"We have not learned one new fact that is inconsistent with our original thesis that the company is a pyramid scheme."
- Bill Ackman
What a day to be in the air yesterday, away from internet access. First, I miss Ackman's presentation that simply dismantles Herbalife's (NYSE:HLF) China operation. Second, I missed an early morning skewering of Herbalife's PR strategies by one of the best writers on the issue on the web, in my opinion, Matt Stewart. His article, "Argumentum Ad Hominem Shows Herbalife Desperation", can be read here.
The article states that the company's flailing and screaming about Bill Ackman, rather than its focus on the fundamental issues, is a forewarning that the company is backed into a corner. I tend to agree. For instance, let's look at Herbalife's PR that was issued in response to this week's NY Times article detailing the amount Ackman and Herbalife used to lobby Washington for their side of the case:
Herbalife issued the following statement:
For the past 15 months, Bill Ackman has executed an unfounded, relentless and fraudulent public attack on Herbalifes business model, blasting Herbalife to any media outlet or hedge fund audience willing to listen. As The New York Times reports, Ackman has, out of desperation, shifted his focus from Wall Street to Washington and key states across the country. Ackman's unprecedented campaign to destroy Herbalife has now been exposed for what it is: a cynical, self-serving attempt to manipulate the market by buying his way into an investigation to cover his own reckless $1 billion dollar bet.
There has never been merit to his accusations. Now we know how he has been orchestrating the appearance of outrage and concern. There should be no question any longer about Ackman's motives, his techniques and his goals.
Matt, myself and others ask - why waste the time with the ad hominem attacks on Ackman when the truth, as you claim it, could so easily set you free?
You could make the same argument about Michael Johnson barking at Bill Ackman during the company's last conference call. For some reason, this isn't something I could see a Tim Cook or an Alan Mulally doing.
It comments like the ones left in his article and the ones that appear on my own that will likely be the first place I visit for some leisure reading if the government ever does wind up stepping in and shutting down Herbalife. It simply befuddles me that people can continue to ignore the facts and evidence against the company as they stand today.
Herbalife has the potential to be the ultimate lesson in costly ignorance for longs.
And just to reiterate my personal disclaimer, while we're on the topic of getting it all out on the table, I have absolutely zero connection to Pershing Square. I'm an individual investor, not an adviser or stock broker, that saw Ackman's original thesis and thought the evidence was well-presented, objective, and quite frankly, overwhelming. I don't act in concert with Pershing Square, Matt Stewart, or any other entity that I'm often accused of working with. I'm just a regular private investor that can, in my own opinion, see the forest through the trees - the writing on the wall, if you will, here for Herbalife and I have staked my own personal, hard earned money according to the conclusions I've drawn from looking at both sides of the argument.
Having said that, yesterday was the long-awaited conference call regarding Herbalife's business in China, presented by Pershing Square. Ackman started the call with a very fast-paced tone, indicating there was a ton to cover, and they moved deftly and quickly through an hour's worth of evidence that seemed to point out that Herbalife's China operation is very suspect.
The first thing that he went over was to squash some "conspiracy theories" about Pershing, namely:
1. Why they were lobbying, as reported by the New York Times earlier this week - the law requires you to hire firms if you're going to spend more than a certain amount of time in Washington.
2. Pershing was first made aware of Senator Markey's letter by a reporter from the New York Times on the morning of the 23nd, contrary to the "conspiracy theories" that some had come up with based on the date of the letter on Markey's website versus the date on the letter on Pershing website. The questions were the same questions that Ackman's team asked simply because they are:
- The questions necessary to determine whether or not Herbalife is a pyramid scheme
- The questions that company continues to fail to answer time and again
These are questions such as the one that pesky bears continue to bring up regarding how much product is sold in network versus out of network - what could turn out to be a smoking gun of a pyramid scheme, as defined by the SEC themselves as part of 7 parameters that govern what they think make up pyramid schemes. Presented for your judgment here is a clip from the SEC website on pyramid schemes and an excerpt from the Senator's letter:
(click to enlarge - SEC.gov)Click to enlarge
(click to enlarge - Sen. Markey's Letter to Herbalife)Click to enlarge
Pretty fair question to ask, right? Since, in the balance, hangs one of the massive components that arguably governs whether or not the company is operating in accordance with SEC guidelines. This is one example of a question that Herbalife refuses to answer, seemingly because they either don't have the data, or they don't like what the data says.
