I had the pleasure of meeting the guy who writes under the handle Quoth the Raven last week when he came to New York City to see Ackman's presentation in person (I had no idea who he was prior to that - I just liked reading his stuff). He's a very smart investor with a good nose for fraud and deception (not just with Herbalife (NYSE:HLF) - see the other stuff he's written on this site) and he's really done his work on Herbalife - more than anyone I've seen outside of Pershing Sq. He published his magnum opus yesterday entitled '24 Ways Herbalife Is Mocking The Regulators', which does an excellent job of summarizing all of the immoral and illegal things he thinks the company is doing. Here's the beginning:
· As I wrote yesterday, sentiment among a lot of Herbalife bulls is that they concede the company is deceptive, but invest because they think regulators are spineless.
· So, Herbalife continues business as usual, inclusive of these 24 ways that it's mocking regulators on a daily basis.
· Per its own internal strategy documents, Herbalife targets those that live in extreme poverty and who may not have the education necessary to understand they're being defrauded.
· This is more than an investment thesis, these are ethical and moral wrongdoings that need the full on attention of those smart enough to discern it.
· From a personal standpoint, allowing this company to operate does a huge disservice to the country that I have also been a major beneficiary of my whole life.
I think by now it's obvious that the market seemed to shrug off Mr. Ackman's Manhattan presentation on Herbalife's Nutrition Clubs given earlier this week. I continue to contend that the information delivered in the presentation was rock-solid evidence of a massive business model flaw that's hiding under the Nutrition Clubs that are producing as much as 40% of the company's revenue.
In other words, Mr. Ackman's claims are extremely material to the company, its investors, and regulators. Simply put, if Mr. Ackman is proven right and Nutrition Clubs have to be shut down or modified in the way they operate, it's going to cripple Herbalife's growth - quickly.
As I read this, it reminded me of one part of Ackman's presentation (posted here) that I wasn't quite satisfied with in which he addressed one of the most common arguments made by Herbalife and its supporters: if the company is such a fraud, how come it's gone on for so long and gotten to be so big without it being shut down? Ackman's answer, the "Big Lie" phenomenon, is incomplete I think. In my mind, there are four answers (in descending order of importance):
1) The fact that Quoth the Raven came up with 24 (!) items to highlight underscores how complex Herbalife is. Even after more than two years of focused effort by untold numbers of people and the expenditure of $50 million, Ackman and his team are still coming up with new information and insights. This complexity makes it really hard for investors and regulators to get their heads around what's going on - and, as we saw on Tuesday, really hard for Ackman (or, in fairness, anyone else) to make a simple, clear, succinct case against the company. There's always a "But wait, what about this…" argument and/or data point the company or its supporters make.
2) Even after one has done the exhaustive fact finding and analysis to understand all of the bad things Herbalife is doing, the laws and regulations governing this industry are unclear. There are few bright lines and most multi-level marketers (MLMs) are clever enough to operate in the vast gray areas. The devil is in the details to determine if something is a legitimate MLM (e.g., Pampered Chef, which is owned by Berkshire Hathaway) or an illegal one (e.g., BurnLounge).
Even when people agree on the facts, there can be big differences of opinion as to whether Herbalife is legal - for example, a prominent bull publicly called HLF "scumbags", but is still very bullish on the stock. Because of the ambiguity in the laws and regulations, countless MLMs (mostly private companies) are doing sleazy things - and only the most extreme violators are being shut down.
Incidentally, I think China has it right: just ban all MLMs (in the sense that it would be illegal to pay people for building a downline; I have no problem with a company recruiting people to sell its products to their family and friends and making a commission on it (like Pampered Chef) - it's anything related to the "business opportunity" where most of the abuses occur). Sure, that would hurt some legitimate businesses, but I think the whole sector is so poisoned by bad actors that drastic action is necessary.
3) As much as I don't like to admit it, there are elements of Herbalife's business that are legitimate - there is a veneer of legitimacy, however thin - that makes it a tough nut to crack (as Ackman and other shorts like me are learning the hard way). Ackman claims that Herbalife is exactly like BurnLounge, but I don't think it is. While they are very similar, it's not the same open-and-shut case. Herbalife has some sales outside of the network - just not very much. It has some profitable, happy distributors - just not very many.
On the spectrum of MLMs, with Pampered Chef at one end and BurnLounge on the other, I'd say Herbalife is 80-90% of the way toward the latter - but not 100%, which makes the company that much harder to bring down. As Charlie Munger once said, "If you mix raisins and turds, they're still turds." Herbalife has enough raisins floating around to convince a lot of people to ignore the turds - especially if it's in their self interest to do so (e.g., Herbalife is a good client of Wall Street so analysts aren't going to say a critical word; it pays prominent people a lot of money to endorse it; it spends tens of millions of dollars annually on public relations and lobbyists, etc.).
Ackman and his team have done yeoman's work collecting extraordinary amounts of information and using it to make a compelling argument that Herbalife, at its core, is a predatory, illegal business - but this is a judgment call that investors and regulators (and, I suspect, eventually, courts) have to make.
4) Lastly, Michael Johnson and his team at Herbalife are really clever. There's a reason this company has become the largest and most profitable MLM (and it's not because the powder it's selling has magical properties, contrary to widespread claims by many Herbalife boosters). I think Ackman was right when he said on Tuesday that Johnson will go into the fraudster Hall of Fame alongside Bernie Madoff. The parallels are striking: both of them operate/operated in loosely regulated industries with lots of gray areas; both were charismatic, smooth, polished - and exceptional liars; both were very clever in building and maintaining a veneer of legitimacy; both cleverly parried the occasional inquiry from regulators and the media; and both attracted the attention of dogged whistleblowers.
The only question now is whether Ackman will prove to be more successful than Harry Markopolos in catalyzing regulators to take action. I'm betting that the answer is yes for two reasons: a) Ackman has the deep pockets to match the company's; and b) I've known Ackman for nearly 30 years and I've never encountered anyone who's more driven and persistent when he's convinced he's right.
Disclosure: The author is short HLF.