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Dear Pershing Square Investor: Our goal in our communications with you is to give you the information we would want if our positions were reversed, that is, if we were the investor and you the investment manager. Using this paradigm, we endeavor to inform you about business challenges and related developments as promptly as practicable, as good news generally takes care of itself. It has been one year since our December 20, 2012 Herbalife presentation. In light of the passage of time, recent developments, and questions we have received, I thought it would be useful to review this investment and our approach year-to-date. After our presentation, we began a dialogue with U.S. and foreign regulators about Herbalife’s illegal business practices. Our discussions with regulators included the information we presented in our presentation plus additional analysis and facts that we have not yet disclosed publicly. Contemporaneously, Herbalife became fodder for business television and other media, and the public discussion moved from questions about the Company’s business to commentary about a battle between Wall Street personalities. Because we believed that the Wall Street story was distracting to the regulatory community, we elected to discontinue our public dialogue and focus on our discussions with regulators. Since our initial presentation, scores of non-profit and community-service organizations as well as local, State, and Federal legislators have come forward to decry Herbalife’s business practices and to demand governmental investigations and remedial action. For example, last week, the President of the New York Police Department Hispanic Society noted in a press release:
The NYPD Hispanic Society is calling on the New York State Attorney General Eric Schneiderman to launch an investigation into the multi-national company Herbalife Ltd, which is a complex pyramid scheme unfairly targeting and misleading independent Latino distributors, promising profits that are all but unattainable. Many Latinos have been victimized by Herbalife’s aggressive recruitment and illegal business practices. Many of these sellers known as distributors have discovered that selling the products has been harder than they thought. After reaching out to family and friends to buy these Herbalife products, some have resorted to spending hundreds and even thousands of dollars buying sales leads, which often times have led nowhere. The real money is in recruiting others to sell the product, creating what’s known as a “down -line” of distributors. The more distributors they recruit, the more money they are likely to make based in part on a combination of bonuses and commissions. Unfortunately, once new recruits become Herbalife sellers they most often end up in debt and unable to make a profit. It’s difficult for these people to sell enough of the
product in order to realize a significant return on investment. Many of these Latinos are ending up in serious debt as a result of Herbalife’s recruitment and illegal business practices.
We believe that Herbalife’s response to our initial presentation and its actions over the course of this year are notable. In our experience, there is a high degree of correlation between the accuracy of a short seller’s arguments and the aggressiveness with which the target company attacks the short seller. In contrast, in cases where a short seller is wrong, the target company typically responds by providing full transparency to the investing public in lieu of attacking the short seller. On January 10th, Herbalife management publicly committed to answer any questions from Pershing Square, but later refused to answer even one of our questions that we thereafter released publicly to the Company. Herbalife continues to be unwilling to collect and disclose its distributors’ retail sales data which could serve to dispel some of the concerns we have identified. Instead, Herbalife has focused its resources on attacking Pershing Square. In our experience, Herbalife’s response to Pershing Square is unprecedented in the history of short selling. The Company has hired public relations firms, lobbyists, law firms, an investment bank, and paid-for spokespeople to attack us in the media, on social networks, and in the halls of Congress. Herbalife has spent tens of millions of dollars attacking Pershing Square, going so far as to engage Moelis & Company in a campaign to convince Pershing Square investors to redeem from the Funds in an attempt to force us to exit our position. Moelis & Company even offered to stop this campaign if we would agree to no longer push our regulatory agenda and to refrain from any further public statements. We believe that the Company and Moelis may have recently abandoned this campaign as a result of media scrutiny. If Herbalife were confident it was not in violation of the law, instead of lobbying Congress to stop the FTC from launching an investigation, it would welcome an FTC investigation into the issues we identified. Similarly, its conference calls would not be limited to questions from only the most bullish analysts and buyside investors. When Kinder Morgan and its CEO Rich Kinder were attacked by short sellers many years ago, Rich Kinder held an open conference call in which he welcomed short sellers, and kept the call open for hours until all questions had been asked and answered. We note that on Herbalife earnings calls CEO Michael Johnson only reads prepared remarks and no longer answers questions. We challenge Mr. Johnson and Herbalife to respond to our questions and for the Company to invite the FTC to examine its business practices. If Herbalife is truly a legitimate operation, why would it not welcome a thorough investigation by its regulators to dispel what it calls “confusion” about its business? Beginning in early January and up until the present, we have been contacted by a number of former Herbalife employees who have shared with us additional information that confirms the illegality of the Company’s business practices. We have also communicated with hundreds of former Herbalife distributors who have shared their stories of being seduced into the so-called Herbalife “business opportunity,” and manipulated into spending thousands, and often tens of thousands, of dollars on the false hopes of financial success as a distributor.
