March 26, 2013 - 11:30am EST by
2013 2014
Price: 37.55 EPS $4.05 $4.67
Shares Out. (in M): 112 P/E 9.3x 8.0x
Market Cap (in $M): 4,200 P/FCF 0.0x 0.0x
Net Debt (in $M): 154 EBIT 661 716
TEV ($): 4,354 TEV/EBIT 6.6x 6.1x

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  • MLM


Herbalife has been one of the world’s most-discussed stocks for the past few months, but much of that discussion is superfluous.  The decision to own or short Herbalife primarily rests on one question:  Will the Federal Trade Commission take action to shut it down.  The answer, in turn, rests primarily on a legal question:  Do Herbalife’s practices meet the FTC’s definition of an illegal pyramid scheme.  Among the scores of recent articles and blog posts about Herbalife, I have seen only a few that focus on this question and have not seen any that do so adequately.

We purchased Herbalife stock after its December decline for six reasons:

  1. The stock has 92% upside to get back to where it was immediately before the new regulatory fears started, and its value has grown since then thanks to business growth and substantial company buybacks of cheap stock.
  2. I can answer the legal question with a reasonably (but not completely) confident “no.”  Although my experience as an ex-litigator makes me more comfortable with the question, legal analysis is not brain surgery, and the analysis here is one that any intelligent investor can confirm for themselves.
  3. Other practical factors make FTC action unlikely.  (I discuss them near the end of this write-up.)
  4. Even if the FTC acted, it would likely demand manageable changes to Herbalife’s practices, not shut it down.
  5. Only 20% of Herbalife’s profits come from the U.S.  Herbalife is undervalued even assuming U.S. profits were wiped out.  (The actual likely outcome of FTC action would be a modest reduction in U.S. profits and a modest reduction in international profits as other countries took copycat actions, which combined would be less of an overall impact than zeroing out U.S. profits.)
  6. Carl Icahn recently purchased 14% of Herbalife’s stock, will act as a value-creating catalyst, has reduced the odds that leave-no-stone-unturned legal analysis produces a different answer, and may generate a short squeeze.

Bill Ackman’s latest attack, which compares Herbalife to a pyramid scheme that the FTC recently shut down, provides both a good opportunity to highlight the key legal issue and an easily-accessible set of  source materials.  When I read his new deck and the FTC’s court filings, I was surprised by how much the case hurts his position; the FTC's case focuses on pyramid scheme design components that are absent from Herbalife.  Ackman’s deck draws many superficial parallels to Herbalife but ignores those components. 

Ackman is often right and occasionally spectacularly right; we have profitably invested on the same side as him several times in the past.  In this case he has just shown his losing hand, if you know how to look.



I assume that everyone reading this piece is well aware of Ackman’s $1 billion short position against Herbalife and that most have at least skimmed his 334-page slide deck.  (His anti-Herbalife web site with this deck and all his other ammunition is factsaboutherbalife.com.)  You are also aware that Carl Icahn, Dan Loeb, and Robert Chapman have each purchased large chunks of Herbalife’s stock and very publicly proclaimed that Ackman is wrong.  Carl Icahn essentially said on TV that he both wants to make money and wants to hurt Ackman personally.  If you haven’t seen them, I recommend you read these excerpts from Loeb’s letter, Chapman’s write-up, and this interview of Chapman – for entertainment purposes if nothing else.



Analyzing Herbalife’s FTC risk requires only four legal precedents.  For ease of use, I also cite the FTC’s recent brief from its January case against a real pyramid scheme, FTC v. Fortune Hi-Tech Marketing, which Ackman has posted here.

