Tuesday, November 4, 2014

That supposed Herbalife miss

Herbalife results was a miss on volume growth. And first I was disappointed - but as I read the 10-Q carefully I became more and more cheered.

The last post outlines what the range of outcomes on Herbalife is.

On the binary issue of the FTC inquiry we have no explicit news. As stated in the last post (and I think most shorts would agree with me) the earnings power of this company is completely secondary to whether the company is allowed to operate.

The real debate which is about the legality of the business model will continue.

The secondary debate is about the profitability of the company.

Most of this post is about the secondary debate - and the entire stock movement is about the secondary debate.

Slowing growth

In the third quarter of 2011 (as the last post makes clear) the company had volume growth like this:

Third Quarter 2011 Regional Key Metrics 2,3,4
Regional Volume Point and Average Active Sales Leader Metrics
Volume Points (Mil)Average Active Sales Leaders
Region3Q'11Yr/Yr % Chg3Q'11Yr/Yr % Chg
North America252.912.2%58,89715.3%
Asia Pacific261.236.2%51,64438.5%
South & Central America149.739.5%35,99321.8%
Worldwide Total1017.123.4%236,19123.6%
Volume Points (Mil)Average Active Sales Leaders
3Q'11Yr/Yr % Chg3Q'11Yr/Yr % Chg
Emerging Markets544.526.9%134,46726.4%
Established Markets472.619.5%109,33919.3%
Worldwide Total1017.123.4%236,19123.6%

This was astounding growth. Normal companies do not grow sales volume at 23.4 percent for long.

In that quarter sales volume (23.4 percent) was very closely correlated to the growth in the number of active sales leaders (23.6 percent). This correlation should be expected.

And whilst the correlation was not perfectly accurate by region - it was pretty close and remained close for a long time.

Over time sales growth slowed. However as recently as the first quarter volume growth was 9 percent (off very big numbers) and sales-leader growth was 11 percent. These are still perfectly adequate numbers.

In the second quarter Herbalife had its first miss in recent years. Here were the numbers for sales growth and volume growth:

Volume Points (Mil)Average Active Sales Leaders
Region2Q'14Yr/Yr % Chg2Q'14Yr/Yr % Chg
North America335.8(1%)75,7725%
Asia Pacific320.21%74,9166%
South & Central America206.3(7%)62,17214%
Worldwide Total1,430.95%340,6449%

The 5 percent sales growth number is by far the worst the company had seen. However active sales leaders continued to grow at 9 percent. There was a question as to whether you believed sales leader growth led volume growth - because if it did volumes will rise over time.

More on that later.

Some of this poor volume results in the first quarter was Venezuela - and for reasons explained in the last post declines in Venezuela are good news not bad news. Net of Venezuela sales growth was probably 7 percent - still a very acceptable rate - albeit a definite slowing.

I stated in the last post that the fair value for Herbalife (assuming an FTC clearance which the shorts think is unlikely) depends critically on the volume numbers.

If volume growth resumes as 8% plus (consistent with the number of active sales leaders) then the stock was worth something around $200.

If the volume growth declined from the growth above then assuming FTC clearance a number around $80 was fair value. [And $80 is about the 12 month high - and predates the FTC inquiry. As someone who still held stock at $80 I would be disappointed.]

Alas for the longs the numbers came in and volume growth declined further.

Here they are:

Regional Volume Point and Average Active Sales Leader Metrics
Volume Points (Mil)Average Active Sales Leaders
Region3Q'14Yr/Yr % Chg3Q'14Yr/Yr % Chg
North America303.0
Asia Pacific (ex. China)304.53%76,6495%
South & Central America204.4(17%)64,2797%
Worldwide Total1,350.30%352,2488%

Note volume growth of ZERO.

This was not meant to happen and is a big miss. Net of Venezuela it is not so bad - volume growth of 3%.

The earnings number was awful but that was because of bunch of expected charges. Venezuela has largely gone away (the sales there collapsed and the charge for currency loss has been taken). If the FTC inquiry goes away so do all the remaining charges.

