Herbalife Defends Itself Against Pyramid Allegations. But Does the Market Believe?

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One of the more entertaining spectacles in the financial world this past month has been the recent battle between hedge fund manager Bill Ackman and nutritional supplement company Herbalife. The multilevel marketing (MLM) firm came under serious pressure late last month when Ackman put a massive $1 billion short bet on the company, following a high-profile, three-hour presentation during which he accused Herbalife of being nothing more than a complex pyramid scheme that would either collapse under the weight of its own fraudulence or fall apart due to regulatory action by the Federal Trade Commission (FTC).

Since that time, several high profile investors have lined up on the side of Herbalife — not necessarily endorsing Herbalife’s business model as completely ethical, but arguing that the firm is selling real products to real people and that it doesn’t face the risk of any regulatory intervention. And yesterday, Herbalife itself weighed in with a two-hour-plus presentation of its own in which it picked apart some of Ackman’s presentation and generally argued for the financial strength of the company.

In my opinion, Herbalife failed to put Ackman’s critique to rest. The market was also unimpressed, as Herbalife’s stock actually fell on the day by 1.78%.

Ackman’s argument is long and complex, but its basic contours are as follows:

  • Herbalife compensates its distributors mainly for recruiting other distributors, rather than for selling products. If true, this would make Herbalife a pyramid scheme practically and by the FTC’s definition.
  • Herbalife has only grown by entering new markets. Each time it enters a new market it experiences a “pop and drop,” in which rapid revenue growth is followed by a steep drop in sales.
  • Therefore Herbalife’s growth cannot continue forever. Once it exhausts new markets, it will collapse — if, that is, the FTC doesn’t shut it down first.

Herbalife did manage to poke holes in some of Ackman’s critique, but by no means did it provide a point-by-point, definitive rebuttal. While Ackman explained in detail how he arrived at his determination that over 90% of distributer compensation is derived from recruitment, Herbalife didn’t offer an alternative analysis, or alternative figures for what percentages of compensation comes from recruiting and sales.

When it comes to the “pop and drop” argument, Herbalife did not address the statistics that Ackman presented, which showed that when Herbalife entered countries like Japan, Germany, France, and Russia, its retail sales initially spiked and then fell. Instead Herbalife presented a different set of statistics, which said that 92% of  Herbalife’s 2012 “volume points” came from markets it entered more than ten years ago. If this is true, why not address Ackman’s country-by-country claim head on? And why use obscure, internal statistics like “volume points” to make your argument? Why doesn’t Herbalife measure its performance in dollars or Euros like any other multinational corporation? I understand why Herbalife would want to present the best possible picture, but by not directly addressing the statistics Ackman presented, it only raised further suspicions.

The third point Ackman makes is that he believes Herbalife will collapse on its own or face FTC regulatory action. Herbalife responds that a court has only once declared it to be a pyramid scheme, and that was a case in Belguim that is currently under appeal. Ackman had noted that a judge in California found Herbalife to be a pyramid scheme before dismissing the case on procedural grounds. Herbalife does not give an alternative reading of this case, however, so why not believe Ackman’s interpretation?

On the other hand, Herbalife did succeed in convincing me that there are many people across the country who enjoy and value its products. But the fact that Herbalife sells products that some segment of the population values does not mean that its business model is sustainable, or that it’s not in danger of an FTC crack down.  In theory, Herbalife could be a company with legitimate and valued products that is using the tactics of a pyramid scheme to artificially inflate its performance.

Ackman himself said in a statement that he will be releasing a series of questions in response to Herbalife’s presentation. Meanwhile, I’m still not ready to draw any conclusions — but I do think Herbalife should have done a better job addressing Ackman’s concerns.