Herbalife - The Fractal Nature Of Failure

| About: Herbalife Ltd. (HLF)

Summary

Why product-based illegal pyramids are harder to spot than plain Ponzi-schemes.

Why regulators are so toothless, even if they try.

Why deception and financial harm, not "pyramids," are the key.

Herbalife (NYSE:HLF) is in the news. Why it did take this long for the FTC to show up, and why the ending could happen surprisingly fast. The following are some common sense observations on the dynamics of this play, that may be helpful in understanding the actions of various parties.

We're now fully in silly season with Herbalife (HLF), and similar (MLM) stocks are feeling the pressure as well. Separately, there is a private action under way that is equally important, the RICO/Class action suit against Ignite/Stream, which is about a $1bn MLM-subsidiary of Stream Energy of Houston, TX. This Saint Patrick's day Carl Icahn must have been having his Wile.E.Coyote moment, and realize he has precious little ground under foot. He may not have dumped his stock yet(?), but it looks increasingly likely in the opinion of many - not to mention hard to pull off. So the net effect of his involvement would be "pump and dump," and not quite as intended.

Analysis, Polarization and Obfuscation

Ever since Pershing Square announced its short position against the company, the polarization has been extreme, and the amount of obfuscation equally extraordinary. From the moment that emotions exploded onto the scene, with Carl Icahn inveighing against Bill Ackman on CNBC, clarity has been hard to find. On balance however, it would seem as if the cool and rational arguments have been on the side of the shorts, starting with Pershing Square and the websites they have on Herbalife. Since then, SeekingAlpha has had some powerful analysis from Matt Stewart, Quoth the Raven, Bruce Craig, Doug Brooks and others, and in the mainstream press it's been Michele Celarier at the NY Post, and Dan McCrum at FT/Alphaville with his priceless "Living the Herbalife" blogs, who have been producing a steady stream of good information.

Compared to that, reliable company information has been hard to come by, often tendentious, rife with repeated re-statements and fumbling, as well as being frequently confusing, and in the end it sounded disingenuous when they "welcomed" the current FTC inquiry. The FTC meanwhile would have to be grateful for the amount of forensic analysis that has already been done for them. They know where to look now.

Why so late?

Why wait this long? That's the question on everyone's mind. It's always much simpler than people think. First, companies are too small to worry about, unless the abuses are extreme. Then, there is a factor of credibility just because they've been around for a while, and there are not a lot of complaints. And after that they get too big to make an easy target, as was demonstrated by Amway in its famous case in 1979. In short, the regulatory system has built-in inertia, which then results in a position that when they take action it has to count. The Herbalife case is likely to become one for the history books, no matter how it comes out. The amount of forensic analysis that has been done by Pershing Square and others is extensive, and it means that regulators have a virtual blueprint. They just need to go in and pick up the evidence.

The lobbying factor

The New York Times, in a belated attempt to regain relevance, reported on Pershing Square's lobbying attempts, putting Bill Ackman on trial, as if that were the issue. Of course lobbying is an activity that easily slides into abuse, and there may or may not have been missteps. But realistically, Herbalife outspent Pershing Square by 7 or 8 to 1 in their lobbying, and the history of the MLM industry is rife with lobbying abuse. Amway would have come to grief a long time ago without extensive republican connections, political contributions and arm-twisting.

The tone of the Times report also sides with the emotional appeal that short sellers are somehow bad people. No doubt some short-sellers are abusers, but so are pump and dump stock promoters. Bill Ackman however is hardly a "short-seller," if this is only the second short position of any significance that he's had. The history of the first one demonstrates how and why a good analyst can do well by doing good through the mechanism of shorting a stock. Good riddance, MBIA.

Common Sense

Common sense has been the victim in the whole development of the direct sales, now largely MLM industry, which has often been dominated by companies that abuse the system. The recent paper by Prof. William Keep and Peter Vander Nat sums it up quite nicely.

The logic is that consumer protection is warranted because massive deception, amplified by the pyramidal structure of compensation, has the potential for becoming a simple money transfer scheme from the deluded victims to the conspirators at the top. Surely there are times when the asymmetry of information warrants protection, because the usual caveat emptor is not enough. Prospects are simply rendered unable to do any meaningful due diligence, let alone retain competent legal advice on a relatively small investment.

