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If you google "pyramid scheme", the search engine helpfully suggests a related search for Herbalife (NYSE:HLF) -- right behind MMM, a notorious Russian Ponzi scheme that defrauded more than 30 million people. I was a member of the Russian Securities Markets Commission (analog of the U.S. SEC) when MMM operated. In that capacity I spent several years fighting MMM and dozens of its copycats. When Bill Ackman publicly accused Herbalife of being a pyramid scheme, I could not help digging into their SEC filings and other documents to see for myself. Here are my conclusions.

Is Herbalife a pyramid scheme?

Yes, absolutely. It constantly needs to find new distributors to replace those who quit. One can argue that every company is a pyramid, of sorts, as it needs more customers to grow its business, and that many companies have high customer churn rates. This is true, but there are two key distinctions in the case of Herbalife.

First of all, the turnover rate is huge. In the latest re-qualification period only 52 percent of "sales leaders," which is a higher level of Herbalife distributors, confirmed their status. In other words, the company lost 48 percent of its sales leaders in just one year. This extremely high failure rate is not a result of bad recruiting or, as the company claims, "different skill levels" -- after 33 years in business the company should be able to recruit the right people with the right skills. Instead, this churn rate is built into the business model, and it is a telltale sign of a pyramid scheme. The company has to recruit several thousand new distributors every day and hope that at least 1,000 of them become sales leaders just to keep its revenues steady, even more if it wants to grow. Note that only one person per household signs up as a distributor (larger distributors get better terms), so each year the company has to convince several million people that Herbalife distributorship is worth a try.

Since distributors who quit never come back (why would they after trying and failing to make any profits? The company disclosed that 88 percent of the U.S. distributors earned zero, another 8 percent - less than $1,000 in 2012), at some point the company will run out of fresh candidates. This makes its business model unsustainable, and this is the key characteristic of a pyramid scheme. It may take decades, like in Madoff's case, but it's a process that has an end. In contrast, companies with a high customer churn rate may win their ex-customers back with new products, lower prices, better services, etc.

Second, a "legitimate" multi-level marketing business sells mostly to customers as opposed to its own distributors. This is a standard that the U.S. Federal Trade Commission uses to identify pyramid schemes. Herbalife used to say that it had no visibility into how much product is being consumed by non-distributors. I doubt that in its 33 years in business it never wanted to find out. More likely that it knew all along but did not want to share this information. Recently the company disclosed that 73% of individuals became distributors primarily to buy products for personal consumption. If we assume that the remaining 27 percent of distributors also consume Herbalife products personally, there is not much product left for selling to non-distributor customers.

Note that last year 3.2 million distributors generated $3.9 billion in sales (excluding literature and promotional items), or approx. $101 per distributor per month - hardly an efficient way to reach non-distributor customers. The company now tries to portray most of its distributors as customers in disguise, but this spin is not going to fool anyone. As Ackman correctly points out, there are no other businesses that require customers to sign a 48,000-word Distributor Agreement in order to buy $60 worth of products that are freely available online at lower prices and with no paperwork at all.

We also know from the Statement of Gross Compensation referenced above that most profits are made by a very small number of distributors, because they recruited many other distributors at an early stage of the pyramid expansion. This is how all pyramids work -- people fortunate enough to join early reap all the benefits, while most latecomers lose.

Will this pyramid collapse soon?

No. Unlike Ponzi schemes that collapse suddenly, like an avalanche, and hurt all remaining participants at once, Herbalife is more like a fire -- it burns (financially) a lot of people all the time, and at some point it will slowly run out of fuel.

Ponzi schemes have an "excitement factor:" early investors brag about their returns, helping the promoters to bring in new investors. In contrast, Herbalife's scheme has what I call a "poison factor." There are relatively few people who make significant profits by selling Herbalife products, and there is very little churn in that group for obvious reasons. At the other end of the spectrum, 88 percent of distributors earned zero dollars from the company. Hundreds of thousands of distributors quit every year. Each one of them represents, on average, 2.6 members of his or her household. In addition, they are likely to warn a few more people about their negative experience. This means that each year several million people move into the "I will never distribute Herbalife products" category. Over time Herbalife needs to move into new territories, where fewer people are familiar with its business model.

At this point sales continue to grow in most markets, indicating that enough fuel (gullible people) is still available. Without an external shock (government intervention, disclosure of accounting fraud, major recession, etc.) it may take years before sales start to slow down. On the other hand, a surge in negative publicity can heighten the poison factor, hastening the decline.

Is Herbalife an illegal pyramid scheme?

In the U.S., probably, yes. I say probably, because it has to be established in court. In my opinion, the case on its merits is an easy one for the prosecution, should the government decide to bring charges. On the other hand, Herbalife will line up dozens of witnesses to say that Herbalife changed their lives. Cases like that are never a slam dunk for the prosecution.

