During his conference call this morning, Bill Ackman (Trades, Portfolio) presented on Herbalife’s settlement with the Federal Trade Commission. After summarizing background information of the case, Ackman discussed the implications of the settlement based on three complaint categories.
On July 15, the FTC filed a complaint for a permanent injunction and relief against Herbalife Ltd. (HLF, Financial), a company in which Ackman has a large short position, charging the company with several illegal business operations. The FTC categorized these complaints into three groups: unfair practices to customers, income misrepresentation and false or unsubstantiated claims from retail sales. According to the presentation, Ackman believes the company promoted an unrealistic compensation structure: Several “distributors” claimed in their testimonials that by working at Herbalife, their monthly salaries allowed them to live an extraordinary lifestyle.
However, the compensation structure relies heavily on recruitment bonuses instead of retail-based profits. According to the complaint, the company pays its distributors not due to selling products, but by buying products and recruiting new members to their network. Although most distributors work long hours, those who failed to recruit new members made little profit or even suffered losses as a result. The presentation states that the top 13% of recruiters made less than $300 per year, suggesting that employees seldom earn substantial income.
In addition to promoting unfair customer practices, Herbalife misrepresented its income. As detailed in the FTC complaint, the company reported excessive total revenues in several of its products: fitness products, meal-replacement foods and other retail items. Not only are most of these retail sales false, they are also unsubstantiated, i.e. not easily verifiable with the Securities and Exchange Commission.
The above complaints suggest that Herbalife likely constituted a “pyramid scheme,” an illegal business that promises high compensation for recruiting new members and making qualified purchases. Despite this, Carl Icahn (Trades, Portfolio) concluded that Herbalife is not a pyramid scheme and the management should be vindicated. The chairman of the FTC declared she will not endorse Icahn’s statement, affirming her position that Herbalife is likely a pyramid scheme.
After detailing the FTC’s complaints with Herbalife, Ackman summarized the specific injunctions enacted on it. In addition to curtailing all images promoting lavish lifestyles, the FTC prohibited all “qualification purchases,” those that allow members to upgrade their membership status. Additionally, the FTC made stringent limitations on the company’s compensation program. Herbalife can only pay full compensation if the company’s net “rewardable sales” represents at least 80% of all sales. Otherwise, the FTC limits the compensation to just 41.75% of the “rewardable sales.” The injunction relief defines these sales as follows: sales made to preferred customers that the distributor personally recruited or that were in his “downline,” profitable retail sales to downline customers and up to one-third of approved rewardable personal consumption. Additionally, Herbalife must document all of its sales and present them to the SEC when requested. While it could be tedious, this allows the SEC and FTC to verify that all documented sales actually happened and none are made up.
For more information about Ackman’s conference call, you can view the attached PowerPoint.
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Pershing Square Capital Management L.P. Q2 Conference Call Presentation on Scribd
Disclosure: The author currently has no position in Herbalife.
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