Why Bill Ackman is Wrong About Herbalife

Whoa – I must be out of my mind with that title, right?    Pershing Square’s Bill Ackman is a smart dude.  He  and his team (especially analyst Shane Dinneen) have been tearing apart Herbalife’s business and numbers for the better part of a year now.   Ackman disclosed that he has been short the stock for months – in size – and that he has no options positions in $HLF.    This week he made waves when he called Herbalife a pyramid scheme, and set out to prove it with a 345 slide presentation that he, his analyst, and his lawyer presented over a period of almost four hours on Thursday, Dec 20th.  Ackman called Herbalife his highest conviction short ever, and has a price target of zero.    That’s the background.  Let’s get to the point.

First off, read the presentation from Ackman (thanks to BusinessInsider for providing this).
Bill Ackman’s Herbalife PDF

 

So let’s get to the cliff notes:

 

1)  Ackman cites an FTC definition of a pyramid scheme, emphasis his:

2) Ackman alleges:


I think Ackman errs in his supreme confidence here because the monetary benefits are derived from sales of goods to recruited members – and from the sales of actual goods that those recruits make: not from recruitment fees, which is a key distinction according to the FTC.  I’ll come back to that later.

3) Finally, there’s the “red box” and the “blue box” earnings, which are the crux of Ackman’s allegation.

Ackman goes to great lengths to show that Herbalife’s accounting of the two different “boxes” is flawed, and that in reality, the balance of the two earnings breakdowns (retail vs recruiting – he says recruiting is much bigger than retail) proves that Herbalife is a pyramid scheme.

I agree with a lot of the meat of Ackman’s presentation.

I agree that Herbalife probably isn’t quite the road to riches that they sometimes market it as.

I agree that most people who sign up to be Herbalife distributors probably won’t make much, if any money, and that a very very small number of them will end up making enough money to appear in Herbalife’s marketing videos driving Ferrari’s.

I agree with Ackman that Herbalife’s accounting of product sales is a bit twisted, if not outright wrong – but it’s important to note that this is not a financial accounting fraud: it doesn’t change Herbalife’s bottom line – it’s a “legal” accounting issue that results in problems with the balance of the retail/recruiting earnings mentioned above, and thus potentially runs Herbalife afoul of pyramid scheme rules.   The short version of the problem is this: what Herbalife does is record the difference between suggested retail price and the price that it sells the product to its distributors as “retail profit.”    In other words, if I pay $75 for a product with an SRP of $100, Herbalife records $25 of “retail profit.”  There’s a problem, of course, as the “majority” of Herbalife distributors are self-consumers.  Basically, they sign up as distributors specifically to get this product discount, and they don’t actually sell it to anyone – never mind sell it for $100.   Thus, the “retail profit” isn’t actually realized by anyone, and the balance shifts toward “recruiting profit” and Ackman then concludes it’s a pyramid scheme (Again, this doesn’t affect HLF’s bottom line.)

However, I think that Ackman makes a jump in his “pyramid scheme” conclusion, and the proof that his logic is flawed is right in his very own presentation:

I also have a link to the full 2004 letter from the FTC, and to the DSA’s brief explanation of the details.  This seems like a good time to point out that the DSA – Direct Selling Association – is not an impartial observer: they are the national trade association of direct sales companies.   Of course, Bill Ackman is also not an impartial observer.  That doesn’t make him wrong – it pains me to see people attack Ackman just because he’s short the stock.   I’ve written posts about this in the past, and it should be obvious to intelligent, unemotional market participants, but being short the stock and having an agenda doesn’t mean you’re wrong – just like being LONG the stock and having an agenda doesn’t mean you’re wrong.

So: why do people buy the product?  Well – they buy the product 1) to resell it, or to use it: according to Ackman, the “majority” of Herbalife’s distributors buy the product to consume it.  2) SOME of the distributors buy the product because it makes rational sense to do so based on the sales commission structure, which is a step function.  Ackman gives one such example in his presentation, but he also points out (check that: he doesn’t point it out, but his own data proves) that more than 80% of Herbalife’s distributors do not qualify for such a commission structure, and thus could not possibly be buying the product just to “pay for their paycheck” as he puts it.

Does Herbalife’s commission structure create scenarios where occasionally it will make sense for a sales leader to buy product – as required by Herbalife – in order to earn commissions from his downstream distributors?  Of course – I agree with Ackman on this point.   But the number of such oddly-incentivized members cannot be a significant portion of Herbalife’s distributors – as Ackman’s own numbers prove.  Additionally, such “oddly-incentivized” members, who must by definition have risen from the bottom tiers of the multi-level-marketing structure, cannot possibly be the poor heaps of failed miserable dreams earning zero dollars that Ackman accuses Herbalife of littering the globe with.

Let’s get back to the FTC guidance on pyramid schemes. From their 2004 letter:

“The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are  generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture.

A multi-level compensation system funded primarily by such non-incidental revenues does not depend on continual recruitment of  new participants, and therefore, does not guarantee financial failure for the majority of participants. In contrast, a multi-level  compensation system funded primarily by payments made for the right to participate in the venture is an illegal pyramid scheme.”

