Everyone wants to know if Bill Ackman's short thesis is correct on Herbalife (NYSE:HLF). Many analysts that went through his presentation here believe that there were many slides that provide a lot of background information and circumstantial evidence, but not really enough to definitively conclude that HLF is a pyramid scheme, both from the legal definition and the economic perspective.
From an economic perspective, Ackman's evidence that the company is a pyramid is somewhat flimsy. The argument is that pyramid-like implosions in one country are masked by revenues derived from entering new countries. HLF is almost out of new countries to enter and is therefore bound to collapse. However, anyone looking back at the history of HLF within mature markets, say the U.S., will see that revenues have not imploded there. This article seeks to answer the pyramid question both from a legal perspective and an economic perspective.
First, we need to define a pyramid from both an economic and a legal perspective because the two may be different. Economically, a pyramid involves paying money from outside a system to support members inside the system on higher rungs of the hierarchy. As you enter the system and start recruiting people yourself, those fresh recruits pay you the money, hence a pyramid, and hopefully more than what you are paying out yourself. Obviously, the system is unsustainable because the number of fresh recruits runs out and there are no real sales, only recruiting inflows. Everyone generally knows what a pyramid looks like economically. The FTC, similarly yet different, defines a pyramid per the following:
Criteria of a Pyramid (FTC version)
1. The type of plan that is potentially subject to this definition. There are two key elements of such a plan: (1) the payment by a participant for the right to participate in the compensation plan; and, (2) income not primarily generated by selling products or services to retail customers who aren't themselves participants in the plan.
2. There is a clear definition of "retail sales" that exempts purchases made by the participants (or "distributors" or "IBOs") for their own use from being considered as legitimate retail sales. In other words, you cannot claim to be operating a legitimate MLM marketing a product or service where most of the income is generated from purchases made by the "distributors" themselves for their own self-consumption.
3. The meaning and use of the word primarily by the FTC. In this definition, the word refers to whether the income comes from recruiting or self-consumption or whether it comes from actual sales to retail customers who aren't participating in the compensation plan. (As I understand it, "primarily" means greater than 50% per court cases that ensued).
For more info on the definition of a pyramid from a legal perspective, click here.
The legal definition of a pyramid is what complicates the issue at HLF. Many people have pointed out that HLF has not imploded in its 30 year life which would mean that, from an economic perspective, HLF was sustainable. However, this does not address whether HLF meets the legal definition of a pyramid per the FTC. In that case, the company's model could have some problems. Ackman throws out many details in his presentation; however, the main crux of what needs to be proved is whether HLF meets the legal definition of being a pyramid. So here is the analysis.
We need to essentially prove, per the FTC above, that at least 50% of sales are retail sales. We can't count distributors that use the products themselves as retail sales and we need to estimate the revenue attributed to fees levied on distributors as part of participating in the program.
Before jumping right into this question, there are a couple nuances that need to be addressed.
In the case of HLF as alluded above, there is a wrinkle of whether internal distributors are really just consumers of the product. These do not count as retail sales under the legal definition. This is what David Einhorn famously investigated in May. The transcript is here. Some distributors sign up as distributors just to get the discounted price; they really just want to obtain the better pricing for products that they consume themselves. For HLF, the discount for basic distributors is 25% from the suggested retail price (which Ackman also had a lot to say about). So you really do not know if a distributor is a consumer or they are really trying to pursue a business opportunity as a true distributor. The company reported in 2010 that 29% of distributors were indeed just regular consumers of the product and were not seeking being a distributor for the business opportunity. Per #2 of the FTC criteria, these people will NOT count as true retail sales even though the economic substance of their activity is the same as people that buy at retail: for consumption and enjoyment of the product. This will make it harder to get to the 50% retail sales benchmark.
Another issue, as Ackman pointed out, is that many of the top sales leaders make the lion's share of total compensation. If you look at the compensation structure of HLF, the people at the top make a significant portion of total compensation. Per Ackman's slide 251, the top 1% makes 88% of the compensation. It is important to make the distinction that, per FTC #1 above, the pie is derived mostly from retail sales and not distributor inflows. This is unrelated to the nature of how the commission pie is divided up as demonstrated in this slide.
Just because people at the top make more of the compensation than the underlings doesn't make for a pyramid scheme even though it may be diagramed like that on paper. Probably every sales organization in existence has a carving out of the commission pie that favors a small percentage at the top.
Indeed, this 88% is unsavory, but does not contribute to his argument. No, the distinction being made is that the fuel, the inflows, the revenue is mostly being derived from people within the system (i.e. distributor contributions) instead of retail customers from without the system. A true pyramid involves these internal underlings giving money out of their own pocket (saved from other sources and not derived from the system) into the system as an inflow, supporting the upper rung compensation scheme.
Bernie Madoff used money from an expanding base of new customers to pay the returns of older customers. New money, not real profits, fuels the system. Pointing out the compensation structure was a bit of a red herring laid out by Ackman because it would neither qualify nor disqualify the company from being a pyramid.
