Bill Ackman, founder of hedge fund Pershing Square Capital Management, often claims his public analyses of companies in which his fund has investment positions are "for the good of the country." For example, he rightly criticized the management of (then AAA-rated and now junk-rated) MBIA for writing credit derivatives against fraud-riddled collateralized debt obligation (CDOs).
But he didn't publicly criticize (that I know of) the investment banks that created the fraud-riddled CDOs, and (at least one) fed him information on MBIA's credit derivatives positions with the underlying CDOs along with its model. Ackman apparently gave the investment banks a pass, even though they created built-to-fail CDOs that were a classic situation for fraud. The SEC has held a few of these CDO "manufacturers" -- too few -- accountable with seemingly large fines of hundreds of millions of dollars that, compared to the damage done, were mere wrist slaps.
Just last month, Ackman defended his (so far) losing long position in JC Penny on CNBC, and passed out a marketing gimmick that looked to me like a button-like toddler choking hazard. That didn't seem very patriotic.
Ackman claims his latest idea, a short position in Herbalife, is a "patriotic short." His patriotism seems to flare up when there's money to be made by his fund. As for his motives being "patriotic," he faded quickly from his need to save the country from FNMA's practices after he monetized his position, so I'm deeply suspicious of his assertions about his motives. Moreover, he wraps his own motivation in the flag, but in public, he asserts that the key driver of human motivation is sex (and that money makes it easier to get).
The foregoing is to assure readers that I'm not an unqualified supporter of Bill Ackman's I'm-saving-the-country antics; he can be a galaxy-class jerk. Yet, in pressing his self-interest, he sometimes pushes an important idea that is of great public interest. Moreover, he throws a lot of interesting information at you so you can do your own analysis and form your own conclusions. At an investment conference last week, he gave a presentation on Herbalife that should give regulators, Herbalife distributors, and investors in its shares reasons to worry and act on that information.
Ackman claims Herbalife is a pyramid scheme, and he makes a good case for it. The presentation is 334 pages long, and most people won't have the patience to go through his argument about the numbers. I read the entire presentation and some of Herbalife's SEC filings besides (I don't just take a hedge fund manager's word for it). Let me try to illustrate the issues in a simpler way.
Take the Loot and Scoot?
Even if you don't buy Bill Ackman's argument -- I do accept it, in case you are wondering, but that isn't important for the following discussion -- there are other compelling reasons in the presentation that would make many reasonable people run far and run fast from this company.
In order to simplify this, I invite you to look at pages 251-256 of Ackman's Herbalife presentation. The graphs show a "pop and drop" in retail sales in six countries. This retail sales pattern happened in Japan, Israel, Spain, France, Germany, and Russia. Now Herbalife is attempting the same thing in China and India. This is a classic pyramid scheme profile. Retails sales climb fast and peak, then drop off fast and flatten out.
Why does this happen? One explanation is that distributors recruit other distributors, but the demand for the product was never really there to support the growing number of distributors. The distributors have to buy in, and once you run out of those people, the whole thing collapses. Herbalife's explanation is that highly compensated successful distributors take their money and leave the country. Really? So Hebalife says it's not a pyramid scheme, it's just that when things are going well, the tiny minority of successful distributors at the top of the food chain take the loot and scoot?
A Shocker for Herbalife Users
Why isn't there sustained demand for Herbalife products? Herbalife touts a former Nobel Prize winner in its marketing hype, but Herbalife merely purchases a product based on the Nobel Prize winner's research and resells it, and that's not the only product it sells. I'm no expert on Herbalife, but Herbalife doesn't appear to have expertise in its own products, either. I have an MBA in finance, and my undergraduate degree is in chemical engineering. I love science. Apparently, I love it much more than Herbalife, based on its lack of investment in research and development.
On page 38 of Ackman's presentation, you'll find that Herbalife has exactly one patent in health care and nutrition. Kellogs has 228 patents, Mead Johnson 49, and NBTY and GNC both have 21. On pages 30 and 31, you find that Herbalife claims to have increased its research and development spending "dramatically" since 2003. But it can't be by much, since its spending base was already very paltry. Even a tiny increase in dollars would appear to be a high percentage increase, but in reality it would have very little material impact. But Herbalife is nothing if not drama.
Herbalife's 2004 prospectus says it spent $2 million on research to outside consultants. That's less than 0.5 percent of its current book value, and less than 0.07 percent of its current market capitalization, even at today's fallen stock price. Ackman quotes Herbalife's 2011 Annual Report: "For all periods posted, research and development costs were expensed as occurred and were not material." In English, that means the company spent so little on research and development it wasn't even worth reporting it.
Don't Sell Ackman Short on His Herbalife Call
I disagree with Bill Ackman that this is a "patriotic short," because his highlighting these issues doesn't seem merely to be for the good of this country, it appears to be for the good a great many people in many countries.
Disclosure: I have no position, either long or short, in Herbalife.
See Bill Ackman's presentation on Herbalife: "Who wants to be a Millionaire?" Pershing Square Capital Management, L.P.