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Is Herbalife Ltd. a Short Sell?

By Brian Stoffel - Oct 6, 2014 at 9:19AM

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The battleground stock is being investigated by every agency under the sun. Here's a look at why it might be best to stay away.

Perhaps there's never been a presentation as anticlimactic as famed activist investor Bill Ackman's "takedown" of Herbalife (HLF -0.85%) this summer. Promising a "death blow" revelation, Ackman's long, winding presentation failed to reveal a smoking gun, and the stock jumped 25% before the end of the day.

So, does that mean the stock is a buy, or should investors short it?  The answer probably is neither. Read below to find out why.

At the end of the day, will Herbalife investors have a smile on their faces? Photo: Herbalife 

Why are so many people betting against Herbalife?
Currently, one-third of all publicly traded shares of Herbalife are being shorted. To understand why, we need to rewind the clock about two years.

In December 2012, Ackman announced that his Pershing Square Capital had initiated a huge short position in Herbalife. In a nutshell, he argued that Herbalife -- a company that sells nutritional products -- was an enormous pyramid scheme.

For those unfamiliar with the concept of a pyramid scheme, the Federal Trade Commission provides a simple explanation: "[Pyramid schemes] promise consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public." What's more, Ackman claimed that Herbalife targets low-income and minority -- especially Latino -- communities for its business.

Herbalife's stock has swung wildly since this short position was announced, but now sits at about the same price it did back in December 2012.

What has changed, however, is the scrutiny Herbalife is under: The SEC, FTC, FBI, Justice Department, and a handful of state attorneys general have put the company under investigation during the past two years. Considering that, it's easy to see why Herbalife's stock is still sold short by so many investors.

What's the likelihood of the short thesis playing out?
As I said, Ackman's short presentation failed to deliver on its promise of a "deathblow" to the company. It did, however, provide a solid base of research for investors. Based on that research, there are a lot of questions Ackman raised that should worry those who have money in the company.

The most important part of the short thesis is the role that "nutrition clubs" play in Herbalife's business model. These clubs have become the major point of sale for many of Herbalife's products. In fact, according to Ackman, they account for "substantially all revenue" in Mexico. And these clubs, "may currently account for significantly more than 40% of total volume," for the company as a whole.

But what are the nutrition clubs? Ackman's investigation into 10 clubs in the greater New York area showed that they are largely unremarkable: no logos or advertising are allowed; windows are covered; prices are not listed for products.

In essence, Ackman believes that attending these clubs is simply part of the "training process" that any wannabe Herbalife distributor must go through. That includes paying for Herbalife drinks. The demand isn't coming from a great product, he argues, but a promise of riches for those who start up their own club -- after going through the training process.

Not surprisingly, Herbalife has come out with strong statements denying any such schemes. And Reuters recently visited nutrition clubs on both coasts and wrote, "While some of the people running the clubs were struggling to make ends meet, most were optimistic about being distributors of the products."

Who is right?
In the end, it's hard to say how this will all play out. Personally, I think investing in the company is very dangerous. If one of the many agencies investigating Herbalife comes out with negative news, the stock will take a serious plunge.

And if, on the other hand, Herbalife is in the process of clamping down on any recruitment techniques that could be viewed as questionable, that will no doubt affect its bottom line.

At the same time, I wouldn't suggest shorting the stock either. It is highly volatile, and with one-third of all shares being sold short, the potential for a short-squeeze -- and a call on shorts -- is very high.

Either way, I think it best for most investors to stay away from the stock altogether.

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