But (assuming FTC clearance) the volume growth is what matters. And that is still clearly slowing.

If that were the end of the story I would be adjusting my target price for the stock below $100.

But I am not - and the reason is explained below. My time-to-target has however unfortunately extended.

Two hypotheses - one bearish, one bullish

The volume point number and the number of sales leaders has diverged sharply. Over time these will converge. That is just the way the world works.

However it is not clear whether the volume points converges on the number of sales leaders (ie volume growth converges to about 8 percent) or whether the number of sales leaders converges on volume growth (something nearer 3 percent and declining).

In other words it is not clear whether volume leads sales leaders or sales leaders lead volume. My instinct is the latter - but it is not obvious.

Lets start with the bearish hypothesis

The bearish hypothesis is simple. The product is increasingly harder to sell. It is saturated. The demand for a "business opportunity" however is substantial (especially when labour markets are not good) and so people are "signing up" to be distributors at the old rate but they are selling less and less.

This obviously is not sustainable - and the sales leaders will sell less and less and will be discouraged from being sales leaders.

Over time sales leader growth (now 8 percent) drops back to volume growth (3 percent and falling).

This is the thesis of several Twitter shorts who talk about saturation all the time.

The bullish hypothesis

The company implemented many changes in business practice in response to Bill Ackman. One of these was a limit on first-time orders (which discourages inventory loading). If the change simply defers purchase then you will find sales leaders continue to grow but for a few quarters sales volume lags badly.

Then you anniversary the business change and the sales volume growth (now 3 percent) converges on the sales leader number growth (now 8 percent).

Now here is the cheeriest thing in the whole Herbalife results.

We can distinguish between these two hypotheses. In the bear case the distributors are getting discouraged (by lack of sales) and hence the sales leader retention rate should be falling.

In the bull hypothesis the sales leaders take longer to qualify but they are selling through at an adequate rate - and hence will stick around.

Here is the point: in every market in the world where Herbalife publishes the sales-leader retention rate retention is rising. Rising retention on rising numbers of sales leaders almost guarantees rising sales in the future.

This is still a growth stock (and deserving of way over $100 per share after FTC clearance) but alas the business practice changes have deferred growth. Its a growth deferred stock.

I am going to make a lot of money. Its just going to be slower. But hey - I will take it.

Oh - and here is the table from the 10-Q of retention:

Number of Sales Leaders   Sales Leaders Retention Rate 
   2014   2013   2014  2013 
North America
   86,129     86,469     55.1  54.7
   78,818     78,453     54.2  57.6
South & Central America
   102,152     79,351     54.9  53.6
   62,723     57,071     67.7  60.7
Asia Pacific (excluding China)
   126,229     134,714     39.9  40.1


Total Sales Leaders
   456,051     436,058     51.8  51.8
   30,037     30,304     


Worldwide Total Sales Leaders
   486,088     466,362    

The good news on the FTC

There was no specific news on the FTC front - but what could be gleaned from the report was fantastic. Yes rip-snorting bullish. Eye-wateringly bullish.

The expenses related to the FTC inquiry were $2.7 million in the second quarter down from $3.0 million the prior quarter.

If legal bills are any guide (and common sense says that they are a guide) then the FTC inquiry is not being very problematic. [The shorts have not noticed this. Generally they are lacking in common sense.]

The bad news

The company had lots of one-off expenses and the cash flow net of these expenses was not wonderful. If (when) the FTC inquiry sorts itself out this will go away - but for the moment it limits financial flexibility.

Nonetheless, the bad cash flow this quarter mattered. The company stopped buying back shares. This quarter it bought back no shares and paid no divided. It distributed nothing to shareholders - and as a shareholder I am not thrilled by that.

But that is more than offset by the good FTC news (as described above) and the increasing number of sales leaders. Growth deferred - but growth nonetheless.


Summary: As a bull I am unhappy with the lack of volume growth and the lack of buybacks. This might have curtained the upside of the stock.