How does this apply to Herbalife?  Well revenues that support commissions to Herbalife distributors are based on the purchases of actual, real, Herbalife goods.  They are not based on membership fees which distributors pay to be part of the “scheme.”    That fact alone makes me surprised that Ackman has called this his “highest conviction short of all time.”

Ackman might reply by citing a paragraph just later in that FTC letter:

“The Commission’s recent cases, however, demonstrate that the sale of goods and service; alone does not necessarily render a  multi-level system legitimate. Modem pyramid schemes generally do not blatantly base commissions on the outright payment of fees, but instead try to disguise these payments to appear as if they are based on the sale of goods or services. The most common means employed to achieve this goal is to require a certain level of monthly purchases to qualify for commissions. While the sale of goods and services nominally generates all commissions in a system primarily funded by such purchases, in fact, those commissions are funded by purchases made to obtain the right to participate in the scheme. Each individual who profits, therefore, does so primarily from the payments of others who are themselves making payments in order to obtain their own profit. As discussed above, such a plan is little more than a transfer scheme, dooming the vast majority of participants to financial failure.”

As noted above, Ackman clearly shows in his presentation that there are SOME members who make non-economic purchases  – which he calls “pay for your paycheck” – just to qualify for commissions.   Ackman provides no evidence of how prevalent this behavior is in Herbalife’s structure, but there is plenty of evidence that it affects a very small fraction of the distributors – and again – it does not affect the distributors whom Ackman purports to have sympathy for,  as the affected ones are by definition not part of the masses of money losers who never got off the bottom tier.  Additionally, the point “Each individual who profits, therefore, does so primarily from the payments of others who are themselves making payments in order to obtain their own profit,” is also inapplicable here, as the downline distributors do not have that same incentive.

As the DSA explains it:

“In short, what the FTC watches for—and what the DSA Code of Ethics is designed to protect against—are compensation systems that are funded primarily or exclusively by payments made for the right to recruit other participants. Compensation must primarily be based on the sale of products and services to the ultimate consumer—whether or not that consumer is also a seller of the products.”

Again, I think it’s far from clear that Herbalife is a “pyramid scheme” when you consider this definition: compensation IS primarily based on the sale of products and services to the ultimate consumer.  If the consumers don’t buy the products, the compensation isn’t there.

Finally, I was disappointed in one area where Ackman used deception to try to make it look like Herbalife CEO Michael Johnson was illicitly selling his stock in the company.  During his presentation, Ackman asserted that Johnson was selling stock as the company was executing a buyback after the stock plunged in May.   This is patently false – Johnson sold stock before the big drop in May.  Ackman also presented this slide, which in my opinion is clearly meant to insinuate some sort of wrongdoing by the CEO or some sort of knowledge of pending doom on the part of the CEO.  Note the title: Actions Speak Louder Than Words:

Ackman’s use of the word “discretionary” is highly suspect, as these stock sales were part of a 10b5–1 plan which is how insiders PRE-DETERMINE a way to monetize their equity positions regardless of news, etc.   In other words, Johnson set up a plan that sells his stock automatically based on certain thresholds and criteria.  As far as I know, the details of the plan are not public, but they would typically be triggered by the stock trading at a certain price for a certain amount of time, and would lay out strict details for the amount of stock to be sold when criteria are met.  In other words, Herbalife CEO Michael Johnson didn’t wake up on any of the mornings in which he sold stock and say “I’m going to sell my stock today.”  Is this “shady” or “fishy” or anything else negative?  That’s up to you to decide: there is no doubt that the CEO was monetizing some of his huge value that he held in the company stock, which in and of itself is not at all strange to me.  The guy got paid a ton of money – a lot of it was in stock – he wanted to capture some of that.   Also, Johnson continues to own a lot of stock – more than 900,000 shares (or in-the-money-options to buy stock).

In conclusion, I think that there is a lot of truth in Bill Ackman’s presentation, but I’m surprised at his unwavering confidence and his “$0″ price target for the shares.   It’s far from black and white that Ackman’s altering of definitions and revenue assignments is correct, and unlike a typical pyramid scheme, Herbalife has a product which is sold and consumed.  Might HLF’s growth slow as they saturate the market?  Absolutely – that’s true of every business, not just multi-level-marketing companies.   Is it patently obvious that Herbalife’s business meets the FTC’s definition of a pyramid scheme?  As I’ve attempted to show above, I think it’s quite far from as obvious as Bill Ackman wants it to be.

EDIT: I should also mention that there appears to be some confusion about the bottom line here. I’ve heard people ask “how can a company go bankrupt after 32 years?”  No – this isn’t about bankruptcy – it’s about whether or not the company’s business model is declared to be illegal (a pyramid scheme) and they then get shut down.   As I noted above, the “accounting” issues don’t change HLF’s bottom line, they alter the balance of revenues which are a key factor in the determination of pyramid scheme – or not.

CEO Michael Johnson’s stock transactions

FTC Letter on Pyramid Guidance

DSA Guidance on FTC Letter

-KD

disclosure: I am long $HLF and have bullish $HFL options positions.  All of my positions were established after Ackman’s allegations.   Readers should have no expectation that they will be kept up to date on my positions.

I do not and have never worked for Herbalife, and I am not a member of their network in any way, although if I were a member of their network, it should make you MORE inclined to believe me, not less inclined… I have considered becoming a distributor to see firsthand how it works, but I’m unlikely to do so.

 

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