor from Appellant are either sold by the distributor to a
consumer, or consumed by the distributor himself, or returned by the distributor to
Appellant. “
– Belgian Court of Appeals
As to where the product ultimately goes, the answer is simple… people enjoy it! It is not
hard to find people who use and love Herbalife products. Herbalife has produced a
website with many thousands of distributor testimonials. Discussions with distributors or
web searches readily reveal ample demand for Herbalife’s products and genuine
excitement among its users. On the other hand, I have yet to find or hear of anyone who
has a garage full of product they will not consume, and cannot return or sell.
As reported in the New York Times, Ackman and his firm working with a variety of
consumer advocacy groups have expended millions of dollars in order to find victims of
Herbalife, and they have relatively little to show for their efforts. Out of the millions of
distributors involved with Herbalife, Mr. Ackman has been able to find several hundred
complaints. One Pershing Square lobbyist was quoted as saying, “it’s a problem that we
haven’t been able to find victims to come out.”
What complaints he has found, Mr. Ackman has posted to his website. Studying those
complaints reveals that the vast majority are quite old and are related to an organization
called Online Business Systems, which was operated by a former distributor named
Shawn Dahl. Dahl represented less than one percent of Herbalife’s US sales and was
essentially pushed out of Herbalife because of Herbalife’s dim view of his “work at
home” method of doing business.
Far from supporting Ackman’s allegation that Herbalfe’s business is made up of
questionable practices like Shawn Dahl’s, my research has found that Herbalife has a
deeply ethical culture. One former employee who spent over a decade with Herbalife in
a senior compliance position said, “Michael Johnson views Herbalife’s reputation as his
own.” This sentiment has been echoed by others in the organization and those who
have interacted with the organization.
On a more technical basis, there are a number of rules stemming from the FTC’s
litigation in the 1970s with Amway (called the Amway safeguards) which, if in place and
enforced, have historically been viewed by US Courts as providing reasonable
assurance that a multi-level marketer does not operate an illegal pyramid scheme.
Beyond the Amway rules, Herbalife has developed an entire set of additional
compliance practices designed to ensure that no distributor within the system creates
an illegal pyramid scheme. Herbalife uses algorithmic monitoring of suspicious order
patterns which could indicate inventory loading by distributors and takes steps to
ascertain in those circumstances whether or not inventory loading is really occurring.
Taken in total, I believe that the evidence is overwhelmingly clear that Herbalife
operates a completely legitimate (and thriving) business.
Evolution of Business Model:
Historically, Herbalife predominantly focused on getting its distributors to sell its product
to its customers in one month quantities. Herbalife relied upon the ingenuity, charisma,
and determination of its distributors to convince people to first buy the product, then to
use the product, then, after hopefully seeing the beneficial results, to purchase more of
the product, and eventually to become distributors themselves. If this approach to
selling sounds hard … it is! The customers would struggle to stay with the weight loss
regimen and thus would not see the results that they had hoped for, which in turn, made
it harder for the distributors to sell the product and build recurring business. As such,
only 40% of sales leaders (distributors who have moved to the second rung of the
organization) were able to remain in the organization from one year to the next. Starting
in 2007, the Herbalife’s strategy began to change. Initially, a number of distributors in
Mexico discovered that they were able to build more successful businesses if they
focused less on selling their customers a month’s supply of product and more on selling
the customers a day’s supply through a one day membership in a “nutrition club.”
Herbalife executives have since picked up on this, and nutrition clubs and similar selling
approaches (collectively called daily business methods) have become the core of the
company’s growth strategy.
Customers tend to visit the same club every day, usually at the same time (habit). They
often see the same fellow customers who also came at the same time (social proof).
With the regular use of the product, nutrition club customers lose weight and watched
other customers lose weight (more social proof, not to mention tangible proof).
Distributors sell the product in the same place every day (habit) and get more positive
feedback from their customers (social proof).
By 2012, ~40% of Herbalife’s volume came through daily business methods. As a
consequence, Herbalife’s growth rate in markets where this trend has taken hold has
accelerated, and there has been a significant improvement in the company’s sales
leader retention. The graph below shows sales leader retention from 2006 through
2014. Note the increase from ~40% to over 50%.
Slowing Sales Does Not = Pyramid Scheme:
A slowdown in Herbalife’s business has been used as vindication for bears who see it
as proof that the business is, in fact, an illegal pyramid scheme or, at the very least,
unsustainable and that slower growth is the beginning of the end for Herbalife.
