Sucking the Life Out of Herbalife Ltd. (HLF)

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Ever since hedge fund operator Bill Ackman revealed his massive short position on Herbalife Ltd. (NYSE:HLF) back in December, the dietary supplements makers has battled the demons that always hover on the shoulders of multi-level marketing companies: Is it really just a pyramid scheme?

Herbalife Ltd. (HLF)But it may have more evil spirits to wrestle with as the New York Post exposed that the supplements maker also has a law enforcement probe under way.

Everybody in the pool!
The problem many MLM companies have is the numbers don’t add up, or rather can’t support the weight of reality. To grow, they have to keep reeling in more people to support the ones above. You bring in two friends to sell, then each of them brings two friends in, and like the 1980’s Faberge shampoo commercial said, “and so on and so on and so on.” After a while, though, there aren’t enough people on the planet to support the structure, and it collapses.

Herbalife contends that it is somewhat different in that its distributors can also be its clients. While that’s a hallmark of virtually all MLMs, from Nu Skin Enterprises, Inc. (NYSE:NUS) and Amway to Mary Kay Cosmetics and even Tupperware Brands Corporation (NYSE:TUP), the supplements maker also says it never really tracked retail sales before, but Ackman’s charge it has few if any customers outside its distributor lists is wrong.

Tupperware, on the other hand, distinguishes itself because most of its end users aren’t also recruited to sell the product. The plastic container maker says 90% of the people who buy Tupperware products don’t sell its products compared with only 10% of its users who are distributors too. In contrast, some 30% of Herbalife distributors are self-consumers.

Inquiring minds want to know
While details are scarce regarding what it is the law enforcement inquiry is investigating, it was the FTC that revealed its existence after the Post filed a Freedom of Information request with the agency and got back hundreds of pages of complaints with some sections redacted because they were “obtained by the commission in a law enforcement investigation.”

This could undermine the position of another hedge fund manager, Third Point’s Daniel Loeb, who bet big with the supplements maker shortly after Ackman’s short position was publicized. He stated it was ridiculous to think the FTC would shut down Herbalife and his stance in favor of the company — along with his 8% stake — helped the stock regain all the ground it previously lost. Even the mano-a-mano CNBC matchup between Ackman and billionaire investor Carl Icahn — which made for great theater as they traded barbs and insults two weeks ago — had the stock briefly rising 6% above the previous day’s close.

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