- Why analysts don't analyze.
- Cognitive Dissonance wrecks the MLM-dream.
- Impact on other MLM stocks.
As I am writing this on the morning of the 4th of July, the latest analyst recommendations on Herbalife (NYSE:HLF) reported on Nasdaq are 4 "strong buys" and one "hold," which is a really bizarre picture in a scenario where a not so minor activist investor, in the person of Bill Ackman, has now maintained, and recently again reaffirmed his short position in the stock, and a zero price target, based on extensive and publicly available documentation. What is at work? We already knew that the efficient market hypothesis died quite some time ago, but this is ridiculous!
Recently, I had the pleasure of consulting some SEC lawyers on an unrelated matter, with mixed results, ranging from "no problem" to "you were just handed a stick of dynamite with the fuse lit," and the 3rd one in between with a more moderate and down to earth opinion on how to deal with the issue at hand. Picking a good lawyer is not easy. Neither is picking a good analyst. In law, there is a troublesome potential that minimizing the problems upfront means bigger fees later, when it comes time to defend you under circumstances which were categorized under "in the unlikely event that..."
Minimizing legal problems is a pervasive pattern in MLM-law, where skirting the law has evolved into an art form, and shallow, casuistic approaches and a lot of make-believe have prevailed, which keeps the lawyers busy when the rug gets pulled out from under seemingly reasonable assumptions. In this type of an environment, where problems are dealt with mostly by denial, violent corrections can and will occur, and the MLM-industry seems once more to be at that stage, particularly because of the recent BurnLounge ruling.
The truth comes out
Certainly, the Pershing Square presentation on Herbalife in December of 2012 got the ball rolling, and in spite of attempted rebuttals by Herbalife itself and by other industry insiders, those pincer attacks may have offered some valid points, but had not enough substance to prevent the regulators from eventually taking an interest. And now there are enough investigations and lawsuits pending that any analyst who goes by the numbers only, would reasonably have to explain themselves as to why they think these investigations are not relevant.
This year, unexpected new information arrived in the form of the book Downline... intolerable potential to deceive, by E. Robert Smith, who has been seen commenting on this site off and on. Financial analysis is not the point of the book. It is a historical novel that contains a fictional scenario of how the fate of the MLM-industry might get resolved with a congressional investigation, and it is my understanding that the author is in fact working on making that future come about. Most importantly, it was written by one who knows the industry, who by his own admission worked with Amway twice, and a number of other MLM companies, at times two or three or four simultaneously, in a pattern of risk diversification in a very unstable industry.
In parallel to all that, there have been foreign investigations into industry practices, and most recently we've seen the jailing in India of the CEO of Amway India, and a pyramid finding against Vemma in Italy. Vemma is the company Anthony Powell fled to after leaving the Herbalife fold, and its founder recently acknowledged the Herbalife investigations by preemptively announcing some cosmetic changes to the Vemma program, and publicly stating about the FTC: "those guys have guns you know." He should know, see here for some skeletons in the closet. Moreover, since he painted a big bulls eye on his chest with those statements, somebody took aim, in this (warning: salty language) YouTube video: Vemma/WakeUpNow. (I warned you!)
In short, the street has figured it out, and the prosecutors, the regulators, not to mention the Wall Street analysts are now playing catch up. The public is way ahead. All of this demonstrates the slow process of information percolating into public awareness until it becomes actionable, and a large number of would be analysts might be left in the dust simply by focusing on the numbers too much at a time when the back story is everything.
The simple truth is that endless chain recruiting has been illegal and it still is illegal, but courtesy of inconclusive enforcement, it has continued to separate fools from their money, aided among other things by the veneer of legitimacy created by the '79 Amway ruling, that has been ignored in practice. The actual numbers in the end may not be 10 customers and 70% inventory sell down, but the principle stands that actual sales outside of the network itself prove that the products are viable in the market place, absent the expectation of commissions. And the SEC now says on its website: "Ask to see documents, such as financial statements audited by a certified public accountant (CPA), showing that the MLM company generates revenue from selling its products or services to people outside the program."
Why analysts don't analyze
There is a sound body of work called financial analysis, and another frame of reference that is more probabilistic in nature, called economic analysis. Where the economy is going and how it affects a stock price will be a contentious discussion almost every time - too many things you can disagree on. Then there is a third, much more difficult thing, fundamental analysis of a business. Investors like Pershing Square practice that art form - it presumes you understand the first two, but you take your time to look under the hood and understand how the engine works. So how do we read oil and gas stocks, by pure financial performance, or by the dark clouds over the fracking business, and the divestment movement? How do we read Herbalife or any MLM stock? The very fact that Herbalife is listed on Nasdaq implies some credibility. The fact they were able to find a new auditor does too. And we can go on. They have been around 34 years, and they have survived prior challenges, so surely they will survive this one. Why would anything change now?
Chase made clients sign waivers for years before Madoff came to grief. There were too many superficial signs of credibility, so most folks could not see beyond appearances. Going by the numbers, the analysts could hardly do anything else than end up with a buy rating. An HLF-article on ValueWalk on July 3rd is emblematic. It pits a "buy" ($90 target, Wedbush) against a "hold" (Argus) recommendation, as if this were a public opinion poll. One wonders how an analyst (John Staszak) could cite the litany of problems, and then, after saying: "The company is also vulnerable to legal actions contesting the legality of its marketing practices, and is currently being investigated by the FTC and the DOJ," still be comfortable that it merits a "hold?" So when do you sell? After the SEC seizes the assets of the company?
