In order for a business to be successful over time, everyone in the value chain needs to realize "economic value" or profit.
In a roundabout way, Bill Ackman's short sale of Herbalife (HLF) has latched-on to a fundamental flaw in Herbalife's business model. Put simply, not everyone in the value chain makes money any more. Alternatively, HLF's distributors at the end of the pyramid are not failed businesses but bona fide customers, as CEO Michael Johnson suggests.
To begin, let's deconstruct the HLF Value Chain in a simple way.
The company purchases raw materials, packaging, etc and makes consumer products. It costs Herbalife roughly 20 cents on the dollar to makes these products. The company then invests additional margin points in SG&A and sales commissions to take the product to market. Products are sold at the wholesale level to "Sales Leaders" who buy the product for 50 cents. These Sales Leaders then resell the product to Non-Sales Leader Distributors who buy the product for anywhere from 62 cents to 75 cents. The company also charges a usurious surcharge of 11 cents for shipping and handling fees.
Distributors at the bottom of the food chain pay 86 cents for a product with an SRP of $1. The 16% gross margins are slim pickings. Ultimately, the product is consumed by somebody who values its performance as a weight-loss product at the price they are able to acquire it. This is the end or retail price of the product.
Q. Does everyone on the value chain make money? Put another way? Do all economic participants have a rational incentive to perpetuate the business model?
The suppliers who make the raw materials make money.
The company that markets the product makes money - $4 per share to be precise.
The up-line salespeople make money on every single sale/purchase by down-line distributors/retail customers irrespective of the ultimate retail sale price.
And, the end-user may actually get value for using the product.
At the end of the wholesale chain, however, sits a fleet of 2.8 million distributors who likely do not make money.
Herbalife sold $4 billion worth of product in 2012 through roughly 3.1 million distributors. This is an average of $1,290 of net sales per distributor. Assuming each of these distributors got lucky and paid 50 cents on the dollar for this merchandise, their starting point at retail mark-up of 100% is contribution margin, or $1290 a year. Next, the distributor would have to subtract shipping costs of 11% or $142, overhead costs, factor-in paperwork, gas money, travel time, business development/promotion costs, etc. to service whatever customer base he/she might have.
At the end of the day, the average distributor might be lucky to take home $100 per month or if they work 10 hours a month, $10 per hour. Somewhere close to minimum wage, pre-tax by the way. If the distributor tries recruiting, their time commitment likely increases. If they buy the product for 75 cents instead of 50 cents, the results are worse. From a return on time perspective, this business is a dog.
Put simply, there is not enough economic value in the Herbalife system to continue to behaviorally incent distributors at the bottom of the pyramid. This example is presented with benevolent assumptions. The truth is likely much worse for those distributors who are less than average.
As a result, the Herbalife business model is at odds with shareholder interests in the long-run.
Why? Because rational economic agents do not sustain economic activity absent rational economic incentives. Herbalife has a major and material flaw in its business model. The success of its business relies upon the customer-facing portion of its value chain to sustain perennial economic losses for the business to survive.
Bill Ackman argues that this dynamic is the result of fraud. He argues that the systemic nature of the Herbalife pyramid scheme automatically conspires to make it impossible for low-level distributors to make money. He argues that the company promises great riches to distributors and then disappoints them because the system is rigged. The results are preordained and the fix is in. I believe he has a compelling argument on this point.
However, independent of whether or not Herbalife is a pyramid scheme, the fundamental problem with this business is simply this. The business relies upon the continued recruitment of key salespeople at the end of its value chain who are willing to lose money on an annual basis for the business to succeed. This is an irrational expectations set for any business in the long run.
Shareholder value may be realizable in the short run by capitalizing on the irrational behavior of others. Certainly, Herbalife's recruiting juggernaut is proof of the company's ability to find new distributors. 1.4 million so far in 2012.
But, the laws of economics quickly take hold. In practice, most of these people at the end of the chain find out within a year that there is no money to be made, no wealth to be had, no value in their part of the value chain - and so they leave. Whether or not this makes Herbalife a fraud, I do not know but for certain, it is bad for business and bad for shareholders over time.
For Herbalife's business model to be sustainable and to thrive in the future, the company must be able to ensure that all economic agents in the value chain that ends with the retail customer are able to make a reasonable economic return on capital. Absent this incentive, the company has to fail or de minimus, the results have to deteriorate.
The only other theoretical alternative to the dynamic I describe is simply this: Perhaps there are no material numbers of outside customers beyond the distributor base of Herbalife? Perhaps the last line of the pyramid are actually users of the product? Perhaps they receive value as users of the product while their up-lines make modest commissions? Perhaps? At least this is what the company wants us to believe. The company wants us to believe that everybody is happy, that Herbalife is like "the Girl Scouts".
Unfortunately the financial data does not support this conclusion. The financial data supports the conclusion that many Herbalife Sales Leaders and Non-Sales Leaders each and every year abandon the business because they cannot find a rational economic incentive to remain a part of it.
In Q1 of 2012 439k Distributors signed-up 339k left
In Q2 of 2012 523k signed-up 323k left
In Q3 of 2012 514k signed-up 414k left
The law of large numbers is chasing Herbalife every day.
1,076,000 distributors quit Herbalife in the first 3 quarters of 2012.
Absent economic value created at all parts of the value chain, no business can survive. Ultimately, the people who lose money in the chain have to go bankrupt. This, effectively, is what is happening to low-level HLF distributors. Perhaps they are not losing their entire net worth, but each and every one of them reaches their maximum point of pain/loss before they abandon the enterprise. For some it may be a few cans of shake, for others a few hundred dollars, for more still a few thousand, etc.
But to be sure, they lose and then they leave.
If you are long Herbalife, as a shareholder, it is important to understand how the machine works under the hood. It is important to understand how Herbalife has achieved its growth of late. Herbalife's growth has been subsidized recently by continued recruitment of those willing to sustain economic losses at the end of its value chain. For the company to grow in the future, these losses will not only have to continue but to continue to grow. Herbalife will have to recruit more individuals prepared to absorb a poor economic result. The lifeblood of the business depends on it.
If Herbalife were ultimately committed to the success of all of its distributors, it would take steps to make sure that economic value existed everywhere in the model. Perhaps it would limit the number of distributorships granted or limit them geographically. Perhaps the total number of levels of distributor would be capped.
Except this doesn't happen for a simple reason. The losses of those at the end of the value chain flow to those who are earning money at the beginning of it. For now the company and the up-line distributors have no incentive to stop what is going on. Herbalife, like many businesses, is a business about incentives. When you understand the incentives of all of the agents in the chain, you get a complete and thorough look at the economics of the business at large.
Herbalife's business will be unsuccessful. Inevitably, it will turn upon itself. If you look closely at the numbers it is happening already. Some 3.5 million distributors have resigned since 2010. That's 3.5 million who have declared Herbalife bankruptcy. More will follow. It is systematically inevitable. Over 1 million this year alone.
Again, every dollar of Herbalife revenue is carved up so that everyone gets a slice except for low level distributors who end-up paying the tab. This is what the perennial 1 million distributor churn rate tell us. A closer look at the economics in the value chain confirms it. Perhaps this is why CEO Michael Johnson blew out millions of dollars worth of stock in the past 2 years. Mind you, one man's loss is always another man's gain.
If you are long HLF, beware. You too may fall victim to the Herbalife value chain just as millions of distributors have before you.
Disclosure: I am short HLF.