On May 5th, Herbalife (HLF, Financial) reported improved financial performance for the first quarter of the year and updated their regulatory disclosures as follows:
“The Company is currently in discussions with the FTC regarding a potential resolution of these matters. The possible range of outcomes include the filing by the FTC of a contested civil complaint and further discussions leading to a settlement which would likely include a monetary payment and injunctive and other relief. The Company is cooperating with the investigation and at this time it is difficult to predict the timing, and the likely outcome, of these matters. The discussions with the FTC are in the advanced stages, but there are still a number of material open issues that could preclude reaching final agreement. If discussions with the FTC do not continue to progress, it is likely that litigation would ensue. Although we are confident in our legal position, litigation outcomes by their very nature are difficult to predict and there can be no assurance of a particular outcome.
“The outcome of these matters with the FTC, whether by mutual resolution or through litigation, could have a material adverse impact on the Company’s business operations, its results of operations or its financial condition. The Company believes it is reasonably possible that it may have incurred a loss.
At the present time, the Company’s best estimate of the payment amount that would be made by the Company under a mutual resolution with the FTC is $200 million. The Company has not accrued any amounts with respect to any potential monetary payments relating to this matter. If a resolution is not attained and litigation ensues, the Company is unable to estimate a range of potential loss, if any, relating to these matters.”
The company’s language provides greater specificity and introduces a narrower range of outcomes versus the company’s 10-K, filed on February 25th, which stated:
“The possible range of outcomes include the filing by the FTC of a contested civil complaint, further discussions leading to a settlement which could include a monetary payment and other relief or the closure of these matters without action.”
It is notable that the company removed the “closure of these matters without action” language from the recent 10-Q.
Investors reacted favorably to the company’s disclosure apparently focusing on the modest size of Herbalife’s estimate of the monetary portion of the settlement, less than two quarters of earnings, suggestive of an overall settlement that would be no more than a “slap on the wrist.” While a $200 million settlement would be one of the highest ever in an FTC consumer protection action, it would be immaterial to Herbalife. Investors, however, appear to ignore the fact that the company may not be able to settle with the FTC, and instead, will be sued by the FTC for being a pyramid scheme, or, alternatively, that a settlement’s “injunctive and other relief” may materially impair HLF’s future profitability and growth potential.
Recently, the FTC obtained significant injunctive and other relief in its Vemma pyramid scheme litigation, which, we believe, if applied to Herbalife would significantly harm the company’s ability to operate profitability. We expect the FTC to demand similar safeguards and restrictions for Herbalife as it has required in the Vemma case.
On the evening of May 6th, shortly after HLF’s press statement about a possible resolution with the FTC and the stock price’s substantial increase, Justin Cole, the FTC’s Director of the Office of Public Affairs, provided an on-the-record statement to the media:
“Injunctive relief can be just as significant as the money obtained for consumers and even more influential on a company’s future operations.”
We believe it is very unusual for the FTC to respond to a public company’s characterization of settlement negotiations. The FTC’s reaction may signal its concern that Herbalife or investors are minimizing the significance of potential injunctive relief. The key question is what “injunctive and other relief” may be. We expect that the relief imposed by the FTC will require modifications to HLF’s business practices which will be materially adverse to HLF.
The company reported net sales of $1.12 billion for the quarter, up ~1% year-over-year (after the impact of FX), off a relatively easy comp, beating management’s and analysts’ guidance by 6% and 4%, respectively. A combination of better-than-expected volume growth and a less severe FX environment contributed to this result. China (+39%) and EMEA (+17%) continue to be the strongest regions. Notably, North America (+9%) posted its best quarter since Q1’2014. Driven by higher-than-expected volume and net sales, Net Income grew ~7% year-over-year (“YoY”) and adjusted EPS was up ~5%.
From a cash flow perspective, results were less favorable, as operating cash flow and free cash flow declined ~12% and ~20% YoY, respectively. Total cash on HLF’s balance sheet decreased 13% to $774 million after the company paid down $230 million of debt in the quarter as requiredend, at which point HHC will begin to generate a significant amount of cash flow from condo closings. Anaha, a 317-unit project, is expected to be completed by the summer of 2017. In February 2016, HHC began construction of Ae’o, the third of four mixed-use residential towers planned for the first phase of the Ward Village development. Whole Foods has pre-leased a substantial portion of the retail space at the base of this tower, which is scheduled for completion in 2018. The fourth condo tower, the 424-unit Ke Kilohana, sold 90% of its units in five days (in April 2016). Ke Kilohana is a workforce residential tower with 375 of its units designated for local residents.
From Bill Ackman (Trades, Portfolio)'s first quarter shareholder letter.
