Herbalife was once a major target of short-sellers. Today, its short interest has declined near-zero.
Herbalife has failed to grow in developed countries and has become dependent on emerging market countries with higher physical store dependence.
As COVID causes global stay-at-home orders/fears that are likely to last for sometime, Herbalife is likely to see significant sales leader turnover.
As is the case with most MLM's, turnover leads to more turnover and can eventually bring the business down.
Herbalife also has significant unsecured debt due to excessive dependence on share-buybacks.
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It has now been over three-years since Bill Ackman's 'Betting on Zero' launched a short-seller crusade against the multi-level-marketing firm Herbalife (HLF). Having doubled in value in the two years following the documentary, it went down as perhaps one of the most embarrassing short-bets ever made. However, three years later in the midst of a global pandemic, Herbalife stock is now back at 2017 levels.
Due to allegations of deceptive marketing practices, unjust enrichment, and bribery, the company has paid out over $235M in lawsuit settlements over the past six years. The company's growth in the Americas has hit a standstill and looks to be on the decline. It has grown sales in Asia but has hit regulatory snags in China as its pyramid-based business model is generally not allowed (Annual report Pg. 10) and saw executives recently charged with bribing Chinese officials in order to obtain lucrative direct selling licenses.
Of course, COVID-19 is also likely to hurt the company. In-person sales are likely to decline dramatically. Particularly in areas of the world highly dependent on in-person sales. Online sales, however, are unlikely to be drastically impacted, though the company's generally high-cost products are likely to take a sales hit as many looks to trim their budget.
Looking further out, the company has drastically increased its leverage which may become a problem down the road considering it is unsecured. Even more, due to widespread unprofitability, lawsuits, and increased regulatory scrutiny multi-level-marketing as a business practice is on the decline. Indeed, one need not go far to find the abysmal income statistics of most Herbalife sellers.
All of this aside, the core issue I see with Herbalife is that it does not need outside capital. As equity investors, we are buying a company's capital which is backed by its net asset value. Herbalife has decent cash-flow, but its only true asset (which generates that cash flow) is its sellers. Without sellers, there is no Herbalife. Problematically, at least a third of sellers leave every year (Annual report page 9) which can easily spiral without new sellers.
The few who make an income off of Herbalife do so primarily due to downline royalties. One year of low recruitment would halt this value to those above and potentially exacerbate Herbalife's already high turnover. Such a scenario could bring the entire pyramid down as turnover causes sales losses which causes more turnover. This is a core fragility that only exists in MLM firms and has been the downfall of many if not most (see Tupperware (TUP)). This "reflexive collapse" makes MLM firms about as far on the "fragile" side of the fragility spectrum that a business be (next to social media).
Let's dig deeper into the company's financial situation to see how long it may be until Bill Ackman's original thesis will potentially be proven correct.
Herbalife's Poor Growth and Signs of Decline
From 2018 to 2019 Herbalife was not able to grow its net sales. Sales in North America rose 8% but fell 13.4% in Latin America and 25% in China with overall net sales declining by 0.3%. The highest growth area was Asia Pacific (excl. China) at 18%.
The company's revenue is driven by its sales leaders. This figure grew 35% YoY in North America, 16% in Asia-Pacific, and 13% in EMEA with low growth in Mexico and negative growth in Latin America. Overall, this figure grew 13% globally with a 66% average retention rate. The company also had a 17% direct seller growth in China despite significant net sales declines. This is likely due to a ban on MLM instead of costlier direct selling licenses.
Importantly, less than a quarter of Herbalife's net sales are in North America with over half being in developing countries. In the United States, Google Trends search volume for "Herbalife" compared to its competitor "Arbonne" has shown it has been failing to beat its competition, though it has held USANA (USNA) down:
Similar search volume declines are seen in most Latin American and European nations. In fact, it is the few places where net sales growth has been high (Asia Pacific) where Google Trends search volume is on the rise. Most notably are India and Vietnam which have both seen interest slowdowns in recent months:
Obviously, Google Trends does not give us a one-for-one measure of sales and sales leader growth, but it seems to be generally correlated to last year's growth measures. Problematically, Google search volume appears to be declining for almost all countries.
This comes as Herbalife's EBITDA margins appear to be in decline due to the increasingly saturated health-products market:
Importantly, Herbalife is also a very indebted company. As you can see below, the company's book value is negative and its financial debt has increased in recent years despite no material increases to revenue or EBITDA:
If a multi-level-marketing company is already fragile, a highly indebted MLM is worse. While a financial debt-to-EBITDA ratio of 3.1X may not seem too bad it is made worse by its poor BB- credit rating and lack of securable assets. Most of this debt has gone to its significant share repurchase program, not toward improving its (struggling) core business.
Importantly, the company does not have significant debt maturities until 2023-2026, but I expect its aggressive share repurchase program to slow due to higher financing costs. Additionally, I would not be surprised if COVID impacts cause the company's credit rating to be downgraded into the single-B range.
To be blunt, I believe COVID will negatively impact Herbalife more than most currently expect. Online sales are unlikely to be severely impacted, but Herbalife's growth areas are heavily concentrated in poorer emerging nations which have a greater emphasis on physical sales via "nutrition clubs". These places will likely see significantly lower sales and, as such, are likely to see significant retention issues.
As I mentioned earlier, the core issue with Herbalife's business model is that declines tend to cause further declines. Given a decline in new sales leaders, those "on top" who make high passive incomes will see their revenue vanish and leave the business as well. Without a constant stream of new sales leaders to replace those who leave, the system fails.
This has seemingly begun in most of North America, Latin America, and Europe and is likely to be exacerbated by COVID. Further, COVID stay-at-home and social distancing measures are likely to catalyze this issue in emerging markets. While some believe the virus's impact will end soon, it is far from peaking in most emerging market countries and evidence suggests "second waves" are likely.
Overall, I believe HLF is eventually headed to zero though such an outcome may not occur until its significant debt maturities come near. Despite flat sales, its core business is in decline and the company has been reliant on moving around the world to new countries to target for growth. As seen by its failure in China, it is running out of fresh places to operate.
Despite these significant risks, HLF has a high TTM "P/E" of 14X. While this may not seem "high", it is given the tremendous fragility of its business model, high leverage, and lack of growth. I believe HLF is a clear "sell" with significant potential COVID-related downside.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in HLF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.