The seminal decision distinguishing between an illegal pyramid scheme and legal multi-level marketing (MLM) came in the FTC’s 1975 Koscot prosecution.  The Commission wrote that illegal pyramid schemes “are characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to the sale of the product to ultimate users.”  (Koscot, quoted in FTC Brief at 24-25.)  The key for Herbalife is the final phrase: “the sale of the product to ultimate users.”  As the FTC’s Fortune High-Tech brief explains (on page 24), in a simple pyramid scheme, each new member makes a pure cash payment to those higher in the pyramid, in exchange for nothing other than the right to be in the pyramid.  Pyramid schemes disguised as legitimate MLMs – including the one in Koscot – often still have almost-naked cash payments for recruiting: a new member must pay cash to the company (rather than the higher-ups), and the company pays a (smaller) cash recruiting bonus to the member who signed them up, just for the act of signing them up.  In addition, participants “are frequently forced to buy products they would ordinarily not buy simply as a cost of participating in the business opportunity.  In such situations, it makes no difference in an economic sense whether people simply send cash to the people higher in the pyramid or if they pay money for products they do not really want – the end result is the same: the participants at the bottom lose money.”  These non-consumption purchases are called “inventory loading.”

In its 1979 decision in Amway (available here on the FTC’s web site), the FTC defined what have become safe-harbor defenses against claims of inventory loading.  Although Amway distributors were required to sell or purchase (for resale) specified amounts of product each month to qualify for recruitment rewards, the FTC held that Amway had proven it was encouraging actual sales to consumers rather than inventory loading by enforcing the following rules:  (1) Participants were required to buy back from any person they recruited any saleable, unsold inventory upon the recruit's leaving Amway.  (2) Every participant was required to sell at wholesale or retail at least 70% of the products bought in a given month in order to receive a bonus for that month.  (3) To receive a bonus in a month, each participant was required to submit proof of retail sales made to ten different consumers.  (Amway at 716.)

The court decision taking the hardest line against inventory loading was Webster v. Omnitrition (available here), which was decided by the federal appeals court in California in 1996.  It helps to have a legal background when reading this decision, because the case’s procedural posture is important.  The plaintiffs were disappointed distributors rather than the FTC.  The trial judge had granted summary judgment for the company prior to trial, which means it ruled that, based on the paper evidence submitted to the judge prior to trial, no reasonable jury could find that the company was running a pyramid scheme as defined by the FTC.  By reversing that ruling, the appeals court did not decide there was a pyramid scheme, only that the parties must go to trial and let a jury decide.

The facts in Omnitrition were fairly similar to Herbalife’s situation:  There was no fee to become a distributor.  Distributors had no sales or purchase quotas.  They had the right to buy products at a discount for either self-use or resale.  To become a “supervisor” who could receive recruiting rewards, they had to order minimum amounts of product each month.  The company had all three of the Amway rules intended to prevent inventory loading: the returns rule, the “70% rule” for product sales, and the ten-customer rule.

The appeals court held that these facts were enough for the plaintiffs to avoid summary judgment and get to a jury.  “The program is unquestionably not a pyramid scheme if only the distributor level is taken into account; the participant pays no money to Omnitrition, has the right to sell products and has no right to receive compensation for recruiting others into the program. The distributor level, however, is only a small part of the entire program. Taking into account the ‘supervisor’ levels, a reasonable jury could conclude the Koscot factors are met here,” because of the high required monthly product orders.  (Omnitrition at 782.)  The plaintiffs met their evidentiary burden two ways: “The mere structure of the scheme suggests that Omnitrition's focus was in promoting the program rather than selling the products.”  (Id.)  In addition, the lead plaintiff testified: “[T]he product sales are driven by enrolling people. In other words, the people buy exorbitant amounts of products that normally would not be sold in an average market by virtue of the fact that they enroll, get caught up in the process, in the enthusiasm, the words of people like Charlie Ragus, president, by buying exorbitant amounts of products, giving products away and get[ting] involved in their proven plan of success, their marketing plan. It has nothing to do with the normal supply and demand in this world.”  (Id.)  The company’s Amway-based rules were not enough to avoid trial, because “there must be evidence that the program's safeguards are enforced and actually serve to deter inventory loading and encourage retail sales.  In Amway, the ALJ made that crucial finding of fact, after a full trial.  Our review of the record does not reveal sufficient evidence to establish as a matter of law that Omnitrition's rules actually work.”  In addition, “plaintiffs have produced evidence that the 70% rule can be satisfied by a distributor's personal use of the products.  If Koscot is to have any teeth, such a sale cannot satisfy the requirement that sales be to ‘ultimate users’ of a product.  (Id. at 783.)

