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Herbalife (HLF) is most certainly a business. It is a business that has trailing 12-month revenues of roughly $4 billion. Much of the debate lately has centered around the question of whether or not it's a legitimate (read legal) business or a pyramid scheme (read illegal). Bill Ackman has bet $1 billion it is illegal. Daniel Loeb and Third Point have bet roughly 8% of the company's equity that it is not. Of course, the company staunchly defends itself against Ackman's bear raid. Who knows how it will turn out? Certainly, it is grand theater.

In this article, I would like to explore the question of whether HLF is a strong business or not. Market participants have bid HLF common stock up to $46, or a market cap of $5 billion as of yesterday's close. Is this the present value of the cash flows the company will produce in the future?

Let's explore:

Herbalife is a consumer products company that makes nutritional products that are consumable. Products are mostly sold in bulk canisters, but can also be consumed on a single serving basis if bought through one of the company's nutrition clubs.

Successful consumer products companies spend a lot of time advertising their products, and also getting consumers to sample their products. Procter & Gamble is the best example. How many times have you seen small sample kits for shampoo or detergent, etc.? The simple idea is, if you try the product, you might like it. If you like it, you will buy it again. If you buy it again, you become a repeat purchaser/long-term customer.

Successful consumer products companies have lots of customers who generate long and steady cash flow streams over time. Warren Buffett drinks a Cherry Coke every single day of his life. He is a very valuable customer to Coca-Cola (KO). Why? Because he is a repeat purchaser.

If Coca-Cola is a brand that successfully stimulates repeat purchase in its customer base, what does Herbalife look like at the user level?

According to Herbalife's most recent 10K:

Typically, distributors who purchase our product for personal consumption or for short term weight loss or income goals may stay with us for several months to one year while sales leaders who have committed time and effort to build a sales organization generally stay for longer periods.

I am going to rewrite this statement in a different way. Typically, our distributors who are end-users of the products we sell stop using them in less than a year. Those who build out distributor networks generally stay longer.

Herbalife tells us in the 10K that the Lifetime Value of a typical user/customer is 1 year or less.

So, if I were to model a Ten-Year cash flow stream for a typical customer, it would show x$ in Year one followed by $0 in Years 2-10.

If I accept Herbalife's 10K at face value, it is telling me that the success of the business over time is dependent upon the company's ability to find and recruit new customers and/or distributors. But, does the company offer me any more guidance on this point anywhere else in the 10K?

According to the risk factors section of the 10K:

Our distributor organization has a high turnover rate, which is a common characteristic found in the direct selling industry.

and furthermore...

...our success depends in significant part upon our ability to recruit, retain and motivate a large base of distributors. The loss of a significant number of distributors for any reason could negatively impact sales of our products and could impair our ability to attract new distributors.

To summarize, Herbalife tells us:

a) Typical Distributors who use the product themselves leave in less than a year, and

b) the success of the business "depends in significant part" on the company's ability to find replacements.

Put another way, of the $5 billion of Future Cash Flow Present Valued in today's dollars, equity market participants are assuming that the majority of this cash flow will be produced by distributors Herbalife has yet to recruit.

Let's use 2012 YTD as an example. HLF started the year with 2.7 million distributors. YTD, it has successfully recruited 1.5 million new distributors. As of the end of Q3, it had 3.1 million distributors. So, since the first of the year, 1.1 million of Herbalife's distributors have resigned or quit the company. (2.7 + 1.5 adds - 1.1 left =3.1 remaining).

Now, one might argue that not all distributors are leaving. But it is important to remember that as long as new recruits are coming into the business, up-line distributors will continue to get paid royalty overrides. So, they have an incentive to stay. As Pershing Square has pointed out in its presentation, the top of the Herbalife pyramid stays stable, while the bottom churns over.

Independent of the dynamics within the pyramid structure, Herbalife tells us categorically that its products lack goodwill at the user level. It tells us that those who use the products for personal consumption try them and abandon them in less than a year. It tells us that in order to secure more goodwill for the company in the future, then it must go goodwill hunting by finding new customers/recruits.

In order to be long Herbalife as a long-term, fundamental investor, one has to believe that Herbalife will, in fact, be capable of continuing to recruit the marginal customer, that there is a bottomless pool of customers around the world willing to give Formula 1 a try.

Alternatively, you have to believe that the cash flow stream for products like Formula 1 will look less like a 1-year cliff, and more like a typical Coca-Cola consumer.

Or, you have to believe that for some reason, churn rates will subside, even as the company tells us as investors that most distributors who do not sell the product leave within a year.

Herbalife is a short on the basis of customer fundamentals. Put simply, its customers are not loyal to the brand. The only material participants in the Herbalife pyramid who are loyal to the brand are those who are Sales Leaders who are receiving recruiting rewards constantly based upon the turnover occurring at the bottom of the pyramid. Sales Leaders sit comfortably up top as though sitting on a washing machine on the spin-cycle down below.

Assuming steady churn ratios over the next 5 years, Herbalife will have to recruit another 5-7 million new distributors just to sustain the current size of the pyramid and the cash flow that it produces for shareholders.

If, on the other hand, Herbalife is unsuccessful in this pursuit, the pyramid starts to collapse upon itself. Everybody "up-line" will see a loss of income, reduced incentives to sell, etc.

As I look at Herbalife's business model, I am convinced that it will be unsuccessful at continuing to acquire new customers. I am convinced that this company is on a treadmill to nowhere. I am convinced that the law of large numbers will ultimately undermine this company's earnings power.

Why?

Because the company tells me that those who actually use the products themselves really don't like them all that much... certainly not enough to keep using them for more than a year.

This provides a fundamental reason to Short HLF stock. Bill Ackman's intervention to have HLF labeled a Pyramid Scheme is but a call-option layered on top of this thesis.

I believe longs who are extrapolating HLF's recent growth, who point to the company's reasonable P/E ratio, who are getting juiced-up about potential buy-backs or who just admire the company's chutzpah at fighting back against Ackman are missing the big picture.

At a fundamental level, HLF's entire business is dependent upon recruiting because the product itself is a loser at the customer level.

How do I know?

Herbalife tells me so...

Source: Herbalife Is A Short - Goodwill Hunting