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I'm going to assume that everyone is familiar with Ackman's short thesis on Herbalife (HLF). If not, it can be found here. I'm in agreement with Ackman's thesis that Herbalife is a pyramid scheme. Part of Ackman's thesis was that pyramid schemes must collapse in the end. I disagree with Ackman on this one point. The purpose of this article to examine the end game of this match between Ackman and Herbalife.

Let me explain what I see as Herbalife's ace in the hole - the sustainable pyramid scheme. In a traditional pyramid scheme, Adam recruits Bill and promises to pay him if Bill recruits five Charlies. The five Charlies get paid if they recruit 25 Davids. The 25 Davids get paid if they recruit 125 Edwards and so on. In a traditional pyramid scheme everyone stays in and gets paid. The minute the first person doesn't get paid, the traditional pyramid scheme collapses.

But the exponential growth of a pyramid scheme, in which all the participants stay in and get paid over each cycle, means the number of participants increases as a geometric progression. Using our example above, if each level recruits five people below them, the number of participants would grow thus over each cycle as shown in Table 1.

Cycle Number

Cycle Name

Number of Participants

1

Adam

1

2

Bill

1

3

Charlie

5

4

David

25

5

Edward

125

6

Frank

625

7

George

3,125

8

Harry

15,625

9

Ike

78,125

10

Jane

390,625

11

King

1,953,125

12

Larry

9,765,625

13

Mike

48,828,125

14

Nancy

244,140,625

15

Olga

1,220,703,125

16

Peter

6,103,515,625

17

Queen

30,517,578,125

By cycle Nancy, you would need 244 million people to keep the pyramid scheme going. By the next cycle Olga you would need about 1,220 million people (or the entire population of India) to keep the scheme alive. By the next cycle Peter, practically three quarters of the population of the world would need to be recruited. By the time you reach level Queen, the number of participants required would exceed the population of the earth.

This exponential growth is the reason why pyramid schemes usually collapse after a short time ranging from a few weeks to a few years, usually between levels Harry and King. This is also the defense of Herbalife management, the bullish Wall Street analysts and even people on Seeking Alpha like Helix Investment Management (see their article here). Herbalife and its supporters argue since a pyramid scheme will collapse in a relatively short while, the fact that Herbalife is a going concern after 32 years means that Herbalife is not a pyramid scheme.

Nothing could be further from the truth. Let us remember what Abraham Lincoln said "You can fool all the people some of the time, some of the people all the time, but you can't fool all the people all the time". A traditional pyramid scheme, one that retains and pays all the prior participants, collapses under its own weight as all the people rush in. But, what if you restrict the pyramid scheme at level Jane or level King and concentrate on fooling some of the people all the time?

I believe this is Herbalife's true innovation. They have restricted the growth of the pyramid scheme. Look at figure 1 [from Ackman's presentation]. The top levels of the pyramid scheme, Adam to George get paid (GET Team to President's circle for Herbalife) but the levels from Harry to King get pushed out and replaced (75-90% turnover each year - New Sales leader to Non Sales Leaders for Herbalife). By doing so, Herbalife is much like a weed that repots itself with fresh soil each year and thrives without exhausting the soil.

(click to enlarge)

The above figure does not include the lowermost and most numerous of Herbalife victims, the new recruits, also known as "Non Sales Leaders" and those who made "Sales Leader" but failed to buy enough product or sign up enough new recruits (see figure 2 below). Again, Ackman estimated that about 90% of the lowermost rungs do not continue to participate after the first year. These are the victims who sign up, pay several thousand dollars and realize they've been had. By limiting the number of the lowermost rungs and replacing them with a fresh crop each year, Herbalife has an almost inexhaustible supply of victims and can exist in perpetuity, unlike traditional pyramid schemes.

(click to enlarge)

But, you say, if Herbalife was a pyramid scheme, the victims would be asking for their money back? Herbalife supporters often point out that Herbalife offers a one year time window for return of products and the return rate is about 0.4%. But Herbalife has such strict conditions for returning unsold (and unsaleable) product that victims would lose more by returning the product than by simply throwing it out.

Herbalife imposes a set of conditions that is impossible for any victim to abide by and by "auditing" the victims and pointing out that they "violated" those conditions, Herbalife escapes paying the victims back. See figure 3 below for the relevant slides from Ackman's presentation on how Herbalife prevents returns and avoids having to pay victims their money back, despite having a published one year return policy.

(click to enlarge)

(click to enlarge)

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(click to enlarge)

A traditional pyramid scheme collapses when it cannot pay the last recruited layer. Herbalife has found a legal way to blame the victims for not getting paid as promised. Thus, unlike a traditional pyramid scheme, the Herbalife sustainable pyramid scheme can stiff the last layer of recruits without collapsing.

