Today sell side analyst Tim Ramey of Pivotal Research put out a priority note on Herbalife. Immediately after reading it I remarked that I thought it was so well written, articulate and reasonable in its tenor that I was tempted to post it on the web so I decided to do just that. Presented without commentary or editing is Mr. Ramey's note below. And *of course* "PLEASE CONTACT PIVOTAL RESEARCH FOR ADDITIONAL INFORMATION, INCLUDING RISKS AND DISCLOSURES".
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PRIORITY: HLF - thoughts on timing and direction of the FTC investigation... REIT BUY; $80 PT
BOTTOM LINE: I’ve been wrestling with the idea of writing this note for a good long while. In some ways, it seems a fool’s errand to “make a call” on the timing and outcome of the FTC investigation. We don’t really know, so take these thoughts with that caveat, but we do think a very clear roadmap has been laid out. The benefits of sharing our thoughts probably outweigh the obvious risk of being wrong, at least as to the timing. We see very little risk at to being wrong on the outcome, but a timing call is surely more risky.
We thing the FTC investigation is close to being resolved. Put a gun to my head and make me pick dates, I think it will probably be a “this summer” event. Here are the thoughts that go into that point of view:
First and foremost, we believe that the fact that HLF received a CID in March 2014 rather than a move to close HLF and preserve assets means that the FTC knows what we believe – HLF is not an illegal pyramid scheme. The FTC has had HLF on their radar for decades and it would be naïve to believe that the FTC doesn’t have a great working knowledge of HLF, its compensation plan and its structure. Normally, the FTC will open a case and use the CID (or injunctive relief, for that matter) based on volume of complaints – it is a complaint-driven agency. The HLF CID was different. We believe it was politically motivated – Senator Markey asked the FTC to investigate and so it was done. Ultimately, we believe that this has prejudiced FTC staff against the HLF investigation. The FTC has scarce resources and in some ways a politically-motivated investigation is a distraction from the FTC mission. But a letter from a Senator is hard to ignore, thus we are where we are.
Once the FTC has opened an investigation, there will be a resolution and there will be a closing letter from the FTC – this is not like an SEC investigation, where we might not ever know if the matter closes. So it is a safe bet to say that a FTC determination is ultimately forthcoming.
The mission of the FTC is to protect consumers from abusive behavior by corporations. Certainly operating a pyramid scheme would be abusive behavior, but we have taken that outcome off the table because of our extensive work and close examination of the Herbalife business model; similar investigations undertaken by numerous others, have dismissed “pyramid scheme” as well. The body of research done on HLF by ourselves and many of the large long holders is truly unprecedented. This is perhaps the best body of research ever done on a single issuer. So we operate, and have always operated on the view that “pyramid scheme” is a tiny risk for HLF – and if it was a real risk, the FTC would have not proceeded with the CID route but would have used injunctive relief to close Herbalife, preserve its assets, and stop the ongoing harm that a pyramid scheme would do to millions of consumers.
However, the mission of the FTC is protection of consumers, and harm to consumers can take many forms. Certainly the product claims that HLF and its distributors make regarding weight loss is of interest to the FTC. The income claims that Herbalife and its distributors makes are also of high interest. Excessive or unsubstantiated claims with regard to weight loss or income opportunities are likely to be the two key areas of interest for the FTC. We have also written about our discomfort with “lead-generation.” Herbalife discontinued lead-generation as a business method in June 2013. Lead generation is legal – a practice used by real estate agents, stockbrokers and others. However, in the few egregious cases of harm to consumers with regard to Herbalife – the narrative is almost never about harms caused by Herbalife and its products – lead generation led to consumer losses because a third-party lead generator sold thousands of dollars of “qualified leads” to aspiring distributors. When those leads prove worthless or at best, of little value, the consumer is harmed. Herbalife didn’t create the harm, but it can be argued that they allowed the harm to occur, at least until June 2013. Thus we see the three areas of exposure for HLF as 1) lead generation; 2) excessive income claims; 3) excessive product claims.
It does not take much effort to find examples of all three types of consumer harm with regard to HLF. A simple search of YouTube will do the trick – you will find distributors making excessive product and income claims if you look for them. But again, the FTC is in a numbers game. The standard will never be that there can be zero instances of bad behavior – bad behavior exists in every large organization. The question for the FTC is did Herbalife’s compliance efforts act to aggressively detect and deter bad behavior, or perhaps did they enable it?
