Daniel S. Loeb took many by surprise on Wednesday when he unveiled an 8.2 percent stake in Herbalife, countering a big negative bet by his friend William A. Ackman.

In a letter to investors, the Third Point chief explained exactly why he was so upbeat about the prospects of Herbalife, a purveyor of nutritional supplements that Mr. Ackman has claimed is an enormous pyramid scheme.

From his letter:

The pyramid scheme is a serious accusation that we have studied closely with our advisors. We do not believe it has merit. The short thesis rests on the notion that the FTC has been asleep at the switch, missed a massive fraud for over three decades, and will shortly awaken (at the behest of hedge fund short seller) to shut down the Company. We find this thesis to be preposterous, particularly since the FTC has been sensitive to frauds of this kind. Since 1997, the FTC has brought 13 separate cases against alleged pyramid schemes.

Mr. Loeb argues that, contrary to Mr. Ackman’s assertions, few people feel particularly concerned about the business model of Herbalife. (The company is based on networks of independent resellers who gain incentives by recruiting other resellers.)

The FTC, by all accounts, receives a very low volume of complaints annually about Herbalife – fewer than forty per year – and we find it hard to believe the short seller’s theory that hundreds of thousands of people who have been scammed supposedly are too ashamed to speak up.

Despite being friends with Mr. Ackman, Mr. Loeb takes on his fellow hedge fund manager directly. A three-hour presentation that Mr. Ackman delivered on Dec. 20 to support his investment thesis, in Mr. Loeb’s words, “presented no evidence” that Herbalife would prompt regulators to intervene.

While the short seller’s presentation was lengthy, it presented no evidence to show that Herbalife has crossed a line that would compel regulators to shut it down. Indeed, there was very little “new” news in the presentation and when pressed in later interviews, even the short seller conceded that the FTC was not looking at Herbalife’s practices. In our experience, expert regulators like those at the FTC do not respond to sudden pressure from hedge fund whistleblowers by acceding blindly to their demands. Finally, even if there were some regulatory intervention that changed how the company does business, we are comforted by the fact that 80% of Herbalife’s revenues come from overseas.

And Mr. Loeb defends the company as a “compounder,” one that grows steadily year over year. Revenue, profit, earnings per share and free cash flow all look good, the investor writes. He also does some math to show how much growth he thinks Herbalife can post.

If management were to deploy its existing $ 950 million buyback authorization in the $ 40-45 range (only taking leverage to approximately 1.5x), we estimate that run-rate EPS for 2013 could be $ 5.50-5.70 using the reduced share count. Applying a modest 10-12x earnings multiple suggests Herbalife’s shares are worth $ 55-$ 68, offering 40-70% upside from here and making the company a compelling long investment for Third Point. Given that the Company has historically traded more in the 12-14x range (and traded at 16-20x earnings through much of 2011 and early 2012), the opportunity for the Company to tell its side of the story tomorrow at its Analyst Day in New York, and the significant short interest, we believe shares could even trade well above our current price target.

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