This could be a four word post - Bill Ackman is wrong - but for reasons that we'll explain here and in the next post, the future for the Herbalife share price is now subject to questions about the multi-level marketing industry as a whole. What we want to do then, is share some of the reasons that we've heard for why people have bought the stock of a company that the Pershing Square activist has said is going to zero, and we think still has some serious questions to answer about its business model. What we are not going to do, is try to value a company that still does not have audited financials. Herbalife lost its auditor to a KPMG insider trading scandal this year, and PWC is plugging away at re-auditing the books. Anyway, if the question is a binary one about fundamental legitimacy, cash-flow forecasts seem somewhat beside the point. So, to the bulls. Look at the shoulders you would rub You can say that Carl Icahn would spend a billion dollars on custard pie catapults, so long as they were all aimed at Bill Ackman, but he is not the only notable investor of sound mind to buy into Herbalife. Bill Stiritz is an industry veteran, an early enthusiast for the soy protein isolate that goes into Herbalife diet shakes, and a serious dealmaker who says the idea that Herbalife is not legitimate just blows his mind. The professionals employed by George Soros to manage his fortune have also taken a close look at Herbalife, and saw enough that they were convinced the Federal Trade Commission is not about to bring a case charging that the group is a criminal pyramid scheme. Indeed, rather than trusting the two surveys Herbalife has used to say that it has customers, the Soros fund commissioned its own market research, and found enough buyers to conclude that Herbalife can claim legitimacy. Don't expect them to share this though, because... The first rule of investing in Herbalife, is don't talk about Herbalife Those serious minded, long term investors above would actually prefer that you didn't buy the stock just yet - or so the argument goes. What they would like is for it to stay as low as possible until Herbalife is able to raise debt to buy back a ton of its own stock, a $2bn number seems to have been floated repeatedly. Watch Bill Ackman's head explode then, chuckle chuckle. Of course, you would have to find investors willing to lend $2bn to Herbalife on reasonable terms. As Mr Ackman pointed out in a recent letter: As of March 2011, when Moody's withdrew its ratings on Herbalife, the Company was rated Ba1, a junk rating. When the ratings were withdrawn, Herbalife had only $178 million of debt, approximately 0.5 times the then 12 month trailing operating profits, and there was little public scrutiny of the Company's business practices. If Herbalife were able to issue $2 billion of additional debt today, the Company would have $3 billion of total debt, or 4.3 times 12-month trailing operating profits. With more than 16 times as much debt, substantially greater scrutiny of the Company's business practices, and a regulatory cloud over the Company, we believe that it would now garner a substantially lower junk rating than that of early 2011. A large amount of new debt would also create a liquid market for credit default swaps, which would be an efficient way for short sellers to place that one way bet that Herbalife is a zero. So an immediate head explosion is unlikely. But, were the buyers interested in talking up the stock right now, they would have a few points to make about its "misunderstood" business model. Fat Latinos pay for the support group, not the shake In this view of Herbalife, the fundamental mistake bears make is thinking that the shake is the product. Oh you silly bears. Dieting is hard, and when you find something that works, you stick with it. At Herbalife nutrition clubs a distributor (an independent salesperson in the argot of multi-level marketing) puts the shake into the hands of their obese customer with a reassuring smile: you will be thin (ner). The magic of multi-level marketing is the personal touch, the endorsement from a friend or family member. The Avon lady and the Pampered Chef (a brand owned by Warren Buffett's Berkshire Hathaway, no less) are the gold standard for an industry in which Herbalife is a perfectly normal member. There are around 10,000 of those Nutrition clubs in the US, and an incredible 40,000 odd down in Mexico. Yes, paying rent on somewhere to earn less than minimum wage selling Herbalife shakes is madness, but if you can do it in your own home, why not. And anyway... Who is a Manhattan billionaire to understand the lot of the poor? OK, on the income disclosure that Herbalife publishes, a tiny fraction of its distributors make money, while most must be losing it, and there is no mention of costs incurred. But, that disclosure is just commissions paid out by Herbalife, don't forget the profits they make on their sales of product. Unfortunately, because Herbalife says it is actually more like a buying club, where most distributors (those salespeople) are just buying shakes for their own consumption, you can't really work out what the typical distributor earns. Even so, it might not sound like much money to a hot shot investor, but these are poor people we are talking about. They are grateful for the opportunity to scrape some extra dollars. Sure, a few people at the top are making millions, but what is wrong with a bit of exploitation. Macdonalds doesn't pay a living wage, you still buy clothes made in Bangladesh, right? We'll admit to becoming a bit confused at this point. Its somehow not about the product, but then there are millions of people signed up as distributors but not to be salespeople, just because they like the product so much. But not so much to hang around from year to year, producing huge churn in the customer/distributor base. And it leaves unresolved significant questions about the customers at the heart of pyramid scheme law. But lets press on, because the law only matters if it is enforced, and in the view of the bulls... The FTC is not even going to try to shut Herbalife down Prosecuting pyramid schemes is hard. It depends on the specifics of the case, requires a great deal of work and time, and regulators have limited budgets and don't like to be seen to tilt at windmills. The recent case against BurnLounge, which is appealing a judgement it is a pyramid scheme, took five years to build. Our impression from people familiar with it, is the FTC thinks it has been doing a pretty good job policing pyramid schemes. Attempts to pass more restrictive laws have always run into a very effective lobbying effort by the industry, orchestrated by the Direct Selling Association. What could happen, is that the FTC might change or clarify its rules. But understand that such a change would affect not just Herbalife, but most of the multi-level marketing industry as it currently exists. When hedge funds called out the online universities, there were a lot of federal spending dollars at stake. Victims of pyramid schemes are individuals, and they can very easily blame themselves for their failure. Consumer and Latino groups have called for action, but it is a fair question whether their constituency has a large enough voice to cause action in a do-nothing Congress. Maybe there is more to come that shows Herbalife is particularly egregious in its practices. We await a clean bill of health for the accounts. But realise that Herbalife is just one of the larger cards in an industry pyramid. Pull that one away and many of the others will come tumbling down as well. That it might is the essential basis for the sell case, one which deserves a post all of its own.