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This is the highest conviction I have ever had about any investment I have ever made.

-Bill Ackman

Hefty words coming from the man who made a fortune shorting MBIA back in 2007. Unless you've been living under a rock the past couple of days, you have probably heard that Herbalife (HLF) has recently been the most recent victim of what many believe to be a nefarious hedge fund manager cruelly attempting to manipulate the market and profit by stealing main-street's income and shorting a good company. This hedge fund manager's name is Bill Ackman of Pershing Square Capital. On Wednesday, Bill gave a presentation that was 3 hours long and over 300 power-point slides where he publicly presented his research on HLF over the last year and comes to the conclusion that HLF is nothing more than a pyramid scheme moving from market to market. He's so convinced in the accuracy of his research that he has personally shorted ~20M shares of the company and has a price target of zero. Now because I've seen some heated debate and sharp criticism for his power-point presentation, I've chosen to do something unique. Rather than cry scam and hedge fund manipulation, I've gone through the slides and decided to simplify things a little and focus in on the crux of Ackman's argument: that Herbalife is a pyramid scheme.

Who is Herbalife?

Herbalife's profile says it is a network marketing company, or multilevel marketing firm, that sells weight management, supplement, energy, sports and fitness, and personal care products worldwide. This multi-billion dollar company has been around since 1980 and is headquartered in the Cayman Islands.

Now multilevel marketing firms have consistently gotten a bad rap in the business world due to their suspicious structure, and HLF is in that category along with others such as Nu Skin (NUS) and Avon (AVP). Because of this, there is surely going to be some heated debate of Ackman's thesis. Bulls will note that Herbalife's runaway success the past few years has been from having the highest success rate for managers in the industry as well as having the highest payout ratio to these managers (of 73%). Not only that but it has consistently grown as a company and successfully delivered impressive earnings over the 32 years it's been in business. While these numbers are impressive, Ackman goes into great depth explaining the exaggeration of these claims and contingent accounting shenanigans that take place but we'll get to that later.

The Case for a Pyramid Scheme

According to the FTC, a pyramid scheme is defined as an organization where the participants primarily benefit from the recruitment of new distributors rather than the sale of goods to consumers. These are illegal because while sales will continuously be generated from acquiring new distributors, eventually there will be nowhere left to turn in order to acquire these distributors and grow revenue. In the end sales will thus dry up. This is the basis of Ackman's short position. While both Nu Skin and Avon have proven that their products are sold outside of their distribution networks, Herbalife has a different story.

Interestingly, Herbalife does not report these numbers. On the May 2012 conference call where David Einhorn was present, Herbalife stated that it has no metric for measuring sales generated outside of its distribution network vs. inside it because the company found it irrelevant. Management immediately fired back after Ackman said that Herbalife's network supports its business by claiming that over 90% of product is sold to distributors outside of the Herbalife network as of Friday, December 21st. These numbers are not available so this is really just a bunch of smoke that is clouding us from seeing the facts, but the lack of availability can be a possible cause for concern.

Minkow

A great article from CNBC in May shows previous accusations from Berry Minkow - famous for his fraudulent stint with ZZZZ Best - being handled in a very unique manner. Barry Minkow had brought up the idea that Herbalife was a pyramid scheme years ago, in May of 2010. Herbalife sued Barry Minkow and instead of going to trial Herbalife ended up paying Minkow $300,000 in a settlement. A great video from Ackman's presentation shows CEO Johnson on CNBC discussing the lawsuit (fast forward to 00:42 seconds), stating that it was easier to pay the man his sum than to proceed through a costly legal battle. On the surface, these accusations are suspicious but in the end, adding to my suspicion, Johnson lied through his teeth citing legal actions of Minkow that never occurred as the reason for settlement. It is worthy to note that G. Hudson wrote an excellent blog post here citing that based upon other similar cases, Minkow had a good chance of winning the battle by being protected under the first amendment. If that is the case, it would make good sense for management to simply bury the case and avoid public concerns.

Belgium Nails the Coffin Shut

Ultimately, it is another source of attack on HLF's business model that came from Belgium that really nails the coffin shut. In this court document, the Belgian court concludes that Herbalife is a pyramid scheme and must pay varying fines for all officially documented offenses. Their reasoning is as follows, in point 14:

"This overview shows that according to the judgment of the court, the distributor in the sales network of Herbalife can get more profits out of the indirect profit payments, Royalty Overrides and production bonuses who are calculated over the sale of products…"

This is the statement that says it all. As previously mentioned, the FTC defines a pyramid scheme as an organization where the participants primarily benefit from the recruitment of new distributors rather than the sale of goods to consumers. If Herbalife can get more profits out of the "indirect profit payments, royalty overrides and production bonuses rather than the sale of goods to consumers," then it is, by technical definition, a pyramid scheme in both Belgium and the United States. Adding even more weight to this argument is the fact that the Belgian court found that,

"...The [extension structure] prioritizes therefore the extension of the network"

What this fancy sentence of legalese is saying is that at the end of the day, Herbalife is constructed to extend its distribution network rather than supply its product to end users. Not only does Herbalife already generate more revenue by selling to its own distribution services rather than end users, it is a business designed to continue to expand in this manner.

