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Herbalife (HLF) released its audited results on Monday. This week, the stock has been on a tear. Today the stock broke through $80 for a Market Cap of $8 billion plus. In all likelihood, the company is back in the market repurchasing shares aggressively with its excess liquidity. On a mark to market basis Mr. Icahn is clearly ahead while Mr. Ackman is clearly behind. I have not added to my short position yet. I will await the announcement of any levered recap to do so. In the interim, I remain exposed to a pyramid scheme prosecution.

Notwithstanding the obvious enthusiasm for HLF from longs at the moment, I would like to remind investors that Ackman remains on the side of the "Angels" in this trade.

Let's go back to first principles. "In the short run the stock market is a voting machine, in the long run it is a weighing machine." Herbalife's stock price will follow its business fundamentals over time. Right now, the longs have seized the reigns on the back of healthy operating results and financial engineering. The money transfer scheme continues to pay out. Bravo!

Should we be surprised to see a confidence game print $500 million in Shipping and Handling profits or 80% gross margins or 16% operating margins or 11% net margins?

Should we be surprised that all of this profiteering is happening while another 1.5 million to 2 million people will quit Herbalife this year alone?

As a reminder, the question before the house remains, is Herbalife a business opportunity fraud or not?

The answer to this question starts from the following insight.

Q. What is a business opportunity fraud?

A business opportunity fraud occurs when the promoter of a business opportunity seduces an investor to misallocate capital in pursuit of a business venture that leads to economic loss. The loss is baked in the cake. The fraud occurs because the sponsor deliberately deceives, misrepresents facts, and misleads the recruit.

The misallocation of capital may extend beyond the realm of money. Human capital is misallocated, reputational goodwill is risked. And, of course, there is an opportunity cost that goes along with the fraud too. Absent an effort to pursue a business opportunity that is destined to fail recruits might otherwise allocate their scarce resources elsewhere.

The reason the free markets have regulators is to make sure that the forces of capitalism don't overreach. There is nothing untoward about marketing or sponsoring business opportunities. There is everything untoward about engaging in fraud.

A pyramid scheme is a particularly sinister kind of fraud. The reason for this should be obvious by now. Ostensibly, pyramid schemes look like successful businesses. They can look that way for a long time. A global pyramid scheme can really go on for a long time before the identities of its victims become ever clearer. Money is relentlessly transferred from those at the bottom of the scheme to those at the top. This can go on ad nauseum in a world with 7 billion people.

If one looks exclusively at the experience of the sponsor/senior levels of the scam, everything looks rosy. Shareholders like Carl Icahn make out like bandits, CEOs like Michael Johnson get paid a fortune, President's Team Members like John Tartol also make a fortune off their recruiting efforts and the simple fact that they were fortunate enough to get in early. As long as there is velocity in the bottom levels of the pyramid, the spoils continue to flow upstream.

Over time, the salesforce multiplies. The reason it multiplies is because participants are encouraged to recruit by a pay plan that incentivizes recruiting. As the salesforce expands, the marketplace for distributors starts to fill-up. And fill-up it does. Until finally, there are too many distributors chasing too few customers. Why? Because the pay plan places no speed limits on the number of people who are recruited. There are no territorial restrictions, no franchise rights, no limitations whatsoever.

You see, a pyramid scheme is designed to proliferate to the point of pain. This dynamic is called saturation.

There is an argument that is tabled that advances the position that pyramid schemes are destined to collapse. I am not convinced that this is necessarily the case. In the case of Herbalife, we have direct evidence that the scheme can survive for a very long time. Herbalife has been around for 30 years. Since 2008 they have expanded from 65 countries to 88 countries. Each year their revenues continue to grow.

The reason they grow is simple. Herbalife recruits new participants faster than it loses old ones.

Herbalife has recruited well over 8.5 million people since the beginning of 2008. Over the same time frame, 6.5 million people have quit. Unfortunately, when the schemes don't collapse they are capable of inflicting the greatest amount of damage. Like a Category 5 Hurricane, the longer the scheme swirls around the globe the more economic harm it inflicts.

Much of the focus of whether or not Herbalife is a confidence game seems to focus on whether or not the company generates retail sales to "ultimate users" or not. Should "personal consumption" count or not? Are recruiting rewards financed by retail sales or not? etc.

This is all very interesting stuff though at the end of the day I am not sure how relevant it is to whether or not Herbalife is a fraud.

I tend to view this question simplistically. Herbalife is a fraud if it promotes and sells a business opportunity that leads to inevitable economic losses.

The ingredients in the Herbalife fraud are simple.

Oversaturated Markets + Deceptive Recruiting Practices = Economic Losses

The loss for the last guy in is baked in the cake.

