Herbalife’s (NYSE: HLF) share price has been on quite a roller coaster for the past 18 months and everyone that follows it seems to believe it’s a strong buy or a strong sell. This article is in two parts: the first is the short case and the second is the buy case — and conclusions.
Herbalife reached over $70 in early April 2012 before a sharply declining shortly after. It has a 52-week low of $24.24 but has since rebounded to almost $70 again. Although fellow billionaire David Einhorn predicated the initial sell-off with a question on a conference call, Bill Ackman leads the way for the shorts currently. Ackman reiterated his case on November 22, 2013 despite its round trip to when the sell-off started. The movement back up in the stock prices tells us, as far as a majority of the Street is concerned, the company’s results have not supported a short thesis and are actually relatively solid. That said, the short case for the end game here is a fundamental one:
- It’s hitting a wall in sales due to the pyramid scheme nature of the company.
- It’s running into the Justice Department/FTC/SEC first.
The Herbalife Short Case
Bill Ackman, billionaire and founder of the $11 billion fund Pershing Square Capital Management, stated in late October at Oxford’s business school that, “The business will be shut down.” He also reiterated his case in a presentation on November 22, 2013. The slides are posted at factsaboutherbalife.com.
Ackman essentially believes that Herbalife is a pyramid scheme and the recent presentation is titled “Robin Hood in Reverse.” He believes the business requires current agents to recruit a steady stream of new ones to sign up and sell the product to build their inventory. Mr. Ackman holds that a significant portion of sales are never consumed by any retail customer and essentially sit idle in inventory with each sales representative. When current reps cannot recruit new ones to sign up to generate sales from the one-time stocking of inventory, the company’s sales will start to decline and the house of cards will fall.
The SEC Investigation
The SEC opened an investigation in January 2013 but the news from that has clearly not been negative given the stock performance. The presentation from Ackman uses some scare tactics, noting that the SEC issued a warning regarding pyramid schemes in October and particularly stated that a business primarily based on recruiting new reps is potentially a pyramid scheme. In this statement from the SEC, there was no reference to Herbalife.
The argument goes on to show how Herbalife’s marketing is more like a pyramid scheme than one that actually wants to sell product to actual consumer, particularly retail consumers. It outlines how the company’s model fits all seven criteria outlined as a warning of a pyramid scheme.
Retail buyers are defined and distinguished from distributor sales by Herbalife as sales to non-distributions, but the company does not share the data. Herbalife does require its distributors to maintain detailed records of retail sales.
When asked directly about retail versus distributor sales, the CEO, Michael Johnson, claimed in CNBC that 90% of its sales are retail and made to non-distributors in December 2012. One month later he went back on CNBC and said that was not actually the case, and that many distributors are also possibly buying for their own consumption and that is included in the 90%. Furthermore, the company, despite having the ability, does not release data on retail sales.
The Company Claims MLM
While management at Herbalife could do a better job of providing visibility into its sales operations, its structure as a multi-level marketer alone does not make it a pyramid scheme. Companies like Tupperware (NYSE: TUP) and Amway both go to market via a similar method. Many of Ackman’s claims based on recruiting reps and other structural issues can also be made here. However, there is one difference: Tupperware provides a detailed breakdown of its sales.
There are further problems that are concerning. According to company documents, its target segments for sales and new reps are urban areas. In particular, it stated in 2010 that it wants to focus on ethnic minorities and support an African American initiative with distributor trainings and events.
As a result of this, some Latino and other organizations are raising awareness and stating that Herbalife is victimizing the poor and selling them on the idea of starting their own business. This business requires an investment from them. According to company data, the dollars are not evenly distributed. The top 1% of distributors receive 87% of commissions and 88% of all distributors receive no commissions.
Conclusion — Part I
While the evidence Ackman presents makes a compelling case, it is still based on making some assumptions and presented in a way that tries to create shock value. The timing of a scheme like this falling apart is uncertain and while the Justice Department has been notified multiple times in complaints from consumers and other advocates, the continuation of operations does show signs that no wrongdoing was immediately apparent.
That said, these investigations, done correctly, takes time. In the meantime, other billionaires and fund managers, such as Carl Icahn who has a particular distaste for Bill Ackman, bought the stock after its fall and have made strong returns on the way back up. Icahn currently holds 16% of Herbalife.
The question is, were other hedge fund managers just rallying and pumping the stock to make a quick trade and going against Ackman or is there a buy case? In Part Two, we take a look at the case to own the shares and what investors should do at this point: buy or sell.
What are your thoughts on the short case for Herbalife?
John has seven years of experience as an equity analyst following various stocks and sectors. As a senior equity analyst, he received awards from the Wall Street Journal and Financial Times for his writing.