In short, there is a level of "noise" in the market place that obfuscates all real information, and tends to be conservative until something breaks. It is hard for an analyst to break ranks in the face of the strong financials Herbalife represents, with presently a new earnings release on the way for July. After the expiration of the share buyback, it seems the prospective earnings announcement is the next life support, but volumes are very, very low. This is why opportunities do exist. Time will tell if Pershing Square analyzed HLF correctly. My guess is the answer will be yes. That comes not from listening to the analysts, but from watching what goes on in the industry, and as pointed out above, public sentiment, which can be ahead at times. The stats about MLM are that over 90% who pursue it as a business lose money, and these folks are prone to believe it is a scam, even if they don't understand the legal analysis of what separates a legal MLM from an illegal pyramid (don't worry, regulators don't understand it either, but they're working on it). Pershing Square's campaign has started to get the negative experiences in the public square.
Herbalife and the MLM-industry
Herbalife has not helped themselves by avoiding answering the fundamental challenge with their business model, and stooping to ad hominem attacks, and even an attempted raid on Pershing Square investors. It all becomes a case of: "The lady doth protest too much."
The pattern is par for the course, in as much as the DSA was the conduit for fighting off the FTC's Revised Business Opportunity Rule (RBOR), thereby putting itself in the position of potentially giving cover to scoundrels, after evidently failing to effectively self-regulate the industry. Obfuscation works only until the inevitable purge of disclosure that always follows. Recent interest in the weightloss industry, including a congressional investigation with Dr. Oz in the hot seat, may be a harbinger of things to come. I am providing some links to popular entertainment because it demonstrates the mood of the times, as well as introducing some levity. The time for change is ripe, and that is very relevant for politicians and even regulators are supposed to serve the country, not cover up abuses.
It should be noted that Herbalife's business model is also a bit behind the times in the eyes of some in its industry, and the MLM business model is definitely evolving. Nevertheless, the fraudulent core business opportunity claim (the "unlimited income opportunity" marketed for "good and valuable consideration," to unlimited hopefuls) remains firmly entrenched, and provides the juice for the endless chain recruiting that always runs afoul of the law sooner or later, when damages become too obvious. It is the reason why retail sales are so important to prove the viability of the program. Eventually, that central deceit that is now at the core of all MLM, will have to go. We are now starting to see class action RICO suits by distributors - there are the "Dana Bostick" class action cum RICO against Herbalife, and the class action cum RICO against Ignite/Stream.
If we look at the rest of the industry, clearly Tupperware (NYSE:TUP) has left the fold because they don't want to go down with the sinking ship, and waste their money fighting a rear guard action against regulators. There are some publicly listed companies that are interesting to watch. We should bear in mind the upshot of the various legal challenges, namely that recruiting must not take priority over sales, which it probably does in all MLM companies today. As much as some would like to believe that MLM-law is settled, and that it is clear what makes a "legal MLM," it would be salutory to notice just how many MLMs try to pretend they are "not MLM" and "not one of them pyramids," this includes such names as Market America, Maleleuca, and recently, most hilariously, Vemma.
The stronger the product, the better the opportunities for companies to morph into a new model that will pass legal muster. LifeVantage (NASDAQ:LFVN) seems to be contending with other issues, but it has a very strong product, well supported by a leading-edge scientific research - their President is now on the DSA board, could they be a champion of change, or will they fight the forces of change? Momentis (Just Energy (NYSE:JE) subsidiary) is a rather ho-hum "pay to play" energy company. Blyth (NYSE:BTH) seems to be dealing with lots of challenges and a murky outlook. Mannatech (NASDAQ:MTEX), Medifast (NYSE:MED), Nature's Sunshine (NASDAQ:NATR), Nu Skin (NYSE:NUS), Reliv (NASDAQ:RELV), and USANA (NYSE:USNA) seem to occupy center field, and have a strong following that may make them capable of change if they should choose to do so. An interesting laggard is Immunotec from Canada, listed on the Toronto exchange, which has good science behind its products, but never got their marketing right. They could be looking for the exits out of the MLM model, and have a strong interest in a viable alternative. Besides all of that, we see CVSL OTCQX:CVSL being promoted on this site, a penny stock and an MLM-roll up, that would appear to be an unreasonable bundling of concentrated risk in the current legal/regulatory environment. They seem unlikely as a change agent, as their business idea relies on the assumption MLM is a settled matter.
One way or another whatever new models will emerge, the principle seems clear that to be legal, the product must sell the opportunity and not the other way around. If the opportunity sells the product, that means the product is not a good value in the market place in its own right and the money games justify the price, and that's a recipe for trouble. As usual it is all very simple from 30,000 feet, but when you get down into the details it gets murky.
At the moment, earnings are mere background information to the long-term HLF outlook. Only the investigations of SEC, FTC, FBI, two state AGs, as well as shareholder class action lawsuits and the Dana Bostick class action cum RICO suit really matter, but they are unknowns, and hard to value -question marks. The nature and timing of such actions are uncertain. If you have been a long time investor, you might be concerned by the recent suspension of dividends in favor of the stock buyback. While the intrinsic value of the stock remains good based on the financial performance, the many question marks don't support a "strong buy," or a "hold." If you can't make up your mind with this avalanche of information about Herbalife, a reasonable take on the probable future range is a 50/50 chance of $90, or $0, and in that case, the current $65 is high by $20, and likely to come under pressure after the earnings announcement or sooner if there are developments. Taking money off the table might be the best advice, and that means "sell," or, if you have the stomach for it, current levels might still support short strategies.
Editor's Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
Additional disclosure: The author remains convinced that MLM-derivative forms of marketing have merit for certain products or services, and that at least some of the MLM-industry will evolve in that direction.