February 01, 2014
Ackman’s Folly: 7 False Assumptions on Herbalife
by Kevin Thompson
Editor’s Note: Direct Selling News contacted Kevin Thompson directly and requested a condensed version of a longer article he recently wrote. We reprint his point of view because we feel it is a perspective that should be shared with our DSN audience.
The full article is also available on Thompson’s website at www.thompsonburton.com.
It’s been almost a year since Bill Ackman announced his short position on Herbalife (HLF—NYSE). With much media fanfare, he gave a 300+ slide presentation explaining the validity of his thesis. On Bloomberg, he confidently declared, “This is the highest conviction I’ve ever had about any investment I’ve ever made.” To the casual onlooker, it appeared that all hope was lost for Herbalife. But those of us who benefited from a little more context knew better. We’ve seen this movie before with convicted criminal, Barry Minkow. Admittedly, Bill Ackman is different than his felon predecessor. While Minkow concealed the fact he was paid for his attack (fraud), Ackman made his position clear from the start. And really, that was the only difference. They both relied on the same worn-out anti-MLM arguments. They both stitched together various quotes and articles, most of them out of context, in an effort to stretch the truth and create an appearance of filth.
They both ultimately failed. As I’ve watched the debate unfold over the past year, I’ve been greatly puzzled by the amount of effort Ackman has expended to kick down this “unsustainable pyramid.” While I don’t think he’s a bad person, I think he’s obviously crossed a line and gone from an objective fund manager to a mean-spirited fund manager. It can happen to anybody. I tell all of my children, “Thompsons control their emotions.” I started reciting this maxim when I noticed my 4-year-old daughter making poor decisions during one of her fits. Under the influence of strong emotions, we all make mistakes. Ackman is clearly under intense emotions when he says things like,
“This is not a trade for me, we are going to take this… to the end of the earth.” He’s ignoring basic fundamentals and investing purely on ego. At some point, he got off track. I’m calling the game. It’s over for Ackman’s bet, no matter how hard he postures. Herbalife is not going to be shut down as a pyramid scheme. I can count seven assumptions made by Ackman that have all turned out to be faulty. It was his reliance on these assumptions that led to his reckless confidence.
1. He Assumed Bigger Means Better
Central to Ackman’s thesis is a legal report prepared by someone at Sullivan & Cromwell. To this date, Ackman has not provided this report, though he still falls back on it when pressed about his thesis. Sullivan & Cromwell is an enormous law firm based out of New York. With over 800 lawyers and $1 billion in revenue, it’s safe to place them in the “big firm” category. But bigger is not always better. While Sullivan touts a number of reputable brands as clients, they’ve likely advised zero clients regarding their sales in a network marketing format. I represent network marketing companies, and I know the competitive landscape of lawyers in my space. Candidly, Sullivan & Cromwell is completely off the map. With MLM law, being a generalist is a plan for failure. If someone at Sullivan & Cromwell told Ackman that Herbalife was a pyramid scheme, he or she lacked meaningful experience to know better.
2. He Assumed He Could Hypnotize the Market
Ackman assumed that with the awesomeness of his initial PowerPoint presentation, the market would panic resulting in a massive selloff. And truthfully, the market did panic for a couple of weeks before growing immune. Bob Chapman and I published the first article that challenged Ackman’s position. (Chapman is the Founder of Chapman Capital LLC, a Los Angeles-based investment company, and was an activist versus Herbalife following the death of Herbalife Founder Mark Hughes in 2000.) Two weeks after Ackman’s initial presentation, when the wound was still fresh and the stock was trading in the low $30s (it’s now at $75 per share), we pointed out that the emperor had no clothes. Ackman did not anticipate large fund managers betting against him. As other funds began doing some due diligence, they all started piling on the long side based on the realization that Ackman’s only shot was government intervention. As the market sobered up, Ackman’s presentation was placed under a microscope and found to be grossly inadequate for purposes of finding illegality.
Bottom line: He assumed the market would follow his “well-researched” logic. He thought wrong. The most notable of long investors are Carl Icahn, George Soros and Bill Stiritz. Notable investors in Ackman’s camp: zero.
3. He Assumed the Salesforce Would Collapse
When I first saw Ackman’s presentation last year, I thought to myself, “There’s no way Herbalife distributors can build with this kind of negative publicity.” They surprised me, and they surprised Bill Ackman. Ackman’s presentation was almost a self-fulfilling prophecy. If the salesforce were rendered inert, the stock would tank, thus proving his theory that Herbalife is a volatile pyramid destined to collapse. While the collapse would have been directly tied to Ackman, he would have attributed it to the volatile nature of pyramid schemes. As stated earlier, the stock bounced back. As for the salesforce, they trudged forward, producing significant results under tremendous pressure quarter after quarter. It’s hard enough to build a network without impediments. If there’s negative press, it only compounds the difficulty. Somehow, the Herbalife distributor found a way.
4. He Assumed He Could Confuse the Public about Market Saturation
This is somewhat related to Assumption No. 2 where Bill Ackman expected to mesmerize the market with his logic. Ackman assumed that his argument regarding market saturation would actually fly. In theory, it seems to make sense. At some point, assuming everyone is successful at recruiting Herbalife distributors, the market would be exhausted. In Ger-Ro-Mar, the FTC tried to make this “geometric progression” argument and failed. In that case, the company was in the business of selling women’s lingerie. The court cleverly wrote, “We find no flaw in the mathematics or the extrapolation [presented by the FTC] and agree that the prospect of a quarter of a billion brassiere and girdle hawkers is not only impossible but frightening to contemplate, particularly since it is in excess of the present population of the Nation, only about half of whom hopefully are prospective lingerie consumers. However, we live in a real world and not fantasyland.”
