Herbalife Falls on Reports of Federal Probe - Analyst Blog

As per a Financial Times report, the U.S. Department of Justice (DOJ) and the Federal Bureau of Investigation (FBI) have begun a criminal investigation against Herbalife Ltd. HLF for running a pyramid scheme business model. Herbalife however issued a statement stating that it was unaware of the FBI probe. Shares of this nutrition supplement network marketing firm plunged 13.97% after the news.

Last month too, the company received a Civil Investigative Demand (CID) from the FTC to investigate its operations on similar grounds.

Though a criminal probe might not result in any substantial penalty for Herbalife, the civil inquiries by the FBI, DOJ and FTC definitely raise investor concerns for the nutritionist company, which is already facing attacks by activist investor William Bill Ackman.

Herbalife's business practices have been criticized since Dec 2012, when Ackman, hedge fund manager of Pershing Square, first accused the company of making money by recruiting new sales people and not from its sales. Ackman also unveiled a $1 billion short position in the company's shares in 2012.

Last month, media reports said that the billionaire investor told his clients that Herbalife is likely violating multi-level market restrictions in China. Ackman pointed to internal documents obtained from a former employee at Herbalife and argued that the company's Chinese operations were identical to its business in other countries such as the United States and Mexico.

Per the reports, Herbalife responded to Ackman and stated that its business model complied with Chinese direct-selling and anti-pyramid regulations. In Jan 2014, First Financial Daily, a Chinese newspaper, also suspected that Herbalife adopted illegal marketing practices in China. Later in the same month, the Canadian Competition Bureau announced a formal investigation into the pyramid scheme business model complaints against the company, as per a report by New York Post.

Furthermore in Dec 2013, Ackman had sent a letter to its investors about the improper recruiting methods adopted by Herbalife.

Given the recent development, it seems that Ackman's persistent push for an investigation by the state and federal regulators has finally met with some success.

This Zacks Rank #2 (Buy) company, on its part, has been denying the charges since 2012. The company also came out clean in Dec 2013 when its UK-based auditor PricewaterhouseCoopers (PwC) completed the re-audit of more than three years of financial statements and found no material changes in them. Moreover, despite allegations and numerous attacks on its multi-level marketing model, the company's earnings continue to increase.

Herbalife is not the only company, which employs sales representatives to sell its products. Other multi-level marketing companies like Nu Skin Enterprises Inc. NUS, USANA Health Sciences Inc. USNA and Avon Products Inc. AVP also follow the same distribution model.