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A Matter of “When”, not “If” with Herbalife?

Today we had a call with Professor William Keep, an expert on Multi-Level Marketing and Pyramid Schemes, to further the discussion on Herbal (HLF). For a replay of the call CLICK HERE.


Professor Keep gave a very balanced presentation on the industry and outlined some important agency and company-level considerations, including that he believes Pershing Square’s “subtlety” has likely forced the hand of a government agency to look at the company.   That is completely consistent with our thinking.


He thinks that regulatory bodies were not prepared for Herbalife, and are now left holding a bag full of something that may get on them if there is another Madoff moment (failure to act). He notes that any potential agency will not be quick to act, there’s not a lot of capacity at the state level to prosecute these cases, and that Peter Vander Nat (head of the FTC tasked with MLMs) has prosecuted 15 cases and won them all.


Professor Keep suggested that the size of the industry and likely scope of any potential case against HLF won’t keep Pandora’s Box closed given the brightness of the spotlight shining on the situation.


He says that if there’s any investigation, it will take years. He cites Burn Lounge, a case that took 5 years and a significant expenditure of limited regulatory resources to prosecute, as an example. Further, companies like HLF will put up plenty of money to defend themselves as Amway did, spending $30MM + to defend itself across multiple states back in 1979.   


On company-level reforms and transparency Keep believes that MLMs could do a better job tracking retail sales inside and outside of the network. He believes this is currently possible and the only explanation for the lack of it is due either to laziness or for perceived gains through obfuscation.  Also, he sees that the need of regulators to better address incentive structures based on recruitment. Finally, he believes the industry shrouds reporting the numbers of active vs inactive distributors, and the distinction between the two, as areas for all companies to comply with to limit obfuscation.


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.


Robert  Campagnino

Managing Director





Matt Hedrick

Senior Analyst 


Takeaway: The Currency War is perpetuating mixed signals out of the KOSPI, which many consider a leading indicator for the slope of global growth.



  • The impact of the Currency War is perpetuating mixed signals out of the KOSPI, which many Macro analysts consider a leading indicator for the slope of global growth.
  • The fact that the KOSPI chart is not up-and-to-the-right as a pro-growth signal (itself perpetuated by declining prices for energy and raw materials inputs) doesn’t necessarily imply global growth is destabilizing.
  • Rather, it implies a loss of int’l market share among South Korean manufacturers and exporters to their Japanese counterparts amid the sustained trend of yen depreciation – which remains firmly intact.


Manufacturers of “capital goods” (using the Industrials and Tech sectors as proxies) account for 41.9% of the market capitalization of South Korea’s benchmark equity index (the KOSPI). That compares to 29.6% for Japan – South Korea’s chief regional competitor across a variety of key industries and export markets – which itself is also well above the regional average of 20.4%.






Over the weekend, South Korea’s newly appointed finance minister, Hyun Oh Seok, revived his nation’s concerns over JPY debauchery said that the G20 should revisit the issue. On just his second day as finance chief, Hyun firmly proclaimed, “The yen is depreciating while the won is gaining and this is flashing a red light for Korea’s exports… While we will do what we can, we need international cooperation to deal with the weak-yen problem.”


Hyun’s whining may fall on deaf ears, however, as Japan was able to escape any semblance of int’l censure of its Policies To Inflate at the last G20 summit. Because Japanese officials have been very careful in their rhetoric that their economic policy agenda is targeted at overcoming domestic headwinds and not for the sake of currency devaluation, G20 finance ministers are broadly on board with Abenomics – making it very hard for South Korea to find reprieve in the form of int’l censure(s).


Even if Japanese officials weren’t as adept at sidestepping int’l criticism, it’s unlikely the G20 has the political ethos to censure Japan anyway; the US, Eurozone and the UK have each taken multiple turns at being the world’s biggest money-printers and currency debauchers over the past ~5 years.




Net-net, that should continue to perpetuate a loss of market share among many South Korean manufacturers that compete head-to-head on price with their Japanese counterparts. In effect, Hyundai’s loss is Toyota’s gain in a world where consumer demand for automobiles isn’t necessarily robust.






All told, the impact of the Currency War is perpetuating mixed signals out of the KOSPI, which many Macro analysts consider a leading indicator for the slope of global growth. The fact that the KOSPI chart is not up-and-to-the-right as a pro-growth signal (itself perpetuated by declining prices for energy and raw materials inputs) doesn’t necessarily imply global growth is destabilizing. Rather, it implies a loss of int’l market share among South Korean manufacturers and exporters to their Japanese counterparts amid the sustained trend of yen depreciation – which remains firmly intact.


