February 19, 2012
The “Bully”, The “Cry Baby”, and Herbalife
By Brady Willett

Former longtime Wish List Holding, High Liner Foods Inc. (HLF), is a great company that has been around for 114-years. Like many companies, HLF has intangibles on its balance sheet and, from time-to-time, the company acquires a potentially ominous amount of leverage.  But given High Liner’s consistent ability to generate cash, balance sheet stress has always been remedied. 

Herbalife Ltd. (symbol HLF off of New York), is a great growth story that has been around for 32-years.  Herbalife also has a significant amount of intangibles on its balance sheet, but, unlike High Liner, has never really been tested in the marketplace. That is, after more than a decade of nearly perfect growth, Herbalife’s highly leveraged balance sheet and its potentially worthless ‘assets’, have never been all that much of a concern. 

In the second quarter of 2012 a small sign of stress occurred at Herbalife when its debt/equity ratio jumped from 1.53 in 1Q12 to 4.65 in 2Q12.  This increase in leverage, thanks largely to the company borrowing money to repurchase its own stock, brought the company back to a negative tangible equity position for the first time since 2Q10, and pushed total debt above $1.2 billion for the first time.  While potentially only a bump in the road, the sheer size of the debt figures, not to mention the companies nearly maxed $700 million credit facility, was and is cause for concern.

Enter Ackman (aka The “Cry Baby”, according to Icahn)

Founder and CEO of hedge fund Pershing Square Capital Management, Bill Ackman, released a report in December attacking Herbalife as being little more than a pyramid scheme.  With some eye-candy and cherry-picked quotes, Ackman makes an impressive case that Herbalife’s products are ‘commodities’ and in some sales channels (online sites and Ebay) are already behaving as such.  The report also outlines some of the basics of what quantifies a pyramid scheme, and how Herbalife and its affiliates care more about recruiting new distributors than actually selling product.  If you can handle the bias (Ackman is proudly short), the information provided is definitely worth reading (see full report).

But while Ackman’s report is perceptually compelling, it is also statistically weak.   To be sure, that Ackman doesn’t bother to delve into HLF’s financials deeper suggests he is trying to create negativity in the stock rather than report facts. Here is a fact: the income statement is a work of fiction at many companies, including Herbalife, and Mr. Ackman didn’t bother to delve deeper than HLF’s income statement.

Beyond The Income Statement

The bigger potential train wreck, that Ackman doesn’t mention, is Herbalife’s balance sheet. Here we see a company with steady cash, minimal immediate stress (1+current ratio), but a massive amount of intangible assets.  Most of Wall Street doesn’t care about these numbers, but if are looking for clues of what a giant growth story looks like before it turns to dust, here they are.

The danger doesn’t rest explicitly in the financial ratios per se, but rather the $416 million in intangibles, the $313 million in inventory, and the other non-cash or illiquid lines. With no financial buffer or a 114-year history of ups and downs in place, when Herbalife’s growth phase stalls the writedowns and cash demands could prove deadly. 

But Maybe The Cash Will Keep Flowing?

Surprisingly, baring accounting trickery or outright fraud, the above numbers are very attractive.  Herbalife has produced $3+/share in free cash in each of the last 6-quarters, it has paid a dividend (a number that can not be fudged) since 2007, and, given its model, there is never any pressing need for massive capital expenditure plans. Quite frankly, if you think Herbalife will remain a going long-term concern, it is definitely worth paying 10-time free cash!

But will Herbalife remain a going concern?

Enter Icahn (aka The “Bully”, according to Ackman)

Once upon a time a ruthless corporate raider, today Carl Icahn is regarded as a shareholder friendly activist. Mr. Icahn, quite openly, dislikes Ackman, and the two have a history fighting in court and on CNBC. Last Friday Mr. Icahn disclosed a position in Herbalife, effectively attacking Ackman’s short.  The astute Icahn is not likely to have involved himself in HLF unless he analyzed the probability of regulatory agencies investigating and/or cracking down on the company.  Which brings us to the question of the day.
Who Will Be Right?

If the stakes remain the same, I believe Icahn will ultimately be proven correct.  This is not to say Herbalife will not slow its potentially reckless options/repurchase policies, the dividend will not be cut, or some new fine or regulatory action will not be imposed on the company.  All this could certainly happen.  Rather, only that the company is unlikely to be shut down by regulators for being a pyramid scheme.

The basic problem with calling Herbalife a pyramid scheme is that innocent people are not throwing money at the company based upon a get rich quick idea.  Using the 2.4 million ‘bottom of the pyramid’ number offered by Ackman on page 195, there is no amount of math that can be done to account for $3.4 billion in sales (partially phony or not), $515 million in cash from operations, and $125 million in dividends (annually).  As Ackman notes, pyramid schemes become ridiculously widespread quickly...but, apparently, not at HLF? Moreover, when the Brussels Commercial Court rendered a negative decision against Herbalife International Belgium for “establishing, operating or promoting a pyramid scheme” in 2011 Herbalife did not cease to exist. Rather, the company is currently “exploring various relatively minor clarifications and changes to ensure compliance with the trial court’s decision pending the appeal” (HLF 2011 10K).  Isolated pyramid-like practices does not a full-fledged pyramid scheme make.

The next problem for Ackman is that, as noted, the company generates a lot of cash.  Mr. Ackman notes that Herbalife is selling essentially the same product it did years ago, does not spend much on R&D, doesn’t have an advertising budget, and has only a single patent. For a value hawk this is what makes Herbalife so attractive!  That Herbalife does not need to constantly reinvent itself is precisely why it generates cash!

Finally, Mr. Icahn will be ‘right’ because if the stock goes low enough this could compel him to make a tender offer for Herbalife.  If the company goes private the stock price doesn’t go to zero.  Under this scenario Mr. Ackman is ‘wrong’, even if Ichan or someone else is unable to keep the company thriving in the years ahead.

In short, Herbalife is a train wreck waiting to happen because there is no financial cushion in the company’s balance sheet to absorb a couple of bad quarters, much less a bad year. Herbalife is also a cash cow that throws of a decent dividend. The conclusion to be made is that even though HLF.N is not going to zero, its pyramid-like model and short operating history lacks the longer-term sleep-at-night comfort of an HLF.T.

Disclosure: I do not own any investment position in Herbalife or High Liner. 20-years ago when I had to lose weight for a football league I drank this horrible tasting juice in the morning, a handful of pills, and a shake for lunch and supper. Within only a few days I wasn’t hungry and I was able to make the weigh-in.  Thanks to Herbalife...

Icahn, Ackman in Epic Showdown of Billionaires
David Einhorn Singlehandedly Crushed Herbalife (May 2012)


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