It's been almost a year since Bill Ackman announced his short position on Herbalife (NYSE:HLF). With much media fanfare, he gave a 300+ slide presentation explaining the validity of his thesis. On Bloomberg, he confidently declared, "This is the highest conviction I've ever had about any investment I've ever made." To the casual onlooker, it appeared that all hope was lost for Herbalife. But for those of us that benefited from a little more context, we knew better. We've seen this movie before with convicted con man, Barry Minkow. Admittedly, Bill Ackman is different than his felon predecessor. While Minkow concealed the fact he was paid for his attack (fraud), Ackman made his position clear from the start. And really, that was the only difference. They both relied on the same worn-out anti-MLM arguments. They both stitched together various quotes and articles, most of them out of context, in an effort to stretch the truth and create an appearance of filth.
They both ultimately failed. As I've watched the debate unfold over the past year, I've been greatly puzzled by the amount of effort Ackman has expended to kick down this "unsustainable pyramid." While I don't think he's a bad person, I think he's obviously crossed a line and gone from an objective fund manager to a spiteful schoolboy. It can happen to anybody. I tell all of my children, "Thompsons control their emotions." I started reciting this maxim when I noticed my four-year old daughter making poor decisions when she was uncontrollably angry. Under the influence of strong emotions, we all make mistakes. Ackman is clearly under intense emotions when he says things like, "This is not a trade for me, we are going to take this . . . to the end of the Earth." He's ignoring basic fundamentals and investing purely on ego. At some point, he got off track. I'm calling the game. It's over for Ackman's bet, no matter how hard he postures. Herbalife is NOT going to be shut down as a pyramid scheme. I can count seven assumptions made by Ackman that have all turned out to be faulty. It was his reliance on these assumptions that led to his extreme confidence. And when the market largely ignored him, those faulty assumptions led to his extreme and continued bitterness.
1: He Assumed Bigger Means Better
Central to Ackman's thesis is a legal report prepared by someone at Sullivan Cromwell. To this date, Ackman has not provided this report, though he still falls back on it when pressed about his thesis. Sullivan Cromwell is an enormous law firm based out of New York. With over 800 lawyers and $1 billion in revenue, it's safe to place them in the "big firm" category. But bigger is not always better. While Sullivan touts a number of reputable brands as clients, they've likely advised ZERO clients regarding their sales in a network marketing format. I represent network marketing companies and I know the competitive landscape of lawyers in my space. Candidly, Sullivan Cromwell is completely off the map. With MLM law, being a generalist is a plan for failure. Context is everything and it's important for any lawyer in the MLM space to have a broad historical perspective. There's more to a company than what can be gleaned on paper. The sales culture matters and it's impossible to critique an organization without a bit of experience. If someone at Sullivan Cromwell told Ackman that Herbalife was a pyramid scheme, he or she lacked meaningful experience to know better. Ackman was wrong to assume that paying $1,000 per hour (or more) was likely to lead to better analysis. If someone reads "Basketball for Dummies," it doesn't mean they're equipped to coach.
2: He Assumed He Could Hypnotize the Market
Ackman assumed that with the awesomeness of his initial powerpoint presentation, the market would panic resulting in a massive selloff. And truthfully, the market did panic for a couple of weeks before growing immune. Bob Chapman and I published the first article that challenged Ackman's position. Two weeks after his initial presentation, when the wound was still fresh and the stock was trading in the low $30s (it's now at $75 per share), we pointed out that the emperor had no clothes. Chapman understood Herbalife's model and once he made his position public, other funds followed. Before there was Icahn, there was Bob Chapman. Ackman did not anticipate large fund managers betting against him. As other funds began doing some due diligence, they all started piling on the long side based on the realization that Ackman's only shot was government intervention. As the market sobered up, Ackman's presentation was placed under a microscope and found to be grossly inadequate for purposes of finding illegality.
On a side note, I suspect Ackman saw the stock tank after David Einhorn's questions to Herbalife on May 1, 2012. He likely surmised that if the stock would drop severely after a few questions, he could topple it with one well-placed strike (300+ slide presentation). Bottom line: he assumed the market would follow his "well-researched" logic. He thought wrong. The most notable of long investors are Carl Icahn, George Soros and Bill Stiritz. Notable investors in Ackman's camp: zero.
3: He Assumed the Sales Force Would Collapse
When I first saw Ackman's presentation last year, I thought to myself, "There's no way Herbalife distributors can build with this kind of negative publicity." They surprised me and they surprised Bill Ackman. Ackman's presentation was almost a self-fulfilling prophecy. If the sales force was rendered inert, the stock would have tanked; thus, proving his theory that Herbalife was a volatile pyramid destined to collapse. While the collapse would have been directly tied to Ackman, he would have attributed it to the volatile nature of pyramid schemes. As stated earlier, the stock bounced back. As for the sales force, they trudged forward, producing significant results under tremendous pressure quarter after quarter. It's hard enough to build a network. If there's negative press, it only compounds the difficulty. Somehow, the Herbalife distributor found a way.
