Tuesday, February 25, 2014

BilLACK HISTORY MONTH: The BilLACKsploitation of the American Investor

In honor of Ack History Month(or BilLACK HISTORY MONTH in my household) I thought it prudent to stop and reflect on the sacrifice of those before me. As I investigated history, I was awestruck by just how much so many people have ceded in support of this cause. It is more than I can bear to imagine.

In an effort to ensure that those losses were not in vain I allowed history to instruct me, ever hopeful that my own bias would not lead me down a path of my own determination and that truth instead would be my navigator. I have noted before that I was switching teams, so it should come as no surprise that I continue to vacillate and I am back in Ackman's camp. In my search of history I came across some forgotten information that has convinced me how sage and wise Mr. Ackman is. It is Mr. Ackman in nearly perfect form.
And what better way to express my gratitude and appreciation for BilLACK History than to write a script! I smell an EGOT! This story is way too dignified to try and fit to the lowly framework of pulp flicks such as To Kill A Mockingbird, The Color Purple, Roots, Guess Who's Coming to Dinner, A Raisin in the Sun, Malcolm X, Glory and Carmen Jones, and it is much better suited for genre-defining, eternal classics such as Sweet Sweetback's Baadasssss Song, Blacula and Black Mama White Mama.

Fade in from darkness. The camera is looking directly up at Bill Ackman from the floor as he straddles the camera lens, peering intently down at the observer. He is in control and his position clearly asserts this. His face is quivering in rage, yet stoic. In an instant, almost without warning he begins his recitation in a dramatic, yet fantastically bloviating tone, almost as though he's rehearsed it time and time again, but this is his first opportunity to use it on someone. "If I quit now, then I took all this chance for nothing and I go back to being nothing. Working some jive job for chump change day after day. Well if that's all I'm supposed to do then they gonna have to kill me 'cause that ain't enough."

Before we get into the gritty details of the script, in which I will undoubtedly I demonstrate for you how smart a guy Mr. Ackman is, as a matter of background I first want to lay out my former LONG thesis for Herbalife. I've written extensively on the company, so before I eat crow and explain why I'm changing my mind, I should at least explain why I formerly loved Herbalife's prospects, so here it goes in all its monotonous glory. Please bare with me though as I absolutely, positively, 100% promise that it's worth the full read.

Topline summary of my Herbalife long thesis:

  1. one of the most heavily shorted public companies in America
  2. the company has used and, I expect, will continue to use all of its free cash flow to repurchase and retire shares. At the current share price, the company can repurchase nearly 11% of its outstanding shares each year.
  3. for a modest fee, members receive discounted access to products, and independent sales associates earn commissions based on memberships sold.
  4. to motivate sales, the company pays associates 70% commissions on sales
  5. in a four year period, memberships grew 130%
  6. conservative valuation based on member base, off-balance sheet pre-paid commission assets and membership growth ranging from 2-8% per year
Background of my long thesis:
Now granted, throughout my enthusiasm for the company there have been some very vocal short sellers. These shorts seem to believe all multi-level marketing business must be frauds or pyramid schemes. I'd urge them to consult the company's website, the Direct Sales Association and other public sources to see that they are mistaken. Many well known companies employ multi-level marketers, for example, Amway, Tupperware, and Primerica. True, many of the company's sales associates will earn nothing this year, but many of those will have expended no effort trying to make sales. More than 120 of the company's sales associates will earn over $100,000 this year. In our opinion this fact speaks volumes about the quality of the product and the sales opportunity. It is an impressive statistic.

I have found the press coverage of the company to be unfair, lopsided, superficial and often just plain mean. Obvious errors go uncorrected; SEC filings and company statistics are misread on even simple points; charges that prove false are not withdrawn or conceded; and sarcasm and innuendo are rampant. Nowhere does the criticism address seriously the extremely attractive and growing cash-flow of the business, nor does it grapple with the weaknesses in the shorts' arguments.

Having considered all of the shorts' arguments, as well as the negative coverage of the company, I remain convinced that it is extremely undervalued and that the combination of continued growth in revenue and cash flow and aggressive share repurchases by the company will ultimately lead to a much higher share price.

My typical investment is a high-quality business that generates reliable, preferably growing, free cash flow. I generally invest only when I believe that management will direct the business' free cash flow to maximize value on a per share basis. In many cases, the companies in which I invest are misunderstood by other investors, creating the opportunity to invest at an attractive price.

