Herbalife is Worth $24.50-$31, if Bad Things Don’t Happen (But They Will and Are Happening)

Herbalife is Worth $24.50-$31, if bad things don’t happen.  Putting aside the probability of the government shutting it down, and the very real potential of deteriorating fundamentals, which makes this just an exercise for me, Herbalife is worth $24.50-$31 to an informed private buyer.  I used as a proxy the purchase multiples of JH Whitney and Golden Gate Capital from August ’02, when they bought Herbalife, and applied those same multiples to the June 30, 2014 Quarter (annualized) Revenue and Ebitda.

JH Whitney and Golden Gate paid 60% of Revenue and 4.5x Ebitda.  The details can be pieced together from the 2004 IPO prospectus here.  They paid $685M and Ebitda was running $150M when they closed.  There were no regulatory clouds, no media spotlight, Top Recruiters were making huge profits running Web recruiting programs, selling Internet leads and motivational business building Tools with impunity, and Nutrition Clubs were a big growth engine.

Herbalife stumbled a bit in early ’07 and JH Whitney, having already sold about $300 million of stock in the short 2 years it was public and still owning $700 million of stock, on an original $87.5 million investment, made an offer to buy Herbalife again (Golden Gate had sold and moved on).  But that deal never happened and JH Whitney wound up selling all of their stock instead.  It is important to note that JH Whitney, for instance, had their $87.5 million at risk for less than 2 year as a private company before they flipped it to the public, took almost all their original investment off the table, thereafter “playing with $1 Billion of house money.”

Today, Herbalife is under intense regulatory scrutiny, the Internet leads and motivational tools have been shut down and the Nutrition Clubs have come under a cloud of suspicion.  The best salesmen still need some tools to practice their craft, without which it will be increasingly difficult for Top Recruiters to replace the huge numbers of “Members” that quit each year.  Not being able to sell stuff (in addition to shake mix) to new recruits has also put a big dent in their income.  Top Recruiters derive more income from selling recruits “the business building tools” to help them sell Herbalife than they do actually selling Herbalife.  If you sign up a new Supervisor you might make $1,500 from Herbalife product, but you can make $3-6,000 more selling him 50-100 Internet leads at $60 each!  If just 100,000 Supervisors spend $4,500 each year on leads, you realize there’s another $450 Million that went into someone’s pocket.  That was recently taken away from Top Recruiters and I’m sure they weren’t happy.  But Herbalife promised them Nutrition Clubs were the replacement! Now Clubs have quickly come under attack.  Top Recruiters may perceive their income is under sustained attack and see clearer skies elsewhere.  (more on this below.)

Herbalife also appears desperately in search of new “customers” pushing into the World Bank List of Poorest Countries.  China is frequently touted as the growth market.  But it is illegal to operate a Multi-Level Marketer (MLM) in China, so they will be threading a compliance needle for some time.

In 2003 Herbalife had the wind at its back and the forward 10 years operating and investment results reflect that.  In 2014 Herbalife has the wind in its face.

Consequently, $24.50 – $31 is optimistic.  Certainly, there needs to be a discount to this value until the outcome of the Federal investigations is known.  And there also needs to be close scrutiny as to whether or not the same powerful pyramid economics, combined with financial leverage, are dangerously close to playing out in reverse.  Pyramids compound up fast, but they can unravel even faster, particularly if they are financially leveraged, as Herbalife now is, courtesy of the massive stock buyback.

Think that’s unlikely or too pessimistic?  In January 2013, a President’s Team member with a 16,000 distributor downline quit to join a competitor (see here).  The Top Recruiter in Malaysia recently left and joined a competitor and it clipped the results for all of Asia.  That’s just one here and there, and it’s showing up in the numbers.  But what if discontent and uncertainty among Top Recruiters has been festering for 2 years and they begin to believe their financial future is brighter and more secure elsewhere?  Herbalife is a company built upon people and relationships, “confidence” is the game.  When Michael Johnson talks about maintaining distributor confidence, he’s not referring to the whole 3.9 Million.  He’s referring to the Top 50-100 Recruiters, who in turn lead the next few thousand Recruiters below them.  After that, we’re down in the weeds.  Without Mark Hughes, Herbalife was a rudderless ship.  If Top Recruiters lose confidence in Michael Johnson (or they simply lose Michael Johnson) who is going to step up or jump in to ably lead them?

Club 100 and Universidad del Exito are not trademarks or brands owned by Herbalife.  Why would a loyal, dedicated Top Recruiter personally trademark a name, logo and brand identity different and apart from Herbalife?  Hypothetically, if instead of shutting them down, the FTC said Herbalife had to bring Nutrition Clubs “into compliance” (which would mean far less profit for their owners), would Club 100 and Universidad del Exito clubs (tens of thousands of clubs throughout Latin America, controlled by a small group of owners, more than 1/2 Herbalife’s total) decide to stay with the good ship Herbalife or launch themselves into a lifeboat apart from the sinking ship?