Herbalife’s slower sales growth has resulted from a stronger dollar and weaker
volumes. 82% of Herbalife’s business is outside the United States. Moreover,
Herbalife’s costs are disproportionately in dollars as compared to its sales. Thus, a
strengthening of the dollar as compared to other currencies negatively impacts
Herbalife’s revenue and margins.
Exhibit 3              
Herbalife YOY, constant currency sales, major countries              
  Q313 Q413 Q114 Q214 Q314 Q414 Q115
North America              
US 10.2% 5.1% 8.2% 1.4% -2.3% -3.2% 3.5%
Mexico 8.7% 8.4% 7.4% 6.5% 3.5% -1.1% -2.1%
Brazil 31.5% 30.5% 25.5% -0.6% -1.5% -9.9% -7.8%
Italy 19.7% 15.2% 25.0% 24.0% 24.8% 27.1% 13.9%
Russia 31.2% 23.9% 39.0% 43.3% 21.0% 23.5% 35.1%
Spain 19.9% 34.7% 45.4% 35.3% 21.7% 21.8% 13.1%
South Korea -0.2% -10.2% -11.4% -3.5% 0.3% -20.2% -25.3%
Taiwan -19.5% -10.2% -16.8% -10.7% 19.9% -31.6% 1.5%
Malaysia -18.8% -28.9% -42.9% -33.8% -38.4% -40.7% -21.8%
India 5.5% 8.5% 12.2% 33.2% 5.5% 5.4% 5.8%
Indonesia 60.6% 22.5% 13.0% -0.6% -14.6% -4.9% -17.4%
China 70.3% 121.0% 94.8% 45.7% 33.5% 20.3% 23.4%
Total 20.5% 23.2% 16.9% 10.8% 6.3% 0.0% 4.0%
Source:  Herbalife              
Herbalife’s quarterly year-over-year volume growth is shown in Exhibit 2. Clearly,
growth has been slowing. So the question we must answer is: “Is slower growth a sign
that Herbalife’s business is collapsing or is it normal variation – perhaps exaggerated by
a number of identifiable issues and business pressures – which we as owners should
expect over time?”
To address this question, it is worth considering the source of Herbalife’s growth
historically and deceleration recently. Exhibit 3 shows Herbalife’s year over year growth
on a constant currency basis in its top geographies (collectively these geographies
represent over 70% of Herbalife’s business).
Analyzing Exhibit 3 reveals a few notable observations. First, growth on a market-by-
market level is volatile quarter to quarter. Second, while growth has slowed in many
geographies, there are a number of areas with rapid or accelerating growth. Third, with
the exception of Malaysia (and Venezuela which is not included on the table), no market
seems to be collapsing; many are simply growing slower or shrinking slowly. I would
note that Malaysia is a unique circumstance. Herbalife’s country president for Malaysia
left to found a new multilevel marketing firm and solicited away Herbalife’s most
productive members and their downlines in Malaysia. Both the Herbalife country
Exhibit 3

president and the members who have departed are operating in violation of their
agreements with Herbalife. Unfortunately, due to Malaysia’s corrupt/ineffective courts,
Herbalife has been unable to enforce these agreements.
While it is reassuring to see that none of Herbalife’s key markets are collapsing (as the
company’s opponents would lead you to believe), Exhibit 3 raises more questions than
it answers. Is this variability a sign that either the business is unsustainable or that the
business is a pyramid scheme, or is it a normal feature of MLMs?
Does the deceleration in a number of markets signify that those markets are saturated/
ex growth or is this a normal ebb and flow for this type of business?
We can attempt to answer these questions by comparing Herbalife performance to
other MLMs that we know to be legitimate and successful. Exhibit 3 shows analogous
data to Exhibit 4 but for Tupperware.
