Ackman's Case On Herbalife Doesn't Live Up To His Short

Dec.21.12 | About: Herbalife Ltd. (HLF)

Yes, folks, I have read through the entire 350+ plus slide presentation given on Herbalife (NYSE:HLF) by Bill Ackman at a special Ira Sohn conference yesterday that has caused a 20%+ drop in the stock over the last 2 days. Let me provide some (much briefer) thoughts.

First, Bill Ackman is a hedge fund manager, the founder of Pershing Square Capital. He has disclosed that he holds a short position in Herbalife of over 20 million shares (18% of the float), according to him over $1 billion in value. So this is a BIG bet.

There are a few themes in the presentation. The first and most important is that Ackman believes Herbalife is a "pyramid scheme". The primary argument is that Herbalife distributors make substantially more compensation from recruiting than on retail margin, contrary to the company's claims and running it afoul of the FTC's definition of a pyramid scheme. The main support is that Herbalife's "suggested retail price" is rarely used in actual sales, an assertion backed up by providing evidence from a handful of distributor websites, and eBay statistics. He also claims that other recruiting-based payouts are mis-categorized as retail margin.

There are other attacks also. One is that Herbalife targets ethnic minorities and lower-income demographics to recruit new distributors. Another is that the company's "clubs" are nothing like the company portrays them (backed up with photos - they DO exist though). Yet another is an attack on the company's strict return policies, which props up their low product return rates.

Let me first give Ackman some credit here. This is an absurdly detailed presentation. Clearly I disliked some of the things I saw. The return policies are especially distasteful. This was probably the single biggest concern I had here, that Herbalife wins a lot of its business through forcing distributors to stock inventory and penalizing them heavily for returns (including loss of distributorship!). Also, the pictures of the "clubs" were almost amusing, considering how much management talks them up on conference calls.

Herbalife should be given a chance to rebuke these claims before passing final judgment. The brief statement they put out after the presentation isn't enough.

Despite some concerns raised by the presentation, I am okay with holding the position for now. For one, Ackman's short thesis is heavily reliant on the FTC taking up his cause. Even if they do (a big if), the most likely negative outcomes would probably be a fine and forced changes to the business model (specifically return policy and compensation terms). 80% of sales are outside the U.S., and I saw little from Ackman that reached outside the FTC's definitions and case history. Also, I found the evidence used to support the "suggested retail price" allegations to be rather light.

Herbalife is a real company with real profits and cash flows, a real auditor (KPMG, one of the "big 4"), that pays a real dividend and puts real cash towards buying back stock. I can understand feeling a little uneasy about holding it, but the fact is that unless the FTC decides to act, not much is going to change with the business.

Disclosure: I am long HLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.