Tuesday, July 29, 2014

That Herbalife miss

Herbalife's streak of beating earnings guidance every quarter since 2008 is over. They missed this quarter - not by much - but it is a miss for a company that seems to grow like topsy.

The shorts on Twitter/Seeking Alpha having spent some time saying that the numbers don't matter (just the business model) are now claiming some victory on numbers. Herb Greenberg (the only regular short I really have a lot of time for) stated that he thought the numbers don't matter but he now wants to assert meaning in the numbers.

--

But lets examine them dispassionately.

Short-sellers in this stock (particularly Bill Ackman) have a thesis that the company is a con - a scam which requires endless new victims to sign up and buy a whole lot of inventory in the promise of getting rich. They assert that there are very few real customers. [In Bill Ackman's first presentation one of his staff suggested it was possible that there were no real customers.]

They want government intervention to shut the company down - but if it is a pyramid as such it will collapse on its own. New victims can't be found forever. In other words the shorts would like government intervention but they are not dependent on it.

My view (and the long view generally) is that there is a huge amount of real consumption and real consumption is easily visible. Go to a few Herbalife distributors and you will see daily consumption. Lots of it. (I have visited Herbalife distributors in multiple countries and spoken to many more and I have yet to visit a Herbalife distributor consistent with the Ackman thesis).

What you find is a sort of cult of weight loss. If you drink protein shakes and diet suppressing teas daily you will lose weight. The only problem is sticking to that diet. Enter Herbalife who provide a (for profit) community to help you to stick to that diet. The community combined with the shakes is the product.

Visit Herbalife distributors and what you see is very large numbers of people who have entered or aspire to enter a routine of "daily consumption".

You see repeat customers.

Repeat customers are central to the bull case. If you get more of them earnings can grow for a very long time. Moreover it is very hard (nay impossible) to argue that someone who buys $100 worth of product, then in two months buys $100 more, and two months later buys some more and so on for years is scammed in the Bill Ackman sense. They know what they are getting. They are not deceived.

In my view the network recruits vast numbers of people to the diet-cult. Most fail consistent with most diets. A small number become daily consumers and this tribe of daily consumers grows nearly continuously. Most of the sales of Herbalife are to the tribe of daily consumers - the sales to new recruits whilst important don't actually drive current quarter sales. [Some of these new recruits however will become daily consumers and drive sales for years.]

The bull case - and it is a very strong bull case indeed - is that the daily-consumption tribe will continue to grow at mid-single digit for a very long time. You could wake up in ten years and earnings be $30 a share and the stock (say) $600.

---

The problem with endless growth stories

Imagine a company growing 10 percent per annum with a very high return on equity (so little capital is needed for additional sales).

Moreover assume that the discount rate is 7 percent.

Then try doing a discounted cash flow analysis.

If you assume that the growth goes forever then the value of the company is infinite.

So you must quite reasonably assume that the growth stops at some point. And the value of the company depends critically on when the growth slows. If it slows in 30 years it makes sense to pay a very big PE ratio for the company now.

If it slows next year you will get crushed buying at a high price.

Herbalife has grown fast enough since 2008 that you can engage in fantasies as to its ultimate valuation. Revenue in 2008 was $2.3 billion. It is now over $5 billion. And until the first quarter of this year it was growing uninterrupted in every geography. And the growth was volume growth - not just revenue.

Moreover the potential market is huge: fat people. This company sells roughly 10 percent of the number of "meals" as McDonalds but it sells then to far fewer people (mostly daily consumers). The potential number of daily consumers is a large multiple of the current number.

The enormous growth does enable fantasies. This stock could be very good indeed.

--

Alas - the slowing down of Herbalife growth

Herbalife was growing, quite fast, in all jurisdictions in all quarters until very recently.

One year ago they published their volume growth and sales leaders numbers and they looked as follows:




Volume growth was 11 percent in North America, 16 percent in Europe, Middle East and Africa, 33 percent in South and Central America and 49 percent in China. It was 1 percent in Asia Pacific - which mostly means Malaysia. But that was after years of torrid growth.

Jokingly I suggest: try putting those numbers into your discounted cash flow analysis.

But the shorts would argue that the Chinese numbers are anomalous - they are just finding another billion people to scam. That seemed delusional. The sales growth in North America - the most mature market - and hence the one where the pyramid-style collapse should have already happened - was still double digit. [I concluded - and still believe - the shorts are slightly unhinged.]

Moreover the sales growth per active sales leader is increasing in many markets. This means that mid-level distributors are getting paid more. That makes for a happy network.

In the first quarter of this year Herbalife had its first slowdown of any kind. These numbers shocked me to the downside and my position has been smaller ever since.


Note the sales decline in Asia Pacific. This was the first sales decline in any region that I remember.

The point is that if sales are shrinking in one region they may in turn shrink in any region. It means the growth that seemed bullet-proof from 2008 to 2013 was no longer bullet proof.

