Herbalife: Trap Doors And Double Bottoms
In a delicious story of a run-in at a restaurant, the myth that Herbalife's (NYSE:HLF) future is all about Bill Ackman and Carl Icahn lives on. Regardless of whatever the outcome may seem to be in the end, it never was and never will be about this battle of Wall Street titans. Nor is it about the FTC. It always was, and always will be about pure economic perversion and an unsound business plan. Having said that, all these skirmishes certainly add to the fun, and are part of shaping the eventual outcome. The question is if any lessons will be learned (usually this is not the case), or if we will go on and continue this aberration of pyramid schemes dressed up as direct sales, in the bizarro alternative universe that is called MLM (Multi Level Marketing).
Despite all the stories and the arguments, it is all about economics and economics is about the financial forces of nature that shape our commerce and industry in the broadest sense. Government regulation and politics also enter into it and are inevitably part of the landscape. What we should always keep in mind is that as politics change, the long-term costs of serious distortions tends to become exposed. It is needlessly hard and pointless to try to swim against the tide, including the laws of economics, and business can subvert reality only so long. Eventually, the flood tide of economic forces will sweep away the unsound. Creative destruction, as Schumpeter called it, is a real thing in capitalism.
In the case of pyramid schemes, the very simple reality is that the structure is unsound, because it is designed for 99.9% of people be sold by pure deception on a proposition that must fail, and ultimately the business itself must fail when its reputation as a bad business precedes it (saturation). At that point, turnover becomes so high that the business collapses. MLM uses an utterly deceptive, illusory business proposition to transfer vast amounts of money in small amounts from the victims to the organizers. Just like the bank thief who figured out that he could get away with the rounding errors on every transaction and become rich, MLM pyramid schemes, like Ponzi-schemes, are an improvement over armed robbery, because the victims seem to part with their money voluntarily, and the appearance of a business proposition provides a foil to keep law enforcement and regulators at bay. And law enforcement and regulators have been easily bamboozled, especially since the A mway decision of 1979. It remains easier to rob with the ballpoint pen than with a gun.
What's with regulation and law enforcement?
It pays to remember what is the ONLY justification of regulation, never mind the fact that capriciousness enters the domain with regularity because of political forces at work. The ONLY pure justification of any regulation is to prevent predictable harm to others. It is important to remember this. It implies that the predicted harm must be an inevitable and preventable outcome of the behavior that is being regulated. If the drunk driver only gave himself a hangover, and presented no danger to others, there would be no laws against drunk driving.
The purpose of law enforcement is not to catch every single law breaker, but to catch enough of them to form a deterrent. This certainly failed in MLM for the last forty-five years. The enforcement was too timid and too haphazard, and an entire industry sprang up out of driving a truck through these failures, but in the Herbalife case something seemed to change for the better with the recent FTC settlement. And then politics seemed to interfere, putting the FTC follow-through in doubt.
Where is the FTC now?
Nobody knows where the FTC is now, after the resignation of Chair Edith Ramirez, but the settlement stands, and is now in full effect. There is the specter of Carl Icahn advising Trump on regulation, which could have been abused by Icahn and ended up in obvious self-dealing, but that is less and less likely as Trump shoots himself in the foot with regularity, and one has to wonder how many losing causes he wants to take on. The new administration is full of MLM-sympathizers, so we can hardly expect vigorous enforcement, although democrats have not been very effective at it either. We are reminded of Bill Clinton's $700,000 speaking fee at Amway.
The new rules should put Herbalife in compliance with their California injunction as well, but as long as the management is hell-bent on negating the terms of the settlement, or ignore it altogether as they did with the California injunction, things can blow up at any time.
The bottom line is, the settlement with Herbalife is a powerful document, and the FTC stipulated clearly that the full adoption of the changes it provided for were to be the beginning of Herbalife "operating as a legitimate company." Herbalife for its part, as per former CEO Michael O. Johnson, and biggest investor Carl Icahn, has been treating the same settlement as a "vindication of the business model," as if it were just a minor tweak, but the numbers already show the effects, and a couple of brilliant recent articles here on SA have laid that bare: Gary Milne wrote: How Herbalife Fooled Wall Street With Its Preferred Member Numbers, and Herbalife Q1, Not So Good and Duane Bair added his two cents worth with New Rules May Force Herbalife To Stop Claiming It Is Healthy.