Ackman then, to clear the air, disclosed his history of supporting politicians and his goal to avoid lobbying politicians that he's personally supported specifically to avoid conflicts of interest.
Regardless, Herbalife outspent Ackman 7:1 (or 8:1 depending on which source you read) in lobbying on congress.
Additionally, Herbalife spent $30 million "defending the company from a short sellers allegations", a number that isn't itemized and certainly wouldn't need to even exist if the company could simply put up data that refute the evidence, right?
As Ackman said on his call, Why would a company with nothing to hide need to spend such an enormous amount of money, instead of just welcoming the FTC and SEC to investigate? Good question.
Then, as part of the brilliant part of establishes that Herbalife is aware of the questionable promotional tactics that its company uses, Ackman went on to point out individual distributors like John Tartol, who currently sits on the Board of Herbalife - and how the company promotes these people, despite their very questionable recruiting tactics. $10,000 a month in less than a year? That sure sounds great, if you can deliver it.
(click to enlarge - source HerbalifePyramidScheme.com)Click to enlarge
It seems as if the manner in which the company is choosing to defend itself, from a macro level, is "this is how we've always done it, so it's alright". That, while constituting some form of defense, isn't likely to do much to actually refute the evidence.
But, anyway. Back to the call.
First, it was identified that China makes up an important role in Herbalife's current growth. The company also acknowledged that China has a different set of rules and regulations for MLMs than those that exist in the US - a notably stricter set.
(click to enlarge - slides sourced from Pershing Square's conference call, available publicly here)Click to enlarge
Pershing immediately brought up a quote for COO Rich Goudis, who said that the company, for competitive reasons, "didn't want to disclose our compensation program" with regards to China.
So, the obvious question is why keep it secret, right?
Pershing seems to think that they're obfuscating the details of how they operate in China for good reason - it's illegal.
Just looking at that list, from what I know, it's clear that the way Herbalife operates in the U.S. would simply not fly in China. And, OTG Group, Pershing's "on the ground" research team, seems to think that the company knowingly breaches some or all of these laws by operating in China the same way that they operate in the U.S.
OTG's investigation was done by speaking with Chinese staff and distributors on the ground. Their research came directly from the source (distributors and potential recruits in China), and was then compared to Herbalife's filings and company statements. OTG set out to figure out how the process worked on the ground, indicating that the company may be turning a blind eye as to how its operations are actually taking place.
Pershing and OTG claim that Herbalife in China has three levels:
It takes about $16 to become a "preferred customer". The level offers to little to no benefit. Ipso facto, it's simply just a way of starting your path to "distributor". $200 in China (or 100 volume points) will get you from the "preferred customer" level to the "business representative" level (akin to the leveling up system used in the U.S.) - but, the interesting part is that volume points can only be earned through recruitment or sales through your downline. You can't earn volume points by simply selling to retail.
ELAINE: Do you know how embarrassing this is to someone in my position?
JERRY: What's your position?
ELAINE: I am an associate.
GEORGE: Hey, me too.
Anyway, as a "business representative", you're issued retroactive credits in accordance with how much product you purchase. (i.e. you purchase the items at full price, the company kicks you back what your discount is supposed to be after the fact - like a rebate). The baffling thing is that OTG claims that Chinese people refer to this as "pay", when in essence, it's really their money just being funneled back to them. Oh, yeah, and its taxed. So, you're buying the product up front at full price, selling it for full price, waiting on the difference to get mailed back to you, which you're then taxed on. The whole thing has a very Ponzi-like feel to it.
