Why Ackman May Be Wrong on Herbalife

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Hedge fund manager Bill Ackman recently made a case for his short position in Herbalife (NYSE: HLF), a nutritional products multi-level marketing (M-L-M) company.

Ackman asserts Herbalife operates a "Pyramid Scheme." He believes they dupe the poor and uneducated into buying products by offering a chance to make a lot of money. He says only a few at the top really make money and everyone else ends up broke.

The "Pyramid Scheme" assertion against M-L-M’s is not new. Publicly traded firms such as Avon Products (NYSE: AVP), Nu Skin (NYSE: NUS) and Tupperware Brands (NYSE: TUP) have all faced similar questions about their M-L-M business model. But I believe there is enough evidence to suggest that Ackman may be incorrect in his view on Herbalife. I found two key legal precedents that offer some clarification on the traits of a "Pyramid Scheme."

1. Federal Trade Commission (FTC) v. BurnLounge 2007

BurnLounge was a company selling websites that offered retail customers music over the Internet. Distributors would have to buy the website, but also sell the website to others to earn a commission.

The FTC action found that BurnLounge was operating a "Pyramid Scheme." The verdict against the company seemed to hinge on a few facts.

Distributors had to pay an initial amount plus monthly and annual fees for a non-refundable product (website) that was not the final consumer product (music sales).

Distributors had to sell a minimum amount of the non-refundable website product to earn cash compensation.

There was an overwhelming amount of evidence that the company marketed the wealth that could be made by selling the website versus very little mention of the selling of the music end product.

I'm not a lawyer but it does not seem that Herbalife has any significant commonality with BurnLounge.

Herbalife does not charge annual or monthly fees for the right to sell their refundable product that can go to an end user. Herbalife does not seem to have a minimum quota for increasing distributor count. Herbalife marketing seems to stress the health benefits of their product as well as the business opportunities of selling the product.

2. Webster v. Omnitrition 1996

Omnitrition is a nutritional supplement retailer that uses an M-L-M business model to distribute its product.

The case was a class action lawsuit brought by some distributors. The trial’s initial verdict was in favor of the company. This verdict was overturned on appeal and the case settled out of court.

The negative judgment of the appeals court indicated that there was a legitimate question as to whether Omnitrition was operating a "Pyramid Scheme" based on the potential for inventory stuffing.

Inventory stuffing is when distributors are induced to recruit others to become distributors and buy product. Those new distributors in turn recruit more people that will buy product, etc. Unfortunately, the poor individuals at the end of the line have a room full of product that they can't get rid of.

The court ruled Omnitrition had insufficient evidence showing intent for sales to end customers. The court also saw that the company’s 30-day product refund policy did not give enough time for distributors to judge their chance for success thereby sticking them with product they could not move.

There seems to be evidence that Herbalife does not undertake inventory stuffing. Herbalife has a 12-month buyback policy, which would seem to be enough time for a distributor to reasonably judge the odds of success and get a refund if desired. The company also accrues for the refunds on their financials based on historical return rates. This indicates that at least some unsatisfied distributors have taken part in the policy.

Another persuasive factor is the projected large number of defrauded distributors Herbalife would have needed to enroll to have run an effective "Pyramid Scheme."

In the BurnLounge case, in over a few of years of operation, the company showed revenues of about $28 million and had around 62 thousand total distributors. The court found about 56 thousand distributors lost on average around $500 revenue equivalent dollars per distributor.

Herbalife reported net North American sales, predominantly the USA and Canada, of $3.13 billion from 2006 to 2011. If one assumes 50% of those revenues were for inventory stuffing, that would be roughly $1.56 billion of sales.

Using the BurnLounge methodology and assuming that a duped distributor lost $1,200 on average, that would mean around 1.3 million individuals accumulated over the last six years would be left holding nonreturnable and unsellable product ($1.56 billion divided by $1,200).

If one takes Ackman's view that Herbalife focuses on the poor and uneducated and assumes the distributor loss at a lower $600 on average, that would necessitate roughly 2.6 million defrauded distributors accumulated over the last six years, or nearly one out of every 110 adults in the population.

These calculations, based on only 50% of Herbalife's stated revenue, seem to indicate that the company would have needed to obtain an incredibly high number of defrauded distributors to maintain a successful "Pyramid Scheme."

I think there is enough evidence to suggest that Ackman’s assertion of a "Pyramid Scheme" may be wrong. But this is an extremely complicated situation and I'll admit that my analysis may not be definitive. So I would encourage interested investors to investigate to their own conclusion rather than take my, or anyone else's, word on the legality of Herbalife’s business model.


grahamsway (Bob Chandler) is long both Herbalife and Nu Skin. The Motley Fool owns shares of Tupperware Brands. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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