Sucking the Life Out of Herbalife

Editor's note: A previous version of this article referenced a New York Post article that was later found to contain false information. This article has been updated to reflect new information. The Fool regrets the error.

Ever since hedge fund operator Bill Ackman revealed his massive short position on Herbalife (NYSE: HLF  ) back in December, the dietary supplements makers has battled the demons that always hover on the shoulders of multi-level marketing companies: Is it really just a pyramid scheme?

Everybody in the pool!
The problem many MLM companies have is the numbers don't add up, or rather can't support the weight of reality. To grow, they have to keep reeling in more people to support the ones above. You bring in two friends to sell, then each of them brings two friends in, and like the 1980's Faberge shampoo commercial said, "and so on and so on and so on." After a while, though, there aren't enough people on the planet to support the structure, and it collapses.

Herbalife contends that it is somewhat different in that its distributors can also be its clients. While that's a hallmark of virtually all MLMs, from Nu-Skin Enterprises and Amway to Mary Kay Cosmetics and even Tupperware (NYSE: TUP  ) , the supplements maker also says it never really tracked retail sales before, but Ackman's charge it has few if any customers outside its distributor lists is wrong.

Tupperware, on the other hand, distinguishes itself because most of its end users aren't also recruited to sell the product. The plastic container maker says 90% of the people who buy Tupperware products don't sell its products compared with only 10% of its users who are distributors too. In contrast, some 30% of Herbalife distributors are self-consumers.

Inquiring minds want to know
The debate around Herbalife intensified on Monday after the Federal Trade Commission disclosed, through a Freedom of Information request by the New York Post, that the company was subject to a law enforcement investigation. Enlightened shareholders ran for the exits, only to learn later in the day that that it was a mistake by the FTC, and that an investigation was not really underway.

While it didn't turn out to be true, it's clear that a future criminal investigation would undermine the position of another hedge fund manager, Third Point's Daniel Loeb, who bet big with the supplements maker shortly after Ackman's short position was publicized. He stated it was ridiculous to think the FTC would shut down Herbalife and his stance in favor of the company -- along with his 8% stake -- helped the stock regain all the ground it previously lost. Even the mano-a-mano CNBC matchup between Ackman and billionaire investor Carl Icahn -- which made for great theater as they traded barbs and insults two weeks ago -- had the stock briefly rising 6% above the previous day's close.

Yet when the FTC moved in and closed down a different MLM scheme last week, Herbalife's stock has turned tail, falling 20% in the week because it hit so close to home. Echoing another of Ackman's charges against Herbalife, Fortune Hi-Tech Marketing is accused of misrepresenting the business opportunity the scheme presented. Rather than fabulous wealth, distributors often found themselves up to their eyeballs in debt.

Other multi-level marketing companies are also finding it hard to remain buoyant, with Nu-Skin down 8%, Usana Health Sciences down 7%, and Medifast tumbling 12%. Tupperware's stock, in contrast, is up 10% over the past week.

Stay on the sidelines
While a new law enforcement inquiry turned out to be false, there are still others to be aware of from the SEC and FTC. At this point -- it's probably wise to stand on the sidelines and watch the drama unfold. Let the Ackmans, Icahns, and Loebs go at it as they've got money to burn if their bets are wrong. For the average investor, letting Herbalife exorcise its demons first is a more prudent course of action. You may not get in at the absolute bottom, but it also prevents your portfolio from getting handcuffed because you moved too early on a stock that turned out to be possessed.

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