Finally, to move all the way up the "bridge to total freedom", to "distributor", you need to - you guessed it - accumulate more volume points. This is done by having people in your downline purchase items, which then again puts the emphasis on recruitment. The "distributor" rank has 5 subsets, the highest of which requires you to be purchasing $1.19 million worth of product per month, on an ongoing basis. The second highest of which requires you or your downline to be purchasing $472,800 worth of product per month, on an ongoing basis.
As Ackman joked on the call, it can't just be one, very obese person that makes it to these levels. You need a substantial recruitment initiative and a massive downline.
Another way that distributors make money is through "hourly consulting pay". HCP is an Herbalife term, and it's the way Herbalife skirts the rules in China. It's not based on consulting, nor is it based on hours - interesting. HCP is based on commissions from downline sales and bonuses through downline sales.
By calling it "hourly consulting pay", it allows the company to publicly talk about its pay tiers without fear of recourse from the rules. HCP is a reverse engineered figure that is made up of fictional hours.
A company so brazen in its approach in a company where pyramid sales are so scrutinized make it seem as if the company is operating legally, when at its root, it may not be.
When Chinese law is applied to the way it operates in China, it becomes really quite clear that the company could be at best stepping into some grey areas, and at worst, blatantly breaking the law.
Pershing then goes through the SEC filings of Herbalife, breaking out and systematically dismantling the way the company accounts for all of this mess in their public filings. I'd encourage you to watch the call at length, especially if you're a CPA or have previous public disclosure experience with regards to financing. The way the company books all of its China "royalties" is baffling. What we find out is that China's royalty numbers are derived almost exactly the same way as they are in the U.S. - as a percentage of retail sales.
Ackman then goes on to point out that he thinks Herbalife is purposely trying to hide the fact that China royalties move in lock-step with the amount of retail product sold, and he encouraged PwC to take another look at this specifically.
Ackman then goes on to take an hour's worth of questions - something that Herbalife hasn't been able to do on their conference calls, where the participants have been pre-screened. Ackman basically said, again, that the company wouldn't need to spend $30 million on "defending itself" if it would simply invite the FTC or someone of the like in to audit the business and figure out how it operates.
Herbalife could be backed into a serious corner here - unless they've already done so and just haven't disclosed it. In that case, I'd be extremely interested in seeing the results of such an audit - as would many others.
Longs took to Twitter during and after the call haranguing Ackman for anything and everything, including a bathroom break he took during the back end of a 60 minute conference call. Dear Lord, Ackman uses the can? There goes all of the credibility of the mountain of demonstrable evidence he just presented. This is what I mean by ridiculous ignorance to the facts:
When I think about the words, demonstrable evidence, this is exactly what I think of. These are the types of ad hominem attacks that the company and its longs have used during the duration of this affair. After Ackman's original thesis, it was clear that the company was acting in an extremely questionable manner. After a presentation like this regarding China, it continues to be crystal clear. the challenge for investors seems to be focusing on the evidence, and not the noise coming out of the long side of this argument. If I witness a crime and point out the evidence, and then the person accused of committing it calls me names and lashes out at me publicly, does that make the evidence of a crime any less potent as evidence at its core?
The stock? I'm ignoring the price - the writing, I believe is already on the wall. As Buffett said, ''In the short run, the market is a voting machine but in the long run it is a weighing machine.'' The weight of the bear argument on that particular side of the scale continues to grow. The company is in the midst of a massive buyback and I'm certain that when the public digests the voracity and massive impact of this presentation, I'm not expecting the stock or the company to hold up in the long-term.
I remain extremely long-term bearish on Herbalife and contend that those who ignore the facts in this case could be potentially setting themselves up for the ultimate lesson in costly ignorance, should the government step in. The upside is limited here, and the downside is massive. At best, step out and watch from the sidelines.
- If you were the FTC or SEC, could you ignoring this ever growing mountain of evidence?
- What about PwC - can they ignore the accounting questions raised by Ackman with regards to Herbalife's Chinese royalties?
- What about Chinese regulators - think they were listening?
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. I'm bearish on Herbalife and own options spreads accordingly. I reserve the right to modify or change any position, without notice, at any time.