On July 15, 2016 the FTC filed a damning Complaint against Herbalife (HLF, Financial) and simultaneously entered into a Stipulation to Entry of Order for Permanent Injunction and Monetary Judgment (the “Permanent Injunction”). The FTC alleged that Herbalife operates illegally and alleged violations of Section 5(a) of the FTC Act. Notably, the findings of the FTC substantially agree with our long held assertion that Herbalife operates as a pyramid scheme. Select assertions by the FTC include that:
- “[Herbalife] does not offer participants a viable retail-based business opportunity.”
- “Herbalife’s business model primarily compensated members for recruiting new distributors to purchase product, not for selling product at retail…”
- “[P]articipants’ wholesale purchases from Herbalife are primarily a payment to participate in a business opportunity that rewards recruiting at the expense of retail sales.”
- “The overwhelming majority of Distributors who attempt to retail the product make little or no net income, or even lose money, from retailing the product.”
The Permanent Injunction, as described by the FTC, represents Herbalife’s agreement to engage in a “top to bottom” restructuring of its business model in the United States to “start complying with the law.”
In November 2016, Herbalife announced that Michael Johnson will transition to Executive Chairman in June 2017 (shortly after the FTC Permanent Injunction takes full effect in May) at which point Rich Goudis, the current COO, will take over as CEO.
Also in November, John Oliver’s Last Week Tonight aired a 30-minute segment on multi-level-marketing companies with a specific focus on Herbalife which has been viewed more than 9.5 million times on YouTube (including 2 million views in Spanish). We believe this segment, coupled with the recent theatrical release of “Betting on Zero” on March 17, 2017 (with AppleTV and Amazon distribution to follow in April), will continue to shape the public narrative and highlight the tremendous harm Herbalife has and continues to inflict upon millions of Americans.
From a financial perspective, HLF’s operating results in 2016 were disappointing to long investors as mid-single-digit topline organic growth was negatively impacted by significant foreign exchange headwinds causing sales to be relatively unchanged vs. 2015. Organic growth decelerated across most regions as the year progressed, declining 1% in Q4. The deceleration of Herbalife’s China business was particularly notable, posting a -6% organic decline in Q4 (-12% actual). Adjusted EPS, which for Herbalife substantially overstates economic earnings, declined modestly in 2016.
Management has guided to 4% to 7% 2017 constant currency revenue growth and currency neutral EPS growth of -13% to - 5%. HLF’s 2017 EPS guidance of $3.65 to $4.05 implies realized EPS declines of -25% to -16%. This guidance includes the incremental interest expense associated with the company’s $1.3 billion refinancing completed in February 2017, but does not include any benefit from potential share buybacks (the board has put in place a $1.5 billion normal-course authorization). Actual EPS will likely be better than current guidance if the company repurchases shares.
In February 2017, Herbalife disclosed a new investigation by the SEC and Department of Justice related to Herbalife’s anti-corruption compliance in China. While it’s difficult to know the specific focus of the probe, any disruption to Herbalife’s China business would likely impact the company’s financial performance given the large size of the China market for Herbalife (~19% of revenue).
Pyramid schemes are confidence games. The newly disclosed SEC/DOJ corruption probe, the CEO departure, declining earnings, and the deteriorating popular perception of Herbalife will likely impair distributor confidence. Furthermore, we believe the injunctive relief demanded by the FTC is likely to affect Herbalife’s financial performance beginning in the second quarter of 2017. With decelerating growth in many international markets, Herbalife’s earnings will likely decline in 2017. We remain short Herbalife because we believe its intrinsic value is meaningfully below the current share price, and we believe the stock should eventually decline to zero.
Herbalife’s total shareholder return was -10.2% in 2016.
From 2016 annual letter to shareholders of Pershing Square by Bill Ackman (Trades, Portfolio).