I have seen one analysis claiming that this final bit dooms Herbalife, and it might, if it were still good law.  But it is not.  In 2004 the Direct Selling Association, which is the MLM trade group, asked the FTC staff for an “Advisory Opinion” on how personal product consumption by an MLM’s members affected the pyramid scheme analysis.  The staff issued a lengthy response (available here):

[T]he amount of internal consumption . . . does not determine whether the FTC will consider the plan a pyramid scheme.

The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture.

A multi-level compensation system funded primarily by such non-incidental revenues does not depend on continual recruitment of new participants, and therefore, does not guarantee financial failure for the majority of participants. In contrast, a multi-level compensation system funded primarily by payments made for the right to participate in the venture is an illegal pyramid scheme. . . .

Modern pyramid schemes generally do not blatantly base commissions on the outright payment of fees, but instead try to disguise these payments to appear as if they are based on the sale of goods or services. The most common means employed to achieve this goal is to require a certain level of monthly purchases to qualify for commissions. While the sale of goods and services nominally generates all commissions in a system primarily funded by such purchases, in fact, those commissions are funded by purchases made to obtain the right to participate in the scheme. Each individual who profits, therefore, does so primarily from the payments of others who are themselves making payments in order to obtain their own profit. As discussed above, such a plan is little more than a transfer scheme, dooming the vast majority of participants to financial failure.

If an MLM does not charge membership fees and pays commissions based on sales and purchases rather than on pure recruitment, but has significant internal consumption, the question becomes simple, as Ackman’s original deck notes (p. 158): Why do participants buy the product?  If they buy primarily to qualify for commissions and don’t really want the product (inventory loading), the MLM is in trouble.  If they buy primarily because they genuinely want to consume it, the arrangement is fine, because the system is funded by that consumption, does not depend on continual recruitment, and does not guarantee financial failure for most participants.

Ackman’s deck highlights (on page 117) one more “legal” document that appears to help him the most but actually hurts him.  In 2009, the FTC staff wrote a brochure for consumers called “The Bottom Line About Multilevel Marketing Plans and Pyramid Schemes.”  It contained the following text in a highlighted box:

Yes, it’s a pyramid scheme!

      • Do distributors sell more product to other distributors than they do to the public?
      • Does the amount of money distributors make depend more on recruiting, (that is, getting new distributors to pay for the right to participate in the plan)?
      • Does the money made depend mostly on selling to other distributors than on sales of the product to the public?

If taken literally, this text means that all MLMs with significant internal consumption, even if genuine, are pyramid schemes.  That assertion is at odds with the much more authoritative 2004 Advisory Opinion that directly addressed the issue, and it contradicts the fundamental logic in 40 years of FTC discussions of MLM pyramid schemes.  And it is clearly not what the FTC believes.  The FTC pulled the 2009 paper off of its website.  (A Google search lets you call it up – from Google’s servers, not from the FTC’s.)  The FTC has replaced that document with the following web page, whose title is identical to that of the 2009 PDF file: http://business.ftc.gov/documents/inv08-bottom-line-about-multi-level-marketing-plans.  The current page replaces the erroneous text with the following more accurate assertion (emphasis added): “One sign of a pyramid scheme is if distributors sell more product to other distributors than to the public — or if they make more money from recruiting than they do from selling.”  The changes are telling.



