Embattled nutritional supplement firm Herbalife Ltd. (NYSE:HLF) has been downgraded from Buy to Hold by the investment analysts at TheStreet (NYSE:TST). Kevin Baker and colleagues cite “deteriorating net income, weak operating cash flow and a generally disappointing performance in the stock itself” as reasons for the downgrade in their report published Wednesday, August 13th.

Herbalife LTd. HLF

More on Herbalife

Herbalife Ltd. is a global firm that produces a variety of weight management, healthy foods, sports and fitness, energy and targeted nutritional products as well as personal care products. Herbalife Ltd. (NYSE:HLF) has a current market cap of around $4.9 billion. The firm has been embroiled in controversy for the last year or two as hedge fund activist Bill Ackman has claimed that HLF is just a fancy pyramid scheme. Shares of the supplement maker are down 33.8% so far in 2014 as of midday Thursday.

HLF mixed bag financials

TheStreet’s report highlights that Herbalife’s revenue growth is slightly above the industry average of 4.2%. Revenues are also up by 7.1% year over year. However, of note, this additionall revenue does not appear to have made it to the company’s bottom line, given a slight decline in EPS.

Herbalife Ltd. (NYSE:HLF) gross profit margin is, however, very high; currently it stands at 52.19% and is up slightly from the same quarter last year. The firm’s net profit margin of 9.15% is also well above the supplement industry average.

The company’s 2Q EPS came in just below the year earlier quarter.

HLF future potential

This firm has suffered from volatile earnings recently, but TheStreet analysts Baker at al. believe the firm “is poised for EPS growth in the coming year.” They note HLF increased its annual bottom line by earning $4.91 versus $3.95 in the prior year. Moreover, analysts are expecting a continued improvement in earnings to $6.28 next year.

However, on the basis of change in net income from the year-ago quarter, Herbalife Ltd. (NYSE:HLF) has underperformed relative to the S&P 500 and to the personal products sector average. Net income is also down by 16.5% when compared to the year-ago quarter, slipping from $143.16 million to $119.53 million.

Of concern, net operating cash flow has also declined to $156.93 million, a decrease of 26.60% compared to the same quarter last year. Last but not least, the firm’s cash generation rate is well below the industry average.

Bill Ackman had some comments about Herbalife today in a letter to investors, below is a brief excerpt (the full letter can be viewed here)

In summary, under Michael Johnson’s leadership, Herbalife developed systematic methods to recruit the poor, preying on their interest in entrepreneurship, education, and the American Dream by holding out the potential for these individuals to eventually earn $500,000 or more per annum, a level of income achieved by fewer than 0.04% of Herbalife distributors. These nutrition club training programs have been remarkably successful and now account for about 40 to 50 percent of Herbalife worldwide revenues and likely 100% or more of Herbalife profits.

As a result of our investigation, we are now able to explain and document to regulators that what Herbalife management has deemed “daily consumption” at nutrition clubs, is in fact a low-income, pyramid scheme concealed within the larger pyramid scheme, where the lower ticket price enables the poor to aspire to achieve wealth through the Herbalife pyramid scheme. Unfortunately, the outcomes for these aspiring recruits parallel those of the higher-income victims of Herbalife. They spend countless unpaid hours striving to become money-making entrepreneurs, ultimately stopping only when they have lost large amounts of their and their families’ savings, and thousands of hours of uncompensated time, as their dreams inevitably turn to failure.

 

While the media and short-term investors seemed to ignore our presentation as evidenced by the stock’s rebound that day, we did achieve our objective in increasing attendance. Nearly 30,000 logged on to the presentation including individuals from 154 countries, with more than 9,000 viewers remaining for the entire three hours. This compares to our previously highest-watched webcast, our Herbalife China presentation, which had 1,100 viewers. Subsequently, the recorded webcast presentation has been watched by tens of thousands of additional viewers including regulators, Herbalife employees (174 logged on from HLF headquarters in California), and likely thousands of Herbalife distributors from around the world.

 

While my overly promotional preview led to a public relations failure and a complete rebound in the stock price that day, we were fortunate in having attracted a high degree of attention to the webcast. Ultimately, all pyramid schemes collapse due to their running out of victims or Substantially all of these so-called nutrition clubs are in violation of U.S. labor laws, minimum wage requirements, and state sales tax collection requirements as well as state and local food-service regulations in addition to the anti-pyramid laws of many states and the Federal government.