While some of Herbalife's most notable leaders left Herbalife during the drama, it has not significantly impacted the company. We saw this when Amway was challenged back in 2006 after the UK attempted to shut them down. Similar to Herbalife in Belgium, Amway ultimately prevailed in the UK. Amway took the crisis as an opportunity to tighten some screws with respect to distributor compliance. There's nothing that gets a sales force in line better than a good controversy. While Amway lost a lot of its leaders in the process, they survived without a serious decline in revenue and emerged a stronger company. It happens. Again, historical perspective is key when evaluating these events. Ackman assumed the sales force would collapse. He was wrong.
4: He Assumed He Could Confuse the Public About Market Saturation
This is somewhat related to Assumption #2 where Bill Ackman expected to mesmerize the market with his logic. Ackman assumed that his argument regarding market saturation would actually fly. In theory, it seems to make sense. At some point, assuming everyone is successful at recruiting Herbalife distributors, the market would be exhausted. In Ger-Ro-Mar, the FTC tried to make this "geometric progression" argument and failed. In that case, the company was in the business of selling women's lingerie. The court cleverly wrote, "We find no flaw in the mathematics or the extrapolation [presented by the FTC] and agree that the prospect of a quarter of a billion brassiere and girdle hawkers is not only impossible but frightening to contemplate, particularly since it is in excess of the present population of the Nation, only about half of whom hopefully are prospective lingerie consumers. However, we live in a real world and not fantasyland."
In his article, notable MLM consultant Len Clements said it best when he wrote, "I wonder, how many more years does a 32 year old company like Herbalife have to exist, and continue to grow, before this notion of MLM company's succumbing to 'inevitable market saturation' becomes folly?" Full article here. In his first presentation, Ackman asserted that Herbalife was running out of markets; thus, doomed to experience "market saturation." Keep in mind, Amway is 22 years older than Herbalife, operates in 20+ more countries and has over three times the sales revenue of Herbalife...and they have yet to "saturate the market." But I digress. At his second presentation given recently, he vectored on the territorial aspects of market saturation. Based on the screenshot below, Ackman is arguing that it's improper to have a concentration of distributors in a small geographic territory.
This focus on geography is folly. Herbalife distributors are not franchisees charged to serve a targeted segment on a map. They're networkers. The notion that network marketing is flawed because there are no territorial protections is absurd. The opportunities for distributors is not limited to their place of residence. By paying a few bucks, they can sell products throughout the entire world with zero hassle. In the age of information, they can explode their territorial restrictions by networking online, sponsoring people across the globe. The pay plan does not discriminate between sales volume generated in their zip code or in other zip codes or countries.
The word "Independent" in "independent contractor" is what distinguishes the network marketing model from traditional franchising. Due to the independence of each rep and the ease of entry (and egress), networks can grow without significant capital investments. With this model, companies can scale across the world without complex corporate layering. Free flowing competition among distributors is a strength of network marketing, not a weakness.
5: He Assumed He Could Confuse the Issue of Internal Consumption
Bill Ackman assumed he could stitch together an argument that criminalized heavy internal consumption. As a recap, "internal consumption" is a term used to describe the act of paying commissions on downline consumption / sales. If distributors buy the product for personal use (distributor = "internal"), commissions are triggered. The criticism of internal consumption: it can lead people to buy things they never would buy while they're under the influence of a pay plan i.e. "opportunity driven demand." This issue is the main source of criticism of network marketing and Ackman seized on it. First, the conclusion: it's legal to pay commissions on internal consumption. The debate has always revolved around the appropriate amount i.e. is it ok if 90% of a company's revenue comes from the sales force instead of third-party customers? Ackman subscribes to the belief that a company is a legitimate MLM if 51% of its revenue comes from retail sales. If it's at 50.5%, it's a fraudulent pyramid scheme destined to collapse.
Given the low cost of entry into network marketing companies (oftentimes less than $100), this sort of black and white standard is intellectually disingenuous. Since it's so easy for distributors to join a program to "give it a shot" or save money on product, it blurs the line between retail sales and distributor volume. In an often quoted FTC advisory memo in 2004, the FTC said, "In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme." The key is motivation: what's driving the consumption? If it's opportunity driven demand, the motivation is misplaced. In its rebuttal presentation, Herbalife released some data that put this issue to rest. Based on its objective data, 31% of all orders are drop-shipped to non-participants. This at least indicates that the products have legitimate value and are not merely token items. As for the issue of distributor motivation, 73% of all distributor orders are made by participants that are not qualified to receive commissions. Click here to see the full presentation, pages 50 and 59 specifically. As if that's not enough, Herbalife commissioned Nielsen to conduct a survey. The results: Herbalife has over 7 million customers in the United States alone, which dwarfs its distributor numbers by 6.5 million. The verdict: the products have value.