The industry if full of examples.  Amway and Herbalife were started that way.  The owner of OmniLife, Jorge Vergara, was formerly the Top Recruiter for Herbalife in Mexico, recruited by Mark Hughes and John Peterson.  In 1991 Herbalife was going through a difficult transition, was about to reinvent itself with the introduction of the “production bonus” (which led to 10 years of explosive growth).  Jorge Vergara copied the Herbalife plan and formed his own company in Mexico.  (I call that “Royalty over Loyalty.”)  He’s a multi-billionaire now, owns three soccer clubs, and privately held OmniLife, nearly as large as Herbalife, has $4 Billion in Revenue with a heavy emphasis in Latin America.  I don’t know if they have any history that would preclude it, but if I were Team OmniLife I’d be making a run at Club 100 and Universidad del Exito while Herbalife is on the ropes.  While Herbalife’s Top Recruiters and Nutrition Club owners are contemplating their future with Herbalife, I’d be very cautious about projecting future Revenue and cash flow.

In any event, here’s how I get to the per share value based upon JH Whitney and Golden Gate’s purchase:

$960M (QtrlyEbitdaAnnualized) x4.5 averaged with 60% x $5B Revenue = $3.7B Enterprise Value less $1.45B net Debt = $2.25B Equity divide 92M s/o = $24.50
$960M (QtrlyEbitdaAnnualized) x4.5 = $4.3B Enterprise Value less $1.45B net Debt =$2.85B Equity divide 92M s/o = $31

Then apply a discount to reflect your view regarding whether the Feds shut it down, modify it or slap it on the wrist.  And consider the potential risk and impact of Top Recruiters defecting.

If you think 4.5x Ebitda is too low a multiple, don’t forget Herbalife needs to replace 85% of its Customers (“Members”) every year and must empower Top Recruiters with the “Tools” necessary to not only replace them, but hopefully grow.

To get to the numbers being tossed around by the maret bulls, you really need to depart from all historical long term reference for Herbalife.  Here’s a rough table of stock price translated into Ebitda multiple:

  • $36 =    5.0x Ebitda
  • $53 =    6.7x Ebitda
  • $75 =    8.8x Ebitda
  • $100 =  11.2x Ebitda
  • $200 = 20.8x Ebitda (throwing this in for John Hempton)

The market values Herbalife at $6.35 Billion Enterprise Value today.  $53 per share times 92 millions shares, Equity Market Value $4.9B, plus $1.45B Net Debt.  (Net debt includes $250M repatriation tax and $100M hit for Venezuela.)

The “E” in Ebitda is the real boogey man.  As fast as “E” grows, it can evaporate in MLM.  Herbalife has always traded a mid-low single digit multiple of Ebitda.  In 2010 Herbalife traded at approximately 5x Ebitda.  A low valuation has been a perennial issue for Herbalife.  It is ludicrous to suggest it deserves a revaluation or anywhere close to a market multiple; with regulatory scrutiny and fundamental decay looming.  Herbalife did only added fuel to the fire by leveraging its balance sheet in order to buy back stock in a frenzied and fear driven attempt to beat back the evil short seller.  I wrote a bit about that here.

I’m going to come at this from another angle, as well, and use some analysis that Matt Stewart wrote in a recent Seeking Alpha article.  I’ll round the numbers a bit, and take the concept a step further.

From Herbalife’s SEC filings we learn that Herbalife “Members” (non Sales Leaders) quit in less than 1 year.  What is the value to the company of 3.3 million Members/Non Sales Leaders who quit in less than 1 year?  Let’s figure they are each worth $180 lifetime value to Herbalife ($30 per month x 6 months).  So, the Non-Sales Leaders that make up about 85% of the customer base, who are recruited to join and quit in less than a year, these Non-Sales Leaders are worth about $600 Million.  Interestingly, that’s 100% of Herbalife’s free cash flow (in round numbers).

The point isn’t that the Non-Sales Leaders are worth $600 Million and when they quit the value will be lost.  The point is that the Non-Sales Leaders are the whole point of being in business.  The business is not selling shakes.  The business is:  recruiting these people, shaking them down, churning them in a blender.  And the profit from the shakedown is split between Herbalife and the Top Recruiters.

If we value the Non-Sales Leaders at $600 Million, then the 600,000-odd Sales Leaders (Recruiters) are worth something like $5.4 Billion (all Intangible) or $8,333 per Sales Leader.  But we know that most Sales Leaders quit within two years or less.  (The vast majority of Sales Leaders stick around longer, striving in desperate hope of one day making it to the elite, yet always elusive upper ranks.)

