“IF I am right, its share price will go to zero,” says Bill Ackman, the founder of Pershing Square Capital, a hedge fund, who insists he has never felt so confident in shorting a company’s stock. On December 20th he invited an audience of his peers to hear his declaration of war against Herbalife, a seller of dietary supplements and vitamins. His claim that the 32-year-old company is an “illegal pyramid scheme” had an immediate impact: Herbalife’s share price fell from over $40 a couple of days before the presentation to $26 on December 24th. However, Herbalife is fighting back. Its managers deny Mr Ackman’s accusations and promise a detailed rebuttal soon. The company’s shares have rallied, ending 2012 at almost $33, a market capitalisation of around $3.6 billion.
Herbalife is one of the world’s best-known “multilevel marketing” companies, along with Avon and Amway. Hordes of independent individual sellers, many sporting badges with the slogan “Lose weight now. Ask me how”, distribute its products. These sellers are recruited by people on a higher tier of the marketing structure, who receive a slice of the commission on sales made by those whom they recruit.
Multilevel marketing is a huge business. In 2011 direct selling (the vast majority of it through multilevel marketing) by around 16m distributors generated sales of almost $30 billion in America. Worldwide, some 92m distributors grossed $154 billion, according to the Direct Selling Association, an industry group.
Multilevel marketers take pains to distinguish their businesses (which are legal) from pyramid schemes (which are not). In a pyramid, recruitment is everything. People pay to participate, and are rewarded by finding others willing to pay to join. At some point the supply of new recruits dries up and the pyramid collapses.
Multilevel marketing is not like this. Legitimate firms rely on sales of real products for their income, not on fees charged to new recruits. Mr Ackman contends that Herbalife relies on recruitment, not sales of its products to genuine customers (as opposed to new distributors, who are required to buy a batch to join the sales force). Michael Johnson, Herbalife’s chief executive, retorts that over 90% of product sales are outside its distribution network.
Mr Ackman says Herbalife’s marketing materials give a misleading impression of how easy it is to make money by selling its products. By his calculations, only 0.14% of Herbalife’s 2.7m sellers earn more than $20,000 a year gross, and 93% earn no commissions at all. Herbalife is continually entering new markets, from Mexico to Ghana, but the supply of virgin markets may soon dry up, claims Mr Ackman.
Mr Ackman is not always right, but he has made a packet by shorting overpriced firms such as MBIA, a bond insurer. His attack on Herbalife follows tough questioning of the company in May, shortly after its share price reached an all-time high of $73, by David Einhorn, another hedge funder who made a fortune by calling the financial crisis correctly.
However, in July Anne Coughlan of Northwestern University’s Kellogg business school published a paper arguing that Herbalife is legitimate, and “fails to meet the fundamental test of a pyramid scheme, because its compensation is directly related to sales volume (not to recruiting) and therefore its business cannot collapse under the weight of its compensation plan.” (Herbalife helped finance the paper.)
As The Economist went to press, regulators had not reacted publicly to Mr Ackman’s accusations. Much may depend on Herbalife’s detailed response at an event for analysts scheduled for January 10th. Analysts will want to see convincing evidence that most of its sales really are to people outside its network of distributors.
One thing is certain. Even if he is right, it will not add to Mr Ackman’s vast fortune. He describes his campaign against Herbalife as a philanthropic act, and has promised to give his personal share in any profits from shorting its shares to charity.
Posted by Elmir Mujkic
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