Herbalife's Clean Bill of Health Means Nothing

Despite the auditors of personal care supplements maker Herbalife (NYSE: HLF  )  giving its books a clean bill of health, its stock remains far too risky to invest in one way or the other because its valuation is not being driven on the merits of its business but rather on the personalities behind the debate. 

As is well-known, hedge fund operator Bill Ackman took a big, vocal short bet on the supplements maker, declaring Herbalife was a pyramid scheme that would be shut down by the SEC. Coming as it did after David Einhorn at Greenlight Capital had seemingly questioned the veracity of its business model, shares of Herbalife plummeted. It was Einhorn, after all, who rose to fame by presciently shorting the stock of Lehman Brothers and proclaiming its accounting practices questionable. Considering how right he turned out to be, similar questions about Herbalife's practices followed by a massive short bet from another well-known hedge fund pro was too much for the market to bear.

On the level
Multi-level marketing operations are gray-area beasts that risk running afoul of the law by virtue of whether their highest-paid promoters make the bulk of their money selling product or recruiting more salesmen. In a legitimate MLM, it should be possible for a salesperson to make money by simply selling product directly to customers. Amway, Mary Kay Cosmetics, and Tupperware (NYSE: TUP  ) are the grand dames of MLM operations and have years of proven results to back them up.

Source: Herbalife.

Some, like Nu Skin Enterprises (NYSE: NUS  ) , seem to oscillate between accusations of running a pyramid scheme and making bloated claims about its products for which it runs afoul of federal trade regulators. 

Others, such as nutritional supplements seller Omnitrition in the 1990s, BurnLounge just a few years ago, and Fortune Hi-Tech this past January, have all been declared pyramid schemes by courts. While Omnitrition is still in operation today and BurnLounge is appealing its ruling, it's apparent that the shady practices of some cast aspersions over those who abide by the rules.

It's not me, it's you
Amongst the many charges Ackman levels against Herbalife is the claim that its operations don't abide by the law, that it makes more money recruiting sales people than it does selling product. Management disputes that, and the case attracted other high-profile investors like Carl Icahn and Daniel Loeb, who've said Ackman's accusations are ludicrous. With personal animosity driving some of the decisions, they've bought large long positions in the supplements maker, pushing its stock up.

The stock is up more than 80% over the past year, 135% in 2013, and 220% from its 52-week lows. The meteoric recovery has impaled Ackman on his convictions, with Pershing Capital losing more than $500 million on the short sale. He was forced into a strategic retreat from the stock last quarter, covering more than 40% of his position and realigning his bet to make it less exposed to a short squeeze.

Take this into account
Earlier this year, Herbalife's auditor KMPG resigned after it was revealed a senior executive leaked confidential information to a stock trader. PricewaterhouseCooper was brought on with the mandate to review its financials for the past three years. While Ackman said the accountant was conflicted, the SEC permitted the appointment and PWC issued its report on Monday essentially giving Herbalife a clean bill of health. Shares jumped more than 9% in response.

Ackman, though, contends it's not the role of the accountant to say whether Herbalife is a pyramid scheme or not, and previously said he would take the bet "to the end of the earth." 

With forces on both sides so passionate about their stake, and each willing to bet large sums of money on the outcome, common shareholders can't simply look at Herbalife's business or its (now clean) financials and come to a conclusion about whether the stock makes a good investment. Those factors have become secondary to Ackman, Icahn, and others pushing their agendas and until they've cleared out of the stock for good or ill, it's just not worth the risk to bet with one side or the other, no matter what you feel about Herbalife's merits.

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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 December 20, 2013, at 12:59 PM, powershake wrote:

    Clean audits is the shorts and ackman's nightmare!

    Add to that the Belgian Court decision and you've got disaster for the shorts!

  • Report this Comment On December 20, 2013, at 4:17 PM, TraderatWork wrote:

    Not sure what the SEC & FTC are thinking, Herbalife is such an obvious pyramid scheme, attend one of their brainwashing session if you need any proof. But they sure know how to sell ice to Eskimo, they have sales of this dietary powder in some Africa countries and I heard they are selling it Cambodia & Vietnam.

    People are not really that smart.

  • Report this Comment On December 20, 2013, at 10:57 PM, powershake wrote:

    What matters is the law and Herbalife. In its 33 year existence, has been vetted countless times by the federal government as well as vetted by short seller attacks, the Belgian government and PwC. Herbalife continues to improve their business model to increase transparency. If you don't like the law that allows MLM's then you need to lobby congress to change the law. In addition, it appears that the attack on HLF is solely for financial gain. If it were really because Ackman and everyone who believes like Ackman really cared about the MLM model hurting people, they would be going after all MLM's, not just HLF. It's hard to take Ackman and his followers seriously when they are only going after HLF, and doing so via the stock market instead of lobbying congress to change the industry.

  • Report this Comment On December 21, 2013, at 3:54 PM, NotAfoolHere wrote:

    Main factor of Ackmans claim is HLF make more money through the recruitment of members than through the sales of its product. This it the fundamental basis for the assertion that it is a pyramid scheme.

    If it uses MLM to sell products it is not a pyramid scheme, if it uses the claim of riches through the sales of product to make the majority of its income from recruitment then it is.

    Simply put does it sell products as shown on its financial reporting or does it lie on its reporting and in fact make it from deceiving and misleading the gullible? The answer sits in its financial records.

    He sent the auditor a list of items they were to review. PWC has an obligation to review and verify all item listed within HLF financial records and is liable if it falsifies, alters or through willful blindness allows the perpetration of a fraud. It also had the responsibility to review all issues Ackman claimed in his list as these concerns were brought to its attention and in a very public manner.

    PWC was well aware of the sensitive nature of its audit of HLF and the fact that it would be under the microscope for it's actions If it failed in its obligation it could be liable to either the longs or the shorts for billions.

    If any third party could verify if the sales were for the materials produced or for the enrollment of members it would be PWC. If any party would be able to confirm if HLF is making the majority of revenue from recruitment verse sales of products it would be the auditor.

    So when the audit comes back clean and proving what they show for revenue is what was reported and not for some hidden source such as recruitment Ackman changes his story. Basically claiming the auditor would not know what their sales are. Are your serious????

    So it should be fair to say what Ackman claimed is "malarkey". Only question should be is he the next GOP vice presidential candidate?

    By the way is everyone really stupid? Dont you know who Stiritz is? Look at what he has done and what type of person he is. He did his due diligence and did it well before investing a massive amount of his own money. Do you think someone like him is stupid??

    The shorts are dead or dying fast, their little adventure is over. Some just will not admit it.

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