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I must admit, when Bill Ackman first came out with his Herbalife (NYSE:HLF) short thesis I thought he was dead on. Multi-Level Marketing just "feels" like a pyramid scheme, and the line can sometimes be murky. Ackman did an immense amount of work on the company, and I am sure most of it had some credence. Heck, two members of Herbalife's management team even boast prior experience at Sunbeam on their bios. If that's not a red flag, I don't know what is.

The problem for Mr. Ackman is that you can be both right and wrong at the same time. Pershing Square's entire thesis rests on the fact that the Federal Trade Commission must classify Herbalife as a pyramid scheme and initiate legal action against the company. Ackman needed to go public with this, in a very loud way, for anyone to pay attention and for the thesis to play out. However, after going through the analyst day materials the company posted on Jan 10, I find it incredibly hard to believe this company is in any near term trouble.

Management managed to debunk nearly all of Ackman's key points.

Ackman Assertion: There is no R&D spend and Herbalife's products are commodities that sell at high prices.

Herbalife Reply: Dietary supplements are classified as food, not drugs, and thus cannot be expensed as R&D. R&D expense is thus consistent with the peer group of GNC and NBTY. Further, Herbalife spent $44 million in 2012 on product development, scientific affairs, quality sourcing ("seed to feed" program), product safety, etc. which was not classified as R&D so Ackman missed it.

Further, Ackman compared pricing per 200 calorie serving and found the price was almost double the nearest competitors, however pricing should be compared per serving at SRP, and Herbalife is priced right in the median. The notion that Ebay is a proxy for the true retail price is also bunk, as 99.9% of product sales are away from Ebay.

Ackman Assertion: Herbalife has a minimal outside customer base and only sells to their own network

Herbalife Reply: The company began working with Lieberman Research to do a comprehensive study on customer base in July of 2012 to independently verify customer numbers for the company. Lieberman found that over 90% of recent purchasers would likely purchase Herbalife again in the future and 92% of customers who purchased the product in the last 3 months were not distributors.

Ackman Assertion: The distributors are getting roped into this scheme and nobody ever makes money or is satisfied

Herbalife Reply: According to the Lieberman survey, only 27% of former distributors joined to make supplementary income. The remaining 73% joined for product discounts. Further, 44% of distributors expected to earn no money. An additional 28% of distributors only expected to earn between $1-$500 per month.

Ackman Assertion: All former distributors are dissatisfied

Herbalife Reply: In the survey, 63% of former distributors would recommend becoming a Herbalife distributor and 87% would recommend Herbalife products.

Herbalife also has a very liberal return policy, where there is no restocking fee and customers have up to 12 months to return their orders. Only 0.5% of orders are returned. Bear in mind that the restocking fee was removed in May 2012, but I don't think this materially impacted the return number.

Ackman Assertion: Products are only being shipped to distributors are not directly to customers

Herbalife Reply: 31% of orders are shipped directly to customers. 460,000 unique addresses on file.

Debunking the Pyramid Scheme

As I stated earlier, the entire thesis rests on the fact that the FTC must classify Herbalife as a pyramid scheme. Herbalife presented a letter from the FTC about how the commission applies the pyramid scheme label to companies, and what MLM entities must do to remain compliant.

Quoting from the letter:

"The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are simply incidental to the purchase of the right to participate in a money-making venture".

Essentially, the primary motivation for purchasing should be resale and/or consumption. Nowhere can I see where Herbalife fails to meet this standard. Herbalife does not charge any fees to join, there are no minimum product purchase requirements, a liberal refund policy, and plenty of satisfied customers.

Ackman Assertion: Drops in mature markets are masked by pops in new markets. All growth is thus coming from new markets and will eventually run out. Affinity groups like Latinos are making up all the growth.

Herbalife Reply: 92% of 2012 YTD sales volume came from markets entered more than 10 years ago. Most is from markets opened 20-32 years ago. Non Spanish speaking customer volume point growth has outpaced Spanish speaking volume growth since 2010.

Ackman Assertion: Herbalife's accounting techniques attempts to conceal the amount of commissions paid to distributors and increase the amount of retail profit.

Herbalife Reply: Policies in accordance with GAAP, passed KPMG audit. Further, the retail price paid for Herbalife's products does not change net sales. We treat wholesale commissions as a form of discount. The alternative is recording rebates in SG&A, which would still result in the same profit number and increase net sales.

Herbalife then goes on to disprove a few minor points about what percent of sales were spent on recruiting rewards and the amount of times Herbalife reclassified regions, but Herbalife seems to be clearly in the right regarding these details.

Unless this company is completely lying (which is not outside of the realm of possibility) I don't see how Ackman's short thesis can play out. While he may be onto something, just because there's smoke does not mean there's fire. The amount of things that need to go in Ackman's favor far outweigh the chance that the SEC and FTC take a look but don't take action.

Personally, I wouldn't touch Herbalife with a ten foot pole, although betting on near term volatility with some option plays may be a good idea. Assuming you want to be in it for the long run, I would think this PR nightmare would trim the multiple a bit. The company is still generating solid cash flow and has a history of initiating buybacks. Applying a 10x multiple (HLF was at 16-20x from 2011 to 2012) to earnings of 5.50 yields a $55 share price, assuming management goes through with buybacks as scheduled.

Source: Herbalife's Analyst Day Sheds Light On The Brand