Herbalife Ltd. (NYSE:HLF) Short
Despite weak financial performance in Q1, Herbalife’s share price has appreciated by more than 50% year-to-date. We believe this is due in part to Herbalife’s misleading portrayal of its first quarter operating performance and the company’s share repurchase program. Below, we summarize this quarter’s recent developments, and provide further detail in an attached exhibit for those who would like to learn more.
For the first quarter, Herbalife reported flat year- over-year constant-currency sales growth across the business. Growth in some markets (Mexico, EMEA and China) was offset by substantial declines in others (South & Central America, North America, and Asia Pacific). The company reported significant persistent declines in South Korea and Brazil (historically large growth markets for the company), and stopped reporting individual market results for the United Kingdom this quarter after sales declined substantially. As recently as 2010 and 2013, respectively, South Korea and the U.K. were trumpeted as high growth markets for Herbalife with 82% growth and 81% growth, respectively. We expect that Herbalife will also eliminate the disclosure of South Korea’s sales when they drop below reporting thresholds. Herbalife’s Management Discussion and Analysis (“MD&A”) disclosures in its SEC filings do not accurately describe the causes for these declines, often relying on the same factors to describe why certain markets are growing and others are declining.
The dramatic “pop” and “drop” reflected in Herbalife’s individual markets are highly characteristic of pyramid schemes, which achieve accelerated growth until a market reaches saturation, after which there is a dramatic decline in volumes as participants recognize that being a distributor is a money-losing proposition. Bullish analysts on Herbalife have attempted to characterize the company as comparable to a consumer packaged goods companies (as these companies often trade at 20+ P/E multiples), which do not experience massive growth followed by massive declines.
On a consolidated basis, modest volume gains in the quarter were offset by price/mix and foreign exchange (“FX”) headwinds. Herbalife’s business declined across most geographic regions. Adjusting for the pull -forward of volume in China (described below), worldwide constant-currency growth was negative ~4% year-over-year, a sequential decline compared to Q4’2016 which was negative 1%.
For the quarter, the company reported headline “adjusted” EPS of $1.24, including $0.26 of add-backs, the magnitude of which has become highly material in recent years. Although management increased full-year guidance by $0.40 (now $4.05-$4.45), this actually represents a reduction in expected future performance when one factors in Q1 outperformance (which is overstated for the reasons we describe in detail in the attached exhibit), certain one-time tax benefits, a revised FX outlook for the balance of the year (itself a ~$0.35 positive adjustment to guidance), and the impact of share buybacks to date.
While bullish investors in Herbalife have suggested that the company’s recent results show that it can manage effectively through the requirements of the FTC settlement, North American performance in the quarter, which declined 7%, does not yet reflect the impact of the FTC permanent injunction. Nearly all of the business model changes required by the FTC do not take effect until May 25th. The company’s Q2 results will include five weeks of operations subject to these structural changes, but the run-rate impact of the FTC injunction will not be fully reflected in operating performance until Q3 results are released in the fall.
China, at 20% of sales, is Herbalife’s second largest segment after North America. While China realized +17% volume growth in Q1, management noted that there was a significant pull-forward in volume ahead of a 5% price increase in April. On a normalized basis, excluding the pull-forward, China would have declined 17% to 20% in Q1 on a constant-currency basis. Given the volume pull-forward and other factors, reported Q2’2017 results for China are likely to be down significantly compared to Q2’2016.
Herbalife’s 10-Q included a number of significant notable changes to risk disclosures with respect to China, including language which now identifies “uncertainties relating to interpretation and enforcement of legislation in China governing direct selling and anti-pyramiding” (emphasis added). We have described at length in a prior presentation, available here, the fact that Herbalife operates illegally in China. As such, we were not surprised to see these changes in risk disclosures. We would not be surprised to learn that Herbalife is under investigation by Chinese authorities, particularly in light of the recently announced Foreign Corrupt Practices investigation of Herbalife’s China operations by the Department of Justice and the SEC. Management increased its projected “Expenses Related to Regulatory Inquiries” from $0.06 (~$5m) as of February 2017 to $0.11 (~$9m) implying that the company expects regulatory scrutiny to increase. Herbalife, of course, adds these costs back in calculating Adjusted Earnings. Every large-scale business incurs regulatory oversight costs in the ordinary course. The notion that these should not be counted as part of a company’s ongoing expenses is ludicrous in our view.
We believe the injunctive relief imposed by the FTC is likely to weigh significantly on Herbalife’s financial performance in the coming quarters. Coupled with decelerating growth and substantial deterioration in many international markets (including China), we expect earnings to decline on an operational basis in 2017. Despite the above issues, Herbalife is now trading at ~17 times the midpoint of management’s adjusted guidance (~21x on unadjusted EPS). It is currently trading at the highest P/E ratio in its history as a result of the recent stock price increase and its declining earnings.
From Bill Ackman (Trades, Portfolio)'s first quarter 2017 shareholder letter.