To date, we have shared the information we have received since our initial presentation and the analysis and results of our investigation only with regulators, and we have continued to respond to their ongoing requests for further information. Why Have We Chosen to Keep Our Information and Analysis Confidential? We have chosen not to disclose this information publicly in order to allow the regulators the time to do their own investigations and analysis. For this reason, at the recent Robin Hood investor conference, we were careful to limit our presentation to disclosures which would not interfere with ongoing regulatory activity. Our Robin Hood presentation described the SEC’s recent investor alert which identifies seven hallmarks of a pyramid scheme and an Herbalife victim video made by Make the Road, a well-regarded Latino advocacy organization. While we believe that our approach has been successful in garnering significant regulatory interest, there has been a substantial short-term economic cost to Pershing Square due to our silence. Because Pershing Square has a reputation for doing extremely thorough research, Herbalife investors incorrectly assume that we have disclosed everything negative we know about the Company’s business, particularly in light of the more than 300-page original presentation. While the original presentation was certainly comprehensive, we limited it to an introduction to Herbalife and only those facts and issues that we could prove at the time, with a plan to present additional information in future presentations as we completed our research. Other than the initial disclosure of the SEC Enforcement Division investigation in January, the lack of public disclosure from regulators over the past 12 months – despite public calls for an investigation by members of Congress, other elected officials, and from consumer, Latino, and public advocacy organizations – has comforted Herbalife longs that no regulatory action will be forthcoming. Two recent developments, a Belgian appeals court decision and the recent completion of the Pricewaterhouse reaudit, have been mischaracterized by analysts and misconstrued by the market. When combined with the false rumor that Pershing Square has quietly capitulated on its position, these developments have caused the stock to rally to new all-time highs. Herbalife is now trading at the high end of its historical multiple of management’s forward earnings guidance suggesting that the market believes the probability of regulatory action is zero. Analysts have made the argument that the absence of regulatory action over the past year, particularly in light of the issues raised by Pershing Square, suggests that the business model and regulatory cloud that has historically overhung Herbalife has now been permanently lifted. While we and Herbalife victims would welcome prompt regulatory action, we are not surprised that, other than the initial disclosure of the SEC Enforcement Division investigation in January, there has been no other public disclosure of regulatory action at Herbalife. Pyramid scheme frauds are more complicated to analyze than accounting frauds with their phantom warehouses, fictitious inventory, off-balance sheet SPVs, concealed losses and debts, and inadequate reserves. Furthermore, the high profile nature of this situation has likely led regulators to take a more measured approach. Based on our recent discussions with regulators, we believe that they are making substantial progress, but it is difficult to predict the timing of regulatory intervention.
