Tuesday 10/27/15 was a good day for all people who are fed up with Herbalife (NYSE:HLF), and the reign of dubious multi-level marketing schemes that more often than not are likely pyramid schemes.
From an investment standpoint it is becoming increasingly clear with a lot of in-depth analysis available on this site and elsewhere, that there is no place to hide for these public companies if their business plans skirt the law, and systemically risk outright violations at their core. Herbalife is a case in point, and the symptoms have been evident for a long time. The hiring of large numbers of former government officials risks making Herbalife's management suite look like the ruling junta of some banana republic.
The mounting number of investigations made it increasingly likely that the cracks would start to show sooner or later, and the direction it came from was quite surprising. Having worked somewhat with the office of my NYC Council Woman Annabel Palma on some related activities in public education and information had made me aware that at least some New York politicians were taking an interest in the problem, although NY AG Eric Schneiderman did not distinguish himself in this matter, possibly because of the widely reported connection to his ex-wife Jennifer Cunningham, who was engaged by Herbalife as a lobbyist.
Schneiderman's actions amounted to keeping up appearances that he might be investigating the company and keeping his options open. Well, the moment has passed. This week Senator Jeff Klein (Democrat form the Bronx), along with several other NY politicians including Council Woman Annabel Palma, and Public Advocate Letitia James, held a press conference, calling for a crackdown on Herbalife, and promising a legislative proposal law to rein in multi-level marketing companies.
It is one more example of both law enforcement and regulatory failures at the federal, and in this case also state level, and how local action is needed for a fed-up population to deal with the polymorphous problem of MLM/pyramid schemes. An undercover video released with the report is priceless.
The strong tendency on Wall Street of looking only at the numbers, and not at the soundness of the business plan and operations is coming in for punishment. As I, and several others beside me, have pointed out on this site, one of the very deceptive differences from an investment standpoint about pyramid schemes compared to Ponzi schemes, is that they generate a lot of cash while their market is in fact collapsing. There tend to be high levels of recruiting in these companies that are large, and in some cases public like Herbalife, because longevity creates some level of credibility: "How could it be a pyramid scheme if it has lasted thirty years?" The answer is: ask Madoff...
3Q15 for HLF will be long remembered
At the same time as all the above happened, the tireless Michelle Celarier of the New York Post delighted many with a pretty incriminating video of Herbalife CEO Michael O. Johnson, while the majority of mainstream media are more scared of reporting on multi-level marketing than sex. The video leaves the indefatigable Johnson hoist on his own petard, as the saying goes. We should remember that aside from the legislative initiative by state senator Jeff Klein, the DOJ is also still investigating Herbalife, and US Attorney for the Southern District of New York, Preet Bharara, is presumably in charge. Who knows what that may bring.
Numerous painful investment lessons are being learned, in particular for the large funds that still own Herbalife. Was nobody doing due diligence? The level of noise alone should make it a top priority to look into a company, and as more and more information comes out investors could have grounds to seek redress against investment managers who are asleep at the wheel.
It should be remembered that at the end of 2Q15 Herbalife equity holders were $200 million in the hole, and the company was experiencing declining revenues everywhere except China, where its business model is patently illegal. That in spite of the fact that some sell-side analysts such as Meredith Adler from Barclays (target $73) and the tireless Tim Ramey of Pivotal reiterated his $100 target price. Scott van Winkle at Canaccord Genuity seems equally unperturbed at $58.
Maintaining and reaffirming these stratospheric ratings of Herbalife stock is more dubious by the day. Where are the earnings going to come from to sustain such numbers? After the FTC action against Vemma, it should be nigh-on impossible to defend such positions any longer. It simply defies imagination when the evidence of legal, regulatory and law-enforcement challenges is so clearly mounting that any professional analyst could willfully ignore the red light, and counsel investors not to worry, and cross the intersection anyway.
Life after Vemma
For anyone following the ongoing issues between Vemma and the FTC, it should be clear that the FTC now gets it. The latest gem was a recent piece by Peter Vander Nat, Ph.D., formerly Senior Economist at the FTC, and now consultant to the SEC on pyramid schemes. The title says it all, The Enduring Primacy of Retail Sales in an MLM Context, on the website of Truth in Advertising (aka "TINA"), which has become the one organization that has been needed for so long to take on the deceptions of MLM systematically. On this website there have been numerous recent contributions by Dr. Bill Keep, also pointing in an interesting new direction of a new regulatory model. If we are indeed historically stuck with the notion that MLM may be legal, it should be clear that in order to be legal an MLM should have a marketing plan that is focused on sales, not recruiting.
It is to be hoped prosecutions going forward could produce a disambiguation of the MLM concept, for the last forty years of legal obfuscation basically amounted to the FTC shouting to MLM: "You're a pyramid scheme," and the industry shouting back: "No, we're direct sales companies," as DSA president Mariano is still doing today. The whole culture of the DSA is driven by the wish that the law is not what it is, and Mariano's comments are totally out of touch, as Peter Vander Nat's analysis documents point for point.