What is immediately obvious is that Tupperware’s performance by country exhibits
similar and arguably even more volatility than Herbalife’s. South Africa, for example, has
experienced year over year growth of between minus 19% and plus 28% over the past
Exhibit 4              
Tupperware  YOY, constant currency sales, major countries    
  Q313 Q413 Q114 Q214 Q314 Q414 Q115
North America              
US/ Canada 0.0% -3.0% -8.0% -6.0% 3.0% 7.0% 7.0%
Mexico  4.0% 14.0% 12.0% -3.0% 9.0% -11.0% 1.0%
Brazil 36.0% 19.0% 23.0% 22.0% 21.0% 43.0% 46.0%
Europe & Africa              
Germany -20.0% -14.0% -3.0% -29.0% -6.0% -5.0% -11.0%
France -13.0% 2.0% -6.0% 0.0% 1.0% -1.0% -14.0%
Turkey 34.0% 24.0% 19.0% 28.0% 9.0% 9.0% -2.0%
CIS na  na  -18.0% -38.0% -14.0% -3.0% 1.0%
South Africa -11.0% 28.0% 13.0% -3.0% -19.0% 0.0% 17.0%
China 23.0% 21.0% 29.0% 28.0% 24.0% 20.0% 19.0%
India 3.0% 1.0% -14.0% -9.0% -15.0% -8.0% -5.0%
Indonesia 31.0% 33.0% 25.0% 16.0% 14.0% 16.0% -6.0%
Malaysia/ Singapore 10.0% 17.0% -4.0% 8.0% -7.0% -4.0% 6.0%
Total 6.0% 5.0% 7.0% 3.0% 4.0% 6.0% 3.0%
Source:  Tupperware              
Given that Tupperware is known to be a high quality multilevel marketer, it is fair from
this comparison to extrapolate that multilevel marketers in general exhibit this sort of
 period-to-period volatility on an individual market basis and that we should therefore
expect this sort of volatility from Herbalife. Examinations of other MLMs (Nu Skin,
USANA) further demonstrate that an ebb and flow of business is a normal feature of
MLMs and not a sign that the company is operating an illegal pyramid scheme.
But does the slow growth indicate that Herbalife’s growth is over, or worse yet, that it is
on the verge of collapse?
To answer this question we need to look for past instances where Herbalife or other
MLMs experienced a period of slower growth or declined. If we see a record of periods
of slow growth or decline followed by periods of faster growth, then the implications of
this slowing growth are probably insignificant. Conversely, if we find that once an MLM’s
growth has slowed, it never recovers, or worse yet the MLM melts away, then this slow
growth would be a very bad omen.
Exhibit 5 lays out year over year growth for the past 21 years in the United States for
Herbalife, Tupperware and USANA (another multilevel marketer). Periods where the
business contracted are highlighted in yellow. As you can see, all three multilevel
marketers have had periods of negative growth in the US market, but over time they
have been able to maintain and/or build their businesses. From this table, it is clearly
not reasonable to believe that a period of lackluster growth or decline presages a
collapse of the business.
Exhibit 5:      
  YOY Growth - US Market
1993 200.2% 8.8% na
1994 19.5% 1.5% na
1995 13.1% -8.8% na
1996 -16.2% -13.2% 107.7%
1997 6.8% -13.6% 31.9%
1998 22.0% 5.8% 18.4%
1999 14.2% -4.7% -3.0%
2000 8.9% 13.2% -6.4%
2001 -2.5% 15.8% -3.5%
2002 9.9% 5.0% 5.9%
2003 -10.3% -17.2% 29.9%
2004 -8.0% -15.3% 25.9%
2005 12.6% -9.0% 18.8%
2006 18.8% 0.7% 18.7%
2007 23.9% 13.4% 6.4%
2008 14.0% 4.7% -5.0%
2009 7.4% -3.1% -5.9%
2010 16.1% 11.7% -0.5%
2011 13.7% 6.2% -1.9%
2012 20.7% -2.0% 3.0%
2013 7.8% 3.8% 3.3%
2014 2.1% -2.3% -8.8%
Source:  Herbalife, Tupperware and USANA filings.  Year over year data computed based on most comparable available information for the US market.
Bolstering this evidence are recent experiences for Herbalife outside the United States.
Italy, for example, after growing by 16% per year from 2007 to 2009, was flat from 2009
to 2011 and declined 11% in 2012. However, since 2012, the business in Italy has been
revitalized, growing by 10% in 2013 and over 25%in 2014. Similarly, the Korean market,
Herbalife’s third largest and one of its most penetrated, declined in Q1 2014 by 11.4%
year over year but returned to growth in Q3 2014. Similar episodes of slow
growth/declines followed by stabilization/ growth were experienced by Herbalife’s
businesses over the past eight years in Mexico, Spain, the United Kingdom, South
Korea, Taiwan and Brazil. To understand why MLMs like Herbalife can grow in such fits
and starts, it is helpful to conceptualize two different Herbalife business models. In one
model, imagine a member organizes walking clubs, recruiting customers and other
future members to join him/her for healthy walks and a Herbalife shake after. In this
business model, walking club members are encouraged both to use the product at
home in order to further their weight loss goals and to invite their friends to come on the
Over time, dedicated club members would start their own walking clubs, and it is not too
difficult to imagine a large and enduring network of walking clubs being built and driving
a meaningful amount of sustainable demand (not to mention healthy walks and
Alternatively, it is possible to imagine a Herbalife member who challenges his/her
friends to a three-month weight loss competition over Facebook, encourages those
friends to post their success, and invites their friends to participate as well. Just as the
“Ice Bucket Challenge” was an impactful but short-lived phenomenon, it is possible to
see how this second model could lead to an explosion of demand within a particular
social circle followed by a collapse in demand once enough people have finished their
90-day diets.
