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Herbalife has had a rocky ride for the past year. It all started when the poker playing David Einhorn asked astute questions regarding the business model last April in a results call. The next play was made by Bill Ackmann and Pershing Square Capital management in December, where he alleged in a 300 plus page presentation that Herbalife was not a Multi-Level-Marketing-Scheme but your modern Ponzi or Pyramid scheme. The stock fell to the low 20’s. The Company soon found renewed buyers in the form Dan Loeb and Carl Icahn, both with their own angles.
Herbalife – A (brief) History
The Company was founded in 1980 by the charismatic Californian Mark Hughes with his goal to alter the nutritional habits of the World. The Company floated in 1986 on the Nasdaq, but was taken private by J.H.Whitney after the founders untimely demise (after marrying JC Van Dam’s ex-wife) on a cocktail of alcohol and the anti-depressant doxepin. In 2004 the Company was re-listed on NYSE under Michael Johnson, an ex employee of Walt Disney.
The Company sells health and weight loss shakes through distributors who either profit by recruiting others to sell the product, or by directly selling it themselves. This is classified as a multi-level-marketing-scheme, although historical precedence has shown this line is often blurrily similar to that of a Pyramid scheme, such as that which occurred with the closure of Zeek Rewards in 2012. Accusations have been made against Amlin, Nu-Skin and a host of other MLMS’s, whose counter claim is that they allow flexible working hours, provide a business opportunity and are simply outsourcing labour costs.
Ackman’s Thesis – J’accuse:
The entire supposition, and 20% short stake, relies on guideline rules by the FTC that recruiting cannot be the main genesis of sales, and that if it is, there is likely indication of the MLMS being a Pyramid scheme. The 300 plus page presentation attempts to strip apart the Gordian knot of the Herbalife business model, and below are a list of the main points.
- Manipulation of the topline – The assumption that revenues are sold at the recommended retail price by distributors, when competitor pricing in commoditised market shows the RRP is at a significant premium on a calorific basis.
- The pop and drop – entering new countries and affinity groups within countries to mask falling sales and recruitment in others, as the market of potential distributors saturates. For example, in America, entering the Latino market.
- Exaggerating potential earning claims for distributors and targeting low income distribution markets where financial sophistication is lacking.
- General masking/obfuscation of any internal dynamics of the business through reporting changes – such as geographical sales changes or active inactive supervisors and their metrics.
But ultimately Ackmann’s premiss is that the FTC (Federal Trade Commission) has been asleep at the helm (although an alternative supposition might be that various donations and extensive lobbying have sheltered the Company from regulatory attention – a more nefarious form of the industry capture hypothesis). In fact the Belgian authorities have already ruled that Herbalife is a Pyramid scheme.
Herbalife’s Retort to Ackmann
Herbalife responded to Ackmann’s claims in a special presentation on the 10th of January, where they had hired Liebermann research and a Kellog University PHD to undermine his thesis. They showed that 5% of US households had purchased a Herbalife product in the past three months, and insisted that a large percentage of their distributors were in fact discount buyers in the vein of Cosco. Reading between the lines, the whole presentation looked like a lesson in Derren Brown’s suggestion, mis-direction, psychology and showmanship – and as Ackmann swiftly replied:
“Herbalife did not respond to our identification of overstatements and inaccuracies in the company’s earnings statement for distributors, which among other deceptions, excludes the 93% of distributors that have zero gross earnings”
Ackman’s History
Ackmann has been embroiled in a fair number of activist battles, most famously his short on MBIA in 2002 –which took 6 years to come true in the unfolding of its AAA rating in the fall out of the American sub-prime crisis, after protracted court room battles and appeals to regulators. Although he rarely goes short and tends to follow fundamental value stories, such as J C Penny, he’s not one to shy away from glitzy hard hitting media campaigns to get his message across, as has occurred with Herbalife. Other court room antics tie up with Carl Icahn after a $5m real estate deal settlement was awarded to Ackmann.
Word on the street was that no New York restaurant would dare to sit the two in any form of proximity to each other. Back in early January, Icahn went public with his attack on Ackmann’s thesis and defence of Herbalife, after Dan Loeb (another activist fund manager) disclosed his own 8% stake.
Ackmann Vs Icahn
The crunch point was the CNBC interview between the pair on Jan the 25th. Icahn refused to disclose whether he had a position in Herbalife and berated Ackmann’s methods on publicity, rarely sticking to the points in hand, whilst Ackmann remained cool and calm throughout (the whole episode a clear whitewash to Ackmann with a lot of commentators seeing only revenge for past slights with Icahn’s diatribe). Last week Icahn disclosed he had built a 13% stake in Herbalife through acquiring options as well as stock (leveraging by selling puts to purchase the calls), and was open to talking to management regarding further financial transactions as seen verbatim below:
“The Reporting Persons intend to have discussions with management of the Issuer regarding the business and strategic alternatives to enhance shareholder value, such as a recapitalization or a going-private transaction.”
So could history be re-repeating? Is there a potential buyout on the cards for Herbalife and the potential for a Volkswagon/Porsche short squeeze.
Short Squeeze Vs FTC takeout and tumble to “0”?
Well it’s one of the two, but it’s also a question of timing. No doubt the FTC are aware of the claims by Ackmann, and that dialogue between the two is becoming increasingly frenetic as the threat of Icahn’s potential LBO has come to the fore. Furthermore, in January, the FTC closed down the nutritional supplement supplier Fortune Hi-Tech Marketing (similar to Herbalife), suggesting they are starting to “take the bull by the horns”. Maybe there is one way to play this – volatility.
A Hypothetical position to play the volatility
A high risk method to take advantage of the binary outcome of these two extremes is a long straddle, where you buy “at the money” call options and put options. Hypothetically taking the position you would need to assume dates by which you believe either one of the two extremist points of view will take precedence in the stock price.
At 39 the March Long Call is priced at $3.1 and the Put at $3.8 leading to a position cost of $6.9 excluding other charges – so profit if the stock moves above $45.9 or below $32.1.
At 39 the May Long Call is priced at $5 and the Put at $6.3 leading to a position cost of $11.3 excluding other charges – so profit if the stock moves above $50.3 or below $27.7.
If taking this position, the catalysts for swings in the stock price are further announcements by Icahn, Ackmann and the results calls tomorrow (and analyst call the day after), where no doubt both activists will play their part in the questions. The time value discount of the March position, in comparison to the May, looks to provide significant leverage on the potential up and coming newsflow, whichever side of the story you believe.
(Note this is no way intended as investment advice and is only meant as a discussion of a hypothetical high risk high reward investment strategy)