The Belgian Decision In November 2011, the Commercial Court in Belgium found that Herbalife operates a pyramid scheme under Belgian law, a decision we found supportive of our view because of its findings about how Herbalife’s system operates in practice, namely its focus on recruiting rather than retailing. On December 2, 2013, the Court of Appeal of Brussels overturned the Commercial Court judgment. For several reasons, however, the Appeal decision provides no comfort to Herbalife under U.S. law and that of other foreign jurisdictions where the Company operates. Of key importance, the Court of Appeal said that under Belgian law, “regarding consumption, the [statute] does not require that this must be consumption by non-distributors.” Belgian Appeal Decision ¶ 10. This interpretation of the Belgian statute directly conflicts with wellsettled U.S. law. In October 2013, in denying Herbalife’s motion to dismiss a class action brought by a failed distributor, the U.S. District Court for the Central District of California rejected Herbalife’s argument that sales to its own distributors constitute retail sales.1 In that decision, the U.S. court held that “downline distributors are not ultimate users for purposes of the second element of the Koscot test [a seminal FTC precedent which is applied to determine what is a pyramid scheme].”2 The Bostick Decision is fully in accord with controlling U.S. law. In addition, recent FTC cases have emphasized the critical role of genuine retail sales to people outside the distribution network in determining whether a multi-level marketing company constitutes an illegal pyramid scheme. For example, in January 2013, in shutting down the Fortune Hi-Tech Marketing pyramid scheme, the FTC’s complaint noted: “few of FHTM’s products and services are ever sold to anyone other than the Reps themselves” and “Reps receive minimal financial rewards from FHTM for selling the products and services to outside consumers.” Similarly, in an appellate brief recently filed in FTC v. BurnLounge, Inc., the FTC argued: “If Koscot is to have any teeth, such a [non-retail] sale cannot satisfy the requirement that sales be to ‘ultimate users’ of a product.’” 3 Given the legal and factual distinctions, the Belgian Appeal Decision will have no bearing as to whether Herbalife is a pyramid scheme under U.S. law. Belgium is one of Herbalife’s smallest markets with fewer than 8,000 (out of several million) distributors when last reported in 2010.
Bostick v. Herbalife International of America, No. 2:13-cv-02488-BRO-RZ, Dkt. #40 (C.D. Cal. Oct. 11, 2013). Id. at 9. 3 Nos. 12-55926, 12-56197, 12-56288, FTC Brief at 42 (9th Cir. Apr. 1, 2013) (emphasis in original) (quoting Webster v. Omnitrition, 79 F.3d at 783). Moreover, in an October 17, 2013 Investor Alert, the Securities & Exchange Commission (the “Commission”) encouraged potential investors in multi -level marketing companies (“MLMs”) to “[a]sk to see documents, such as financial statements audited by a certified public accountant (CPA), showing that the MLM company generates revenue from selling its products or services to people outside the program.” http://www.sec.gov/investor/alerts/ia_pyramid.htm.
PricewaterhouseCoopers PwC completed the reaudit of Herbalife’s financial statements on December 16th. The stock rallied more than 10% on this news as analysts and the Company have mischaracterized the reaudit as evidence of the legality of the Company’s business model. Furthermore, investors believe that the completion of the audit will enable Herbalife to complete a highly accretive debtfinanced share repurchase further boosting the stock price. The role of an auditor is to determine whether the financial results of a Company are presented fairly in accordance with GAAP. PwC did not audit Herbalife’s retail sales to consumers nor did it evaluate or opine on the Company’s business model. Unless a regulator or a court finds Herbalife to be a pyramid, we expect that the Company will be able to obtain a clean financial opinion from its auditor. The fact that Herbalife has obtained audited financials is not, however, evidence of the legality of Herbalife’s business. Herbalife is not an accounting fraud; it is a business opportunity fraud that relies on deception. The PwC audit shows that pyramid schemes can be extremely profitable and generate large amounts of cash, but it does not in any way prove or even suggest that the Company operates legally. Unfortunately, every large public company fraud – Enron, Worldcom, and Adelphia, for example (and these were accounting frauds) – had a clean opinion from a Big Four auditor until they failed. With respect to the ability of Herbalife to complete an accretive leveraged recapitalization, we continue to be skeptical. Bullish analysts have previously suggested that once the audit was complete, the Company would promptly launch a $1.5 billion to $2.0 billion buy back at a purchase price of $75 per share, which at the time represented a substantial premium to market. In order for the Company to complete a buy back of this size, the Company would likely have to offer a substantial premium to the current market price. Now that the stock has reached $80.61 and considering the high cost of debt for such a junk financing (Herbalife was last rated Ba1, a junk rating, by Moody’s because of business model concerns in March 2011 when it had no net debt) and Herbalife’s low tax rate, we do not believe that a recap would be accretive to earnings, nor would the Company materially reduce its outstanding float. In addition, when one considers the high degree of leverage that would result from the buy back, we would expect the Company’s earnings multiple to compress accordingly. While a recap would facilitate the exit of large illiquid shareholders, we