This second example is not entirely hypothetical. In 2010/2011, a multilevel marketing
company founded in 2005 named Visalus (a subsidiary of Blyth) hit upon a very
successful business method called the Visalus 90-Day challenge, which is much like the
hypothetical model described above. Visalus sales grew from $37 million in 2010 to a
peak of $623 million in 2012. Since then, sales have fallen off substantially. In 2013,
Visalus did $351 million of sales and during the first six months of 2014, (when they
were reported by Blyth), sales were $110 million (or $220 million annualized).
Whether this experience was good or bad for Visalus depends on your perspective.
Visalus sales are up six fold from where they started but down two-thirds from the peak.
Within Herbalife, given its size and diversity, there are both members whose businesses
look like the walking clubs described above, members whose businesses look like the
Visalus model at various stages of development, and plenty of models somewhere in
between. Arithmetically, it is simple to see how a blossoming and collapse of even a
small Visalus-type business within any given geography would lead to volatile year over
year performance, even if the vast majority of the business is fairly stable. The likelihood
that a significant portion of Herbalife’s business is subject to collapse like Visalus is
small for several reasons. First, none of Herbalife’s fastest growing markets have
experienced the rate of growth that Visalus experienced. (Visalus grew 17 fold in 2
years!). Second, none of Herbalife’s markets are collapsing the way Visalus collapsed
(it was down 50%+!). Third, a large portion of Herbalife’s members have been involved
with Herbalife for many years and discussions with long-term members reveal that they
have built enduring businesses.
That the bulk of Herbalife’s business is fairly stable does not mean that it is immune
from volatility. There are two major factors that are weighing on Herbalife’s volume
growth. First, over the past decade, Herbalife has been modifying its business model to
foster more stable, long-lasting businesses, more like the walking club example I
described earlier. These modifications, when implemented, tend to negatively impact
growth/sales initially, but they ultimately result in a larger, more durable and faster
growing franchise. Herbalife has been accelerating these improvements across its
business, and these changes have undoubtedly had a negative impact on volumes,
although the impact is difficult to quantify.
Second, Herbalife has been subject to substantial public criticism by Ackman for a long
time. While this criticism had little effect initially, at this point the documentaries,
negative press, FTC investigation and other pressure by Pershing Square are having an
effect on volumes in the United States. In particular, while Herbalife’s members have
continued to have success retailing the products, some have reported more difficulty
converting customers into new members.
The situation in the US is not dissimilar to a situation Herbalife faced in Spain six years
ago. In April 2008, the Spanish Ministry of Health issued a warning to consumers that
Herbalife products might cause liver damage. Consequently, Herbalife’s sales in Spain,
which grew by 26% in 2007, fell by 14% in 2008 and 19% in 2009. The Spanish
Ministry of Health completed its investigation of Herbalife’s products and removed the
warning. Herbalife’s Spanish business has since thrived and is now bigger than ever. If
the Spanish example is a good proxy for Ackman’s impact on the US business, we
should expect US performance to improve once the FTC investigation is complete.
Change in Business Model Should lead to a reacceleration of growth:
Herbalife is in the midst of making improvements to its business. These improvements
are not being made owing to any impact from Ackman, instead they are the continuation
of a process which Herbalife began in the early 2000s and accelerated in 2008 with the
testing and introduction of the 12 month qualification method. Herbalife is, however,
using the “crisis” created by Ackman and the FTC to implement changes which require
member approval so the timing is not coincidental. The changes have the following
logic: Members who become supervisors in HLF over the 12 month method versus a
one month period are 60% more likely to requalify and are more productive when they
requalify. What’s more, members who build businesses where most members in their
networks join via the 12 month method build more stable, enduring businesses. Thus,

Herbalife is putting in place business rules and incentives which encourage this slower
initial approach to the business.
While these changes should improve Herbalife’s growth and stability, they do have a
temporary drag effect on revenue as members who would have bought 4,000k of
product upfront instead buy lesser amounts initially. There are also other issues such as
field qualification in Mexico, which are having a short-term impact.
