Herbalife’s Woes Point to Further Weakness
The stories about the company all began with a similar sentence, “Herbalife reported weaker than expected results on Thursday, sending its shares tumbling 6 percent in after-hours trading.”
Many included comments from the CEO that the business was doing fine, or at least would be doing fine soon. “During this year of transition, we believe our performance has now stabilized and we are seeing improvements in trends,” Herbalife Chief Executive Rich Goudis said in a statement.
The transition he mentioned is actually the result of a Federal Trade Commission investigation into Herbalife. The regulator demanded the company changes in the way the company operates its business in the US.
As a result of the investigation, the company paid a $200 million and agreed to completely restructure its business. The company declared victory after the settlement. The announcement from the FTC can be a read in a less than flattering light.
“This settlement will require Herbalife to fundamentally restructure its business so that participants are rewarded for what they sell, not how many people they recruit,” FTC Chairwoman Ramirez said.
“Herbalife is going to have to start operating legitimately, making only truthful claims about how much money its members are likely to make, and it will have to compensate consumers for the losses they have suffered as a result of what we charge are unfair and deceptive practices.”
The company is no longer allowed to make claims that people who participate can expect to quit their jobs, earn thousands of dollars a month, make a career-level income, or even get rich.
Traders have generally greeted the settlement with a shrug.
The stock has been volatile but is higher than it was when the settlement was reached.
Sales Have Been Dropping
Traders might be overly optimistic about the company’s prospects. The most recent earnings were disappointing. Herbalife posted adjusted earnings per share of $0.82, four cents lower than Wall Street projections.
The company also narrowed its full-year adjusted guidance to a range of $4.42 to $4.62. This update reduced the top of the range by eight cents.
The longer term picture also looks disappointing as the chart of reported revenue over the past ten years shows.
Source: Standard & Poor’s
Revenue has been in a downtrend for three quarters. Sales in North America are leading the way lower.
In the latest update, management noted product volumes slid 5.6% in the third quarter. Regionally, volumes in Europe, the Middle East and Africa (EMEA) and Asia Pacific climbed 2.7% and 1% respectively.
Sales volumes in all other regions fell, with North America suffering the maximum plunge of 16.1%. Volumes at Mexico tumbled 9%, while South & Central America and China witnessed volume declines of 6.8% and 3.5%, respectively.
Distractions Hide the Financials
With so much bad news about financials, the stock’s performance looks surprisingly strong. But, the financials are probably the least interesting story about Herbalife. The company has long been locked in a battle of billionaire investors.
Hedge fund manager has been betting on a decline in Herbalife, arguing that it was a pyramid scheme and worth nothing. His billion dollar bet was countered by Carl Icahn who owns about 24% of the company.
Herbalife also garnered publicity with a share buyback earlier this year. Under the offer, the company agreed to buy back $600 million worth common stock in cash at a price of not less than $60 or exceeding $68.
This reduced the number of shares outstanding but created a problem that could prevent a buyout of the company. “Also against each of its tendered shares, shareholders will be provided with a non-transferable contractual CVR.
The CVR allows shareholders to receive a contingent payment in cash, in case Herbalife gets acquired through a private transaction in the forthcoming two years. Such an initiative indicates commitment toward enhancing shareholder value.”
This means a buyer will have to pay a premium for shares that were retired. This makes the company unattractive, and also used a large amount of cash. Without the ability to stay in the news, the stock is more likely to trade based on its fundamentals.
A Trading Strategy to Benefit From Potential Weakness
Because of the stock’s weakening fundamentals, traders should consider using an options strategy known as a bear put spread to benefit from the expected price move.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This options trading basics strategies generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for HLF
The bearish outlook for HLF, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the December 15 $65 put can be bought for about $2.25 and the December 15 $62.50 put can be sold for about $1.50. This trade will cost about $0.75 to enter, or $75 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spend to open the trade, or $75. This loss would be experienced if HLF is above $65 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in HLF, the maximum gain is $1.75 ($65 – $62.50 = $2.50; $2.50 – $0.75 = $1.75). This represents $175 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $39 to open this trade.
That is a potential gain of about 133% on the amount risked in the trade. This trade delivers the maximum gain if HLF closes below $62.50 on December 15 when the options expire. There is a relatively low probability of that according to the options pricing models. That indicates the gain is likely to be less than the maximum possible gain.
Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $75 for this trade in HLF.