The goal is to determine the extent that new distributors fuel revenue into the system instead of real retail sales from both an economic and legal perspective. This will determine the extent of the system being a pyramid scheme. Below is a breakdown of the sales leaders and their retention rates by region. Sales leaders are above the distributors in the hierarchy. David Einhorn's second question in May related to why the company did not disclose the number of regular distributors anymore. I calculate that there are about 5.4 distributors for every sales leader per previous disclosure averages.
Another issue that cropped up is the case of Anthony Powell as outlined in slides 163 through 179 in Ackman's presentation. His case is a demonstration of how upline leaders will actually buy product to increase their Volume Points in order to get to higher rungs of payouts. These could also represent internal sales if they were not resold.
Anthony Powell paid for new product in order to get even more money than what he spent in those product purchases because he gets into higher bonus levels awarded from his downline activity. Ackman claims that these sales do not represent retail sales because they are purchased not for consumption but to receive more Volume Points. And they are. However, from an economic perspective, Powell would not have done this unless the system would have provided even more in bonus commissions.
The problem with this argument is that the money to fund these purchases was financed from within the system and not from without as Powell's own money. Powell spends X to get a sum bigger than X. Remember, pyramids are fueled by money coming in from without the system instead of money earned from within. If you follow the money, Powell purchases these items and gets even more money from his downline; the purchases are financed from money derived from within the system. It would not have made sense for him to do this transaction unless he was getting even more money in return. The downline is where to look because that is the money that drove Powell's transaction in the first place.
Additionally, Powell could very well dump these products on the market as retail sales, albeit at discounted or regular prices. In fact, the beginning of Ackman's presentation, slides 111 through 118, cites instances on eBay where products are sold at a steep discount to the suggested retail price. I reckon these instances are the likes of Anthony Powell on higher rungs of the organization (who receive the best wholesale prices on the products), dumping their products on the market to get their minimum volume points in order to "pay-for-paycheck" as Ackman says. This would still be a retail sale from without the system. Furthermore, trying to count internal sales at higher rungs is difficult and I will assume that the Anthony Powells of the system sell their products to end retail consumers even if it appears they only make these sales to get bigger bonuses.
From the law's perspective, if Powell did not resell these products, they would count as internal sales. They would qualify towards being a pyramid; however from an economic perspective, transactions like this would not contribute to an implosion because they are financed from funds earned from within the system. Either way, I assume that these types of transactions do not constitute internal sales and will focus on the downline because that represents the spirit of the pyramid argument. Again, Ackman lays out good circumstantial evidence but this instance lacks teeth in supporting this "internal sales even from upper rungs" premise.
Ackman's presentation has many instances of circumstantial evidence that did not get to the heart of the pyramid argument. Right from the start of his presentation, he compared Herbalife products to other brands around the world. He asked the audience to raise their hand if they had used HLF products and few if any people raised their hand. The presentation proceeded to describe the company as preying on lower income people and the financially vulnerable.
Now, I am guessing that, if you were attending the Ira Sohn Conference to hear this investment thesis, you were likely not in the same social strata as Herbalife users and distributors as described by Ackman. So the idea of asking people in that room if anybody used Herbalife and getting no response was meant to prove a point, it came off flat and not exactly appropriate for that audience. He probably could have gotten the same result if he had asked if anyone in the room drank Faygo instead of Coca-Cola, smoked Swisher Sweets, or shopped at Aldi. This type of "gotcha" evidence told me that his argument lacked teeth.
Another example is showing pictures of shanty Nutritional Clubs decrying that every one of these Nutrition Clubs should look like some glowing brochure. These are lower income people that are in this segment; many of these supposed issues were very superficial in proving that the company was a pyramid.
So, in my opinion, there were a lot of unnecessary ideas offered in Ackman's presentation. The real meat and potatoes lie in determining if HLF meets the legal definition of a pyramid as set forth by the FTC.
Is it a Pyramid?
So we need to look at the downline in this supposed pyramid because that is where the non-retail fuel is entering the system from the savings of distributors derived from without the system, just like Bernie Madoff. Per above, the FTC outlines the three criteria for a pyramid which are the basis of this analysis.
I calculate the #1 criteria above, which relates to revenues related to obtaining and keeping membership in the system, based on the turnover rates and the cost to enter the program. These are membership-related revenues. The company discloses turnover rates of sales leaders and, as pointed out by David Einhorn in May, does not even disclose the number of its distributors anymore. Based on those previous years' numbers, I calculate total distributors to be in a ratio of 5.4:1 as compared to sales leaders for an estimate of 1.72 million total distributors in 2011. The turnover rate for sales leaders is 48.9% and the turnover rate of distributors is estimated to be about 50% based on turnover rates at other companies. Based on these numbers you can calculate the number of new entrants into the system each year. Once you determine that, you can multiply this figure by the cost incurred by each person entering the system. Ackman says that it costs between $55 and $91 on slide 128 per person to enter the plan; I will use $100 because that may include other services provided. All told, the revenue attributed to new entrants purchasing their right to participate in the plan is estimated at $102 million. That is 3.15% of total sales of $3.24 billion, excluding China. I exclude China because the company has a different model there; that country does not allow MLM marketing.