"But the BurnLounge decision says sales to distributors cannot count towards commissions." When Ackman and critics make this argument, they're quoting BurnLounge out of context. As a recap, the final BurnLounge decision states, "For purposes of this definition [or a pyramid scheme], 'sale of products or services to ultimate users does not include sales to other participants or recruits or to the participants' own accounts.. At first blush, it's pretty damning. It says that paying commissions on internal consumption is bad. But Ackman knows better because the Order also states, "For purposes of this Final Judgment....the following definitions shall apply." Historical perspective: this definition is identical to the definition used in ALL of the FTC cases. There's nothing new. And the FTC has already made its position clear with respect to the significant of these definitions. In its 2004 advisory memo, it wrote, "To protect the public from those who have demonstrated an unwillingness to follow the law, these orders often contain provisions that place extra constraints upon a wrongdoer that do not apply to the general public . . . [These orders] do not represent the general state of the law."
Bottom line: Ackman is clamoring for the wrong piece of data. He's asking that Herbalife reveal their retail sales data. The key factor is "motivation," and motivation is not easily quantified. And given the low cost of entry for all network marketing companies ($60 for Herbalife), this piece of data is not the determining factor with respect to pyramid allegations. Does Herbalife have this data? Yes. Are they obligated to provide it? No. They've already shown some compelling statistics AND they're tightening the screws with respect to distributor compliance. Going forward, I suspect Herbalife will do a better job distinguishing its customers from business-builders.
6: Surgical Strike on Herbalife
Ackman likely assumed that he could keep the pressure solely on Herbalife without agitating the rest of the MLM industry. Keep in mind, the direct sales channel represents approximately $167B in global revenue. When he relied on common arguments used against all network marketing companies, he brought the entire industry into the melee. Initially, he was careful. On Bloomberg after his initial presentation, he said, "I'm not saying that companies like Amway are pyramid schemes." Now, his arguments are growing more broad with each presentation. With this in mind, every company in the industry benefits from his failure. It's led to a more unified direct sales industry and bolstered support for outreach efforts. And quite candidly, it's made the space better.
7: He Assumed He Could Refute the Value of the Buy-Back Policy
The value of Herbalife's 12-month buy-back policy cannot be under-stated. When I see former distributors crying foul about the money they've lost, I care....but....I wonder if they knew about the return policy. Herbalife offers a 12-month refund on all unused / unsellable inventory (without a restocking fee). When people are upset about money lost, it's clear that the issue is regret. They regret using the product. But they still used it and derived value from it. The 12-month buyback policy, which is adopted by Herbalife and strongly encouraged across the entire industry, is the ultimate consumer safeguard. It's designed to help distributors get their money back on unsellable and unwanted inventory when they decide to exit.
And for the sake of argument, suppose Herbalife distributors are consuming over-priced products with the expectation of deriving returns from the pay plan (opportunity driven demand). This argument is central to Ackman's thesis. If you look at the full BurnLounge Statement of Decision, which has never been referenced by Ackman or other critics, the judge dedicated almost 10 pages to the value of the BurnLounge product (or lack thereof). He ultimately concluded that the products had SOME value; thus, he discounted the amount of consumer harm calculated by the FTC. As an example, if a product was really worth $100 but sold for $500, the consumer harm could be pegged at $400. In Herbalife, if distributors are being duped into consuming over-priced items, it cannot be ignored that they derived SOME value; thus, dramatically minimizing the exaggerated losses claimed by Ackman and others.
When you factor this element with the 31% drop-shipping statistic + the 73% statistic of orders from non-qualified distributors + the 12-month buyback policy + the 0.2% return rate + the minimal amount of consumer complaints...it paints a clear picture: the products have legitimate value and the consumer safeguards are sufficient.
Ackman's gamble is over. This is not false bravado. I'm calling it now like I called it with Bob Chapman weeks after Ackman's first presentation. Ackman can waste his investors' money as long as they'll allow. It does not change the fact that Ackman's argument was premised on several assumptions, all of them faulty. It took little skill to craft an argument and seem convincing to those unfamiliar with the issues. The MLM space is murky, to say the least. But Herbalife has never taken ranks with the companies on the bottom-rung. Ackman knew this, relied on an undisclosed legal report from a firm with zero experience in the category, relied on several other assumptions, took a gamble, and failed. Recent statements from Ackman seem to be coming from a man with a bruised ego, leading with his emotions and not his head. Herbalife is not a pyramid scheme and with each passing day, they evolve into a better company.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Our firm has not been retained by Herbalife and I'm not being compensated to write this article.