by Scott Wapner
Johnson had just passed his ninth anniversary leading Herbalife—a pretty good feat considering he’d almost quit within a few months of taking the job. In reflecting on nearly a decade at the helm of the company, Johnson noted how much Herbalife had changed through the years and how more people than ever seemed to be using its products every day.
“We call that daily consumption,” he said. “It is one of the key drivers of our growth. Today, we estimate that more than a third of our volume is being transacted through daily consumption.”3 It was Johnson’s way of saying the company’s business model wasn’t simply the distributor-to-distributor enterprise that had drawn so much criticism in years past. Herbalife not only had real customers, he intimated, but the numbers were growing—and growing fast.
Johnson then handed the duties off to Walsh, who echoed Johnson’s assessment of the business and lauded the company’s rapidly rising nutrition clubs, which were helping to fuel the meteoric growth.
“We estimate that in the first quarter of 2012, there were approximately 33,500 commercial or non-residential clubs,” Walsh said. “As we mentioned in our last quarter, and at our recent Analyst Day, we believe that approximately 34 percent to 41 percent of our overall volume is currently driven by daily consumption business methods.”4
Walsh was especially upbeat about the strength overseas. Volumes in Brazil grew 22 percent in the quarter, he said, and by 26 percent in Russia. Planned Herbalife extravaganzas in South Korea and Singapore were expected to draw twenty thousand and twenty-five thousand participants, respectively, a sign of how popular the company was becoming around the world.
Following the remarks from Walsh and CFO John DeSimone, Chapman, who was leading the call, cleared in one of the analysts from the awaiting queue. Mike Swartz from SunTrust Robinson Humphrey asked a few basic questions, with Walsh running through his typically rosy view of the world. When Walsh clicked off the line, Chapman welcomed in the next caller—a man whose name alone made some in the room straighten in their seats.
“Your next question is from the line of David Einhorn with Greenlight Capital,” said Chapman.
“Oh, shit,” DeSimone admitted thinking when he heard the name come out of Chapman’s mouth. Though Johnson himself had never heard of Einhorn before that moment, most of the investing public certainly had. Einhorn was a famed hedge-fund manager who many on Wall Street considered to be a genius. He’d called out Lehman Brothers during the financial crisis and dumped all over Allied Financial before that, and had made a fortune doing it. He was a billionaire who seemed to like toying with people he thought were suspect. He’d also recently made the papers for shorting Green Mountain Coffee, but Johnson and Walsh, in their distant Los Angeles offices and surrounded by the associated cultural mores, had been too removed from the Wall Street scene to really notice.
“I got a couple of questions for you,” said Einhorn. “First is, how much of the sales that you’d make in terms of final sales are sold outside the network and how much are consumed within the distributor base?”5
It seemed a simple and straightforward query—how many sales were being made to “real” customers outside of Herbalife’s web of distributors versus those made from one distributor to another.
But Walsh, who spoke with an accent reflecting his Irish heritage, appeared flustered by a question that should have been a layup.
“So, David, we have a 70 percent custom rule, which is—which effectively says that 70 percent of all product is sold to consumers or actually consumed by distributors for their own personal use,” said Walsh, virtually stammering through the answer.
“What is the percentage (of product) that is actually sold to consumers that are not distributors?” Einhorn pressed.
“So, we don’t have an exact percentage, David, because we don’t have visibility to that level of detail,” said Walsh.
“Is there an approximation?” Einhorn continued.
“So, well, again, going back to our 70 percent rule, we believe that it’s 70 percent or potentially in excess of that,” Walsh answered.
“Des Walsh was a great spinmeister and very smooth,” said Herb Greenberg, who covered Herbalife as a reporter for CNBC and hosted a network documentary about the company. “I can understand why they put him as their front man. He has that Irish charm, could be very disarming. He had the right answer to every single question.”
Except, this time, he didn’t. The 70 percent number was wrong, at least by the way Herbalife accounted for which of its members were distributing the company’s shakes as a business and which ones weren’t. It seemed Walsh had clumsily cited the Amway threshold from the 1970s instead of a number reflective of Herbalife’s current business.6 Walsh knew he’d screwed up, but in the heat of the moment, he didn’t immediately correct himself.
That wasn’t the only problem. Back on Wall Street, Herbalife shares were in free fall. From the moment Einhorn had appeared on the call, Herbalife stock, which opened the day at $70, began falling—first 10 percent, then 20 percent, then even more.7 By lunchtime on the East Coast, not even an hour from when the call had started, CNBC’s Greenberg dialed in live to talk about the slide with Sue Herera, one of the network’s longtime anchors.8
“We were in the Denver airport and got the message to call in to the network immediately,” remembers Greenberg, who was also blindsided by Einhorn’s questions. “I was more intrigued that they took his questions, because typically companies would screen those out. I thought, boy, if Einhorn is there, that is interesting.”
Greenberg recapped some of the questions Einhorn had asked, while showing a real-time stock chart documenting the stock’s sharp decline. The reporter had long been skeptical of multilevel marketing companies in general and laid out for viewers why the questions were so damning for the stock, which was now plunging.
