The Calm Before the Storm

The outcome for Herbalife hinges on whether or not it is an illegal pyramid scheme, not the quarterly results of the business.  Talking about the fundamentals today is like talking about Mardi Gras with the potential impending doom of Hurricane Katrina in the background.  So many seem to be making party plans while a small group of “quacks” prepare for a regulatory storm to slam into the good ship Herbalife.  Several State & Federal agencies have also “warned” of potential danger.  If the partiers, or their semi-sober lawyers, acknowledge the issues at all, they claim them to be the same old issues from 35 years ago – “no big deal, nothing we haven’t dealt with before, just a few tweaks will be necessary.”  That seems very foolish to me.

Herbalife is Cheap on the Numbers

Without the regulatory issues, most investors would concede Herbalife appears to be a reasonable fundamental story, it’s cheap relative to earnings, its capital return policy has been excellent for shareholders and it has grown like a weed the past 5 years.  (But let’s not get carried away with the bull case.  Even legit MLMs have fundamental flaws in their business model.)  No doubt, it is highly profitable to be Founder #1 in a huge pyramid scheme.  As I have said many times, the fastest way up the pyramid is to buy Herbalife stock because it is what Mark Hughes owned.  That’s why Golden Gate and J.H. Whitney bought in in 2002 after Mark Hughes died (of a reported overdose from alcohol and pills), ramped up international growth to minimize U.S. regulatory scrutiny in what was a relatively benign regulatory regime in any event, and flipped it to the gullible public 2 years later.  Owning a pyramid scheme is a hot potato.  You don’t want to leave your principal on the table too long.

Over the last 10+ years Wall Street has figured out how profitable it is to be at the top of a pyramid scheme.  Mark Hughes knew.   So did Jorge Vergara.  He’s the Mexican billionaire, former taco and time-share salesman who was recruited by John Peterson and Mark Hughes in the 1980’s to open Mexico, but after working in their downline for a while, decided to start his own pyramid scheme in 1991.  Vergara learned from the best and it was a carbon copy of Herbalife – named Omnitrition.  It has since been renamed OmniLife and is based in Mexico. You may recognize the former name, Omnitrition, from an important court case.  Most of these MLM pyramid schemes trace their DNA back to the same clan.

In the short term, Herbalife will continue to remind us that pyramid schemes are highly profitable.   So was the Medellin Cartel, for that matter. But every now and then the government smashes one or more illegal enterprises. Unfortunately, the members who escape with their life or liberty scatter, and then pop up like mushrooms to form yet a new one illegal enterprise.

Here’s where I come out on Herbalife’s fundamentals. All is not as it appears, but it is still highly profitable. They have distributable reserve issues (as previously pointed out in an excellent Seeking Alpha article), foreign tax issues, Venezuela issues, some markets have slowed, some are getting choked and reveal what happens when they have to operate with anti-pyramid restrictions. For the time being, they are relatively manageable issues, or so it would seem, but any one or more of these problems could accelerate. To the casual observer or committed believer, management has been able to spin their way through them in their statements and press releases.  As for my investment thesis, I’m not counting on any operating troubles to bring them down before the Feds do.

Having said all that, and given the impending regulatory storm (more on that below), I believe it is more rational for Herbalife to trade at $45 per share today, which is approximately 7.5x the approximately $6 reported adjusted normalized earnings (whatever that means, but it’s basically what Herbalife wants to use). If they get a clean bill of health, then $90 per share (or 15x) seems like the next stop just because a bunch of yahoo’s are going to get really excited.  Alternatively, if they do not get a clean bill of health, this is not a “modest adjustment” or slow decline on its way to or below $45. This is the kind that goes “news conference, halt trading, does not reopen, $0.”

Herbalife has been throwing the kitchen sink at the stock price. Q1 they spent $680MM, in April they’ll spend $300MM on light volume, May and June they project $150MM each month. They are running out of U.S. parent and subsidiary cash and distributable reserves (as noted above) and they are running out of gas. Short interest remains 25%. Icahn won’t buy more.  It doesn’t appear that Stiritz will buy more (he had the opportunity at lower prices and didn’t). Who else is left? Dan Loeb might hop in and out again? But we know he’s just an amoral greedy trader and the fundamental case he made in his LP Letter was a bunch of bunk.  Herbalife ran to $80, then back $50, now it’s up to $60+.  I think this is just noise and gasping in the face of an alphabet soup of investigators.  Next stop is $45, which is a more rational and temporary “weigh station equilibrium” of 7.5x the $6 “earnings” while we wait to see if the alphabet soup is too hot, too cold or just right..