Moreover the sales leaders grew faster than sales. This meant the income of mid-level distributors was starting to get pressured. This is not good news.

Still North American growth was high (9 percent, not double-digit) and China was off-the-scale good.

These are not the numbers of a stock trading at a 10 times forward price earnings multiple. But they are no-longer the numbers that allow me to indulge $1000 a share fantasies. To get to $1000 a share in any reasonable time-frame growth numbers have to be impregnable. They clearly showed some vulnerability.

The sales decline it appears was almost entirely in Malaysia where one explanation on the ground is that they had a new competitor. Malaysia was at the time the number one market in the world for Herbalife according to Google Trends. Trends in Malaysia had been unbelievably good.

Malaysia for the unaware (meaning most my readers) has a different typical Herbalife distributor to (say) New York. New York tends to have "nutrition clubs" which feel a bit like down-market coffee shops where people sit around and drink shakes.

Malaysia has boot camps.

The shtick is that you turn up in a public park on a weekend morning and you do fitness classes. The first class is typically free. They are hard work. Over time they sign you up for both paid fitness classes and Herbalife shakes.

There is a quid-pro-quo. The fitness classes also have evening social outings - dances which serve multiple functions: weight loss support, Herbalife cult-revival, matchmaking. There are several vidoes on YouTube of these.

The first is a picture of a (soft) exercise class in a park for overweight (mostly Muslim) Malays:





The second video shows something that I have never seen elsewhere - women in full Muslim dress dancing.





This is a different image of Herbalife: part bootcamp, part fitness club, part diet club, part dance party. There are many hundreds of people at some of these clubs. These are reasonable sized businesses.

There is one of these clubs in Sydney now - with a Malaysian upline. See the 24 Fit Club. It is clearly a Herbalife club - but the meal plan is only part of what they sell.

I always - and instinctively thought that the Malaysian model was better than the Latin American/New York model. Exercise plus diet shakes clearly works better than just diet shakes. [I have seen cycling groups associated with Herbalife clubs in Miami - so the models do change according to the skills and interests of the distributors.]

Anyway an ugly sales decline in Malaysia was a decent sized kick to the Herbalife fantasy. If sales declined sharply in one market because of competition - especially when the market looked so viable - they could decline everywhere. It was impossible to project growth forever.

The 2014 second quarter earnings miss

This quarter the sales growth by region does not look anywhere near as good as in the past.



Notably there was a sales decline year on year in North America. That is a first. And there was a sharp sales decline South and Central America. This is clearly evidence that growth at this company is no-longer a given. Fantasies of enormous stock prices become more difficult to support.

However the observant will notice that Asia Pacific grew quite substantially (6 percent) quarter on quarter even if the annual growth rate was only 1 percent.

According to the short thesis this is not meant to happen. These things are meant to implode like Ponzis, not stage resurgences.

The resurgence is particularly notable because it seems that the competitor did not gain traction: the network effects of Herbalife are particularly strong. That is bullish.

Moreover whilst Herbalife sales have some seasonality (people want to lose weight for summer because of bikinis and the like) Malaysia is - climate wise - probably the least seasonal market possible. It is just hot there. So there is not a seasonal driver here.

Volumes are essentially flat quarter on quarter in North America. Its annoying and a challenge to the bull thesis but it is not disastrous.

By contrast the quarter on quarter declines in South America were quite sharp. I am wondering whether this looks like Malaysia last quarter or whether something else is happening. Whatever: as a Herbalife bull it is not good news.

Valuation

This stock remains less than ten times forward earnings. Volumes are still growing 5 percent though that volume growth is down from 14 percent a year ago and the numbers no longer look impregnable. Incremental ROE is high - and there is a huge runway for growth in Asia and China.

They buy back their shares with their profits.

The management are focussed on returning profits to shareholders through buy-backs at least in part to drive out the shorts.

I can think of no other business with that sort of volume growth, such a high incremental ROE and equity shrink. This is a great stock.

Just not as great as it was before. The upside has shrunk. No question about it.

But I can imagine few worse shorts. I have visited many Herbalife distributors and the Ackman thesis is supported nowhere. And the shorts flit between the numbers not mattering and the numbers being critical.

The numbers do matter. They are not as good as they were. The upside is capped at a lower number but still closer to $200 a share than $100. I think I can wait. Just not as happily as before.



John

Disclosures: I purchased some in the morning of Ackman's speech. I turfed some later in the day (and I am not normally a day trader). I repurchased some of those in the after-market today. The core holding is much smaller than it was last year - but it is still meaningful and we intend to sit on it a very long time.

J

===========

Post-conference call comments:

In the conference call they revealed that Venezuelan sales were down 40 percent. They had previously had trouble getting cash out of Venezuela and ran the risks of assets there being nationalized. This was a rational reduction in sales. Brazilian sales were down 1 percent - completely coincident with the World Cup. It seemed Brazilians wanted to party, not to diet. The rest of Latin America grew nicely.

