Herbalife: The Lay-Up

| About: Herbalife Ltd. (HLF)

Summary

The recent U-turn of the FTC is much more significant than you think.

Herbalife is much more vulnerable than they let on in their IR and PR.

Carl Icahn truly is hoist on his own petard and he missed the last exit.

The Rest of the World will not take forty years to find out they've been had.

The MLM/pyramid scheme scandal is ten times bigger than the Madoff affair.

The Herbalife (NYSE:HLF) settlement with the FTC is the dawning of a new era for MLM, when it will have to become a legitimate direct sales business. Yet the company is continuing to fight the terms including retaining agents for their dirty tricks department such as the Heather Podesta action of buying up half the tickets for the recent showing of Betting on Zero in Washington. Of course, such maneuvers are bound to backfire, and merely help promote the film. They will not prevent the movie from entering circulation, but will encourage it. In the meantime the Wall Street equivalent of the shootout at the OK Corral continues between Icahn and Ackman.

Carl Icahn (NYSE:IEP) permitted himself to go long Herbalife out of spite in May of 2013, six months after Ackman's short position in the name became public. It is now becoming the almost surreal culmination of a lifetime of corporate warfare dedicating to extracting value, not creating value, and war on the middle class, as beautifully argued recently by the indefatigable Michelle Celarier in Fortune. And, for now at least, the kicker was Icahn buying another 2.3 mln shares at $59.31, bringing his position to near 21% of outstanding shares, and averaging nearly $40.

Icahn has repeatedly shown that he is out of touch with the reality of Herbalife, among other things by comparing it with the Fuller Brush company of old, for a young Carl Icahn once sold Fuller Brush long before that company too fell into the MLM trap. Since the FTC settlement Herbalife has been denying the reality of that settlement, and unquestionably CEO Michael O. Johnson is misleading investors by completely misrepresenting the settlement as a validation of Herbalife's business model, when the FTC clearly said the company has to "start operating legally." Recently, an excellent article on Morning Consult called him on it. And, while the SEC remains asleep at the wheel, what the FTC has delivered is an operational enforcement template for the entire MLM industry, and a complete lay-up for the SEC or other agencies to take on Herbalife for their continued deceptions, as the company blunders along, seemingly determined to ignore and violate the settlement any chance they get. Carl Icahn has done his part to spread the notion that the FTC ruled Herbalife not to be a pyramid scheme, incomplete violation of the spirit and the letter of the settlement.

In the meantime Carl Icahn is posturing by seeking the right to increase his holdings to 50%. I think (strictly tongue in cheek of course) the FTC should grant him his wish but with an obligation to do so within a month, so that some of the existing shareholders can get out with their skin intact. The Morning Consult article shows just how badly out of touch Icahn really is at this point, and it's hard to see why he would be permitted to buy 50% of the company, and it's equally hard to see why he would act on it if he could. So, the longer you think about it, the more it looks like posturing, for Icahn Enterprises has bigger problems on its hands, such as some of its energy positions. Icahn has enough on his hands to keep him from digging this Herbalife hole any deeper. The concept of taking the company private would leave him holding the bag even more than he is already, for the realities of the revisions to the company structure post settlement are starting to set in.

The FTC/Herbalife settlement of 2016 creates an entirely new regulatory environment after nearly forty years of dereliction of duty by the FTC, subsequent to the judicial error of Administrative Law Judge Timony in the 1979 Amway ruling, which was never recognized for the mistake it was. Quietly, effectively and firmly the old regime has now been replaced by a very practical, comprehensive and to the point ruling by the new FTC under Edith Ramirez. In form, it tries to do the same thing as the Amway '79 ruling, but in content it makes a world of difference, for instead of addressing some superficial issues and window dressing, creating the false appearance of regulation, this new settlement establishes a bright line, a line the FTC has sought for so long, and with great precision it prohibits the precise behavior that turns an MLM into a pyramid scheme.

The only part where I would disagree with the FTC is that the end result should properly be called a legitimate direct sales company, and not a 'legitimate MLM,' for that is really an oxymoron. The very purpose of an MLM is to create a direct sales front to cover up an illegal pyramid scheme at the back end, hidden in the compensation plan. The trap door by which one enters the pyramid scheme is the compulsory consumption, or 'personal volume' quota system in MLM which guarantees the basic cash flow that enables the pyramid scheme - one of the key features now explicitly prohibited by the FTC in the Herbalife settlement.

Regulatory Capture is the Rule, not the Exception

Meanwhile, the SEC is still soundly asleep at the wheel, tweeting away under the heading of how to tell a pyramid scheme, by saying that if it sells real products, it's not a pyramid scheme. Evidently the SEC has not read either the Vemma case, or the Herbalife settlement, so they have not realized that those cases are exactly the same as the Zeek Rewards pyramid scheme case the SEC just won. To continue to pretend that product-masked pyramid schemes would be OK, is simply a cover-up for their own failing enforcement regime. The FTC is starting to turn the corner, and it is time for the SEC to catch up.