But the growth in sales leaders (at higher levels of retention) absolutely puts paid to this. This is a growth stock - just not this year. But we will lap the sales practice changes and this will be an blisteringly good growth stock.

And the evidence in the accounts is that the FTC inquiry is not pressing is overwhelmingly positive.

I was disappointed when I read the results - but hey - I am thrilled now.

Hope they get to buy back some stock in the 40s. That will just be the icing.



Anonymous said...

I have done next to no work here, but the "sale leader retention" table that you publish as part of your "bullish hypothesis" is quite flimsy.

Not the sentence that precedes the table in the 10Q:

"The table below reflects the number of sales leaders as of the end of February of the year indicated (subsequent to the annual re-qualification date) and sales leader retention rate by year by region."

The table you link hasn't changed from the 2Q14 10Q because (presumably) they only update the information as of February of a particular year (?).

It seems to me that retention could be completely decimated and you wouldn't know based on this disclosure.

webko wuite said...

Shareholder equity December 31, 2013: $551. Shareholder equity September 30, 2014: $(441)m, or an equity loss of $992m in 2014. Your glass is clearly half full John.

Anonymous said...

John, Is it possible the FTC is waiting until after Election Day to announce their decision?

There may be some new congressmen that need convincing after today.

Anonymous said...

The realty is that the cat is out of the hat here. Herbalife has been exposed as a dishonest and misleading organization. Whether or not the FTC shuts it down, the debate itself is having an impact on the ability of the firm to bring in fresh distributors. Without fresh distributors, there is inevitable decline...
Hence, they are pushing into new markets to try to offset this decline. But it's only a matter of time.

Anonymous said...

2015 guidance includes $.45 headwind from VZ.

It appears VZ will continue to be a drag. And, they could have been more aggressive with the exchange rate. Do they think the Bolivar will strengthen?

I would like to hear them discuss why they are tolerating the losses from VZ and why they cannot or don't attempt to ring-fence the damage.

Inventory was a big hit to OPCF, otherwise OPCF was maybe 4th best qtr all time. But, 2015 FCF guidance is flattish.

HLF could easily reduce sharecount another 6 to 8 mm by end of 2015.

Anonymous said...

John- make sure your behavioral bias isn't keeping you in this name too long. Just because it isn't a pyramid scheme (it may be... I could care less) doesn't mean all the publicity behind it doesn't kill the actual business and make it a bad stock regardless. This was in no way shape or form, a good earnings report.

Anonymous said...

@webko weuite

Do you know there's a thing called "share repurchase"?

Anonymous said...

It looks like the number of sales leaders is actually declining in most regions... and even in China. The whole number went up because of a massive jump in Latin America... which just happens to be the region with the worst volume numbers (Venezuela, yes I know).

How do you square that?

Anonymous said...


As an investor who benefited tremendously from your Fannie/Freddie analysis back in 2009, I truly feel sad to see you fall into the trap of being married to a position.

HLF is simply not worth your time and effort.

Anonymous said...

Let's see: Apart from any bullish or bearish argument, doesn't it seem odd the first 2 misses this company reported were immediately after the FTC came in?
How about Ackman claiming the Venezuelan numbers were reported at a mythical exchange rate...the company responding they are following GAAP, and the next thing we know there's a huge write-off for Venezuela?
More than bearish or bullish arguments, IMO, I am suspicious of defalcations and statements that seemingly prove wrong.
If you want to own a company where the cheeriest statement is , "We're almost certain the FTC won't shut us down" then be my guest. I'm 100% certain the FTC won;t shut them down and there will be a big pop. Long run, not so much.
Ponzi scheme? No way. That's overstated.
Bad investment long-term....well maybe not at $40 for the pop when the FTC ruling comes in.

- said...

