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Summary

  • FTC investigation narrows set of outcomes for Herbalife.
  • Best case is likely a consent order.
  • Worst case, the pyramid is shut down.

Yesterday afternoon, Herbalife (NYSE:HLF) released an 8K stating that the FTC has launched a formal investigation into the company. Perversely, the company responded that they welcomed the FTC's interest begging the question, why did it take them so long to extend the invitation?

Couldn't they have saved shareholders $30 million or so had they simply mailed the FTC an evite to an extravaganza or two in 2013?

Still, the Herbalife spin doctors are always at work. Evidently, Herbalife is "welcoming" the colonoscopy they are about to receive or so the story goes.

The truth about the FTC investigation to Herbalife is simple. In all likelihood, it is a game changer. For those unfamiliar with the Commission's investigative techniques I encourage you to read the following from the FTC's website. Make no mistake, the FTC will leave no stone unturned as it winds its way through the ever-opaque Herbalife and its problematic business practices.

Recall, investors like Mr. Icahn took the position that an FTC investigation of HLF was an unlikely outcome. Icahn consulted a so-called expert in FTC law. So much for those fees I guess. Now that we know for certain that an investigation is underway we can now start to handicap some of the outcomes.

I think we can reasonably conclude that at this point one of three things will result from the investigation

Option A - regulators find nothing untoward and close their file. Frankly, this seems like a pipe dream. Obviously the FTC has enough evidence already to issue the CID. It is unlikely they will find that their suspicions are just plain wrong.

Option B - regulators find material issues with the way the company conducts business and coerces the company to change its business practices and sign a consent decree. This may be a likely outcome but may also be a pipe dream too.

Option C - The FTC confirms that Herbalife is, centrally, a recruiting scam and shuts the company down.

If you are a Herbalife long, it is important to fully digest the following reality.

IT IS HIGHLY UNLIKELY HERBALIFE'S MARKETING PLAN WILL SURVIVE IN ITS CURRENT FORMAT.

In this article, I would like to explore the reasons why I think that a consent order will be as damaging to HLF longs as a complete shutdown of the company.

Recall, the Herbalife short thesis is built upon a simple premise. Namely, the demand for HLF Formula 1 is driven centrally by those pursuing advancement in a recruiting scam. That is to say that the demand for F-1 using a traditional direct selling model would, in all likelihood, be de minimis. Herbalife is a confidence game. Business opportunity seekers buy product to try to get to SUPERVISOR. Most fail on the way up unable to find retail customers or downline recruits. The company survives because it is constantly recruiting.

Herbalife's success as a confidence game relies upon its momentum/velocity. Any regulatory action that will interrupt that velocity will cripple the HLF juggernaut going forward.

Q. Can we predict what kind of restrictions the FTC might table should they impose a consent order on HLF?

I think it is reasonable to suggest that the following 5 business practices are now as dead as a Do-Do bird.

#1 Exaggerated Earnings or Income Claims - Under no circumstances will HLF distributors be allowed to tell their rags to riches fables to potential recruits in the future. This is an outright certainty one would think. Recruiting efforts, therefore, would likely have to revolve around product efficacy and actual retail sales to real consumers. The Mark Hughes story has likely run its course.

#2 Business Development Tools/Lead Generation Systems will be Shuttered - a central element in the Business Opportunity Fraud is the sale of leads to new participants looking to recruit. This is big business that is ongoing. The FTC is unlikely to allow this to occur much longer.

#3 Tiered Wholesale Pricing Will Be Dust-Binned - As I have pointed out many times before, Herbalife price discriminates against its own salespeople by charging different wholesale prices to different levels in the salesforce. This is likely an anti-trust violation. This sinister element of the marketing plan is what triggers inventory loading and the relentless pursuit of SUPERVISOR status by new recruits. It is also the sordid dynamic that drives the HLF topline.

#4 Nutrition Clubs will be shut down. Nutrition clubs are illegal food service operations masquerading as health clubs. Their illegal presence is likely to be short-lived.

#5 Retail Sales Reporting Will Become Mandatory - Herbalife will have to demonstrate that its salespeople generate real sales to people who are not participants in their marketing plan.

Make no mistake, Herbalife is now a wounded animal. There is no way it survives in its current modus operandi. This is a material statement for the following simple reason.

Herbalife is an illegal pyramid scheme. Investors who think that the company sells $4 billion worth of overpriced and undifferentiated shake mix because it is the secret cure for global obesity are delusional.

Investors who believe that this miracle cure for obesity only appeals to the lowest income members of society with a heavy skew towards Latinos exclusively are illogical.

Investors who believe that there is natural demand for Formula-1 independent of its ties to the pursuit of a business opportunity are kidding themselves.

Herbalife sells hopes and dreams. More specifically, it sells SUPERVISORSHIPS. Coincidentally, to get to SUPERVISOR business opportunity seekers have to buy a material amount of HLF inventory. This is the incentive that drives the business model. This is the dynamic that drives the business.

If it were not, if Herbalife actually manufactured a product that people love to use and want to use habitually the turnover in the salesforce would be low not high. The demand for territorial exclusivity from distributors would be robust. Health conscious consumers across the country would be consumers, not just mainly Latinos.

Make no mistake if you are long. The Herbalife business model is now on life support.

Equity investors remain unconvinced it would seem. A $6 billion market cap implies that investors expect HLF to survive beyond this year. This strikes me as an optimistic expectation.

Over the next few months we will see how HLF trades. Will Mr. Stiritz awaken to the error of his ways and cut his losses? Will Mr. Icahn eat crow? Will the SEC join the regulatory fray? Will China get involved too? Will the media begin to side with the logic that underpins Mr. Ackman's case?

Finally, what respectable Chief Investment Officer of an open-ended fund company will allow Portfolio Managers to own this name while it is under investigation?

I expect HLF to trade lower as market participants digest the enormity of the news released yesterday.

Herbalife's business model is over. Full Stop.

The investigation will end-up a formality.

Yesterday's FTC investigation is a game changer for longs. My recommendation, sell your shares into the company's buyback while you can because once they exhaust their powder keg no right-minded investors will want own this stock.

Source: FTC Investigation Is A Game Changer For Herbalife Longs