Tilson 76% Sure About Herbalife Ltd. (HLF) Short – Follow Up

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Whitney Tilson said that he was 76% sure about his Herbalife Ltd. (NYSE:HLF) short in a letter which we posted earlier this week. Tilson has a short follow up on why he thinks Herbalife is a good short and Bill Ackman is correct – below is an email which Tilson sent to followers this morning.

Whitney Tilson on Herbalife

The slides from Bill Ackman’s 3-hour presentation on Herbalife Ltd. (NYSE:HLF) on Tuesday (plus a handout) are now posted at: http://www.herbalifepyramidscheme.com/webcast. I think a lot of people have looked at the stock price reaction and the scathingly bad press and concluded (without doing the work) that Ackman presented nothing new. Au contraire. If anything, the problem with the presentation is that he’s uncovered so many bad things Herbalife is doing that it led him to try to present too much. That doesn’t work so well in today’s investment climate, dominated by investors making snap decisions based on a few headlines or bullet points.

But keep in mind that the key audience for his presentation (and all of the work he and his team have done) is not investors – the stock price is irrelevant – but rather the half dozen or so regulators scrutinizing the company. Ackman has handed them, in my opinion, an exceptionally detailed roadmap of all sorts of illegal and nefarious things Herbalife Ltd. (NYSE:HLF) is doing, and it’s inconceivable to me that they won’t take significant steps to rein in the company.

Case studies

To understand how this is likely to play out, there are two good case studies:

a) MBIA Inc. (NYSE:MBI), where Ackman was mocked for years before being totally vindicated (and making $1 billion in one of the greatest trades ever) (full the full story, I highly recommend Christine Richard’s book, Confidence Game: How Hedge Fund Manager Bill Ackman Called Wall Street’s Bluff); and

b) The for-profit ed sector. Just like Herbalife, these companies preyed on the most vulnerable, unsophisticated people in our society, selling them the American Dream, and instead delivering the American Nightmare to almost all of them. It didn’t happen quickly (and is still going on), but regulators eventually acted, slowly but surely forcing the companies to stop their exploitative actions – and as you can see from what’s happened to nearly all of the stocks in the sector, it turns out that there’s no business left when you remove the fraud and deception.

Herb Greenberg: The importance of what Ackman presented

Amidst all of the bad press, I found three articles that cut through the noise and nailed the importance of what Ackman presented. Here’s Herb Greenberg:

As I wrote in a blog post Tuesday night, Ackman’s presentation was clearly an “anticappointment.”

Yet it was blockbuster or would have been considered a blockbuster if it was being presented to an investment committee at a hedge fund to support a position. And it would have been blockbuster if it was written as a 5,000 word piece in a major newspaper or online investigative site like Pro-Publica, based on the superb investigative skills of the no-razzle-dazzle Christine Richard, a former journalist who has worked at Dow Jones and Bloomberg and was contracted by Ackman to do much of the digging. (Sorry to break the news to you, but good investigative reporters often aren’t good TV.)

But in this world of Wall Street, where all anybody cares about is the symbol and the next trade, Ackman made two mistakes:

1. Going on TV the day before and priming the pump for investors to expect something blockbuster, and

2. Not thinking like a TV producer — something, as a former print newspaper guy, that still sometimes gets lost on me in the world of TV, where the mantra is “Just tell us the headline”

Instead — silly him — what Ackman did was lay out, step by step, in the laborious, methodical and even sometimes boring nature of an investigation, what he found. He was giving viewers in a world where attention spans are shorter than memories, too much credit for caring about the details.

Dan McCrum nails Herbalife as well

Dan McCrum of the FT nails it as well (in the 38th installment of his Living the Herbalife Ltd. (NYSE:HLF) series – links to the first 37 are at the end of his article):

So, Bill Ackman cried on Tuesday at the end of a presentation the showman investor had said will define his career. He remains committed as ever to what he first trailed as “the patriotic short”. For better or worse the reputation of his hedge fund, Pershing Square, will be hard to disentangle from this campaign to shut down Herbalife Ltd. (NYSE:HLF), the multi-level marketing company he has said is a fraud.

What did we learn, then, in 250 slides over the course of three hours?

Actually quite a lot about the way a pyramid scheme targeting the very poor can work. Which is not to say that Herbalife will be declared fraudulent and shut down — the multi-level marketing company says it is misunderstood and legitimate, while government agencies are doing their own work and will form their own opinion.