In order to find out whether or not this is true one needn't look further than the experience and economic outcome of the marginal recruit. It is the bottom of the pyramid that should be analyzed and the bottom of the pyramid that reveals the fraud. When you isolate the view to the last guy in the fraud should become obvious.

Imagine you are walking down the street in Queens, NY and somebody walks up to you and invites you to a Herbalife "opportunity meeting". During the meeting you are told about this great business opportunity. You can buy product and drink it. You can buy it and sell it. You can buy it and recruit other people to buy it. It's the opportunity that will "change your life". There are other people in the room. You are told stories about Mark Hughes, you are told stories about how much money people are making every month. You might be told how the product helps you lose weight or helps cure cancer. The story is so obviously exciting. It sounds too good to be true. Except for one thing.

It is too good to be true.

Why?

The recruiters fail to tell you about all of the other people in Queens who are pursuing the same dream.

Unfortunately for you, Queens is saturated with other distributors.

You don't know it yet but you are one of the last guys in in your Zip Code.

So, you try your best to sell the product. You buy it for 25% off and hunt for customers. Except, of course, there are none. You find people who are already signed-up as distributors buying for "personal consumption". No dice there. You find people who are already buying their product from other retailers. The market in Queens is saturated so you are out of luck. You try to think about opening a Nutrition Club but you look around and see that there are already lots of them.

What do you do then? Perhaps you switch gears to recruiting. You stop people on the street to invite them to an "opportunity meeting". You tell them about the product, you try to get them excited. Except, you live in Queens and so pretty much everyone has already been solicited.

What is the end-result?

The end result is obvious. Your business has to fail. The reason it fails is not because you were lazy nor because you were dishonest nor because you were stupid. The reason you failed actually has nothing to do with you at all.

Put simply, the reason you failed is because you were deceived. You were the victim of a sophisticated Global Pyramid Scheme that operates with the veneer of legitimacy in the shadows of the legitimate economy.

It is mathematically impossible to sponsor a business plan that deliberately promotes an endless chain of recruits without harming the last guy in. It is an absolute certainty that anyone who signs-up to become a distributor once a given geography is already saturated with distributors will end-up failing at the business opportunity.

1) There will be no retail profits to be earned.

2) There will be no recruits to be recruited unless you resort to deception.

Q. Is there evidence of this dynamic in Herbalife's economic results?

Of course. The evidence sits in the churn data. Herbalife told us in its original Prospectus all the way back in 2004. 100% of Members resign every year and 70% of Sales Leaders also resigned. Over the years, Sales Leaders seem to resign at a 50% clip. Members continue to resign at close to a 100% clip.

Why do they resign if the business opportunity is so good? Why would anyone quit a profitable business venture?

Or does common sense reveal that the reason so many marginal recruits quit is because they lose money.

The only reason Herbalife continues to grow is because it recruits new people faster than they leave. It does this by expanding geographically. Cambodia is next up on the list of new markets.

Q. Is the "retail question" moot? Can Herbalife be a fraud even if it generates retail sales?

The answer, of course, is yes.

Section 5 of the FTC Act regulates deceptive marketing practices. A Pyramid Scheme is but one of many deceptive marketing practices. Exaggerated Earnings claims is another. "Cherry-picking" testimonials is another. Herbalifers do all of this stuff and more.

If you are long Herbalife at this point in the year, I think one has to ask themselves two questions:

1) Does the release of audited results exonerate Herbalife as a business opportunity fraud or is that idea a fallacy?

2) If SEC and FTC investigators are taking an independent and honest look at Herbalife's business practices, what is the likelihood that they will discover evidence of fraud?

Longs have been doing well lately siding with the likes of Icahn and Stiritz and Soros and Ramey. Herbalife's 100 million share count helps longs push the stock price around effectively.

Mr. Ackman has been relatively quiet and is obviously taking his mark to market lumps along the way. Still, he remains committed to his fundamental thesis. He continues to side with the "Angels".

As to how the final chapter of this story unfolds? That remains anyone's guess it would seem.

It strikes me as somewhat obvious, however, that if you don't ultimately find yourself on the same side as the "Angels" who continue to be victimized by the Herbalife recruiting juggernaut day after day after day then you still may end-up with a capital loss one day.

Some of you may be enjoying guys like me and "Quoth the Raven" eating crow. Just don't forget the following:

Herbalife's entire business plan is constructed on a simple idea. The central incentive is to recruit other people to compete with you for retail customers and to have those people then recruit other people, and so on, and so on, and so on. This system is both perverse and fraudulent for one simple reason.

The last guy in gets left holding the bag.

A pay plan that sponsors:

Deceptive Marketing Practices + An Endless Chain of Recruits = Pyramid Scheme

Source: Ackman Still On Side Of The 'Angels' In Spite Of Mark To Market Loss