Unsustainable, Fragile, Overvalued And Under Attack: The Case For Going Short Herbalife Now

Summary

• The short thesis presented by Pershing Square is compelling and should be taken very seriously.
• Herbalife trades at a valuation that does not reflect the huge regulatory risk, default risk and weakness of the balance sheet.
• The company is fundamentally unfixable and cannot operate as anything other than an MLM.
• The entire MLM industry is, at its core, fundamentally flawed. The substantial majority of MLM participants lose money, and criticism of the industry is growing.
• Herbalife possesses the necessary characteristics for a short: high valuation, limited stock upside, unsustainable and financially distressed.

Charlie Rose once said to Steve Wynn of Wynn Resorts (WYNN) on 60 Minutes, "The only way to win in a casino...", and Wynn completed the sentence by saying: "is to own one", then added, "unless you're very lucky". Herbalife is very much analogous to a casino, though for the bottom-of-the-pile punter, the odds are much worse. Perhaps if things get much worse at Wynn, the company could rebrand the casino as a business opportunity. Similarly, Michael Johnson, CEO of Herbalife (NYSE:HLF), once allegedly (according to the NY Post) described Herbalife as a lottery ticket. Although this is closer to reality than some other statements about company, it's still not entirely correct. Since the Herbalife marketing plan is a pyramid (try drawing it), a distributor of average means joining now with a substantial upline extending to an incumbent Chairman's Club member in a mature Herbalife market has, realistically, no chance of joining the Chairman's Club. Given the structure of Herbalife's Royalty Override Points (ROPs), it is practically impossible for this new distributor with a substantial upline to get to the President's Team or Chairman's Club, as ROPs explicitly require recruiting. It's never been a worse time to become a Herbalife distributor. Based on Herbalife's own data, the business opportunity has always been, on average, terrible for almost everyone.

Conversely, I'd argue that it has rarely been a better time to short Herbalife. Entering the short now allows you to create a trade much more profitable than Ackman's if the thesis plays out. Pershing Square (PSQ) is reported to breakeven around the low $30s, while new investors can breakeven at a much higher level. A major reason why investors shorting now are at a huge advantage to Ackman is that he had to pay for his research (in excess of $50 million has been reported), and investors have access to a substantial amount of this research for free. Ignoring this research is insane. Shorting now means you will pay less carry than Ackman, and short at a higher level than Ackman originally did and when Herbalife's fundamentals are much worse.

The quality of the research done, led by Christine Richard and furthered by Bill Ackman and his team (Shane Dinneen, David Klafter and others), is exceptionally high-quality and highly compelling. Critically, Pershing Square has allowed us to peer into its ivory tower by publishing its research on factsaboutherbalife.com and herbalifepyramidscheme.com. Naturally, this research has been heavily criticized by those with a vested interest in the company's prosperity; however, the research should be taken very seriously and objectively analyzed. When looking at this company, you need to drill down into the facts and ignore the noise. Look at Herbalife and Herbalife alone. Focus on the math, not on the media spin. Herbalife just does not add up (see my challenge to bulls).

If we take the entire short case and condense it down, you basically get a list of five things you need to believe, which will be discussed subsequently. These are that Herbalife is:

1. Likely to be shut down by the government

2. Fundamentally unsustainable

3. Ultimately unfixable

4. Otherwise uninvestable

5. Intrinsically worth much less than the current share price

The most pressing argument for going short now is where the stock is currently trading. At over $50, it is easy to construct a case that the stock is hugely overvalued. Irrespective of what the FTC and other regulators do, Herbalife is a fundamentally terrible business. The evidence of this is in the "pop and drop" growth pattern, which management has discussed on conference calls, and the data to back this up is readily available in previous SEC filings. The real engine of growth for Herbalife is China, which presents a huge potential regulatory risk. Put simply, the Chinese business is an exceptionally high-risk investment, as it faces dangers on four fronts:

1. An adverse ruling from the FTC would effectively close the company or force the parent company into insolvency.

2. Chinese regulators could close the company in China or seriously impair its profit potential if they consider it to be an MLM. Direct sales is a much less profitable business than an MLM from a shareholder perspective. Again, to be bullish, you have to assume or prove that PSQ's analysis is wrong.

