Herbalife: Never Again (NYSE:HLF) - Seeking Alpha

The movie ending to the Herbalife (NYSE:HLF) investigation would have been a reincarnation of Eliot Ness riding in on a white horse, and launching a RICO prosecution of the entire MLM industry, so it would be over and done with, but that would have come with years of spectacle. I guess we have no such prosecutors today, and all of Preet Bharara, Eric Schneiderman, and Kamala Harris, and numerous others missed the opportunity to finally produce redress for the masses that were deceived by generation after generation of fraudsters that were all enabled by the judicial error of and inexperienced Administrative Law Judge James P. Timony at the FTC in his Amway '79 ruling, which was then blessed by the whole Commission under Chair Robert Pitofsky. But we won't have that type of a John Wayne ending. Only Illinois took action, and got a settlement for the citizens in that state. There may of course still be other actions. However, compared to the years of an FTC lawsuit the present settlement has a ring of practicality about it, and any lawsuit is always a risk, not to mention it would extend past the tenure of all current commissioners.

In all likelihood, the surgical precision with which the situation has been addressed by the FTC under Edith Ramirez, is more productive, as it is a shorter path to compensation for the victims, and redress. In the simplest terms, besides having to disgorge $200 million for victim compensation, it now allows Herbalife a chance to succeed as a legitimate direct sales business, after the apparatus of the pyramid scheme has been excised from its business model. The completely misleading statements of CEO Michael O. Johnson, and investor Carl C. Icahn, are mostly spin, including the slightly absurdist and comical board resolution to grant permission for Icahn Enterprises (IEP) to raise its allowable stake as high as 34.9%, just in case.

The upshot is, Herbalife was given a chance to succeed on its own, based on legitimate demand for its products, without the benefit of its deceptive, pyramidal marketing structure. The absurd interpretations offered by both its chief executive and Carl Icahn suggest that a criminal prosecution might have been more desirable in some respects, but now the remaining issue is investor deception, and the SEC should take a lively interest since the business projections and reporting that have resulted from perpetuating, defending and justifying a scam that was built on deceptive practices, must themselves be questioned. This should be the time for the company to show leadership in handling the transition ahead, hardly to deny it. To begin with, it will be interesting to see how Herbalife cleans up their reporting, and comes clean with investors. Indications are they won't, based on the statements from Icahn and Johnson.

The upshot of the settlement

With the Amway '79 decision, the FTC saddled itself with the Trojan horse of a completely unenforceable regulatory framework for MLM enforcement, which served no other purpose than to legitimize the scam and indirectly enabled the growth of the industry, as has been admitted even by insiders like MLM Attorney Jeffrey Babener. It was a ruling you could drive a truck through, and for the next forty years, the industry drove a whole convoy through the loopholes it created. Without the Amway '79 decision, there would have been no MLM industry. The FTC relegated itself to the role of a captive regulator, they were regularly present at industry events, and were deeply influenced by the pyramid scheme academy, a.k.a. the Direct Selling Education Foundation. Most recently, it was Commissioner Maureen Ohlhausen who still seemed to be shamelessly pandering to the MLM industry with a speech in that venue, on April 7th of 2015. The exemption of the MLM industry from the FTC's business opportunity rule was perhaps the crowning achievement of the political influence of the MLM industry, but perhaps also overreach.

The current settlement with Herbalife was done with surgical precision, and takes out all the pyramidal elements out of the Herbalife marketing plan. It may indeed be a framework for cleaning up the industry. So the chickens may be coming home to roost. Vemma was the warm-up, but the Herbalife settlement creates an enforceable solution as well as at least some level of redress for the victims of Herbalife, but also a framework for the rest of the industry going forward. The press conference by FTC Chair Ramirez was a classic.

One practical implication is this: the MLM industry in general treats any customer (i.e. non-distributor) on monthly autoship as "preferred customers." At Herbalife the practice has been to relabel distributors without a downline as "members," which means their preferred customers all paid the $60 to $100 entry fee. Eliminating that requirement strips perhaps $100 million of annual cash flow from Herbalife operations.