Rather it is that two of the biggest criticisms of the short case have been answered head on. Any serious defence of the company now requires more than simply pointing to the existence of customers at so-called Nutrition Clubs as a sign of legitimacy, or the role of one alleged bad actor who has left the Herbalife system as the source of the worst alleged abuses.

Indeed, the investigation by Pershing Square has fundamentally shifted the debate. Since Mr Ackman’s first presentation in December 2012 the key issues have been legalities and the question of internal consumption, due to Herbalife’s defence that its business is misunderstood rather than illegal.

The point about such internal consumption is that it’s easy for a multi-level marketing scheme to look like a pyramid from the outside. A pyramid fraud is defined by its structure, where recruiting new salespeople into the scheme is the only real way to make money, and a small minority at the top profit from spending by the majority. Herbalife sells both nutritional shakes and the opportunity to build a team selling nutritional shakes, but only a small proportion of recruits make money. At a glance it is pyramidical.

Herbalife Ltd. (NYSE:HLF)’s line has been that actually most people are not building a business at all, they just like the product. Its salespeople — known in the jargon as distributors — buy diet shakes at a discount and such internal consumption is fine. There are several problems with that argument, as we have outlined here, here and here, but without internal company data it produces a stalemate until investigations (which Herbalife has said it is co-operating with, where it is aware of them) by the Federal Trade Commission, the Securities and Exchange Commission, the Federal Bureau of Investigation and state attorney generals are concluded.

Which brings us to the presentation.

How do you target the poor with a pyramid?

The core of the presentation was an attempt to link the strategy of chief executive Michael Johnson for growth with the pattern of behavior that Pershing claims to have uncovered in several countries. Alleged pyramid-fraud behaviour at Nutrition Clubs might be dismissed as bad actors, but the aim is to place those practices at the centre of the company’s overall strategy and structure.

…What Pershing has described is the workings of a system that is not based on real consumption but instead a treadwheel of recruitment. It charges that the design of the system is not accidental, but at the heart of the strategy of the world’s best run pyramid scheme that has found a way to exploit the hopes of the world’s poor, what it calls the bottom of the pyramid. And without the contribution from Nutrition Clubs, Herbalife Ltd. (NYSE:HLF) would collapse.

Quoth the Raven on Bill Ackman’s Herbalife presentation

Lastly, here’s Quoth the Raven’s take:

In between tons of exposition (some of which, admittedly, which was longwinded), Bill Ackman did just seem to expose a massive fundamental flaw behind Herbalife’s business model.

Not only that, but Ackman made an entirely different and equally important short thesis behind the company. If regulators don’t shut the company down, Ackman has offered us today what is seemingly another method in which the company could implode. This is especially important for those that take the long view on the company assuming that regulators – yes, all 7 of them (SEC, FTC, FBI, DOJ, 2 AGs, Canada) – are not going to have the testicular fortitude to step in and shut the company down.

Say that’s true, and the regulators exonerate the company (unlikely, in my opinion). We still have this nutrition club mess to clean up.

…Nutrition clubs make up a massive amount of Herbalife Ltd. (NYSE:HLF)’s revenue. That revenue is a product of distributors consuming each other’s product as part of an Herbalife training program. Ergo, Ackman’s argument states, if nutrition clubs face a crackdown, the company regresses financially in a massive way.

I can’t speak for the rest of the world bidding up the stock today, but it sure makes a hell of a lot of sense to me.

This is significantly more important that people are noticing, in my opinion. The reasoning behind that is that this is an entirely new outlet in which the company could face turmoil. It is, in essentia, an entirely different and completely valid short thesis that would stand alone on its own; let alone with the facts that have already been disclosed.

The others, of course, having to do with the false income claims, false medical claims, and pyramidal structure of the company’s fundamental business model. Oh yeah, and pesky items like current Board members flushing their fiduciaries down the toilet and leading uneducated marks to believe they can earn $100k/month.

Although it slipped under the radar — for now — this message was delivered loud and clear to me today. I continue to believe that it’s only a matter of time until Herbalife collapses — whether it’s under its own weight, or at the hand of a regulatory agency.

The case of Herbalife Ltd. (NYSE:HLF) is not one of a sprint. This isn’t about what the stock price is at today, it’s about what the long-term result of shining light on every aspect of the business plan is going to do to the company.

So, bulls, enjoy your day. Admittedly, your gains are my paper loss today.

The market didn’t notice today, but they can’t ignore the facts forever. I will continue to hold and add to my short as funds become available. Regulators now have more than ample rope to hang the company — and I believe they will.

Time is on the side of the shorts and regulatory action is more likely now than it’s ever been, in this investor’s opinion.

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