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The jury may still be out on whether or not Herbalife (NYSE:HLF) is a pyramid scheme. Investors have placed their bets. Since the end of 2012 when Pershing Square revealed their allegation that HLF is a pyramid scheme much has changed and much has not.

This article offers a summary of some of the changes and some of the tactics that have been employed by the company in defence of the attack on its credibility.

At the end of 2012 Herbalife distributed its products in 88 countries through 3.2 million distributors. In the first two quarters of 2013 the company's distributors recruited another 1.076 million new distributors.

At the end of Q2 the company had 3.4 million distributors for a net gain of 200,000 distributors. Stated a different way, 876,000 distributors resigned from Herbalife in the first half of 2013. Herbalife has not entered any new countries since the start of the year.

The company's Book Value was $421 million at the end of 2012. The Book Value at the end of Q2 is $434 million. Herbalife is not a company that retains its earnings.

Where does the cash go?

Herbalife has generated in excess of $500 million of free cashflow on a trailing twelve month basis.

Herbalife's share count has dropped from 118 million shares to 107 million shares. The company repurchased $162.4 million worth of stock in Q1. This repurchase activity occurred on the heels of over $500 million worth of buybacks in 2012. Herbalife has a $1 billion repurchase program of which $787 million remains outstanding. Share repurchases have been suspended until the company's new auditor can sign-off on its historical financials.

The company also pays a dividend of 30 cents per share per quarter. Cash used to pay dividends has actually declined YOY due to the reduced share count.

The company also has capital expenditures of $60 million plus YTD. Last year the company spent $122 million on capital expenditures.

Has the Balance Sheet changed?

Even as Net Worth has not changed the following accounts have experienced material change since the end of 2012.

Long-Term Debt has increased from $431 million to $894 million. The company borrowed money to accelerate its share buybacks.

Cash on hand has also ballooned from $334 million to $850 million. This liquidity surplus becomes a powder keg for additional share repurchases once the audit trail is cleaned up. Alternatively balance sheet leverage could be reduced or dividends could be increased.

At today's Market Price of $64 per share Herbalife could retire 7.8 million shares with an additional $500 million worth of share repurchases. If the company were more aggressive in the debt markets, the company could theoretically retire an additional 10-15% of its float.

Hedge fund managers have taken the opposite side of Pershing Square. The combinant forces of Carl Icahn, Soros and Stiritz now own over 25% of the company. Icahn's 17% has a lock-up agreement in place until February of 2014. The incoming free cashflow, surplus liquidity and Pershing Square's 30 million share short position effectively act as a headlock (or is it a Full Nelson?) around the shorts/buoy the longs. With 25% of the shares in friendly hands and the company using most of its cashflow/leverage to repurchase shares, the avenues of escape for the shorts seem limited.

Or do they?

In order for the short thesis to pay off one of two things has to occur.

a) Herbalife's business fundamentals need to deteriorate.

b) Regulators need to intervene

As has been pointed out many times before, Herbalife's business model relies upon velocity. Specifically, the company must be successful recruiting new participants due to the annual exodus/short lifetime value of its existing customer base. To date, the HLF recruiting juggernaut has masked the churn inherent in the business model because it recruits more people annually than those who resign. However, it is apparent to anyone with a rudimentary understanding of mathematics that the more successful Herbalife is today, the more successful it needs to become tomorrow in order to continue to grow. Today's recruits become next year's resignations. If HLF recruits 2 million new distributors this year it must also find 2 million new recruits next year for the top-line to stay positive.

Already, HLF is teetering on the brink of net distributor attrition. From Q1 to Q2 the company actually saw its distributor base contract by 200,000 people. Whether or not this trend continues remains to be seen, but the toughest part of Mount Everest to climb is the last 1,000 feet. Most climbers actually die on the way back down from the summit. Once Herbalife's recruiting metrics turn negative, what will happen to the valuation of the equity? Will a 10 P/E become a stretch? Can management ethically continue to buy-back shares in the face of a shrinking customer base?

As for regulatory intervention, it strikes me that this outcome is analogous to a game of Russian Roulette. If you are long Herbalife you are speculating that regulators will not intervene. However, even if there is only one bullet in the chamber of the revolver - that bullet can kill you. The history of regulatory intervention in the U.S.A. is the confiscation of all of the company's assets and the immediate seizure of the operations in the event an investigation finds the enterprise to be a pyramid scheme. Under this scenario, HLF likely becomes a $0.

So - What's Next?

If you believe that HLF is a legitimate enterprise it becomes obvious that everything the management of the company is doing seems entirely rational. They are buying back shares at a discount to the market's multiple, they continue to pay dividends, they are borrowing money at an inexpensive rate to acquire equity in themselves at a high free cashflow yield. They believe in themselves. Ostensibly, it all looks good. Add-in the additional gravitas provided by Mr. Icahn and Mr. Stiritz and Mr. Soros and the short side of the trade still looks curious - at least on a near-term basis.

However, lurking in the wings if you are long remain the following untold stories:

What will the SEC conclude from its own objective investigation?

What will the FTC conclude from an equally arm's length review?

What will States AG's conclude?

What about the class action lawsuits?

And finally, where will the next 2 million plus new distributors the company needs to find come from? In 2012 & 2013 trend data HLF has signed-up over 4 million new distributors. Can they repeat this effort ad infinitum? Doubtful.

Pershing Square has been squeezed to be sure. The last 9 months have been painful on a mark to market basis. The market cap of HLF has more than doubled since the end of 2012. There are some reputable foes on the long side of the table.

Of course if the business model deteriorates and/or the regulators step-in, all of the share buybacks the company has done over the past 3 years will end-up a total waste of capital. Also, the balance sheet that is more levered today than it was when Mr. Ackman revealed his short position becomes a tailwind for shorts if the company's recruiting efforts start to slide into negative comps.

Lenders may also start to get antsy as the company has no real hard assets to offer as collateral.

Within a year investors will likely learn whether or not regulators find HLF's compensation scheme to be a pyramid scheme or endless chain.

Equally so, we will likely find out if the recruiting juggernaut continues to slip off the rails or not. Will "Pop & Drop" finally hit the mothership?

What is for certain is that both Mr. Ackman and Mr. Icahn will likely be along for the ride until at least February of 2014.

Will HLF be private by then?

Who knows?

I remain convinced that HLF is:

a) an Unsustainable business model and

b) an endless chain that victimizes unsophisticated individuals with an entrepreneurial dream.

At a market cap of $6.6 billion and Free cashflow of say $550 million you are getting a FCF yield of 8.3% on HLF equity v. 2.9% on a ten year treasury. The latter seems money good. As for the former?

At $64 a share the long bet seems increasingly perilous.

Source: Herbalife Still Ascending Mount Everest - Look Out Below