By the above standards, the company is an ideal investment for me and other like-minded investors.

I believe that much of the press coverage of the company has been unfair, unbalanced and in many cases simply wrong.

In analyzing the company I have also read and taken seriously all of the negative commentary I found. While I am primarily a long investor, I occasionally sell stocks short. I believe that short sellers do the best research on Wall Street and are too frequently maligned by corporate managers. Rather than attack the messenger, it is my intention in the post to rebut the message of those who have been bearish on the company.

The company sells memberships through a network of independent sales associates who earn commissions on membership fees. In addition to selling memberships, these associates are also responsible for recruiting new associates and share in the commissions generated by the associates they recruit.

Over a four year period the company's membership grew by 130%. During the same period, the company's outstanding share base shrank 19.5% Nearly all of the cash needed to grow the business and simultaneously retire approximately 20% of its shares has been internally generated.*
*I understand the company has recently tapped a bank line of credit in order to fund share repurchases. I do not believe that the amount borrowed is material.
The company provides a valuable service and has growing acceptance. One of the criticisms of the company is that it does not pay enough to the providers for their services to be worth much. On this point, the shorts might want to consider that the company's members are getting valuable free services, reduced fees, access, and high quality customer service.

The company has engaged in one of the most consistent and aggressive share repurchase programs we have ever seen. The company has repurchased and retired over 20% of the starting share base. I applaud the company's share commitment to its core business and agree with management's conclusion that the best way to enhance shareholder value is for the company to buy back its stock.

I have to ask how the Shorts sleep at night? As a percentage of shares outstanding, I believe that the company is one of the most heavily shorted of all companies listed on a U.S. exchange. The shorts are playing a dangerous game of musical chairs. When the music stops, I believe that there will be a furious rush to match players with chairs and the price at which the market clears will be materially higher than it is today. If that were not enough, the game of musical chairs gets more dangerous with each passing week. I estimate that the company currently generates millions of free cash flow a week and uses that cash to retire shares. At the current share price, the company is able to remove millions of shares annually.

The classic short is highly leveraged, burdened with off-balance sheet liabilities, cash flow negative, dependent on the capital markets to provide debt and/or equity to support its business plan, employes aggressive accounting, trades at an excessive multiple of earnings or cash flow, may have been assembled through a series of acquisitions and is notable by the amount of stock sold by insiders. Not a single one of these attributes can be applied to the company. It has no material debt outstanding. It is materially cash flow positive. It does not require additional debt or equity capital. In fact it is returning capital to the markets, being a purchaser as opposed to an issuer of securities. Time is the friend of the company and its shareholders as the company grows its membership base and simultaneously generates free cash flow that it uses to retire shares. Short sales actually benefit the company by depressing the market price and allowing the company to repurchase more shares at a lower price.

As for valuation, the company's cash flow multiple is 9.5 times for the current year and 8 times for next year. The company's business has consistently grown, is non-capital intensive and deploys its free cash flow to retire shares. I feel that a cash flow yield of 10.5%(1 divided by 9.5) is extraordinarily attractive for a business with these attributes.

I conclude that the company is worth 32% more per share even if sales decline by 2% per year every year in the future and 103% more per share if the company can maintain its current growth rate of 8% per year.

MLM businesses are legitimate. Anyone interested in the topic can start by visiting the web site of the Direct Selling Association which disseminates information about direct sales. Click through to the members' directory and you'll see familiar names like Amway, Avon, Fuller Brush, Kirby Vacuums and World Book Encyclopedia(both owned by Berkshire Hathaway), Mary Kay Cosmetics, Shalee and another 134 members. According to the DSA, the company has been a long time member in good standing. Also, MLM businesses are carefully regulated by the states and the Federal Trade Commission. Without question, some MLM businesses sell worthless products and violate the law, but to gain traction for their bearish views, the company's critics must do more than merely smear the company as being a multi-level marketer.

Have there been missteps by sales associates? Undoubtedly. You can't have hundreds of thousands of independent sales associates selling products without some of them overstepping their instructions. But what strikes me is (a) the seriousness of the company's efforts to set and police its policies and practices, and (b) the lack of any material regulatory attention to the company. For example, TheStreet.com mentioned that the company has resolved a regulatory inquiry, suggesting something ominous had happened. The company has also answered an inquiry and as far as we know, nothing further has happened. None of these seem cause for alarm for a company generating hundreds of millions of dollars (and growing) of annual free cash flow. Finally I come back to the fact that the product being offered is of substantial value to the prospective customers. These are not outlandish promises of miracle cures (losing weight while you sleep, etc.), instead, -as detailed above, I believe the company fills an important need in the lives of most middle-income Americans. Yes, this product is being sold door-to-door by commission-hungry sales associates who have to convince their customers to buy something, but that does not make the company a fraud. Think of all the products sold by aggressive sales people - cars, magazines, banking and telephone services, you name it - but these are all valuable products that are being sold in a lawful way.

