Herbalife Shares Could Become Worthless Within One Year

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In a letter to his investors released Tuesday, hedge fund manager Bill Ackman argues that shares of Herbalife (NYSE: HLF  ) could become worthless within a year.

Brushing off the criticism that has plagued his position for the last eight months, Ackman provides a detailed argument as to why Herbalife shares are set to collapse.

"The probability of...regulatory intervention has increased materially"

As I've said before, if Herbalife shares are going to $0 (Ackman's price target) it will be due to regulatory action. If the company is, as Ackman claims, running a pyramid scheme, the SEC or FTC could shut the firm down, seize its assets, and wipe out its shareholders.

In the letter, Ackman writes that he has reason to believe that the probability of forthcoming regulatory action is likely, but does not say why, writing that "we are not at liberty to disclose the nature of these developments." He does, however, put a timetable on the possibility of such action. Earlier in the year, the FTC shut down Fortune Hi-Tech Marketing, a multi-level marketer deemed a pyramid scheme by regulators.

Ackman notes that it took two years for the FTC to shut down the company, after a lengthy investigation process. Yet, he believes that any action taken against Herbalife (should it take place) would occur far sooner given the heightened scrutiny surrounding the company.

Ackman first accused Herbalife of being a pyramid scheme last December, exactly eight months ago. In another year, it will be 19 months -- just short of two years. Therefore, if regulators are going to act more swiftly against Herbalife than they did against Fortune Hi-Tech, investors could expect a regulatory event within a year.

A confidence game

Ackman also argues that Herbalife as a company is very dependent on the confidence of its distributors. As roughly 90% of new Herbalife distributors give up at the end of one year, the company has to recruit some 2 million new distributors every year to keep its business going.

Moreover, existing distributors have to continue buying thousands of dollars worth of product each year in order to qualify for referral bonuses. Therefore, confidence in the company's product and the firm's business opportunity are of the utmost importance.

Since Ackman's attacks, Herbalife has adopted new policies that make life harder for its distributors. Some top distributors, like Shawn Dahl and Anthony Powell, have defected.

At the same time, there are questions surrounding the quality of Herbalife's products. A former Herbalife employee has come forward alleging that the company has, in the past, violated safety regulations in the manufacturing of its products.

The MLM industry in the crosshairs

If Ackman is ultimately proven right and Herbalife is shut down, it should reverberate through the entire multi-level marketing space. Most of the big MLM firms, like Amway, are private, but others, like Usana (NYSE: USNA  ) and Nu Skin (NYSE: NUS  ) , are publicly traded.

While Herbalife has had a good year (shares have nearly doubled in 2013), both Usana and Nu Skin have outperformed it, each rising more than 130%.

As I've written in the past, criticism against the MLM business model is widespread, and yet most of the big name companies have persisted, untouched by the US government. But shutting down Herbalife, one of the biggest companies in the sector, would send a message that the regulatory environment has changed.

Should the FTC take action against Herbalife, investors will likely project the effects onto shares of Nu Skin and Usana, too. Although Ackman has never once mentioned those firms, shares of both companies plunged last December following Ackman's original Herbalife presentation. Their recent recovery has paralleled the rise in shares of Herbalife. 

If Ackman is right about Herbalife, expect a similar recurrence. However, if regulators fail to act, both stocks appear to be solid investments.

Usana beat earnings expectations each of the last four quarters, particularly last quarter, when it absolutely crushed expectations ($1.72 per share against a $1.30 estimate). Despite shares rising 136% year-to-date, the company remains cheaper than the broader market, trading with a price-to-earnings ratio near 14. Analyst Tim Ramey at DA Davidson raised his price target on the stock to $92 last month, suggesting that shares could have further upside of about 16%.

Likewise, Nu Skin has also been crushing earnings estimates in recent quarters. But more importantly, it's been returning that cash to shareholders in the form of a large stock repurchase program. Earlier this month, the company announced that it would boost its share repurchase program by $400 million -- roughly 8% of the company.

Nu Skin isn't as cheap as Usana--with a P/E ratio near 22, it's more expensive than the market. Still, analysts remain bullish -- JP Morgan raised its price target to $97 earlier this month, suggesting a 13% upside from current levels.

Investing in Herbalife

Given that Ackman has taken a bath on his J.C. Penney position, and Herbalife shares having appreciated so significantly, some investors might have expected the activist hedge fund manager to cover his short.

But they'd be wrong.

In his recent letter to investors, Ackman actually appears more confident in the trade than ever before.

Ultimately, it will come down to a question of regulatory action -- will the FTC shut the firm down? Ackman believes it could happen in the near future. If that's the case, it wouldn't be wise to hold Herbalife shares -- or the other multi-level marketing firms.

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Read/Post Comments (12) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 22, 2013, at 2:36 PM, Mjpbfool wrote:

    Even if there would be regulatory impact, North America (not just U.S.) accounts for less than 21% of all sales. Much of the growth opportunities Herbalife has created are located in South America and Asian economies. Even without sales in North America, the company is still a cash flow machine.

    The example you cited was FHTM, a company that has been around since 2001, while Herbalife has been around since 1980. They've met with the SEC and FTC countless times... so what makes this time any different?

    If your entire investment thesis is based on the U.S. government declaring a company that has been around for more than 30 years an illegal pyramid scheme, you're in for a world of hurt. In the meantime, the company trades at a discount to market (P/E of 14) and the cost of borrowing shares to short is only going to continue to rise at these levels.