The FTC and Peter Vander Nat’s Model

The FTC went from an informal to a formal investigation. The full commission voted, notwithstanding the scrutiny that might come from “convicting” Herbalife and handing a fortune to the billionaire Bill Ackman. Ironically, Carl Icahn gave the regulators political cover or a counter-weight. It isn’t just Bill Ackman who wins. If the regulators “exonerate” Herbalife, then they hand a fortune to the billionaire Carl Icahn. The argument must work both ways. Either way, the regulators are going to hand a billionaire a fortune in profit, so they’re off the hook. And they knew that when they voted for a formal investigation. Same with the DOJ, FBI and several States AG.

Peter VanderNat has the case for the FTC. I am not writing this to persuade anyone about his declarations, pyramid models and testimony in prior pyramid cases. That’s a useless exercise. I have my opinion about what he will conclude with respect to Herbalife. I’ve read others attempts to persuade the opposing team regarding VanderNat – it has not been productive. Soon enough, Peter VanderNat will have gathered the necessary inputs and together with the Herbalife pay plan, put it into his Gumby Machine and spit out his result for the full commission.  Then we will be on to interpreting the consequences. When the FTC goes after a pyramid scheme they have a perfect batting average, with the exception of Amway 35 years ago. (Peter Vander Nat has a perfect record.)  When the FTC “lost” to to Amway they specifically said “it’s time to move on.”  I don’t believe they concluded they were wrong, I believe they concluded “it was time to move on.”  What a grave mistake that was for many millions of people in the U.S and around the world.

The Courts and the Practical Outcome of Participants

Putting aside VanderNat, his model and any recommendation to the commission, when it comes to prosecuting pyramid schemes, the courts have and will use another standard, one that is supported by case law and has nothing to do with economic or academic models. It has everything to do with the structure and function of the enterprise and the practical outcomes of the participants. The courts will focus on what is damning evidence in the case of Herbalife, such as:

(1) The failure rate of participants, (2) financial harm, (3) how much of the financial benefit/reward accrues to the top of the pyramid, (4) how much of the marketing material promotes recruitment and the business opportunity, (5) actual enforcement of the Amway rules, (6) the incentives of the compensation plan, whether or not it provides more compensation to participants who actively recruit, (7) whether or not participants are required to purchase product in order to receive commissions, (8) whether commissions are a function of a retail sale to an ultimate user, (9) whether or not the business opportunity has real world potential or not, and (10) how much of the product is sold outside the distributor network.

Taken together (the output from Vander Nat and the court standard looking at these 10 or so factors) the FTC will likely tip the first domino by determining that Herbalife is an illegal pyramid.

Miscellaneous Other

It is also likely that the FTC will find violations of False Claims (income and medical), as well as violations of the Clayton Act (price discrimination between different purchasers, substantially lessening competition, tending to create a monopoly to benefit top of the pyramid to the detriment of bottom of the pyramid).

Incidentally, violations of Wire Fraud (the whole enterprise was facilitated by movement of money in this manner) and Securities Fraud (it is a NYSE listed company, has filed many SEC documents, has bought and sold registered securities, etc.)

I believe it is no coincidence that we learned of the formal FTC investigation first, and more recently learned of the DOJ, FBI and States Attorneys General. The first FTC domino sets off a chain reaction that requires the involvement and cooperation of multiple Federal and State agencies. So, they need to be prepared.

The FTC history is not to negotiate fines and modifications. They seek injunctions, forfeiture and restitution. In an April 29, 2014 interview with the LA Times, Michael Johnson was quoted saying, “If they come to us and say, ‘You could have done this better,’ we’ll fix it. There’s nothing structurally wrong with this company.”  The interesting part of that is, it appears they’ve had no discussions with the FTC. I’m also not aware of FTC policy negotiating like that with pyramid schemes.

The full impact of the storm might sound something like this:

“The corporate entity is responsible for the operation of a pyramid scheme, as well as the conduct and offenses committed by numerous top distributors/co-conspirators, which was made possible by institutional practices that encouraged, enabled, promoted and financially incentivized widespread offenses without any meaningful commitment to compliance and turning a blind eye. This conduct by individuals and an institutional indifference to that conduct resulted in offenses that were substantial, pervasive and on a scale without known precedent in the industry. The entity and it’s top distributors were a breeding ground for this type of activity, reaping billions of dollars in system wide illicit profits at the expense of the public.”

You may recall that the Department of Justice held SAC Capital criminally responsible for the acts of employees, secured billions in fines and shut them down. They also held the pharmaceutical industry criminally responsible for the false claims of sales reps promoting off label drug indications, securing billions in fines and an avalanche of private lawsuits that followed. The drug companies only survived because they had substantial and sustainable cash flow and a breadth of product that consumers actually wanted and needed. If the government charged Herbalife from any one or more of these angles, it would be an insurmountable hurdle. Once they choke off the recruiting machine, it’s over.

With Herbalife at far better than even odds of going to $0 (I believe it’s more like a 6 to 5 shot) the January 2015 $45 put option, paying more than 10 to 1. I still like those odds.

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