The upshot is, regulatory capture is more normal than we would all like to think. If in doubt, it pays to reread the history of Theodore Roosevelt fighting police corruption in NYC (see Island of Vice, by Richard Zacks). From an economist's point of view it is automatic: forbidding or regulating something creates an incentive to corrupt the regulators. The level of corruption that the MLM business has achieved is of historic proportions, and reminiscent of some banana republics of old, or episodes like the endless scams in the telecom world when the old government monopolies fell apart, and all too frequently it was the ministers of telecom in many countries who ran the illegal international telecom switches and made more that way than their salaries as a minister, while keeping up the charade of the international telecom tariffs. It is a statistical certainty that regulatory capture will happen some of the time around any regulatory intervention. Besides this example of telecom regulation, you only have to look at the histories of prostitution, illegal drugs, alcohol, tobacco, and firearms, as much as pyramid schemes and Ponzi schemes.

For MLM, the history of regulatory capture has been extensively described, and it has reached all the way to the White House, with the appointment by the first President Bush of Tïmothy Muris to head up the FTC (2001-2004), while his firm had formerly represented Amway. That was the period when the MLM industry was consolidating the victory over their comatose regulator in the wake of the Amway '79 ruling, and under Reagan and Bush they enjoyed a practical free pass and a cessation of all efforts to enforce the law.

Meanwhile, MLM lawyers from Gerry Nehra to Jeff Babener and many others made their living out of helping companies to pretend to honor the Amway ruling just enough to let sleeping dogs lie, and they were largely successful at it. And if all else failed, they could defend those clients. Episodes like these give meaning to Gore Vidal's famous quip that the USA is country not of laws, but of lawyers. All the more reason to have tremendous respect for the current FTC in pulling out of this historical skid, and restoring their mission and credibility as regulators and consumer protectors. As long as they follow through with the rest of the industry, we may have seen the beginning of the end of this particular aberration. Meanwhile Kamala Harris, the California AG is now being challenged in her senate race by her opponent Loretta Sanchez, also a Democrat, among other things on her failure to enforce the laws in the Herbalife case, but it may not be enough... In this political season her opponent challenged Harris on taking money from Corinthian, while Sanchez lambasted Harris for failing to prosecute Trump University as well as enforce the law on Herbalife.

The regulatory lay-up

The FTC/Herbalife settlement was a lay-up, exactly because it avoided the battle royal over a pyramid scheme prosecution, but with a brilliant woman's touch took care of all the symptoms of a pyramid scheme, and simply forbade those - after which it is simply irrelevant if you call it an MLM or a direct sales company, or whatever, it just can no longer operate illegally (read: as a pyramid scheme).

The result however is that if there is any risk at all of the ball not going in, other regulators and law enforcement can yet dunk it in, for the template the FTC created defines the bright line that operationally defines the pyramid scheme, and Herbalife is an irrevocable signatory to is. In short, the SEC could well take notice that both the CEO, Michael O. Johnson, and the lead investor Carl Icahn are misleading investors by misrepresenting the deal. The interesting point here is that because the company must lie to distributors so as to retain them and keep them from running off to other companies, by direct consequence they must be lying to investors, and last time I checked, that is not popular at the SEC. By extension, there is also potential of criminal action and either DOJ, or state AGs can have could dunk the shot because a lot of their work has been done for them by virtue of the settlement. Lastly, law enforcement and regulators in countries around the world can have reference to the FTC settlement, and revisit their own regulatory weaknesses, in dealing with MLM/pyramid schemes.

The unsung heroes of the HLF/FTC 2016 ruling

The first category that requires recognition is the endless string of victims of MLM, especially those who had the courage to file complaints. I have met a number of these victims and the stories are gut wrenching. Evidently the FTC got it too, but it was hard for many of these people, who lost friends, homes, marriages, their retirement savings, or faced bankruptcy, because they financed a hopeless scam on credit.

Unfortunately for Bill Ackman, the vindication of his short is taking longer and is more painful than seems reasonable (remember Keynes...), but in all likelihood it is coming eventually for the funnel is narrowing. But regardless of how it plays out, the world will forever owe him a debt of gratitude for taking on Herbalife. Reasonably it should end somewhere close to the Betting on Zero premise, and at least good enough to end up in a profit.

The Commissioners of the FTC are to be commended for their obviously very profound investigation, where they produced a result that is both legally tenable, and cuts to the chase, as much as it is economically profound because it radically excises the pyramid scheme from the MLM.

Those Herbalife Speakeasies, aka. Nutrition Clubs

I could not tell you if this is a trend, but my district in the Bronx used to have the highest density of Herbalife nutrition clubs, and I've seen them start to disappear. That may be the first sign of spring. Evidently, the new terms imposed by the FTC put a lot of emphasis on professionalizing the nutrition clubs and ensuring that the owners understood the costs and the risks, and it would not surprise me if the number of US nutrition clubs will simply collapse. I began to notice this recently, for I live half way between two subway stations, and on both routes I used to pass a "nutrition club," and both have now disappeared.