As long as that attitude prevails, MLM companies will keep running in to the realities of pyramid scheme prosecutions, and we are obviously at the stage where new rule making is in order. Even MLM lawyer Kevin Thomspon is now sounding the alarm and sees Vemma as an industry issue, certainly more so than Mr. Mariano, as is evident from his two recent articles on Lessons Learned from Vemma, Part 1 and Part 2.
The disambiguation of "MLM" should be all about separating the direct sales front from the pyramid scheme back end. Can you have a sales organization with multiple levels? Of course. But it's the back-end, the compensation plan that can make it into a pyramid scheme. Hence, whenever the compensation plan skews the operation to prioritizing recruiting over sales, that compensation plan is an implied pyramid scheme, making the MLM company the pretend-legal money laundering front for the covert pyramid scheme that is created by means of its compensation structure. The infamous Tirelli agreement that is holding Herbalife together would be categorically illegal in view of the findings with Vemma today for it decisively preserves the pyramid scheme structure that drives Herbalife.
From a regulatory standpoint, clarity that an MLM is legal if it has a direct sales compensation structure, and illegal if the compensation structure is a pyramid scheme, is elegant for in the second case the MLM then becomes the money launderer for the covert pyramid scheme behind it. If such a finding were to be made, this has several advantages for prosecutors and regulators, notably the SEC and Treasury would have a well-defined interest, and the prosecutorial framework for DOJ would be more clarified.
There are other developments in the market place that point to ways to control MLM, such as the increasing efforts of disgruntled Uber drivers to engage the NLRB to protect their interests. The various attempts in MLM to protect the rights of distributors against the companies might one day take note that they should not protect the scam, but become part of the solution and change for the better. A 120-page distributor agreement like Herbalife has is excessive even for employment contracts, and makes a joke of the notion of 'independent' distributors. I assume there will always be products and services that do well with direct selling, and the insurance and real estate industries have worked well with those types of agency structures. So it can be done.
The last obvious method of control would be the IRS, by disallowing business deductions for pyramid schemes, and treating them as a hobby, which would make promoting MLM as a business opportunity illegal overnight, for it would amount to promoting tax-evasion. The odds against the participants in MLM are far worse than in some forms of gambling, and in gambling at least there is full disclosure. There is ultimately no reason to treat MLM any different.
Once there were one solid ruling to establish MLM as a money laundering scheme for the covert pyramid scheme that is designed into its marketing plan, the financial industry would need to be on guard against servicing any MLM clients, lest they be implied in money laundering, and the SEC and Treasury would have an interest. Suddenly companies would no longer be eager to call themselves MLM companies, but would go back to direct sales.
It is hard to predict what avenues will be followed, and the initiative in New York, in the upcoming legislative proposal by Senator Jeff Klein and Public Advocate Letitia James, adds yet more possibilities to the regulatory arsenal to control this problem at the level where it occurs. MLM as we know it is over.
What does Q3 hold in stock for HLF and other MLMs?
Simply put, we should expect the effects of gravity to make themselves felt increasingly. Sometimes stocks respond to the merest whiffs of investigation, but Herbalife, with the passing of time seems to have shaken off those concerns, it is now simply an accepted fact that the company is under investigation, seemingly forever, and this situation is furthermore being ignored.
Next, there are those who have personalized the whole issue, and take heart from the recent challenges at Pershing Square with its position in Valeant. Any comments in that direction make the mistake of killing the messenger, and ignoring the message. Both the economic reality of decelerating earnings and the increasing likelihood of serious restraints on the business model, make it unlikely that earnings are very sustainable (MarketWatch reports a consensus estimate for Herbalife of $1.05 for 3Q15). And it should be expected that China may start to pay attention to its own laws, and could crack down at any moment on the MLM legerdemain that permanently tries to skirt the law by relabeling things, and pretending problems can be made to go away that way.
We are clearly at the stage that all MLM companies should take notice, and the public ones even more so, especially Avon (NYSE:AVP), which is already reeling from the internal contradictions created by its partial adoption of MLM, but the list of top MLM companies that TINA is looking into is a good guide, as is the whole list of public MLMs on the site of MLM attorney Jeff Babener, here. Notably, Primerica (NYSE:PRI) has recently been in the news over conflicts of interest of its sales people, without due attention to how and why its sales structure creates or at least exacerbates those problems. Public companies on TINA's list include, besides Herbalife, The Kirby Company, owned by Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), LifeVantage (NASDAQ:LFVN), NuSkin (NYSE:NUS), and Usana (NYSE:USNA). It is no longer just "buyer beware," it is the season for investors to beware.
At this point, the countdown in Herbalife should resume in earnest. The stock gave up another $1.40 in after hours on Tuesday, and bounced back a little the next day, but there is precious little left to hold on to. Investors in all other public MLMs should take note. Performance has been bad, but you ain't seen nothing yet. After forty years of legal obfuscations that allowed these businesses to continue by exploiting legal loopholes and even become publicly listed, the pendulum is now swinging the other way.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.