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Herbalife: A Goose Well-Cooked, Part 1

By Michael Lewis - Dec 24, 2012 at 10:35AM

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This latest bit from activist Bill Ackman should nail the coffin

Famous activist investor Bill Ackman is pushing the envelope yet again, this time going as far as to launch a beautiful website dedicated to educating people on the wrongdoings of weight management multi-level marketing company Herbalife (HLF -2.20%). Now, Herbalife is no stranger to big-shot investors claiming that the company is a few steps short of a hoax -- not even a year ago David Einhorn asked a few simple questions about the company and sent the stock reeling. With Ackman and his newfound love for the Internet, though, this may be the company's biggest whistleblower yet. Are you still invested in Herbalife? Why?

Bulls going extinct
I was surprised to see a major sell-off in Herbalife stock this week, as I was unaware that anyone still owned shares of the company. Sure enough, there are still some believers out there. As late as Friday afternoon, after a rough week in the markets, Herbalife traded down nearly 20%, bursting through the floor of its 52-week low of $33.05. Investors can thank Bill Ackman and a talented team of programmers for putting together quite an elegant and professional website explaining to us all why Herbalife is the worst.

The site, Facts About Herbalife, is riddled with reports, videos, presentations, and SEC correspondence. It's really quite a fun site to peruse regardless if you care about Herbalife.

One of the first videos I came across was one with Herbalife founder Mark Hughes talking at a conference. In it, Hughes tells the story of a young Herbalife that had hit $2 million in sales. During that time, Hughes was telling everyone that the company was headed for $100 million in sales. He confides to the audience that he did not believe the company would ever hit $100 million, but he believed in the mantra "Fake it 'till you make it." Certainly not the best thing to hear from a public company.

There are plenty of cultish videos from Hughes, team members (Herbalife individual business owners), and board members that are downright creepy. All investment advice aside, this stuff is just weird.

But let's talk about the more substantial issues outlined by Ackman's team.

Ackman was recently a keynote speaker at the Sohn Conference, where he presented his short case against Herbalife.

One of the first scores for the investor was rebutting Herbalife CEO Michael Johnson's claim on Thursday that Ackman was a market manipulator trying to take advantage of a put expiration date. The fund, Pershing Square, didn't have any options in Herbalife; it is only short shares.

Ackman wastes no time, pointing out that Herbalife values its "Formula 1" brand at $1.8 billion, more than Palmolive and right under Gerber baby food and close to Crest toothpaste. But is Herbalife's protein powder anywhere near as well known, in your mind, as these other brands? No way.

According to the presentation, Herbalife sells six times more nutritional powder than GNC, Unilever, and Abbott Labs' products combined. The company compares its brand to that of Nike and Disney, yet it spends essentially nothing (in a report to the SEC, the company spends "de minimus") on advertising.

In trying to justify the price premium that consumers pay for Herbalife products, Ackman looks at R&D spending, since the company's products don't seem to have any blatant advantage over competitors' in the commodity health and weight management goods business.

R&D is done by outside consultants and costs around $2 million per year.

How can a company that basically doesn't advertise and spends virtually nothing on product development have such an incredible line of goods that warrants industry-leading prices and constitutes one of the fastest-growing companies in history? I think the insinuation is that it doesn't.

Ackman spends the first 17 minutes of the video completely destroying the Herbalife business model. The video is three hours long.

It takes 25 minutes for Ackman to get to the big kahuna -- that he thinks Herbalife is a pyramid scheme.

If an entity is paid primarily (> 50%) by recruitment versus sale of products or services, according to the SEC, that's a pyramid scheme. The people at the top of the pyramid -- who recruited people who have then recruited many more -- make enormous amounts of money, while those at the bottom are usually left with nothing. This is the reason that one of the "biggest brands in the world" is a product very few of us have ever seen or used.

To explain Herbalife's high pricing compared to competitors, Ackman believes they inflate the suggested retail price of the goods to cover the fact that the bulk of company earnings are from recruitment, which would violate SEC rules. There is simply no other way to explain Herbalife's pricing and massive revenues.

Stay tuned for part two of this article, which will further outline the allegations made by Pershing Square. In the meantime, if you are an Herbalife shareholder, please tell me why in the comment section.


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