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Can You Profit On The Herbalife Fiasco?

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

On Dec. 20, Bill Ackman from Pershing Square Capital Management, revealed a large short position in Herbalife (NYSE: HLF). He gave a lengthy presentation on why he believes that the multi-level marketing company that sells nutritional supplements is nothing more than a pyramid scheme.

The implications

Claiming that a $5 billion company is a pyramid scheme is a very risky statement. On the one hand, operating in a pyramid structure is not a criminal act. This means that Herbalife is probably not going to become the next WorldCom or the next Enron. On the other hand, it basically implies that the value of the business is downright zero. Put differently, five billion dollars of investor's monies are hanging by a thread.

It is no wonder that following Ackman's presentation, the stock quickly shaved 40% of its value. When the news came out that the prominent hedge fund manager Dan Loeb took advantage of that price drop to establish a long position in the stock, the weather quickly changed in favor of Herbalife. Take a look at the cliff and spike below.

<img border="0" height="234" src="http://chart.finance.yahoo.com/z?s=HLF&t=3m&q=c&l=on&z=m&a=v&p=s&lang=en-US&region=US" width="512" />

Who should we side with?

It's extremely difficult to take sides between such two prominent hedge fund managers. But after a lot of pondering on this issue, I believe that the ultimate truth, as always, is somewhere in the middle. I believe that the following statements will be proved true in regards to Herbalife. I also believe that the short-term future will prove me right.

Statement #1: It's a pyramid

I have no doubt in my mind that Herbalife operates in a pyramid structure. The multi-layer marketing technique that the company employs guarantees exactly that. In specific, only 1% of all distributors take out 88% of total commissions. The lower you are in the chain, the less likely you are to earn any income from your work. At one point, distributors began to catch up on this incentive system and how it works. This led to 1,076,000 distributors quitting Herbalife in the first 3 quarters of 2012 alone. Sooner or later, the company will run out of its most important asset, its distributors and marketing personnel.

Statement #2: It's a rather stable pyramid

It's important to keep in mind that the company's sales have been growing at approximately 25% a year since its inception in 1980. It's quite a remarkable growth. The key for that high growth was a high turnover rate of its distributors. As recruitment of key salespeople at the end of the chain continues, more merchandise will be purchased from the company and more business will be heading its way. In other words, this pyramid could well keep operating for many many profitable years.

Statement #3: It's a very cheap pyramid

Herbalife trades at a P/E of 11x and at a price/sales of 1.2. Its competitors in the nutritional supplements industry trade at much higher prices. Church and Dwight (NYSE: CHD), for example, trades at a P/E of 24 and price/sales of 2.8. Other rivals such as Energizer Holdings (NYSE: ENR) and The Clorox Company (NYSE: CLX)  trade at a P/E of 14 and 18, and at a price/sales of 1.2 and 1.8, respectively.

Another perplexing fact is that Herbalife is able to consistently maintain a remarkably high gross profit margin of 80%. That comes as a striking contrast to the gross profit margin of CHD, ENR and CLX that stand at 44%, 47% and 42%, respectively.

On the face of it, Herbalife is a very cheap company that operates in a fast-growing industry.

So, can we make money on it?

You will probably make the most money by simply avoiding this company altogether. On the one hand, it is cheap and hated right now. On the other hand, over the long run - it is 'eating' itself away. At one point in time, there will be no more fresh supply of distributors willing to lose their shirts. This obviously points to a very problematic business moat.

In short, save your money for other, more lucrative investments.

shmulikarpf has no position in any stocks mentioned. The Motley Fool recommends Energizer Holdings. The Motley Fool owns shares of The Clorox Company and 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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