Why the Herbalife Short Was Doomed

 | Aug 13, 2013 | 8:08 AM EDT
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Could Herbalife (HLF) sell its product like Tupperware (TUP) does? Could it shift out of the recruit model -- which entails simply trying to pile on hosts -- to a model used to sell new, best-in-class kitchenware that seems to be loved the world over? Could Herbalife become a retailer of product via parties?

On Monday night, as I talked with Rick Goings, the terrific CEO of Tupperware, I was conscious of the differences and similarities between the two companies. First, Tupperware is a great business. Several million women are hosting parties for the product, one every second and a half around the globe, and the products are constrained in supply. Tupperware's offerings are proprietary, and innovation has kept the company ahead of the game. In Turkey, Indonesia, China and Mexico -- wherever emerging markets are -- there are women selling these products to earn a little extra money or just to be the breadwinner.

Herbalife has parties, too. It has new product. But this is a recruitment company that is graded by its own point system, and not its actual end-market sales -- although it has data showing that most of the product does go to end markets.

It is true that an unscrupulous Tupperware salesperson could try to bury an unsuspecting individual with product in order to get sales done, but I haven't heard that charge being made. But getting more salespeople in each country is a priority in the same way that opening new stores is a priority for any retailer, and you just have to consider this method a handy way to open new stores.

I think Herbalife could emulate the Tupperware model, but I think its earnings would proceed to be much lower short-term. Still, if the product is as good as Herbalife claims, it would likely have nothing to worry about were it to adopt Tupperware's strategies.

Here's the issue, though. Why bother? Herbalife has terrific cash flow and lots of good expansion plans, and its model is working for shareholders. It's just not working for short sellers and failed recruiters. Imagine if, tomorrow, Michael Johnson said, "OK, that's it. We are going Tupperware's way." The sales would fall dramatically, the firm would miss estimates and the stock would take a severe hit -- and Bill Ackman would make a ton of money.

In fact, if Ackman had demanded that Johnson go the Goings way -- if he had gotten a government agency to endorse it, to the point at which it would threaten to shut down Herbalife if the company didn't comply -- then he would have won this battle. Here's the hilarious thing: Ackman would merely have needed to buy enough shares to get himself elected to the board, and then demand Johnson clean up the company by adopting a Tupperware model.

But, of course, a Tupperware model would mean fewer sales -- so, in this case, he would be electing to hurt his investors. Instead, he is campaigning to help his investors by getting Johnson to try to switch to a Tupperware model -- which wouldn't make as much money as a Herbalife model for Herbalife product. Remember, despite what Mr. Going to Zero says about Herbalife, no government agency is going to try to pull an Arthur Andersen on this company. Instead, that agency would recommend that Herbelife "reform" its practices by going toward Tupperware's methods.

In the end, the two companies aren't really in the same business. One sells product, while the other sells franchises. The product that Tupperware sells could easily sell in retail, but it wouldn't do as well because it would then be missing that connection that women make with other women. The product Herbalife sells wouldn't cut it in a world where GNC (GNC) dukes it out against Vitamin Shoppe (VSI). Both could make money, but neither would be as profitable.

In the end, though, you can see why the Herbalife short was doomed. There's an alternative model to Herbalife, and this was the best hope for Ackman -- but, without an agency pressuring the company, there's no reason for it to change. With that lack of change comes more recruits and a higher profit -- because, just as Tupperware is good at hosting parties, Herbalife is darned good at getting more recruits.

Herbalife's business is not one I would want to be in myself -- but it is a business, and unless someone outlaws a business that recruits others to sell product, however undifferentiated, the short just seems an errant one. The long side, on the other hand, makes a ton of sense, given the small amount of capital required to recruit or to make a relatively undifferentiated product.

In the end, Herbalife product is simply a MacGuffin at this point. There's nothing sinister about the MacGuffin. It's just unimportant to the drama, regardless of how important Ackman has tried to make it seem. My conclusion? He should go watch some Hitchcock movies and cover his short.

Oh, and this may be totally gratuitous, but he should blow out of J.C. Penney (JCP) while he is at it -- because, guess what? The company he's betting with is selling as undifferentiated product, too -- as undifferentiated as that of the company he's betting against. He's got a chance now that he's off the board. He ought to take it. Maybe that's just what he's doing.

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