This note was originally published March 25, 2013 at 16:12 in Consumer Staples
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).
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.