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Shortzilla has spent months of painstaking research in examining the various facets of the multi-level marketing firm Herbalife. Herbalife has come under fire from several short-sellers in the past. The argument is typically always the same; Herbalife has little to no actual retail sales and is therefore operating as a Pyramid Scheme.

David Einhorn's inquiries into the actual percentages of retail sales (those outside of the distributor network) on the May 2012 earnings Q&A ignited renewed fears surrounding the legitimacy of Herbalife's operations.

The following three discussion points offer a glimpse into the labyrinth of Herbalife. The full report, which covers several other additional topics is available at our website.

Part One: Herbalife is operating in violation of a 1986 California Court Order

Herbalife has been omitting and misstating information to the public since it listed its securities on the NYSE in 2004

The Ground Rules: The rules and regulations of the Securities and Exchange Commission ("SEC"), including but not limited to Rule 10b(5), apply to all publicly listed companies, including Herbalife. (See a more thorough explanation here.

Shortzilla will give you the facts, then you can decide if this information had been known to you; would you have included it in your decisions in connection with trading in Herbalife securities.

Is Herbalife operating its enterprise in violation of a court order?

A court order which specifically provided the conditions under which Herbalife's Marketing Plan will be in compliance with the state of California's endless Chain Scheme Code.

The following statement is included in Herbalife's prospectus in connection with its NYSE IPO in 2004, and in each Annual report thereafter.

All of our officers and directors are subject to a permanent injunction issued in October 1986...instituted by the California Attorney General...We consented to the entry of this injunction...The injunction... required us to implement some documentation systems with respect to payments to our distributors.... (Emphasis Added) Page 22, 10K 2011.

TS: Herbalife has admitted in regulatory filings, in litigation and on its 1Q 2012 conference call that it does not have any system whatsoever that does, or has the capability to, track retail sales.

What are the details of the 'documentation systems' imposed by the court; and why did Herbalife omit these details from all regulatory filings? The Final Judgment and Permanent Injunction mandated that Herbalife must set up a system to:

"verify or document that any and all participants who receive commissions...and/or advancement from defendants in defendants marketing program, after entry of this judgment, are based on retail sales".

Question: Would Herbalife conceal the very existence of the permanent injunction from a court?

Answer: Yes they would and they did.

On June 1, 2009 there was a hearing in connection with [then] active litigation involving Herbalife; wherein Herbalife's attorney admitted:

"And, yes, we don't keep track of retail sales".

Consequently, it was imperative that both the existence and details of the permanent injunction be withheld from the court.

At the beginning of the hearing, the court informed the parties that:

"First of all, subject to the Court's ruling on the endless chain scheme, and that's really what I want to hear most about today because, in my view, in this case that's --that is the elephant in the room"

and

"All of the other issues depending on how it's resolved is whether or not Herbalife's business model is lawful under the California endless chain legislation".

In response to the Court's statements above, Herbalife's attorney stated:

...the company has been here for close to 30 years. It's been overseen by the...State of California...and it has not yet, other than in California in 1980 or '81, I believe it was, has it been looked at as a pyramid scheme. (Emphasis added)

The Court:

...you have indicated that Herbalife has been in business for 30 years without being found to be an endless chain.

Part Two: Belgium Court's Pyramid Scheme Ruling

The Belgium pyramid scheme case had been ongoing for several years. The findings of the court that Herbalife was operating a pyramid scheme was a significant blow to Herbalife; because, among other things, its MLM Marketing Plan is the same throughout the word, with the exception of China.

In December 2011 a Belgium Court ruled that Herbalife has established a pyramid scheme; the court ordered cessation of Herbalife pyramid scheme; and the court ordered that Herbalife would pay a fine of 5,000 Euro for each breach that is established from two months after the date of this ruling".

Herbalife engaged in a concerted effort to conceal the Belgium court findings from the public.

The court's ruling that Herbalife is operating an illegal pyramid scheme is a material event. However, instead of issuing a 8K (which is mandatory for a material event) Herbalife issued a press release. The press release is dated December 16, 2011 and omits the material fact that the court found that Herbalife was operating a pyramid scheme.

We tried to find references to the Belgium case in Herbalife's Q's and 10K's. This task was difficult because Herbalife omitted any mention of, or even reference to, this case from the appropriate sections of these filings; which is "Item 3. Legal Proceedings". We finally found disclosure of the case in its 10 Q's and the 10K 2011. In both cases, the disclosure was slipped into the description of Herbalife's Network Marketing Program under risk factors.