3. The threat from "pop and drop" profitability historically seen in Herbalife's markets.

4. Macro risk is an important consideration. Further currency devaluations against the US dollar would hurt reported profits. The fragile nature of the highly leveraged Chinese economy is a risk to the demand for expensive weight loss products sold through direct sales (or so we are told). Herbalife should not grow during a Chinese hard landing.

I also find it amusing to contrast Herbalife with other companies that tried to crack China. Getting into a new market is high-risk, takes time and sacrifices near-term profits for growth. Las Vegas Sands (LVS) almost collapsed spectacularly trying to expand in China. Whereas Herbalife just turns up with a negative working capital model and very quickly starts hoovering up money. If we give Herbalife the benefit of the doubt on the multitude of issues facing the company and assume that there will never be a "drop", it is entirely reasonable to argue that the company is better than Coca-Cola (KO).

Coca-Cola, historically, has made more than 110% of its operating profits in the 8-10 biggest markets in which it operates, which means it loses money in the markets where it's not dense and doesn't have scale and distribution.

- Professor Bruce Greenwald

The Stock is Not Cheap

Another important consideration is that the stock is actually not particularly cheap at a P/E of around 12 (based on $4.50 EPS guidance), which is not hugely far from its historical average. However, this P/E is not a good metric of what Herbalife is worth. The company has undergone a huge amount of financial engineering by way of its enormous buybacks, the scale of which will not be repeated. Hence, as Herbalife's ability to buy back stock declines (as it has already), so will its ability to meet expectations over the medium term. There is also the convertible to take account of, which means that EPS is probably lower than you think. If you take a skeptical view of China, add back the convertible and factor in lower buybacks, then Herbalife looks highly unattractive and expensive. That is before we slash the EPS in previous quarters with more conservative accounting in Venezuela (as detailed in Christine Richard's article).

Also, on the valuation side, it is important to observe that the equity has been completely wiped out. The company has negative book value. Worse still, the inventories and intangibles of the company are potentially worthless in a worst-case scenario (leaving a $1.1 billion hole). If the company stopped operations, the equity would be worth absolutely nothing. The entire value of Herbalife is in its earnings power value, which, given the fundamentals of the business and an appropriate risk weighting, should not be valued at all that much. This is not in any way, shape or form - even under the most loose and fantastically generous of definitions - a value stock.

The Balance Sheet Train Wreck

Fundamentally, Herbalife is walking on a tightrope of solvency - one gust and it's gone. The company is really quite fragile. Without the credit facility extension, it would likely collapse in March 2016. From the Q2 results, you can see that the company is hoarding cash and has expensively repatriated cash. To invest, you need to have a huge amount of confidence in Herbalife. There is a reason that there are no dividends or buybacks: the company can't pay them without damaging its credit facilities ($2 lost facility for every $1 paid). Furthermore, shareholders are unlikely to see any of the cash flow until March 2017 in a best-case scenario (assuming survival, 2019 is more likely), because most or all of that will have to go towards fixing the debt problem.

The debt problem is further complicated by the convertible. The initial conversion price is $86.28, and the bonds can be exercised at a 30% premium. The convertible is huge, with outstanding principal of $1.15 billion. In the unlikely event that Herbalife stock rockets, there will be massive dilution (the repurchased stock will be partly resurrected). You must have a very strong belief in growth to counteract the effect of this. Worse still, if the share price lags or Herbalife is hit by regulators in a way that permanently impairs its profitability, the share price will remain below the conversion price. Hence, the company will have to pay it back, which, in adverse circumstances, would not be possible - hence default. In a more moderate scenario, much of the cash flow would be eaten up in repurchases and the final repayment. Furthermore, if things go well for the company, the price of the convert will rise, making it expensive to repurchase. Basically, if you are investing in Herbalife, don't expect a great deal of cash before 2019.

The fact that the company's credit was extended is not much of a surprise when you think about it. Ultimately, the banks want their money back. The easiest way to get it back is to gobble up all of the cash flow, which is what is very likely to happen. The extension was in no way a sign of confidence from the banks. The banks are slashing exposure - potentially to zero in 17Q1. They have already slashed the credit facility and forced the company to keep all of the cash generated in-house. The convertible was not much of a show of confidence either, because the buyers just short the stock at an appropriate hedge ratio. Part of the reason that the bonds have traded so low is that it is expensive to short Herbalife.