Against the trend

MLMs needed consumable products that people ordered on a regular basis, so the idea of meal replacements was conceptually a good fit if your purpose was to design a pyramid scheme. The confusion for many marketing people was that the MLM construct actually produced "sales" in the classical sense, but the truth is that it produces only a bubble of false demand that evaporates once the pyramid runs out of steam. MLMs are therefore the perfect way to destroy the market potential of a good product, and they are a surprisingly good way to market mediocre products that would not stand a chance on their own - for the financial incentive can carry them for a long time.

The shifts in MLM are when products go out of style. This happened in the early to mid nineties when there were several MLMs in phone cards, who marketed against the major carriers with prepaid cards, renewed on your credit card, but soon it turned out the real demand for phone cards was in the cash market, for immigrants, who called home with their remittance. Those cards had really low rates and were available at every newsstand, convenience store, etc. and the phone card MLMs just evaporated in the face of these ubiquitous discount cards, for no longer were they competing against AT&T, Sprint and MCI, where it was easy to undercut their rates for phone card usage, but against upstart discounters who sold really low rates and were omnipresent.

A similar change in trends is now happening in the diet area. The trend is away from diet replacements with low cost ingredients that allow the insane mark-ups you need to sustain an MLM/pyramid scheme. Millennials are changing to veganism in mass numbers. Personally, I decided to go fully vegan in the year I was 64, and within a year I went from 190lbs back to 165, which was my weight when I was in my 20's, and in the process, I had more fun learning new ways to prepare food than ever before in my life, and cooking was always a major hobby of mine. By the time I was 65, I was back at fighting weight, my cholesterol was below 150 without even trying, and my blood pressure was normal again too, so I celebrated my 65th being free of any medications, which beats spending the rest of my life worrying about the side effects of my medications. Then I found myself in another trend, eating at home. I detest going to restaurants any more, while for decades I ate out sometimes 50% of the time.

The meal replacement racket was based on the unwillingness of people to change their bad food diets, and teaching them to replace their bad stuff with something different part of the time. It turns out the trend now is towards making the radical change towards vegan eating for there is simply too much evidence that animal protein in all forms has horrible health consequences, and we now have Physicians Committee for Responsible Medicine promoting the vegan lifestyle as the way out of the health crisis, as well as the Maine medical school offering a nutritional curriculum, not to mention Harvard nutrition and the UN all advocating for plant-based nutrition. The upshot is who wants to munch on sawdust with added vitamins, if you can have so much fun with food and be healthy? The meal replacement thing competed against the bad old food pyramid, which is furthermore obsolete, even if the USDA has yet to find out. The trend is changing, and the market for the Herbalife model is evaporating quickly.

There is yet another trend, giving up meat will do more for the environment than leaving your car at home. In short, as the climate change issue gains traction, that will be yet another impetus for plant-based cooking, and healthier food will eliminate the need for dubious substitutes for food like 'meal replacements.' Needless to say, Herbalife at this time is badly out of sync with the times, and although they are introducing new products in markets where they have no name recognition, the company will have to contend with not only their business model having to change, but the foundational concept of their product lines is now about 40 years out of date.

21%, 35% or 50% for Icahn?

When Icahn fumbled his recent attempt to bail on Herbalife, on the rebound from a failed attempt to shop his stake, he ended up with 21%, still well below his cap of 35%, and in that light his move of asking the FTC to permit him to go to 50% looks more like bluff poker than anything else. The company more than likely does not have the time to pull off the massive re-think that would be necessary to remain relevant if they have to do legitimate direct sales, and provide value for consumers, just at the time when the demand for their core product is being eroded by a very powerful trends. The settlement demands that the change of their business model has to be completed by May of 2017, and the patron saints of MLM are out of the game: Donald Trump, will not be president, and Icahn will not be Treasury Secretary, so Herbalife's options of fighting the FTC seem limited.

Conclusion
Herbalife is in denial, and their largest investor, Carl Icahn, is completely confused about their business model and thinks the company can make the change and thrive, or if that's not the case, at least he pretends and he plays bluff poker very well, but in all likelihood he has now missed last exit on his highway of doom. The posturing is immaterial. Dumb deals are done all the time, but it is hard to see who he could line up to partner with him in taking Herbalife private, given the atrocious prospects. By the third quarter of 2017 the transition will become fully reflected in the company's financials, but the facts on the ground indicate that the deterioration is setting in, and will be a steady erosion from hereon out. The slide is unstoppable at this point and it is time for Herbalife management as well as their lead investor, to follow the advice from M*A*S*H psychiatrist Maj. Sidney Freedman: "Ladies and gentlemen, take my advice, just pull down your pants and slide on the ice."

Disclosure: I/we 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.