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By now the world knows that Bill Ackman and Pershing Square have sold short $1 billion of Herbalife (HLF) common equity. This as Herbalife sold over $1 billion worth of product in the past quarter. But, as we all know, the PV of a security has little to do with "what have you done for me lately?" and everything to do with what tomorrow looks like.

The headlines hitting the tape lead me to delve into HLF's public reports myself. As I looked closer at their business, a number of questions came to mind. I asked myself how I might behave at different parts of the value chain as a brand new HLF prospect.

  • How would I behave if I was an end-user/retail customer?
  • How would I behave if I wanted to retail the product to end-users?
  • How would I behave if I wanted to build out a salesforce?

RETAIL CUSTOMER

As a retail customer, I would assume that as an at home user, the rational decision I would make would be to try to source HLF product for the best price available. This begs the question, "Why would I buy a can of HLF Formula 1 from my neighbor for $40 if I can become an HLF distributor/member myself and acquire it for $30?

Seemingly, HLF places no restrictions on granting distributorships, so as a regular, end-user of the product ... surely my best way to capture value is to buy the product myself. As a retail customer, I have a rational incentive to become an HLF distributor because I can save money that way. But what if I want to sell the product?

RETAILER

If I sign-up as a distributor tomorrow I get a 25% discount on product. Meanwhile "up-line" my local sales leader in my area is able to buy the same product for 50% off. This begs the question, how can I compete with my local sales leader for customers if he can sell a can of Formula 1 at my cost and still make money? Isn't the answer "I can't"? My ability to make money retailing HLF product would seem to hinge on my ability to find customers who are unaware that they can buy the product themselves for less either by becoming a distributor themselves or by buying from a local sales leader at my cost or who simply admire my charm and unique selling ability.

This seems like a completely irrational expectation set - which probably explains why Herbalife loses over 1 million distributors annually due to churn.

SALESFORCE

As a new HLF distributor, my ability to build-out a salesforce seems problematic at best. Building out a salesforce from the bottom of the MLM structure of HLF requires me to find a pool of individuals who can equally find a pool of individuals, who can equally find a pool of individuals who would be:

a) unaware that they could sign-up as distributors themselves at a level equal to me

b) unaware that their product costs would be perpetually trapped at levels higher than mine as their "up-line" sponsor.

Again, this seems like an irrational expectations set.

________________________

Herbalife's distributor base is 3.1 million as of the end-of Q3. Over the past 2 3/4 years 3.4 million distributors have left HLF. This number is higher than HLF's entire distributor base.

Why is this churn level so high?

The answer seems to lie in the fact that distributors at the bottom of the MLM pyramid have little rational incentive to remain with HLF unless they are consumers themselves. They have no chance at competing with "up-line" distributors who can secure product at more competitive pricing, and they would seem to have little chance of building-out meaningful "down-line" salesforces because those distributors "downline" would have even worse economic prospects.

Whether or not HLF is an illegal pyramid scheme or not - I do not know. But, I seemed unable to articulate any rational economic reason I might want to become a reseller/distributor myself at all at this late stage of the company's life-cycle.

Bill Ackman's argument, centrally, is that pyramid selling relies in the existence of the greater fool and that once the greater fool fails to appear then the pyramid has to cascade on itself.

This argument seems cogent.

YTD, HLF has found 1,476,300 "newbies" around the world who seem willing to join the party. According to their public disclosures, most of these individuals have done so for "personal consumption". Over the same time frame, 1.1 million existing distributors have left the company. 79% of "newbies" or more than 1/3 of the distributor base of 2.7 million at the start of 2012 have left.

This kind of churn is downright scary if you're an HLF long. Any business that has to replace such a huge percentage of its network each and every year would seem to be on a treadmill to hell and does not, actually, speak well to the LTV of the HLF Formula 1 brand. I've been eating Oreos my whole life. This as many users of HLF seem to churn out in less than a year - not good.

As you look at the rational incentives for this business at the bottom of the HLF pyramid at this late stage of the business's life-cycle, it becomes easy to see why Bill Ackman is short. Even if his FTC battle is unsuccessful, the business seems destined to turn on itself at some point. Ackman argued in the presentation at the end of 2012 that this may occur sooner than many people anticipate.

The day HLF reveals that the Distributor base is no longer growing on a net basis will be the day Ackman's short starts to really go to work.

As a reminder:

  • At the end of 2009, HLF had 2 million disributors. Over the next 12 months, 1.2 million of these people left.
  • In 2010 1.3 million signed-up, 1.2 million left...net gain 100,000
  • In 2011 1.7 million signed-up, 1.1 million left...net gain 600,000
  • YTD 2012 1.5 million have signed-up, 1.1 million have left....net gain 400,000

How many more countries are left for HLF to fish in for "newbies" before the churn starts to bite?

This business is at the tail-end of its growth phase as an MLM company. Based upon trailing churn trends, HLF has to source at least 1 million new distributors annually just for the base of the MLM hierarchy to remain constant.

Seems like a pipe-dream to me.

HLF seems like a brand that has very little goodwill. That is to say that a huge percentage of those who try the brand abandon it in less than a year. That is to say that the LTV of a customer/distributor is not conducive to a long and steady stream of stable, corporate cashflows.

The fact that HLF's brand is on the front of the LA Galaxy's Jerseys is, in an odd way, not a sign of corporate strength, but rather a mask that hides the termites rotting away inside this business. Churn rates at the bottom of the HLF pyramid are simply too high for this company to sustain itself.

Ackman will be right - not if, but when.

Source: Herbalife Headscratchers