The most interesting thing in the Q2 report which disclosed the terms of the agreement is the following part, which very few people have previously commented on. This clause could potentially be extremely important.

The Company is also required to maintain a minimum balance of $200.0 million of consolidated cash and cash equivalents.

If you work through the cash, you can easily figure out that Herbalife can't have substantial negative cash flow, and hence, can't withstand a large fine and the class action suits that would piggyback in on the ruling associated with a fine. You can also see that the company will likely have to repatriate a large amount of cash to meet its credit obligations, which will put pressure on its near-term results. If the government does not shut Herbalife down, but instead, simply fines it and forces changes on it, the company is still likely to collapse. It has mortgaged its future cash flows, and the current cash balance (much of which is held abroad) only just covers the company's near-term debt obligations. Worse still, if Herbalife stops growing, it is going to have working capital move against it. This capital structure does not exactly scream out "Buy".

Massive Regulatory Risk

The odds are high that Herbalife will be fined if it is not shut down. It is very unlikely that multiple government agencies who have investigated for well over a year will not find something, anything, anywhere. If the government investigated a wonderful company like Unilever (UL), they would find something, somewhere to fine. Maybe only unauthorised use of a government photocopier, $10. We already know that Herbalife has spent a huge amount of money defending itself and in expenses related to the investigations. Something, somewhere will be found. Nutrition Clubs? Club 100? Income claims? Health claims? Lead generation? Naughty top distributors? Pyramid scheme? Venezuela? China?

Even those who are most bullish agree (including mega-bull Tim Ramey) that the company will get some sort of fine. Ramey reckons $10-50 million. As we have seen above, it can't withstand a cash flow hit in the way of a large fine, combined with operating changes that cut free cash flow generation.

The standard form bull case now rests on the idea that Herbalife has been fixed. I don't believe this is the case. The marketing plan is the fundamental problem, and it has not really changed. Furthermore, the company actually has less control than you think. How many Chairman's Club or President's Team members have been kicked out lately? One does not need to look hard to find misleading claims and unethical behavior at the top of the distributor chain. Don't look at what the rules are, look at what is actually happening on the ground. Watch some of the old Herbalife Broadcast Network videos. The company has improved (lead generation was a bad idea), but it is certainly not fixed. When Herbalife abolishes supervisor requalification, I'll be impressed. Why doesn't it? If you believe what management says, this should not hurt sales too much (sales are mainly to end-users and "discount members").

The next argument is that regulators could not have missed this. Herbalife has been around for over 30 years. Therefore, everything is fine. Similarly, when Harry Markopolos went to the government, Madoff was immediately shut down. There were also no savings and loans crises, and liar's loans have never been a problem. There is much more that needs regulated than there are regulators, and this is not helped by the fiercely anti-government stance taken by many Republicans.

This is another argument that moves focus away from the important questions. Regulators are by no means incompetent or lazy. MLM law is a mess (expertly documented here by MLM expert Robert Fitzpatrick - you can never read enough of this man's excellent work). Herbalife requires substantial research and is not amenable to back-of-the-envelope analysis, and the complexity of such an investigation is further complicated by the concept of a legitimate MLM. The biggest risk for the shorts is that the company is ruled to be a legitimate MLM, which requires that either Ackman (and the army of other bears around him) is wrong or his evidence is ignored. Furthermore, presenting and defending a case against Herbalife would be very expensive and time consuming. It would also be a complete disaster for the FTC if it decided that Herbalife was an illegal pyramid scheme, moved to shut it down, but had the case repeatedly thrown out of court.

It is, therefore, no surprise that the FTC investigation has gone on so long. The typical argument from Ramey and other bulls is that if Herbalife were a pyramid scheme, the FTC would have taken action. But why is the opposite not true? If Herbalife were 100% squeaky clean, then why spend so much time and money investigating? We know Herbalife has run up a big bill on its end.

The most plausible explanation for why the investigation has taken so long is given by retired FTC senior economist (and now SEC consultant) Peter Vander Nat (see here for the Bloomberg report). He cites the lack of a clear rule and the fact that each case must be individually built from the ground up, which is, of course, time- and resource-intensive.