Herbalife’s senior managers are not stupid.  They have had lawyers looking at the FTC rulings for 30 years, and they are headquartered in California where the Omnitrition case was decided.  Here is the system they have created, in simplified terms:

  • Distributors do not pay a material fee to join or stay active.  New members must buy a starter pack costing $55-91, which includes a meaningful amount of sample products.  Continuing members pay $15 per year.
  • There is no minimum monthly purchase requirement.
  • All distributors get a 25% discount off the suggested retail price when they purchase.  They get a 35% discount if they purchase ~$360 or more per month and 42% for ~$650 per month.
  • Distributors get no upfront reward for recruiting new members.  Those who sell more than $2,600 per month (“Sales Leaders”) get a 50% purchase discount and are eligible for royalties based on their downline’s purchases and sales.
  • A substantial number of distributors purchase products only for themselves and make no resales.  The precise number is not known – yet.  I say more on that immediately below.
  • Suggested retail prices for Herbalife’s products are far higher than for competing products.  However, given Herbalife’s distributor and discount structure, it is obvious that most end-use sales – including both internal consumption and to third parties – occur at less than the suggested retail price, probably substantially less.  Indeed, anyone who intends to be a regular consumer would be foolish not become a distributor themselves to get the discount, unless they can find an upper-level distributor with a bigger discount who is willing to sell to them for even less.
  • Herbalife employs all three of the “Amway rules” – allowing buybacks, requiring 70% of Sales Leader sales to be to end users (who can be distributors themselves), and requiring that Sales Leaders sell to ten customers per month.

The biggest numerical unknowns are how much consumption is internal and how many distributors are merely “discount buyers” or “wholesale customers” with no recruits.  The recent Herbalife financial markets drama began on Herbalife’s May 2012 earnings call, when David Einhorn asked for an internal consumption number and was told: “We don’t track that number and do not believe it is relevant to the business or investors.”  That brief exchange immediately dropped Herbalife’s stock price from $70 to $52, a drop from which it has never recovered.  Herbalife’s management continues to be not-stupid.  In light of Einhorn’s question, the question’s effect on the stock, and Ackman’s attack, management has realized that their best approach to counter pyramid-scheme charges isn’t to hide the internal consumption but rather to highlight it and show that it helps rather than hurts their legal position.  Last year Herbalife published a written answer to Einhorn stating that “the majority” of its distributors are discount buyers.  On its most recent earnings call, management announced:

In April of this year, we will announce name changes for how we categorize distributors and customers that will more clearly delineate the portion of her 3.2 million distributors who are in fact wholesale customers versus those who are active distributors or sales leaders. The goal of these changes is to have the categories more closely match the intent and the actions of our distributor base so that investors and the public can more easily understand our business.

In short: Herbalife is about to re-categorize a large number of “distributors” as “customers,” which will enable it to increase the amount of product sales that are visibly “for consumption” and increase the amount of active-distributor compensation that is visibly consumption-based.

Given these facts, Herbalife’s system is one that the Omnitrition court likely would have ruled could be considered a pyramid scheme depending on what a deeper factual record showed, but that the FTC’s 2004 advisory opinion explains is not a pyramid scheme, as long as most of the internal consumption is genuine consumption and not inventory loading.

So which is it?



For some factual digging into the actual practices that take place within Herbalife’s system, I can draw on my friend John Hempton, via our phone conversations and his blog posts.  John’s second post on Herbalife is his best in a long time, and he has had many great ones.  It completely changed my view of what it is Herbalife sells, the value it provides, and the likelihood that its internal consumption is real consumption.

John wrote in his first post that “Herbalife is mostly about ripping off distributors and people at the end of the chain.”  They are scumbags – “but they are scumbags working for stock market investors.”  Compare them to tobacco companies:  “Tobacco companies kill 5 million people globally per year - 400 thousand of them in the USA. Is anyone stupid enough to think the government would close them? That has been a bad short thesis for decades!”

That was mostly-correct but fairly conventional thinking among us contrarian value investors.  It is John’s next post that gets interesting.  The Ackman deck’s opening argument is that Herbalife primarily sells diet-drink powder that is no different than competing products but costs twice as much, which is a suspiciously terrible value proposition.  That is not accurate even on its face, given the huge discounts to distributors and the amount of internal consumption.  Much more importantly, Herbalife doesn’t only sell the powder; it helps its distributors set up “nutrition clubs” – tens of thousands of them all over the U.S. and tens of thousands more all over the world.  John took a field trip to one of these clubs in Queens.  Diet drinks have two important qualities: they end up working for a greater percentage of people than almost any other diet regimen, and most people find them nasty to drink.  It turns out that a nutrition club is

not a club selling diet drinks (but it clearly did that). It [is] a social support group necessary to drink diet drinks. These diet drinks work (especially when combined with a modicum of exercise). What happens though is that normal people do not have the will-power to maintain a diet drink and exercise regime. . . .   