The following are few interesting excerpts from the Belgium Court's Order.

The Court: Herbalife argues...products are sold by the methods of direct sales whereby they are sold to the end consumer by independent entrepreneurs...Sometimes the distributors are 'consumers', yes even 'members', other times the distributors are 'retailers'. The fact that the distributors are no consumers is shown from 'The Distributorship Agreement' of Herbalife.

The Court: Contrary to what Herbalife is arguing, this case does not show that the distributors are selling to the end consumers.

The Court: Payments at Herbalife are calculated on purchases, whether these are by sponsored distributors or end-consumers does not make any difference to Herbalife. Moreover, Herbalife cannot even answer the question by the court as to how many of its products are eventually sold to an end-consumer.

Part Three: Packaging & Handling Fees Inflating Bottom Line

According to the above snapshot taken from Herbalife's Investor Relations page, Herbalife generated net sales of $3.5 billion in 2011. This number includes shipping & handling charges and sales generated from literature and promotional tools.

Therefore, in 2011, Herbalife only generated $2.94 Billion revenue from its distributors' purchases of its products ("product sales").

In 2011 Herbalife generated $509.8 million (over half a billion dollars) in revenue from Shipping and Handling charges (see above); representing 17.3% of Herbalife's total product sales. We wondered why revenue from this category was so high?

Here's what we discovered.

Herbalife is charging distributors on average 7% of the total retail sales price of the items purchased for 'packaging and handling fees'; with shipping charges adding an additional 3-4% (also based on the retail sales price). There are no shipping and handling charges in China, so if we extracted the $210.8 Million in China Product Sales in 2011, shipping and handling as percent of product sales is even higher at 18.6%.

Remember that the Retail Sales number doesn't mean anything to Herbalife. If I am a distributor at a 50% discount and order $100 of product at retail price, I pay Herbalife $50. Yet, I still am charged a packaging fee and a shipping fee based on that $100 retail price.

We thought that 7% for just packaging and handling fees seemed high, especially when it never really equates to 7%. Here are the discount groups for Herbalife and what that 7% number really means:

Distributor Discount

Packaging Charge Based on Actual Purchase Price

25%

9.33%

30%

10.00%

35%

10.77%

42%

12.07%

50%

14.00%

We searched Herbalife's marketing materials and found this in one of their guides:

Herbalife is also levying shipping charges based on the "Retail Sales" Price. Please see below for a list of US Shipping charges for distributors:

So let's get back to my original example. If I order $100 worth of 'Retail Product' and I am in a 50% discount group, I would pay the following to Herbalife:

Product Sales: $50
Packaging and Handling Fees (based on $100 Retail Price) = 7%*$100=$7
Shipping Fees (FedEx Ground Delivery): $6
Total Packaging, Handling and Shipping Fees: $13
Total Amount Sent to Herbalife = $63

In the above example, my packaging, handling and shipping fees equate to 21% of my entire order.

I thought it would be interesting to see what happened to Herbalife's bottom line if we stripped out charges for handling and literature/promotional sales.

I started with Total Product Sales of $2.94 Billion (Note this is the amount paid by distributors to Herbalife for Products). I subtracted Literature and Promotional Revenues for reasons that will be explained in the second in our series of reports on Herbalife, which will be published in January.

I also subtracted my estimate of $362.8 Million for packaging and handling charges. (this had to be estimated, since this number is never revealed by Herbalife in SEC filings).

I adjusted Cost of Sales, using the same percent of product sales (16.8%) as reported by Herbalife in 2011. They do note in the 10-K that shipping and handling costs are included in Cost of Sales.

Taxes are adjusted utilizing the same tax rate as reported of 26.3%

Based on my findings, Herbalife overstated EPS by nearly 66% in 2011. My normalized figure for Earnings Per Share is $1.34, as compared to the $3.89 reported by HLF. Utilizing the current trailing P/E ratio of 12x 2011 Earnings, we arrive at a value per share for Herbalife of $15.84.

Note that these normalized numbers still could be adjusted even lower.

We include 147 Million in Revenue for Herbalife, which still equates to 5.3% of Total Product Sales in 2011. If we normalize shipping charges to 3% of total product sales, EPS drops to $1.03, with a value of HLF at $12.15.

In Summary, Shortzilla believes that Herbalife is utilizing 7% packaging fees, inflated shipping charges, and the questionable recognition of Literature and Promotional material in order to help compensate its distributors.

(click to enlarge)

Source: Navigating The Labyrinth That Is Herbalife