Don't Get In The Middle Of This Cat Fight

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Well-known hedge fund managers William Ackman and Daniel Loeb are publicly jousting over Herbalife (NYSE: HLF). One says it’s a fraud, the other thinks there's a buying opportunity. Who's right? 

Herbalife
Herbalife reported sales of nearly $3.5 billion in 2011. It has operations in 88 countries. It employs over 6,000 people. Basically, it's a pretty big business.

Founded in 1980, the company sells “protein shakes and snacks, energy and fitness drinks, vitamins and nutritional supplements, and a complete bath and body care line.” While the body care line seems out of place, these are all legitimate, though not particularly special, products.

The company sells its products via independent sales representatives. It describes itself in its Securities and Exchange filings as “a global network marketing company.” That sales model is associated with companies as well known and respected as Avon (NYSE: AVP), and also with companies like Amway, which has the unfortunate nickname “Scamway.”

Even Avon has had to periodically deal with questions about its sales methods, notably in new markets like China. In fact, after a decent run, the last few years haven't been kind to the makeup retailer, leading to share declines, a management change, and a dividend cut. Part of the problem was the company's disparate sales base.

The Sales Model
Essentially, “network marketing company” is a nice way to say that Herbalife relies on individuals to sell to their friends and family on a one to one basis. On the surface, this is a great business model, since there are no stores and little advertising to pay for at the corporate level. However, there is usually a great deal of churn within the ranks of sales representatives and there is usually a pyramid design to compensation, as sales reps who convince people to become sales reps get additional benefits.

The draw for sales representatives is that it doesn't cost much to get started and, if you can build a network of sales reps, can be massively profitable. The problem is that most people rightly see this business model as a little dicey and, for potential customers, pushy. Few people actually create huge sales forces.

The Accusation
Pershing Square's William Ackman has publicly accused Herbalife of being a Ponzi scheme. He calls the company's wares overpriced commodity products, with the real sale being the “dream” of getting rich by creating one's own network of sales agents. He goes on to suggest that the company's financial reports are questionable and that key sales information can't be, or isn't, tracked.

In typical short-seller fashion, Ackman has created a lengthy public presentation that outlines his concerns. Some appear to be very valid, while others seem to push the envelope (not uncommon for a short-seller). Either way, he's publicly and loudly talking up his concerns.

The Other Side
On the other side, Herbalife itself has created a lengthy public document refuting Ackman's claims. That said, some of its information does little to reduce the feeling that the company is, in some way, taking advantage of individuals desperate to make money. In fact, the company's shares actually fell after the presentation. While investors may be uncertain about Herbalife, Third Point hedge fund manager Daniel Loeb seems to think the company is going to be just fine.

His argument rests on two facts. First, that Herbalife isn't a Ponzi scheme. While he concedes that the multi-level marketing set up poses risks, he doesn't think the government has been asleep at the proverbial wheel regarding a company that has been around for 30 years. Indeed, Herbalife hasn't gone unnoticed by regulators and has yet to be shut down, so there appears to be some merit in this first point.

Second, Loeb notes that the business appears to be doing well. Top and bottom line growth, coupled with a history of returning value to shareholders via dividend payments and stock buybacks, would seem to support this argument.

Basically, Loeb thinks that Herbalife shares are being held down by Ackman's accusations. If his position proves correct, then the shares could see a notable jump when the waters clear. If he's wrong, and Ackman is correct, the company could cease to exist.

Long-Term Bears
Allied Capital was dogged by David Einhorn of Greenlight Capital for six years. He focused on what he believed were deceptive lending practices that defrauded the U.S. government, along with shareholders. The situation got very ugly and included legal complaints that brought in the New York State Attorney General. In the end, however, Allied Capital crumbled under the stress of the 2007 to 2009 recession as some of Einhorn's complaints came home to roost.

That company was eventually bought by Ares Capital (NASDAQ: ARCC), which has subsequently divested many of the troubled assets it acquired in the Allied's transaction. Ares paid a very low price for Allied based on its historical valuations and Einhorn made a lot of money from Allied's fall. Everyone but the shareholders won.

There were many people who thought the hedge fund manager was wrong about Allied all along the way, but, in the end, he proved correct. It just took a long time to proven correct. So there is reason to take Ackman seriously, even if his fight may be years from completion.

Move On
At the end of the day, investors should stay out of it, no matter how compelling the opportunity may look—regardless of who's side you're on. There are so many other companies available that this one simply isn't worth the drama that's currently surrounding it. Based on Herbalife's 3% dividend yield, investors could do just as well buying Dow-30 giants Johnson & Johnson (JNJ) or McDonald's (MCD), which both yield more and have rock-solid business models.

Yours,

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ReubenGBrewer has no position in any stocks mentioned. The Motley Fool has the following options: Long Jan 2014 $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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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