Once more with feeling

While the FTC, for historical reasons, is still saddled with the unfortunate term MLM, and has to entertain the notion of a legal MLM, the facts, from an economical and criminological standpoint are quite simple:

• An MLM is a mixed breed enterprise, consisting of a covert pyramid scheme, disguised behind an overt direct sales company, it is therefore de-facto a criminal enterprise.
• The symptomology is that the money is in recruiting, not selling, and hence people will recruit, not sell. That is how you tell a pyramid scheme in practice, and it means that retail margins at first go to zero, and eventually product will even be given away as samples, so that the wholesale cost of the product becomes a business expense.
• Participation in the income opportunity is contingent upon quotas, conscripted consumption mandated in monthly or annual terms, which ensure the sustained cash flow that keeps the show going, and that ensures the money transfer from the millions below (4 million in Herbalife's case) to a few at the top. This is the "pay to play" component, and along with other fees, it is the entry fee, the price of the lottery ticket.
• The direct sales business in effect is the money launderer for the illegal gambling operation that is the pyramid scheme, and in fact in many jurisdictions, pyramid schemes are viewed as a form of illegal gambling.

The brilliance of FTC settlement with Herbalife is that it avoided the battle royal over the pyramid scheme allegation, by focusing on the behaviors that cause trouble. By doing so, it excised the pyramidal elements out of the marketing plan, so that what is left is a direct sales company, which ultimately stands or falls with the demand for its products, absent the concealed lottery. Needless to say, the majority of MLMs would not survive that change, but a few might have products that are unique and valuable enough that they can indeed make the transition. The current framework appears eminently enforceable, which the Amway '79 framework was not, and it was typically honored more in the breach than in the observance, to such a degree that the industry association DSA did everything it could to declare it moot, an effort which culminated in the recent attempt at an end-run around the FTC by means of the absurd H.R. 5230, which would seek to legalize illegal pyramids for good, under the false pretense of consumer protection.

The fallout for investors

For Herbalife itself, the settlement rings in a period of radical cultural change at Herbalife, and CEO Michael O. Johnson has given every indication that he is not fit to handle the transition, but he does not have an independent board, and is heavily supported by Carl Icahn who has his own need to perpetuate the lie just to salvage his own tenuous credibility in this matter. Only the SEC could force change at this level, if they paid attention to the serious obfuscation that is now already happening.

Inside Herbalife, the settlement means that the infamous (and highly illegal) Tirelli agreement has been voided, and that was likely the glue that kept the top operators glued to the company, for the company had its hands tied. The situation mirrors how Amway has often found itself in difficulties trying to restrain its top distributors. Without that agreement, a significant exodus is likely, for the Tirelli agreement protected the position of Herbalife distributors. At lower levels, duking it out through the changes within Herbalife may not be so attractive if you're not making any money to begin with, and the future is murky.

All publicly listed MLMs are going to be affected and possibly at least some have products that may be viable and could make it, but many won't be able to succeed if they have to tell the truth. Here is the Stock Watch page from MLM Attorney Jeff Babener's site for the close of the day of the announced settlement. Worth referring back to for the next few years.

To spell it out, we should observe one general issue: the older and more mature MLMs are already dealing with saturation and to retrain entire sales forces that have been trained the wrong way is an unlikely feat, so attrition is likely to be huge at the top, particularly, if newer entrants create compliant models to begin with, and have viable products. It will be much more attractive for independent distributors to join companies that are on the right side of the law. Here are some comments about the individual companies:

• Avon (AVP) has been in a tailspin because of its own misshapen and half-hearted embrace of MLM, which has nearly destroyed the franchise of the Avon lady. It is now forced to undo that unfortunate episode. If it has a business after that remains to be seen, but it made the first step in the right direction when it quit the DSA, in a letter dated September 12, 2014. It should now exit the MLM model as soon as possible, and reinvent itself all over again.
• Medifast (MED) was recently at highs for the year, so depending on how it goes about changing, there might be a lot of downside there.
• LifeVantage (LFVN) has also been trading at highs for the year, although there have been many signs of trouble. A lot will depend on how it handles the transition.
• Nature's Sunshine (NATR). Has a P/E ratio at 19.43, so depending again on how it handles the change, it looks like a stock with a lot of downside.
• NuSkin (NUS) also is trading at highs for the year, and it remains to be seen how it might address the new realities.
• Primerica (PRI) has had its run-ins recently, in particular around its opposition to financial regulation to prevent the type of ethical conflicts it has found itself in, which are exacerbated by the unfair and deceptive practices of its MLM structure. Its CEO could barely get out of his own way at the time, when Sen. Elizabeth Warren challenged him. He would not appear to be material to create the type of organizational change that is now indicated, and the stock has been touching highs for the year recently as well. Plenty of downside as well, it would seem.
• Tupperware (TUP), like Avon, pulled out of the DSA, because they considered them too cozy with overt pyramid schemes, but did not do anything about its own business structure. Now it can't avoid dealing with it much longer. Ignoring these developments is not an option if you've already partially committed to the change. Recently, the stock was also near highs for the year, so it remains to be seen if this company can make the change complete.
• USANA (USNA) is another older and mature MLM, meaning a wrenching change of culture is ahead.
• Youngevity International (OTC:YGYI) looks like a weak player, and depending on how the changes propagate post the Herbalife settlement, this could come unglued really fast.
• JRJR33 Inc. (JRJR), is the reincarnation of the misshapen MLM roll-up CVSL, and likely to come unglued very quickly, depending on how the FTC goes about the next steps.
• Educational Development (EDUC) is an interesting case. SA author Jeff Blum has been singing its praises. It appears more of a party plan model, like Tupperware, but if it can support itself on retail sales alone remains to be seen. History makes clear that it was competing against Amazon. Without the deceptive earnings claims indigenous to MLM, it may find itself competing on price. Worth some research, particularly if management gets ahead of the curve, and finds a way to make the change. It's been close to highs for the year recently.
• ForeverGreen (OTC:FVRG), is from an ingrained MLM culture, and will likely have a tough time making the change. A review is here. The stock tells a strange story, bouncing between 31 and 36 cents for the year, and there may not be a lot of resilience here.
• Mannatech (MTEX) is another long-standing MLM. Closing at $20.40 on Friday at the low end of this year's range, it would seem to be another ingrained MLM story that is going to be hard to change. It had a brief moment of glory because of its affiliation with Ben Carson, but that may now be against it. Alex Pitti has been doing some good work on it, on SA, here.
• Natural Health Trends Corp. (NHTC), a younger player, and it is Hong Kong based, so it could possibly just abandon the US market, though eventually other governments might catch on. Fellow SA writer Duane Bair thought the numbers did not add up.
• RBC Life Sciences, (OTC:RBCL) is another penny stock play. It would not seem to have a lot of runway, and the changes could easily do it in.
• Berkshire-Hathaway (BRK.A) has three MLMs under its wing, and given its public stance on the Herbalife matter where Charlie Munger vocally supported Bill Ackman's position, one would imagine it would make it their business to clean up its operations, so Kirby, Pampered Chef, and Worldbook will all have work to do. This is one place where a new model could emerge at least for some, if the products are indeed viable. One might presume there is an interest in staying on the right side of the law.
• Immunotech (OTC:IMMB) is more or less a joke, another OTC stock, but it might have one viable product. Its Immunocal whey protein supplement has been listed in the PDR for a long time, as a viable glutathione precursor. It might have value. The rest of the company may not be worth the time of day, and abandoning their MLM operations may be the death of them, apart from the value of one or more products that could survive in their own right.
• Oriflame (OTC:OFLMF) trades on the OTC and is from Switzerland. Could they ignore the US? Those are going to be interesting questions for foreign-based MLMs.

There are other interesting cases for those who want to dig a little deeper. Dutch financial giant Aegon (AEG), with 65% of sales in the US, owns World Financial Group, which is a Primerica clone. WFG would need material reforms if it wants to stay on the right side of the law, and the Aegon board might be sensitive about such issues. Aegon might be particularly interested in doing some house cleaning, because it is not performing well as a company. No doubt many other examples like this could be found.

The regulatory and political angle

Only time will tell if this settlement was a practical masterstroke by the FTC under Edith Ramirez, setting a precedent for the clean-up of a troublesome industry, or a sly maneuver to get the industry out of the spotlight by a face-saving move for one of its worst offenders.