With regard to the Herbalife of today, we hold the point of view that its compliance function is absolutely best-in-class and could not reasonably be criticized. The company is extremely vigilant with excellent training, systems and surveillance to prevent, detect, and deter bad behavior. The Herbalife of today has many robust consumer protections in place. First-order limits, the 100% return policy and the affirmative declarations that a new member must make are strong consumer protections. The compliance function, headed by Pamela Jones Harbour, a former FTC Commissioner, is truly best in class. So when the FTC looks at today’s Herbalife, we see virtually nothing that should or could be changed.
The question for the FTC is, has it always been that way? A reasonable person would have to acknowledge that it has not. We cited the discontinuation of lead-generation in June 2013; but before that date, it is arguable that consumers were harmed by third-party lead generators and Herbalife was not vigilant in detecting and deterring this behavior. Herbalife closed independent distributors websites in September 2014, requiring that distributors use the www.goherbalife.com platform to host their sites. Since this change, we can say with particular certainty that Herbalife is preventing abusive income and product claims from being made on the web. But it is clear that this was not always the case.
We have always argued that the FTC investigation would have two principle outcomes of interest to Herbalife shareholders. First, it will be a thorough vetting of the MLM model and to the extent that the FTC finds that the Herbalife of today is operating a fair, reasonable and vigilant MLM, it will be a huge value creator for HLF shareholders. Herbalife is a growth company with enormous opportunities to grow for decades to come in 91 markets around the world. But the taint of MLM, the risk that the model was not sound, is the principle reason why HLF is not priced like a growth stock. We see the resolution of the FTC investigation enabling the Herbalife of tomorrow to trade like a growth stock, unlocking value in an unprecedented way.
A reasonable investor, examining the growth trends of Herbalife, even in light of the current negative impacts to growth of F/X and the compensation plan changes, would likely result in HLF shares trading at 20x EPS or more in our view. The MLM taint is the single factor that holds the stock back. If the resolution of the FTC matter clears that taint – once and for all – these shares will go much higher, we believe. We believe $100+ is a reasonable medium-term target, hence our risk-adjusted price target of $80.
The second outcome of the FTC investigation is that Herbalife will most likely be held responsible for something that harmed consumers. We have argued that there will be a price to be paid for sins of the past – lead generation, excessive income claims and excessive product claims. Once the FTC investigation opened, it was a near-certainty that there would be a finding that Herbalife was not always as vigilant and as effective as it is today at detecting and deterring bad behavior. So there will be some price to pay, likely a fine for its failure to supervise properly its distributors. It would be unreasonable to think that the FTC would get into this investigation and not extract some pound of flesh. In our view, there will be a fine, perhaps ranging from $10 to $50 million that Herbalife will be forced to pay to acknowledge that it was not always as good as it is today. The size of the fine will be subjective and a matter of negotiation, we believe. It must be considered that the Herbalife of today is likely not at all problematic. We believe the FTC will “give them credit” for the proactive steps they have taken to protect consumers. Taking these two impacts together, one positive, one negative, one can see why Herbalife “welcomed the FTC investigation.” Net-net, the day the FTC decision comes down is likely to be a very happy day for those who own the stock.
So when will it be? Herbalife has offered, we believe, unprecedented cooperation with the FTC. Herbalife has tremendous visibility into its distributors purchasing behavior with its Oracle business platform. Any Herbalife executive can drill-down and analyze the purchase behavior, timing and motivations of any distributor. We don’t know it for a fact, but we assume Herbalife has given the FTC access to this system to enable their analysis. Nearly 15 months have gone by now and we believe that Herbalife has given the FTC all of the tools and documents it will need to make its analysis.
Clearly the body language and confidence of senior management has supported our view that the process is well underway and if not complete, close to its completion. The recent aggressive actions by the company to wage battle with their infamous adversary bespeaks confidence as well.
Arguably, Herbalife’s largest shareholder, Carl Icahn, who holds five of 13 board seats has been frozen with the knowledge that its board members would have gained from this FTC process. If the information flow was negative, nothing would stop Mr. Icahn from having his directors resign and, after a time, selling his stock. But no such resignations have occurred and it seem far more likely that positive news at the board level has prevented Mr. Icahn from buying more shares, but induced him to see this process through to its resolution.
So, knowing that I might be later embarrassed by the prediction, and with no particular knowledge that my analysis of the timing is correct, we humbly offer the view that “this summer” will give us closure on the FTC process.