The first proof of the longer-term model is Russia ,where the system was implemented
in 2007 and has led to well over 20% annual growth. The success in Russia, is what led
HLF to change the system elsewhere. You may question the decision to change the rest
of the world all at once. The company did this because of cross-selling between
countries (i.e. a distributor in the U.S. may have downlines in Mexico). The next proof is
the early retention numbers of the program changes. On the 1Q call, HLF stated, “on
the most recent sales leader requalification data, members who qualified through the
three-month to 12-month cumulative method are approximately 62% more likely to be
retained during their first requalification period than those sales leaders who qualify
using the one-month to two-month method….three-month to 12-month qualifiers are
approximately 68% more likely to be active 12 months following their qualification
period, based on data from our first quarter.” While our data points do not guarantee a
return to growth, it would certainly seem likely. The growth initially given what we have
seen in Russia, the early retention numbers and the easy comparison, should be above
the company’s historical growth rate of 13%, yet analyst consensus has under a 6%
growth rate for 2016.
HLF is trading under 9X Earnings Power:
EPS guidance for 2015 is $4.30 - $4.60. While Guidance was raised slightly on
improved cost control, margins are still much lower than normal for the company. The
most significant driver of lower margins is higher planed SG&A spending as a percent of
sales. The long and the short of it is that Herbalife plans a good deal of its expenses 6-
12 month in advance (extravaganza, sponsorships, etc). These expenses have not
been reduced to reflect the current lower volume levels, and this is a drag on
margins. As it stands, Herbalife does not plan cuts to their SG&A expenses as they
expect volume to recover and that the business will grow back into its marketing and
promotion spend. The cost cuts so far were largely changes like coach instead of
business class for a company that appears to have grown very plump from years of
good times. It is fair to view the $4.45 of EPS as net of ~$1.25 of “excess” costs. Thus,
earnings power is $5.70+, so the stock trades for 9x current earnings power. This still
understates Herbalife’s earnings potential as the company has another $233 mln in
buyback capacity that I expect them to use shortly. Even assuming a buyback price of
$58.25 per share, this would trim another 4 million shares off the company’s 92.4 mln
current share count. Thus earnings, power will be $5.96 per share.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Hard Catalysts Coming in 2H:

The one thing bulls and bears agree on is that the FTC will issue its ruling sometime this year. I obviously think Herbalife will prevail. If they do, it will be a major catalyst for the stock. Besides the analysis I laid out above, there is some reading of the tea leaves to be done. In the recent Bostick case, in which a judge approved a settlement with Herbalife, the judge stated in summary, “a reasonable fact finder could conclude Herbalife does not operate an illegal pyramid scheme”, among other pro Herbalife statements. Additionally, an FTC Chairwoman, Edith Ramirez, shared a stage with Pamela Jones Harbour at an event in February.

The business model changes discussed above should also begin to bear fruit, perhaps as soon as 3Q. A return to growth would be a major catalyst for the stock, so looking forward to 2016, you should see roughly $7.00 per share of earnings and double digit sales growth on a very uncapital intensive business. Furthermore, the company would have been given a clean bill of legal health from the U.S. government and withstood the most aggressive well-funded short-selling attack ever. The company has an extremely dedicated customer base, which one could argue is close to religion (go to a sales meeting and you will see what I mean). Herbalife has a historical growth rate of roughly 13%, but the recent changes, I believe, will propel them to 20% over the next few years.  Additionally, the advent of social media should seemingly boost the viability and growth rates of MLMs in general. So what will the market pay for this? My guess would be 20-30x with additional upside from further buybacks and a possibility of a short-squeeze.  Conservatively, I believe the stock will hit $140 over the next 18 months, or 20x 2016 EPS.



The main risk for Herbalife is that the company faces severe penalties from the FTC, potentially forcing them to shut down in the U.S. As I laid out in my analysis above, I see this as a very remote possibility, but in any legal or regulatory process, the chance of an unforeseen outcome is there. Being conservative, the U.S. is only 18% of will assume a 30% cut to earnings power and get EPS of $3.99.  Now, even with this, I still believe the risk is still more short-term, as I expect the rest of the world to be largely unaffected by the U.S., and one could easily argue for 15x multiple, put a $60 valuation on Herbalife, and still see upside from today’s still depressed levels. However, the short-term pain could admittedly be very severe. It’s quite possible to see EPS with costs being a little more sticky short-term, dropping below $3.50, and the market assuming the worst and having the stock trade for 6x and let’s call it $20.00.  This is short-term and once again a very remote possibility.


Of course HLF is a complex system and growth may not return, which would put the shares a lot closer to fair value and eliminate a lot of the upside.

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