Herbalife Shares Could Become Worthless Within One Year

Herbalife Shares Could Become Worthless Within One Year

In a letter to his investors released Tuesday, hedge fund manager Bill Ackman argues that shares of Herbalife could become worthless within a year.

Brushing off the criticism that has plagued his position for the last eight months, Ackman provides a detailed argument as to why Herbalife shares are set to collapse.

"The probability of...regulatory intervention has increased materially"

As I've said before, if Herbalife shares are going to $0 (Ackman's price target) it will be due to regulatory action. If the company is, as Ackman claims, running a pyramid scheme, the SEC or FTC could shut the firm down, seize its assets, and wipe out its shareholders.

In the letter, Ackman writes that he has reason to believe that the probability of forthcoming regulatory action is likely, but does not say why, writing that "we are not at liberty to disclose the nature of these developments." He does, however, put a timetable on the possibility of such action. Earlier in the year, the FTC shut down Fortune Hi-Tech Marketing, a multi-level marketer deemed a pyramid scheme by regulators.

Ackman notes that it took two years for the FTC to shut down the company, after a lengthy investigation process. Yet, he believes that any action taken against Herbalife (should it take place) would occur far sooner given the heightened scrutiny surrounding the company.

Ackman first accused Herbalife of being a pyramid scheme last December, exactly eight months ago. In another year, it will be 19 months -- just short of two years. Therefore, if regulators are going to act more swiftly against Herbalife than they did against Fortune Hi-Tech, investors could expect a regulatory event within a year.

A confidence game

Ackman also argues that Herbalife as a company is very dependent on the confidence of its distributors. As roughly 90% of new Herbalife distributors give up at the end of one year, the company has to recruit some 2 million new distributors every year to keep its business going.

Moreover, existing distributors have to continue buying thousands of dollars worth of product each year in order to qualify for referral bonuses. Therefore, confidence in the company's product and the firm's business opportunity are of the utmost importance.

Since Ackman's attacks, Herbalife has adopted new policies that make life harder for its distributors. Some top distributors, like Shawn Dahl and Anthony Powell, have defected.

At the same time, there are questions surrounding the quality of Herbalife's products. A former Herbalife employee has come forward alleging that the company has, in the past, violated safety regulations in the manufacturing of its products.

The MLM industry in the crosshairs

If Ackman is ultimately proven right and Herbalife is shut down, it should reverberate through the entire multi-level marketing space. Most of the big MLM firms, like Amway, are private, but others, like Usana and Nu Skin , are publicly traded.

While Herbalife has had a good year (shares have nearly doubled in 2013), both Usana and Nu Skin have outperformed it, each rising more than 130%.

As I've written in the past, criticism against the MLM business model is widespread, and yet most of the big name companies have persisted, untouched by the US government. But shutting down Herbalife, one of the biggest companies in the sector, would send a message that the regulatory environment has changed.

Should the FTC take action against Herbalife, investors will likely project the effects onto shares of Nu Skin and Usana, too. Although Ackman has never once mentioned those firms, shares of both companies plunged last December following Ackman's original Herbalife presentation. Their recent recovery has paralleled the rise in shares of Herbalife.

If Ackman is right about Herbalife, expect a similar recurrence. However, if regulators fail to act, both stocks appear to be solid investments.

Usana beat earnings expectations each of the last four quarters, particularly last quarter, when it absolutely crushed expectations ($1.72 per share against a $1.30 estimate). Despite shares rising 136% year-to-date, the company remains cheaper than the broader market, trading with a price-to-earnings ratio near 14. Analyst Tim Ramey at DA Davidson raised his price target on the stock to $92 last month, suggesting that shares could have further upside of about 16%.

Likewise, Nu Skin has also been crushing earnings estimates in recent quarters. But more importantly, it's been returning that cash to shareholders in the form of a large stock repurchase program. Earlier this month, the company announced that it would boost its share repurchase program by $400 million -- roughly 8% of the company.

Nu Skin isn't as cheap as Usana--with a P/E ratio near 22, it's more expensive than the market. Still, analysts remain bullish -- JP Morgan raised its price target to $97 earlier this month, suggesting a 13% upside from current levels.

Investing in Herbalife

Given that Ackman has taken a bath on his J.C. Penney position, and Herbalife shares having appreciated so significantly, some investors might have expected the activist hedge fund manager to cover his short.

But they'd be wrong.

In his recent letter to investors, Ackman actually appears more confident in the trade than ever before.

Ultimately, it will come down to a question of regulatory action -- will the FTC shut the firm down? Ackman believes it could happen in the near future. If that's the case, it wouldn't be wise to hold Herbalife shares -- or the other multi-level marketing firms.

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The article Herbalife Shares Could Become Worthless Within One Year originally appeared on Fool.com.

Sam Mattera has no position in any stocks mentioned. The Motley Fool has the following options: long January 2015 $50 calls on Herbalife Ltd.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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