Full Disclosure: Up until last December I had never heard of Herbalife (NYSE:HLF). It seems all of the fitness crazed Moms and Dads here in Short Hills, NJ don't see Formula 1 as the key to the fountain of youth. To this day I have never seen anyone around where I live mention or drink an F-1 shake.
I had, however, followed Mr. Ackman's investing career. I was certainly familiar with his in-depth analysis on MBIA and Ambac Financial and his success outsmarting both Warburg Pincus and Third Avenue Management on that investment. I have also read Confidence Game. Anyone who underestimates Mr. Ackman's tenacity should read this book. The story is fascinating.
So, when I heard that Mr. Ackman had made a 3 hour presentation on a new Short Sale idea I was intrigued. I did not watch the presentation live. I watched a postview. I am not affiliated with Perhsing Square in any way. I have never met nor spoken to Mr. Ackman. My contact with Pershing Square begins and ends with a request from one of their analysts to link to some of my Seeking Alpha articles on factsaboutherbalife.com. Otherwise, I know nothing about their progress on this investment other than what is reported in the news.
My due diligence started by watching Pershing Square's presentation. From there I jumped to the 10ks and 10Qs and 8ks. I struck up a dialogue with some very well-informed individuals including Mr. William Keep who I highly regard and Mr. Robert Fitzpatrick. I have also been shown great kindness by other concerned citizens including Bruce Craig and Doug Brooks to name but a few.
I am a marketer by training with an MBA from Babson College. I studied retail strategy with Douglas Tigert, the world's pre-eminent expert in his field. I used to run the marketing department for Canada's largest bank's Wealth Management Division. Marketers become experts in demographics and psychographics and consumer behavior, etc. Mostly what we are preoccupied with is the acquisition, development, and retention of customers that have a high life-time value/positive NPV.
The first time I looked at Herbalife's financials I was immediately perplexed by the following.
Herbalife prints some of the most outstanding financial metrics I have ever seen.
- 80% gross margins
- double digit net margins
- ROE north of 80%
- ROIC north of 50%
- executive compensation in the multiple millions of $
Investors can review Herbalife's metrics here. These metrics are what I would call "super normal". Companies like Proctor and Gamble or Diageo would drool to get these kinds of gross margins for a consumer product. Funny, when something seems too good to be true it usually is.
So, I started digging further. The more research I did the more obvious it became to me that the reason Herbalife is able to make so much money is because their business partners make so little. In practice it is likely that most Herbalife distributors realize a negative NPV on the capital they risk.
By now you all know that the reason they all make so little is because they are deceived - deceived by a deceptive enterprise. At least that is my thesis.
Yesterday Carl Icahn was on CNBC talking about how Herbalife is undervalued. As I listened to him talk to Scott Wapner it struck me that perhaps Mr. Icahn himself has become the promoter of a fraud. More on that later.
The building blocks for the thesis that Herbalife is an illegal enterprise are as follows:
- Herbalife manufactures an array of undifferentiated weight management products.
- These products are sold to a network of individual distributors
- The company attains usurious gross margins when it sells the product.
- The company also surcharges the product with usurious Shipping, Handling and Administrative Fees
- In order to move product the company markets a business opportunity to its distributors.
- The business opportunity is outlined in the company's Marketing Plan.
- The company's Marketing Plan is a pyramid scheme
Why is the Marketing Plan a pyramid scheme?
At the top of the scheme are the plan's sponsors. These are the folks like Doran Andre and John Tartol and Leslie Stanford. These folks spend the bulk of their time traveling the globe as evangelists for the company's Marketing Plan. These individuals are the company's most senior recruiters. Let's call them the P.T. Barnums of Herbalife. To the plan's sponsors "Every Crowd Has a Silver Lining." If you are part of the Latino crowd all the better it would seem.
The first step in the Herbalife pyramid scheme is obvious - the promise of riches. Distributors up and down the Herbalife pyramid scheme routinely advance wildly exaggerated earnings claims/business prospects to naive recruits. The evidence of this kind of exaggeration is literally everywhere. For a small taste of it visit factsaboutherbalife.com. Here is but one small example of a recruiter romanticizing a group of new recruits.
Indicia #1 of a Pyramid Scheme - Exaggerated Earnings Claims
What is the key to achieving great wealth and prosperity? How do you too drive a Ferrari like Doran Andre?
A. Follow the Company's Marketing Plan
The company's Marketing Plan has a pathway to success. You start as a distributor at the bottom and immediately look-up to the Top of the pyramid 11 levels above you as a newbie.
How do you advance in the plan?
Volume Points. Every time you make a purchase you acquire Volume Points. The more Volume Points you acquire the faster you advance in the plan.
Herbalife's Marketing Plan immediately encourages the purchase of Volume Points. To advance to SUPERVISOR and to acquire a 50% discount on product purchased you must acquire 4,000 Volume Points or two consecutive months at 2,500 Volume Points. Let's let John Tartol and Leslie Stanford tell you how it works.
