Herbalife (HLF): All Roads Lead To Profit, Says Ramey

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D.A. Davidson & Co. analyst Timothy S. Ramey maintains a Buy ratings for Herbalife Ltd. (NYSE:HLF). Below is his latest research note on the company.

We appreciate Herbalife Ltd. (NYSE:HLF)’s participation in a conference call with us today. Management was rightly constrained from saying much of anything “new” but the visibility and dialog is important and was well appreciated by investors.

Herbalife’s capital structure

The most important thing said, and it was consistent with all prior statements, was that in regard to Herbalife Ltd. (NYSE:HLF)’s capital structure, the company will be guided by economics and economics alone. Herbalife will gather information and seek out the advice of financial advisors, and its board, before choosing a strategy.

Davidson has been an outspoken and aggressive bull on the company’s prospects and Herbalife Ltd. (NYSE:HLF)’s shares. On January 2, 2013, we chose Herbalife as our Single Best Idea for a variety of reasons. At that time, we were using a $72 price target, which has been met and exceeded. We cited an accelerating growth rate; we cited China as a potential upside surprise of 2013. And we talked about the possibility that if “multilevel were to be fully vindicated as an operating company strategy, why wouldn’t HLF deserve to sell at 25x EPS?” We cited the “impressive margins, huge cash flow, which has been used to benefit shareholders with aggressive share repurchase and dividend increases.” All of that came true, except to date we have not seen a dividend increase, which we would expect soon, now that the re-audit cloud has lifted. And while the valuation is much improved – almost 2x last year – we believe there is more opportunity ahead.

Herbalife’s access the debt market

Being guided by economics is a good thing, and citing accretion/dilution as the guiding principal is to be expected. We expect the company to access the debt market with two objectives: a $1 billion term loan or note of seven to ten years in maturity coupled with a $1 billion LOC. Such a structure would be consistent with the company’s stated objectives of an investment grade balance sheet. The net debt position is zero and cash generation is strong. We would expect the company to use the $1 billion of note proceeds to do a $1 billion Dutch auction to repurchase shares with a price range of $82-$86. This is likely to be the cheapest way to repurchase a substantial amount of stock. Given our $115 price target, waiting and doing something incrementally may well cost more.

The cost of funds on the proposed notes is estimated at 5%-6%, probably a conservative estimate. If the company then acquires $1 billion of shares at $83, that would be 12 million shares. If done near the start of the new fiscal year, based on that cost of funds, it would be accretive to EPS by $0.25 per share in year one. We assume that Herbalife Ltd. (NYSE:HLF) will pay down short-term borrowings and keep the assumed $1 billion LOC as dry powder. Dry powder is good.

Herbalife’s damages claim against KPMG

CFO DeSimone was unprepared to speak to the damages claim that Herbalife Ltd. (NYSE:HLF) will have against KPMG (or other parties for that matter). We have to assume that this too could be a significant source of future liquidity. KPMG would not likely want such a claim to go to trial, given that their former audit partner is awaiting sentencing on insider trading. Settling claims sooner rather than later seems logical.

Herbalife Ltd. (NYSE:HLF) has choices to make – all roads possible look good, but some roads are better, economically, for the shareholders and the company. Management’s record of doing the right thing with shareholder capital is excellent.

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