Why Bill Ackman’s Key Argument Is Flawed: Herbalife Ltd. (HLF)

Page 1 of 3

Bill Ackman PERSHING SQUAREHerbalife Ltd. (NYSE:HLF)’s saga is becoming more interesting day by day. The battle lines are drawn and the players have big money/goodwill at stake. On the bullish side are a bunch of hedge fund managers including activists Carl Icahn, Dan Loeb, Robert Chapman; tiger cubs Patrick McCormack, Philippe Laffont; and Stephen Mandel. On the bearish side there is one man army of Bill Ackman. His friend/fellow short seller David Einhorn has publicly distanced himself from the dispute saying “When you look at the range of outcomes, it’s so wide that it’s not clear to me that I want to be long or that I want be short.” His other friend, Whitney Tilson, has actually reported a long position in the call options of the company (It may be just to hedge any short position he has, but it does show Tilson’s lack of conviction). Nevertheless, Ackman’s $1 billion short position (out of which he hasn’t covered anything yet) shows his high level of conviction in the bet.

For every stock, there are always two sides of investment argument. For Herbalife, I am sure readers will be familiar with both bullish and bearish side of the story. So, I won’t rehash them again here. Instead, I will directly address why Ackman’s key argument is flawed.

Distributing rewards > Retail profit does not imply organization is a pyramid scheme

Ackman’s key argument is “if participants make more money from recruiting rewards rather than retail sales, the organization is deemed to be a pyramid scheme”. He devoted the first half of his 334 slide presentation just to prove that Herbalife’s distributors make more money from recruiting rewards rather than retail sales. More recently in Harbors Conference, he said that an organization in which participants makes more money by recruiting other distributors as compared to retail sales is deemed to collapse as eventually the organization would run out of interested distributors.

In this article, I will be showing why this argument is flawed with the help of an example.

Consider an MLM Company which produces and sells product X through its distributors. The average cost of production of X is $15. The company sells this product at $30 to distributors who in turn sell this product at $35 to Retail clients. For simplicity, let us assume 100% of sales are outside the network and there is zero self-consumption among distributors. Also, for this example let’s assume recruiting rewards are limited only to the one level directly hired by the participant. (You may of course assume multiple levels of recruiting or upline rewards, but that would unnecessarily complicate things. Hence, I am avoiding it to keep things simple in this illustration).

Here are the incentives for distributors:

1). $5 profits for retail sales

2). $10 reward for hiring a new distributors

Other important conditions:

1). Zero self-consumption

2). Zero upfront cost for participation

3). At least 1 sale to be classified as distributor

4). No commission on sales made by down line distributors (for simplicity)

Suppose the MLM organization develops in a symmetric way where each distributor does two retail sales and hires two new distributors, until the final level “n” when the organization runs out of prospective distributors. In final level, since there are no willing new hires for distributors, existing distributors will do just a single retail sale each to qualify as distributor and will not hire anyone. The following diagram illustrates this MLM scheme when there are just four levels of distributors. (Please note that I have to assume organization develops in a symmetrical way to avoid unnecessary complication in developing model. In reality, it may be a different, more complicated structure but the outcome will be the same.)

Let’s see how much do the participants in above scheme earn from retail sales and recruiting rewards if the scheme goes up to four levels.

Page 1 of 3
blog comments powered by Disqus
Insider Monkey Headlines
Insider Monkey Small Cap Strategy
Insider Monkey Small Cap Strategy

Insider Monkey beat the market by 52 percentage points in 24 months Click to see monthly returns in table format!

Lists

The 10 Countries with the Highest Suicide Rates

The 10 Most Technologically Advanced Countries in the World

The 10 Safest Countries in the World to Live in Peace

The 10 Top Selling Smartphones in the World 2014

The 12 Biggest Shopping Centers in the World

The 10 Friendliest Countries in the World

Qihoo 360 Technology Co Ltd (QIHU), Actavis plc (ACT), Yahoo! Inc. (YHOO) Among 20 Long Ideas from Sohn Canada

The 10 Laziest Countries in the World

The 10 Most Polluted Countries in the World

The 10 Most Dangerous Cities in America 2014

The Top 10 Gold Producing Countries in the World

The 10 Tallest Buildings in the World

The 10 Richest Stand Up Comedians in the World

The 10 Fattest Countries in the World

The 5 Best Summer Jobs for Teens

The 10 Most Religious Countries in the World Keeping the Faith

The 10 Most Educated Countries in the World

The 10 Most Popular Cell Phones in the World

The 10 Drunkest Countries in the World

The 10 Most Expensive Private Schools in the World

The 10 Smallest Countries in the World

Walking Dead Season 5 Spoilers You’ll Wish You Didn’t Know

The 10 Poorest Countries in the World

The 10 Greenest Countries in the World

The Top 10 Countries with the Highest Population in the World

The 10 Most Visited Countries in the World

The Top 10 Star Wars Characters in the Iconic Series

The 10 Most Expensive Android Phones in the World

5 Reasons Why The Illuminati Is Real and a Threat to Society

The 6 Scariest Halloween Costumes Ever Screamed At

The 4 Biggest Hedge Fund Managers in the World Today

The 15 Most Densely Populated Countries in the World

The 10 Biggest Tea Drinking Countries in the World

Top 6 Ways to Improve Your Checkout Process and Close Sales

The 5 Most Profitable Online Businesses You Can Start Today

The 20 Most Profitable Hospitals in the US

The 5 Most Profitable Home Businesses to Start

The 7 Teams that Will Win the Stanley Cup in 2015

The Top 10 Most Expensive Digital Cameras to Snap Stunning Shots With

The 10 Highest Quality Fast Food Restaurants In America Today

The 8 Best Halloween Decorating Ideas to Spook Up Your House

10 Marvel Women that Should Get a Movie Right Now

The 20 Best Remixes of Popular Songs that Will Make You Forget the Originals

7 Most Expensive Cities in the World

5 Least Expensive Cities in the World

10 Celebrities Who Believe In Scientology

10 High Margin Food Products to Build a Business Around

The 10 Most Expensive Clothing Stores in the United States to Get Decked Out At

The 5 Biggest Kickstarter Scams That Swindled Backers’ Donations

The 10 Most Expensive Boarding Schools In the World

Subscribe

Enter your email:

Delivered by FeedBurner

X

Thanks! An email with instructions is sent to !

Your email already exists in our database. Click here to go to your subscriptions

Insider Monkey returned 47.6% in its first year! Wondering How?

Download a complete edition of our newsletter for free!