The FTC Could Be About to Wipe Out Herbalife Shareholders

With Herbalife now under investigation, investors in the multilevel-marketing firm could face a total loss of principal.

Mar 15, 2014 at 8:30AM

Last January, the FTC halted Fortune Hi-Tech Marketing, seized its assets, and charged its executives with operating an illegal pyramid scheme. While the ultimate outcome rests on a trial, if it had been a public company, its shares would've plummeted.

This an outcome Herbalife (NYSE:HLF) investors have to live with every day. It could take years (Pershing Square's Bill Ackman insists that won't be the case), but with a formal investigation now under way, the FTC could conceivably shut down Herbalife at any moment.

FTC on Fortune Hi-Tech Marketing
"These defendants were promising people that if they worked hard they could make lots of money. But it was a rigged game, and the vast majority of people lost money," said C. Steven Baker, director of the FTC's Midwest region. He was referring to Fortune Hi-Tech Marketing, but Baker could've just as easily been talking about Herbalife.

In a series of videos freely available online, Herbalife Director John Tartol boasts about the opportunity offered to Herbalife distributors, explaining how to rack up monthly bonuses totaling several thousand dollars:

You could become a Millionaire Team member ... Wow! Can you imagine getting to tell people that you're part of the Millionaire Team! Such an honor! ... It's possible to earn a total of $5,500 or more [per month] ... Those who have reached the President's Team level ... could potentially be earning a total of $13,000 and up, every month!

Herbalife CEO Michael Johnson has often made similar remarks. In a presentation to Herbalife distributors in 2012, Johnson offered up the rags-to-riches story of a now-successful Herbalife distributor:

Then you look at Herbalife, you meet a distributor ... This is me before Herbalife, this is me after ... this is the apartment above the garage [where I used to live] ... I met Herbalife on a bus bench, and I cleaned homes, and 10 years later I went back and I purchased one of the homes that I cleaned -- that's an Herbalife story!

Later, Johnson presented Herbalife's top 10 distributors with bonus checks totaling more than $50 million. "Give me one of those checks!" Johnson shouted, as the crowd went wild.

But the million-dollar bonus checks are reserved for the very few -- indeed, 88% of Herbalife's distributors receive no commissions at all. In fact, 87% of all commission checks go to the top 1% of Herbalife distributors.

The bull case has evaporated
The best-case scenario for Herbalife is that the FTC finds no evidence of wrongdoing -- which, while possible, seems unlikely. Obviously, the multitude of issues Pershing Square has raised regarding Herbalife's business has been enough to attract regulators, a possibility that has been downplayed by Herbalife shareholders.

Herbalife's largest shareholder, Carl Icahn, has argued that an FTC investigation was unlikely -- "The FTC investigates fraud; it does not put people out of work ... especially [not] to satisfy guys like Ackman who ... sort of insults them, tells them they're not doing their job," Icahn told CNBC.

And yet, here we are with an investigation looming. Some have claimed that Icahn's investment was motivated by his personal dislike of Ackman -- which seems plausible, given that Icahn has said things about Herbalife's business model that seem downright ludicrous. "Multi-level marketing is here to stay," Icahn told CNBC last year. "It's a great way to move product to consumers." I suppose Amazon and Wal-Mart should be concerned.

Not the same FTC
In truth, the multilevel-marketing industry is sketchy at best, one that has, throughout its history, received a level of scrutiny far more intense than any other type of retailer -- the Chinese government outlawed multilevel-marketing firms entirely for almost a decade, before allowing them (under strict regulation) to reopen in 2005. Even those who have argued in favor of Herbalife, like John Hempton, say that the company is run by "scumbags."

Of course, the regulators haven't always won in their battle against multilevel marketing firms -- Amway survived its 1979 run-in with the FTC, while the SEC did little to clamp down on Usana in 2008. But there's reason to believe this time will be different.

It's no secret that the multilevel-marketing industry has enormous ties to the Republican Party. The DeVos family, owners of Amway, have donated millions to the Republican Party in recent years -- Dick DeVos even ran for governor of Michigan (as a Republican) eight years ago. Pyramid Scheme Alert's Robert FitzPatrick notes that, under the George W. Bush administration, MLMs faced almost no prosecution; the FTC head at the time, Timothy Muris, was a former industry lawyer.

Earlier this week, The New York Times, in an article that was largely critical of Ackman, noted that he's been able to mobilize members of Congress to support him in his battle with Herbalife -- not so coincidentally, they're Democrats. The current FTC head, Chairwoman Edith Ramirez, was sworn into office in 2010 -- an Obama appointee.

It may be best to avoid political issues when discussing investments, but given that the case in favor of (or against) Herbalife rests almost solely on government action, the political ties of regulators cannot be discounted.

A terrible risk/reward profile
Ultimately, Herbalife is a stock investors should stay away from. While continued earnings growth could send shares to the upside, the looming possibility of an FTC shutdown means that the worst-case scenario is an ever-present danger.

Should the FTC find nothing in its investigation, Herbalife shares will more than likely surge to the upside. But given that the agency has found Ackman's argument to be compelling enough to take a look, the risk/reward profile for the stock is, at best, terrible.

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Sam Mattera has no position in any stocks mentioned. The Motley Fool recommends and owns shares of and has the following options: long January 2015 $50 calls on Herbalife Ltd. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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