Continuing on the regulatory risk front. It is occasionally argued by bulls that even if the FTC shuts Herbalife down in the US, the company will survive, as the US is only fraction of its business. Let's imagine, for the sake of argument, that the FTC does shut down Herbalife in the US. If that happens, the business is toast. The US factories will need to be rebuilt at a huge cost, and the company's credit facilities and bonds still need to be paid. Remember, Herbalife does not really have any balance sheet to fall back on. Who would give money to an FTC-designated pyramid scheme with its balance sheet in shambles? Furthermore, how many governments would stand by and let a company shut down by the US government continue to do business freely? If the FTC closes the company, Herbalife will shut down. If the FTC does nothing or clears the company, Herbalife is still a stock best avoided. This short is very much asymmetric. I think Ackman is right on the "multiple ways to win" theory.

However, even under the assumption that everything documented by PSQ and other bears is 100% true, that is not a guarantee that the company will be shut down. It is possible that the FTC commissioners could deny the evidence and stick dogmatically to an anti-regulation ideology. Given the track record of the current commissioners, the recent Republican commissioner resignation and the shut downs of Vemma, BurnLounge and Fortune Hi-Tech Marketing, the "regulators failing to correctly interpret the evidence" theory is implausible. Furthermore, the chance of defending the company by reclassifying failed distributors as customers is increasingly unlikely to succeed, based on recent cases. A Belgian judge (whose ruling was later overturned on appeal) wrote that "obviously, this is not serious".

More simplistically, I would argue that an investment in a company whose operations are suspect or currently being questioned from a moral perspective should be subjected to extra due diligence. Any company whose demise would be (or is suspected to be) a net benefit to the prosperity and welfare of the world is a potentially dangerous investment. Though, as John Hempton correctly and eloquently pointed out, if you shorted tobacco companies, you would have been "run over". Personally, I would argue that in a utopian society, there are no MLM companies. Furthermore, the most ethically questionable method utilized by top distributors is lead generation. This could potentially get the company in hot water (this allegedly official document is worth reading). Investors should hope that the document is a forgery or factually incorrect.

MLM: A Fundamentally Flawed Industry

The most important thing that investors who are getting into this debate need to understand is that it is far more complex than you think. No pro- or anti-Herbalife thesis fits on the back of an envelope. You need to come to the debate unencumbered by intuition. MLM is not like the direct-selling companies you grew up with (e.g., the encyclopedia salesman). A good primer that will shake your preconceptions is a historical analysis available here, which was originally shared on Seeking Alpha by William Keep. Although MLM companies are mainly marketed to, and succeed in recruiting, people typically at the lower end of the income, education and financial literacy scale, actually understanding the companies requires significant financial and mathematical literacy. MLM sounds like a wonderful idea - until you figure out that it's not. Most people stop at wonderful. An effective MLM scheme is one which is simple enough for most people to think they understand it, but too complex for them to actually understand it. Consider the claim that 40% of people make $0-8,000 a year. At first glance, it sounds good, but it is really (if you think about it) a fantastically uninformative statistic.

The reality is that multi-level marketing is fundamentally flawed. The problem is that there are too many people trying take out of the pie (i.e., a sale). In direct sales, the company and the seller both get a cut of the pie. The company gets an efficient route to market, and the salesperson makes a nice profit. We know that in MLM, very few people make a reasonable amount of money. The problem is that in MLM, you have to share the pie with many people who are not directly involved in the sale. At Herbalife, if a distributor makes a sale to their mother, money will wind its way through the complex marketing plan and could end up in the pocket of a Chairman's Club member who has never met the distributor and who lives thousands of miles away. The problem is that this squeezes your margin on the sale - they are eating out of your pie. The only way to maintain the distributor's slice of the pie is to make the pie bigger by increasing the prices. This is why goods sold using MLM are typically so fantastically overpriced. This overpricing decreases retail demand. If they took out the "ML" in MLM, the retail side of the business would improve greatly. That's not going to happen, because doing that would reduce the volume of product shipped, which is not good for shareholders. Circling back to paraphrase Steve Wynn, if you want to make money in an MLM, own one. Though not Herbalife now.

