On Monday, August 14, 2017, Chinese media outlets reported that the Chinese government has launched an investigation and crackdown on multi-level marketing and pyramid selling companies. HLF (HLF, Financial)’s stock declined 5.25% on the day’s news. As we previously noted in our first quarter letter, Herbalife updated its risk-factor disclosures in its first quarter 10Q, adding new language about regulatory risk in China. China is approximately 20% of Herbalife’s revenues. A substantial decline or shutdown of HLF’s China business would have a material adverse effect on the company.
With the implementation of the FTC mandated injunctive relief in late May, the second quarter provided the first opportunity for investors to witness its partial effects on Herbalife’s financial performance. While the changes to its U.S. business practices were only in place for a fraction of the second quarter, Q2 results were disappointing to HLF investors and analysts from a top line perspective as volume declined 8% year-over-year. Year-over-year constant currency sales declines in North America (-18%), South & Central America (-9%), Mexico (-1%) and Asia Pacific (-1%) were partially offset by growth in EMEA (+4%) and China (+5%). Note that China benefited in the quarter from the recognition of certain revenue for product which was shipped in Q1 (ahead of a price increase) but was in transit at quarter end; for context, China volume declined 14% year-over-year, a more accurate measure of current trending.
We expect the U.S. business to continue to suffer as distributors attempt to comply with the new restrictive elements of the FTC consent order, with the full impact more evident in Q3 and thereafter. The company materially reduced Q3 implied and full year top-line guidance as the business begins to adapt to the significant changes required in its largest market (the U.S.). Other regions of the world remain weak including major markets such as China, South Korea, Brazil, and Mexico. We expect sequential operational deterioration to continue and to weigh further on Herbalife’s share price.
During the second quarter, HLF stock increased significantly after the company announced a large share buyback despite a reduction in guidance and substantial insider selling. While Herbalife’s share price has declined approximately 16% from its June high, it has still appreciated approximately 30% year-to-date. We believe this result is largely due to technical factors and financial engineering, as significant share repurchases, more than 5% of shares outstanding since February, cost deferrals and one-time tax benefits have enabled the company to meet and increase EPS targets despite deteriorating underlying business performance.
HLF continues to trade at a high valuation multiple particularly when compared to its actual GAAP earnings. Remarkably, investors appear to have accepted the company’s Non-GAAP EPS metric which excludes interest expense on its $1.15 billion substantially out-of-the-money convertible note that is due in 2019. Adding back interest expense to earnings as if it were not an expense is perhaps the most aggressive example we have seen of Non-GAAP earnings addbacks. Herbalife also adds back expenses “related to regulatory inquiries,” expenses “related to the FTC settlement implementation,” and “expenses related to challenges to the company’s business model.”
We expect continued business deterioration and ongoing regulatory and public relations issues for the company, which should lead to further stock price declines. This is likely to be compounded by Herbalife’s aggressive buyback program.
From Bill Ackman (Trades, Portfolio)'s second quarter 2017 shareholder letter.