    If no regulatory actions take place before the end of 2013, it will be interesting to see if Pershing's investors start to redeem (given that the fund is severely underperforming both the S&P and Nasdaq). If that's the case and Ackman has to choose between maintain his firm's solvency or looking foolish publicly, he would probably have to start buying back shares of HLF, which would trigger an insane short squeeze.

    People in the media act like Ackman is the only one who has lawyers looking in to this. I would guess that Icahn and Soros, two of the most famous investors of the last 30 years, have done their due diligence and have looked in to Ackman's legal claims as well. While you may not want to hold long, I would be much more petrified of shorting.

  • Report this Comment On August 22, 2013, at 3:10 PM, Dadw5boys wrote:

    Strange pump and dump in reverse. Goes to show you if your rich enough and can get media exposure you can drive a business into the ground. Demoralize the employees and customers with media ?

  • Report this Comment On August 22, 2013, at 3:17 PM, Tedwanker wrote:

    Greater Stooge Theory. At some point 90% of the Stooges are left holding the bag. They have to find 2 million new Stooges every year. How is this a business plan ? So they are finding most of their Stooges internationally, that still doesn't make it right. If it was private that would be one thing, but real live investors supposedly protected by the SEC are going to also become Stooges when the house of cards falls.

  • Report this Comment On August 22, 2013, at 9:04 PM, robertw4772 wrote:

    Ill bet you dinner and the Bill Ackman that HLF will not be zero in a year. It will be higher than where it is now. Anything else is sheer stupidity. And I am not long this one BTW. Motley Fool for sure. Just an article trying to get hits. When is the last time Soros, Icahn and those guys had a stock go to zero that they just bought? Anyone?

  • Report this Comment On August 22, 2013, at 11:19 PM, grahamsway wrote:

    Hey, anything can happen but Ackman's analytical reputation certainly seems more damaged than Herbalife's reputation about now.

    I'm out of Herbalife now but here's why I thought Ackman might've been wrong back then:

  • Report this Comment On August 23, 2013, at 2:48 PM, healthybody wrote:

    Ackman was hoping to bluff investors again, but it didn't work - HLF dropped only about 5% on his letter - lots of info that doesn't amount to a hill of beans.

    The smart money is jumping on board the mother of all squeezes happening right NOW!

    Ackman’s “argument hinges on the idea that too much of their sales are in the inside crowd,” or distributors, “rather than outside crowd,” said Ramey. “The problem with that argument is that there are 3.2 million official distributors but only 300,000 behave like small businesspeople. The rest are discount buyers.”

  • Report this Comment On August 23, 2013, at 5:50 PM, Textextextextex wrote:

    A financial rape everyone should be aware of is the Amway Tool Scam. Google "Stop The Amway Tool Scam Wordpress" for more information, and forward this to every non-Distributor/IBO you know, so they don't get financially raped.

  • Report this Comment On August 24, 2013, at 7:09 PM, Gotbones2 wrote:

    Hitler was a propaganda genius. He lost not only the battles but the war. There is allot of propaganda here by non other than Bill Ackman!

  • Report this Comment On August 25, 2013, at 8:31 PM, constructive wrote:

    "the SEC or FTC could shut the firm down, seize its assets, and wipe out its shareholders."

    I'm as big a HLF bear as anyone, but neither the SEC nor the FTC have the authority to do anything like that.

  • Report this Comment On August 26, 2013, at 4:27 PM, LordBerendzen wrote:

    "Ultimately, it will come down to a question of regulatory action -- will the FTC shut the firm down? Ackman believes it could happen in the near future. If that's the case, it wouldn't be wise to hold Herbalife shares -- or the other multi-level marketing firms."

    Key words here being the FTC taking action. Also, Herbalife could just as easily be taken out via LBO within one year. Or go sideways for one year. One things for sure, a lot of institutional firms taking up a lot of the float. Something will give. Taking into account all possibilities here.

  • Report this Comment On August 27, 2013, at 10:47 AM, ffbj wrote:

    "The mother of all short squeezes?" I thought that was Tsla.

    Let's see Tsla goes from $30 to $160 in 3 months, Hlf goes from what $40 to $65 in the same period.

    "Hlf will be higher than it is now a year from now and anyone who thinks otherwise is displaying sheer stupidity."

    Are we really supposed to take these ruminations seriously? I don't care for Hlf and their business model and believe it is a bad business, but neither do I think they will go to zero, though I think they are overvalued and their share price will fall. Just because certain famous/infamous investors support or decry them is no sole reason to go long or short, imho. Do your own due diligence and follow your own ruminations. That way you only have yourself to blame when it turns out you are wrong.

  • Report this Comment On August 27, 2013, at 2:34 PM, reluctanttrader wrote:

    Personally, I would like to thank Ackman. His actions tanked the stock of an extremely strong company so I was able to buy at a price well below value (2500 shares at 28.69 on 12/28) and now that it has risen to a price higher than it was before his short, I have made a tidy sum (Sold 1500 shares on July 28 at 59.78).

    As far as HLF goes, it is a strong company with over 30 years history. It is not going to be shut down by regulators for some figment of Bill Ackman's imagination.

    Bill Ackman made a gamble, an evil-hearted gamble, that has backfired. He tried to bankrupt a company merely for his own personal gain and at the detriment of hundreds of thousands of people who make their livelihood from that company.

    Ackman stands to lose hundreds of millions of dollars. At this point, with the stock price over $62, he cannot back down from his statements regardless of their veracity.

    All he can do is make unsubstantiated claims. It's sad what greed can do to you.

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