A presentation on the FactsAboutHerbalife.com site set up by Ackman quotes Herbalife CEO Michael Johnson as saying “what we’re doing at Herbalife, is we’re building the best business opportunity on the face of the Earth.”
That, to Ackman, is exactly the problem. The company isn’t really in the business of selling protein supplements and using multilevel marketing to sell them. It’s in the business of selling distributorships and using weight-management products as a vehicle. Pershing Square believes that the vast majority of distributors earn little-to-no income while, crucially, those who do earn income earn the vast majority from selling new distributorships rather than selling actual products. Key to his argument is that all Herbalife is selling is commodity products (as witnessed by the company’s scant R&D budget) at inflated suggested retail prices. That’s not a business that can possibly sustain Herbalife’s profit margins, suggesting the real business is the distributorships themselves—which would put the company squarely into the danger zone identified in previous case law on pyramid schemes.
The company and Loeb say this is a total misrepresentation. They cite a Lieberman Research survey indicating that about 5 percent of American adults have tried Herbalife, note that competing firms with different marketing strategies such as GNC also have little research and development spending, and, most of all, say that up to 70 percent of distributors joined up to gain access to wholesale prices, not as part of a get-rich-quick scheme or a fraud.
As far as Ackman’s bet, it would be a long shot for the Federal Trade Commission to step in and essentially destroy a company at the behest of a hedge fund. But viewed in a certain light, Herbalife’s self-defense is damning. The company is essentially saying that it’s not a fraud; it’s a run-of-the-mill business in which customers buy distributorships in order to gain discount pricing on overpriced stuff. That doesn’t necessarily mean it’s a bad business. Monster, Inc. seems to do a nice business selling overpriced electronics cables of various kinds, and Beats By Dre has achieved frighteningly large market share with its overpriced headphones. There are all kinds of ways to make a buck in the world, and many of them are dishonorable without being illegal. If Pershing Square can essentially bait Herbalife into explaining its business model in a high-profile way, that alone might damage the company and make the short play pay off.
But for now Ackman’s bet against Herbalife looks to be in trouble. Shares in Herbalife tumbled to $24.24 on Dec. 24 when Ackman revealed his campaign. But they rallied on Loeb’s vote of confidence and they soared Monday morning all the way back to pre-short highs. Now the company’s in a position to squeeze short-sellers with a large buyback program that will push shares even higher. A short-seller is exposed to potentially infinite losses if the target firm’s shares go up and up, so it’ll be a nerve-wracking moment for the participants. But for those of us who are just spectators, it’s a case—an all-too-rare case—of the financial system acting in a real way to test and probe the actual economy. Herbalife’s various accounting and business practices are now being but under the microscope in a way that doesn’t happen to most companies. If the company survives, it’ll be by withstanding scrutiny rather than flying under the radar—exactly the way it should be.