Furthermore, there is an annual fee that also is incorporated into revenue which is $15 as per Slide 127 of Ackman's presentation. I calculate revenue from this fee as $30.5 million or 0.94% of sales, excl. China.
So now we know that the total figure of 4.09% of sales is new entrant fees plus annual fee revenues (and not retail sales). These are the recruiting revenues and seem to represent a small portion of sales. Now, you need to calculate how much, on net, distributors sink into the business without getting recouped including sales by distributors that are intended for their own consumption.
For it to be a pyramid, retail sales need to be at least 50% of total sales. That leaves us 50%-4.09%=45.9% of sales, at most, contributed out-of-pocket by the distributors for Herbalife to be a pyramid under the law. That works out to about $867 per year per distributor. Said differently, $867 is the net amount per distributor that is spent out of pocket that distributors eat every year. If a distributor buys product and sells it, then that is a retail sale and would not count. The $867 would represent the average amount lost in their business opportunity.
Now some of this $867 will also include other merchant products and services offered by HLF not accounted for above that is also reflected in the revenue. This may include credit card processing equipment, websites, other marketing materials, etc. that are available for sale by members in a higher rung in the hierarchy to the distributors at the lower rung. Higher rung members take a cut off of these type of sales too.
So the question is: does the average distributor spend $867 a year in losses that are not recouped (or spent for personal consumption)?
If yes, then that takes the company up to the 50% threshold of the FTC's criteria for being a pyramid.
In 2010, the company identified potential sales leaders as 14% of the distributor base. If you assume that potential sales leaders are not taking a net loss in their activities per above, then the average loss incurred by non-performing or internal consumption distributors would increase to $1008 of out-of-pocket contributions per distributor to get to the 50% threshold.
If you do not believe that the average net money sunk into HLF by unsuccessful or consumption distributors is as high as $1008, then it is likely that HLF does not meet the legal definition of a pyramid scheme because revenues by internal distributors would not reach the 50% threshold.
Why the Model has Not Imploded
Per #2 of the FTC's criteria above, there are many people that sign up as distributors just so that they can buy products at discounted prices. They are not interested in the business opportunity aspect of it. In 2010, the company reported that 29% of distributors fit into this category. If you counted these people as retail sales, that 50% benchmark would appear far more easy to obtain. Under the FTC guidance as elaborated above, you cannot count these types of "distributors", making it more likely for HLF to meet the legal definition of a pyramid because these people are not counted as retail sales.
Under the law, internal consumption by distributors does not constitute a retail sale and therefore the company looks more like a pyramid as these sales make up a bigger portion of total sales. However, the economic substance of this activity points to money entering the system that is indeed traded for actual consumption of the product (and not the right to sell the product or other chain letter-type inflow). Because these types of distributors make up a significant share of total distributors, 29%, their purchases help create enough revenue to prevent the system from collapsing under its own weight over time (if there was a large portion of chain-letter-type inflows in revenues). Therefore, contrary to under the law, the economic perspective is that this type of revenue is indeed based on the value of consuming the product, driving a larger bloc of revenue that is indeed based on consumption.
A system is more likely to implode, economically, if revenues derived from chain-letter-type inflows make up a bigger share of total revenue. There are many actual users of the product that are internal distributors; these people contribute, as do retail sales, to the share of customers that consume the product for its own sake. They just don't count towards meeting the legal definition because they are classified as internal distributors.
It also seems like an easy fix legally. You might just be able to call these consumption distributors "preferred customers" or some other name that takes them out of the system, counting their sales as retail sales. At 29% of all distributors, counting these people as retail sales will very much help the company to reach the 50% retail sales threshold quickly if they are not there already.
If you believe that the average distributor sinks about $1004 of his own money into the company each year with nothing to show for it, then there is a good chance that the company meets the legal definition of a pyramid. After taking into account new entrant fees and annual fees, that $1004 represents the amount that every unsuccessful distributor or consumption distributor must pay, on average, as a net out-of-pocket-not-recouped cost in putting the company at a level where retail sales represent less than 50% of revenue. This level breaches the FTC threshold for the definition of a pyramid.
From an economic perspective as opposed to the legal definition of a pyramid, many of the sales not counted toward the 50% retail sales threshold do indeed have the same economic substance as retail sales, which is actual end-use consumption of the product. These are derived from internal distributors that sign up as distributors just to get the discount. Because this makes up a sizable portion of total revenue and because there are many other retail sales that do exist, this "pyramid" has sustained itself and has ongoing viability from an economic standpoint. When the chain-letter-type revenues are sizable, the legal definition of retail sales aside, as a portion of total revenues, there is more likely a chance that the system will implode.
Ackman has a vast presentation that hits home on really one point: that distributors get screwed and are over-promised success. This may break some other law, but it does not necessarily prove that HLF is a pyramid under the FTC's definition.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.