HLF: Where There is Smoke, There May Not be Fire, but There Will Be Firemen
We expect that someone, somewhere (SEC, FDA, FTC, or IRS) has to take a look at the company. Regardless of the merits of the position or motives of Pershing Square, the fire alarm has been pulled – the firemen will come, shiny red trucks and all.
When and if the negative news flow we anticipate does materialize, look out below.
We think the reaction of HLF’s stock to the news that the Federal Trade Commission was launching an investigation into Fortune Hi-Tech Marketing is a useful road map for what are the likely pitfalls of an investor trying to call an end to the Herbalife saga. On the day the market learned that the FTC took action against another company, HLF’s share price declined more than 8%, actually accelerating to the downside once it was clear that Herbalife was not the FTC’s target, as was originally speculated.
We believe that the opportunity to buy HLF for the long-term comes lower, during and after an agency investigation, recognizing that significant fines or some degradation of the company’s business model is the possible result. Pershing Square’s allegations may represent an inflection point in the company’s business model and momentum in the U.S. That doesn’t mean the U.S. business necessarily goes away, but what we could see is more focus on the sale of its products and away from the recruiting side as a driver of the business model, with a lower growth profile. Admittedly, investors’ focus has been gravitating away from the U.S. for some time, but keep in mind that one of the few things that the U.S. manages to export is regulation.
Not for the faint of heart
Bottom line, volatility and potential government intervention are not the friend of the fundamental investor. Fortunately, we have a model that allows us to trade the noise, and we defer to that model in the short term. We believe that the next data point will be a significant negative catalyst, therefore preferring to wait and observe what may be a lengthy process, with a more constructive view in the longer-term as the process unfolds. As that process unfolds and the company continues to buy back stock, we could be looking at a short squeeze that makes NFLX look like a little hug.
Clash of the Titans
It’s more than a little daunting wading into what has become a Wall Street version of Clash of the Titans – the Herbalife debate. We take heart in a quote from the Old Testament that the religious and non-religious among our readers will almost certainly recognize:
“And David put his hand in his bag, and took there a stone, and slung it, and struck the Philistine in his forehead…”
-1 Samuel 17:49
Thusly emboldened, we set forth with our hand in our bag, expecting what will likely be a target rich environment.
Is Herbalife a pyramid scheme?
Let’s get down to brass tacks -honestly, we don’t know whether it is or isn’t. We think there are some unsavory elements to the business, to be sure, but that leaves us well short of declaring the company a pyramid scheme.
We simply don’t have sufficient data to arrive at an answer. Pershing Square spent 18 months analyzing HLF and developing its short thesis and it still has missing data and holes. Let’s be clear here – we don’t think anyone outside the company currently has sufficient data to make a determination. That includes the funds that have lined up against Pershing Square. Aside from a lack of information, there wasn’t sufficient time for those funds to even begin to conduct the necessary research. Rather, we suspect the strategy was shorter-term in nature – relying on the reputation of the fund managers (much the way Pershing Square did when the short thesis was presented) in order to engineer a short squeeze, hurting an individual that it is abundantly clear they didn’t like on a personal level. Make no mistake; this is personal for some of the people involved. One only has to look online for the video of the personalities involved to see some of the absolute best/worst (depending on your taste for sublime slime) financial TV in recent memory.
We refer investors to comments that appeared on http://brontecapital.blogspot.com/2013/01/notes-on-visiting-herbalife-nutrition.html
“Bill Ackman a Harvard educated (magna cum laude) billionaire New York hedge fund manager bet over a billion dollars on a short position (imperiling his fund and his reputation) without checking the facts. And he did not check the facts because he was so rigid with a misplaced silver spoon that he could not stoop to sit on a subway for thirty minutes and talk with poor people for ninety minutes.”
Ninety minutes of conversation isn’t enough to prove that Herbalife isn’t a pyramid scheme. Ninety hours isn’t enough, nor is ninety days – unless those ninety days are spent with the internal financial statements of the company (a theory we suspect the FTC will test at some point). However, ninety minutes is a sufficient amount of time to get caught up in some common misconceptions as to what isn’t a pyramid scheme. For example:
- A multi-level marketing firm can’t be a pyramid scheme because it sells products and services
- Duration matters – a multi-level marketing firm that has existed for a long time can’t be a pyramid scheme because pyramid schemes collapse under the weight of the illegality, usually sooner rather than later
- A multi-level marketing firm that has a viable and efficacious product is not a pyramid scheme because it doesn’t need to be one.
Please don’t buy Herbalife on the basis of any of the above statements as they are all incorrect.
According to the 2004 FTC Staff Advisory, the "critical question" regarding what constitutes a pyramid scheme centers around "the revenues that primarily support the commissions paid to all participants." Specifically, what is the source of that revenue? If the primary source of the revenue is recruitment and upfront fees paid to join the system, then there is a problem. Again, with respect to HLF, we simply don’t have the information to make that call.