The acquisition of Volume Points to secure a higher discount/to advance in the Marketing Plan is called Inventory Loading.
Aside: "Inventory loading" occurs when distributors make the minimum required purchases to receive recruitment-based bonuses without reselling the products to consumers.
Indicia # 2 of a Pyramid Scheme - Incentives that Promote Inventory Loading
How do you make money?
All commissions in the Herbalife Marketing plan are paid out based upon product purchases. Not a single commission is paid when product is purchased by a retail customer. Whether or not a can of shake mix is ever sold to a retail customer does not influence whether or not an upline sponsor earns a commission. As long as the upline sponsor can convince a downline recruit to make a purchase of inventory the upline sponsor makes a commission.
Indicia # 3 of a Pyramid Scheme - The payment of compensation facially unrelated to retail sales.
What is the focus of the Marketing Plan?
Legitimate Multi-Level marketing plans focus on retailing as their primary objective. Herbalife's marketing plan incentivizes recruiting.
How can we be sure?
Over 4 million new recruits have been recruited in the past two years alone.
Indicia #4 of a Pyramid Scheme - a compensation system that emphasizes recruitment over retail sales.
Do distributors make money?
According to the company's annual Statement of Compensation the promises of great riches advanced by the recruiters like Doran Andre don't exactly come to pass. Most participants don't make much money at all. As a result, most participants quit the business within a year or two.
Indicia # 5 of a Pyramid Scheme - High Churn Rates/Failure Rates
How does the company continue to grow even as it loses so many of its distributors?
A. Relentless recruiting. Specifically, Herbalife's marketing plan encourages an endless chain of recruitment. The company is now in over 88 countries around the world. The Marketing Plan has aggressively saturated most geographies globally.
Indicia # 6 of a Pyramid Scheme - a compensation system that encourages an Endless Chain of Recruitment.
Q. Is Herbalife one of the largest frauds in history operating within the jurisdiction of both the FTC and the SEC?
The answer is likely "Yes"
Why? What is unique about Herbalife is the following.
Not only does the company's Marketing Plan siphon cashflow from junior recruits into the hands of these recruits' upline sponsors, the company takes the initiative a dramatic step further.
The company has taken the cashflow produced by its Marketing Plan and issued securities to the public. Retail and institutional investors can acquire a stake in the work product of Herbalife's Marketing Plan. This is a critical observation for the following reasons.
If Herbalife is a multi-billion dollar pyramid scheme then not only are its promoters likely guilty of promoting a business opportunity fraud but in all likelihood the promoters are also guilty of promoting securities fraud.
The securities fraud would likely exist on two levels.
1) The distributorships themselves are likely fraudulent securities. Selling a business opportunity that doesn't deliver the goods due to the systemic problems manifest in a pyramid scheme is a form of securities fraud under both state and federal law.
2) The equity and debt issued by the company is also a fraud of epic proportions. Selling securities in a firm under the premise that said firm is legitimate if and when it is actually an illegitimate pyramid scheme is an obvious promotion of fraud. Today, the capitalized value of HLF common equity is around $7 billion. Almost all of it likely financed by the churn in Herbalife's distributor base.
Which leads me to Mr. Icahn.
Mr. Icahn has taken an aggressive long position in Herbalife's common equity. Ostensibly, this sets-up Icahn Partners to be a potential victim of the fraud advanced by Mr. Johnson and the rest of Herbalife's Board of Directors. Mr. Icahn may find himself a victim as might any other long investors in Herbalife's common equity when regulators intervene, except for one thing.
Mr. Icahn crossed over the line from being an outside, passive, minority investor to being an inside, active, minority investor.
Specifically, Mr. Icahn's company has two seats on the Herbalife board and now forms an integral part of the company's governance.
In effect, Mr. Icahn is now a promoter of the Herbalife narrative or if you prefer a promoter of the Herbalife scheme. As investors we have already seen evidence of Mr. Icahn talking his book. As recently as yesterday, Mr. Icahn repeated again publically that Herbalife is an undervalued company. This struck me as odd as we sit here 2 days before their Q3 release but what do I know?
More notably, as the Chairman of a company that has two seats on Herbalife's Board of Directors, Mr. Icahn is now a promoter of the Herbalife Marketing Plan, just as John Tartol is, just as Mike Johnson is, just as John Di Simone is and just as every other participant in the Herbalife story is.
From Webster v. Omnitrition the case law on this point is clear. Pyramid schemes not only violate a number of anti-fraud statutes but they also run contra to securities laws.
 In S.E.C. v. Glenn W. Turner Enters., Inc., 474 F.2d 476 (9th Cir.), cert. denied, 414 U.S. 821, 94 S.Ct. 117, 38 L.Ed.2d 53 (1973), we declared that investments in a pyramid scheme were "investment contracts" and thus securities within the meaning of the federal securities laws. If Omnitrition's program is a pyramid scheme, investments in the program's supervisor positions are securities.
