Herbalife Ltd. (HLF) sells a variety of products that fall into four broad categories: weight management, targeted nutrition, outer nutrition, and sports and fitness. It operates through its network of 2.7 million independent distributors as well as through its retail stores in China. On May 1st, famed hedge fund manager David Einhorn asked a few pointed questions during the company's conference call, precipitating a 20% drop in the company's shares. Specifically, Mr. Einhorn asked about the company's distributor network:
"...how much of the sales that you'd make in terms of final sales are sold outside the network and how much are consumed within the distributor base? When you had your previous 10-K, you disclosed three groups of distributors at the low-end...how do you track that and why did you stop disclosing that in the last 10-K?"
The company called the questions "elementary" in a press release following the call, but that didn't stop the decline. The shares have fallen another 20% since the initial drop, prompting a stock buyback by the company in which it will use cash and a revolving credit line to repurchase $428 million worth of stock.
Just to be clear, the company is a multi-level marketing firm (you sign up as a distributor, then you sign up your family and friends, and so on); distributors make money when the people they sign up sell products or sign up others. However, as Herb Greenberg notes, a multi-level marketing firm that does not track how many of its customers are from outside its network of distributors is likely trying to hide something. This, of course, directly contradicts the company's contention that information regarding the breakdown of its customers is "not valuable information to the company or to investors." This is extraordinarily counterintuitive -- the whole purpose of questioning the company's business model is to determine whether it has a customer base outside its salespeople.
Indeed questions have been raised on multiple occasions about exactly who is buying the company's products. The fear is that, outside of distributors, the company has very few customers. Greenberg also notes that the company lost a court case in Belgium in which the judge ruled that Herbalife was an illegal ponzi scheme and, additionally, a ninth circuit district judge questioned whether Herbalife's rules were designed to give the impression of legality while concealing a fundamentally flawed (and perhaps illegal) business model. Keep in mind that on top of all this, the company paid Barry Minkow (the felon who masterminded the ZZZZ Best scheme) $300,000 in what looks like 'hush money' after he criticized the company--Herbalife claims it did so to avoid the inconvenience litigation would have occasioned.
While Herbalife may well be operating a technically legal business, there are bound to be questions going forward about the viability (and legality) of Herbalife's model. Some of these questions are likely to be raised at the Sohn Investment Conference tomorrow by David Einhorn. While there is no guarantee Mr. Einhorn will mention Herbalife, according to the Financial Times, Caris Investment Bank puts the odds of Einhorn mentioning the company at better than 50%. If he does, expect a precipitous decline in Herbalife's shares similar to that which occurred when Einhorn made his presentation on Green Mountain Coffee Roasters last October. Even if Einhorn doesn't target Herbalife tomorrow, there a plenty of reasons to bet against the company. Short Herbalife or get long Herbalife puts.
Additional disclosure: Long HLF puts