Canaccord Genuity analysts Scott Van Winkle and Mark Sigal weigh the ramifications of the recent news surrounding the FTC investigation of Herbalife Ltd. (NYSE:HLF).
We believe Herbalife Ltd. (NYSE:HLF)’s efficient business model along with deployment of its daily consumption models globally will continue to drive revenue and earnings growth. However, a formal FTC investigation will limit valuation.
Investment highlights
The FTC investigation announced yesterday into the allegations against Herbalife Ltd. (NYSE:HLF) will provide a definitive opinion to a debate that seemingly wasn’t going to end otherwise.
We suspect it could be over a year before a conclusion occurs. The SEC’s 2007 investigation of USANA Health Sciences, Inc. (NYSE:USNA), which ended with no action on the same arguments, took 10 months and HLF is larger and more complicated.
While 15 months of publicity has had little impact on Herbalife Ltd. (NYSE:HLF)’s domestic sales, US trends should be the near-term focus.
Valuation
At 10x forward earnings forecast, Herbalife Ltd. (NYSE:HLF) continues to trade at a discount to peers, growth and its historical average PE. We don’t expect a normal valuation under FTC investigation. Lowering target to $73 from $87, or 11x preliminary F2015 EPS estimate.
FTC Investigates the accusations
Given the high-profile nature of the accusations leveled against Herbalife Ltd. (NYSE:HLF) and recently heightened mainstream media coverage surrounding another round of formal attacks, the announcement and timing of a formal FTC investigation of Herbalife probably shouldn’t be a major surprise given a front page story in the New York Times this week brought new revelations to how the fight was being waged…not to mention throwing a US senator into the mix. We can only suspect that this week’s coverage led to an “enough is enough” opinion atop FTC. Given the market reaction, which was volatile but modest as far as daily stock price corrections go for Herbalife Ltd. (NYSE:HLF), it would appear that holders were somewhat conditioned for this outcome as well. We knew something had to happen, but didn’t know what form or how public an inquiry would be. Frankly, we are surprised an inquiry wasn’t already in process given how public the accusations were.
Herbalife is a pyramid scheme
As we have long contended, the accusation that Herbalife Ltd. (NYSE:HLF) is a pyramid scheme is not an accusation indicting just Herbalife, but the entire multi-level marketing industry. An FTC investigation may lead to revelations of marketing practices or distributor activity specific to Herbalife Ltd. (NYSE:HLF), but a business model question isn’t specific to Herbalife, in our opinion. We continue to believe that the risk isn’t an investigation that shuts down Herbalife (as its opponents contend), but rather Herbalife being the current version of the precedent case for the direct selling model. We expect that the direct selling industry as a whole, where most have long held up Herbalife Ltd. (NYSE:HLF) as benchmark and standard of industry leadership, will be watching how multi-level marketing is viewed by regulators.
As the headline hits and is likely to receive broad media coverage, particularly after this week’s New York Times front-page article, our near-term question is what the impact could be on US growth trends. We believe a formalized investigation brings greater risk of member churn and decelerating new member growth in the US. But it is hard to forecast how the media coverage progresses beyond day 1. We also suspect that Herbalife Ltd. (NYSE:HLF) could be more constrained in responding to near-term negative headlines and further attacks while under a formal investigation. Ultimately, an FTC determination should be the final ruling to pyramid scheme allegations that helps restore clarity and confidence in Herbalife and the broader direct selling space. The FTC overhang will weigh on HLF shares until a final determination is made, and while it is challenging to predict investigation duration with a high degree of confidence, the nine- to 10- month SEC investigation of USANA Health Sciences, Inc. (NYSE:USNA) (USNA : NYSE : $69.82 | HOLD) in 2007-08 over similar allegations seems like a base case, as Herbalife is significantly larger and more complicated given its size and global scope. The SEC ultimately took no action against USANA Health Sciences, Inc. (NYSE:USNA).
We maintain our BUY rating as the valuation already discounts a negative regulatory outcome, although not worst-case-scenario. However, we are lowering our 12-month target to $73 from $87 as we doubt there is a conclusion to the FTC investigation within 12 months that would be a catalyst for an expanded valuation. As such, we do not expect the valuation to normalize soon, particularly with peer Nu Skin Enterprises, Inc. (NYSE:NUS) (NUS : NYSE : $77.89 | HOLD) facing China challenges that added to negative sentiment in the sector.
Valuation
Herbalife Ltd. (NYSE:HLF) is trading at 10x our F2014 EPS estimate and under 7x EBITDA, a valuation that remains discounted to the peer group and Herbalife Ltd. (NYSE:HLF)’s historical average. Our $73 price target implies 11x our preliminary F2015 EPS forecast in the $6.70 range (assumes just 10% growth off normalized F2014 EPS that would be north of $6.10 if the recent buyback had a full-year effect on F2014). The 11x multiple would reflect a 20% discount to the historical average PE of about 14x forward earnings, which is also the peer average currently.
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