The Carl Icahn vs. Bill Ackman spat over Herbalife was probably the most entertaining public feud in 2013. It's very rare
that two high profile investors go head-to-head in this manner.
Moreover, in doing so, they put their reputations at risk in a very
public manner. It's difficult not to conclude that Icahn has come out
the winner in 2013. Herbalife's stock is up over 130% this year, and
Ackman's short position has hurt his fund. However, is it possible that
both investors are right?
What matters to direct-sales companies
Herbalife
belongs within a class of companies that use a direct-sales model. In
other words, they rely on local representatives to generate their sales
revenue. There is nothing new about this model. In fact, Tupperware Brands parties and rictus-grinned Avon Products ladies knocking on the door have become part of most Americans' vocabulary. In addition, Nu Skin Enterprises a stock up more than 250% this year) and Herbalife are rapidly acquiring household awareness.
All these companies critically
rely on their representatives to generate sales. Nu Skin can talk all it
likes about the science behind its skin-care products and Herbalife can
wax lyrical about the benefits of its nutritional products, but if
their sales distributors aren't motivated then their businesses will
fail. Keeping representatives happy isn't easy. For example, Avon has
been forced to fundamentally restructure its sales organization after
some disappointing performance.
The bottom line is that these businesses don't
solely rely on the intrinsic value of their products. The good news is
that having products targeted at growth industries such as skin care (Nu
Skin) and nutrition (Herbalife) is obviously going to inspire
distributors and their customers. In addition, Tupperware has gone to
great lengths to expand into emerging markets, therefore tapping into a
new distributor base to offset its slow growth in North America.
Enter George Soros
Ackman's
short arguments on Herbalife center around the lack of intrinsic value
of its products (he cited poor price comparisons for Herbalife products
on eBay), and his belief that the company is structured to sell
products to its distributors. He may well turn out to be right!
However, the entry of George Soros as an investor
in Herbalife goes a long way to help explain why -- even if you are
sympathetic to Ackman -- it's dangerous to short in this sort of
situation.
Soros is best known for his theory of reflexivity,
and how it causes investment bubbles. The basic idea is that pricing
movements generate feedback loops into earnings, which then encourage
higher pricing. A bubble is formed, which then collapses when a tipping
point is reached.
The key point to understand here is that the
positive effect on earnings from the feedback loop makes the stock look
fundamentally cheap. In other words, this isn't about a stock reaching a
sky high valuation! In fact, the stock will look a great value.
Confused? I will try and explain what could happen with these direct
sales companies and their distributors.
How the bubble might burst, but not when you are shortSay,
for example, a listed direct sales company launches a new product that
captures distributors imagination. It could be anything. Perfume,
laundry powder, skin cream, nutritional tablets or whatever.
Sales start slowly and hit a $1 million a year, the
company trades on ten times earnings or $10 million, and has had steady
5% growth for a while. So its P/E ratio is 10, and its PEG (PE divided
by growth rate) ratio is 2.
Suddenly, the product starts to accelerate sales, a
buzz forms around the product and more distributors are recruited.
Sales go up 20% for the company, as does its earnings. A sober and
conservative analyst produces a report stating that its growth rate is
now 20%, with projected earnings of $1.2 million.
He goes on to argue that if it trades on its
previous PEG ratio of 2, and its growth is 20%, then the 'correct' P/E
valuation should now be 40 times earnings. So, now its valuation should be $48 million instead of $10 million. Remember what I said above about the fundamentals looking cheap?
After a while, the product's popularity starts to
peter out. New distributors find it tough to become profitable. Sales
start to slow again, then suddenly everyone is looking at their stock
holding in a company on a valuation of current 48 times earnings with a
5% growth rate again. The stock crashes. It could even be on 20 times
earnings and still be very expensive at this point.
Again, the key point is that Herbalife, Nu Skin and
the others all have a critical reliance on their ability to recruit and
maintain distributors. The problem is that no one rings a bell when the
crash is about to come, and you could find yourself shorting a stock
that just moved from a valuation of 10 times earnings to 48 times.
Why Ackman and Icahn may both be right
If
this is the sort of scenario (and I stress "if") that awaits Nu Skin
and Herbalife, then investors need to consider what stage these
companies are at in this process. Are you buying/selling it in the
middle of the bubble-like euphoria? Do you really want to short a stock
during this strong momentum phase?
Ackman and Icahn may both turn out to be right.
Icahn may end up being lauded for riding the stock higher and getting
out early. Ackman could be feted for sticking to his guns while he waits
for the inevitable collapse. If this scenario is correct, then the only
ones not winning any prizes will be the long-term investors who are
stuck in their positions after the possible collapse.