“You have a situation where is this a pyramid sort of operation, or is it a genuine business selling products to you and me—that is the crux of the issue here,” Greenberg told Herera.9
There were nine Einhorn questions in all that morning, which must have felt like one hundred to the overmatched Herbalife executives, before the quizzing mercifully ended.
“OK, thanks so much guys,” Einhorn said, cordially, if unfulfilled.
At the end of the trading day, Herbalife stock closed at $52—a stunning 40 percent drop—one of the worst declines in its history as a publicly traded company.
Blood was in the water, and the hungry sharks on Wall Street sensed it.
At 2:20 p.m., a headline on the New York Times website blared, “Einhorn Questions Prompt Selloff at Herbalife,” with the Times reporter Michael J. De La Merced writing, “When David Einhorn speaks, investors around the markets listen.10 So when he asks critical questions on a company’s earnings calls, shareholders apparently panic.”
Panic is exactly what happened next inside Herbalife headquarters, where executives were now wondering what to do. Johnson urged everyone in the room to remain calm, reminding the team that they didn’t even know if Einhorn was short on the stock and that other analysts were still in the queue, waiting for their turn to ask questions of the team.
Walsh, who was always the rosiest of Herbalife’s top executives, now claims he wasn’t as concerned as the others. Walsh felt Herbalife had nothing to hide and that the team of c-suiters knew the business far better than some interloper three thousand miles away.
That Herbalife would even give the famed hedge-fund manager a platform in the first place is a decision that would haunt the executive team afterward, especially since earnings calls are typically reserved for company investors and the analysts who followed the company for their clients. Taking Einhorn’s call without even knowing his position in the stock, including whether he even had one, was a calculated risk, and management knew it. They also felt they had no choice.
In just two days, CFO DeSimone was scheduled to meet with investors in New York and Boston, and he was worried that keeping Einh
orn off the call—and Einhorn’s attempts to join a secret being kept from other investors—could trigger a violation of SEC disclosure rules. Since Johnson had never even heard of Einhorn, he deferred to DeSimone to make the call on the fly. DeSimone figured that if Einhorn actually was shorting the stock, they might as well know about it right there and then.
But Einhorn wasn’t your average skeptic. He had earned the reputation of being one of Wall Street’s undeniable superstars from all of his earlier exploits.
Einhorn, who grew up outside Milwaukee and went to Cornell University, had founded Greenlight in 1996 with a former colleague, Jeff Keswin, and $900,000 in assets under management. Einhorn and Keswin set up shop inside the Manhattan offices of Spear, Leeds and Kellogg, using the free desk space to save money while sharing the lone photocopier with the five other firms on the floor.11 It didn’t take very long for the duo’s investment chops to pay big dividends. In its first year, Greenlight didn’t suffer a single losing month, returning 37.1 percent in the final three months alone.12 The following year was even better, with returns for the now $75 million fund reaching 57.9 percent, partly from a successful short position in the restaurant chain Boston Market. Einhorn returned 31.6 percent in 2001 to firmly solidify his place as one of the hedge-fund industry’s up-and-comers.13
Former associates say Einhorn liked the ground-game aspect of investing, the weeks of analyzing companies down to the nitty gritty. It was that sort of bottom-up attention to detail—the mining of corporate balance sheets and financial statements for hours—that would pay off in 2002 when Einhorn shorted the finance company Allied Capital at $26.25 per share, claiming it defrauded the Small Business Administration through questionable lending practices.14 Einhorn went public with the investment on May 15 of that year at the Ira W. Sohn Investment Research Conference in Manhattan, an annual charity get-together where the biggest names in the business appeared onstage to reveal their best investment ideas. The forum frequently moved stocks, which is exactly what happened after the fresh-faced investor grabbed the microphone three-quarters of the way through the event and unleashed his takedown. Einhorn branded Allied a fraud, likening it to WorldCom, the now defunct telecom firm whose CEO, Bernard J. Ebbers, went to prison for accounting fraud and other crimes.
It was the first time Einhorn had stood before a group of that size to deliver such a meaningful speech. Wearing a blue suit and multicolored necktie with a buttoned-down collar, the visibly nervous investor took the stage and, with his name tag slightly askew, led the captivated audience through Allied Capital’s business and the reasons he was short during the fifteen or so minutes allotted for the presentation.
Einhorn’s delivery was so effective that the next day, Allied shares were primed to plunge more than 20 percent at the open of trading on the New York Stock Exchange. However, the shares didn’t even open out of concern among investors that selling would lead to a panic and that shares would fall even further.15
But beyond a sudden and swift stock move, Einhorn’s presentation had set off a firestorm. The company attacked Einhorn personally, accusing him of manipulating the market. CEO William L. Walton accused Einhorn of trying “to scare people, make a quick buck and move on.”16 Allied hired private investigators, who illegally obtained phone records of Einhorn and his firm through a process called pretexting, where someone impersonates another individual to obtain confidential information.