Darius Dale

Senior Analyst



Emerging Markets and the Dollar

Takeaway: Here's why equities markets in some emerging markets are struggling.

As the US dollar strengthens, many stock markets around the world are also moving higher, but they're not all headed in the same direction.


Equities markets in emerging markets that don't have pegs to the US dollar are seeing localized inflation, and are struggling. Equities markets that are commodities-linked, like Brazil, are losing ground, too. 


Emerging Markets and the Dollar - spx brazil  2

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Looking at LINN Energy

Takeaway: Here's a deep dive into LINN Energy and the company's accounting practices.

Energy sector head Kevin Kaiser digs into the accounting practices of LINN Energy LLC (LINE, LNCO) and comes up with more questions than answers.


LINE is a Master Limited Partnership (MLP), a tax-advantaged corporate structure that traditionally attracts individual investors looking for a mix of above-average yield and safety.  Oil and gas exploration and production (E&P) MLPs typically acquire and operate older producing oil and gas fields with low decline rate fields (approximately 10% per year).  These fields tend to throw off decent revenues and, since the MLP does not pay corporate income taxes, the company distributes excess cash flow to its unit holders.


These so-called “upstream” MLPs typically grow through acquisition of producing fields, rather than through exploration, which is an expensive and capital intensive process. Simply, E&P MLPs are in the cash flow business, and the MLP structure mandates them to distribute the majority (+90%) of their excess cash flows to unit holders.


Today there are 11 publicly-traded upstream MLPs in the US.  LINE is the largest with a $19B enterprise value.  Pro forma LINE’s recent acquisition of Berry Petroleum, the stock trades at ten times 2013 EBITDA.  LINE shares closed Friday at $36.40.  Kaiser says his analysis indicates the stock is probably worth about $15 a share based on multiple of cash flow and net asset valuation approaches.


Are E&P MLPs Over-Valued?

Oil and gas wells are, by definition, declining assets, and cash distributions rely on the MLPs ability to manage its properties to sustain stable production – an difficult task, as any oil company executive will tell you.  Kaiser believes the upstream MLP sector is overvalued and riskier than most investors recognize, but no company more so than LINE. 

Kaiser points to two key generators of cash flow: hedging and maintenance capex. 


In both cases, he says, LINE’s accounting practices appear nontransparent.  Kaiser re-calculated certain of LINE’s key cash flow metrics using more conventional accounting approaches and arrives at the conclusion that LINE’s distribution is not sustainable.  In the period 2006-2012, LINE paid out approximately $2.2 billion to unitholders.  During that period – according to Kaiser’s calculations – actual free cash flow was a deficit of  approximately $1 billion.  In short, distributions are paid with capital raises as opposed to free cash flow.  This cannot continue indefinitely.


Among key issues Kaiser raises are LINE’s accounting for their hedging.  The purpose of hedging is to offset fluctuations in revenues from their oil and gas properties.  LINE appears to be accounting for its options hedge strategy in a way that makes all put option transactions look profitable, and appears to be accounting for its hedge transactions as part of the company’s recurring cash flow. 


Finally, Kaiser says there are limits to how far a company can take its growth-by-acquisition strategy. MLPs buy assets when markets are strong, and often overpay.  Then they suffer in weak markets, making the group highly pro-cyclical – meaning it tends to rise and fall together with broad market trends.  Kaiser says LINE will need meaningful capital expenditures to maintain their cash flow stream.



LINE may be the tip of a very large iceberg.  Investors who are enjoying above-average returns from high-yield MLPs should look under the hood.  While it is too early to say this whole business model is in jeopardy, LINE looks like a company trying to stay ahead of the curve by taking advantage of a series of accounting strategies.  We do not mean to imply that there is anything improper about what LINE is doing.  It should be enough warning for investors that their books are not transparent. Accounting rules have been so distorted by Congress and lack of clear regulation that no one needs to break the law in order to pull the wool over investors’ eyes.



DRI: A Rare Opportunity

Bountiful, Low-Hanging Fruit


Darden’s core concepts, Olive Garden, Red Lobster, LongHorn Steakhouse, account for approximately 90% of the company’s consolidated sales and have average unit volumes of roughly $4.1 million.  Chili’s accounts for 83% of Brinker’s sales and produce average unit volumes of $3 million. 