17 comments:

Anonymous said...

Quick question - how often does a previously loyal customer return. e.g daily consumer to 2y, stops for 6-8m, then returns to previous? I know that may be very difficult to ascertain but just wondering if that data/literature is out there.

Anonymous said...

John, it's ironic that you state that shorts are detached from reality on this one because it seems to me that you completely fail to see the ugly reality here. Do you have nothing to say of Club Cien and the other "educational" programs that force you to consume product? Have you ever sat in on one of these classes? It is no coincidence that South/Central America is seeing the biggest declines. The bubble has popped on the pyramid within a pyramid nutritional club program that started there (remember, there are 37000 of these in Mexico alone!).

Oh, the company sent you to some nutrition clubs to confirm your bias? I wonder if they made sure to send you to one of the top performing ones...hmm...

If I have to choose between your due diligence, and Bill Ackman's, I'll choose the latter. Your confirmation bias is much stronger and you, my friend, have zero moral compass. Good day.

Tim Lamb said...

John
do you think Bill A is trying to 'scare' the constituents / customers of Herbalife i.e. by publishing enough about the $HLF listed stock supposed 'ponzi' scheme consumers get worried and consume less. That is, he is trying to actively discourage the actual consumers or members?
Tim

Anonymous said...

My question is this

Longs (as per SEC filings)
Institutional owners 112,002,230
Stiritz 7,484,804
Insiders 1,395,868
total 120,882,902

Float now 91,172,000
as per Q10

short position 25,867,578
7/15/2014

total liquidity 117,039,578

over liquidity 3,843,324

so not including the retail or smaller investor the liquidity is less than the total large investors holdings

so where are all the added shares coming from, illegal naked shorts?

All for SEC filings as of July 28, 2014

Anonymous said...

fewer and fewer shares. more volatility on fewer shares. like it.

David Tan said...

"Weight loss cult" is a good description for Herbalife, and something Shorts just don't get! The successful distributors do care about helping customers lose weight & keep fit. That's the key driver of daily consumption & sales growth, not some fantastic conspiracy that Ackman dreamt up for his failed Pyramid Short Scam.

John Hempton said...

David Tan is right. The successful distributors really do care about the fitness and diet of their customers.

Its the personal care that is the product.

J

Anonymous said...

John,

Completely off topic, but a fun little short idea is Tianhe Chemicals Group (1619 HK). 60%+ EBITDA margins, 50%+ net income margins. Good size, USD 7-8Bn market cap.

The only chemical company I know that makes those type of margins sell drugs - the illegal type...

-CT

Anonymous said...

I think part of the bear case not mentioned here, by voiced by Matt Levine and others is that selling placebos in a cult-like atmosphere is not a good business model.

I mean, if you replace 'diet shake' with 'sugar + water' it's the same biz model isn't it? You would still get the same sense of community, socializing, the dancing, etc. Would you be as bullish on that?

I don't think Matt Levine is 'unhinged.' But I agree with you that the #s always matter!

Anonymous said...

John,
in your research do you detect that concerns raised by Ackman are having an effect on public / consumer perception?

John Hempton said...

I have no real opinion on whether Bill is having an effect on sales.

Outside the US nobody gives a rats-

Inside the US many people are angry with him. Ackman is clearly having an effect on sentiment.

I guess sentiment translates to sales - otherwise people would not advertise.

But that transition is never obvious.

Anonymous said...

Maybe that was purely a World Cup effect?
Everybody eating pizza, drinking beer and watching soccer instead of going to Herbalife clubs?
Would explain poor performance in the Americas.

bidrec said...

I was once buzzed into a soft drink bottler during a sales meeting so that I could do on-site-warranty-repair-of-a-computer. The pressure to make quota is unbelievable. I would heretically suggest that many Americans don't get themselves fat any more than a goose from which foie gras is made gets itself fat. They are fattened.

As long as there is a business case for making people unhealthy there will be a business case for making them healthy.

Anonymous said...

P.t Barnum : "no such thing as bad publicity"

Josh Maher said...

No mention of the extra $1B on their books here - if sales are so great, why do things like this to the capital structure? Is there a good reason that I'm not seeing?

David said...

John,

In the 1990's Amway became saturated in Australia. I was finding I was being approached by an Amway distributor about every few months.

With Herbalife I have never been approached to join the system.

That fact alone I think speaks to Herbalife being much less a scam than Amway is.

David

Anonymous said...

"Malaysia was at the time the number one market in the world for Herbalife according to Google Trends."

You do realise Google Trends only measures Google search volume right and not offline interests or 'trends'? - Which therefore doesn't necessarily translate into sales.

You'll probably find a lot of people search for porn, but sure as hell don't buy it!

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.