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Herbalife : A Ponzi scheme scandal

04/03/2013 | 11:09am US/Eastern

Herbalife, a company founded in 1980 and specialized in the sale of nutrition, weight management and skin-care products, is currently at the heart of a scandal which reminds us the Madoff case.

The firm’s business is based on a MLM system (Multi Level Marketing), the same which made the success of Tupperware. The principle is easy to understand: distributors are recruited among the general public, then these people sell their products to their families and friends and hire them, as well, as resellers. They have to spend 400 dollars to buy a first product pack in order to start their activity, according to a distributors interviewed by the Wall Street Journal.

Thus, the group is accused to make the majority of its sales through the recruitment of new staff, and not thanks to the sale of slimming products, what would make Herbalife’s activity a Ponzi scheme.

William Ackman, founder of the highly successful investment fund Pershing Square, has protested in December 2012 against the practices of the company and announced he had short sold for the modest sum of one billion dollars, saying the actual value of the Herbalife’s share was zero dollar. Indeed, we have learned in the New York Post the Federal Trade Commission (FTC) might have started a “law-enforcement investigation” into Herbalife (however the firm asked a correction to the journal and denies the information). Mr. Ackman has defended its position in a 342 slides oral presentation in Manhattan: he affirms that Herbalife sells its nutritional powder, which represents 27% of sales, twice the competitors’ price in average and its multivitamins, the triple. He adds that these products have no competitive advantage, R&D expenditures being very low. Thus, it is unlikely that the firm manages to sell its products to actual customers, and that revenues may come in major portion from purchases made by new distributors.

Carl Icahn, Bill Ackman’s historic adversary with whom he has had several financial disagreement, announced on 14th February, after having heavily argued with Ackman on U.S. medias, that he has invested in 13% of Herbalife’s capital. Hard blow for Bill Ackman, which sees the share skyrockets and which is now in a very bad situation with its billion dollars short sell.

Icahn is not the only one to support Herbalife and to contradict the Persing Square’s boss. One of the Bronte Capital’s managers issued a note in January in order to discredit the William Ackman’s theory: “Bill Ackman’s thesis is the most easily falsified bear-thesis I have seen from a major hedge fund ever”. The editor said he went visiting an Herbalife’s nutrition club in Queens and realized that most customers were as well distributors, but principally in order to get a 25 percent discount on products they buy. Above all, he notes while discussing with customers and owners of the club the obvious presence of a community’s spirit which helps users in their efforts to lose weight. He adds that the strength and the wideness of the community are possible thanks to the Multi Level Marketing.

This Bronte Capital’s manager, contracts the arguments of Mr. Ackman point by point:

- Competitive advantage, absent according to the Mr. Ackman’s thesis would be, actually, the community support provided by Herbalife’s products: “Herbalife is sold with a community support mechanism. In Central Park anyone can go and have a run. It is free. It costs you $20 an hour if you exercise with a personal trainer”, the value of Herbalife’s products would come therefore from the support provided by the community.

- Ackman notes the lack of advertising spending and therefore the incapacity to maintain such prices. The editor responds: “Herbalife has the best advertising possible – word of mouth”.
 
- The main argument of Bill Ackman is that the real Herbalife product is not a physical item, but actually a business opportunity proposed to customers who appear to be, in fine, distributors. Its detractor agrees with him that many customers are resellers, but also states that they clearly are consumers of the product, as he notes in the club visited in Queens.

The note concludes: “Bill Ackman (…) bet over a billion dollars on a short position without checking the facts”. Mr. Ackman did not go see what was happening on the ground, but it seems a little bit pretentious to claim to have invalidated the Ackman’s theory using as argument an example of a single Herbalife’s point of sale. Nobody can confirm that the findings identified in the club, are true everywhere else.

Anyway, it is very difficult to predict the outcome of the Herbalife’s case. It is therefore best to stay away from this security before we get answers to our questions. Indeed, only convinced investors remain committed in the stock, generating as a consequence an extreme tension on the share. One day or another, one of our two investors will withdraw its position, causing a collapse or a surge in prices, depending on the case.

Herbalife' stock chart (candles in daily data):



Mr. Ackman will be named winner in case of a decision of the Federal Trade Commission defining the Herbalife’s activity as illegal. Only problem for Ackman: the FTC did not want to confirm that an investigation was actually ongoing, without refuting. As shown by the graphic of the Herbalife’s stock, prices are forming a configuration in triangle which ends in mid-April. It seems likely that, in the absence of a decision from the institution or new revelation, the scandal gradually disappears by itself, sellers lose hope and buyers strengthen sending back prices towards new annual highs, even historical records.


© 4-traders.com 2013
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