Does the FDA take a look at Herbalife?
Aside from the key investment controversy, we think that there is some risk that Herbalife may run into some issues with respect to making false claims regarding the products. The supplement industry has come under increased scrutiny by both the FDA and the FTC and false claims regarding product efficacy is one area beyond the issue of the primary source of revenue that may trip up the company and investors. More specifically, false claims may be made at the distributor level, with the company having little incentive or ability to reign in its distributors. Eventually (and we have no time frame for this outcome), we believe that the entire supplement industry will meet a stronger and more vigilant FDA and FTC. We do believe that the HLF likely isn’t the worst offender in the industry in this regard and that management does endeavor to make sure that only company literature is offered at nutrition clubs. In comparison, we believe the claims made by NUS distributors are more likely to run afoul of the FDA.
With respect to potential issues at the distributor level (and associated issues between the relative power of certain distributors versus the company) we point investors to a recent article.
“The more the money flowed, the stronger the relationship became between the informants and the traffickers. In one candid conversation, the traffickers boasted about who was able to move the biggest loads of money, the way fishermen brag about their catches. One said he could easily move $4 million to $5 million a month. Then the others spoke about the tricks of the trade, including how they had used various methods, including prepaid debit cards and an Herbalife account, to move the money.”
To be clear, we don’t for a moment believe that Herbalife management had, in any way, shape or form, knowledge of this. But with a large number of distributors with a high level of turnover, management’s ability to scrutinize the behavior of each distributor is more like a mall security guard than the Secret Service.
Does the IRS take a look at Herbalife?
Pershing Square spent a fair bit of time asking why there were so many “distributors” and not so many “customers”. Pershing Square was likely in the right church, but the wrong pew. Our understanding is that sales to distributors are not subject to sales tax, whereas sales to customers obviously are subject to sales tax. If we are correct, a concern for investors is that someone clever at the IRS (if anyone there fits the bill) decides to take a look at Herbalife.
What do we do with stock?
Well, we have the table set, so what’s for dinner? We have some data (other than common sense) to support our view that it is much more likely than not that some government agency takes a look at Herbalife. In our research, one of the experts that we contacted already indicated that that due to a recent conversation with the SEC he is not making any comments to investors or analysts about HLF.
We also think that there is a class warfare component here that the political class can’t ignore. It’s hard to set foot out the door these days without being bombarded by class rhetoric in one way or another. In this case, there is a very real issue with the income levels of the “average” Herbalife distributor and if there is a scheme here, it is very much regressive. We don’t think the SEC (for example) can afford to ignore the fire alarm (keeping with our metaphor) again as it did initially with the Madoff issue. Obviously, the SEC ultimately acted in that case, but we seriously doubt that the political class wants to be in a position to defend the notion of going after the guy that stole a lot of money from a relatively few wealthy people and ignoring the company that (possibly) is stealing a little bit of money from a whole lot of poorer people.
Picture this – Washington DC, 2015 - you are a staff attorney at the FTC, its 4:00 in the afternoon and you have just put in a half hour of overtime courtesy of the U.S. taxpayer. As you are walking out the door, your superior informs you that it has come to light (don’t ask how) that Herbalife was, after all, a pyramid scheme. The question now becomes why no one took a look at it way back at the start of 2013 when someone said, hey, this is a pyramid scheme. That is the textbook definition of a CLM (career limiting move). The go to move for government employees is usually CYA, which means that someone may decide to look into the company.
Therefore, we can’t abide being long the day that investigation (see our comments above regarding the stock reaction when Fortune Hi-Tech Marketing was investigated) is announced and since we consider it a high probability that the day comes, it is very difficult for us to have a bullish bias over the short to intermediate term. We are happy to defer to our models for trading levels on the long side in a name that is very susceptible to a short squeeze as weaker shorts get shaken out on random occasion.
As we are fond of saying at Hedgeye, bottoming is a process, not a point. Well, government investigations are a process as well and both sides will be paid by the hour. Herbalife recently announced that it has retained David Boies (of the law firm Boies, Schiller & Flexner LLP). He’s good, and likely bills out hourly at a rate that would pay the FTC enforcement staff for a day.
There is obviously a potential range of outcomes that it is impossible to handicap – from a clean bill of health to a finding that Herbalife is indeed a pyramid scheme.
What we are going to rely on here is some perspective from history:
- Having expensive lawyers is usually better than having government lawyers
- Government agencies are usually loathe to open up Pandora’s box – the investigation of an entire industry
- The appetite in general for the prosecution of pyramid schemes is not very large
- Herbalife may very well not be a pyramid scheme
- There may very well be issues with certain distributors
Bear in mind that volatility and potential government intervention are not the friend of the fundamental investor, and we believe that the next data point will be a significant negative catalyst. Therefore, we prefer to wait and observe what may be a lengthy process, with a more constructive view in the longer-term as the process unfolds.
Good luck with earnings,
HEDGEYE RISK MANAGEMENT, LLC