It remains unclear why, if I sell you the Brooklyn Bridge it is a fraud, but if Herbalife does it two million times per year it is a business that may need to be regulated, but we won't make a stink... If this settlement is managed in the right way and leveraged to clean up the MLM industry once and for all, it may prove to be a masterstroke. Anything short of that the FTC will become permanently irrelevant, as a captive regulator.

The big unknown is H.R. 5230. It should be laughed out of Congress, but if it is taken seriously, or snuck in with some other bill, and passed, it will gut everything the FTC just did, and the mess will be even greater than post Amway '79.

On the other hand, the SEC has been shown up. Why allow obvious pyramid schemes to be publicly listed? They are nothing but Ponzi schemes on the installment program for people who are not "qualified investors." Why allow Carl Icahn to overtly shore up the stock price on the day of the announcement of the FTC settlement with this empty board permission to acquire up to 34.99% of the stock, raising his prior ceiling from 25%, while he continues to hold just 17%? And besides the fact that other states may yet seek relief, there is also a wide range of other issues, particularly around the nutrition clubs, that could trigger local action.

The International Dimension

Internationally, there are many indications of trouble for MLM, starting with some countries banning it altogether, like Bahrain did, and the big unknown may be China, which has the legal framework to put an end to MLM if they want. In Europe, the corruptive influence of the DSA and its international arm have profoundly hampered pyramid scheme prosecutions, as has been documented in a recent doctoral thesis by Orsolya Tokaji-Nagy, here. Simple fraud, and unfair and deceptive practices might still be illegal for a while, so there might be hope, once law enforcement realizes that the MLM/pyramid scheme model is really a criminal enterprise (the pyramid scheme aspect is a form of illegal gambling under most European law), that is disguised as a direct sales business. The changes of the Herbalife settlement, if they are enforced industry-wide in the US would return MLM to being actual direct sales, and recruiting would take a back seat, like it should be.

On the plus side, Vemma was thrown out of Italy before the US shut it down, and there was a judgment against Xango in Italy in 2010, although right now it is taking off in Europe, with some of the action in my native Holland, as was recently written up in the FD (Financieel Dagblad), the Dutch equivalent of the FT, or WSJ, in extensive coverage of the progress of Xango, especially with their recruitment among college students, just like Vemma did here. In short, the Herbalife settlement may be enough to wake up the rest of the world, or it may exactly be weak enough to let sleeping dogs lie. Time will tell.

One thing is sure, in some foreign jurisdictions, there might be more chance of an interest in other areas of consumer protection, such as labor laws, and other regulations. Nutrition clubs need lots of loopholes and sleepy regulators to operate...

Conclusion

Conclusion? It is too early. In fairness, even my John Wayne ending with a new Eliot Ness riding herd on the pyramid scheme racket would not be as easy as it seems. What matters is creating a path forward. If the aftermath of the current settlement is executed correctly, forcing change might prove the better way to go. Whatever the appeal of Michael O. Johnson and Carl Icahn in handcuffs, it would bump into the reality of needing to jail an entire industry. In short, if seven years from now the Direct Sales Industry is reformed, and a model of corporate citizenship, Edith Ramirez would be a hero. If this settlement results in a muddle that allows the industry to fight another day, this is an ungodly mess, and a complete failure.

From an investment standpoint, with all the risk of generalization, it would seem smart to abandon the old companies that will have to struggle through this change and focus on any players that come up with viable new models. At the current highs, most of the industry might be a viable short, unless it becomes clear that the FTC does not follow through. The country owes Bill Ackman a debt of gratitude, and even though his payoff will be a bit slower in coming in the current scenario, it will come, for Herbalife's transition to legitimate direct sales, will be a challenge.

As a final note, in my first article on this mess, right after Icahn took his position, I predicted he would lose his investment. Obviously, my timing was off. However, presently Icahn has compounded that error by his obvious support for the stock with the PR relating to increasing the ceiling on his position, issued on the day of the announcement of the FTC settlement, and violating the terms of that settlement on the very day it was announced. Icahn thus seems committed to going down with the sinking ship, and continuing to conflate the old direct sales model he once knew in the Fuller Brush Company with the plainly illegal MLM model of Herbalife. Instead of leaving well enough alone and cashing in, he is committing himself to supporting a management that got the company into its current troubles. Given the size of his position, his options for liquidating it are minimal to non-existent.

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