The bottom line is, the facts are starting to show, and a reasonable person would have to expect that the lack of performance will show increasingly, for there is nothing in the numbers that would indicate a business improvement, and foreign governments by and large still have not spoken, but could at any time. The company pulled out all the stops to harvest its old customer base and somehow make it seem like it was advantageous to people to sign up as members. As reality sets in, the retention numbers are what we want to watch. The trend has not been Herbalife's friend.
The problem however, is not Icahn versus Ackman, and not Herbalife vs. the FTC. The problem is that a pyramid scheme eventually implodes even if nothing is done about it. Remember, the only rationale for regulation is to prevent greater harm, but left unchecked, we will see that greater harm. The perverse effect of prosecutorial and regulatory negligence for the last forty years is that MLM managed to retain an aura of credibility. "A few bad apples" were culled out of the herd, but the rest happily marched on, with firms taking comfort in the fact they were not prosecuted.
Why MLM inevitably causes unacceptable harm
At its core, there is the simple fact that the design of MLM must, with mathematical certainty, lead to great economic harm to the overwhelming majority of participants. Most computations that have been attempted suggest a near zero effective success rate, except for those at the very top, the instigators, and the primary shills. The odds of making money in MLM are therefore comparable to lotteries, and pyramid schemes are usually regarded as illegal games of chance in the laws of many countries.
The bottom line is that a pyramid scheme is not a pyramid scheme because someone called it that, but because it is, based on the pure economics. Under the new rules, Herbalife would have to create a more sales oriented culture, or it would have to flaunt the rules so obviously that it would invite prosecution at any turn. We will now start seeing if that will or won't work, but that is hardly Herbalife's only problem. The true demand for their product is under siege two ways, first, if it's salable without the MLM lottery ticket attached, and second, if the market for the "meal replacement" style of supplements is growing or shrinking. I suspect the latter is going to be increasingly the case - that market is shrinking.
As the diet-fad fades away
The movie Betting on Zero WILL have an effect, but documentaries like Forks over Knives, and the new What the Health, are likely to become category killers. The old style of "dieting," left the Standard American Diet mostly intact, or in some cases (Atkins) made it even worse, and in many cases used supplements and/or meal replacements to help people lose weight. Ever since the China Study first came out, the emerging and solidly science-based trend is towards what is often called the Whole Foods Plant-Based diet, and within it, people find they can eat as much as they want, and they regain their optimal weight usually within six months to a year without any effort. Time for Weight Watchers (NYSE:WTW) to start paying attention. Oprah was closer to the right course when she met with Howard Lyman, and won over the lawsuit from the cattle ranchers in Texas. A simple vegan lifestyle, once you get it, is easier to maintain than either Weight Watchers or Herbalife, or any o ther "magic bullet" diet solution. The new dieting is an altogether new lifestyle, with a much healthier relationship to food, where you give up your bad food habits not as a sacrifice but because you embrace the abundance of wildly exciting food options that opens up to you once you understand the vegan lifestyle. Oprah makes her money fighting her demons in public, but if she'd like to find out how it's done, she should give her old friend Howard Lyman a call - he will show her a simple, vegan lifestyle.
Conclusion
The MLM business model is over the hill, and suffers from ever greater reputational problems. Herbalife is fighting the spirit of the settlement they made with the FTC, which does not bode well for their compliance. In the interim it is showing the early signs of failure from within. All indications based on the recent reports are negative, but you would not know it from Herbalife's management commentary. More importantly, the very concept of the "diet" and "meal replacement" business is going the way of the horse and buggy, and Herbalife is unlikely to succeed with more and more products in other categories, where they don't have any track record.
Carl Icahn (NYSE:IEP) is increasingly stuck with his Herbalife position, and there is no way out for him. He explored selling out a while ago, but he is now truly hoist on his own petard, as my first Herbalife article on this site predicted on May 11th, 2013. Watch out below.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Source: Herbalife: Trap Doors And Double Bottoms
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