The history of Herbalife (NYSE:HLF) over the past 2+ years, starting with some questions about their retail sales by David Einhorn, shows a constant pattern of IMH, the Inefficient Market Hypothesis. Time and again the market has panicked, first from David Einhorn's questions, and then from Bill Ackman's presentations, but every time the financial news takes over again shortly afterwards. In other words, the market processes the language it understands best, financial reports, and takes them more or less at face value. The market does not understand less quantitative, and more qualitative information, such as the arguments of potential illegality of the enterprise which Ackman has now advanced three times, but really without interruption via the two websites Pershing Square set up for the purpose:
- December 2012, with the fundamental presentation that HLF was a pyramid scheme, there was a violent down reaction, with the market resuming where it left off fairly quickly.
- March 2013, with the China presentation, Herbalife's biggest growth market, the market dribbled down a little bit, but resumed where it left off pretty soon.
- Presently in July 2014, the market responded violently to the news of another Ackman presentation, this time about the nutrition clubs. The findings that were presented raise lots of questions about the legality of these clubs, and specifically about how they may increase the likelihood of a pyramid finding. But again, the market shook it off when no bodies were produced on the day of the presentation.
Then, on 7/28 there was the earnings call, after hours, and given the reduced number of shares outstanding after the buyback, the under-performance was not insignificant, and the market reacted violently. And on 7/29 the slide continues, with one analyst concluding that with the stalling growth rate, $60 would be a fair value ABSENT pricing of the regulatory risk into the stock. Just like Madoff was sunk by withdrawals, with regulators looking on dumbfounded, the good ship Herbalife is hitting an iceberg now in terms of slowing growth, and soon distributor departures could begin to show. Evidently, the FTC won't act until it's over, if then, or perhaps they are waiting till China takes action.
The forest and the trees
What enforcement pattern there has been so far has been one of creating rules that can be circumnavigated easily. The Amway case of '79 was a case in point. It resulted in most MLMs implementing the rule and pretending they were legal because they were just like Amway, but ignoring the enforcement in practice. So, the impact has put a whole swath of the industry in some sort of limbo in this respect, Herbalife included. That ruling prompted the periodic interest in the "retail sales question," starting with David Einhorn.
If regulations are to succeed they need to capture the nature of the beast, not just proxies and benchmarks which can be circumnavigated. In other words, the focus of regulation should be on the substance of what a company does, not how it does it. If that is not accomplished, the FTC would merely make work for more MLM lawyers to circumnavigate the rules by teaching companies how to follow the letter and violate the spirit of the law. So, the rule should not be you must sell 70% of inventory before you can reorder. Many companies don't even work that way any more, though in Herbalife inventory still does matter. But the rule must capture the need for free and unencumbered retail sales based solely on the value of the product.
Greek tragedy, and Harry Markopolos vs Madoff
The disconnect from reality, which is the nature of the MLM business model, calls up visions of a classical Greek drama, where the hero appears to be celebrating his greatest successes, with the hubris that tells the spectator he has lost touch and is about to come unglued. And therein lies the drama. Study that for a while, and it could help you more with some investment dramas than a lot of financial analysis that can often miss the forest for the trees, as argued above.
Harry Markopolos' story with the Madoff Ponzi-scandal is a case in point. The nearly ten years that he worked on it, it was completely clear to him and his associates that Madoff was a scam. If not before, regulators (the SEC) could have stopped it from the first filing by Markopolos and under $10 billion in funds under management. But the party continued unabated, and nobody even attempted to stop it until it reached $65 billion, and crashed because the market called a halt, while the regulators were still sound asleep.
The big advantage Pershing Square has over Harry Markopolos is that they could put the money behind researching all the intricate details of the case, but they are publicizing it first, which has put the regulators on notice, and all eyes are now on them. Well, admittedly not all eyes, some folks continue to think the Earnings Release mattered. Pershing Square's forty pages of questions for Herbalife, which went unanswered, are paralleled in the Madoff story by Markopolos sending off his associate to meet with a clueless compliance person at Fairfield-Greenwich with a long list of questions they could not answer. We are approaching the point of impact. The course seems set, the Titanic is headed for the iceberg, the time of impact is just hard to predict, but it is coming closer.
Saturation or the Ackman effect?
Herbalife likes to claim that Ackman is just an evil stock manipulator, who preys on vulnerable old ladies who invest their pension money in honest companies like Herbalife. Then some commentators like to imply that maybe the slow down in North American sales is due to the evil work of Pershing Square. But a new analysis by The Specialist today shows clearly that the slow down of growth in North America predates the Ackman show, and is evidently unrelated. This again goes to the point of IMH, the market is responding immediately to the impression of slower growth, while it is leaving the harder questions of illegality on the table for someone else to decide. It is this kind of ostrich behavior that always costs people lots of money, and these are the opportunities where sharp traders have a chance if they trust their own eyes, and are not swept up in "popular delusions and the madness of crowds." Ackman is in business because of IMH, and if EMH worked he would be out of business. The operators of the five or six Hispanic nutrition clubs that are within walking distance from my apartment have no clue who Bill Ackman even is, and happily go on with their daily routines. People were wondering why a minimum wage population needed overpriced diet shakes before Ackman came along. He may have been the catalyst, but the course was set, and the issues were going to come to life sooner or later. Saturation is not the real story either, for that can be fixed with a new product, such as the skin care line.
The ending could be violent with a lot of volatility
With the stalling of growth, and the ongoing regulatory cloud, I would expect desertions to start. John Hempton, the unapologetic Herbalife bull, already noted that the decline in Asia was due to a new competitor pilfering Herbalifers, and in general that a faster growth of sales leaders than sales indicated decreasing results for those sales leaders, which makes them susceptible to looking for greener pastures. A slowdown in recruiting seems to be already in evidence, but the real news will be when some prominent sales leaders leave for greener pastures elsewhere. It is likely to start at middle levels, but eventually some big players will move. There are enough MLM companies out there that are trying more reasonable models, and at least appear less likely to be challenged by regulators.
In my first blog on this site about Herbalife, I predicted that Carl Icahn might end up having a Wile E. Coyote moment with this whole episode. He may be having that now. A whiff of a long squeeze is in the air. As one comment recently observed, since Icahn and Ackman are friends again, perhaps Icahn could hedge his sale of HLF by putting some money in Pershing Square.
Any of these scenarios or variations on them are likely to go with significant volatility
- Perhaps the FTC needs to see the complete dismemberment in the market of HLF before they decide it is time to start regulating this industry, but after forty years there is every reason to at least attempt to start getting it right.
- The daily price movements are fun to watch, and it is possible that with HLF not meeting expectations, their credibility about the regulatory exposure could also start to suffer, but adjustments in the stock price are likely to be jerky and very irrational at times, particularly if "names" make moves.
- In retrospect, Ackman's presentations just had a delayed effect, because the abuses are so outlandish, and the market remains slow to digest the information.
- Keep your eyes on the great story line, the daily details are going to continue to be noisy, unless you're a day trader, but you might prefer cleaning up some landmines in Iraq.
- After the FTC catches on, perhaps the "analysts" will catch on too... I just checked on Nasdaq, the majority still have "strong buy" and "hold" ratings, as if the regulatory issue did not exist, although there are some beginning signs of downgrades.
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.