One would have hoped that there was some lull in the Herbalife (
) saga with the recent company conference. But no such luck.
Perhaps with the same hook as reality TV, it continues to draw
attention in a stage full of debt limits, euro gyrations and
Japanese monetary politics. Recently, a manager and blogger I
respect, John Hempton posted his "
Notes on visiting an Herbalife nutrition club in
." WSJ MarketBeat picked up the story headlining one of Hempton's
claims as ''
the most easily falsified bear-thesis I have
'' and I got sucked in.
Ackman may very well be wrong, but it's clear that he's done his
homework. And given the time-frames, he has had more time to do so
than those who are more reactionary (Loeb, Hempton and the rest of
the late-to-the-party players including myself). I'd venture that
his research is more thorough than even Ann Coughlin's who was
given company access. But hard work and correct answers are not
always correlated (as a few of my old college grades can
John Hempton's post confuses many issues together. The three
issues of interest are:
- Is Herbalife an
- Is Herbalife a good buy for investors?
- Does Herbalife have some value for society -- at least in the
sense that any productive company does?
Clearly, the answer to #1 is the realm of FTC lawyers and
perhaps the SEC has some stake in consumer protection (of
investors). I am not a lawyer, but to my novice eyes it appears
that the definition of an illegal scheme revolves around whether
the revenue accruing to the company and to the "uplines" are more
the result of sales or recruiting. Herbalife, I suspect
intentionally, has tried to confuse the two. Its proposal to split
out the consumption-only distributors will help greatly in making
his assessment. It remains to be seen, though, how many become
"special customers" to get a discount on a product that is no
cheaper (and perhaps quite a bit more expensive) than a competing
product, if no business opportunity dream comes attached? What is
the price of a hug?
Ackman details his case on the fraud - I am not an expert here
to judge but at least he has made a case. It doesn't matter to
regulators what social good a company does, if by the letter of the
law, it runs an illegal MLM scheme. Lance Armstrong can hardly
claim back his medals, regardless of however good of a person he is
or what good he does for society if he broke the rules in winning
his medals. The problem is not solved by merely calling negative
P&L businesses "customers." And on this point, I found the
evidence in Hempton's blog fairly light.
#2, on a fundamental level, is Herbalife a good buy? With
Herbalife, we have come to a binary outcome because expectations of
growth rates are clumped at two opposite ends. Its historical
growth rates, buy-back strategy, cash-flows etc. are all irrelevant
at this stage. If it turns out, either through regulatory action or
via bad publicity, its "distributors" just don't buy and more
importantly recruit others, the game is over. Herbalife' s core
business is about selling "hope" - the management knows this and
even the founder knew this and it will last only as long as people
believe and more importantly, regulators cooperate. But if, in
fact, this is actually a tempest in a tea-pot (as has been in the
case in the past accusations), and Herbalife can continue to put up
the numbers and discover untapped markets, it is a screaming buy.
It boils down to sustainability.
Even if it turns out that Herbalife is exploiting under-informed
masses but doing so without running afoul of FTC laws, it says
little about its future prospect. And hedge fund managers, of all
people, know that "exploiting information asymmetries" is quite
legal and very profitable. The only question relevant here is
whether the down-line will continue expanding and whether Herbalife
can keep reaching into new markets for that "pop." It may
eventually run out, but "hope" is a very deep well and HLF may very
well enrich investors for a long time.
But, whatever the answer about fundamentals, there is still the
money that can be made from the technicals. This is a stock that is
grabbing headlines, TV-screens and webpages, distracting as they
may be when much bigger issues are at stake. The stock is
hard-to-borrow. And float and short interest are both concentrated
with a few players. Big swings will be the norm. An emotional
retail base is mostly playing with leverage -- options, especially
on the short side (borrow, time structure of vol, IV all point to
this). As this past Monday must have demonstrated to many ITM put
holders, you can be right on the direction and go very wrong on
technical flows come option expiration. But there is a lot of money
to be made predicting technical flows correctly. I would wager that
Loeb and Hempton are more in the latter camp than the former. I'm
not sure that Loeb believes that HLF is a stock to be put away for
children and grandchildren or even a "pick of the year," as much as
he believes that Herbalife can survive long enough for him to be
able to put a massive squeeze on the shorts.
The third question is interesting but rather peripheral to most
professional investors. Whatever your ethical opinions, when you
play with other people's money, you are beholden not to your
personal ethical feelings but to a fiduciary responsibility. Here
is where I objected most to Hempton's post. One, John knows very
well that Herbalife is not AA. AA does not charge people an entry
fee for the social support it provides. It does not pitch one
product and sell another. You cannot blame Ackman for being
out-of-touch with low-income distributors in one breath, and with
the other believe it's no big deal for Herbalife to peddle its
products for a $50-$100 (real money to low-income distributors)
"entry-fee" alongside a story of Ferraris and mansions that these
"business owners" have no chance of realistically achieving.
Clearly, Herbalife products are not low-cost leaders. Herbalife
itself doesn't claim they are "cheap" even if they sell them
primarily to a population that is normally very price-sensitive.
So, it smacks of a
mindset to imply that it's okay to overcharge or dupe unsuspecting
parties in order to do them some good because they don't know
what's good for them or are able to make best decisions on how to
spend that money. If it is indeed exploitative, Herbalife can no
more redeem itself socially on the "community service" and "hugs"
card than Madoff could have by building hospitals and schools with
his ill-gotten wealth. Herbalife has a much bigger obligation to
play it fair and transparent with its distributors than it does to
solve their health or social issues.
On the other hand, I find Ackman's implicit or explicit claims
about being a hero to the downtrodden equally superficial and
self-serving. His fiduciary responsibility is to his investors and
all the bravado would be for naught if he does indeed turn out to
be right but loses money on the trade. He has no more of a right to
spend his clients' money on social betterment than Herbalife does
to try to improve its customers' health via deception.
There appears to be a fascinating game of poker between
big-stake players and sadly, as often is the case with great games,
with real lives and livelihoods at stake. While I understand
Ackman's motivation in publicity once he made his bet, I do not
understand opening the kimono so wide. Why reveal the form of the
bet (no options)? I can even understand declaring that he will not
cover - in essence making it a "Thunderdome" trade with only one
winner. But why reveal your hand and size of your bet, other than
to play hero to the CNBC crowds? With respect to legitimacy, he
only needs to answer to the SEC. I even find rumors of Herbalife's
high-powered lawsuit far-fetched (the last thing Herbalife wants
and the thing that Ackman actually wants is a bright light on
Herbalife's business model). I may be too poor a poker player to
not know an ace up his sleeve (some SPV with borrow locked-up), but
I fear that is more bravado and bluff and it will be hard for
Ackman to withstand a big squeeze. The February earnings will start
revealing the endgame and I, for one, can't wait to get on with the
next episode of "must-watch market-TV".
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
I may initiate either long and short this stock around events if I
find a compelling trade and risk/reward compelling in one
direction. I have no fundamental view about the stock and am
equally content to sit this out.
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