MLM often takes on a cult-like status, which is necessitated by the fact that the business model is fundamentally flawed, and almost nobody makes good money from it. Some are better than others, but taken collectively, the results are a train wreck. Once you explore the world of network/multi-level marketing, the cult thesis gains substantial credibility. You really do not have to look very far to find vast quantities of nonsense being peddled. Consider the example of this totally absurd quote:

37% of [the] GDP of [the] U.S.A. comes from this [network marketing] industry

- Network Marketing Coach Vineet Gupta's blog

Let's imagine that he's right, and that network marketing was declared its own country with a GDP equal to 37% of US GDP. This is the new-world GDP rankings: United States, China, Japan, Network Marketing, Germany, United Kingdom, France and Brazil. Maybe if Germany spent less time on manufacturing and more time on network marketing, they might move up in the world.

Herbalife is an MLM company. There is no question or reasonable doubt on this subject. It is not a direct selling company in the way that the door-to-door encyclopedia salesman was. It is also fantastically implausible that the vast majority of "distributors" sign up for the discount because they love it so much. This is fantastically simple to rebut: If they love the product so much, why do they quit so soon? Would you own stock in Costco (COST) if its members turned over at the rate that Herbalife distributors do? At best, there is little Herbalife brand loyalty among distributors. Furthermore, why does Herbalife need my driver's license/passport number before I can get 25% off?

The whole MLM business model is fundamentally unsound. Markets are finite, geographic restrictions are typically non-existent, retail margins after expenses are small (sometimes non-existent), direct selling is hard and nobody is ever told "no". The number of distributors reaching supervisor level is absurd. To provide the greatest business opportunity, Herbalife needs to say "no". "No, you can't become a supervisor now - we've got enough to 'supervise' everyone here." "No, you can't become a distributor - the market is saturated." MLMs are really not a good business opportunity at all, and should be avoided.

Despite being, statistically speaking, a terrible business and the fact that the majority lose money, MLMs generate very few complaints. Consider the worst kind of MLM which is a pyramid scheme, and consider an FTC study which provides statistics and probabilities, here (see pages 80, 82 and 92). If we run the numbers, we see that 22.7% of people in pyramid schemes complain, and of those who complain about consumer frauds, 1.4% complain to the FTC. Hence, we can estimate an FTC complaint frequency of 0.003178 per victim. In other words, if a scheme recruited 100,000 people, you would only expect around 320 complaints to the FTC. However, many will be poorly written and lacking substance. Vemma only received around 200 complaints, according to the NY Post. Though, this number can be skewed (or managed) down, as certain groups complain less, on average, than others. Furthermore, it is likely that well-disguised pyramids would generate fewer complaints than an obvious fraud. For example, it is likely that a completely nonsensical company like "EZ Wealth By Design", which sold a fake, worthless product called "search engine submissions" for a massively inflated price, would generate more complaints than something that appeared entirely plausible (e.g., a product pyramid scheme). This means that although a low number of complaints to the FTC is a good sign, it is not an absolute defence.

Ignore Ackman Because...

An even worse defence is attacking your opponent. If you are vaguely familiar with debating etiquette, it is important to focus on attacking the facts, rather than attacking your opponent personally. Herbalife has taken many steps unbecoming of a public company in attacking its critics. The most ludicrous of which is the website therealbillackman.com, which includes a video with the fantastical title "Prince of Darkness". There is compelling evidence (see here) that companies that attack short sellers are statistically much more likely to have abnormally large negative returns than those that refrain from such activity. Anyway, let's consider a few of the arguments against PSQ and Ackman personally.

Argument: Ackman is manipulating Herbalife stock.

Rebuttal: Ackman has been clear right from the Ira Sohn conference that he expects Herbalife to go to $0. Ackman's trading patterns and paper losses are radically inconsistent with market manipulation.

Argument: Ackman was wrong about J.C. Penny (JCP).

Rebuttal: Warren Buffett bought Dexter Shoe in 1993, which was a huge disaster. Therefore, investors should have totally shunned Buffett from 1993 onwards. This argument is really just cherry-picking. Ackman's track record is deserving of being taken seriously.

J.C. Penney is not analogous to Herbalife in any way. This was a turnaround story which did not turn around. The facts changed, and so PSQ's investment changed. The facts at Herbalife haven't changed materially since Sohn.

Argument: Ackman overhyped the Nutrition Club presentation.