I am a fairly disciplined person and - without social support I could not drink these shakes. In the richer-parts of our society we have a solution to diet-and-exercise will-power problem. We hire a personal trainer (usually someone cheerful, younger and good looking) and they cajole us into weight-loss. This is a “for-hire” personal support group. But Herbalife is another valid mechanism of getting personal support – and it clearly worked on the customers I saw. . . .

Herbalife works in the same way as alcoholics anonymous – by supplying (and in this case selling) a support group to help you kick the “fat addiction.”  Like Alcoholics Anonymous it has millions of members and looks – at least externally – a bit like a cult.  Herbalife like Alcoholics Anonymous has millions of members because it works. It does not work because one nutrition powder is better than another (indeed some nutritionists argue soy based powders are inferior). Herbalife works because of the support group.

My brief summary cannot do justice to John’s post, which is fairly long; you should read it yourself.  He concludes, “It was striking how totally Bill Ackman’s thesis fell apart from observing for just a few hours in a nutrition club” – or, for the rest of us, from reading John’s observations.  On first look Herbalife uses typical slightly-unsavory multi-level marketing techniques to push overpriced commodity products.  On second look Herbalife is indeed using those techniques, but to sell a differentiated product-plus-service that actually works and, with the distributor discount, is worth every penny to many of the people who buy and use it.

Although Ackman’s lead argument is that Herbalife’s products are suspiciously overpriced, based on the suggested retail price, he later offers impressively extensive research showing that you can buy these products online at a 30-40% discount for diet-drink powder and 50% for a health-drink powder – which, not surprisingly, brings the price almost exactly in line with that for competing powders.  His lead argument attacking the internal-consumption issue is to ask rhetorically, “Why would anyone pay $55 to get a 25% discount when Herbalife products are widely available online for discounts of more than 35%?”  The answer should already be clear to you from the nutrition club insights:  If you buy online, all you get is the powder, while if you become a nominal distributor, you also get the social support group.

That takes care of distributors’ motive for genuine consumption rather than inventory loading.  We can also look for more direct evidence of inventory loading – and Hempton did.  (I also did to a limited degree while on the phone with him.)  It isn’t there.  If the Herbalife system were full of failed distributors who had inventory-loaded, the world would be full of that unwanted inventory, and you would expect much of that inventory to end up being for sale on Craigslist and eBay.  But if you go look, that is not what you find.  Most cities on Craigslist have one or maybe a few listings, and those listings aren’t even for a specific product; they say some version of, “I’m an Herbalife distributor, contact me to buy Herbalife products.”  eBay does have a lot of product for sale – but not by failed low-level distributors.  If you click on the seller for almost any Herbalife product listing, you will find someone who (1) sells a lot of Herbalife products on eBay, (2) sells for a ~35% discount off suggested retail prices, (3) sells almost no non-Herbalife products, and (4) has been doing so for a long time.  These sellers are fairly obviously successful upper-level distributors using their 50% discount, not failed lower-level distributors.

None of this is to suggest that no Herbalife distributor ever inventory-loads.  I would be shocked if some distributors didn’t sometimes inventory-load to meet their sales-level quota.  Ackman provides one convincing example of inventory-loading by a distributor named Anthony Powell.  That would not be enough to make the entire enterprise a pyramid scheme.  Perhaps more importantly, why wouldn’t these “inventory loaders” resell that product on eBay?  There appears to be a readily available market for it, at a price that at least covers their costs.  Doing so probably violates Herbalife’s distributor agreement – but it also means the product is sold for genuine consumption and isn’t inventory-loading.  Routinely tolerated violations of an MLM’s rules can hurt it in the pyramid-scheme analysis, in the case of Amway defenses, but it can also help.