believe that it would destroy rather than create shareholder value. As a result, we would welcome a recap which would have the ancillary benefit of the creation of a CDS market where we could more efficiently effectuate our investment at greater scale, at lower cost, and with less risk. A further pillar of the bull case has been the large positions in the Company taken by certain well known investors which have catalyzed others to follow their lead. In light of the more than doubling of the stock price over the course of the year and the lifting of restrictions on the sale of these shares, we expect that the market will eventually view the nearly 30% stake held by the three largest investors plus the holdings of their followers as an overhang on the stock rather than a source of support. In light of the high degree of followership in this investment – where later investors are relying on the due diligence (or lack thereof) of high profile early investors – we
would not be surprised to see the short squeeze work in reverse if one or more of the large shareholders were to exit. We believe there is little additional upside in Herbalife stock at current levels. That said, the Herbalife bulls are unlikely to be swayed by anything other than the public disclosure of regulatory action against the Company. As a result, we do not expect the stock price to decline until regulators take action. What We Plan to Do Going Forward In one or more future presentations and/or other communications, we will be describing our analysis and conclusions from the last 12 months of our investigation including information we have obtained from former Herbalife employees, a number of whom have sought whistleblower status with regulators. Our next presentation, among other issues, will include an analysis of the three principal sources of revenue growth for the Company: Internet-based Lead Generation, nutrition clubs, and the Company’s China operation. We will show that the Company’s decade-old Lead Generation recruiting methods promoted by Herbalife’s top distributors, which were ostensibly prohibited by Herbalife beginning on June 30th – several months after we shared the details of this business method with the FTC, SEC and several State Attorneys General – continue to this day. We will show that nutrition clubs, which the Company has suggested demonstrate “daily consumption” for products principally from the Latino community, are in fact recruiting venues to attract low-income distributors who do not have the $3,000 required to become an Herbalife supervisor. We will show how Herbalife’s Chinese operation likely violates the multi-level marketing restrictions in that market. We will share data that will enable investors to understand the extremely high distributor failure rates in countries around the world, providing additional evidence of the deceptive nature of what Herbalife management calls “The Best Business Opportunity in the World.” Finally, we will focus on the plight of the Herbalife victims and share their stories in their own words. We continue to believe that our Herbalife short position offers an extremely compelling, and, as now structured, even greater asymmetric payoff than before because of the stock price’s substantial rise. Other Business While our Herbalife investment has garnered a remarkable amount of press coverage, the vast majority of our capital and mindshare are invested in our other commitments, as these investments will disproportionately drive our long-term returns. On the good news front, Canadian Pacific, Air Products, Procter and Gamble, Beam, Howard Hughes, General Growth, Burger King, Platform Acquisition Holdings, and Fannie and Freddie 6
continue to generate substantial business progress and appreciate in intrinsic and stock market value. As importantly, the idea generation machine is working effectively and we should have a new commitment to discuss in the New Year. We look forward to seeing you at our upcoming Annual Dinner on February 13th. We wish you Happy Holidays and a Happy New Year. Sincerely, Pershing Square Capital Management, L.P.
William A. Ackman
General Disclaimers and Notes Past performance is not necessarily indicative of future results. All investments involve risk including the loss of principal. This letter is confidential and may not be distributed without the express written consent of Pershing Square Capital Management, L.P. and does not constitute a recommendation, an offer to sell or a solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential private offering memorandum. Any returns provided herein based on the change in a company’s share price is provided for illustrative purposes only and is not an indication of future returns of the Pershing Square funds. This letter contains information and analyses relating to some of the Pershing Square funds’ current positions. Pershing Square may currently or in the future buy, sell, cover or otherwise change the form of its investment in the companies discussed in this letter for any reason. Pershing Square hereby disclaims any duty to provide any updates or changes to the information contained here including, without limitation, the manner or type of any Pershing Square investment. In addition, the analysis in this letter includes forward-looking statements with respect to future events and financial performance, which are subject to various risks and uncertainties. There are or will be important factors that could cause actual outcomes or results to differ materially from those indicated in these statements. Pershing Square does not undertake to update or review any forward-looking statements, whether as a result of new information, future developments or otherwise, except as required by law
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