Rebuttal: Personally, I (and Whitney Tilson) don't think he did. Remember, if that presentation is substantially correct (I don't possess the resources to independently verify it), then Herbalife is in serious hot water. If what Ackman said was entirely true, the company should be made to sit on the naughty step indefinitely. For those of us who have dedicated a substantial amount of time to researching Herbalife, the presentation was hugely helpful and filled in several holes in the short thesis. On balance, I consider it more probable that Ackman was substantially correct, as opposed to substantially incorrect.

Argument: PSQ is wrong, because the stock price is higher than when they shorted it.

Rebuttal: Fundamentally, the stock price is there to serve you rather than inform you, and this is another example of looking to the periphery rather than tackling the core facts. The stock price is, to some extent, manufactured by way of the buybacks and the crazy and bizarre convertible bond issue.

A Note About Nutrition Clubs

Moving on to Nutrition Clubs, briefly. There has been a lot of interesting work done here, and there is little scope to add value in this area. If you're long the stock, you better cross your fingers that everything in PSQ's presentation is wrong. I have yet to see a robust and direct debunking of the presentation.

Though, one argument I will consider is the one put forward by John Hempton, which is that the strenuous rules for Nutrition Clubs exist to protect the second sale. This is partially plausible. The first objection is: When did Herbalife start seriously protecting the economic interests of distributors? The company does not impose geographic restrictions on clubs. It does not let you display the price of products. It does not allow Herbalife signs. If you believe Ackman, it does not, on average, really allow you to make a profit. For a sophisticated business person, this would make a nutrition club uninvestable. Furthermore, the idea behind becoming a distributor is to sell to your network. What distributor's mother buys Herbalife products from a random nutrition club shake by shake, and not in bulk, from their child? Also it is worth considering the following quotations which help you understand the odd concept behind a nutrition club:

Retail establishments are defined as fixed locations whose primary activity is the on-site sale or delivery of goods to consumers.- page 109

Nutrition Clubs are not retail establishments - page 110.

Is Herbalife a Pyramid?

One of the most important questions that needs to be answered is whether Herbalife is a pyramid scheme or not. On the basis of the evidence thus far, it is more likely that the company is than is not a pyramid scheme. It can, at least, be easily established that the company is very pyramid-like. A few key signs to observe and investigate are as follows:

1. If you plot the Herbalife "marketing plan", you get a pyramid. While this is not legally sufficient, from a commonsense perspective, the case is closed.

2. The "infinity bonus" is meaningless without a pyramid structure. How could an infinity bonus have any utility without a substantial downline, and how can a substantial downline be plotted without a pyramid?

3. If every President's Team and Chairman's Club member vanished in a puff of smoke, the impact to Herbalife's retail business should not be significant. Those paid the most sell next to nothing personally.

4. Movement to the top levels in the "marketing plan" requires that you build Royalty Override Points, which can only be obtained from recruiting.

5. The company created a production bonus for top distributors at the same time that it pushed up costs for those at the bottom with very high shipping charges (which are very profitable for shareholders)

6. Top Herbalife distributors repeatedly make outrageous income claims. Furthermore, Mark Hughes, the company founder, is on tape making many outrageously misleading statements.

7. The 10-Customer and 70% rules are not an absolute defence, and the evidence on their enforcement and effectiveness is weak. Likewise, the lack of complaints is not an absolute defence.

Stating categorical whether Herbalife is or is not a pyramid scheme is extremely difficult and mired by legal complexities. The author simply does not have the resources to make an exact determination with absolute certainty. On the basis of the available evidence, it is reasonable to short the stock on the basis that the company is, in many respects (for the reasons above), similar to a pyramid scheme. Though, as we have seen before, this is one of several reasons to short the stock.

Who is Managing Your Money?

Common sense dictates that before you make an investment, you have to be comfortable with the people who are managing your investment - if you're not, you can't invest. The characters in the Herbalife story should also cause you concern. I would never dream of going into business with Michael Johnson, Des Walsh, Leslie Stanford, John Tartol or Mark Hughes. The fact that John Tartol is on the board of Herbalife should set off alarm bells. Likewise, the fact that Michael Johnson appeared in the infamous "Why Herbalife, Why Now" advert should make you question whether you really want this man as a fiduciary for your investment. Although, on the other hand, Johnson is, in many respects, a highly talented business operator, and short sellers should not forget this. You should also find it alarming that the founder of the company advised distributors to "fake it 'till you make it". Likewise, you should hope that the chairman's club member (Stephan Gratziani) is talking nonsense in the video put out by Pershing Square. Consider the following quotations from the video:

Who wants to bring their family into a struggle to make it? Who wants to bring their family into an eventual deception? (Disc 2, 7:20.)