In an article online, MLM consultant Len Clements said it best when he wrote, “I wonder, how many more years does a 32-year-old company like Herbalife have to exist, and continue to grow, before this notion of the MLM company succumbing to ‘inevitable market saturation’ becomes folly.” In his first presentation, Ackman asserted that Herbalife was running out of markets; thus, doomed to experience “market saturation.” Keep in mind, Amway is 22 years older than Herbalife, operates in 20+ more countries and has over three times the sales revenue of Herbalife—and they have yet to “saturate the market.” But I digress.
5. He Assumed He Could Confuse the Issue of Internal Consumption
Bill Ackman assumed he could stitch together an argument that criminalized heavy internal consumption. As a recap, “internal consumption” is a term used to describe the act of paying commissions on downline consumption/sales. If distributors buy the product for personal use (distributor = “internal”), commissions are triggered. The criticism of internal consumption: It can lead people to buy things they never would buy while they’re under the influence of a pay plan, i.e. “opportunity driven demand.” This issue is the main source of criticism of network marketing, and Ackman seized on it. First, the conclusion: It’s legal to pay commissions on internal consumption. The debate has always revolved around the appropriate amount.
Given the low cost of entry into network marketing companies (oftentimes less than $100), this sort of black-and-white standard is intellectually disingenuous. Since it’s so easy for distributors to join a program to “give it a shot” or save money on product, it blurs the line between retail sales and distributor volume. In an oft-quoted FTC advisory memo in 2004, the FTC said, “In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme.” The key is motivation: What’s driving the consumption? If it’s opportunity driven demand, the motivation is misplaced. In its rebuttal presentation on Investor Day (Jan. 10, 2013), Herbalife released some data that put this issue to rest. Based on its objective data, 31 percent of all orders are drop-shipped to non-participants (found on page 50 of the presentation). This at least indicates that the products have legitimate value and are not merely token items. As for the issue of distributor motivation, 73 percent of all distributor orders are made by participants that are not qualified to receive commissions (page 59). As if that’s not enough, Herbalife commissioned Nielsen to conduct a study on the penetration of Herbalife distributors and end users in the United States. The results: Herbalife has over 7 million customers in the U.S. alone, which dwarfs its distributor numbers by 6.5 million. The verdict: The products have value.
Bottom line: Ackman is clamoring for the wrong piece of data. He’s asking that Herbalife reveal their retail sales data. The key factor is “motivation,” and motivation is not easily quantified. And given the low cost of entry for all network marketing companies ($60 for Herbalife), this piece of data is not the determining factor with respect to pyramid allegations. Does Herbalife have this data? Yes. Are they obligated to provide it? No. They’ve already shown some compelling statistics, and they’re tightening the screws with respect to distributor compliance. Going forward, I suspect Herbalife will do a better job of distinguishing its customers from business-builders.
6. He Assumed He Could Launch a Surgical Strike on Herbalife
Ackman likely assumed that he could keep the pressure solely on Herbalife without agitating the rest of the direct sales industry. Keep in mind, the direct sales channel represents approximately $167 billion in global revenue, according to the World Federation of Direct Selling Associations. When he relied on common arguments used against all network marketing companies, he brought the entire industry into the melee. Initially, he was careful. On Bloomberg after his initial presentation, he said, “I’m not saying that companies like Amway are pyramid schemes.” Now, his arguments are growing broader with each presentation. With this in mind, every company in the industry benefits from his failure. It’s led to a more unified direct sales industry and bolstered support for outreach efforts. And quite candidly, it’s made the space better.
7. He Assumed He Could Refute the Value of the Buyback Policy
The value of Herbalife’s 12-month buyback policy cannot be understated. When I see former distributors crying foul about the money they’ve lost, I care, but I wonder if they knew about the return policy. Herbalife offers a 12-month refund on all unused/unsellable inventory (without a restocking fee). When people are upset about money lost, it’s clear that the issue is regret. They regret using the product. But they still used it and derived value from it. The 12-month buyback policy, which is adopted by Herbalife and strongly encouraged across the entire industry, is the ultimate consumer safeguard. It’s designed to help distributors get their money back on unsellable and unwanted inventory when they decide to exit.
When you factor this element with the 31 percent drop-shipping statistic + the 73 percent statistic of orders from non-qualified distributors + the 12-month buyback policy + the 0.2 percent return rate + the minimal amount of consumer complaints, it paints a clear picture: The products have legitimate value, and the consumer safeguards are sufficient.
Ackman’s gamble is over. This is not false bravado. I’m calling it now like I called it with Bob Chapman weeks after Ackman’s first presentation. Ackman can waste his investors’ money as long as they’ll allow. It does not change the fact that Ackman’s argument was premised on several assumptions, all of them faulty. It took little skill to craft an argument and seem convincing to those unfamiliar with the issues. The MLM space is murky, to say the least. But Herbalife has never taken ranks with the companies on the bottom rung. Ackman knew this, relied on an undisclosed legal report from a firm with zero experience in the category, relied on several other assumptions, took a gamble, and failed. Recent statements from Ackman seem to be coming from a man with a bruised ego, leading with his emotions and not his head. Herbalife is not a pyramid scheme, and with each passing day they evolve into a better company.
+Kevin Thompson is an MLM attorney with extensive experience in helping entrepreneurs to launch their businesses on secure legal footing. He is a founding member of Thompson Burton PLLC and a Supplier Member of the Direct Selling Association.