For an excellent and very detailed discussion of the case law, read the post by Dan McCrum.

Herbalife executives are getting visibly nervous -- it appears that they now take the possibility of a legal action seriously. Recently they made a number of statements that directly contradict their SEC filings and their own statements made earlier, because their previous assertions lead directly to legal troubles. They also disclosed information which may damage recruitment of new distributors, if it becomes widely known. This is not a good sign for Herbalife shareholders.

Will the government intervene?

While the accusations are serious and well-founded, I find it unlikely at this point. First, Herbalife is not a kind of pyramid scheme that the regulators can't ignore.

Second, politicians are not eager to be seen as helping a billionaire hedge-fund manager while possibly alienating thousands of Herbalife distributors. There are no stories on CNN about regular folks losing their life-long savings after joining the Herbalife network, so it's difficult to score points by going after the company.

Finally, shutting Herbalife down now would raise two obvious questions: why it was not done before, and who should be fired as a result.

The regulators will most likely wait until the audit of the company is complete before taking any action. Civil servants are risk-averse by nature -- they will act only when the evidence is overwhelming and the public opinion is not polarized. Most of the time that means they act too late (Enron, Worldcom, etc.), but if I were a Herbalife shareholder, I would not bet on that. Remember that there is a permanent injunction against Herbalife in California, dating back to 1985. It was a small company back then and it survived, but this time it may not be that lucky. All it takes is one ambitious state Attorney General going after the company, and the legal troubles for Herbalife will snowball.

Will PwC approve Herbalife's financial reports?

Currently everyone is waiting for the audited financial statements for the past three years. The company hired PricewaterhouseCoopers, and the results are expected soon.

It was possible that PwC would have approved these statements with little fuss before Ackman put the spotlight directly on PwC. Now PwC auditors and executives may have to defend their choice of accounting policies publicly, possibly in court. This puts them in a tough spot. For example, as Ackman points out, PwC also audits Nu Skin (NYSE:NUS), and Nu Skin treats wholesale commissions differently from Herbalife. If PwC does end up in court, it would not be easy to defend two very different interpretations of the same accounting rules.

Herbalife will put a lot of pressure on PwC to rubber-stamp its financials, and PwC will try hard to bring Herbalife's accounting more in line with the industry standards in order to reduce its legal exposure. The are many possible outcomes in this battle. As a side-note, it is possible that the audit will take longer than the market currently expects, which may lead to a weakness in stock price.

What should investors do?

Based on the review of all the questions that Pershing Square posed in its letter to PwC, referenced above, I estimate that there is a 20 percent chance that the audited statements will contain no, or minor, changes in accounting policies. I put a probability of substantial, but not earth-shattering, changes at 70 percent. Finally, there is a 10 percent chance that revisions will be very significant, or that the auditor will resign. The letter contains a number of allegations that auditors would find difficult to ignore. If you are fluent in accounting, read this letter and draw your own conclusions.

My assessment implies that Herbalife stock can move in different directions, and there is a possibility that such a move will be extreme. I find this distribution conducive to a profitable short trade, although the possibility of a major move to the upside should be considered and properly hedged.

The first possible outcome (no revisions) will send the stock up -- possibly by 20 percent or more. In the most likely middle-ground outcome the bulls will focus on the word "approved," and the bears will pair the words "revisions" and "fraud" to express their excitement. Shareholder lawsuits are very likely. Government may be compelled to take a closer look. Therefore we might see a lot of volatility in the stock, and it is in no way guaranteed that the trend is going to be up.

Finally, if PwC resigns or forces major revisions dating many years back, the stock will drop like a brick. The government will be forced to intervene, as there will be angry investors, analysts, editors, and bloggers everywhere you look. And even though I find this outcome the least likely, it may lead to the stock going all the way down to zero.

This uncertainty surrounding Herbalife is reflected in the options market. May 2014 long straddle at $70 strike costs a whopping $29, implying a 41 percent move in a stock price. A similar November straddle costs $14 and requires a massive 20 percent price move to make a profit. Note that if PwC is taking a tough stand right now, bad news may start coming out as soon as the next quarterly report.

Also note that we did not examine the company's valuation and the expectations for its performance. At this point these questions, very important when evaluating most companies, are overshadowed by legal, regulatory and accounting issues surrounding Herbalife.

Personally, I would never invest in a company that lures millions of people into its network knowing perfectly well that the vast majority of them are not going to make any profit. This is my personal choice that many investors apparently do not share. If you do decide to go short, and this trade proves to be the right one, you may derive additional pleasure from the fact the company is involved in unethical (or, as many believe, downright illegal) business practices.

If you believe that Herbalife will be forced to change its business model or restate its financials, and you have stamina and guts, now may be a good time to start building a short position or buy put options. Manage your risks very carefully, though: this stock is not for the faint-hearted, and the put options are not cheap.

Disclosure: I am short HLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Herbalife: An Ethical Short