'Fake it til you make it.' Some of us got so good at faking it, we forgot to make it! (Disc 1, 54:04.)

Switch to Direct Sales?

Perhaps one of the most ludicrous arguments put forward by Herbalife bulls is that the company could somehow switch from being an MLM company to a product company. The simple reality is that if you take the business opportunity and the distributors out of Herbalife, the company is toast. This is because:

1. Herbalife products are massively overpriced when compared to their product competitors.

2. It is extremely unlikely that Herbalife will succeed in direct head-to-head competition with SlimFast (a Unilever spin-off), Ensure (Abbott Labs (ABT)) and Lean Shake (GNC)).

3. The Herbalife brand has little value. Any action by regulators would substantially devalue the brand from its probable low base.

4. Retailers are unlikely to be enthusiastic about stocking Herbalife products, given the controversy and any judgments made against it by regulators.

5. Herbalife has debts which need to be serviced.

Ultimately, this is a leveraged company with negative equity, which clearly is not in a position to undergo a rapid reversal in operating leverage and absorb massive restructuring costs. Herbalife is fundamentally incapable of transitioning from being an MLM to a fast-moving consumer goods company. Basically, I would argue that Herbalife is unfixable.

A Challenge to Bulls

Fundamentally, the bear case for Herbalife is easily falsifiable. It is very difficult to prove that a company is an illegal pyramid scheme, but it is actually very easy to prove that it is not. If someone can thoroughly and rigorously debunk the following slide from the original PSQ presentation, then the bear case is defeated. If you can prove that the majority of the compensation comes from retailing to end-users, as opposed to recruiting, this would provide an absolute defence to pyramid scheme allegations.

Hence, I challenge anyone to publish on Seeking Alpha - a blog or otherwise - a post that rigorously debunks the following slide. In other words, prove that PSQ's calculation is substantially incorrect such that recruiting rewards are less than 50%. If any Herbalife bull succeeds in doing this, the case against Herbalife will be, at best, seriously impaired. However, if the assumption is used that the majority of distributors are not distributors, but discount customers, this has to be similarly rigorously supported.

What Does Google Say?

Few people are aware that it is actually possible to see roughly how many people are searching for a certain keyword on Google. This is done with the Adwords Keyword Tool, and it's extremely useful if you're in the online content business. If you run some Herbalife keywords through the tool, the results are really bizarre. Consider the following data, which shows the average number of searches per month for all locations for the following keywords:

This reinforces the assertion that a massive number of people signing up for a discount membership is improbable. There are apparently hundreds of thousands of discount customers with a high turnover, while very few people are looking up discount membership. Curiously, if you search for "Herbalife discount", the company is not even in the top organic results. If you search for "Herbalife discount membership", the first official result is all about the business opportunity.

Regardless of whether the short case is right or wrong, it is flowing through into the search data. The volume of searches for "Herbalife scam" has increased hugely. Given that the search results are not very flattering, this cannot be good for the business model.

Conclusion

The simple idea that I keep coming back to is that good, investable companies simply don't behave this way. What company bases its business model around a word that is well defined and then redefines it to mean something completely different? If you asked 1,000 people what a distributor is, you probably would not find one that said "sometimes it's people who distribute products, but most of the time it's someone who wants a discount". Why does Herbalife not have discount customers sign up as discount customers? Costco has members, not unpaid independent contractors. This is just one of the many lunacies and inconsistencies one finds when studying Herbalife deeply.

To conclude, Herbalife is a prime short opportunity. It is very unlikely that the company will not be hit hard by regulators. Even if it survives the regulatory onslaught (it is currently reported to involve, or have involved, the FTC, SEC, DOJ, FBI and state AGs), the underlying business is still terrible. Herbalife is very fragile at the moment, and it has no balance sheet to fall back on. The company's business model is, in the long term, as implausible as a new recruit becoming super-rich from Herbalife. The law of large numbers will be obeyed. The company is rapidly running out of pops. Cue the final drop.

Disclosure: I am/we are short HLF. 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.