If Omnitrition's program involves the sale of securities, Omnitrition is liable under § 12(1) for failing to file a registration statement. Section 12(1) imposes civil liability on one who "offers or sells a security in violation of section 77e." 15 U.S.C. § 77l(1) (1981). Section 77e(c) makes it unlawful "to offer to sell ... any security, unless a registration statement has been filed as to such security ..." 15 U.S.C. § 77e(c) (1981). There is no scienter requirement to § 12(1). Wolf v. Banco Nacional De Mexico, 549 F.Supp. 841, 853 (N.D.Cal.1982), rev'd on other grounds, 739 F.2d 1458 (9th Cir.1984), cert. denied, 469 U.S. 1108, 105 S.Ct. 784, 83 L.Ed.2d 778 (1985).
The ruling goes on to state the following:
Section 10(b) of the Securities Exchange Act of 1934 makes it unlawful "[t]o use or employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe ..." 15 U.S.C. 78j(b). Securities and Exchange Commission Rule 10b-5 prohibits engaging "in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security." 17 C.F.R. § 240.10b-5(c). Federal antifraud securities laws are to be construed broadly. Herman & MacLean v. Huddleston, 459 U.S. 375, 386- 87, 103 S.Ct. 683, 689, 74 L.Ed.2d 548 (1983).
 We hold that operation of a pyramid scheme violates 10b-5's prohibition against engaging in an "act, practice or course of business which operates as a fraud or deceit upon any person." A jury could rationally conclude that the promotion of a pyramid scheme demonstrates the necessary fraudulent intent. See In re Software Toolworks, Inc. Sec. Litigation, 50 F.3d 615, 628-29 (9th Cir.) (holding summary judgment on 10b-5 claim to be improper, even in absence of direct evidence of fraudulent intent, where evidence permitted a "reasonable inference" of scienter), cert. denied, --- U.S. ----, 116 S.Ct. 274, 133 L.Ed.2d 195 (1995). Because there is a genuine dispute of material fact as to whether Omnitrition operated a fraudulent pyramid scheme, the district court should not have granted summary judgment on Webster's 10b-5 claims.
Section 12(2) imposes civil liability on any person who "offers or sells a security ... by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading ..." 15 U.S.C. § 77l(2). There is genuine dispute over whether Omnitrition made false statements of fact when it declared Omnitrition was not a pyramid scheme. Even absent such statements, a company which promotes an inherently fraudulent pyramid scheme "omits to state a material fact" for purposes of § 12(2) when it does not explain that the program is bound to collapse.
Mr. Ackman is convinced that Herbalife is a pyramid scheme. I agree with this analysis. If we are correct, there are a number of second-order effects/implications for those on the other side of the trade.
To say that the members of Herbalife's management team are "all-in" reputationally with the Herbalife juggernaut would be an understatement. Nothing might be more humbling than going from making $10 million one year to doing a perp walk the next. Even a small probability of this kind of outcome must be very stressful for Herbalife executives and their families.
One might wonder if some insider will turn state's evidence at some point along the way to mitigate his/her exposure as a whistle blower. Who knows?
As for Mr. Icahn?
It strikes me as curious as to why anyone would voluntarily want to try to pick-up reputational nickels in front of a bulldozer. If Mr. Icahn is correct about Herbalife then he likely makes a great amount of money.
If he is incorrect then it strikes me that he has now exposed himself to the potential liability that comes with being the promoter of a fraud.
After completing a significant amount of due diligence piggy-backing on the great work done by Shane Dineen and his team at Pershing Square it is obvious to me that Herbalife's Marketing Plan is a pyramid scheme. That's my take. To be long and disagree is one thing. To be long and disagree and take two seats on the company's Board of Directors is quite another.
It seems doubtful that both the SEC and the FTC will turn a blind eye to a massive fraud now that it has been brought to their attention with both thorough and rigorous amounts of investigation and evidence.
How anyone can argue rationally that this company's senior distributors don't over-exaggerate earnings potential escapes me completely. These exaggerations are, of course, the first step down the Yellow Brick Road on the way to find the Wizard of Oz.
"We hear he is a wizardful Wiz if ever a Wiz there was." - at least that is what Michael Johnson tells us (metaphorically speaking).
It seems equally unlikely that the members of the Hispanic Caucus in Congress will stand by idly as their fellow citizens are victimized.
It also seems doubtful that Herbalife will be able to prove that upline recruiting rewards are financed by legitimate retail sales rather than the ongoing purchases of distributors churning and dying on the climb to Mount SUPERVISOR in pursuit of riches that will never materialize.
As for whether or not Mr. Icahn may be involved in the promotion of a fraudulent business venture?
As always, Time will Tell
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.