On a trailing-twelve-month basis, Darden’s consolidated restaurant-level operating margins are 560 bps higher than Brinker’s. While part of the gap in restaurant-level operating margins can be explained by Darden’s large real estate position, it is interesting to note that Brinker’s operating margins are, on a trailing-twelve-month basis, 100 bps higher than Darden’s.  The money Darden saves by not paying rent is being spent on a fat corporate structure.  We think that fat can be cut by an activist either by straightforward cost-cutting measures alone or by reorganization or both. 



What About Scale?


Darden management has been exalting the efficiency-related benefits of a multi-brand portfolio for years.  If that were true, the company’s operating margins would be better.  However convincing, or convinced, Darden’s executives may seem when discussing the “economies of scale” of the business model, we do not see it in the numbers. 


Cutting SG&A is the best way to achieving the 10-11% operating margins that we believe are within the company’s capabilities.  On a trailing-twelve month basis, the company’s operating margins have been running at 7.7%. 


We estimate that cutting SG&A by $239mm on an annualized basis, or 28% versus current levels, would bring margins to 10.5%.


In our recent Black Book, we discussed a sum-of-the-parts analysis that suggested a $17 premium to the current share price based on a valuation of the company's chains and real estate. Combining this with the SG&A savings of $239 mm pretax, or $1.40 per share, implies $37 per share of potential upside available if the company is reorganized and SG&A levels are rightsized. 


This implies a 75% premium to the current share price.



DRI: A Rare Opportunity - dri big 3 chilis auv


DRI: A Rare Opportunity - eat dri rest levl marg


DRI: A Rare Opportunity - eat darden opmargins



Howard Penney

Managing Director


Rory Green

Senior Analyst



Today: Expert Call with William W. Keep on Pyramid Schemes and the Multi-Level Marketing Industry

The Hedgeye Consumer Staples team, led by Rob Campagnino, will be hosting an expert call featuring William W. Keep TODAY at 1:00pm EST entitled "Pyramid Schemes and Multi-Level Marketing."



  • Date: Monday, March 25th at 1:00pm EST
  • Toll Free Number:
  • Direct Dial Number:
  • Conference Code: 587456#
  • Additional reading materials: CLICK HERE



  • What is Multi-Level Marketing (MLM) and where does it come from?
  • What are the key factors that determine a pyramid scheme versus a legitimate MLM company?
  • Framing the industry's learnings from such pyramid schemes as Equinox, Burn Lounge and Fortune Hi-Tech Marketing
  • Discussion of the FTC's role in the industry
  • Contextualizing Herbalife moving forward




Keep is a professor of marketing at The College of New Jersey and currently serves as Dean of the school. His research and writings -- published in the Journal of Marketing, the Journal of Public Policy and Marketing, the Journal of Business Ethics, and The Chronicle of Higher Education, among others -- focus on long-term business relationships, business ethics, public policy and higher education. As a consultant he worked with a variety of firms and served as an expert witness in the prosecution of pyramid schemes, including Security Exchange Commission (SEC) v. International Heritage Inc., at the time the largest pyramid scheme ever prosecuted by the SEC. Keep has appeared on CNBC to discuss the topic of pyramid schemes, the MLM industry, and Herbalife and published articles on the subjects for CNBC and Seeking Alpha.


Professor Keep holds a PhD in Marketing from the Eli Broad College of Business at Michigan State University (MSU) and a B.A. from James Madison College at MSU in social science and economics.




Please email  to obtain the dial-in information for this call and a copy of the presentation, or to learn more about our research.




Rob has nearly 20 years experience in the industry and within the last 5 years on the buy side at some of the top hedge funds in the business, including Pioneerpath, Diamondback Capital, and Searock Capital. Prior, he was a senior equity analyst at Prudential Securities where he was consistently Institutional Investor ranked. Before Prudential he was at Sanford Bernstein as an equity research associate covering food, beverage, and retail. He began his career as a strategic consultant with PricewaterhouseCoopers. Rob has a MBA from Columbia and BA in Economics from Duke.



Hedgeye Risk Management is a leading independent provider of real-time investment research. Focused exclusively on generating and delivering actionable investment ideas, the firm combines quantitative, bottom-up and macro analysis with an emphasis on timing. The Hedgeye team features some of the world's most regarded research analysts - united around a vision of independent, uncompromised real-time investment research as a service.


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