FTC or no FTC, the developed world is wising up to the fact that the MLM model is hazardous to participants. The third world will follow shortly. Furthermore, due to the complacency of the FTC and the lobbying of legacy MLMs, there has been a proliferation of these MLM schemes. Just search the net and you will find hundreds of MLMs and they are popping up every day. The word is out, since everyone knows that the best part of the pyramid is the type, then why not just start your own?!?
Now you have a clear issue of supply & demand. Particularly for the adept con-artist in the upper middle of the pyramid. Someone who can go out there and active cultivate and recruit new "distributors" (suckers) is now in demand. This means that the real foundation of the pyramid is starting to shake, as the sergeants of the army are now being lured away by the opportunity to join a new pyramid at a level they'd never be able to achieve elsewhere... As this occurs, revenue will inevitably deteriorate and profitability will fall even faster. As the base crumbles, the top of the pyramid becomes more vulnerable, and the whole thing will come crashing down...

Anonymous said...


I am a fan of yours generally but I have to say that you are in complete and utter denial re HLF.

1st, your point about FTC legal expenses is completely laughable. $2.7MM vs $3??? Really??????? I can't even bring myself to accept that you actually believe this is somehow a "tell".

2nd, they won't be buying back shares anytime soon. See today's CNBC Fast Money Halftime interview with the CFO.

3rd, re your comment:

"Here is the point: in every market in the world where Herbalife publishes the sales-leader retention rate retention is rising. Rising retention on rising numbers of sales leaders almost guarantees rising sales in the future."

I disagree. If they continue to lower sales requirements to become an active sales leader, then you can have higher numbers of sales leaders but stagnant volume points - or volume point growth could easily lag growth in sales leaders - for an extended period.

Bottom line, the more they try to "reform" their practices to conform to the legal requirements of a legitimate MLM, the worse their financials will be going forward. This is not a 1-time blip. This is a permanent deceleration of the business - it's systemic, b/c more "reforms" are on the way. They will almost certainly need to make additional "reforms" just to remain a legal entity (when the FTC sanctions them). Of course, the alternative to being sanctioned is that the FTC puts them completely out of business.

Sorry for the harsh words, but somebody needs to try to talk you off of the ledge that you've put yourself on. Ask yourself one question - if I sold today, would I buy my shares back tomorrow? I bet the answer (if you're 100% honest) would be "Hell no".

CrocodileChuck said...

I understand your thesis on Herbalife-and that people do find value in the clubs, the relationships they cultivate and that these assist them in managing, or, losing weight.

But the product itself is crap: generic nutrients thrown into a plastic jug with artificial sweeteners, & sold @ swingeing mark-ups.

So what are customers buying? The brand?

Its always seemed to me that this is the only 'moat' that Herbalife has-any other formulator could mix, pack & ship an identical commodity to make 'protein shakes'.

Am I missing something?

Anonymous said...

John - do you know who you remind me of with your 1/2 pleading 1/2 completely deluded HLF blogs? This guy! Kinda ironic, no?


Anonymous said...

I actually wants to step in john's defense here, he might be in denial but what he's saying doesn't sound crazy at all. The company implements a first order limit, you have active sales leaders growth but volumes don't keep up, there might be some growth deferral there, it makes perfect sense.They've clearly being growing for a long time, their addressable market is as big as ever, industry insiders like Bill Stiritz are bullish on this product category, time to not doubt them yet, maybe next quarter not this one. So John might be wrong but we must wait some time before we can say that, his arguments deserve the benefit of the doubt.

Jeff said...

I like John and his blog but I would be concerned about buying into a stock owned by such a large concentration of genius and short term hedge fund managers. The risk is that you get one bad earnings release and everyone piles out at the same time and the stock goes down 20% one day and 10% the next day and now you are down 30% despite nothing having changed in the underlying business.

Now, buying after such an incident could be interesting... John have you done a basic analysis of FCF per share to show how much this company could be work if they buy back a modicum of stock each year? If you can get comfortable that it's going to hit a 20% FCF yield in 2-years without any assumptions of growth whatsoever, then maybe this becomes interesting!

Mark Alexander said...