However, common sense makes it easy to see the deceptions at work, once you understand them, and know what questions to ask. One of the central arguments in the criticisms of Herbalife is that their pay structure creates a motivation for inventory loading, and channel stuffing, which then by forensic accounting leads one to conclude that the incidence of financial benefits (commissions) coincides with the number of fools who are convinced that it is worth the $4,000 to become a "supervisor," and thus while nominally, as the accountants label the books, HLF may not "pay for recruiting," but constructively they do. In other words, the economic view, as opposed to the accounting treatment reveals the true intent of the program. This provides a clear example of a company making money at the expense of its distribution force, instead of collaboratively, with a proper alignment of incentives.

A similar example is the Ignite/Stream case. Since when does it make sense to pay for the privilege of selling someone's product or service? In the case of these commodity services, what are you paying for, when you pay $500 to $1,000 in first year fees, particularly when you consider that anyone who can fog up a mirror can walk into an energy company and sign up as a rep for free? In short, you are paying for the multi-level comp plan, which is a money game. The companies know that 9 out of 10 people fail, so effectively they raise between $5,000 and $10,000 for every successful representative, which funds bonus moneys and owner profits. In short, in this case there is an effective circumvention of the franchise laws, which may work from an accounting/legal point of view, but the economic facts are that the companies raise significant money for every successful rep. This in turn funds the program, and fuels the deception by promoting the fast money at the top.

Ponzi's are easier to spot than product based Pyramid Scams

Sure, it took too long to stop Madoff, and too many warning signs were missed, but all things considered a Ponzi scheme is easy to spot. The underlying business is either non-existent, or cannot be scaled to absorb the investment and produce the results that could honor the increasing claims from investors. Early on, the going is good, and redemptions are not an issue. As investment and growth accelerate, doubts rise because of "too good to be true," etc. and before you know it, redemptions grow and begin to cause pain. Then word gets out, and you now have a substantial pile-up of financial losses that was entirely predictable, and therefore preventable, and should not have happened but for the inability to do proper due diligence. Enter regulation and enforcement. We still need to learn to catch them sooner.

A product-based illegal pyramid is much harder to spot, and there is not one single train wreck at the end. Instead there is a fractal pattern of ongoing failure, and mostly people who are embarrassed to admit failure, and would sooner forget than complain. But the industry stats are that 9 out of 10 people fail, so these small investments are hugely rewarding for those at the top. Companies base their business model on this predictable failure, and deceitful presentations combined with lack of disclosure allow this go on for a long time. Indicators of problems include up-front payments, or ongoing "maintenance" fees, renewal fees, etc., and also wildly overpriced products, where the padding of the price fuels the money game. It's like the selling of shovels in the gold rush. In other words, believe in the opportunity, but pay me cash up front - there's gold in them thar hills! The fact that the failure is so dispersed, and not a single train wreck at the end, makes it harder to spot.

The facts are that many people fail, which would be no problem if it did not cost them money. It's the combination of deceit and financial damage which correctly invites regulation. The failures of prior attempts are evident. Will anything change this time?

Conclusion

It's the fractal nature of failure that makes bad MLMs so hard to spot for the uneducated lay person who is trying to make a business decision. But there are tip offs. There are "good" pyramids and bad. General Motors, the government, and even Pershing Square are pyramidal in shape: I assure you that Bill Ackman makes more than his receptionist, and if she did not add more value than they pay her, she would not last. Illegal pyramids are based on fraud and deceit, and cause widespread financial damage. Once trouble starts, it tends to quickly get compounded, and an FTC investigation may trigger state AGs, or an SEC action, not to mention a rush for the exits by the representatives, distributors, customers, who look for a more stable venue. Once all these factors play together, rapid endings are not all that uncommon. The move from $80 to $50 could be slower than the move from $50 to $20, or even $10, or Bill Ackman's favorite: $0.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have had MLM experience, and currently still use some excellent products that are distributed through MLM. I also participate in a customer referral program with multi-level compensation.