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Bill Ackman Thoughts On Herbalife $HLF

On November 1, 2016, Herbalife reported its third quarter financial results. Modest financial performance in the quarter, disappointing 2017 guidance and the unexpected announcement of a CEO transition caused the stock to decline. HLF stock has traded down more than 33% since the announcement of the company’s settlement with the FTC on July 15th, 2016, a 15% year-to-date decline, as investors have come to increasingly ignore the company’s fraudulent characterization of the FTC settlement. At its December 2, 2016, price of $47.99 per share, HLF currently trades at approximately the price at which we shorted the shares in 2012.

On a consolidated basis the company reported net sales of $1.1 billion for the quarter, up 1.7% year-over-year. Headline adjusted net income of $105 million for the quarter (down 3% YoY) translated into adjusted EPS of $1.21 (down 4% YoY). On a constant currency basis the company reported net sales growth of 5%, driven by EMEA (+15%), Mexico (+14%) and North America (+10%).

The deceleration of Herbalife’s China business during the quarter is notable. Once a high-flying growth market (regularly posting 20-30%+ top-line growth), the China business has slowed in recent quarters, achieving modest 1% currency-adjusted, year-over-year top-line growth in Q3 (or negative 5% on actual basis).

Along with earnings, Herbalife announced that Michael Johnson is slated to transition to Executive Chairman in June 2017 at which point Rich Goudis, the current COO, will take over as CEO. Goudis has been largely absent from the public eye in recent years.

Since HLF’s earnings call, two other notable events have taken place. First, on November 6th, John Oliver’s Last Week Tonight aired a 32-minute segment on multi-level-marketing companies with a focus on Herbalife. In his typically colorful style, John Oliver points out the hypocrisy and fraud inherent in Herbalife’s business and shines a spotlight on how the company harms hundreds of thousands of people every year. You can watch his scathing take-down of HLF here. To date, the John Oliver segment has been viewed on YouTube more than 8 million times including over 1.7 million views of the Spanish-language version representing about 11% of the Hispanic households in the U.S. These 8 million views are in addition to the 4.1 million viewers of Oliver’s show on HBO and millions more on Facebook.

Second, on November 7, 2016, the documentary film “Betting on Zero” secured distribution rights, which will include a 30 or so city theatrical release in early 2017 and online video-on-demand dissemination thereafter. We believe that the John Oliver segment and the wide distribution of the film are materially positive developments which will help elevate the Herbalife story beyond traditional financial news media.

Despite its weak financial outlook, Herbalife is trading at $47.99 or about 10 times the midpoint of management’s new 2017 guidance ($4.60 – $5.00). Importantly, however, this guidance does not assume a significant disruption in Herbalife’s U.S. business. We believe the negative earnings impact is likely to be substantial as the U.S. accounted for ~23% of Herbalife’s contribution margin this past quarter (a measure of profitability before general selling and administrative expenses), and a substantially higher portion of earnings when giving consideration to the inherent operating leverage of the business.

Furthermore, Herbalife’s “definition” of earnings continues to exclude certain items which we believe are actual ongoing costs of the business but which Herbalife adds-back (including ~$0.46 for “non-cash interest expense”). This excludes additional fines and/or injunctive relief that may arise from other regulatory agencies. On a pro-forma basis, assuming a modest decline in the U.S. business and expensing the add-backs, we estimate Herbalife is currently trading at 12 to 15 times 2017 pro forma earnings (and a potentially much higher multiple depending on the magnitude of the impending U.S. decline).

Fundamentally, pyramid schemes are confidence games. The CEO exit, deteriorating earnings, the declining stock price, and the John Oliver segment should materially impact Herbalife distributor confidence. When distributors reduce their purchases and/or leave the company, the financial results of the company should decline on an accelerated basis. Furthermore, we believe the injunctive relief demanded by the FTC is likely to significantly impact Herbalife’s financial performance beginning in the second quarter of 2017. Coupled with decelerating growth in many international markets, especially in China, we expect earnings to decline in 2017. We remain short Herbalife because we believe its intrinsic value is zero.