Herbalife (NYSE:HLF) is in the news again, and it will take some time before the new information on its Nutrition Clubs program is digested by the market. Yesterday was "sell on the news" day, and today was "buy on the event" day. The message from Pershing Square is that the Nutrition Clubs are nothing but an illegal pyramid within an illegal pyramid, and the number of potential legal violations is beyond count. The event was well-organized and well-attended. Clearly, the retail customers John Hempton thought he saw are nothing but misguided hopefuls being "trained" to open their own nutrition club one day and sip Formula-1 to fill their quota. The advantage is you have no problem with garage qualifying people, as the product gets consumed.
Meanwhile, it pays to think about potential collateral damage from the eventual demise of Herbalife. Some time ago, law professor and equities trader Dan Ravicher lost his case against Carl Icahn and Herbalife's bankers, after accusing them of causing a loss in his short position by knowingly aiding and abetting a pyramid scheme. In a comparable development, DOJ has indicted FedEx for shipping illegal drugs for online pharmacies. In short, vendors and service providers can't simply look the other way if something is really wrong, and they are aware of it.
Just examining these cases superficially, it would seem that the Ravicher case was too far-fetched, but it was an interesting thesis. He lost money on a short position because Carl Icahn and several banks supported Herbalife, causing the stock to go up. The court could not see the reason why either Carl Icahn or the banks were obligated to favor Mr. Ravicher's trading position in any way. Different in the drug case, there the problem was straightforward and easy to see, and reported on by FedEx employees. It was a matter of supplying drugs to junkies by FedEx and looking the other way. We'll have to wait for the results, but it sounds plausible FedEx might have an issue.
It begs the question at what point complicity in malfeasance is actionable. The most recent stock buyback in Herbalife comes to mind, which was launched with investigations pending. It gets even more interesting when combined with insiders, including CEO Michael Johnson, selling into the buyback. What about complicity of the banks in that deal? To what extent can the victims go after the providers, for Herbalife won't have any cash on hand at the current rate.
Given the financial dimensions, it would seem that banks, in particular, may be in a drafty position when they help companies like this perform financial magic or even any ordinary banking service, if it is found to be criminal or even if serious class action lawsuits get filed. Those who helped disappear the money that could have satisfied victims' claims might get a call.
Revocability of payments may be an avenue for victims
In the event of distributor class action suits, payments by the victims may be another possible avenue. As has been seen in the mortgage meltdown, in some cases, mortgage processors were wiped out overnight when a class-action suit was mounted charging fraud in the inducement; and with revocability of ACH payments of up to 24 months, some mortgage holders got up to two years of payments reversed overnight, and the banks had to honor these recisions. If you were a processor living off points, massive reversals of up to 24 months of payments of principal and interest were quite devastating. For checks revocability is 9 months, for credit cards normally 6 months, but it can be up to 3 years if there is fraud involved. Elementary consumer protection requires protections against any vendor who has the right to debit your account. Even debit cards with the Herbalife logo might be used for such reversals.
In short, depending on how things unfold, providers of payment services to the company may become instrumental in its quick demise, and on top of that, they may potentially also be a target in an indictment, if it is deemed they should have known the operation was a pyramid scam. The people who are overbuying inventory to qualify for positions and denying it will be the first to cry foul when the pyramid collapses. This type of a scenario is one reason why often it is difficult to obtain payment services in the MLM industry. In this scenario, Herbalife's "gold standard guarantee" may be trumped altogether by reversals on the strength of "fraud in the inducement." Suddenly, it will be evident that they would have bought a cheaper shake or no shake at all if the prospective earnings fall away.
Withholding dividends for buybacks has not worked
There are a number of shareholder lawsuits pending already, but in the latest stock buyback, Herbalife canceled its dividend in favor of buying back more shares. This idea has not proven an evident success, given the fairly quick slide from $65 to $60 and then on to $54, upon only some vaguely bearish news items that merely add to a growing laundry list. So far, the markets have been shrugging it off, but it may now have reached some form of critical mass. Today's bounce brought the stock back to nearly $68, but it remains to be seen how solid that is.
Canceling dividends and bailing out its executives and board members may not be equally appreciated by all shareholders or by regulators.
Investors on the hook
Along with service providers, investors, certainly after the posting of the Pershing Square pyramid scheme presentation, and more particularly if they have publicly promoted the business, may be affected by an eventual pyramid finding and be held accountable. Today's incredible detail on HLF's Russian doll arrangement of the nutrition clubs as a pyramid within a pyramid, making up 50% of HLF sales volume (PS estimate), adds a whole new level of liability to the company. Bill Ackman did not hesitate to call HLF a criminal enterprise.
Meanwhile, in other news, Whitney Tilson has "officially" weighed in on the short side as well, and he was in the audience at the AXA Auditorium today to hear Bill Ackman make the presentation in person.
Carrots and sticks - a side note on the Hispanic front
One of the key themes that has played through the Herbalife story is its relationship with the Latino community, and LULAC has been at the center of that controversy. In its usual manner of avoiding to address the issues directly, Herbalife has tried to alternate opposition to LULAC with courting individual LULAC chapters, but, judging by the turn of events in Chicago at another Herbalife extravaganza, clearly it has not managed to buy influence at all LULAC chapters. Now, Herbalife has resorted to threats. Given the mounting stories of business losses by former Herbalife distributors, the systemic losses by operators of nutrition clubs, and the specter of exploitation, the company may be in the process of completely antagonizing a community that is important to its success, just when politicians recognize the importance of the Hispanic vote more than ever before. Here again, the Pershing Square analysis added a new level of granularity about the company's targeting the "Bottom of the pyramid" -- poverty-level consumers who could not otherwise afford its products, but are now lured in with hopes of opening their own nutrition clubs one day.
Besides the cloudy prospects for Herbalife itself, its investors and direct vendors may be affected by the ensuing mess in a variety of ways. The Ravicher lawsuit may have had too shallow a foundation, but it may still prove to be a harbinger of things to come. If so, this will have a significant chilling effect on the industry and its service providers, for again, by dint of being public, Herbalife has become the poster boy for the industry at this point.
In general, the fallout will likely impact the entire MLM industry, and there will be a lot of soul searching going on in executive suites as to who exactly has a taste for spending time with Bernie Madoff and some MLM execs who seem to have reservations waiting for them in club Fed. Other candidates for collateral damage were listed by Ackman today, including Madeleine Albright, to Ken Moelis, Antonio Villaraigosa and others, including sports figures sponsored by the company - basically anyone who "rented" their professional credibility to the company.
Based on the above, I maintain that for those for whom all of this is "too much information," the only rational way to value HLF at the moment, in view of the uncertainties, is probabilistic, at about $45, absent further news, simply on the strength of the fact that based on the financials it might be in the $90 range, if there were no clouds on the horizon; and on the other extreme, there is a shutdown scenario and the Pershing Square target of $0. Giving each extreme a 50/50 chance, the value would be $45 right now, and perhaps it should be valued lower if the company continues to withhold dividends -- not to mention any signs of criminal prosecutions or regulatory action pursuant to Pershing Square's presentation on nutrition clubs.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.