So, we conclude that the $5.4 Billion Value is heavily concentrated at the very top of the Recruiting Pyramid.  The market has placed a HUGE VALUE on the very small group of Founder’s, Chairman’s and President’s Team Recruiters.  An educated guess:  somewhere between 50-100% of Herbalife’s value is ascribed to the Top 50-100 Recruiters.  That’s $25 – $100 million each.

Take a look at this list of Top Recruiters.  The thing that jumps out at me is the dates they joined:

  • Founder’s – exclusively 1980’s.  Forget about getting in that group.
  • Chairman’s – 1980’s to early 1990’s.  Forget about getting in that group.
  • President’s Team – 1990’s.  Pretty much forget about that group, too.

If you didn’t join Herbalife 15, 20, 30 years ago – you will be stuck at the bottom, either a Sales Leader striving to break the elusive “breakage barrier” and quitting in less than 2 years when you realize it is futile, or a Non-Sales Leader (“Member”) quitting in under 1 year when you realize their is no retail market.  But Herbalife will dress up the occasional Black Swan that makes it through the breakage barrier and parade them around on stage for million of hopefuls to see and hear.

The Top People are Mega-Recruiters.  They are not “Independent Distributors” who signed up for the same program that everyone signed up for.  That is a ridiculous claim.  They are functional and practical employees of Herbalife.  They work in a close partnership with management to accomplish a very focused goal – to recruit new members – which is distinctly different than the goal that 99.9% signed up for.

Herbalife used to be owned by Mark Hughes, Founder #1 in the Pyramid (cannot get any higher than that.)  In the MLM Mafia that is referred to as  the “Capo di Tutti Capi” or the Boss of All Bosses.  The Founder’s, Chairman’s and President’s Team are the Underbosses and Capos.  They are the “Made Guys”.  The Boss has to share the spoils and allow the Made Guys to “earn” or they will not remain loyal to the Family.  It is a delicate balance.  In the 6 months ended June 30, 2014 Herbalife had Ebitda of $370 Million and paid Royalty Overrides of $772 Million.  It would be interesting to know exactly how much went to the Top 50 or 100 “Made Guys.”  In addition, the Made Guys used to make huge money on the side businesses.  (Keep in mind, Herbalife is now a public company, but it used to be owned 100% by the Boss, Mark Hughes.  So think about the $370 Million as going to “The Boss” and $772 Million + $450 Million “earning on the side” going to the 50 or 100 “Made Guys in the Crew”.  The Top Recruiters constantly want more, but the more they fleece from the marks the potential “heat” they bring on the Boss.  It’s a delicate balance.  (Herbalife paid $6 million settlement for Top Recruiters in one case.  When Shawn Dahl got busted twice for an Internet lead scam, Herbalife finally threw him under the bus.)

The rest of the 600,000 Sales Leaders are the Soldiers, who do the grunt work for the Family, never make any money, show off like they do, really look up to the Bosses and Capos but never get the call to be “Made into the Family” so they eventually quit.  If you think I go too far with the Mafia analogy, read this by Professor G. Robert Blakey, who helped draft the RICO, federal anti-racketeering, Act 1970 or this from Boies, Schiller Federal RICO Case against Amway.

IN SUMMARY

Herbalife is vulnerable – both from inside and outside.  From outside:  Regulators are diligently doing their thing.  I’m of the opinion any serious Federal & State enforcement action will result in Herbalife at $0.  Competitor MLMs should sense weakness and be approaching Top Recruiters.  From inside:  Top Recruiters and Nutrition Club owners (who own the trademark and branding for Club 100 and Universidad del Exito) may be considering their future.  The value of Herbalife is heavily concentrated among a small group of Top Recruiters.  If more than a few quit, it will have a significant downward pyramid and leveraged impact.

Sunlight is the best disinfectant.  Bill Ackman has put the faces, names and details of the Top Recruiters (particularly those subject to U.S. jurisdiction?) on the Internet for the world to see.  At last count, 44,000 people viewed his Nutrition Club webcast.  People who walk the edge of the law (or on the wrong side of it, but don’t make a habit of advertizing it) don’t like media attention.

Among the most important things to remember in a distributor business are: (1) don’t overpay, (2) don’t get in bed with greedy, bad actors/distributors because they will choose “royalties over loyalties” every time, and (3) if you get a fire in the kitchen, it spreads fast and leverage is gasoline.

I believe Herbalife violates all three:  (1) is overvalued in relation to the fundamental business risk, (2) top recruiting distributors are “bad actors”, have had their primary source of income (side businesses) significantly cut, and many will eventually take their downline to another MLM or start their own (in the case of Clubs), and (3) the leveraged buyback will prove to accelerate the downward spiral.

Bill Stiritz may love buybacks, and may be the last shareholder “sucking on that all day sucker” (his words, not mine) by himself.  But seriously, to say Herbalife is an American Icon is either ignorant or immoral.  You be the judge.  Either way, it’s overvalued.

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