On January 24, 2013, the FTC filed a complaint against Fortune High-Tech Marketing and simultaneously filed an ex-parte motion for a temporary restraining order, asset freeze, and appointment of receiver.  An “ex-parte” motion is a filing without notice to the other party.  To paraphrase the motion: “Judge, these are bad people.  You need to let us swoop in, shut them down, and grab everything without warning to them, because if they get warning they will hide the money and destroy the evidence.”  The court granted the motion.

Ackman has posted a 15-page slide deck drawing 52 parallels between Herbalife and Fortune High-Tech.  I give credit to whichever Pershing Square analyst or Sullivan & Cromwell lawyer came up with that many items, but I can’t think of a way to characterize this deck other than “throw a lot of mud on the wall and hope something sticks.”  Most of the parallels ignore the key Herbalife issue; they range from irrelevant to unsupported conclusions to, at best, superficial indicia of a pyramid scheme.  Here are the first three:

  1. Page 3 shows Fortune High-Tech’s mission statement, which would be a perfectly acceptable statement for a legitimate MLM.  I’m not sure why it is damning for Herbalife’s mission statement to be similar and just as acceptable. 
  2. Most Fortune High-Tech distributors make no money; 88% of Herbalife distributors make no “gross compensation.”  (Page 4.)  That is a very curious “parallel” to choose.  “Gross compensation” here means royalty payments from the company based on a distributor’s recruited downline.  If most Herbalife distributors made all their money by selling product to non-distributor consumers and earning the margin between their discounted purchase cost and their resale price, they would earn zero “gross compensation,” and Herbalife would be the least pyramid-like MLM in the history of MLMs.  Of course, that isn’t what happens.  According to Herbalife, most of its “distributors” sell nothing and self-consume, which is also innocuous for pyramid-scheme purposes.  You can see why Herbalife has announced it will re-categorize these “distributors” as “wholesale customers”:  Doing so will help clean up the optics.
  3. Page 4 says that Fortune High-Tech has caused consumers hundreds of millions of dollars in harm – true – and Herbalife has caused billions in harm – false, unless someone proves Herbalife’s system is built primarily on inventory loading.

Other parallels address the key issue but assume away the key facts.  The fourth, for example (top of page 5), says Herbalife distributors earn ten times as much from “recruiting rewards as they do by selling to “bona fide retail customers.”  That is true only if a distributor who purchases for himself cannot be a “bona fide retail customer.”  Ackman assumes he cannot be; the FTC says he can.

Nowhere in this deck is even a glancing reference to the core facts about Fortune High-Tech’s system that made it a slam-dunk pyramid scheme case – all of which are absent from Herbalife’s system.  Fortune High-Tech’s new recruits were required to pay a $249 sign-up fee (lowered from $299 earlier); Herbalife has no sign-up fee, only a $55 starter pack that includes full-sized products. Fortune High-Tech distributors pay $249 annually to maintain their status; Herbalife distributors pay $15, or 6% as much.  Fortune High-Tech distributors who recruit a new member receive “at least” a $100-190 cash recruitment bonus, even if the recruit sells nothing; they get another $100-190 bonus when that recruit signs his own recruit, and so on all the way down to the bottom of a distributor’s downline.  The FTC calculated that these naked recruiting bonuses made up over 88% of the company’s compensation to distributors.  (FTC Brief at 29.)  Herbalife distributors get no up-front recruitment bonuses.

