It has always amused me that Bill Ackman loved Valeant (NYSE:VRX) and hated Herbalife (NYSE:HLF) - because they clearly both operate on the same fundamental premise. How can we extract maximum value from society without contributing any?
And indeed, while the companies are in completely different industries, there are uncanny similarities between the stories. Profits for Herbalife's distributors are derived from selling the exact same product at an increasingly ridiculous markup as you go downline. Profits for Valeant were derived from buying and then aggressively raising prices for drugs. After years of confusing contradictions on how much of product was sold to actual consumers, Herbalife's internal controls are so bad that it reported wildly inaccurate member counts - so out of whack with what turned out to be real that it should've easily failed the sniff test and been flagged for review by one of the many people who reviewed the press release. Valeant, similarly, couldn't get its own guidance right. Herbalife is obviously somewhat less indebted than Valeant; offsetting that, Valeant actually has some products of real value (Bausch + Lomb contact lenses, for example).
But all in all, they both boil down to the same two questions:
- Is this company's business model sustainable?
- Can management be trusted?
In the case of both Valeant and Herbalife, the answers to both those questions are a resounding "no." Yet, Valeant has imploded over the past few weeks, while Herbalife has skyrocketed. This provides Herbalife's shareholders with a chance to sell out - because inevitably, the company will end up going the same way as Valeant.
Setting aside technicalities of what does or does not legally qualify as a pyramid scheme, the primary research by Ackman and others very clearly demonstrates that Herbalife's business model is not primarily about selling protein shakes to consumers - it's about selling a supposed business opportunity (that in reality is either nonexistent or very close to that, as the majority of distributors don't make money). CEO Michael Johnson has said in so many words that the company's model relies on continuing to recruit based on that premise. And now, when you Google "Herbalife", you get the company's website, Twitter page, Wikipedia page, Facebook page, and then:
Even if you assume that Herbalife will not be regulated out of existence, and even if you are able to set aside basic human decency and agree to underwrite Herbalife's business model with your capital, the business model looks deeply broken. Any potential recruit can use Google, and with the first page of Google pointing potential recruits to very compelling and serious evidence that what Herbalife is selling isn't real, the ability of Herbalife to continue to recruit new members going forward over the long term is very suspect.
In light of this, Herbalife's current run up in spite of its admission that its member growth numbers were substantially below what it previously thought they were is quite astonishing. For now, the stock may continue to trade higher given that "take positions opposite Bill Ackman" is the trade du jour.
But any remaining shareholders would do well to take their profits now - because there are a whole lot of reasons to believe that five years down the line, shares will not be worth anything near what they are today (if they're still worth anything at all.)
It is a fact that sooner or later, business models that are unsustainable will stop working. With its brand severely impaired and its secrets exposed for all to see, Herbalife's business model is not sustainable, and it will not work forever. Even if a smaller, more consumer-focused company were to emerge over time, management's lack of transparency makes it hard to trust the company at all. They're certainly good at showmanship (this press release was too funny), but at the end of the day, they've done nothing to establish credibility with serious investors.
And at the end of the day, what's most hilarious is that even if you can get over everything else, Herbalife isn't even all that cheap, fundamentally speaking. At the current stock price of $61, it trades at over 13x forward earnings, with growth that - even in constant currency - is nowhere near double digit. North America sales are declining (in constant currency) despite strong growth reported by just about everyone in the health and wellness space. What's the upside? The questions go away and it trades up to 20x? Balanced against a legitimate possibility of a 50% (or much greater) drop, even if the business does somehow manage to continue to exist, that just doesn't seem appealing.
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