It was a full-on war. Allied said Einhorn was engaging in a “campaign to spread misleading or false statements.” Walton even convinced the Securities and Exchange Commission to investigate the brash hedge funder, but Einhorn was undeterred.17 Over a span of five years, Einhorn fought back. He released hundreds of documents detailing the alleged fraud, painstaking work that paid off in June 2007, when the SEC found that the company itself had broken securities laws related to the value of illiquid securities. By 2009, Allied shares had sunk to $1.56 a share.18
Allied would eventually end up bankrupt, and the legend of Einhorn was born. He would later recount the tale in his book, Fooling Some of the People All of the Time.
But if Allied gave Einhorn a certain mystique on Wall Street, his crusade against Lehman Brothers, just months before the firm collapsed, made him seem like a seer. On May 21, 2008, once again under the lights of the Sohn stage, Einhorn publicly revealed his Lehman short in a fifteen-minute presentation titled “Accounting Ingenuity.” Einhorn tore apart the bank’s balance sheet, questioning the true value of its assets and whether it was hiding risks from investors and the markets. He ridiculed CFO Erin Callan’s recent descriptions of the company’s financial performance, drawing parallels to his scathing Allied thesis. He then summed it all up by saying the bank needed to raise capital and raise it now. Shares fell more than 6 percent after Einhorn spoke.
Afterward, a Lehman spokeswoman said, “We will not continue to refute Mr. Einhorn’s allegations and accusations. He also makes allegations that have no basis in fact with the same hope of achieving personal gain.”
Four months later, Lehman Brothers collapsed in the largest bankruptcy filing in US history, with $639 billion in assets and $619 billion in debt.
Now one of the most feared financiers around, Einhorn set his sights on the coffee company Green Mountain, laying out his case at the Value Investing Congress, an industry conference, in a 110-slide PowerPoint presentation titled “GAAP-uccino,” a reference to the company’s accounting methods. Green Mountain’s K-Cup coffee pods had become ubiquitous in offices and homes nationwide following the company’s acquisition of Keurig and its popular single-serve machines. Einhorn pointed out that from 1991 to 2000, Green Mountain’s revenues had grown 25 percent a year, but that growth had slowed to nearly half that in the ensuing years. The company operated under the familiar Gillette razor model, selling the Keurig brewer near cost and the disposable pods at highly profitable margins. By 2011, Green Mountain had sold more than thirteen million single-serve coffee brewers and a stunning nine billion K-Cups, with the in-home market now the company’s most important growth engine.
There was only one issue. Einhorn thought it was wholly unsustainable. He concluded his presentation by mentioning an SEC inquiry into the company’s revenue-recognition practices and suggesting that the issue was more problematic than the company was letting on. Einhorn concluded his presentation with a latte-art picture of a bear made in the drink’s foam.
Shares dove 10 percent that morning, yet another victim of the “Einhorn Effect.”
Einhorn was still headlong into the Green Mountain short when the name Herbalife came across his desk in late 2011, in the same report the Indago Girls had sent to Ackman. Einhorn had also read Christine Richard’s initial work and, like Ackman, was also unconvinced the stock was a good short candidate. Richard had actually come to Einhorn first, but he politely passed on investing in the name. Shorts were never taken on lightly because of the damage they could inflict, and Einhorn wasn’t one to jump in without being fully convinced.
Over the next several months, Richard kept checking in, until finally Einhorn capitulated and assigned a Greenlight stock analyst to have a look. The analyst visited Herbalife nutrition clubs and went to recruiting meetings around the United States, noticing some of the same practices Richard herself had raised red flags about in the research report. The analyst reported what she had seen to Einhorn, who was now intrigued enough to go see the operations for himself.
One morning, Einhorn and Richard boarded the #7 subway train from Grand Central Station to Corona, Queens, with plans to visit four or five nutrition clubs. On one visit, along a busy street loaded with bodegas and other storefronts, Einhorn and Richard entered a club that was only identifiable by a neon green light out front. Once inside, the two encountered a young man, probably in his early twenties, who, according to Einhorn, looked “fit and buoyant.” The young man told the two that he had opened the club just a few months prior with dreams of reaching the upper levels of Herbalife’s sales
force—its Chairman’s Club, where the real money would start rolling in. Einhorn and Richard sat and drank an Herbalife tea, along with aloe water and a nutrition shake.
Only, something seemed off. The man told Einhorn and Richard he’d worked nearly one hundred hours per week, beginning at breakfast, spending part of the day passing out flyers to people in the neighborhood hoping to attract new customers. They noticed that the man tracked everything in pencil in a three-ring spiral notebook and placed a small gold star—the stick-on kind an elementary school teacher might give—next to repeat customers or the ones who seemed the most promising. There was no cash register to be seen, as they were strictly forbidden because the nutrition clubs were to be viewed as social clubs, not retail stores.
Most troubling, Einhorn thought, was that the man appeared to be consuming most, if not all, of the products himself as his main food source, and slept each night on the dusty floor of the club. And the only people who ever showed up to buy products were other distributors.
Einhorn thought there was no way the man could even pay his monthly rent.
Einhorn and Richard drank Herbalife shakes and teas all morning long—enough so that after they had finished, the hedge-fund manager hit a nearby convenience store for a bag of chips or Cheetos to settle his stomach. Einhorn and Richard would meet several people that trip, all with the same goal—to strike it rich selling Herbalife products.