This "innovation" of blaming the victim for not getting paid back allows Herbalife to import a steady supply of new victims each year, suck them dry and discard them. Much like a ravenous herd that grazes a range down to the bare ground and moves on to the next grassland, Herbalife sustains itself by moving from one demographic group to the next - African Americans, Koreans, Chinese, stay at home moms, college students, etc. Herbalife sucks each group dry over a period of years and then moves on to the next.

This explains how Herbalife has stayed in business for 32 years in the US. Internationally, it's much simpler, Herbalife simply moves on from one set of countries to the next.

Graphically, it can be shown thus in table 2. The Janes and Kings are replaced each year by fresh Jills and Kurts, while Adam through Ikes stay in place since they have been paid by the money sucked from the Janes and Kings. Adam through Ike represent the levels of Herbalife from the "World Team" up to the "President's Circle". The Janes and Kings represent the rest of Herbalife from new Sales Leaders down to the Non Sales Leaders.

Cycle Name

Number of Participants

Adam

1

Bill

1

Charlie

5

David

25

Edward

125

Frank

625

George

3,125

Harry

15,625

Ike

78,125

Yearly

Jane<<<<

<<<<<Jills

390,625

Replacements

King<<<<

<<<<Kurts

1,953,125

Larry

Mike

Nancy

Olga

Peter

Queen

It's clear that Herbalife, unlike a traditional pyramid scheme, can exist indefinitely. After all they only have about three million people at the lowest rungs of the scheme, on a planet of eight thousand million people. Even if they operate on this scale for the next hundred years, Herbalife would have only 300 million victims or about 3.75% of the world population. With fresh generations growing up, generations passing away and fickleness of attention spans, there is nothing to prevent Herbalife from continuing to exist profitably, indefinitely. This is Herbalife's ace in the hole against Ackman.

Here is where I believe Ackman may have made a strategic error. Short of an external force like the FTC or the SEC, there is nothing that stops Herbalife from profitably operating a pyramid scheme. The people targeted by Herbalife certainly do not read the financial press or read 343 slide presentations. There will always be a supply of uninformed victims for the Herbalife sustainable pyramid scheme. Herbalife is certainly not going to collapse under its own weight, given that it controls its diet of victims rigorously. So what is going to drive Herbalife's stock price to zero (or something else) and what is an investor to do?

There are several alternate scenarios, like a sort of futuristic "Rashomon", that we should look at.

Scenario 1: The SEC and/or FTC do nothing and large institutional investors stay put. In this scenario, Herbalife's stock price slowly recovers as investors realize that the sky isn't going to fall, and Herbalife continues to lead a very profitable existence. Investors should cover shorts and go long, hedging with deep OTM LEAP puts to limit losses.

Scenario 2. The SEC and/or the FTC do nothing, but large institutional investors like Fidelity/TIAA-CREF decide they want nothing to do with a pyramid scheme and unload their shares. In this scenario, the stock price could drop steeply in the short term but recover in the medium term, as less public image conscious investors (hedge funds and the like) buy up the stock for the yield. Also Herbalife may explore going private by buying back the shares. A lot of Ackman's case came from SEC filings and by going private Herbalife could escape future scrutiny. Herbalife doesn't need capital and is certainly profitable. This "going private" possibility may also help the stock price. Investors should buy short dated ITM puts and go long the stock when they exercise the puts or roll the returns from the puts into medium dated ITM calls.

Scenario 3. The SEC and/or FTC announces an investigation into Herbalife, large institutional investors flee and/or file lawsuits alleging fraud. In this scenario, Herbalife stock will fall steeply. It's possible that SEC and/or the FTC winds up merely rapping Herbalife on the wrist. Regardless, in the medium term this is likely to place serious constraints on Herbalife's pyramid scheme and earnings. This would result in serious pressure on the stock. The more serious outcome could be that SEC and/or the FTC announces serious sanctions that pretty much curtail the profitable Herbalife sustainable pyramid scheme. This would effectively end Herbalife as it is today. Herbalife supporters point out that 80% of revenues come from outside the US. However, if Herbalife is sanctioned by the SEC, I believe it would create a domino effect across the world and would be the end of Herbalife as investors flee/sue and victims vanish. In this case, investors should short Herbalife/buy ITM puts and buy deep OTM calls as a hedge.

In conclusion, I believe Ackman made a mistake when he believed that the Herbalife pyramid scheme would collapse of its own weight and all he needed to do was shine a bright light. Herbalife is a sustainable pyramid scheme that will keep operating without an external shock to stop it. Ackman needs the SEC and/or the FTC to drive a stake through Herbalife. The FTC and/or SEC could get pressured by the politicians, whom the Herbalife CEO Michael Johnson "sees every quarter in Washington". If the SEC and/or the FTC don't pursue actively pursue action against Herbalife, Ackman is likely to lose his bet.

Source: But Mr. Ackman, Herbalife Is A Sustainable Pyramid Scheme