John, you are obviously getting emotional about this stock and not thinking clearly. The "cheeriest thing in the whole Herbalife results" you reference, the retention rates in the 10Q, are over 9 months old!
The data is as of February 2014. Refer to the 1st quarter 10Q. The numbers are identical.
So therefore you have no idea what the current retention rates are, and won't until next February.
They may turn out to be disastrous.

I've always enjoyed your posts and analysis, but in my opinion your obsession with herbalife is getting the best of you.


Anonymous said...

I agree with you John and I believe you gave the best analysis of anyone and you are reading HLF exactly right - it is a growth stock, just growth deferred.

I personally see no forthcoming issues with the FTC and I am absolutely certain that Herbalife will be cleared once the FTC completes their investigation. Need we remind everyone that the FTC investigation only came about because of Bill Ackmans buddy Sen. Markey?

The earnings were disappointing for sure. Retention numbers considering this chaos are very impressive. And let's not forget that Herbalife faced a much more severe test back in the 1980s and came out smelling like a rose.

Speaking of that, it was also determined back in the 1980s that Herbalife was saturated. This of course is pure bull. Here we are 30+ years later and Herbalife is still growing.

Herbalife controls the major part of the market in meal replacements. People are repeat buyers. This will not change. If anything, it will increase. The meal replacements are well past the "fad" stage and now are considered mainstream.

It is my belief that HLF is vastly oversold and undervalued. It is a buy here, but don't expect to see a big pop right away.

Those who buy now and hold on and slowly build their positions will be well rewarded in the future. Remeber Bernard Baruch always boughtumbrellas when everyone else was selling and then when everyone else wanted to buy, he was the only one who had they to sell.

When the buyers come back. When Ackman covers, and he will, HLF will SOAR.

Hang on for the ride of your life.

Dmitry said...

John, I too will join my voice with the crowd here.
What herbalife fundamentally is? Seller of commodity products with both entry costs (to manufacture and to enter market) close to zero for far from competitive prices extracting their mark-up from the "power" of their MLM network.
The very same MLM network which is under attack presently, and while I too believe it will survive, certainly it leaves a mark. (We already see that in effect of their policies).
This in no way seems good going far forward.
Bill Ackman is wrong, and him being wrong will cause some upswings in the stock. I hope you capitalize on these. However, one simple point against looking for "growth stock" here is that Herbalife is what, 20 years old already? A company must be a miracle of apple/jobs proportions to be "growth stock" in this mature age. Please ask yourself this: what it is Herbalife suddenly doing so well? Because I only see one major driver appearing, frankly, and that is the need to "get their MLM structure more legit". Which is a bearish case, not a wonder-iphone one.

Best of luck with this one at any rate, just make sure you are not deluding yourself on the false dilemma fallacy (e.g. if Ackman is wrong, it doesn't suddenly make an intensely bull stock).


Anonymous said...

John - quick quiz, who said the following in July 2010?

"I collect super-smart people as friends. Ackman clearly fits the bill"

Answer: YOU DID! See the end of your blog post from July 4, 2010.

Ackman was right about AMBC and MBI (and you were wrong). Same thing with HLF. Bottom line - Ackman has built an $18,000,000,000 hedge fund by being right an incredibly high %age of the time. His track record is amazing, despite a few high profile misses. He is in the process of proving himself right (yet again) on HLF.

You continue to be in denial. You called HLF "scumbags" on national TV - yet you now claim they're doing great things for low income folks. BTW, go look at the academic background of those in HLF's C-Suite - all 3rd rate universities (other than Walsh) - what does this tell you? HLF does not have "honest and able" management (Buffett criteria), which renders the company uninvestible IMO.

Anonymous said...

$625 million free cash flow on market cap of $3.5 billion... what's not to like??

Anonymous said...

Does anyone have an educated guess on when the FTC issue is likely to be resolved?

Anonymous said...

Chapman now admits to Bloomberg that he threw in the towel on HLF in Sept. When will Mr Hempton do the same?

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