I said that, based on their history, Herbalife’s management isn’t stupid.  Fortune High-Tech’s management was stupid; otherwise they were so venal that they knowingly set up an illegal operation with a plan to suck as much money out of it as possible before it was shut down.  Their up-front recruitment fees, paid up to the company and then right back down to the recruiters, are the defining attributes of an old-school naked pyramid scheme.  The FTC’s 2004 Advisory Opinion noted, “[m]odern pyramid schemes generally do not blatantly base commissions on the outright payment of fees” – and yet these jokers did so.  As the FTC stressed in their Fortune brief, “The fundamental problem with the pyramid structure is that, inherent in its design, at any point in time and no matter what the size, most participants will be out the money they have contributed to the pyramid.  This inherent characteristic of pyramids – rewarding recruitment with no relationship to retail sales – inevitably leads to a situation where only a small number of participants can ever even recover their money.”  (FTC Brief at 23.)  The FTC highlighted this description from a Fortune High-Tech supervisor of how to make money: “’50 people join your team in a month, times $200, that’s a $10,000 check that month.  That $10,000 check that Fortune would send you has nothing to do at all with the usage of products and services.’”  (Id. at 32.)  And another one: “’you need to figure out a way to get a check from somebody every single day for $299,’ which was the enrollment fee at the time.”  (Id. at 33.)  The FTC’s senior economist noted in his declaration that “The vast majority of the accrued rewards . . . remain perpetually unfunded” by product sale profits.  Thus Fortune High-Tech’s “compensation plan is fueled by the failure of representatives, it is not because of the revenue their minimal sales have brought into the company.  It is because those representatives pay fees to sign up and have also paid for services that are necessary to run their business.”   (FTC Brief at 19-20.)



“Retail profit” versus “recruiting rewards.”  Herbalife’s accounting and presentations pretend that its distributors earn “retail profit” equal to the full suggested retail sales price minus the distributor discount.  That is false, given that most sales occur at lower prices and distributors must also pay non-trivial surcharges for shipping and handling.  Ackman’s deck spends 65 pages making various adjustments to Herbalife’s financials, using this and other insights to prove that the majority of the average distributor’s compensation comes from royalty payments rather than their resale gross margin.  It is an impressive piece of analysis but was, quite simply, a waste of his analyst’s time.  Ackman thinks the analysis is important because his favorite FTC statement, from the FTC’s Senior Economist who specializes in MLMs, says “the organization is deemed a pyramid scheme if the participants obtain their monetary benefits primarily from recruitment rather than the sale of goods and services to consumers.”  All of Herbalife’s royalty payments are directly based on the amount of product sold.  Whether labeled “recruiting awards” or “retail profit,” they are cash generated by “the sale of goods and services to consumers” – as long internally-purchased Herbalife products are genuinely consumed and not inventory loading. 

I am aware there are FTC statements suggesting the majority of distributor income must facially be from distributors’ direct resale gross margin or resale commissions and not from royalties based on their downlines’ sales.  It seems clear from the substance of the FTC’s analysis that it is unlikely to enforce this literal interpretation against Herbalife.  Even if it did, Herbalife should be able to make changes to comply.  It would not take much work to transform “wholesale buyer” purchases from the company, which generate royalty payments, into purchases from their upline distributors, which generate re-sale gross margin.

“Focused on recruiting rather than selling.”  The FTC uses a focus on recruiting rather than buying as one indicia of a pyramid scheme.  I have not focused on whether Herbalife even facially crosses the FTC’s line to create such an indicium, because if most Herbalife distributors are really wholesale buyers, then most Herbalife recruiting is recruiting of customers.

Overpromising to new recruits.  Even if an MLM is not a pyramid scheme, it can run afoul of the FTC by systematically misrepresenting to recruits their chances of making substantial profits.  (See, e.g., the FTC’s Fortune High-Tech brief pp. 12-21.)  Ackman’s deck is laced with quotes from Herbalife materials and management promising “the dream.”  I suspect that Herbalife overpromises to some extent.  Indeed, these portions of Ackman’s deck suggest to me that Herbalife is not a business I would want to run and, probably, its senior managers and millionaire senior distributors are not people whom I would want as friends or business partners.  I have not focused on to what extent Herbalife overpromises or on the FTC’s standards for taking action because it is not material to the investment case.  If Herbalife is a legitimate MLM and not a pyramid scheme, the FTC is unlikely to shut it down based on its corporate representations to recruits or on its policing of its distributors’ representations.  Instead, the FTC would require changes to the disclosures or the policing, and if that is all that happens to Herbalife, its stock price will rise.



Herbalife is an unlikely shut-down target even apart from the legal standard, for four reasons.

