Ever since hedge fund operator Bill Ackman revealed his massive short position on Herbalife Ltd. (NYSE:HLF) back in December, the dietary supplements makers has battled the demons that always hover on the shoulders of multi-level marketing companies: Is it really just a pyramid scheme?
Everybody in the pool!
The problem many MLM companies have is the numbers don’t add up, or rather can’t support the weight of reality. To grow, they have to keep reeling in more people to support the ones above. You bring in two friends to sell, then each of them brings two friends in, and like the 1980’s Faberge shampoo commercial said, “and so on and so on and so on.” After a while, though, there aren’t enough people on the planet to support the structure, and it collapses.
Herbalife contends that it is somewhat different in that its distributors can also be its clients. While that’s a hallmark of virtually all MLMs, from Nu Skin Enterprises, Inc. (NYSE:NUS) and Amway to Mary Kay Cosmetics and even Tupperware Brands Corporation (NYSE:TUP), the supplements maker also says it never really tracked retail sales before, but Ackman’s charge it has few if any customers outside its distributor lists is wrong.
Tupperware, on the other hand, distinguishes itself because most of its end users aren’t also recruited to sell the product. The plastic container maker says 90% of the people who buy Tupperware products don’t sell its products compared with only 10% of its users who are distributors too. In contrast, some 30% of Herbalife distributors are self-consumers.
Inquiring minds want to know
While details are scarce regarding what it is the law enforcement inquiry is investigating, it was the FTC that revealed its existence after the Post filed a Freedom of Information request with the agency and got back hundreds of pages of complaints with some sections redacted because they were “obtained by the commission in a law enforcement investigation.”
This could undermine the position of another hedge fund manager, Third Point’s Daniel Loeb, who bet big with the supplements maker shortly after Ackman’s short position was publicized. He stated it was ridiculous to think the FTC would shut down Herbalife and his stance in favor of the company — along with his 8% stake — helped the stock regain all the ground it previously lost. Even the mano-a-mano CNBC matchup between Ackman and billionaire investor Carl Icahn — which made for great theater as they traded barbs and insults two weeks ago — had the stock briefly rising 6% above the previous day’s close.
Yet when the FTC moved in and closed down a different MLM scheme last week, Herbalife’s stock has turned tail, falling 20% in the week because it hit so close to home. Echoing another of Ackman’s charges against Herbalife, Fortune Hi-Tech Marketing is accused of misrepresenting the business opportunity the scheme presented. Rather than fabulous wealth, distributors often found themselves up to their eyeballs in debt.
Other multi-level marketing companies are also finding it hard to remain buoyant, with Nu-Skin down 8%, USANA Health Sciences, Inc. (NYSE:USNA) down 7%, and Medifast, Inc. (NYSE:MED) tumbling 12%. Tupperware’s stock, in contrast, is up 10% over the past week.
A distinction without a difference?
A law enforcement investigation doesn’t have to mean criminality, though investors aren’t parsing the difference right now, having sold off the stock in early morning trading.
With inquiries coming from all sides now — the SEC, the FTC, and now law enforcement — it’s probably wise to stand on the sidelines and watch the drama unfold. Let the Ackmans, Icahns, and Loebs go at it as they’ve got money to burn if their bets are wrong. For the average investor, letting Herbalife exorcise its demons first is a more prudent course of action. You may not get in at the absolute bottom, but it also prevents your portfolio from getting handcuffed because you moved too early on a stock that turned out to be possessed.
The article Sucking the Life Out of Herbalife originally appeared on Fool.com and is written by Rich Duprey.
Fool contributor Rich Duprey has no position in any stocks mentioned. The Motley Fool owns shares of Tupperware Brands (NYSE:TUP) and has the following options: Long Jan 2014 $50 Calls on Herbalife Ltd. (NYSE:HLF).
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