Ancillary Arguments

Now I've read a lot into the complicated 343 slide presentation that Ackman gave earlier this week and I've also seen a lot of comments saying that if Ackman's argument was so simple then why the need for such complexity in explanation? My reasoning is that when you're putting $800M in an investment thesis, you better have all of the facts. While that is just my opinion, it is why I chose to bring out the crux of this argument in the first part of this article. It simplifies things for the Herbalife bull to see through the clutter at what the short argument is. Everything else that Ackman has cited, from accounting shenanigans to the poor quality of the nutritional clubs around the world, is simply supporting evidence for the bigger thesis that this company is a pyramid scheme. Since the debate on this post is going to be heated, here are some of the simpler ancillary arguments supporting Ackman's thesis that he has presented:

Ancillary Argument 1. Revenues

Pyramid schemes are defined by this 50% rule because if less than 50% of product is sold through the network, then there are consumers outside of the network that support the organic growth and consumption of the product. If more than 50% of the product is consumed within the network, then there not enough consumption to support the company and growth is artificially inflated by the use of the marketing network. If the latter is the case, then in order for revenues to grow the business must continue to recruit more and more sales distributors to push its product. When a critical mass is reached and no more sales distributors are available, then revenues will sharply fall. When shown graphically, this revenue phenomenon gets the name of being a "pop-and-drop."

(click to enlarge)Spain, revenues, from Herbalife

(click to enlarge)Japan, revenues, Herbalife

As you can see from these charts, Herbalife used to report its earnings for the countries of Spain and Japan separately in its 10-K until after the drop had occurred. Ackman uses these charts as supporting evidence for the theory of Herbalife being a pyramid scheme. In both of these markets, it is argued that the critical mass was reached in 1992 (Spain) and 1998 (Japan) that led to the lack of new recruits and subsequent drop in revenues.

(click to enlarge)

Herbalife's revenues have been rising consistently, which is not in line with what an expected "pop-and-drop" would do to a company. As noted by the graph above, there has yet to be a drop in earnings because the company has continued to expand into more and more countries to boost its revenue and has used each new country's growth to mask the drop in each country it has reached critical mass in. From a perspective using common sense this model is unsustainable.

*it is worth noting that these numbers could be claims of fraudulence but this data comes directly from Herbalife's 10-Ks/Qs

Ancillary Argument 2. R&D

In an article in March, vocal critic Herb Greenberg questioned Herbalife on its R&D spending. While Herbalife claims it has spent over $25M since 2003 and continued to invest in developing its products, there is no record of this spending in the financial statements. Quite the contrary as a matter of fact. In the last conference call, research and development is completely omitted from the conversation. Additionally, there is no recorded spending on R&D in the quarterly or annual reports.

Since there are no R&D charges recorded in the past, I decided to look at the fruit of Herbalife's labors. Surely any company that is spending aggressively on R&D will start to accumulate rewards in the forms of intellectual property, or patents. After a quick search, I've found that Herbalife has only applied for 3 patents, all in 2006. In an interesting turn, these were at the same time that the company had been in a lawsuit with United Therapeutics that it lost. Ackman cites in his presentation that it only has 1 patent.

Ancillary Argument 3. The Herbalife Nutrition/Fit Clubs

On the surface, the Herbalife FitClub is a really cool idea. It's a fitness club where people meet in order to workout together for free and the club would push Herbalife product. Nutritional clubs on the other hand are simply where someone will pay a membership fee and enjoy complimentary shakes. Investigation into the existence of these clubs yields a poor level of execution. There are firsthand accounts of people looking into these clubs and finding that they are simply additional outlets supporting the recruitment of Herbalife distributors. Additionally, rules for these clubs in the Latin American countries show that they are misrepresented by Herbalife. While the financials state that these clubs will be driving sales to new highs, there may be a cause for concern. (In the fine print it is noted that Herbalife does not allow its logo to be on display outside of a store, nor are they allowed to have people see inside the store, hence the curtains on all of these "nutrition clubs.") As far back as August some analysts, including members of Seeking Alpha, have been questioning the validity of Herbalife's business results considering its strict regulation. If these Fit Clubs are proven to be outlets supporting the recruitment of more distributors, then there is even more evidence supporting the original findings by the Belgian government that the business model is designed to recruit distributors rather than sell product to end users.

Conclusion

While these ancillary arguments can clearly be debated and there is a plethora of additional data you can peruse to develop an investment hypothesis, I feel that the crux of Ackman's thesis, that Herbalife is a pyramid scheme, is justified. This is based on the findings from the Belgian government. This is not based on the fact that someone does not understand Herbalife's accounting procedures or business model.

While revenues have seen growth due to international expansion, there will definitely be a saturation point at which revenues will sharply decline. If the US government does seek to investigate these matters and shut down Herbalife, it will have some difficulty in doing so because Herbalife is registered in the Cayman Islands. However, I don't find it out-of-line to speculate that it may be possible for the FTC to limit business done by Herbalife in America, jail high-level management, and/or de-list the stock from our exchanges which would hurt liquidity of the investment as well as earnings potential and tarnish the brand's reputation in the developed world. While the ultimate fate of Herbalife is uncertain, what is clear is that anyone choosing to buy at this moment in time will be facing a bumpy and volatile ride in the months to come. Personally I feel there is far too much risk to justify an upside movement in this company, and I'd rather look into recently battered Nu Skin and Avon to see if there has been some temporary selling on other quality businesses due to the blood spilled regarding Herbalife.

As for whether or not Ackman is justified in publicizing his findings? Considering all profits from his trade will go to charity, the investment thesis has been created from a rational thought process, and if he was accumulating a position over the past year he is most-likely already in the black I believe the answer is a clear and resounding yes.

*Data from 10-K/Q's, conference calls on Seeking Alpha, and Ackman's powerpoint presentation, as well as other misc citations

Source: Is Ackman's Hatchet Job On Herbalife Justified?