The shorts like to attack personally the people associated with the company. I believe these attack are unwarranted. Overall, I find the company's governance to be wholly legitimate. While I might have done things differently on occasion, I find no grounds to condemn the company for its past conduct, which, as far as I know, has always been legal and fully disclosed.

One standard I use to evaluate a company is whether its SEC filings provide all the data a reasonable investor would want to know in order to value the enterprise and judge whether the principals are intelligent, capable and of good character. I find the company has always met that standard.

Sales associates lawsuits, spearheaded by contingency-fee layers, assert two claims: (1) that commission advances constitute "loans" and (2) that the sales associates' contract, permitting them to sell the company's products constitute 'securities' that should have been registered with the SEC and should have carried a prospectus.

On the merits, these cases make no sense. The membership contracts spell out precisely what services they do and do not include and on what terms. Finally I note that the member suits are brought individually, meaning that each person must show how he or she personally was misled: how the person making the inaccurate statements acted intentionally, in order to mislead the prospective member; how the company is responsible for the intentional wrongdoing of its sales associates, who are independent contractors; how and why the members misread or ignored the stated conditions of membership; how the members actually and reasonably relied upon any such misrepresentations; how and when they realized their error and what they did upon discovering it; how much they actually suffered in damages (minus how much they received in value); and why the company's conduct was so egregious as to warrant punitive damages. Each of these standards seems like a high hurdle to me.

To conclude the synopsis of what was formerly my long thesis for Herbalife, the single most important aspect of my entire thesis is that it is not my thesis at all, but Bill Ackman's (cue the M. Night Shyamalan, Sixth Sense mind fucking plot twist, a la "I see dead theses"). You see, what I've been passing off as my own long thesis for Herbalife is in fact, Bill Ackman's published research in support of Pre-Paid Legal Services (formerly PPD, subsequently purchased by MidOcean Partners and now privately operating under the name LegalShield). If you're a repeat reader of my blog, you probably recognized this is not the first time I've used such a bait and switch plot device. You may also have been wondering why most of it was written in a strange tangerine colored font; the tangerine is simply to provide visual contrast and denote that the text was taken almost verbatim from Ackman's published report on Pre-Paid Legal. You can pretty much replace every instance of "the company" I used in the above text with Pre-Paid Legal. Other than that, what I've written above is almost verbatim to the Gotham research report, with the primary exception being that I was pretending it was my own research in support of Herbalife.

Gotham Partners published their research report on November 19, 2002. Gotham was in the midst of a flurry of redemptions during this period and their average cost in PPD was about $25/share and Gotham exited their position a couple weeks after they publicized their research at an average price of approximately $30/share. There is a lot of very interesting background material on Ackman and his fund's investment in PPD(see links at bottom). Aside from  the haunting echo of Ackman's research it is also noteworthy to point out another entertaining, yet damning parallel. A NY Times article from 2003 pointed out that although the Gotham website still carried a "recommendation" for Pre-paid, the fund was shedding 10% of its position. That hearkens back to the www.factsaboutherbalife.com  disclaimer that falsely stated the fund did not own any options in Herbalife, although they were actively transitioning a huge chunk of their short interest to OTC puts. As Gretchen Morgenson and Geraldine Fabrikant noted in their original article, just over one month after Gotham published their research touting the virtues of PPD (while selling into the rise) Gotham announced to investors that Gotham's funds would be wound down and the assets sold. The best estimate I've received so far is that Gotham investors received about $.05 on the dollar in the liquidation.

A few months later in May of 2003, Bill Ackman was deposed by Charles Caliendo of the NY State Attorney General's office. 

