Whether you have seen their logo on the jersey of your favorite soccer player, drink one of their nutrition shakes every morning, or have been part of the company’s recruiting mechanism; you are probably aware of the multi-level marketing company Herbalife.
According to the company website: “Herbalife Nutrition is a global nutrition company whose purpose is to make the world healthier and happier. We have been on a mission for nutrition – changing people’s lives with great nutrition products & programs – since 1980. Together with our Herbalife Nutrition independent distributors, we are committed to providing solutions to the worldwide problems of poor nutrition and obesity, an aging population, sky-rocketing public healthcare costs and a rise in entrepreneurs of all ages.”
The company’s main channel of distribution is through its Herbalife Distribution model, which allows anyone with a tax number to register and start selling Herbalife products under the incentive of receiving a commission on sale premium. Distributors are encouraged to recruit other individuals to redistribute their product to even more individuals – creating a distribution web where the original distributor receives further premiums from any sales that result from their distributors. This allows consumers of Herbalife products to benefit from an additional cash flow while expanding the company’s direct sales network.
If you break it down, this isn’t exactly anything new. Purchasing a single unit from a manufacturer will always result in the consumer paying the full price, while purchasing bulk, or wholesale amounts almost guarantees the purchaser a discount. The problem that most people have with Herbalife is the misrepresentation of this opportunity, and false promises of a get rich fast business. In short, many investors and critics will call the Herbalife business model a pyramid scheme. One such investor is Bill Ackman, hedge fund manager, activist investor, and owner of Pershing Square Capital Management.
In May 2012, Bill Ackman shook Wall Street by short selling Herbalife stock (NYSE: $HLF) to the tune of roughly 12% of his fund’s capital, equal to roughly $1 billion. Bill Ackman made the case that the MLM relies entirely on a pyramid-scheme to keep earnings afloat, scams millions of consumers yearly, and deserves to be brought to court and – obviously – feel the firm hard of the market price discovery process that will drive the stock down to a target price of $0.
Short-selling offers traders the chance to bet against the success of a company, and profit from a decrease in the assets price. This pessimistic move comes with a significant risk premium.
While purchasing a stock offers the investor a chance to profit from an increasing asset price, the stock can grow endlessly increasing the value of the original investment. However, if the company that issues the stock price crashes, or is under the influence of a financial crisis, the stock price cannot fall below 0 and the investor risks losing only the sum of his original investment. When a stock is shorted there are several other factors in place.
An investor cannot sell what they do not have, and a pessimistic investor does not want what they wish to sell short. Therefore, an investor must borrow shares from the company or another investor and sell them at the current market price – thus becoming short the shares that they have borrowed. When the stock price drops down to the investors target price they must then repurchase the shares from the market (at the lower price) and return them to the lending party – covering their short. The difference between the original price and the covered price is then pocketed by the investor. There are two more issues with this scenario. An investor lending out their shares is sacrificing the opportunity to use those shares, and collect dividends. This opportunity cost is reflected in an interest that is paid to them by the borrower. This interest is also subject to change based on the market outlook of the company. Lastly, as aforementioned; a stock that is bought may increase in value infinitely, and decrease only to 0 – a fixed maximum loss. A stock that is shorted; may continue increasing in value infinitely, creating an infinite loss for the investor, and decrease in value only to 0. A short seller must be prepared to have their maximum possible profit capped, and their losses infinite. This also means that a short selling investors maximum profit is 100% of the investment. When your original investment is $1 billion, infinite loss doesn’t exactly roll of the tongue nicely.
Bill Ackman entered his position in May 2012; where the average trading price of Herbalife was $44.5 per share (the real prices Ackman traded at are not available). Unfortunately for Ackman, his position is still getting squeezed as the stock has continued to appreciate in value and currently trades for $67.21. Not only, is he experiencing a mark-to-market loss $115 million, Ackman holds 75% of Herbalife’s short-interest which forces him to pay $63,000 a day to maintain his position – putting him further out of the money.
2017 has seen Herbalife entertaining the idea of selling the company to an unknown private investor, and has prompted Herbalife to announce in August the recall of $1.5 Billion shares over a 3-year program. On August 31st Herbalife also announced a share-price minimum of $57, and a share-price maximum of $71.40 that gives the company the right – with no obligation – to repurchase their shares. Herbalife insiders will also retain their company ownerships stakes. By decreasing the supply of outstanding shares two factors come into play. Firstly, with a decreased supply of shares, and a consistent company earning schedule the share’s value increases. Secondly, the lower supply of shares also will raise Herbalife’s short-interest – forcing short sellers to pay a higher premium on borrowing their shares. These constraints may put a squeeze on Ackman that will force him into covering part of his position in order to stay profitable. Financial analytics company S3 Partners estimates that his positions operational costs may increase $300,000 per day, and after the program is complete to $1.2 million. Let’s not forget to mention that Bill Ackman has already spent a lot of money on research and production for his documentary “Betting on Zero”.
Does this mean that Bill Ackman is doomed to see red indefinitely?
Yes, and no.
While the Ackman has pledged any residual profits from the short to his own philanthropic Pershing Square Foundation, there still might be hope.
On Monday, September 18th, 2017, a racketeer influenced and corruption organizations (RICO) class-action lawsuit was filed against Herbalife LTD and its individual defendants in the federal court of Florida. The focus of this lawsuit is centered around Herbalife’s events and the deceitful tactics used by the company in marketing access to these events. Quoted from the filing:
“This action seeks recovery from a corrupt organization of individuals and entities who act together, using misrepresentation and deceit, to sell access to a series of emotionally manipulative live events.”
Herbalife advertised a direct correlation between attending their events and seminars with increasing the attendees’ wealth.
The lawsuit is yet another red flag showing the unethical methods used by the company in an attempt to generate more revenue. The Federal Trade Commission (FTC) has recently brought action against Herbalife, forcing the company to restructure several of their business models. 2017 Q3 will be the first 3-month period in which Herbalife will operate under the new guidelines, while dealing with an additional lawsuit. This period should not only test the company’s balance sheet and potentially influence future investor outlook, but also Bill Ackmans nerves and wallet.
If the earnings pull through Herbalife would definitely be considered a profitable company with a valuable stock. The debate for whether Herbalife is a pyramid scheme or not is ongoing, even so many consider that any company caught in such a debate should not hold weight in their portfolio.