First, The FTC has looked at Herbalife repeatedly for decades and decided its practices pass muster.  There are no new facts to change that conclusion.  In my view the two most significant newer developments are the relatively recent advent of the nutrition clubs, which significantly strengthen Herbalife’s case against pyramid scheme charges, and Ackman’s impressive 65-page accounting forensics.  Those forensics could lead the SEC to require Herbalife to restate its financials, but if so the restatement would show the identical system profits as before and should be irrelevant to Herbalife’s business value.

Second, Herbalife enjoys at least some status as “too big to jail” – less than HSBC had in the face of its money-laundering or the entire upper tier of the financial industry had for its mortgage-related fraud, but far more than Fortune High-Tech.  It is a $4 billion revenue company with many thousands of satisfied distributors and customers who would be harmed by a shut-down.  It has spent years cultivating supporters in Washington.

Third, Herbalife’s business practices are not particularly unsavory.  Hempton compared Herbalife to tobacco companies that kill millions every year.  I will choose something closer to Herbalife: the for-profit education companies.  In summer 2010, Steve Eisman presented his own long slide deck detailing the unsavoriness of for-profit education.  Congress and the Department of Education took the bait, passed new laws and regulations, and helped erase 60-85% of the entire industry’s market capitalization over the next two years.  Like Herbalife, for-profit colleges companies offer a product (degrees) that genuinely helps many people.  But they also offered a number of worthless degrees and pushed them hard on disadvantaged consumers with no little regard for whether a recruit would benefit or was capable of succeeding in higher education.  Their victims wasted up to two years of their lives and were then saddled with tens of thousands in student loans they couldn’t repay, which often ruined their financial lives for many years.  One could directly observe the extent to which the colleges took advantage of students by noting the much higher default rates in their student loans compared to those for non-profit colleges. 

Herbalife’s failings pale in comparison.  Herbalife makes statements that, even if literally true, likely create in some portion of their recruits an unrealistically high expectation of how much profit they will make as distributors.  The system also probably causes some smallish subset of distributors to inventory-load such that they do squander money on unwanted product.  These effects seem inherent in any MLM, which the FTC has decided is not per-se illegal.  And the amounts of time and money lost are relatively low: dozens of hours, not thousands, and perhaps hundreds of dollars, not tens of thousands.

Fourth, Herbalife isn’t hurting the government directly.  The government hit for-profit education companies so hard in large part because it was the government’s money that these schools were flushing down the toilet (while also ruining their students’ financial lives).  Over 80% of for-profit school revenues are student loans made directly by the federal government.  When the schools pumped a program and a loan onto a student whom they should have known had a terrible chance of finishing, or for a program that they knew wouldn’t increase job prospects much, and the student later defaulted, the government was the one who lost money.  That must have greatly increased the intensity and urgency of the government’s scrutiny and been a huge thumb on the scale of how punitive the government was willing to be.



We typically build 10-year DCF-based price targets for the stocks we analyze.  We have not done so for Herbalife, because the upside is so obviously large and the downside risk cannot be plugged into a DCF calculation.  Stocks for companies like this – companies with a widely-known risk of value-reducing government intervention – tend to trade at some sort of a discount to what they would without that risk. An appropriate starting point for an Herbalife stock price target is the $72 it fetched immediately before David Einhorn’s famous questions.  Although my partner and I had never analyzed Herbalife before December, over the years we had seen several discussions of its potential legal issues; the $72 price presumably discounted some regulatory risk.  The price target must then account for the passage of a year’s time, over which the underlying business has grown value by at least another 10%, and to account for the company’s accelerated buybacks while its stock price has been cheap.  Once Herbalife survives the intense scrutiny of 2012-2013, its regulatory risk discount should fall below what it was before.  A nice round target price of $85 – which is 127% upside – requires only an 18% boost from the year-ago $72.  The resulting 15.5x multiple of consensus 2014 earnings is higher than the market’s but is probably justified by Herbalife’s higher growth and better cash flow characteristics, and by continued buybacks that will boost the consensus EPS number.  At the low end, one could take 15x 2013 consensus earnings and still get $70.35, which is 88% upside.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.


Carl Icahn
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