In light of the obviously glowing report that Ackman and his partners issued on a MLM company that not only survived, but was taken private (ahem, hint hint), you must keep in mind that he is now attempting to assassinate a company's character that is far more defensible than that of Pre-Paid Legal Services. His own words against vocal short sellers and in support of PPD are so damning to his short thesis of Herbalife that there is little I can offer to dull the sharpness of his own tongue. If Markey wasn't pissed before about his staff overstepping the trust he ordained upon them, imagine how he must feel after reading Ackman's 2002 report on PPD; or how the SEC, FTC, State AG or any other regulatory agency or governmental representative would feel after reading his forgotten report. It is the same salesman, but a different pitch. It's almost like he pulled up his old PPD research report and did everything in reverse to slander Herbalife. In 2002 he wanted to pump and dump the American dream (what average American citizen doesn't dream of subscription based counsel on obscure legal elements) and in 2012 he was trying to take a dump on what has become the American way for so many. We all know people fighting obesity(most of our demographic is very well fed) and we all know people fighting poverty(if you don't know anyone fighting poverty you should volunteer more). What Ackman has failed to understand in his campaign against Herbalife is that he is not campaigning against a company bent on manipulating an unwitting immigrant public as he has claimed, but that he is campaigning against an empowering lifestyle chosen by millions of Americans and many millions of others across the globe because that lifestyle resonates deeply within them. He is simply incapable of understanding why anyone would ever participate in an organization in which it's members could earn anywhere from $0/year to $100,000+/year, or that they would sign up as members for a discount. He has probably never even uttered the phrase "supplemental income" in his household. He also seems to be incapable of comprehending how the reality of millions of Americans dares to defy 342 of his power point slides, two websites, three lobbying organizations, multiple letters to PwC, ad nauseam infinitum... 

How many times must the public be subjected to his manipulations and double talk? I've heard so many times that Bill Ackman is such an amazing investor with a great track record, but that's only because Wall Street's memory is like a roofied prom night. After knowing that Gotham lost a mountain of cash (mostly due to large illiquid holdings) Pershing investors have awoken, groggy and dazed to find themselves in a similar quagmire.  Had it not been for the surprisingly insatiable Japanese thirst for whiskey, no one would have been talking about Ackman's January performance. Ackman has lost $1.5B in Pershing's AUM in less than one year, due largely to his 20% short position in Herbalife (which he's claiming is running at a 49% loss).  As much as Ackman touts his belief that he can't be squeezed out of the position, hypothetically speaking, what happens to his investors hard earned coin if there were a squeeze in Herbalife and Pershing was forced to cover? Before you trick yourself into not feeling bad for the douchebag Pershing investor (just because it's easy to imagine they're probably some rich financiers with their fancy shmancy orange driving shoes kicked up on their mahogany desks just out of reach of the tight-rolled cuffs on their clamdiggers), you should be reminded that Pershing has many pension programs that are invested with them (Texas Teacher's Retirement System, as an example).

Don't get me wrong, I firmly believe that shorting is a necessary component of market systems. Ackman's short thesis on Herbalife however is the most insidious kind of short. Aside from being an obvious bear raid, I size it up as nothing more than an overt attempt to transfer wealth. Ackman and his Pershing Square associates are effectively wagering the future of $12B of investor's assets in an attempt to earn $1B in gains by destroying a $7B company that employs over 7000 people and pays billions of dollars annually in sales commissions to the very people Ackman is claiming that he is trying to protect.

So what better way to celebrate the close of Ack History Month than to commemorate my admiration for him and his uncanny ability to exploit misinformation and salesmanship by writing a BilLAck-sploitation flick in his honor. Casting should be easy enough with David Klafter, Whitney Tilson, Herb Greenberg, the SEC and the NY AG all being typecast from their previous roles in the PPD drama.

But what about the title? Ooh, that may be tough. So many to choose from:

Ackie Browned, BilLACK HEAT, Detroit 9000 Redemptions, Dole-I-might Cover, For Love of Ivy-League, BilLACK DYNAMITE, They Call Me MISTER Fibs, Ackman Moves to Harlem & cahn's Shaft

Additional reading below:
A rescue ploy now haunts a hedge fund that had it all
NY Times, Pre-Paid Legal Services

Note that the deposition does not start discussing PPD until page 308.


  1. May I ask.....what is your take on legit MLM companies?
    Are you involved with any of them?

    Any recommendations?

  2. I agree with you. Thank you for sharing the update. It is interesting to have it discussed widely so that we can gain more objective opinions.

    consumer product licensing & product licensing

  3. FTC website has nice videos and documents regarding the Herbalife findings, the $200,000,000 fine used for Restitution for 350,000 people and a massive Federal Injunction. The FTC also found Herbalife management to run a predatory scam and imposed an independent auditor.