Hedgeye’s Head of Consumer Staples sector research, Rob Campagnino, and Senior Macro Analyst, Matt Hedrick, co-hosted a conference call today for our institutional clients, featuring Dr. Jon Taylor, an academic expert on multi-level marketing and pyramid schemes. Dr. Taylor has taught business at the university level and is a consultant to a broad range of clients on topics including multi-level marketing (MLM) and direct selling models. Dr. Taylor has authored numerous articles and books on multi-level marketing and has analyzed over 500 MLM companies.
Dr. Taylor says illegitimate pyramid schemes share certain basic characteristics:
- They set aside the basic laws of economics. Pyramid schemes don’t make money from selling products. Instead, they depend on unlimited recruitment of an endless chain of new salespersons. Gullible “down-line” distributors are their “endless virgin market.”
- Those at the top recruit distributors with promises of lifetime revenues from their own “down-lines.” Products are overpriced, and always contain some “secret ingredient” or unique characteristic that you can only obtain by buying through the MLM channel. The unrealistic promise of lifelong wealth is the single biggest selling point – which is why pyramid schemes flourish during bad economic times.
- On average, 99% of participants / distributors lose money. They don’t complain to the authorities because (a) they feel stupid, and (b) by the time they realize they have been swindled, they have also swindled most of their family and best friends.
- Pyramid scam companies fudge their financial reports. Expenses and losses are incurred by individual distributors, so they never appear on the corporation’s books, making the companies look highly profitable – which they are, for a select few insiders.
What does this mean for Herbalife stock?
Herbalife is not for the faint of heart. People are plenty jittery around this name. Uncertainty leads to increased volatility, and lower stock prices, which means a nervous market is a self-fulfilling prophecy.
Consumer Staples head Campagnino notes that the FTC just announced it is investigating Fortune Hi-Tech marketing, another MLM company unrelated to Herbalife. Herbalife shares dropped 8% on that announcement. With all the noise in the media, Campagnino says regulatory agencies – the FTC, and possibly also the SEC, the FDA, or even the IRS – will have to look into Herbalife. When that happens, Hedgeye thinks the stock will drop in price.
But, cautions Hedgeye CEO Keith McCullough, it’s what we call a binary outcome: either Herbalife is a scam, or it’s not. If it’s a scam, it gets put out of business, in which case Game Over. If, on the other hand, the regulators give Herbalife a clean bill of health, then price weakness could represent buying opportunities. And it gives Herbalife management lower prices to buy back their own stock in the open market, raising the likelihood of a Short Squeeze in their battle with Bill Ackman (see Hedgeye definition here: What Is A Short Squeeze?)
Dr. Taylor cautions that, even if the FTC were to come after Herbalife, what he calls the “pyramid scheme lobby” in Washington is so strong, the worst outcome would most likely be a token fine and a requirement that Herbalife write stronger internal rules to protect their down-line distributors. Note that we said “write” stronger rules, which is not the same as “apply” stronger rules. Regulators typically take a cash settlement and force the company to make administrative changes. We think it is unrealistic to expect any individual to be charged with wrongdoing.
Finally, Dr. Taylor points out, other pyramid scheme companies have shut down their US business, yet continued to flourish in overseas markets, where consumers are just as gullible, but where consumer protection laws are much more lax and where there is no strong tradition of an investigative press. Says Dr. Taylor, some of the world’s most successful pyramid scams have left the US, never to return.
What’s Hedgeye’s bottom line?
Says Hedgeye’s Campagnino: we can’t know whether Herbalife is an illegitimate pyramid scheme. Ackman’s team has spent 18 months analyzing HLF, and their short thesis still has missing data.
That said, Campagnino believes it’s highly likely that some government agency will take a look at the company soon, which will cause a drop in the stock price – maybe a big drop.
There’s also a “class warfare” component: pyramid schemes prey on people who are economically vulnerable – folks who are out of a job often flock to such businesses, drawn by the promise of a life-long stream of income. In this environment it is politically compelling for government agencies to make a big show of investigating Herbalife. We note that Herbalife has just retained rock-star corporate defender David Boies, one of the most expensive attorneys in the world. This could make for quite a show, and we think ultimately the government will have neither the stomach, nor the resources for a fight. We’re in for a long period of confusion and, unless a very large Smoking Gun surfaces, Herbalife may ultimately walk away unscathed.
Right now, Herbalife may be high drama, but it is not an investment we can recommend. We believe this could be a lengthy process, one which we are watching closely. Campagnino will be providing updates as the story unfolds.