Smoke and Mirrors in the Herbalife Saga
One would have hoped that there was some lull in the Herbalife saga with the recent company conference. But no such luck. Perhaps with the same hook as reality TV, it continues to draw attention in a stage full of debt limits, Euro gyrations and Japanese monetary politics. Recently, a manager and blogger I respect, John Hempton posted his "Notes on visiting an Herbalife nutrition club in Queens". WSJ MarketBeat picked up the story headlining one of Hempton's claims as 'the most easily falsified bear-thesis I have seen' and I got sucked in.
Ackman may very well be wrong, but it’s clear that he's done his homework. And given the timeframes, he has had more time to do so than those who are more reactionary (Loeb, Hempton and the rest of the late-to-the-party players incl. myself). I'd venture that his research is more thorough than even Ann Coughlin's who was given company access. But hard work and correct answers are not always correlated (as a few of my old college grades can attest).
John Hempton’s post confuses many issues together. The three issues of interest are:
Is Herbalife a _illegal_ MLM scheme?
Is Herbalife a good buy for investors?
Does Herbalife have some value for society -- at least in the sense that any productive company does?
Clearly, the answer to #1 is the realm of FTC lawyers and perhaps the SEC has some stake in consumer protection (of investors). I am not a lawyer, but to my novice eyes it appears that the definition of an illegal scheme revolves around whether the revenues accruing to the company and to the "uplines" are more the result of sales or recruiting. Herbalife, I suspect intentionally, has tried to confuse the two. Its proposal to split out the consumption-only distributors will help greatly in making his assessment. It remains to be seen, though, how many become "special customers" to get a discount on a product that is no cheaper (and perhaps quite a bit more expensive) than a competing product, if no business opportunity dream comes attached? What is the price of a hug?
Ackman details his case on the fraud – I am not an expert here to judge but at least he has made a case. It doesn’t matter to regulators what social good a company does, if by the letter of the law, it runs an illegal MLM scheme. Lance Armstrong can hardly claim back his medals, regardless of however good of a person he is or what good he does for society if he broke the rules in winning his medals. The problem is not solved by merely calling negative P&L businesses “customers”. And on this point, I found the evidence in Hempton’s blog fairly light.
#2, on a fundamental level, is Herbalife a good buy? With Herbalife, we have come to a binary outcome because expectations of growth rates are clumped at two opposite ends. Its historical growth rates, buy-back strategy, cash-flows etc. are all irrelevant at this stage. If it turns out, either through regulatory action or via bad publicity, its "distributors" just don't buy and more importantly recruit others, the game is over. Herbalife’ s core business is about selling “hope” – the management knows this and even the founder knew this and it will last only as long as people believe and more importantly, regulators cooperate. But if, in fact, this is actually a tempest in a tea-pot (as has been in the case in the past accusations), and Herbalife can continue to put up the numbers and discover untapped markets, it is a screaming buy. It boils down to sustainability.
Even if turns out that Herbalife is exploiting under-informed masses but doing so without running afoul of FTC laws, it says little about its future prospect. And hedge fund managers, of all people, know that “exploiting information asymmetries” is quite legal and very profitable. The only question relevant here is whether the down-line will continue expanding and whether Herbalife can keep reaching into new markets for that “pop”. It may eventually run out, but “hope” is a very deep well and HLF may very well enrich investors for a long time.
But, whatever the answer about fundamentals, there is still the money that can be made from the technicals. This is a stock that is grabbing headlines, TV-screens and webpages, distracting as they may be when much bigger issues are at stake. The stock is hard-to-borrow. And float and short interest are both concentrated with a few players. Big swings will be the norm. An emotional retail base is mostly playing with leverage -- options, esp. on the short side (borrow, time structure of vol, IV all point to this). As this past Monday must have demonstrated to many ITM put holders, you can be right on the direction and go very wrong on technical flows come option expiration. But there is a lot of money to be made predicting technical flows correctly. I would wager that Loeb and Hempton are more in the latter camp than the former. I'm not sure that Loeb believes that HLF is a stock to be put away for children and grandchildren or even a "pick of the year", as much as he believes that Herbalife can survive long enough for him to be able to put a massive squeeze on the shorts.
The third question is interesting but rather peripheral to most professional investors. Whatever your ethical opinions, when you play with other people’s money, you are beholden not to your personal ethical feelings but to a fiduciary responsibility. Here is where I objected most to Hempton's post. One, John knows very well that Herbalife is not AA. AA does not charge people an entry fee for the social support it provides. It does not pitch one product and sell another. You cannot blame Ackman for being out-of-touch with low-income distributors in one breath, and with the other believe it’s no big deal for Herbalife to peddle its products for a $50-$100 (real money to low-income distributors) "entry-fee" alongside a story of Ferraris and mansions that these “business owners” have no chance of realistically achieving. Clearly, Herbalife products are not low-cost leaders. Herbalife itself doesn’t claim they are "cheap" even if they sell them primarily to a population that is normally very price-sensitive. So, it smacks of a noblesse oblige mindset to imply that it’s okay to overcharge or dupe unsuspecting parties in order to do them some good because they don’t know what’s good for them or are able to make best decisions on how to spend that money. If it is indeed exploitative, Herbalife can no more redeem itself socially on the “community service” and "hugs" card than Madoff could have by building hospitals and schools with his ill-gotten wealth. Herbalife has a much bigger obligation to play it fair and transparent with its distributors than it does to solve their health or social issues.
On the other hand, I find Ackman’s implicit or explicit claims about being a hero to the downtrodden equally superficial and self-serving. His fiduciary responsibility is to his investors and all the bravado would be for naught if he does indeed turn out to be right but loses money on the trade. He has no more of a right to spend his clients' money on social betterment than Herbalife does to try to improve its customers' health via deception.
There appears to be a fascinating game of poker between big-stake players and sadly, as often is the case with great games, with real lives and livelihoods at stake. While I understand Ackman's motivation in publicity once he made his bet, I do not understand opening the kimono so wide. Why reveal the form of the bet (no options)? I can even understand declaring that he will not cover – in essence making it a “Thunderdome” trade with only one winner. But why reveal your hand and size of your bet, other than to play hero to the CNBC crowds? With respect to legitimacy, he only needs to answer to the SEC. I even find rumors of Herbalife’s high-powered lawsuit far-fetched (the last thing Herbalife wants and the thing that Ackman actually wants is a bright light on Herbalife’s business model). I may be too poor a poker player to not know an ace up his sleeve (some SPV with borrow locked-up), but I fear that is more bravado and bluff and it will be hard for Ackman to withstand a big squeeze. The Feb earnings will start revealing the endgame and I, for one, can’t wait to get on with the next episode of “must-watch market-TV”.
Updated 1/17 9:00AM: Jim Chanos of Kynikos calls out the right question. But Herbalife has come so far because of a complicated pitch. "Hey, this is an expensive product, but look at the business opportunity you are getting for it." and "Oh, perhaps the business didnt work out for you but at least you are living a 'healthy lifestyle'." And it makes that pitch to people who often dont evaluate those two statements together. That is why you dont see Herbalife product piled up in garages. The downline "distributor/customer" buys an expensive product with big hopes, but once there are sunk costs, takes the next best option and consumes it.
